South African tax residents and loans to offshore trusts.

LOANS TO OFFSHORE TRUST IN FOREIGN CURRENCY

South African businesspeople and the more affluent in South Africa find it extremely difficult to place funds offshore in trusts, without generating nasty tax results.

Local South African trusts are at this point in time not permitted to hold offshore investments.

Offshore trusts are therefore the answer to estate and tax planning challenges. However, placing of investments in offshore trusts is not straightforward at all.

There are very few, if any, tax effective ways to place funds in offshore trusts.

This is true for what are known as ‘first generation trusts’. A first generation trust is one where the founder or donor, who establishes the trust, seeks to benefit therefrom, or seeks benefits for his immediate family, who would typically be the beneficiaries of the offshore trust.

The reason for the difficulty is that the SA tax repercussions for, basically all, the methods of placing funds in trusts offshore are fairly onerous.

Before discussing the difficulties that are associated with placing capital offshore in offshore trusts, I shall discuss why it is true that second generation tax planning is a different kettle of fish entirely.

In the second generation trust, that is, after the initial founder or donor has passed on, the trust will usually have capital of its own. This capital can be used to make the investments or purchases that would, in the first generation, have to be funded by a tax resident. It is the funding of such investments by SA tax residents that gives rise to tax – unfriendly results. Well, that is half of the story. Distributions from an offshore trust in the second generation might still be taxable in the hands of the recipient beneficiaries. At least Dad or Grandad isn’t also getting taxed though.

Basically, three methods of placing assets into a trust, onshore or offshore are:

1.   A sale – which, if the trust has no funds as in a first generation trust, gives rise to a loan. In a second generation trust, the trust own capital can be used to purchase the asset.

2.   A loan. The tax authority wants its cut. ‘Wants’ is too light of a word. ‘Demands’ is more accurate. For the trust to accrue capital it is obvious that the trust must gain an amount that is in excess of what the lender is paid, otherwise no capital transfer to trust would take place. The lender would simply be marking time and not making progress. The tax authority is very jealous of the trust gain. This is fundamentally what gives rise to the difficulty.

3.   Donations can be made to trust. These also give rise to large tax headaches. One is permitted to give all one’s money to a bookie or a casino but as soon as it is given away to family, the giving is taxed. Maybe the family should bet amongst each other. There is an idea. And Dad can be a lousy putz that loses all the time!

4.   The fourth method is a rather good one, but is not mentioned among the top three above because it is a passive method. It is the pour-over method of trust capitalisation. This entails the donor bequeathing assets or cash to the trust in their will. Yes, there are difficulties here also, as Estate Duty is payable as well as executor’s fees. The donor also does not get to see the effect of his good planning.

We examine the donation to trust method first.

Straight donations to trust would trigger donations taxes under Section 54 of the SA Income Tax Act (the income tax act). The donations tax rate is 20% upon all amounts that are donated in any tax year in excess of R 100 000. Donations above R 30 Million attract donations taxes at 25%.

One hundred thousand Rand a year is the basic donations tax exemption. This amount is very small, in hard currency terms. R 100 000 is roughly equivalent to $ 7 000.00.    

There are several methods of legally creating much greater value from the donations tax threshold than simply using cash as a donation. These may be discussed with clients on a more personal level.

The donations tax that is payable is not the end of the tax liability. The donation is a disposition. A gratuitous disposition, to be precise.

When distributions are made from the offshore trust, Section 25B comes into play. The result of the gratuitous disposition may be tax payable in the hands of the donor. The Section 25B repercussions can be discussed in more detail in a follow up article.

So, if a donation has unpleasant tax results, what about a loan?

Again the tax authorities have provided onerous rules. Interest will be deemed to run against the lender to the trust as soon as the trust and the lender are identified as connected persons.

Note that the definition of ‘connected person’ is extremely wide. There is also more than one Section in the Income Tax Act that deals with connected persons. Some of these Sections have their own definitions. Thus the issue of connected persons is a highly complex one.

The loans to the offshore trust thus must be made at interest, which interest is then taxed in the hands of the SA lender.

The addition of the interest might easily give rise to large tax liabilities because of the progressive nature of income tax. The more that is earned by a taxpayer the higher up the rate-scale the income is pegged. Thus, any additions result in higher rates of tax.  

So, one might then assume that it be easy to circumvent the progressive tax by way of a dividend declaration, if one is a major shareholder in a company and has the means to control dividend declarations.

No again. Dividend Withholding Taxes are rather high in South Africa at 20%. Especially high when compared to our neighbour, Botswana with a 7, 5% dividend tax rate and Swaziland or Eswatini with a Dividend Withholding tax rate of only 15%.

