BY Peter Dachs
Funding offshore trusts
Many South African tax residents have settled offshore trusts in various jurisdictions outside South Africa. These offshore trusts are often funded by way of rand or foreign currency denominated interest-free and interest-bearing loans made by these South African tax resident individuals. This article examines the principal South African income tax implications in respect of such loans.
Donor attribution rules
The so-called donor attribution rules contained in the Income Tax Act, 1962 (the “Act”) may apply to tax paid by a South African tax resident, who has made a donation, settlement or other disposition to a foreign trust, on the income of that trust which is attributable to such a donation, settlement or other disposition. These donor attribution rules also apply to an interest-free loan or a loan where interest is charged at less than a market-related rate of interest.
The South African resident is obliged to disclose the donation, settlement or other disposition in writing when submitting their tax return for the relevant tax year in which the donation, settlement or other disposition was made.
The income of the trust (determined as if the trust had been a resident) should be apportioned on a pro rata basis to determine the amount of the income which is attributable to the interest which was not charged. If these rules apply, the South African resident must include, in their gross income, the amount of attributable income and may claim a pro rata deduction for allowable expenditure of the trust.
A similar attribution rule applies to a capital gain of a foreign trust (including any amount that would have constituted a capital gain if the trust had been a resident), which is attributable to a donation, settlement or other disposition made by a resident to the foreign trust. Such capital gains may be attributed to the resident donor.
The total amount of income and/or capital gain that can be attributed to the resident donor is limited to the amount of the benefit derived by the trust from that donation, settlement or other disposition. The benefit derived from a donation, settlement or other disposition means the amount by which the trust has benefitted from the non-charging of interest on the loan.
Where interest is charged on the loan by the South African resident connected person at a market-related rate, the resident should not be regarded as having made a donation, settlement or other (gratuitous) disposition to the non-resident trust and the donor attribution rules should, therefore, not apply in that instance.
Section 7C of the Act came into effect on 1 March 2017 and applies to any loan, advance or credit which is directly or indirectly provided to, amongst others, a trust by:
- a natural person; or
- at the instance of that person, by a company in relation to which that individual is a connected person (as defined),
and where either no interest is charged in respect of the loan or interest is charged at a rate lower than the official rate of interest (as defined), subject to certain exclusions.
Section 7C will, however, not apply in respect of any amount owing by a trust or company during a year of assessment in respect of a loan, advance or credit if “that loan, advance or credit constitutes an affected transaction as defined in section 31(1) that is subject to the provisions of that section”. The transfer pricing rules in section 31 are set out in more detail below.
Section 7C will also not apply in the case of a vesting trust, ie, where the loan, advance or credit was provided to the trust by a person by reason of, or in return for, a vested interest held by that person in the receipts and accruals and assets of that trust, and provided that certain other requirements are met.
The “official rate of interest” is defined as follows in section 1 of the Act as follows:
- If the loan is a South African rand denominated loan, the South African repurchase rate plus 100 basis points.
- If the loan is denominated in a foreign currency, a rate of interest that is the equivalent of the South African repurchase rate applicable in that currency plus 100 basis points.
If section 7C applies to a loan, the difference between the actual interest incurred by the trust and the amount that would have been incurred at the official rate of interest (which may be higher or lower than an arm’s length rate), must be treated as a donation made to that trust by the individual who advanced the loan on the last day of that year of assessment of the trust (ie, 28/29 February), for donations tax purposes.
Transfer pricing rules
The South African transfer pricing rules will apply to any transaction, operation, scheme, agreement or understanding where:
- that transaction constitutes an affected transaction (as defined); and
- any term of condition of that transaction, operation, scheme, agreement or understanding results or will result in any tax benefit being derived by a person that is party to the affected transaction.
