BRACKET CREEP, VAT AND THE 2017 BUDGET

B4Year on year the personal income tax tables are adjusted and based on which individuals are taxed based on an increasing sliding scale based on their income earned and therefore into which tax bracket they would fall. The annual adjustments are partly to provide for tax relief or an additional burden on certain salary earners, and partly to provide for the effect of inflation.

Consider for example the primary rebate of 2015/2016 (R13,257) compared to that of the 2016/2017 tax year (R13,500). This has now been increased to R13,635 for the 2018 fiscal year. Applying the lowest tax threshold of 18% thereto, this translates into the annual income tax free receipts of R73,650 in 2016 being increased to R75,000 in 2017, and to R75,750 subsequently for 2018.

This means that the threshold at which individuals are taxed increased by 1.8% and 1% effectively over the past two years. In non-real terms therefore tax relief was effected for those individuals earning at the lower end of the tax bracket: where a salary of R6,138 per month would have been income tax free in 2016, this amount in 2018 is now R6,313.

Taking into account that inflation is considered to have averaged between 5% to 7% over this period though, in real terms therefore even those on the lower end of the income are paying more taxes on income in real terms in 2018 than would have been the case in 2016. The effect of so-called “bracket creep” (whereby taxes are effectively increased through the effect of tax brackets not being adjusted sufficiently to cater for inflation) is a phenomenon acutely effecting not only the rich, but the poor too, and especially so over the past two years.

The observation above is relevant in the context of the debate surrounding the potential change in the VAT rate. VAT is considered to represent a regressive tax system whereby everyone, rich or poor, pays the same amount of tax based on consumption of goods (subject to certain basic goods that are exempted). The personal income tax regime in contrast represents a progressive tax system whereby the rich are taxed proportionately more and at increased rates based on their respective income levels. The political dynamics therefore dictate that a pro-poor tax system be focussed more heavily on income tax with increasing tax brackets rather than a flat VAT rate applied to everyone across the board. It is for this exact same reason why there is so much rhetoric and political noise in the media opposing an increase in the VAT rate, especially where the pro-poor movements such as the trade union movement and the SACP are involved.

What the above effect of bracket creep illustrates though is that Treasury is nevertheless, in an indirect manner, systematically also increasing the tax burden on the poor through bracket creep, yet in a more subtle manner whereby it is at the same time avoiding getting involved in the political quagmire that is the VAT rate. An implicit acknowledgement perhaps from Treasury that the wealthy alone cannot absorb increased tax burdens?

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE)

EXEMPTION FOR FOREIGN SALARY EARNERS

B1South African tax resident individuals are liable to income tax on their worldwide income. In other words, where a South African tax resident individual were to earn a salary for employment which may from time-to-time be exercised outside of the borders of the Republic, that income earned is still included in that South African tax resident individual’s gross income.

An exemption is available though to South African employees where the extent of the services rendered abroad are significant.[1] The exemption is however limited to income earned in the form of remuneration from an employer and only to the extent that the remuneration received is for those services rendered abroad. In terms of the relevant provision, salaries earned in whatever form for services rendered outside of South Africa will be exempt from income tax in South Africa where the employee has been absent from the Republic for:

  • At least 184 days during a 12-month period (in other words for more than 50% of a 1-year period); and
  • More than 60 days of the above will have continuously been spent beyond South Africa’s borders.

As above, it is important to appreciate that it is not the entire salary earned by the employee for the year of assessment which will be exempt from South African income tax. The exemption is limited to only so much as relates to services rendered abroad. In other words, to the extent that the salary is earned for services that will be rendered in South Africa, that portion of a salary earned will still be taxable in South Africa.

The exemption is typically applicable to employees seconded for periods of time to render services abroad. It is quite likely that even though the income earned may be exempt from South African income tax, that the country in which the services are rendered will seek to levy tax on the employee’s income based thereon that the source of the income earned will be in that other country.

It is therefore possible for employees to benefit from the exemption on foreign earned salaries, whilst also paying very little income tax in the other country, if such a country is one with very low individual income tax rates (typically countries in the Middle East, such as Dubai). This incidence of “double non-taxation” has recently drawn the attention of National Treasury, and the Minister of Finance warned in this year’s Budget Speech that South Africa is considering rescinding the exemption if the other country in which the employment services are rendered does not seek to significantly tax the income earned by the employee.

