Preference share and trust structure loophole closed by SARS

Traditionally, people moved their assets into trusts (typically on interest-free loan accounts) to stop or freeze the growth on those assets in their personal estates for Estate Duty purposes. Consequently all the growth on those assets took place in the trusts, rather than in the hands of the estate planners. SARS has been unhappy about Estate Duty capping for years and has considered measures whereby South African resident individuals would be taxed on the growth in their estates based on the growth that is taking place within ‘their’ trusts (both South African or foreign resident trusts). The tax that SARS introduced to compensate for their loss of Estate Duty (in terms of Section 7C of the Income Tax Act) falls within the ambit of Donations Tax, which is charged at the same rate as Estate Duty. Estate planners and their advisors moved quickly and converted their loans to preference shares as part of a scheme in an attempt to circumvent these provisions. After spending material amounts on these structures, the benefits were short-lived, as SARS recently closed this loophole.

After the introduction of Section 7C, estate planners typically replaced their loans to trusts, or companies held by trusts, with preference shares through the application of Section 42 of the Income Tax Act (Corporate Rules allowing asset-for-share transactions) as part of a scheme, by moving trust assets, funded with interest-free or low-interest loans, to a new company held by the trust. The preference shares (at a zero or low dividend rate) were issued to the estate planner by the new company. Preference shares were used to circumvent the provisions of Section 7C, as they are usually non-participating in the profits of the company and their value will therefore not increase, similar to those of ordinary shares. Whereas the increase in the value of the ordinary shares will normally be included in the estate of the estate planner, the value of the preference shares will remain at the original subscription value, which results in the saving of Estate Duty. Through this scheme, the growth in the value of the assets still took place in the trust (indirectly), as the shares in the new company (holding the assets) were held by the trust and the estate planner effectively ‘swopped’ their loan to the trust (to which Section 7C applies) for preference shares. The introduction of this anti-avoidance provision therefore undid the effect of the ‘Section 42 transfers’.

Consideration received by or accrued to the ‘lending’ company for the issue of the preference shares is now deemed to be a loan, and any dividend or foreign dividend accrued in respect of those preference shares shall be deemed to be interest in respect of the ‘loan’. With reference to dividends, the term accrued as opposed to declared is used to align with the principle of interest incurred.
As of 1 January 2021, preference shares (shares other than equity shares – such as ordinary shares – and equity shares where the dividend on the share is calculated using a specified rate of interest or time value of money, as defined in Section 8EA(1) of the Income Tax Act) subscribed for:
·       by a South African resident individual who is a ‘connected person’ in relation to a trust (a beneficiary of a trust or any ‘connected person’ in relation to such beneficiary); or
·       by a company (‘lending’ company) at the instance (discussed below) of a South African resident individual where such natural person is a ‘connected person’ in relation to the ‘lending’ company (for example, at least 20% of the equity shares or voting rights of the company is held by them, together with ‘connected persons’ to them – the South African resident individual should hold at least one share)
in a ‘borrowing’ company in which 20% or more of the equity shares are held (directly or indirectly), or the voting rights can be exercised by a trust – which must be a ‘connected person’ in relation to the natural person or to the ‘lending’ company – whether alone or together with any person who is a beneficiary of the trust. Any shareholding (even 1%, but cannot be zero) in the ‘borrowing’ company by the trust would trigger Section 7C if the holdings of beneficiaries added to the trust’s holding amounted to 20% or more.
This provision will apply in respect of any dividend or foreign dividend accruing during any year of assessment commencing on or after 1 January 2021; i.e. the first Donations Tax may be payable on such ‘loans’ on 31 March 2022, for the first relevant year of assessment commencing on 1 March 2021 for all trusts. The provision is applicable to all preference shares where relevant, regardless when the preference shares were subscribed for, as the commencement date of this section refers to “dividends” and not “subscriptions”. It therefore captures existing preference share structures as well.

If this provision applies, the South African resident individual will be deemed to have made a donation to the ‘borrowing’ company equal to the ‘interest’ forfeited by not earning dividends at at least the variable official rate of interest on the ‘loan’.
If the ‘loan’ is provided by a ‘lending’ company to a ‘borrowing’ company at the instance of more than one person connected to the ‘lending’ company, then a donation is deemed to be made by a person in the ratio of their equity shares or voting rights in the ‘lending’ company to the others.

Estate planners should be aware of this move by SARS to prevent the circumvention of Section 7C and properly review their structures.

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