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Evaluating the use of interest-free loan accounts in trusts and their taxation

Monday, 10 November 2014   (0 Comments)
Posted by: Author: Franscois van Gijsen
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Author: Franscois van Gijsen (Finlac Risk and Legal Management) 

Franscois van Gijsen distinguishes between loans and vested trust capital and discusses the taxation of trusts and interest-free loan accounts. 

Judging by the number of enquiries I have received, the tax treatment of interest-free loan accounts in trusts has many professionals concerned at the moment. And, while it is obviously important for the practitioner to familiarise himself with the rules pertaining to the taxation of such interest-free loan accounts, in order to correctly apply them, the practitioner also needs a thorough understanding of some basic principles of trust and contract law. Unfortunately many practitioners seem unaware of these principles. This often results in flawed accounting records and an increased risk of personal liability for the trustees which could result in an overestimated tax liability. In this article I will endeavour to explain these basic principles and their potential to cause an inflated tax liability. 

Types of trusts: 

I usually encounter these concerns regarding the taxation of "loan accounts”, interest-free or otherwise, in respect of discretionary inter vivos trusts where these trusts are used as a tool in a client’s estate planning.

A definition and brief analysis of what a trust is and a way for a tax- and/or accounting practitioner to distinguish between different types of trusts seems like a logical place to start the discussion. The Trust Property Control Act defines a trust as follows:

"… the arrangement through which the ownership in property of one person is by virtue of a trust instrument made over or bequeathed—

(a) to … the trustee … to be administered or disposed of according to the provisions of the trust instrument for the benefit of the person or class of persons designated in the trust instrumentor for the achievement of the object stated in the trust instrument; or

(b) to the beneficiaries designated in the trust instrument, which property is placed under the control of…the trustee, to be administered or disposed of according to the provisions of the trust instrument for the benefit of the person or class of persons designated in the trust instrument or for the achievement of the object stated in the trust instrument…”

A trust then can be said to be a contract whereby the donor / settlor of the trust transfers an asset/s to a group of persons (the trustees), with the instruction that they (the trustees) administer and manage these assets, not for their own benefit but for the benefit of another person or group of persons named the beneficiaries. 

There are various ways in which trusts can be distinguished from one another, but section 1 of the Act differentiates between only two types of trust. The difference between a trust as referred to in par "a” to that referred to in par "b” is based on where the ownership of the assets under the administration of the trustees rests. The discretionary inter vivos trust, as it is most frequently utilised in estate planning, is a trust as conceived of in par "a” of the definition, whereby ownership of the trust assets vests in the trustees and they have a discretion to use it for any one or more of the trust beneficiaries. Alternatively, the trust as referred to in par "b” places the trustees in administrative control of the asset which was in fact given to beneficiary-X, with the instructions to administer the asset on behalf of X. The important aspect to note here is that it is done on behalf of X: unlike the trust in terms of par "a” the trustees in a trust as referred to in par "b” have no discretion as to whom they want to benefit, and they have to administer the asset in their care for the benefit of the person to whom it belongs.

The birth of loan accounts:

Once a client has decided that a trust is the correct tool for his estate planning purposes, there are in essence only three ways in which he can transfer assets into the trust. 

1) The assets can be bequeathed to the trustees in the client’s will to be kept in trust on behalf of the beneficiaries. But, although frequently used, it is of limited use to the person involved in an estate planning exercise who wishes to reduce the size of his estate in order to try and effect a saving on estate duty and executor’s fees upon his death. Nor does it assist the client who wishes to use the trust form to protect the identified assets from creditors, while engaging in some or other risky activity. 

2) An alternative method to transfer assets to a trust is to donate the assets. However, as donations are subject to 20% donations tax this method is generally too expensive to be of much use to estate owners. Certainly, nobody who has a burning desire to save on 20% Estate Duty sometime in the uncertain future is likely to spend 20% on Donations Tax in the present. This method then is probably only useful in respect of small amounts.

3) The final method with which to effect a transfer of assets from the estate owner to the trust is for the estate owner to lend the money to the trust. This can be done either by selling the asset that he wishes to transfer to the trust and then have the trust owe the purchase price to him, or by providing the trust with actual cash in the form of a loan. 

However, just like the other two methods, this one has its own limitations. It does not effect a saving on either estate duty or executor’s fees in respect of the loan amount, as the outstanding loan is still an asset in the estate owner’s estate and subject to duty and executor’s fees. Similarly, it provides only limited immediate protection to the assets. Should the estate owner in his capacity as debtor to someone else be held liable for an outstanding debt, then the debt owed to him by the trust would be attachable by his creditors. Such a situation could also jeopardise the continued existence of the trust. 