Now, the double taxation avoidance agreements of South Africa (DTAA) are often fairly similar in their provisions and these very often provide some relief for South African shareholders, so that dividend withholding taxes from abroad might be lower than that in SA due to the application of the relevant DTAA.

But don’t breathe that sign of relief too soon.

Be aware of the provisions of Section 10B and the controlled foreign company rules that are provided under Section 9D of the Income Tax Act. A deep dive into these rules will not be made here. These will be discussed in a follow up article.

Suffice it to say that It could be a South African shareholder’s nightmare to find that the net income of the controlled foreign company that he has an interest in has been imputed to them by the revenue authority under the provisions of Section 9D (2).

Placing those offshore company shares into trust might be a good idea, from a controlled foreign company point of view, but a recent addition to the revenue authority’s arsenal of provisions under Section 25B has taken away the potential for tax free dividends to be received by beneficiaries. More of this in the article dealing with Section 25B.

Worse than the controlled foreign company provisions is the risk that the offshore company might become fully taxable in South Africa. This can happen if the offshore company is managed and controlled in South Africa. In that event the company will be taxed as if it was a South African company, because, under the definition of ‘resident’ an offshore company that is managed and controlled in South Africa, is a South African tax resident.

Back to loans to the offshore trust, enter Section 7C. This anti avoidance Section became effective in 2017 and has been amended further since then to increase its effectiveness.

Section 7C stipulates that the difference in interest rate as charged by a lender to a connected trust and the official rate of interest, becomes, under the terms of the Section, a donation which attracts donations tax.

Section 7C provisions yield to those of Section 31 if the terms of the agreement between the lender and the connected trust are not such as would be gone into had those connected parties been independent parties dealing at arm’s length.

If, on the other hand, the agreement between the lender and the borrower, that is, the resident and the offshore trust contains arm’s length provisions, then Section 31 is not applicable and Section 7C is in that event, still ‘live’. Live and dangerous.

So, back to Section 7C. Again, if the terms are arm’s length terms, the resident is faced with having to pay the official rate of interest. If not, Section 31 and its provisions serve to punish him. The sanction provided for in Section 31, except for penalties and interest that might apply, is quite similar for natural persons to that provided for under Section 7C.

The full extent of the punishment meted out by the revenue authority is looked at further below. For now, seemingly, both ways you lose!

Let’s examine the Income Tax Act definition of ‘Official Rate of Interest’ at Section 1.

The definition as it is, has been recently amended. (The time of writing is May 2021). The amended definition has a commencement date of 17 January 2019.

In terms of the definition, if a debt is denominated in South African currency, the official rate of interest is the South African repurchase rate (repo rate) plus 100 basis points. If the debt is denominated in foreign currency, the official rate of interest is the equivalent of the South African repurchase rate in that currency plus 100 basis points.

As at the time of writing, the equivalent to the South African repurchase rate in many foreign jurisdictions is very low. Thus, the loan denominated in such currency with the addition of the 100 basis points doesn’t seem like a heavy burden to bear, tax wise in comparison to the South African repurchase rate plus 100 basis points.

It is assumed that a normal bank rate of interest should be closely similar to the equivalent of the SA repo rate plus 100 basis points.

In the event that the usual interest rate available is lower than this ‘official rate’ the situation might come about that for purposes of Section 31 the lower rate would equate to an arm’s length rate because it is the rate that is accepted by regular investors in the jurisdiction that is home to the foreign currency.

However, because the rate is thus lower than the Official rate of interest the provisions of Section 7C again create a dangerous situation for the lender. The difference between the official rate of interest, being, as discussed above, the SA repo rate equivalent in the jurisdiction of the relevant currency, at whatever low rate that is, plus 100 basis points, or one percent, and the lower rate charged by the lender will give rise to a donation in terms of the provisions of the Section. After the threshold of R 100 000 per annum or roughly $ 7 000, 00 has been cleared, the rest of the difference would attract donations tax under the provisions of Section 7C and Section 54 of the Income Tax Act, at 20%.

It is submitted that the above provision or definition, whilst it lasts, is the next best thing to an actual tax break.

Very good ideas that were validly put forward as solutions in the past, have been hit by tax legislation that has become increasingly effective. Some of these ideas and why they might no longer be effective will be discussed in subsequent articles.

 For more on the topic of offshore financial planning, please check out the newly released book by Roper, Kruger and O’Halloran, ‘The Practical Guide to Offshore Investments’, 7th Edition. Sales are aptly handled by our Nicky Dewar (+27608712234).

 Peter H O’Halloran