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: