Tax Perils of Low-interest and Interest-free Loans
10 October 2013
Posted by: Author: Professor Jackie Arendse
Author: Professor Jackie Arendse (University of the Witwatersrand)
Loans between companies and shareholders are a fairly common feature on the corporate landscape. On the one hand these loans may form part of the financing structure of the company but the opposite could apply where a company advances a loan to a shareholder or perhaps another company in which the shareholder has an interest. The latter type of loan, that is, a loan advanced by a company to a shareholder (often referred to as ‘debit loan accounts’), could give rise to a dividends tax or – depending when the loan was advanced – even a STC liability. These tax implications are discussed in this article.
Dividend’s tax is levied at the rate of 15% on dividends paid on or after 1 April 2012 unless a specific exemption or lower-rate concession applies. Together with cash dividends and dividends in specie, low-interest loans are also brought into the dividends tax net through a deemed dividend provision in s 64E(4) of the Income Tax Act no. 58 of 1962. Under this deemed dividend rule, a company that has advanced a low-interest loan in certain circumstances is deemed to have paid a dividend, giving rise to a liability for dividends tax.
The deemed dividend provision applies where a debt arises ‘by virtue of a share held in the company’ and where the following three conditions are present:
- The debtor is a person other than a company;
- The debtor is a resident; and
- The debtor is either a connected person to the company or a connected person to that person.
If all of these factors exist, the company is deemed to have paid a dividend in specie.
For example, an interest-free loan advanced to the son of a 50% shareholder of XYZ (Pty) Ltd by virtue of the father’s share in the company would fall within the ambit of the deemed dividend provision if the son is a resident. On the other hand, an interest-free loan advanced by XYZ (Pty) Ltd to another resident company in which the father owns, say, 100% of the shares, would not give rise to a deemed dividend under the s 64E(4) rule as the debtor in this case is a company.
Where the deemed dividend rule is triggered, the following consequences arise:
- The amount of the dividend is determined by applying an interest rate to the debit balance on the loan account during the year. The interest rate that is used for this purpose is the difference between the ‘market-related interest’ (de fined as the official interest rate that applies for the purposes of the Seventh Schedule - currently 6%) and the actual interest rate charged on the loan. It is noteworthy that only the interest effectively foregone, not the capital amount of the loan, is a deemed dividend. If interest is charged on the loan at an adequate interest rate, the amount of the deemed dividend is Nil.
- The dividend is deemed to be paid by the company on the last day of the year of assessment and the company must therefore pay the resulting dividends tax, calculated at 15% on the amount of the deemed dividend, by the end of the month following the year-end. As the dividend is deemed to be a dividend in specie, the company (as opposed to the shareholder) is liable for the dividends tax under s 64EA(b).
For example, assume ABC CC advanced an interest-free loan of R100 000 to its member, Sally Shabangu, on 1 April 2012. The loan balance has remained unchanged. ABC CC’s financial year ends on the last day of February each year.
Result: ABC CC is deemed to have paid a dividend of R5 500 (R100 000 x 6% x 11/12) on 28 February 2013. The dividends tax payable is R850 (R5 500 x 15%) and ABC CC had to pay this amount to SARS by no later than 29 March 2013 (the last business day of the month following the year-end). Failure to lodge the dividends tax return to SARS and pay the dividends tax by this due date would give rise to penalties and interest.
The rules described above apply to low-interest loans going forward (effective from 1 April 2012); however we need to also keep in mind the rules that applied under the Secondary Tax on Companies (STC) provisions. Companies are still receiving assessments for STC in respect of low-interest loans - and often for quite substantial amounts, with an extra punch in the form of accumulated interest on the outstanding amount of STC. The STC provisions giving rise to these assessments will be explained in the following paragraphs.
Dividends declared by a company to its shareholders up until 31 March 2012 were subject to STC at the rate of 10%. The STC rules contained a list of various types of transactions that gave rise to deemed dividends, with a consequent liability for STC. Section 64C(2) of the Income Tax Act lists eight different circumstances that will give rise to a deemed dividend and s 64C(4) then lists certain exemptions from the deemed dividend rule. As far as low-interest loans are concerned, s 64C(2)(g) provides that an amount is deemed to be a dividend declared by a company to a shareholder where a loan or advance is granted and made available to that shareholder or connected person in relation to that shareholder. Two exemption provisions are relevant:
- The deemed dividend rule will not apply if interest has been charged on the loan at a rate at least equal to the ‘official rate of interest’ for fringe benefits tax purposes (s 64C(4)(d)) (this rate is currently 6% per annum).
- The deemed dividend rule will not apply if the loan is repaid or otherwise extinguished by the end of the following year of assessment (i.e. the year following the year in which the loan was advanced) (s 64C(4)(f)).
Where the deemed dividend provision applies, the dividend is deemed to have been declared by the company on the date that the loan was made available (s 64C(6)). The dividend cycle therefore ended on this date and the STC became due and payable by the end of the following month. Interest will be charged by SARS on any STC liability that remains unpaid after that due date.
For example, assume FGH (Pty) Ltd advanced an interest-free loan of R500 000 to its sole shareholder, Joe Bloggs, on 1 May 2010. FGH (Pty) Ltd’s financial year ends on the last day of February each year. The loan has not yet been repaid.
Result: The financial statements of FGH (Pty) Ltd for the years of assessment ended 28 February 2011 and 29 February 2012 will reflect a loan to Joe Bloggs of R500 000. The loan does not carry any interest, was advanced during the year ended 28 February 2011 and has not been repaid by the end of the following year, i.e. by 29 February 2012. The full amount of the loan is therefore a deemed dividend under s 64C(2)(g) and STC is payable on the loan at the rate of 10%. FGH (Pty) Ltd therefore has a STC liability of R50 000 (R500 000 x 10%).
Because the STC deemed dividend provision applies equally where a loan has been advanced to shareholder or connected person in relation to that shareholder, the result would be the same if FGH (Pty) Ltd had advanced the loan, not to Joe Bloggs but to another private company in which Joe Bloggs holds 20% or more of the equity shares (making the other company a connected person in relation to that shareholder in terms of the definition of ‘connected person’ in s1).
In the above example, in either situation (whether the loan was advanced to the shareholder or to a connected person in relation to the shareholder) the company is deemed to have declared a dividend of R500 000 in May 2010. The resulting STC should have been paid by 30 June 2010. Assuming SARS raises an assessment for the STC in April 2013, interest will also be payable on the R50 000, calculated at the prevailing interest rate (currently 8.5%) from 1 July 2010 until 31 March 2013. This would result in an interest charge of more than R12 000!
It is clear that both old and new loans have the potential to trigger significant tax liabilities. Directors and advisors need to pay close attention to loans between companies, shareholders and related companies to identify any possible tax risks.
This article was first published in TaxTalk magazine (September/October Edition 2013)