[1] Section 10(1)(o)(ii) of the Income Tax Act, 58 of 1962

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE)

WITHHOLDING TAX ON PROPERTY SOLD BY NON-RESIDENTS

B3A remarkable number of non-residents own property in South Africa. While non-residents are not subject to South African capital gains tax generally, an exception is to be found where non-residents dispose of South African immovable property, or shares in “South African property rich” companies.

An obvious practical difficulty arises though for SARS to collect taxes from non-residents once they have sold their properties and have no further connection with South Africa. There is very little SARS can do to collect a tax debt from such non-residents, let alone compel them to file the necessary tax returns.

Section 35A of the Income Tax Act[1] was introduced for this reason. It levies an interim withholding tax on non-residents selling South African immovable property, required to be withheld from the selling price payable by the non-resident, on the following basis:

  • 5% of the selling price where the seller is a non-resident natural person;
  • 5% of the selling price where the seller is a non-resident company; and
  • 10% of the selling price where the seller is a non-resident trust.

In clause 10(1) of the draft Rates and Monetary Amounts and Amendment of Revenue Laws Bill, which was released concurrently with the Annual National Budget earlier this year, it is proposed that the rates above be increased to 7.5%, 10% and 15% respectively and effective to disposals of immovable property from 22 February 2017.

While ultimately the withholding obligation lies with the purchaser paying the purchase amount, a conveyancer or estate agent may also be liable where the withholding tax is not withheld from payments made to the non-resident seller.[2]

As referred to above, the withholding tax is not a final tax and its purpose is merely to secure the ultimate capital gains tax liability that may ultimately be due (and which would in most circumstances be substantially less the amount withheld). To the extent that a lesser amount is due in the form of a capital gains tax exposure for the non-resident, the balance overpaid is refunded to the seller upon submission of an annual income tax return.

It is also possible for a non-resident to apply for a tax directive that no withholding tax needs to be withheld from the selling price of the property sold. The directive may be based on either:[3]

  • the extent to which the seller is willing to provide for security for the payment of taxes due to SARS on the disposal of the property;
  • the extent of the other assets that the seller has in the Republic;
  • whether the seller is potentially not subject to tax in respect of the disposal of the property; and
  • whether the actual liability of that seller for tax in respect of the disposal of the property is less than the amount required to be withheld.

[1] 58 of 1962

[2] Section 35A(12)

[3] Section 35A(2)

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE)

INTEREST FREE LOANS WITH COMPANIES

B2The latest annual nation budget presented in Parliament proposed the dividends tax rate to be increased with almost immediate effect from 15% to 20%. The increased rate brings into renewed focus what anti-avoidance measures exist in the Income Tax Act[1] that seeks to ensure that the dividends tax is not avoided.

Most commonly, the dividends tax is levied on dividends paid by a company to individuals or trusts that are shareholders of that company. To the extent that the shareholder is a South African tax resident company, no dividends tax is levied on payments to such shareholders.[2] In other words, non-corporate shareholders (such as trusts or individuals) may want to structure their affairs in such a manner so as to avoid the dividends tax being levied, yet still have access to the cash and profit reserves contained in the company for their own use.

Getting access to these funds by way of a dividend declaration will give rise to such dividends being taxed (now) at 20%. An alternative scenario would be for the shareholder to rather borrow the cash from the company on interest free loan account. In this manner factually no dividend would be declared (and which would suffer dividends tax), no interest accrues to the company on the loan account created (and which would have been taxable in the company) and most importantly, the shareholder is able to access the cash of the company commercially. Moreover, since the shareholder is in a controlling position in relation to the company, it can ensure that the company will in future never call upon the loan to be repaid.

Treasury has for long been aware of the use of interest free loans to shareholders (or “connected persons”)[3] as a means first to avoid the erstwhile STC, and now the dividends tax. There exists anti-avoidance legislation; in place exactly to ensure that shareholders do not extract a company’s resources in the guise of something else (such as an interest free loan account) without incurring some tax cost as a result.

