The question often arises whether the tax law obliges certain lenders to charge interest on loans to connected parties. This includes loans between natural persons and a family trust or a company and its shareholders. The answer is arguably that the tax law never requires this. It does not prescribe or compel that a lender charge interest on a loan. Instead, it sets out the tax consequences that follow where the lender does not charge interest, or charged interest below specified interest rates. This article discusses the decision that lenders need to make.
Loans by companies to shareholders
Where a South African company lends an amount to a resident connected person that is not a South African company, a deemed dividend arises under section 64E(4) of the Income Tax Act . The deemed dividend is based on the difference between interest at the official rate and the actual interest. It arises annually and is subject to dividends tax. This annual deemed dividend does not affect the capital balance of the loan. If the company later distributes the capital amount of the loan, that distribution is a separate dividend, also subject to dividends tax.
If the company charges interest, this interest is income taxed at the corporate rate of 27%. As that interest accrues, the company builds up further retained earnings, increasing its distributable reserves. The distribution of those reserves attracts dividends tax in turn.
From the shareholder’s side, deductibility of the interest depends on what the loan funds. Borrowed money used for private or household expenditure, the interest is not deductible, given the prohibition on deducting expenses of a private nature. Where it funds a business activity, or the acquisition of an investment property producing rental income, the interest may be deductible. The parties could then well arrive at a broadly tax-neutral position, with one taxed on the interest and the other deducting it.
Loans to trusts
Where a connected natural person lends an amount to a trust and charges no interest, a deemed donation arises under section 7C of the Income Tax Act. The deemed donation arises on the difference between the interest that would have accrued at the official rate and the interest actually charged, if any. This deemed donation attracts donations tax. It is subject to the same exemptions (for example, the annual exclusion available to natural persons) as any other donation.
There is a second possible consequence to consider. Depending on the facts, the failure to charge interest may be an “other disposition” for the purposes of the attribution rules in section 7. If the attribution rules apply, income is attributed to the person who made the loan. In the context of a loan to a trust, section 7(5) warrants particular attention.
A lender who charges interest is taxed on the accrual of the interest at their marginal tax rate. This interest increases the lender’s estate that would ultimately attract estate duty upon death. Section 7C addresses precisely this. If the loan bears interest, the value remains in the lender’s estate. In the absence of interest, this value, effectively transferred to the trust, attracts donations tax immediately.
For the trust, deductibility again turns on use of the funds. A trust that uses the funds to acquire a holiday property generating no income, and not used in a trade, would in principle not qualify for a deduction. A trust that, on the other hand, applies the funds in, for example, farming operations may well qualify, in which case charging interest can again be a broadly tax-neutral decision.
Conclusion
The tax law does not prescribe whether a taxpayer should charge interest on a loan or not. It sets out only the consequences of not charging interest at the official rate, for example, a deemed donation under section 7C or a deemed dividend under section 64E(4). The decision rests with the taxpayer, and making it calls for a clear understanding of the consequences of each alternative. It is a good idea to model the two scenarios to fully understand the impact of tax in the decision.
You can listen to Episode 79 of my podcast, Tax Break, for more on this topic:
