By Dan Foster, a Director at Webber Wentzel on the Topic of Trusts

The Davis Tax Committee’s final report on Estate Duty has not yet been released, however there were suggestions late last year, after the release of the interim report, that interest-free loans to trusts was one of the main targets of the committee. It is now proposed that this type of planning be subject to punitive measures.

Currently, a founder may fund a local trust with an interest-free loan. As such a loan creates a concomitant debt claim, it is not a donation for Donations Tax purposes. Neither is the interest forgone considered a donation for Donations Tax purposes, as there is no legal obligation to charge interest on loans, in fact charging interest is prohibited in some cultures.

The trust may then acquire assets with these funds, often the founder’s own assets, which grow in value within the trust, protected from Estate Duty when the individual dies, and protected from the exit charge if the individual emigrates. The debt claim remains in the estate of the individual, but does not grow in value.

The interest-free loan may indeed be a “donation, settlement or other disposition” for the purposes of Section 7 and Part X of the Eighth Schedule, however, meaning that some or all of the income and gains of the trust are attributed to the lender/founder. This is not necessarily a problem, however, since an individual will be taxed at the same rate, or lower, than the trust. In the case of Capital Gains Tax (CGT), the rate is much lower for individuals.

Not only that, but the attribution of the trust’s income and gains is only a fiction for the purposes of income tax, and has no impact on the person’s estate i.e. the amounts attributed to the lender/founder in fact remain in the trust and out of the control of the individual, for Estate Duty purposes.

This type of planning has long been viewed with suspicion by SARS, however it is very difficult to attack other than on the basis of simulation, which is hard to prove. Furthermore, there is no general anti-avoidance rule (GAAR) for Estate Duty.

Consequently, Treasury propose to categorise interest-free loans as donations, incurring a 20% Donations Tax charge (whether on the capital or only the interest forgone is not clear, but likely the later). Furthermore, assets acquired by the trust using such loans will be deemed to be property of the founder/lender at the time of his death, incurring a further 20% Estate Duty charge. Such punitive taxation will surely lead to the end of trusts being funded with interest-free loans.

This proposal raises many difficult questions. Will it apply to interest-free loans already in place, or only new funding advanced? How will an acceptable rate of interest be determined, if interest-bearing loans are used instead (will transfer pricing apply, or a prescribed rate)? Will the Estate Duty claw-back provisions also apply to the CGT exit charge?

In order to deal with these and other questions, the legislation implementing these proposals will no doubt be very complex and subject to much debate. Consequently, it may take more than a year to put appropriate legislation in place. Nevertheless, it appears this form of estate planning is on its final legs.

There are also likely to be unintended consequences for the donations tax aspects of this proposal. Many commercial trusts, for example those used for black economic empowerment, receive interest-free loans to acquire shares. Will an exemption be available for these types of loans? The devil will no doubt be in the detail.

Capital Gains Tax Rises To 32.8%

Trusts already suffer under the highest rate of taxation relative to every other class of taxpayer, and this will only get worse from 1 March 2016. The rate of income tax will remain at a flat 41%, however the inclusion rate for capital gains will increase, along with companies, to 80%. The effective rate of capital gains tax for trusts will consequently be 32.8%.

This provides yet greater incentive for the gains arising in trusts from asset disposals to be either attributed to an individual donor, or vested in an individual beneficiary, in whose hands such gains will be taxed at a maximum rate of 16.4% from 1 March 2016.

These attribution and conduit rules are, of course, a focus of the Davis tax Committee, as noted in their interim report on Estate Duty published last year. Their final report has not yet been released, however one wonders how much longer the arbitrage between trust and individual CGT will be permitted to continue.