Section 64E(4) of the Income Tax Act provides that any loan provided by a company to a non-company tax resident that is:

  1. a connected person in relation to that company; or
  2. a connected person of the above person

“… will be deemed to have paid a dividend if that debt arises by virtue of any share held in that company by a person contemplated in subparagraph (i).” (own emphasis)

The amount of such a deemed dividend (that will be subject to dividends tax) is considered to be effectively equal to the amount of interest that would have been charged at prime less 2.5%, less so much of interest that has been actually charged on the loan account.

It is important to also appreciate that the interest free loan capital is not subject to tax, but which would also have amounted to a once-off tax only. By taxing the interest component not charged, the very real possibility exists for the deemed dividend to arise annually, and for as long as the loan remains in place on an interest free basis.

[1] 58 of 1962

[2] Section 64F(1)(a)

[3] Defined in section 1 of the Income Tax Act

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE)

Final and diluted legislation in relation to low interest loans and trust

Images-08The renewed focus by National Treasury on the taxation of trusts was widely anticipated and it came as little surprise earlier this year that the first version of the Draft Taxation Laws Amendment Bill, 2016, introduced what will become the new section 7C of the Income Tax Act, 58 of 1962.

Much has since been written about the new provision, and many commentators have debated its merits, essentially attributing onerous tax consequences to low interest loans provided to trusts. The final version of the new provision, due to become effective 1 March 2017, has now been published by Treasury, and which will be incorporated into the Income Tax Act as soon as passing through the relevant legislative processes.

The final version contains quite a few significant changes to the initial proposal, although the aim of section 7C is still focused on attacking interest free loans to trusts.

To recap: loans extended by persons to connected party trusts at less than prime – 2.5% are potentially deemed to have donated an amount to that trust equal to the difference between interest that was actually charged and the amount of interest that would have been charged at a rate of prime – 2.5%. It is unlikely that such deemed donations will have any direct income tax consequences for the trust, although indirectly donations to trusts may cause certain receipts by a trust to be taxed in the hands of any donors in terms of the so-called “tax back” provisions contained in section 7 of the Income Tax Act.[1] The obvious consequence of section 7C though is the potential incidence of donations tax.

In this regard, the first notable exception to the final version of section 7C is that the annual R100,000 exemption from donations tax may now be utilised against the deemed donation – said exemption was previous expressly excluded from being utilised against the deemed donation triggered by section 7C. Although this does not address the indirect income tax consequence highlighted above in relation to the application of the “tax back” provisions in the Act, it does significantly negate any potential donations tax consequences, while also removing the direct income tax consequence of the previous proposal in terms of which the creditor will have been deemed to have received an interest accrual in its own hands (and which would have been subject to income tax).

A further notable change to the final version of section 7C is that a long list of potential exemptions are now provided for where section 7C will not apply (although these are quite focussed and potentially of limited application only). It is finally also noted that the final proposed legislation makes it clear that the provision applies to loans already existing as at 1 March 2017, where doubt existed in terms of the previous proposal whether the provision would only have applied to “new” loans entered into on or after section 7C comes into effect.

The final version of section 7C presents a much diluted and less threatening version of the initial proposed legislation presented by Treasury earlier this year, and taxpayers will be relieved to learn of the significant concessions since been made. That being said, the provision still has the capacity to significantly increase the ultimate tax bill of a number of trust related structures, and our clients are once again encouraged to have their prevailing accounts reviewed to ensure that their affairs are structured appropriately.

[1] To the extent that a person donates an amount to the trust, income received by the trust as a consequence of that donation is deemed to accrue to the donor, and not the trust.

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE)

PAYE and directors’ (and members’) remuneration from 1 March 2017

Images-06Many would have noted reports in the national media that the Taxation Laws Amendment Act, 16 of 2016, was signed into law by President Zuma on 11 January 2017. One of the many changes that the Act brings into effect is the repeal of paragraph 11C of the Fourth Schedule to the Income Tax Act, 58 of 1962. The provision is repealed effective 28 February 2017, which means that a new regime is introduced for deducting PAYE from directors’ remuneration effective for the 2018 tax year commencing on 1 March 2017.

The repeal introduces a new dispensation for the calculation of employers’ liability to pay over PAYE on a monthly basis as relates to directors’ remuneration paid. (It bears reminding at this stage that members of close corporations are deemed to be directors for PAYE purposes too, so the same would apply to members’ remuneration paid from 1 March 2017.) Ironically, the “new” dispensation that now applies to directors’ remuneration is the same regime that has throughout applied to “regular” employees, and these regimes can now be said to be aligned.

