Family trusts have long been a central feature of South African estate and wealth planning, with high-net-worth individuals using trust structures to protect assets and to save certain assets, particularly from estate duty.
However, many taxpayers who hold substantial assets baulk at the idea of losing complete control over any assets that they may transfer to the trust – one’s house, for instance.
One common mechanism of retaining a modicum of control is for the founder to lend their assets to a trust, rather than selling or donating them. This can appear attractive because it allows the founder (or a connected company) to retain an economic interest while the trust holds legal title.
Unfortunately, SARS is onto this apparent loophole, with Section 7C of the Income Tax Act containing targeted anti-avoidance rules that can make interest-free (or low-interest) loans to trusts rather costly.
This article explains the main tax implications, the mechanics of the key rule, how it interacts with other taxes, and practical steps to reduce risk.
How Section 7C turns cheap loans into expensive tax liabilities
Section 7C is an anti-avoidance provision aimed at preventing taxpayers from shifting wealth into trusts by way of interest-free or artificially low-interest loans.
In essence, the section provides that where a loan, advance, or credit is made by a ‘connected person’ to a trust and the interest charged on that loan is lower than the statutory ‘official rate of interest’, the shortfall is treated as a deemed donation for donations-tax purposes.
The term ‘connected person’ includes founders, beneficiaries, companies at the instance of those persons, and other related parties.
Donations tax is charged on that deemed amount at the normal donations tax rates – currently 20% based on the cumulative value of donations not exceeding R30 million, and 25% on any further donations once the cumulative value of donations exceeds R30 million.
The above is subject to the annual exemption from donations tax on the first R100,000 donated (in any form) in each tax year – applicable to natural persons (i.e., individuals) only.
Who (and what) is caught?
Section 7C applies where:
- A loan, advance, or credit is made directly or indirectly to a trust; and
- The lender is a connected person in relation to the trust; and
- No interest (or interest below the official rate) is charged on the loan.
The rule applies to both domestic and cross-border loans. Interest-free loans to foreign trusts, or loans from foreign connected parties, may also trigger Section 7C or related transfer-pricing adjustments.
How the tax is calculated
In simple terms, the basic arithmetic is as follows:
- Identify the ‘official rate of interest’ applicable to the loan (see table below – such rate is subject to change).
- Calculate the interest that would have been payable at that official rate on the outstanding loan balance during the relevant period.
- Subtract the interest actually charged/received (if any).
The difference (the shortfall) is deemed to be a donation by the lender to the trust, and is subject to donations tax (or other donor tax consequences).
In practice, SARS treats the shortfall as a ‘continuous’ or recurring benefit, which means that donations tax consequences can arise over time as interest accrues. In some situations, SARS’ guidance and rulings have required pro-rating the calculation by period, and tracing when the loan becomes subject to Section 7C.
Other taxes and interactions to watch for include the following:
Donations tax
The immediate (and most obvious) result is donations tax on the deemed donation. Donations tax rates, and thresholds apply as they would to a conventional donation.
Estate duty
Since the deemed donation reduces the donor’s estate, estate duty and estate planning effects should be considered.
Transfer-pricing / income tax adjustments
In cases where the lender is a company, or loans cross borders, transfer-pricing rules or income tax adjustments may apply in addition to Section 7C, potentially producing double adjustments unless carefully structured.
Capital gains/write-offs
If a loan is waived or written off, additional tax consequences (capital gains for the lender, or income for the trust and/or the beneficiary) can arise depending on the circumstances, and whether the loan is treated as a disposal or donation.
Binding Private Rulings show that SARS looks closely at write-offs and waivers.
Common planning responses
Because of the implementation of Section 7C, common approaches include:
- Charging an arm’s-length interest rate (at or above the official rate) on the loan, and documenting terms. This avoids the deemed donation but requires that interest actually be charged, accounted for, and (for individuals) potentially declared as income.
Drafters of such loan agreements should ensure the rate, repayment terms, and documentation are genuine in order to withstand SARS scrutiny.
- Using formal sales instead of loans (with fair market value consideration) – although sales carry their own income tax and capital gains implications.
- Capitalising loans properly, and ensuring loans are repayable and evidenced. Such loans should not be open-ended ‘advances’ with no set repayment terms. Courts and SARS look at what is known as ‘substance over form’ – mere paperwork without economic reality is risky.
- Consider transfer-pricing comparability for cross-border loans, and whether withholding taxes or double taxation treaties apply.
Practical checklist before making a loan to a trust:
- Determine connectedness. Is the lender connected to the trust? If yes, Section 7C is likely to be applicable.
- Check the official rate in force for the currency and period of the loan, and run the shortfall calculation. Note that official rates tend to fluctuate in line with prevailing interest rates (even though they are not directly linked), so don’t rely on old numbers in a precedent file.
- Document the terms (interest, repayment schedule, security),and ensure that the transaction has sufficient economic substance.
- Model the donations tax hit if interest is at below-market (or nil) levels – bear in mind that for high-value items such as a house, a business, or an investment portfolio, the amount of donations tax can be significant.
- Consider cross-border implications (transfer pricing, withholding taxes, foreign trust rules), and obtain specialist advice for international structures.
Recent developments
Since Section 7C came into effect during 2017, SARS has issued rulings and guidance, and has also become increasingly active in the application of this Section.
Commentators and firms have noted ongoing clarifications, proposed amendments, and interactions with transfer-pricing rules, particularly for foreign trusts.
Also, since the official rate changes and interpretative positions evolve, lenders and trustees must ensure that their advice is kept current through regular reviews.
The takeaway
Loans to trusts remain possible and useful, but interest-free or low-interest lending from connected persons is a high-risk tax strategy in South Africa. Section 7C can transform the forgone interest into a donations-tax liability (and trigger other adjustments).
If you are considering making (or have already made) such a loan, ensure that you obtain specialist tax and legal advice, check the current official rate, model the donations tax exposure, and ensure that your documentation and the substance of the loan both align with the economic reality.
While every reasonable effort is taken to ensure the accuracy and soundness of the contents of this publication, neither writers of articles nor the publisher will bear any responsibility for the consequences of any actions based on information or recommendations contained herein. Our material is for informational purposes.