What this method of transfer does achieve is to peg the value of the estate owner’s estate. The Estate Duty savings here are in respect of the duty that would have been payable on the (potential) increase in value of the assets that have been placed in trust from the time that they were transferred to the trust until such time as the estate owner passes away. It is important to note that the use of the trust in this manner gives rise to a genuine loan as it is legally defined. And, the reflection of this loan or debt in the trust’s books of account is the "loan account.” This is a loan in the strict sense.

However, in my experience the term "loan account” is often used in a wider, more general sense to refer to all those interests that can be measured and expressed in monetary terms, which are reflected in the trust’s accounting records and that, for accounting purposes, can be said to be owing to an individual that is in some way associated with the trust – whatever its origins. And so, when consulting in fiduciary matters I frequently encounter so-called loan accounts in favour of the trust beneficiaries that, upon enquiry, turn out to have originated in a manner that is entirely different from that of a loan in the strict sense mentioned above. These loan accounts are usually the result of the trustees exercising their discretion and deciding to vest the trust income or capital in one or more of the beneficiaries. But, instead of transferring the cash or the assets to the beneficiary, the trustees decide to retain control of the assets and to continue administering it on behalf of such beneficiary. Such a vesting of income or capital results in a debt (in the broader sense) being owed to the relevant beneficiaries and has to be reflected as owing to them in the trust’s books of account. These amounts are then included in the trust’s books of account as a loan account. And, if the person who has income or capital vested in him in such a manner happens to have a loan (in the strict sense) owed to him, these two amounts are frequently added together to form his loan account. But, the source of the obligation in this instance is not a loan. A loan, as a form of contract, has certain legal characteristics that are absent in this scenario.

The contract of loan

The first of these characteristics of a loan is the requirement, for the parties involved, to reach agreement on the terms of the loan. For a loan to come into existence there must be some form of offer in respect of the terms of the loan and some form of acceptance of that offer. However, this offer and acceptance alone is not sufficient. The offer and the acceptance thereof must also be made with the intention of bringing about a legally binding loan agreement.

It is usual for a contract of loan to provide for a specific term to be applicable to the loan, on the expiration of which the loan amount would be repayable. But, a fixed term is not a necessity for the existence of a valid loan agreement. However, a loan, by its very nature, has to be repaid at some time and the time of this repayment cannot just be left to the whim of the borrower. Where no term for the loan has been agreed upon, the creditor is able to demand repayment thereof at will, although fairness demands that the borrower be given a reasonable time before he can be compelled to repay the money or return the borrowed goods. The amount involved will determine the reasonableness or not of the period for repayment or return of the loaned goods. Should the debtor consider the claim for repayment that is instituted against him to be premature or unreasonable, the onus is on the debtor to raise the question and to advance reasons as to why he should be given further time to pay.

Trustees’ vesting in beneficiary:

To return to the murky waters of beneficiaries’ loan accounts: when trustees decide to vest trust income or a capital gain in a beneficiary, but retain control thereof, then it is not a case of that beneficiary lending the money, or asset, back to the trust.Instead it is a unilateral exercise by the trustees of their discretionary powers as trustees. There is no offer and acceptance between the trustees as borrower and the beneficiary as lender and as such there can be no question of consensus having been reached between parties to a loan. 

What, however, is the position in respect of the obligations to the beneficiaries thus created? In exercising their discretion and deciding to vest income or capital in a beneficiary, while simultaneously continuing to administer it, the trustees have simply changed the form of trust that exists in regards to that beneficiary in respect of that asset. They have changed the trust from a trust as referred to in par "a” of the definition of trust, to that referred to in par "b” of the definition. After all, nothing has changed in respect of their contract with the donor. The trustees simply decided to settle some of the property entrusted to their care by the donor, for the benefit of the beneficiaries as a group, or the specific beneficiary in accordance with the provisions of their contract with the donor, i.e. the trust deed. But, they also decided, in terms of that same contract that they would continue, in their capacity as trustees, to administer that property for the specific beneficiary’s benefit. The trust in respect of that asset has therefore not ended. The trust, in respect of the vested asset, will only end once they have either paid over the vested amount (or delivered the asset) to the beneficiary, should the trust deed provide therefore, or once they have utilised and expended such amount on the beneficiary’s behalf. Until such time as either of those has been done, they will still be holding, in terms of their contract, an asset entrusted to them by the donor on behalf of the beneficiary – no matter whether ownership vests in them as trustees with the asset to be used as they see fit on behalf of any or all the beneficiaries as they deem fit, or whether it is (now) owned by a specific beneficiary and held by them to be administered on his behalf.