The purpose of paragraph 11C was to provide for the unique circumstances presented in directors’ remuneration, whereby actual remuneration for directors would often be inconsistent and amount to ad hoc payments decided and approved from time to time.[1] Policy was therefore to have PAYE calculated on a notional amount calculated generally with reference to the actual directors’ remuneration paid out in the previous year of assessment.

However, with the introduction of section 7B (dealing with “variable remuneration”[2]) in the Income Tax Act itself in 2013, policy in this regard appears to have changed with National Treasury. If “regular” employees need to account for PAYE on an ongoing basis on variable remuneration (also inconsistent) received, the need to differentiate between employees and directors would fall away and no policy consideration would exist whereby there should be differentiated between the PAYE treatment of variable remuneration received by employees vis-à-vis directors’ remuneration.

The reference to section 7B is only relevant to explain the policy change. It is important to appreciate though that directors’ remuneration will likely not form part of “variable remuneration” as defined in section 7B, and therefore PAYE cannot be accounted for merely on an actual payment basis. PAYE should be calculated and paid over as and when remuneration accrues to an employee (with the exception of variable remuneration), and likewise to directors now too. This would be as and when the employee or director becomes entitled to the remuneration, and not only when the amounts are actually received subsequently (as would be the case for variable remuneration covered by section 7B).

[1] See the now archived SARS Interpretation Note 5 (Issue 2)

[2] A term defined in section 7B of the Income Tax Act

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE)

interest free loans to directors

Images-04It is very often the case that a company extends an interest free or low interest loan to a director. This manifests either as a true incentive or benefit to that director (mostly the case in larger corporate environments) or in a small business environment in lieu of salaries paid. The latter is especially the case for example where a spouse or family trust would hold the shares in the company running the family business, but which business is conducted through the efforts of the individual to whom a loan is granted from time to time.

In terms of the Seventh Schedule to the Income Tax Act[1] a director of a company is also considered an “employee”.[2] This is significant, since directors can therefore also be bound by the fringe benefit tax regime applicable to employees generally.

Paragraph (i) of the definition of “gross income” in the Income Tax Act[3] specifically includes as an amount subject to income tax “the cash equivalent, as determined under the provisions of the Seventh Schedule, of the value during the year of assessment of any benefit … granted in respect of employment or to the holder of any office…”

Clearly, benefits received by a director of a company would therefore rank for taxation in terms of this provision. The question remains therefore whether loans provided to such directors by the companies where they serve in this capacity would amount to such a taxable benefit, and further how such benefit should be quantified.

Paragraph 2(f) of the Seventh Schedule is unequivocal in its approach that a taxable fringe benefit exists where “… a debt … has been incurred by the employee [read director], whether in favour of the employer or in favour of any other person by arrangement with the employer or any associated institution in relation to the employer, and either-

(i)            no interest is payable by the employee in respect of such debt; or

(ii)           interest is payable by the employee in respect thereof at a rate of lower than the official rate of interest…”

Paragraph 11 in turn seeks to quantify the amount of the taxable fringe benefit to be included in the gross income of the director. Essentially, the taxable fringe benefit would be equal to so much of interest that would have been payable on the loan at the prime interest rate less 2.5%, less any interest actually paid on the loan. The benefit therefore does not only arise on interest-free loans, but also on loans carrying interest at less than the prescribed interest rate.

It is necessary to note that a fringe benefit otherwise arising will not be a taxable benefit if the loan amount is less than R3,000, or if it is provided to the director to further his/her studies.

[1] 58 of 1962

[2] Paragraph 1 of the Seventh Schedule, paragraph (g) of the definition of “employee”

[3] See section 1

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE)

Capital gains and cancelled sales

Images-02Many transactions in terms in which assets are sold are subject to suspensive conditions. In terms of such agreements, the sales transaction will only take place once all the suspensive conditions have been met.[1] Many other agreements may however be subject to a resolutive condition. A resolutive condition involves one whereby an agreement is cancelled if that condition is subsequently met. For example, where a person (A) sells a vehicle to B, subject to the condition that the agreement be cancelled if B is unable to obtain a driving license within a year, such a condition could be described as a resolutive condition. From a legal perspective, it is important to understand though that a valid agreement of sale had already been entered into between A and B, irrespective thereof that a year has not yet passed within which B is afforded the opportunity to obtain the contemplated driving license. This is also the case for capital gains tax (CGT) purposes. Only later, if the resolutive condition is met, is the agreement cancelled with retrospective effect.

