Can you still reduce your loans to trusts with tax-free donations?
October 14th, 2021 20:04
You can donate R 100 000 (the annual Donations Tax exemption applicable to each South African resident individual) a year without paying Donations Tax (Section 56(2)(b) of the Income Tax Act). In effect, the exemption allows a couple to donate R 200 000 a year to a trust or other beneficiaries without incurring any taxes. However, you cannot accumulate this exemption. If the exemption is not used in one tax year, it cannot be carried through to the next tax year. It is, therefore, important to make use of the exemption every year. You can also use the R 100 000 annual Donations Tax exemption applicable to each South African resident individual to reduce your loan to a trust, which is an asset in your estate, until the loan is fully repaid. For as long as the loan has a balance outstanding, trust assets are at risk, as a liquidator or executor may have the trust assets liquidated for the trust to settle the outstanding loan. However, be mindful that SARS may now apply Capital Gains Tax as a result of such ‘waiver’.
Until 2012, a physical payment of such donation had to be made to the trust before the end of February each year, for the trustees to then physically make payment to the lender(s) to reduce their loans to the trust, since Capital Gains Tax would be triggered if only a ‘book entry’ was made at the time (in terms of Paragraph 12A of the Eighth Schedule to the Income Tax Act). From January 2013, Paragraph 12A of the Eighth Schedule to the Income Tax Act – which taxes a concession or compromise in respect of a debt, including a loan write-down through a ‘book entry’ – was amended to exclude reductions to loan accounts brought about by a donation (in terms of Paragraph 12A(6) of the Eighth Schedule to the Income Tax Act). Therefore, from January 2013 up to and including financial years commencing on or before 1 January 2019 (when the paragraph was amended again), book entries could be made without triggering Capital Gains Tax implications instead of the lender (and their spouse) being forced to physically making payment to the trust, to avoid triggering taxes.
After the further amendment of Paragraph 12A(6), for years of assessment commencing on or after 1 January 2019, the donation can only reduce the “debt benefit” if Donations Tax is payable. Donations Tax is not payable on the Section 56(2)(b) exempt amount of R 100 000. Therefore, the Capital Gains Tax exemption cannot apply in circumstances in which a person with a loan to a trust waives R 100 000 a year by making a ‘book entry’ only. Therefore, when Paragraph 12A applies, the donation is subject to Capital Gains Tax in the hands of the South African resident trust (non-residents are not subject to Capital Gains Tax) that received the benefit of the write-down. Some, however, hold the view that the R 100 000 write-down should still not attract Capital Gains Tax as it does not apply specifically to any donation on which Donations Tax is payable.
SARS should clarify whether the ‘write-down’ of the loan with the R 100 000 annual Donations Tax exemption still excludes such reduction of the loan from the payment of Capital Gains Tax thereon. Given this uncertainty, and the fact that SARS may trace such cumulative donations, which can directly be linked to reducing such loan, and then apply the Section 7 attribution rules (assignment or allocation rules) to such donations, it may be wise to rather make a physical payment to the trustees for them to decide what the best application of the R 100 000 is before the end of the relevant financial year. If they decide to repay the loan, one probably breaks the link between the loan – which may produce taxable income and capital gains – and the donation. It also addresses the current uncertainty. However, be aware that some are even of the view that such a transaction is risky as it might be viewed as a disguised waiver of debt and ignored by SARS, either under common law, as a sham, or as an impermissible tax arrangement under Section 80A of the Income Tax Act.
An endowment is a ‘safer’ mechanism that can be used to reduce the loan account over time, also utilising your R 100 000 annual Donations Tax exemption – although you will have to ‘fund’ the investment annually before receiving the cash back over a fixed period of time. After the first loan repayment, you could keep the money aside to fund the next investment in the trust and repeat that with every cycle to reduce strain on your cash flow. Once the endowment has matured, the trust can utilise such proceeds to repay the loan account.
Also, be mindful not to create an obligation to annually donate the R 100 000 to the trust to reduce the loan. Otherwise, such receipt by the trust may be regarded as an annuity and be taxed in the hands of the trust. Although the Income Tax Act does not define an annuity, a Special Court case (ITC 761 of 1952) outlined the characteristics of an annuity:
· It provides for a fixed annual payment (even if it is divided into installments);
· The payment is repetitive; and
· It is chargeable against some person, i.e. there is an obligation to pay.
Voluntary payments, even if they are repetitive, are, therefore, not regarded as an annuity.
~ Written by Phia van der Spuy ~