Can trusts provide interest free loans to others?

During the last couple of years there was a great focus on loans made by a connected person to a trust, or a company held by a trust, since the South African Revenue Service (SARS) introduced the punitive tax measures (Section 7C of the Income Tax Act) on such interest-free or soft loans (where interest is charged at a rate below the official interest rate, currently 7.75%), in an attempt to combat estate duty/donations tax leakage on assets moved into trusts, or companies held by trusts.

There is sometimes confusion regarding the application of these tax measures – whether they apply to loans made to trusts, and/or whether they apply to loans made by trusts. It is clear from the wording of Section 7C that it only applies to loans made by connected persons to trusts, and companies held by trusts, and not to loans made by the trustees of a trust to somebody else. Section 7C therefore only applies where a trust is the recipient or borrower of a loan.

This raises the question whether there is any tax or other consequence for trustees making an interest-free or soft loan to a connected person, or company that is a connected person in relation to that natural person. Until the delivery of the judgement by the Supreme Court of Appeal in the case of the Commissioner for the South African Revenue Services v Brummeria Renaissance on 13 September 2007, it was always the view that neither the lender, nor the borrower would incur any income tax consequences as a result of such a loan. This case has created uncertainty and alarm regarding the tax implications of interest-free loans. In this case three companies, Brummeria Renaissance (Pty) Ltd, Palms Renaissance (Pty) Ltd and Randpoort Renaissance (Pty) Ltd developed retirement villages. The companies obtained interest-free loans in order to build units in exchange for granting life occupation rights of the units to the lenders. The Commissioner assessed the companies and taxed them on these interest-free loans, contending that the right to use the loans interest-free had a money value and therefore formed part of the companies’ taxable income. The Commissioner’s contention was dismissed by the Johannesburg Tax Court but upheld on appeal. The Supreme Court of Appeal held that although a loan was not income, the value of the right to use a loan interest-free was income. This judgement does not lay down a blanket rule that an interest-free loan is always a taxable benefit in the hands of a borrower. Each case’s facts need to be considered. It must be remembered that what is in issue is not the loan of money as such, but the value of the right to have the use of the money, without paying interest. If this right is obtained in the context of a trade or scheme of profit-making, such as this case, then it will be of a revenue nature and must be included in gross income and taxed accordingly. A distinction should therefore be drawn between interest-free loans, where the benefit is, in effect, a form of remuneration for goods or services or other benefits supplied by the borrower to the lender (as in this case), and interest-free loans where there is no such supply. It therefore follows that this judgement does not have such a far reaching impact as some commentators may have interpreted it. This case was clearly a barter transaction where the right to the loan was granted in return for the right to occupy the relevant units for no consideration. In the case of an interest-free loan by a trust to a connected person (and even interest-free loans by a connected person to a trust) the causal connection is not present and there is not a quid pro quo (a favour or advantage granted in return for something) for the granting of the loan. It is in this context that one would not be able to apply this judgement in the case of all interest-free or low interest rate loans.

As a consequence of the confusion caused by this case, SARS issued an interpretation note (IN58) in October 2012 in order to clarify when the right to use loan capital free of an interest obligation would result in income tax consequences. It is clear from the facts of this case that the rights to use the interest-free loans were intended by the lenders (the life-right holders) to be in exchange for the life rights granted by the borrower. As a result the principles from the judgement may be applied in all cases in which benefits in a form other than money (such as the right to use an interest-free loan) are granted in exchange for goods supplied, services rendered, or any other benefit given. The receipt or accrual in a form other than money could constitute an amount which should be valued and included in the gross income of the taxpayer in the year of assessment in which it is received or accrued.

Typically interest-free loans advanced by a trust to a connected person or company, which is connected to the connected person in relation to the trust, are loans for consumption and are not granted as consideration for goods or services. It is advisable that these loan terms are captured in a written loan agreement, which will serve as proof that the transaction is not a donation, which will attract donations tax. Under our common law, the borrower and the lender incur obligations under the contract and the borrower is only expected to return a similar object of same value to the lender. Once the lender transfers the loan capital, he has fulfilled his obligations. A continual obligation rests on the borrower to repay the loan capital as agreed, in future. It is clear that the charging of interest is not an essential element of a loan agreement and a loan agreement may be concluded without any stipulation with regards to interest payable. However be mindful of the impact of the National Credit Act, should the trustees aim to charge interest on a loan made by the trust. The term of repayment is also not an essential element of a loan agreement. It is however important to note that a loan which contains no agreed repayment terms, and a loan which is repayable on demand, becomes continuously recoverable at all times. It is therefore wise to agree and record when the debt will become due for payment.