Brummeria: Much Ado About Nothing …
30 August 2011
Posted by: Author: Steven Jones
Brummeria: Much Ado About Nothing …
SARS Binding General Ruling 8 further confirms that the case concerns interest-free loans ONLY in the case of retirement developments
It’s incredible how two months of self-imposed exile due to study commitments can get a person out of the habit and discipline of writing, and as I sat down at my computer to write this column the worst bout of writer’s block I have ever experienced in nearly ten years of writing this column descended upon me with the same vengeance as a crack SARS audit team.
Getting back into the saddle after such an extended period involves a bit of research to ensure that what one is writing is not a repeat of what others have been writing about in the interim, yet at the same time covering something that is still current and relevant.The danger in this game is that people quickly forget about you and move on.This tendency of people to forge ahead without even so much of a glance in the rear-view mirror is the same reason why we not only have fender-benders on the roads, but also forget the lessons of history.
About three years ago a Supreme Court case ,Commissioner: SARS v Brummeria Renaissance (Pty) Ltd (2007) SCA99, hit the headlines.The facts of that case involved a resident in a retirement development granting an upfront interest-free loan to the developer, in exchange for the requirement to pay ongoing monthly rentals.This was seen as a good arrangement for both parties:the retiree was freed of any future obligation to pay rent, while the developer obtained an upfront injection of funds.
However, to the degree to which such loans represented an amount accruing to the developer during the year of assessment, the court found that such interest-free loans gave rise to a taxable benefit in the handsof the developer.Suddenly everyone who was a party to an interest-free loan, in whatever structure and for whatever purpose such loan existed, was running around like a headless chicken. Many commentators at the time joined the frenzy, calling the court decision "the end of interest-free loans as we know it”and adding that taxpayers who used interest-free loans for legitimate purposes, such as the funding of a business, were on shaky grounds and would hence forth face some major tax problems.
In stark contrast to the panic that prevailed, I recall being quite adamant at the time that this decision would not have any impact on interest-free loans used for funding businesses, nor would it affect those interest-free loans used within group structures.In sticking my neck out by stating that the original decision applied specifically to the facts of this case,and dealt with the taxation of a quid pro quo (i.e. the granting of the interest-free loan in exchange for future tenancy rent-free), I stood virtually alone.
However, despite being vilified by many, we were vindicated when SARS brought out a draft Interpretation Note (no. 58) which stated that the Brummeria case is clearly not authority for the general conclusion that the value of the right to the use of each and every interest-free loan should be included in the gross income of the borrower”.It clearly indicated that legitimate interest-free loans, where the lender is funding their business on this basis, would not have any adverse tax consequences.The court decision also would not apply to interest-free loans that arise within a group structure (e.g. where funds are provided from a central source to group companies).
However, there was evidently some lingering doubt in this regard,prompting SARS to issue a Binding General Ruling (BGR 8) in April this year, aimed at providing further clarity around the application of the principles established by Brummeria.
The first thing that becomes glaringly obvious when one reads the Binding General Ruling is that nowhere is the issue of interest-free loans other than in cases where life rights are granted in a retirement village even contemplated.It is abundantly clear that SARS is confining its application of the Brummeria principles to retirement developments, and has not demonstrated any desire or intention to widen the scope thereof to any other form of interest-free loan.
Taxpayers using such interest-free loans for legitimate business purposes can therefore relax as far as Brummeria is concerned.The issue at hand in the Brummeria case, upon which SARS has trained its magnifying glass, is around what is effectively a rental.In a normal property rental transaction, the owner of a property grants the right of use of such property to a tenant, for which the owner is compensated by means of rental payments. Such rental represents gross income in the hands of the owner, and is accordingly subject to income tax.
This owner will have probably obtained loan financing from a bank in order to purchase the rental property, with interest being payable on such loan.And while such interest is claimable as a tax deduction against the rental income,most property investors aim to reach a point where the loan is settled and interest is no longer payable.After all, where’s the sense in spending R1 in interest in order to save 28 cents in tax?