Where a resolutive condition becomes operational, and a historic sale cancelled, this may give rise to practical problems for the seller from a CGT perspective. A CGT cost may already have been suffered in a previous year of assessment in relation to the asset disposed of. Now that the sale is cancelled, a taxpayer cannot revisit previous returns already submitted. The Income Tax Act only makes provision for a capital loss to be created in those instances,[2] but which in and of itself does not necessarily carry any value. Consider for example where future capital gains will not be realised again by the taxpayer and against which it can set-off the loss now created. It is possible therefore for a person to pay CGT on a transaction that was cancelled subsequently.

Such a scenario recently played itself out in the Supreme Court of Appeal judgment in New Adventure Shelf 122 (Pty) Ltd v CSARS.[3] There the taxpayer had sold a property near Stilbaai in September 2006 and declared a capital gain of R9,746,875 to SARS. On this amount, a CGT cost of R1,413,007 arose. Due to financial problems on the side of the purchaser however, the agreement was cancelled in November 2011 and the property returned to the seller. The seller now sought to reopen its past assessments to correct the declaration of the capital gains declared that no longer could be said to have arisen for those years of assessment. SARS would not allow this, and the taxpayer unsuccessfully sought to initiate review proceedings against SARS in the High Court. On appeal to the Supreme Court of Appeal, the taxpayer was again unsuccessful.

The Court confirmed that tax was an annual event. “In summary, the cancellation of the sale did not entitle the appellant to have his tax liability for the 2007 year re-assessed.” And elsewhere the Court reminded again that “… even if in certain instances it may seem ‘unfair’ for a taxpayer to pay a tax which is payable under a statutory obligation to do so, there is nothing unjust about it. Payment of tax is what the law prescribes, and tax laws are not always regarded as ‘fair’. The tax statute must be applied even if in certain circumstances a taxpayer may feel aggrieved at the outcome.”

[1] Paragraph 13(1)(a) of the Eighth Schedule to the Income Tax Act, 58 of 1962

[2] Paragraph 3 and 4 of the Eighth Schedule

[3] (310/2016) [2017] ZASCA 29 (28 March 2017)

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE)

Reform on the taxation of pension funds

 A-08Some controversy surrounds one of the most significant amendments that would have been effected by the Taxation Laws Amendment Act, 25 of 2015, and the Tax Administration Laws Amendment Act, 23 of 2015, being how retirement type funds would have been taxed in future. This includes both the taxation of proceeds from funds, as well as the extent to which the amounts contributed to funds throughout will be deductible for income tax purposes.Although the reform process has been the subject of consultation since 2012, certain key proposals have recently, due to lobbying from the trade union movement specifically, been postponed to 1 March 2018 to allow for further consultation.

What was proposed initially and has been enacted since:

It is important to distinguish upfront between 3 types of funds, being pension funds, provident funds and retirement annuity funds. Historically, in terms of the Income Tax Act, 58 of 1962 (the Income Tax Act), contributions made to pension funds were deductible, limited to 7.5% of the individual’s particular annual pensionable salary. Whereas pension funds are designed to allow for the accumulation of wealth of salaried individuals towards retirement, retirement annuity funds aim to provide for non-salary income to be saved towards retirement. To this end, 15% of non-pensionable income (e.g. income from an own business) contributed to a retirement annuity fund were previously allowed as income tax deductions.

Both retirement annuity and pension funds, however, had certain limitations imposed on them which restricted access to the capital accumulated in these funds only until after retirement, and even then not all capital would have been accessible as a lump sum withdrawal: realisation would generally take place through monthly annuities received from such funds. In this sense, provident funds differed and capital accumulated in such funds were accessible even before retirement. To discourage use of such funds, though (and to encourage a long term savings culture), no income tax deductions were historically allowed for provident fund contributions.

