Tag Archives: Interest free loans

Interest free loans cross border

A consideration of the tax consequences of interest free loans will be incomplete if not also considered in the context of interest free debt funding being provided cross-border. Typically, when “cheap debt” is encountered it is in the form of low interest or interest free loans being provided to related parties (or “connected persons” as defined) due to the non-commercial nature of such an arrangement. This is especially the case for the lender, who could typically receive far greater returns on investment if utilising excess cash in another manner. However, due to group efficiencies, it may be preferable for one group company to provide low interest or interest free financing to a fellow group company, especially if this also has the potential to unlock certain tax benefits.

One such manner in which a corporate group may save on its ultimate tax bill is to ensure that funding is provided by a company situated in a low tax jurisdiction, such as Mauritius for example (which levies a corporate tax rate of effectively 3%). Were the Mauritius company to lend cash to a South African group company, the group would prefer it to do so at a very high rate. This would ensure that the South African company is able to deduct interest in a corporate tax environment where it would create a deduction of effectively 28%, whereas the tax cost would only be 3% in Mauritius.

Where the South African company however is in the position that it sits on the group’s cash resources, it would want to lend money to the Mauritius company at as low rate as possible. Interest, to the extent charged, will now only be deductible at an effective 3% in Mauritius (where the borrower is situated), whereas interest received will be taxed at 28% in South Africa. Such a loan would therefore be most tax efficiently structured as an interest free loan.

The transfer pricing regime, contained in section 31 of the Income Tax Act,[1] seeks to legislate against this tax avoidance behaviour. The provision, which covers all cross border transactions entered into by connected persons, but specifically also cross border debt financing, determines that in such instances “… the taxable income or tax payable by any person contemplated … that derives a tax benefit … must be calculated as if that transaction, operation, scheme, agreement or understanding had been entered into on the terms and conditions that would have existed had those persons been independent persons dealing at arm’s length.”

In other words, the tax consequences of cross border debt funding with connected persons will be calculated as though arm’s length interest rates would have been attached thereto. Therefore, even though the loan extended by the South African company above to the Mauritian company would have been interest free in terms of the financing agreement, the South African company will still be taxed in South Africa as though it has received interest on arm’s length terms. The same is true for the exaggerated rates that may have been charged had the South African company been the lender: SARS would adjust these rates downward to ensure that the South African company does not claim inflated interest costs.

Using interest free or low interest loans as a tool to increase tax efficiency, especially in a cross border context, much be approached with circumspection. It may very often amount to a blunt and clumsy tax planning tool at best.

[1] 58 of 1962

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice.  Errors and omissions excepted (E&OE)

Interest free loans and trusts

The recent introduction of section 7C to the Income Tax Act[1] brought the taxation of trusts, and the funding thereof specifically, under the spotlight again. Briefly, section 7C seeks to levy donations tax on loans owing by trusts to connected parties (typically beneficiaries or the companies they control). To the extent that interest is not charged, a donation is deemed to be made by the creditor annually amounting to the difference between the interest actually charged (if at all), and interest that would have been charged had a rate of prime – 2.5% applied.

What many lose focus of is that interest free (or low interest) loans have income tax consequences too, over and above the potential donations tax consequence arising by virtue of section 7C. Section 7 of the Income Tax Act is specifically relevant. This section aims to ensure that taxpayers are not able to donate assets away and which would rid themselves of a taxable income stream.

In broad terms, section 7 deems any income that accrues to a trust or beneficiary to be the income of the donor if the income accrues from an asset previously the subject of a “donation, settlement or other disposition”. In other words, where a person donates a property to a trust, the rental income generated will not be taxed in the hands of the beneficiary or the trust, but in the hands of the donor. Section 7 therefore acts as an anti-avoidance provision to ensure that taxpayers do not “shift” tax onto persons subject to less tax through donating income producing assets out of their own estates.

It is interesting to now consider what an “other disposition” would amount to. Various cases have confirmed that an interest free loan would be treated as such and that, to the extent that interest is not charged, this would amount to a continuing donation.[2] The implication thereof is this: assume the funder of a discretionary trust sells a property to that trust on interest free loan account. Any rental earned would ordinarily have been taxed in the hands of the trust or the beneficiary, depending on whether distributions will have been made. However, since section 7 will apply to the extent that no interest was charged on the loan account, a portion of the rental income will now be taxable in the hands of the trust funder.

The take-away is that donations to trusts have income tax implications for the donor too, over and above a donations tax consequence. This will also be the case where interest free loans are involved.

[1] 58 of 1962

[2] Honiball and Olivier, The Taxation of Trusts (2009) at p. 84 and following

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice.  Errors and omissions excepted (E&OE)