South African tax resident individuals may consider, whether for estate planning purposes or otherwise, to advance funds to offshore trusts for investment abroad. The South African tax implications arising from the terms of the loan funding arrangement with the offshore trust should, however, also be taken into account. Certain tax anti-avoidance measures are aimed at curbing the transfer of wealth to offshore trusts on loan account where such loans bear interest at below market related rates.
The aforesaid measures include the donor attribution rules in section 7, read with paragraph 72 of the Eighth Schedule to the Income Tax Act, 1962 ("ITA"), and the transfer pricing principles in section 31 in the case of an individual who is a connected person in relation to the offshore trust (ie, a beneficiary of such trust or a relative of such beneficiary). With effect from 1 March 2017, section 7C of the ITA further requires interest to be charged on loans to offshore trusts by South African connected persons at the official rate of interest (as defined).
The interaction between section 7C and the above mentioned long standing anti-avoidance measures is complex and has been the subject of much discussion in recent years.
The donor attribution rules and transfer pricing principles essentially require a South African tax resident individual to charge an arm's length (ie, market related) rate of interest on the provision of loan funding to an offshore trust. The individual should take into account certain factors in determining this market related interest rate and retain sufficient record thereof. This could include, for example, the principal amount, duration and terms of the loan, the currency in which the loan is denominated and whether comparable loans exist between unrelated parties. If a market-related interest rate is charged, the individual should only be taxed on the actual foreign interest accrued at the applicable marginal rate of income tax (between 18% and 45%).
The "official rate of interest" contemplated in section 7C is, however, specifically defined in the context of a foreign currency denominated loan as "a rate of interest that is the equivalent of the South African repurchase rate applicable in that currency plus 100 basis points". The market-related rate of interest as per the above could, therefore, differ from the official rate of interest for the relevant tax year. If it is less, the difference may be treated as a donation made to the offshore trust by the South African tax resident individual for donations tax purposes and be taxable at a flat rate of 20% (after taking into account the available ZAR100 000 exemption). This risk may be mitigated through the terms of the loan funding arrangement between the South African tax resident individual and the offshore trust.
Loans below market-related interest rates
If the loan advanced by the South African tax resident individual to the offshore trust is interest-free or interest is charged at below the market related rate, the individual may be regarded as having made a donation, settlement or other (gratuitous) disposition to the offshore trust for purposes of the application of the donor attribution rules. In terms of these rules, the income and capital gains of the offshore trust may then be attributed to the South African tax resident individual. Such attribution should be limited to the market-related rate of interest that should have been charged on the loan.
The donor attribution rules and transfer pricing rules should not be applied in a manner which results in double taxation for the individual.
Where the requirements for the application of the transfer pricing rules are met and, inter alia, the individual is a connected person in relation to the offshore trust, a primary adjustment would be made to the individual's taxable income consisting of the difference between any interest charged and a market related rate. In addition, the primary adjustment would be seen as a deemed donation for donations tax purposes. It should be noted that section 7C does not apply in circumstances where the transfer pricing rules are applicable to an "affected transaction" (as defined).
South African tax resident individuals should carefully consider the application of the donor attribution rules, transfer pricing principles and the deeming provisions under section 7C to any loan funding arrangements with offshore trusts in light of their specific circumstances. It is also advisable for individuals to obtain advice if any legislative changes to these rules are promulgated in future.
Reviewed by Hanneke Farrand, director in ENSafrica's private clients and tax department.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.