The interaction between Section 7C and the transfer pricing rules: Tightening the noose on perceived avoidance by trusts

By Dr Hendri Herbst and Jané Visagie

In pursuance of the objective to further clamp down on the use of trusts for tax avoidance, section 7C of the Income Tax Act, No. 58 of 1962 (“ITA”) was originally introduced to curb the tax-free transfer of wealth from one generation to the next by using interest-free or low-interest loans to trusts. Since enactment, the section has been repeatedly amended in order to expand the ambit and to close structuring opportunities as they arise. Continuing this trend, National Treasury has yet again proposed certain amendments to section 7C in the 2024 Draft Taxation Laws Amendment Bill (“TLAB”), this time focusing on the exclusion available in the circumstances that the transfer pricing provisions apply. In this article we will briefly discuss the proposed changes to the provision.

Section 7C targets the situation where a person makes an interest-free or low-interest loan, advance or credit arrangement to a trust. The provision has a wide ambit and also applies to cross-border loan transactions. The section deems the foregone interest on the loan to be a continual donation, with the result that the lender will be liable for donations tax on the difference between the interest rate charged on the loan and the official rate of interest.

The “official rate of interest” is defined as:

• In the case of a Rand denominated debt, the South African repo rate plus 100 basis points.
• In the case of a foreign currency denominated debt, a rate of interest that is the equivalent of the South African repo rate applicable in that currency plus 100 basis points.

The official rate of interest is currently 9.25% for Rand denominated debts.

Section 7C(5) contains a list of scenarios where section 7C does not apply. Specifically, paragraph (e) provides that section 7C shall not apply in circumstances where the transfer pricing provisions in section 31 of the ITA apply to a cross-border loan or advance made by a South African resident to a non-resident. This includes cases where a South African resident, as a beneficiary of a foreign trust, loans money to that trust. Due to the wording used in section 7C(5)(e), there has been an ongoing debate about how sections 7C and 31 interact, with the majority view being that section 7C would not at all apply to a loan where the provisions of section 31 apply.

Per the 2024 budget announcement, the issue in question is that the section 7C(5)(e) exclusion does not effectively address the interaction between the trust anti-avoidance measures and the transfer pricing rules in circumstances where the arm’s length interest rate is less than the official rate on these cross-border loan arrangements. This can create a structuring opportunity that if left without legislative intervention, could lead to the erosion of the tax base.

We illustrate the amendment by way of an example:

A South African resident natural person (lender) makes a non-arm’s length interest free cross-border loan to a connected non-resident trust of R10 million. A market-related interest rate of 5% per annum is determined for this loan by way of a transfer pricing study. In terms of section 31, SARS may make a primary transfer pricing adjustment of R500,000 (R10 million x 5%) and a secondary transfer pricing adjustment of R500,000 (deemed donation by the lender).

Absent the exclusion in section 7C(5)(e), the lender could further be deemed to have made a donation of R925,000 (R10 million x 9.25%) in terms of section 7C (which may potentially be reduced by the R100,000 annual exclusion), thus resulting in double taxation.

Given the current wording of section 7C(5)(e), it is unclear whether the exclusion should be interpreted in such a manner that the provisions of section 7C will not at all apply to the loan in our example.

To clarify the policy intent, the 2024 draft TLAB proposes that a legislative amendment be made to ensure that the exemption of the trust anti-avoidance measure in section 7C in respect of a loan that is subject to transfer pricing will only extend to the interest which is subject to the transfer pricing adjustment (5% in the example above). The balance of interest up to the official rate of interest (4.25% in the example above) will be subject to section 7C and will be deemed to be a donation made by the lender, and therefore subjected to donations tax.

If enacted, the proposed amendment will come into operation on 1 January 2025 and will apply in respect of years of assessment commencing on or after that date.

This proposed amendment in the 2024 draft TLAB is a clear indication that the SARS and National Treasury are intent on closing any loopholes in the tax legislation that may allow taxpayers to avoid or reduce their tax liabilities through the use of trusts. Taxpayers who have entered into or plan to enter into any loans, advances or credits with trusts, especially cross-border ones, should seek proper advice to ensure that their structures are not only tax efficient but also fully compliant with the relevant tax provisions. Failure to do so may result in significant tax consequences and penalties in the future.