The effect of a loan v holding in trust:

Having distinguished between the two sources of beneficiaries’ loan accounts it remains to determine why this distinction is important and what to do about it. Let us however start with the "what to do about it?” I believe that trust accountants should (and trustees and affected beneficiaries should see to it that this is done) in the trust’s books of account reflect those obligations that are due to beneficiaries and that have their origins in vesting separately from those that have their origin in an actual loan. I should mention that I have never seen it done this way and in all instances where I have had access to records, the two have been lumped together as if they were of the same origin. What is worse, whenever I have asked after the origin of the loan account, and what amounts it consists of, the relevant persons have always been filled with consternation.

There are however a number of important reasons to distinguish between a trust and a debt. Among others, the responsibilities of a trustee differ from those of a debtor in that a trustee, in terms of the trust deed, is generally obligated to pay the "debt” to the beneficiary when it becomes due, while an ordinary debtor is obliged to pay only once payment is demanded. More importantly perhaps is the fact that a trustee who fraudulently appropriates money or other property held in trust is guilty of theft, while an ordinary debtor who fails to pay a debt, even should he be able to pay, is guilty of no crime and can only be held to account with a civil suit.

Duties and liabilities of trustees:

Trustees have a variety of duties originating from a variety of sources. Firstly, the trustee’s duty originates from his contract with the donor and the beneficiary (once the beneficiary becomes a party to the agreement). Secondly, there are a number of duties imposed on trustees that have their origin in the common law and lastly there are duties imposed on trustees by virtue of statute. When dealing with inter vivos trusts this statute is the Trust Property Control Act. As various trust deeds differ, I will deal only with selected duties of trustees that originate either from common law or statute.

At the heart of all of a trustee’s duties, no matter their origin, lies the concept of the fiduciary duty that is owed to the beneficiary. All the other duties of trustees are encompassed in this one concept which can be summarised as follows: A trustee must at all times act with the utmost good faith in regards to and act in the best interest of the beneficiaries. All the other duties that originated in common law and those that originated from statute are aimed at ensuring that effect is given to this concept. It is even included in the definition of a trust where it refers to "… for the benefit of …” and therefore, by necessary implication, it also forms the basis of the trustee’s contract with the donor and of all trusts. Compare the following two quotes by the Appellate Division (as it was then) in 1915 and the Supreme Court of Appeal in 2006.

"The underlying conception in these and other cases is that while the legal dominium of property is vested in the trustees, they have no beneficial interest in it but are bound to hold and apply it for the benefit of some person or persons or for the accomplishment of some special purpose.” 

"The essential notion of trust law, from which the further development of the trust form must proceed, is that enjoyment and control should be functionally separate. The duties imposed on trustees, and the standard of care exacted of them, derive from this principle.” 

This is perhaps also an opportune time to mention section 9 of the Trust Property Control Act. Sub-section 9(1) entrenches in the Act the principles of care, diligence and skill that are required from a trustee in the exercise of his duty. However, sub-section 9(2) of the Act is the interesting one, as it declares void any provision in a trust instrument to the extent that it would have the effect of exempting a trustee from or indemnifying him against liability for breach of trust where he fails to show the required degree of care, diligence and skill that is required by sub-section 1. There are three applications of the trustees’ fiduciary duty that have developed in common law that immediately jump to mind as probably being  contravened when trustees and their accountants fail to distinguish in the trust’s accounting records between genuine loans and the interests in trust property vested in beneficiaries, and lump them together as "loan account” in the broader sense. The following are the trustees’ duties:  1) to "make the trust property more productive”, 2) to "preserve the trust property” and 3) to "account to the beneficiaries”.

