Who pays the tax on reducing a loan to a trust and are there exclusions?

As explained in the previous article, reducing a loan to a trust may be a minefield. Subject to the exclusions provided for in the Income Tax Act, the debt reduction rules apply, and tax may be payable, where:

1. an arrangement is implemented which results in a “concession or compromise” in respect of debt - for example where a debt amount is cancelled, waived or extinguished, or where a loan is converted into shares as part of an arrangement and the face value of the debt prior to entering into the arrangement exceeds the market value of the shares so acquired;
2. a “debt benefit” in respect of a debt owed by a person arises – this is the amount of the debt reduced or cancelled as a result of a “concession or compromise”; and
3. the amount of the debt was used by that person as envisaged in section 19 (where an Income Tax benefit has been or may be achieved) or paragraph 12A (where a Capital Gains Tax benefit has been or may be achieved).

What the South African Revenue Service (SARS) aims to achieve with the debt reduction rules is to tax the taxpayer (the borrower) on any tax deduction/tax advantage that the borrower has achieved or will achieve in future resulting from any “debt benefit”; therefore undoing any such historic or future tax deduction/tax advantage in the hands of the borrower. It does not deal with taxing the lender. The lender, on the other hand, will be taxed in the instance of a debt reduction as a result of a bequest, donation or employment relationship in terms of other relevant provisions in the Income Tax Act and Estate Duty Act. Therefore in order to avoid double taxation, the debt reduction rules exclude a debt reduction as a result of a bequest, donation or employment relationship. All the exclusions to the debt reduction rules are listed below.

The following exclusions apply to the debt reduction rules:

• Where the debt owed by the borrower (e.g. a trust) to a deceased is bequeathed to the borrower and the debt is included in the property of the deceased estate for Estate Duty purposes; i.e. taxable at 20% on the first R 30 million of the value of the estate and at 25% on the estate value exceeding R 30 million.
• Where the debt is reduced by a donation, but only if donations tax is payable in respect of the debt benefit (donations tax paid at 20% on the first R 30 million of the cumulative donations made during the lender’s life and at 25% on cumulative donations exceeding R 30 million). If no donations tax is payable, it will fall under the debt reduction rules and will be taxed as such. Any exemptions under the donations tax provisions will therefore trigger the debt reduction rules for the borrower. 
• Where the debt reduction is a fringe benefit, which is taxed in the hands of the employee.
• Where the borrower is a company that owes the debt to another company in the same group, if the borrower did not trade during that year or previous year. This exclusion does not apply if the debt was incurred to fund an asset that was subsequently disposed of by way of a corporate rules transaction (e.g. section 42 of the Income Tax Act) or the debt was incurred to settle, take over, refinance or renew any debt incurred by another group company or controlled foreign company in relation to the same group of companies.
• Where the borrower is a company that owes a debt to another company in the same group, and the debt is settled by means of the issue of shares by the debtor company. The companies had to be part of the same group of companies at the time the debt was incurred and when the debt was reduced by means of the share issue.
• Only for paragraph 12A, where the borrower is a company that owes a debt to a connected person in relation to that company, and the debt is reduced in the course of, or in anticipation of, the liquidation, winding up, deregistration or final termination of the existence of that company, but only to the extent it does not exceed the cost to the lender, and only if the company has taken the necessary steps in the process within 36 months of the date on which the debt is reduced, unless it withdraws such steps or does anything to invalidate such steps. If all these requirements are not met, then the debt reduction rules will apply.
• Where debt, which is converted into shares, does not contain an interest element – whether debt was interest bearing or not. Interest-free loans are therefore excluded where debt is converted into shares.

It is important to understand when these taxes may be triggered, whether the lender or the borrower may be liable for any taxes as a result of a debt reduction, whether there is an immediate cash flow impact, and what the amounts involved are. Always consult a professional in order to avoid any surprises.