The first objective of estate planning is to build wealth outside of your estate – effectively achieved by using a trust. The question is, how to transfer your wealth to a trust? This can be done in two ways: donation of asset, or sale of asset on loan account to a trust.
A donation is the cleanest mechanism to transfer an asset into a trust with the trust acquiring full ownership with no future obligation to pay the donor and the donor in turn reducing his or her estate by the value of the donation made. The limitation of this mechanism lies in the donations tax provision that stipulates that a percentage (currently 20%) of the value of all donations made during a year of assessment (the tax year) in excess of the exempt amount (currently R100,000) shall be paid to SARS as donations tax.
Sale on loan
In order to avoid donations tax on donations in excess of R100,000, the balance is reflected as a loan to the trust. For example, if you transfer your listed share portfolio worth R1 million Rand to the trust, the first R100,000 is treated as a donation and the balance of R900,000 is reflected as a loan by you to the trust.
Interest free loan
In order to avoid accumulating value in your hands as the lender of funds to your trust, no interest is charged on the loan account – to charge interest would be counterproductive, as the interest earned would shift value back into the lender’s hands and would also attract income tax. This scenario becomes even more inefficient if the interest expense cannot be deducted against the trust’s other sources of taxable income because the loan cannot be linked to a flow of trading income earned by the trust.
Reducing the loan by ongoing donation
The next part of the estate plan is to ensure an annual donation up to the donations tax exemption back to the trust against the loan. In our example, the R900,000 interest free loan is reduced to R800,000 in the second tax year by a further R100,000 donation by the lender of the funds – an effective technique to shift value out of your hands and into the hands of your trust.
Effective 1 March 2017, section 7C will now stop this well-used technique in its tracks – no more interest free loans without consequences. This provision deems interest to accumulate on the difference between the interest charged and the official rate (currently 8%) during the tax year, and treats this amount as a donation to the trust. This effectively erodes the R100,000 donations tax exemption available to natural persons during each year of assessment and limits the extent to which a planner can reduce the loan he or she made to the trust.
Applies to natural persons and connected persons
It is Important to note that this new section only applies to loans made to trusts and the loan must be made by a natural person or by a company at the instance of a natural person, where such natural person is a connected party to such company.
The effect of s 7C
If the deemed interest on your interest free loan remains less than R100,000 each year of assessment (which would currently be a loan of R1,250,000 x 8% = R100,000) then you have still pegged the value of your asset in your trust without triggering donations tax in your hands, assuming you have not made other donations during the tax year and the official rate does not increase from its current rate during the year of assessment. However, the loan of R1,250,000 remains constant and you cannot reduce the loan by R100,000 each year by utilising your donations tax exemption, as this is now wiped out by the deemed interest donation in terms of section 7C. Any further loans will have to attract interest at the official rate to avoid donations tax coming into play.
The problem with charging interest is that you now earn taxable income in your hands as lender, shifting value back into your hands without any benefit should the trust be unable to deduct the interest expense that it now incurs. This inefficiency is further compounded if you as lender have exceeded your natural person interest exemption and start paying tax on the interest earned.
Section 7C only affects loans to trusts by natural persons or their connected companies. To avoid s 7C, trust assets can be transferred to a company with the trust holding the shares in the company.
The company/ trust structure has always been our preferred structure, primarily because of the advantage of utilising the lower company tax rate when reinvesting returns on investments placed in the company. Furthermore, the estate planning objectives of asset protection, estate duty minimisation and removal of other costs associated with administering and transferring assets on death, remain intact and outweigh the additional cost of utilising two structures in achieving your objectives.