Vesting while postponing enjoyment, along with the duty from then on to always act in that beneficiary’s best interest when administering that asset, brings about some interesting administrative obligations for trustees if they are to meet their obligations as stated above. While there is no legal obligation in terms of a loan agreement to pay interest, unless interest was agreed upon as one of the terms of the agreement, there are, however, a number of trust cases that have found that it is the duty of trustees to protect the trust fund – including protecting it against the effects of inflation. This will of necessity require some form of investment of the trust fund or utilisation of the trust assets. The need to split the two types of debt in the trust’s financial records is once again, highlighted here. Utilising the funds held on behalf of a beneficiary necessarily requires some form of recompense for its use, while loan capital does not. I propose that a failure to distinguish in the trust’s accounting records between loans to the trust by beneficiaries and their vested interests in assets makes it impossible for the trustees to meet their obligations as detailed above. For example, having a loan that does not attract interest may be in the best interest of the beneficiaries as a group, but it is in the interest of the individual in whom the asset is vested to obtain a return on the use of such asset. These competing interests are irreconcilable.

Taxing trusts and the impact of interest-free loan accounts:

It was held in CIR v Friedman & Others NNO that a trust is not a legal person as intended by section 1 of the Income Tax Act and as such it could not be subjected to Tax. The Act was accordingly amended, with retrospective effect to the 1987 tax year, to include trusts in the definition of a "person” and section 25B, which is subject to section 7, was enacted to govern the taxation of trust income. As such trusts were included in the tax net.

A similar conduit provision to that of section 25B has been included in the Eighth Schedule in para 80, which in turn has been made subject to the attribution rules contained in para 68 to 72. These attribution rules are similar in nature to the deeming provisions contained in section 7. These provisions are anti-avoidance provisions aimed at taxing, in the hands of a donor, any income or capital gains which resulted from a "donation, settlement or other disposition” by the said donor.

It should be clear by now that the return received on loan capital (a loan in the strict sense) that was invested is available, using the conduits provided by sec 25B and para 80, to be divided between beneficiaries. In this way funds can be allocated to beneficiaries with a low marginal rate of tax while skipping those with a higher marginal rate of tax, thereby reducing the overall tax liability in respect of the income or gains made – so called income splitting. This is of course provided that the various deeming provisions mentioned above are not applicable, which would see the amounts taxed in the hands of the deemed recipient thereof. It should also be remembered that, in order for these conduit provisions to find application, it is necessary that the relevant income or gain has to be vested in the beneficiary in the year that it accrued to or was received by the trust. As such the trustees have to reach any decision regarding the distribution or allocation of the relevant funds prior to the end of the tax year, as their failure to do so will result in the income or gains being taxable in the hands of the trust.

On the other hand, income generated on amounts or assets that vest in a beneficiary (a loan in the broader sense) have to be credited in the accounting records to that beneficiary. Such gains or income will, by virtue of the same conduit provisions, be taxed in the hands of the beneficiary with the vested right thereto. This too is subject thereto that none of the deeming provisions are applicable. Regardless of whether the deeming provisions find application or not, gains on assets which vest in a beneficiary will at no stage be taxable in the hands of the trust.

These deeming provisions are a convenient place to continue our discussion regarding the taxation of interest-free loan accounts. Interest-free loan accounts were first addressed by the court in CIR v Berold where, in respect of the then equivalent of the present section 7(3), it was decided that as long as the capital remains unpaid, the failure to charge interest on a loan constitutes a continuing donation of the interest to the debtor. Following on this it was decided in the case of Ovenstone v SIR that in determining the rate of interest that should be charged on a loan, regard must be had to what the trust would have paid had it borrowed the funds on normal commercial terms. The rate that the donor would have paid is irrelevant. It was further decided in the case of C:SARS v Woulidge  that the in duplum rule does not apply in determining the amount of interest to be attributed to a donor under the attribution rules. (The in duplum rule restricts the amount of interest that can be charged on a loan to an amount equal to the outstanding capital balance.) According to Woulidge, the in duplum rule can only be applied in the real world of commerce and economic activity where it serves considerations of public policy in the protection of borrowers against exploitation by lenders. In the Woulidge case this was not so, as no interest was charged and no actual interest accumulated.

The SCA’s judgement in C:SARS v Brummeria Rennaisance (Pty) Ltd  has once again seen interest-free loans become topical. The case concerned a group of companies that developed retirement villages. In order to finance the construction of units, the company entered into agreements with potential occupants of units still to be constructed. In terms of these agreements the company obtained an interest-free loan from a potential occupant in exchange for which the lender received a lifelong right to occupy the unit. 

While originally the companies were not taxed on the right to use the loan capital interest-free, SARS later issued revised assessments to the companies on the basis that the right to the interest-free loans had a monetary value which formed part of their gross income. The companies objected to these revised assessments on the basis that the right to use the loan capital could not be turned into money, which objections were upheld by the Tax Court.  

