The unintended consequences of the Trust Clawback Provision – Section 7C

Section 7C of the Income Tax Act has been in media limelight since its initial publication in the Taxation Laws Amendment Bill last year.

The final version of the provision as promulgated on 19 January 2017 in the Taxation Laws Amendment (Act No 15 of 2016) is less draconian that the first published version of the section.

The net economic effect of the section is, with effect from 1 March 2017, to subject interest free loans from a natural person or at the instance of a natural person to SA discretionary trusts in excess of R1,25 million to an annual donations tax of 1.6% of the loan, payable by the lender within 31 days of the end of the trust’s tax year.

But the application of Section 7C has a number of unintended consequences.

The aim and purpose of section 7C was to clawback gains made on any growth assets which have been transferred to discretionary trusts often as part of estate duty planning.  The estate plan, through the disposal of growth assets to the trust for an interest free loan, resulted in future growth of the asset accruing to the trust instead of to the natural person thereby “escaping” the 20% estate duty levy application to the net assets owned by a natural person upon his/her death.

In practice the application of section 7C has a number of unintended consequences compared to similar estate duty taxation provisions in other parts of the world. A good example of this is the United Kingdom’s 10 year inheritance tax charge which is based on the market value of the non-business assets held in a discretionary trust every 10 years during the existence of the trust. 

For example, let’s establish a hypothetical discretionary trust entitled “The Joy Luck” discretionary trust.  Let’s also assume the Joy Luck discretionary trust was established with an interest free loan from a natural person - Mr Luck - of R51.25 million, which the trust used to acquire a residential house for Mr Luck.  The home cost R6,25 million.  The trust further erected a block of flats costing R45 million.

Mr Luck is a beneficiary together with his spouse and children of the Joy Luck discretionary trust.

In addition to the above, the trust owned a company to which Mr Luck lent R40 million, on an interest-free basis to buy a share portfolio. The share portfolio more than doubled in value over five years and was worth R85 million in the hands of the company.

However, the building of the block of flats had significant delays and cost overruns and although R45 million was spent on the flats they were only worth R35 million upon completion.

In applying the rules of section 7C, the R45 million loan will attract a deemed interest of R3,6 million (R45 million x 8%) which will be taxable at a rate of 20% donation’s tax, resulting in R720,000 donations tax which would need to be paid by Mr Luck (ignoring any exemptions).

The loan to acquire the primary residence (R6,25 million) is not subject to section 7C by virtue of the exclusion contained in section 7C(5)(d).  In addition, the interest free loan granted by Mr Luck to the company should also fall outside section 7C.

There are a variety of options available to minimise the impact of section 7C regarding the R45 million interest free loan by Mr Luck to the trust:

  1. Mr Luck can charge interest of at least 8% p.a. on the R45 million loan. This would result in interest income accruing to Mr Luck and deductible interest being incurred by the trust;
  2. The trustees could sell or transfer the block of flats back to Mr Luck at their market value of R35 million but this would still leave a loan outstanding relating to the specific block of flats of R10 million. If the trustees sold the flats to Mr Luck in full settlement of the loan, Mr Luck is losing R10 million and the trust is benefiting by settling a liability for less than its value. On the basis that Mr Luck is a connected person in relation to the trust, the disposal of the flats will be deemed to take place at market value of R35 million. The settlement of Mr Luck’s loan may be regarded as a reduction amount (R10 million) in terms of paragraph 12A of the Eighth Schedule in the trust and would reduce the capital loss arising on the sale of the flats by the R10 million. Mr Luck’s agreement to settle his loan of R45 million for an asset worth R35 million may be regarded as a donation by Mr Luck and subject to donation tax at 20%. To the extent that such a loss arises from a donation by Mr Luck, paragraph 12A of the Eighth Schedule should not apply to such a shortfall, but donations tax would apply in Mr Luck hands.
  3. The company could realise a portion of the underlying share portfolio and declare a dividend to the trust to enable the trust to settle the loan owing to Mr Luck. Such an option would trigger capital gains for the company upon realising some of the shares and this would then result in a further Dividends tax liability on the dividend paid to the trust. This could be a very costly option.

Not only could overcoming section 7C result in a costly exercise, practically speaking section 7C has a distortive economic effect where the asset held by the trust is not growing at a rate at least equal to the SARS official rate of interest.

It makes economic sense to leave assets in a trust which have been funded by loan accounts from natural persons and also which are growing on an after-tax basis of at least 1.6% (8% x 20%). 

Where assets are loss-making or have declined in value, then an economic and cash flow distortion arises as tax is being levied based on the assumption that the assets have grown or are growing in value.  In addition, part of this growth portion may help to settle the donations tax levied in terms of section 7C on the deemed interest on the loans to the trust.

Trying to mitigate or alleviate this situation may lead to tax liabilities being incurred. This distortion could potentially be reduced if SARS rather levied a tax on the market value of the assets held in the trust, similarly to other jurisdictions.

Sadly, Mr Luck is unlikely to find much joy in having to pay R720 000 of donations tax each year, unless the assets held by the trust which were funded by his loan are growing at least 8% on an after-tax basis.

Do you have questions regarding the implementation of Section 7C? Do you need assistance to ensure the legislation is working for you? For further information or for assistance in understanding the impact of these requirements, please contact our tax specialists.