Suppose now that a prospective tenant has a lump sum of cash available, upon which they are earning interest.This interest, save for the first R22 800 that is exempt,is subject to tax.This prospective tenant may have a variety of valid reasons for not wishing to purchase their own property.However, rent paid on a residential property is not tax-deductible, being a private expense of which a deduction is prohibited under Section 23(1)(a)and (b) of the Income Tax Act.
If the prospective tenant were to enter into an agreement with the owner that an interest-free loan would be provided by the tenant to the owner, which would be used to purchase the property.At the end of the lease, the tenant receives their capital sum back.The tenant saves the tax paid on the interest that was being received on the invested funds and does not have to worry about monthly cash outflows in the form of rent, while the owner obtains a cost-free source of funding while at the same time not being liable for tax on rental income.
Depending on how the number-crunching exercise pans out, it sounds like a win-win situation—except for SARS.Now one might argue that such a scenario is an improbable one.After all, who has a lump sum available to offset future rentals?Retirees – that’s who. And while such a loan arrangement would be extremely unusual for people of working age to even contemplate,retirees seeking to "buy” into a retirement village enter into these kinds of arrangements on a daily basis.
There are a number of advantages to providing loan finance on this basis.The retiree saves tax on the interest income now foregone, but that is seldom the main motivation.The benefit of such an arrangement is that should the retiree decide to relocate (say,from inland to the coast), or upon the retiree’s death, there are no complications that come with trying to sell a property – a fresh source of financing is simply provided by the next person on the waiting list(places in retirement villages are in massive demand), from which the original life-rights holder (or their estate) is repaid.
SARS’ take on such an arrangement, as confirmed by the court in the Brummeria case, is actually quite simple.In a normal property rental transaction, the principle of huurgaat voor koopapplies.This common law principle gives the rights of the lessee precedence over that of the owner. In the event that the owner of a property subject to a valid rental lease agreement decides to sell that property, the new owner is legally obliged to honour the terms of such lease.
In effect, therefore, the lease confers upon the tenant the right of use of the property, which means that the owner (including the subsequent owner if the property is sold) is left only with the bare dominium while the lease is in force. This restriction on the owner’s right to enjoy free and unencumbered use of their property is compensated for through the payment of rent which, as already stated, forms part of the owner’s gross income and is taxable. The rent therefore represents the value placed upon the use of the property,as determined by market forces and agreed to by the owner and the tenant.
The principle established by Brummeria, therefore, is that the quid pro quo given by the owner to the holder of life rights, being the use of the unit in the retirement village, also has a value.This value, as determined, is to be taken into account when valuing the owner’s right to make use of the interest-free loan provided by the life-right holder.
BGR 8 provides a formula for valuing such right of use of the interest-free loan, with the calculation based on factors such as the amount of the interest-free loan itself, the present value of R1 over the life expectancy of the life-right holder (based on the understanding that such occupation is not for a fixed period, but rather the remainder of the life-right holder’s life), and the weighted average bank prime overdraft rate during the year of assessment concerned.
The amount as calculated by the product of these three factors is then reduced by 93.1% to determine the value to be included in the owner’s taxable income.This value is taxed in the year in which the interest-free loan is granted by the life-rights holder, and is a once-off inclusion.
No further tax liability arises from the interest-free loan itself;however, if the agreement between the life-right holder and the owner provides that only a portion of the loan is refundable upon death, then the non-refundable portion must also be included in the owner’s taxable income in the year in which the loan is granted.In this case,only the refundable portion of the loan must be taken into account when calculating the value of the benefit conferred by the interest-free loan.
The date of accrual for the granting of an interest-free loan is normally the date upon which the loan agreement is signed.However, if the agreement is subject to conditions (e.g. that the amount will only be paid over to the owner when the life-right holder’s pension fund lump sum has been paid out, or the proceeds of a liquidated investment have been received), then the date of accrual will be the date upon which such conditions have been fulfilled.
This Binding General Ruling provides taxpayers involved with retirement village schemes with much-need clarity around the whole interest-free loan issue, wile at the same time all other taxpayers making use of interest-free loan scan now breathe a collective sigh of relief once and for all.
Source: By Steven Jones(Tax breaks)