ey-tax-alerts

Tax Alert – Proposed ‘third adjustment’ on low or interest free cross border loans looming

Press Contact

Learn more about the amendment on low or interest-free cross-border loans to curb tax base erosion. 

  • The 2024 Draft Taxation Laws Amendment Bill proposes changes to section 7C(5)(e) to address anomalies between anti-avoidance measures in sections 7C and 31.
  • The amendment introduces a "third adjustment" for low or interest-free cross-border loans, potentially increasing annual donations tax liability.
  • Taxpayers should review cross-border loan transactions to understand the impact and explore mitigation options.

On 1 August 2024 National Treasury and the South African Revenue Service (“SARS”) published the 2024 Draft Taxation Laws Amendment Bill (“Draft TLAB”) for public comment.

The Draft TLAB proposes an amendment to section 7C(5)(e) which seeks to limit the exclusion of an “affected transaction” as defined under section 31(1) of the Income Tax Act No. 58 of 1962 (“ITA”) from the ambit of section 7C.

Section 7C contains anti-avoidance measures which are aimed at curbing the tax-free transfer of wealth to trusts and certain companies by way of low or interest-free loans, advances or credit arrangements. Conversely, the transfer pricing rules contained in section 31 are aimed at preventing a reduction or erosion of the South African tax base, which is achieved by applying the arm’s length principle to affected transactions.

Broadly, in terms of section 7C, interest incurred by trusts or certain companies at a rate lower than the official rate, in respect of a loan, credit or advance, is treated as an ongoing, annual donation made by a natural person, on the last day of the year of assessment of that trust or company. The deemed donation is equal to the difference between the interest at the official interest rate (as defined) and the interest at the rate charged.

Similarly, section 31, provides, amongst others, that a cross-border loan arrangement, between a resident and non-resident person would be regarded as an “affected transaction” if the parties are connected persons and if it contains a term or condition that is not reflective of an arms-length transaction between independent persons, including low interest rates.

Where the cross-border loan constitutes an affected transaction as defined, the person who advanced the loan would be required to include the difference between the interest which would have been payable had an arm’s length interest rate been applied and the interest charged (if any), in their taxable income, which would be subject to tax at the relevant marginal rate (this is referred to as the primary adjustment in terms of section 31(2)). In addition, where the taxpayer is a natural person, a secondary adjustment would also be required under section 31(3) leading to an annual donations’ tax liability on the same amount. 

Currently, to avoid overlaps between these two sections, section 7C(5)(e) specifically excludes low-or interest-free loans which constitute affected transactions defined in and subject to section 31(1).

Reasons for the Amendment

National Treasury, notes that the reason for the change is to address an apparent anomaly which currently exists in the interaction between the anti-avoidance measures of section 7C and section 31, respectively. Specifically, the difference in the value of the deemed annual donation arising under the two sections.

As a result of the lower interest rate which may be applied under section 31, National Treasury is of the view that this gives rise to structuring opportunities which could lead to erosion of the South African tax base.

The “third adjustment” introduced by the amendment

The Draft TLAB proposes that section 7C(5)(e) be amended to read “(e) that loan, advance or credit constitutes an affected transaction as defined in section 31(1) to the extent that an adjustment made in terms of section 31(2)”.

In other words, to the extent the amount of interest at an arm’s-length rate for purposes of the primary adjustment under section 31(2) is lower than interest payable at the official rate of interest, the shortfall will not be excluded from section 7C(2) and would give rise to an additional annual donations tax liability.

Section 31(2) of the Act provides that where an affected transaction results in a tax benefit, the taxable income of the person who derives the tax benefit must be determined as if that transaction had been entered into on the terms and conditions that would have existed between independent persons dealing at arm’s length. 

For example, let’s assume a person advances an interest-free loan to the value of R10,000,000 to a non-resident connected trust and the arm’s length interest rate is equal to 5% (as the loan potentially constitutes an affected transaction) while the official rate of interest at the time is 8% (South African denominated loan).

The interest payable at an arm’s length rate under section 31 would therefore be equal to R500,000, however, had the official rate of interest been applied, the interest payable would have been R800,000.

The proposed amendment suggests that the R300,000 differential should still be taxed under section 7C(2), and should not excluded under section 7C(5)(e), notwithstanding the primary and secondary adjustments already made in terms of sections 31(2) and (3) respectively.

Section 31(3) of the Act provides that to the extent that section 31(2) of the Act causes a difference in any amount applied in the calculation of a taxpayer’s taxable income, that difference is subject to a secondary adjustment. This secondary adjustment takes the form of a deemed donation, where the taxpayer is a person other than a company.

To illustrate the tax implications, please refer to the below tables:

ey-tax-alert-image1

Table 2: Effect of the proposed amendment:

ey-tax-alert-image2

Impact and Takeaway

Under current legislation (Table 1), it is clear that the tax liability under section 31 is already higher than the effect of section 7C and this is likely the reason why section 7C(5)(e) was included in its current form in the Act.

However, now the proposed amendment to section 7C(5)(e), as illustrated above in Table 2, effectively introduces a third adjustment to low or interest free cross border loans between connected persons where section 7C applies. In these circumstances, taxpayers will now not only be required to include the deemed interest in their taxable income and pay annual donations tax on the deemed donation, but will possibly also pay a secondary top-up annual donations tax liability under section 7C(2) (refer to the R60,000 in Table 2 above).

It is therefore suggested that taxpayers who may potentially be affected by the proposed amendment carefully review their cross-border loan transactions to determine the potential impact of the proposed amendment and to analyse options available.

How EY can Assist

Whilst the proposed amendment is not yet effective and will only apply in respect of years of assessment commencing on or after 1 January 2025, our EY Private Tax Team can assist in critically reviewing existing cross-border loan arrangements and advise whether the effects could be legally mitigated.

Below are the contact details of the Private Tax consulting team, should you have any queries, require assistance, or need more information on the support we can provide.

Emile du Toit | Partner | Tax  
emile.dutoit@za.ey.com

Jana de Clerk | Manager |Tax
Jana.de.Clerk@za.ey.com

Our latest thinking

Investor lens review: Using ESG as a proxy of readiness for exit.

Investor lens review: Using ESG as a proxy of readiness for exit.

How the role of financial controller is evolving

Discover how financial controllers are now pivotal in shaping business strategies with a forward-thinking approach integrating tech and ESG. Learn more.

How to improve your tax data value chain

Unlocking tax data's potential – harnessing AI and refining data management for value creation. Learn more.

How do you drive transfer pricing certainty in uncertain times?

Businesses are prioritizing transfer pricing certainty in an era of global minimum taxes. That starts with getting the data right. Learn more.

Why ICAP participation could help with BEPS 2.0 Pillar Two compliance

A voluntary tax-risk assessment project could become an important tool for Pillar Two reporting. Learn more.

Three steps to help tax teams prepare for 2023 year-end

Tax teams must review the latest legislation, analyze recent changes within their business, and proactively meet stakeholder demands. Learn more.