What to do about loans to trusts

By David Thomson, Sanlam legal adviser

loans to trustsIf you have a trust and have transferred some assets to it without being paid, you may soon have to start charging the trust interest, or be liable for donations tax.

This change to the Income Tax Act came into effect on 1 March 2017 and will present a unique problem. Most importantly it will apply to loans made to trusts even before this date.

The context is that many people have sold some of their assets to a trust, on loan account. This means an asset is sitting in a trust and is now the property of the trust, but the person who sold it has not been paid for the sale.

Typically, people sold their assets or equity to a trust at a market-related price, and trustees then registered the assets in the name of the trust so that they can become trust property. This way the person transferring the assets would not liable for donations tax (20% on the value donated above R100 000 p.a.). This type of arrangement meant that the trust had acquired a liability to you, the seller – and that this loan was repayable on your death and/or demand.

Before the change to the Act, people who transferred their assets to trusts using this ‘loan’ arrangement (lenders) generally did not charge any interest on the loan. There were a number of reasons for this, for instance the trust would not generate any income from the asset it owns and therefore could not pay interest; or the person who lent the asset to the trust had no wish to pay income tax on interest and did not require such income; or the lender may have been precluded from charging interest due to religious reasons.

Typically, the scenario would have allowed you to ‘write off’ the loan and avoid donations tax through the annual tax-exemption on trust assets of up to R100 000. The growth in the value of the asset took place in the hands of the trust and you, as the lender, therefore reduced your personal estate, thereby minimising the risk of insolvency and exposure to estate duty, among other benefits.

Interest must be charged

But now SARS has decided that although there is nothing illegitimate about the transfer of wealth to a trust, the practice of not charging interest on such loans is akin to a donation. SARS’ reasoning is that if the loan had been made in the ordinary course of business by parties unconnected to each other, market-related interest would have been charged.

So as of 1 March, as a lender you must charge interest at a rate no less than the annual repo rate plus 1% p.a. This currently equates to 8%. Failure to do so can result in a taxable donation equal to the amount of interest forgone or the difference between rate being charged and the ‘official rate’.

SARS has also indicated that 8% will not always be the acceptable rate and that the lender must charge the rate the borrower would have had to pay if the money was borrowed from a third party, like banks, as opposed to a “connected person” as defined by law.

In general this amendment will apply to ‘discretionary’ trusts but not apply to so-called ‘vested trusts’ and ‘special trusts’. However the devil is in the detail, as with most tax matters. There are a number of other exclusions and conditions that require closer analysis.

Trustees and people who have made loans to trusts should thus consult their financial planners and tax advisers to put the appropriate resolutions in place.