“Any transaction, operation, scheme, agreement or understanding where –
(a) that transaction, operation, scheme, agreement or understanding has been directly or indirectly entered into or effected between or for the benefit of either or both -
(i) (aa) a person that is a resident; and
(bb) any other person that is not a resident;
and those persons are connected persons in relation to one another; and
(b) any term or condition of that transaction, operation, scheme, agreement or understanding is different from any term or condition that would have existed had those persons been independent persons dealing at arm’s length.” (our emphasis added)
A “connected person” includes the following in relation to a trust, any beneficiary of that trust and any connected person (as defined) in relation to such beneficiary.
A “tax benefit” is defined in section 1 of the Act and includes any avoidance, postponement or reduction of any liability for tax purposes.
In these circumstances, section 31(2) places an obligation on each party to the affected transaction which derives a tax benefit, to calculate its taxable income or tax payable 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.
If the loan funding was provided by the South African tax resident to the non-resident trust on terms and conditions that would not have existed had they been independent persons dealing at arm’s length (for example, the interest rate is different than what would constitute an arm’s length rate), such loan would be an affected transaction for purposes of the transfer pricing rules in section 31 of the Act. In this situation the South African transfer pricing rules would apply if there was a “tax benefit” to the South African tax resident from the loan transaction.
If no interest is charged on the loan funding provided by a South African tax resident to a non-resident trust or the interest rate is lower than what would constitute an arm’s length, ie, market related rate, that resident effectively avoids the liability to pay tax on the difference. The affected transaction should, therefore, result in a tax benefit being derived by the South African tax resident.
Accordingly, in that instance, the South African tax resident will have to calculate their taxable income as if the terms and conditions would have been consistent with the arm’s length principle, which means that the difference between the actual amount of interest charged and the arm’s length amount would have to be included in the taxable income of the South African tax resident. This is referred to as the “primary adjustment”.
In addition, section 31(3) of the Act deems the amount of the transfer pricing adjustment, in the case of a person other than a company, to be a so-called “secondary adjustment” in the form of a donation for donations tax purposes. This deemed donation is deemed to have been made by the South African tax resident to the non-resident trust on the last day of the six-month period following the end of the tax year in which the primary adjustment is made.
Essentially, the burden of proof is thus on the taxpayer to show that he has entered into the transaction, operation, scheme, agreement or understanding with connected persons on the terms and conditions that would have existed had the persons been independent persons dealing at arm’s length.
In terms of the Draft Interpretation Note issued by the South African Revenue Service, in order to apply the arm’s length principle to funding arrangements, a taxpayer should consider the transaction from both the lender’s perspective and the borrower’s perspective. That is, from the lender’s perspective, whether the amount borrowed could have been borrowed at arm’s length (that is, what a lender would have been prepared to lend and therefore what a borrower could have borrowed) and from the borrower’s perspective, whether the amount would have been borrowed at arm’s length (that is, what a borrower acting in the best interests of its business would have borrowed).
In examining whether the interest rate applied is of an arm’s length nature, all circumstances of the individual case will be taken into account. This may include the following factors:
- The nature and purpose of the loan;
- The market conditions at the time the loan is granted;
- The principal amount, duration and terms of the loan;
- The currency in which the loan is denominated;
- The exchange risks borne by the lender or borrower;
- The security offered by the borrower;
- The guarantees involved in the loan;
- The credit standing of the borrower; and
- The interest rate prevailing at the situs of the lender or borrower for comparable loans between unrelated parties.
In practice, assuming that the taxpayer is a connected person in relation to the non-resident trust, the taxpayer needs to be able to substantiate the arm’s length interest rate in respect of the loan to the trust, for example, by obtaining a quotation from a bank or other financial institution in the applicable foreign jurisdiction for a loan to the non-resident trust on similar terms.
Taxation of interest income
Any amount of foreign interest received or accrued by the South African tax resident from the non-resident trust in respect of the loan will constitute taxable foreign interest and should be disclosed in their South African tax return in the applicable tax year.
Tax | Executive
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