The new amendments now seek to harmonize the tax treatment of these 3 types of funds, and specifically as relates the differentiation on the tax treatment of contributions, as well as access to the fund capital together with the tax consequences of lump sum withdrawals. The single, encompassing provision now dealing with fund contributions is section 11(k) of the Income Tax Act. Section 11(k) now allows for a deduction of any fund contributions up to 27.5% of the higher of an individual’s i) remuneration received from an employer or ii) his or her taxable income for the year in question. The deduction is limited, though, to R350,000, meaning that individuals earning more than R1,272,727 will effectively have a lesser rate applied to them. (Note that the 27.5% will include contributions made by an employer on an employee’s behalf, which amount is also included as part of the individual’s remuneration for income tax purposes in the form of a fringe benefit.)

All of the above proposals have been left unchanged and were signed into law and have become effective.

Legislative reform that has been delayed:

The main concern raised by trade unions was access to the capital of specifically provident funds. It was proposed initially that all funds going forward would fall under the umbrella of what had up to now been the regime for pension funds, i.e. that a capital amount is available for withdrawal at retirement, but the major portion of accumulated wealth is annuitised and only receivable in the form of monthly annuities being paid out going forward. This specific ‘annuitisation requirement’ has drawn the ire of COSATU, especially of provident funds been built up by members which could have been drawn in one lump sum on resignation from an employer. What the effect of annuitisation would be effectively, therefore, is to ensure that not all savings may be withdrawn as one lump sum, but only a percentage thereof. From Treasury’s side, this is obviously to encourage saving for retirement. One also has sympathy for the counter-argument though, being that a savings product intentionally sought out by employees to allow them to access all capital on retirement (e.g. to start an own business at some stage) has now with one foul swoop of the legislative pen been prevented.

It remains to be seen in the coming months and years how this political hot potato will play itself out, especially in the context of looming elections with COSATU publicly reconsidering its support for the ruling party.

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE)

Interest free loans cross border

A-06A consideration of the tax consequences of interest free loans will be incomplete if not also considered in the context of interest free debt funding being provided cross-border. Typically, when “cheap debt” is encountered it is in the form of low interest or interest free loans being provided to related parties (or “connected persons” as defined) due to the non-commercial nature of such an arrangement. This is especially the case for the lender, who could typically receive far greater returns on investment if utilising excess cash in another manner. However, due to group efficiencies, it may be preferable for one group company to provide low interest or interest free financing to a fellow group company, especially if this also has the potential to unlock certain tax benefits.

One such manner in which a corporate group may save on its ultimate tax bill is to ensure that funding is provided by a company situated in a low tax jurisdiction, such as Mauritius for example (which levies a corporate tax rate of effectively 3%). Were the Mauritius company to lend cash to a South African group company, the group would prefer it to do so at a very high rate. This would ensure that the South African company is able to deduct interest in a corporate tax environment where it would create a deduction of effectively 28%, whereas the tax cost would only be 3% in Mauritius.

Where the South African company however is in the position that it sits on the group’s cash resources, it would want to lend money to the Mauritius company at as low rate as possible. Interest, to the extent charged, will now only be deductible at an effective 3% in Mauritius (where the borrower is situated), whereas interest received will be taxed at 28% in South Africa. Such a loan would therefore be most tax efficiently structured as an interest free loan.

The transfer pricing regime, contained in section 31 of the Income Tax Act,[1] seeks to legislate against this tax avoidance behaviour. The provision, which covers all cross border transactions entered into by connected persons, but specifically also cross border debt financing, determines that in such instances “… the taxable income or tax payable by any person contemplated … that derives a tax benefit … must be calculated as if that transaction, operation, scheme, agreement or understanding had been entered into on the terms and conditions that would have existed had those persons been independent persons dealing at arm’s length.”

In other words, the tax consequences of cross border debt funding with connected persons will be calculated as though arm’s length interest rates would have been attached thereto. Therefore, even though the loan extended by the South African company above to the Mauritian company would have been interest free in terms of the financing agreement, the South African company will still be taxed in South Africa as though it has received interest on arm’s length terms. The same is true for the exaggerated rates that may have been charged had the South African company been the lender: SARS would adjust these rates downward to ensure that the South African company does not claim inflated interest costs.

Using interest free or low interest loans as a tool to increase tax efficiency, especially in a cross border context, much be approached with circumspection. It may very often amount to a blunt and clumsy tax planning tool at best.

[1] 58 of 1962

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE)