The Big Debate: Are trusts required by SA law to pay interest on any outstanding loans to SA lenders?
We have seen much confusion on this important topic and here we hope to provide some simple answers to help you navigate this question.
TAKEAWAY: A popular way of financing a trust from South Africa is to sell assets to the trust and leave the consideration outstanding as a loan, or to loan funds to the trust. Previously, no tax was levied on interest-free loans made to trusts, but this has changed in recent years. Many now insist on charging interest, but this is not the only answer.
Is a trust required to pay interest on a loan owed to a South African person?
No. There is no requirement that a loan owed to a South African lender should be interest bearing. While a non-interest bearing loan was previously not subject to tax, the interest not charged is now subject to donations tax in the hands of the lender. Therefore, the law does not require interest to be charged, but levies a donation tax on the interest foregone.
The deemed donation is the difference between the interest charged and the official rate of interest (a defined rate in South Africa). It is important to note that, as the official rate of interest is prescribed by law, it is irrelevant in what currency the loan is made.
For example, assuming a loan of £10 million, with zero interest, and an official rate of interest of 4.5%, the total donation for the year will be:
£10 000 000 x (4.5% – 0%) = £450 000
Donations tax is levied at 20% of the first R30m (about £1,5m) of donations per year, and 25% thereafter. Assuming that the lender made no other donations that year, the lender will pay donations tax of £90 000 for the year on the interest not charged.
What happens if interest is charged?
Where the South African lender charges interest on the loan, the interest payable by the trust, whether actually paid or not, is income accruing to the lender. This interest income is subject to income tax in South Africa.
Assuming a loan of £10m and an interest rate equal to the repo rate + 1% (the same as the official rate of interest), the interest income for the year would be as follows:
£10 000 000 x 4.5% = 450 000
Income tax in South Africa is charged on a sliding scale of 18% – 45%. Assuming that the lender is subject to the marginal tax rate of 45%, the lender will pay income tax of £202 500 on the loan interest for the year.
Is there one solution for all trusts?
No. Not charging interest and paying the donations tax can be a less expensive option for the lender. However, other anti-avoidance provisions may apply when not charging interest, which may complicate the tax return (and hike up the tax bill) of the lender. On the other side, the value of an interest-free loan is fixed so that the lender’s estate duty payable on the loan does not increase.
Charging interest may be a more expensive option per year, but is less complicated for the lender. However, assuming that the trust is not actually paying the interest and that the value of the loan is increasing every year, there may be a secondary cost in the estate duty for the lender which is often overlooked. After just ten years, that could translate to an additional cost of over £1m. If the trust assets are growing at a slower rate than the value of the loan, the trust should possibly be reconsidered.
Loans owing to a South African lender do not have to be interest bearing. Whether to charge interest or not, should be considered in light of the different circumstances of each trust. However, the costs involved – or the potential tax savings – with either option, does justify taking proper advice before making a decision.
Contact us should you wish to review the loan arrangements of the trusts you manage.