A lot of tax planning is done around loans between companies and trusts and it is important to understand the re-characterisation rules contained in the Income Tax Act (“the Act”) which are triggered when the loan agreement suggests a non-commercially motivate arrangement.
To understand the mischief that the legislation is aimed at undermining, one must first understand the key mechanisms of externally financing a company for commercial purposes, namely:
Typically this form of finance is non-redeemable with the yield (i.e. dividends) dependent upon the profitability of the company with payment made at the discretion of the company’s directors or payment thereof deferred without giving rise to legal claims.
Unlike equity finance, debt is redeemable with a yield based on the time value of money, namely interest, quantified and paid or accrued regularly without regard to the company’s ability to pay or the profitability of the company. Importantly, the creditor is entitled to enforce its rights if the company fails to pay as specified in the loan agreement.
Tax effect of dividend and interest yield
Interest is usually tax deductible by the person paying and taxable in the hands of the recipient. A dividend on the other hand is not tax deductible by the company paying the dividend and not taxable in the hands of the shareholder, although the dividend may be subject to dividend tax.
Equity artificially disguised as debt
What distinguishes debt from equity is varied and reference needs to be made to the terms of the loan agreement between the company and trust. What the Act aims to identify are loans which have elements of equity finance where the interest payments should be reclassified as dividends.
Provisions triggering in specie dividend
Where the loan agreement makes the repayment of the loan by the company dependent upon the company’s ability to pay, or the solvency of the company, then the interest levied on the debt instrument will be deemed to be a dividend in specie with no tax deduction in respect of the interest paid and triggering dividend withholding tax.
Where the company is a connected person in relation to the trust lending the money and the loan is not repayable on demand or the company is not obliged to repay the loan within 30 years, the interest paid may also be deemed an in specie dividend.
Furthermore, loan agreements that charge non-market related interest rates or where interest is linked to the profitability of the company, will similarly trigger the re-characterisation provisions in the Act and deem the interest to be a dividend.
The new trust tax return now focuses specifically on these loan agreements and lest you want to fall foul of these rules it is critically important to review your loan agreements and ensure signed copies are available for submission to SARS who will no doubt call for them.