The introduction of Income Tax Act No. 58 of 1962, section 7C in the Income Tax Act has changed the landscape of trust-based estate and asset protection strategies in South Africa. Prior to Section 7 C, transferring an investment property from your name into a trust has been doable with interest free loans. However, Section 7C effectively closes a previously exploited loophole for tax avoidance purposes related to interest free loans in South Africa.
It is unfortunate (and understandable) that transferring a primary residence (or any property) into a trust does not avoid paying bond and transfer costs (and transfer duties).
for companies, however, there is Section 42 Asset for Share transfer that addresses transferring your property into a company without bond and transfer costs. 7C however, doesn’t come close – and is more related to transferring your primary residence into a trust. This does makes it an excellent tool for wealth preservation.
Why was Section 7C implemented?
Section 7C was introduced to address a tax avoidance strategy. Before the implementation of Section 7C, it was a common practice for individuals to transfer assets to trusts through interest-free loans. This method allowed them to move ownership of assets from their personal estates to trusts without facing immediate tax consequences. By lending money to a trust at zero or very low interest rates, individuals could effectively reduce their taxable estates, thereby avoiding estate duties and donations tax.
Tax Implications for Taxpayers
Section 7c specifically targets interest-free or low-interest loans made to trusts by connected persons, such as the founders or beneficiaries of the trust. Under this new legislation, the foregone interest on these loans is now deemed a donation, which is subject to donations tax. This change aims to curb the use of trusts as a means to shift wealth and avoid taxes, ensuring that the tax base is preserved.
For those who have previously transferred assets to trusts through interest-free or low-interest loans, Section 7C introduces new complexities and potential tax liabilities. The interest that would have been payable had the loan been at a market-related interest rate is treated as a deemed donation. This deemed donation is subject to a 20% tax on amounts up to R30 million and 25% for amounts exceeding R30 million. It’s important to note that the South African Revenue Service (SARS) provides a donations tax threshold of R 100 000 annually.
Practical Examples of Section 7C
To better understand the implications of Section 7C, consider two examples:
1. In the case of an interest-free loan, if a trust founder provides a R1 million loan to the trust without charging interest, SARS would calculate the deemed interest at the official rate of 9.25% per annum. The resulting R92,500 would be considered a deemed donation and subject to donations tax. If no other donations were made, this would fall within the threshold of R 100 000.
2. For a low-interest loan scenario, if a family trust receives a R 2 million loan at a 2% interest rate, the deemed donation would be calculated based on the difference between the official rate and the actual interest rate charged. In this case, the difference of R 145 000 would be treated as a deemed donation and taxed accordingly.
Taxation of Trust Distributions
When it comes to distributions made by trusts to beneficiaries, the tax treatment depends on the nature of the payment. Distributions that constitute a return of capital are generally not subject to income tax for the beneficiary. Similarly, principal loan repayments made by beneficiaries to the trust are not subject to income tax. However, any interest earned on these repayments is considered taxable income for the beneficiaries.
Compliance and Associated Costs of Trusts
In light of Section 7C, taxpayers must now re-evaluate their trust structures and loan agreements to ensure compliance with the new regulations. Failure to do so could result in unexpected tax liabilities and penalties. It’s also crucial to weigh the tax benefits and estate duty savings provided by a trust against the associated costs. Depending on the complexity of the trust, fees for professional trustees and administrators can range from R 5 000 to R 100 000 per trust per annum, excluding VAT.
Conclusion
Section 7C has undoubtedly introduced critical changes to how trusts operate in South Africa, particularly concerning interest-free and low-interest loans. Taxpayers and financial planners need to stay informed and adapt their strategies to comply with these regulations while maximizing the benefits of using trusts for succession planning and asset protection. By understanding the implications and requirements of Section 7C, taxpayers can navigate the complexities of trust administration and taxation more effectively.