On appeal the SCA found in favour of SARS on the basis that "… the question whether a receipt or accrual in a form other than money has a money value is the primary question and the question whether such receipt or accrual can be turned into money is but one of the ways in which it can be determined whether or not this is the case; in other words, it does not follow that if a receipt or accrual cannot be turned into money, it has no money value. The test is objective, not subjective.” As such the court held that the value of a legally enforceable right to the interest-free use of loan capital had to be included in the companies’ gross incomes for the years in which such rights accrued to the companies.

An interesting aspect of the case regards the court’s refusal to consider whether or not the accrual was of a capital nature as the issue had not been raised by the companies in their statement of grounds of appeal. Davis et al. argues that it is seemingly possible to argue in a future case that an interest-free component of a loan is of a capital nature. They use the following example as illustration: A sells his factory to B for a loan which is interest-free for 20 years. B can argue that the right to use the money loaned for 20 years constitutes the consideration for the sale of a capital asset.

The Brummeria case was decided on general principles without regard to any of the specific inclusions in gross income. These specific inclusions could potentially foil the argument above. If we accept that the right to use loan capital interest-free qualifies as an "amount” for the purposes of deciding whether or not there was a receipt or accrual for the purposes of gross income then there seems to be no reason that such a right would not also qualify as an "amount received or accrued by way of an annuity” thus specifically including it in the holder’s gross income in terms of paragraph "a” of that definition. Admittedly though, an annuity was defined in SIR v Watermeyer as consisting of a right to regularly recurring "payments” chargeable against some person. It could conceivably then be argued that a right to the interest-free use of loan capital, through an "amount in cash or otherwise”, is not a payment.

However, where an inter vivos trust is used in an estate planning exercise it is unlikely that the interest-free loan account is the result of the scenario above. More likely, as mentioned above, would be a scenario where A sells his factory to the trust, while leaving the purchase price as an outstanding, interest-free, loan owed to him. The question that then arises is whether the arrangement could conceivably give rise to a donations tax liability. There are two aspects to such a transaction that could potentially attract donations tax: 1) the sale of the assets to the trust; and 2) allowing the purchase price to remain owing on interest-free loan account. As far as the first aspect is concerned, as long as the assets are sold at full market value the disposal can’t be gratuitous as there was no appreciable element of liberality or generosity present.

In deciding whether or not the second aspect, namely that of the interest-free loan, gives rise to a donations tax liability, regard should be had to section 58  which provides:

"Where any property has been disposed of for a consideration which, in the opinion of the Commissioner, is not adequate consideration, that property shall for the purposes of this Part be deemed to have been disposed of under a donation: Provided that in the determination of the value of such property, a reduction shall be made of an amount equal to the value of the said consideration.”

Reference has already been made of the case of Berold. Here the court held that, for so long as the taxpayer 1) failed to claim payment of the loan amount due to him in respect of assets sold to the company and 2) also failed to charge interest on the loan, that he was making a continuing donation to the company and the court consequently upheld the Commissioner’s invocation of section 9(3) (now section 7(3)) of the Income Tax Act 58 of 1962.

Davis et al point out that one should distinguish between "a loan where no interest is charged and the lender cannot alter the interest conditions and a loan where no interest is charged but he is entitled to charge interest.” The idea being that if the lender could charge interest but refrains from doing so then there is a donation as a donation includes any "gratuitous waiver or renunciation of a right.” On this basis, it would seem that A, in the example above, has donated an amount to the trust. 

The problem according to Davis et al is that the donation, in terms of sec 62(1)(d) has to be valued at the date when it took effect. On this basis they contend that if the transaction is a demand donation, and the loan can be revoked at any time, then the value of the donation of interest cannot be valued at the date it took effect because it can be terminated at any time.

However, in those instances where the borrower does indeed have a right to an interest-free loan, i.e. the parties in fact agreed to an interest free loan, then there seems to be nothing to distinguish such a loan from a quasi-usufruct over consumables. The question then arises as to whether section 62(1)(d) is in fact the correct valuation provision to apply to such a loan? On the basis that the borrower, until such time as payment is demanded or the loan period expires, has all the rights in the loan capital including the rights to all fruits, does the right to an interest-free loan not in fact fall to be a "other like interest in property” for the purposes of section 62(1)(a) which refers to "fiduciary, usufructuary and other like interests in property?” If so then in terms of that section the interest-free loan should be valued at an annual value of 12%. A similar argument could be made that the interest not charged constitutes an annuity for the purposes of section 62(1)(b). The value of such an annuity, based on the dictum in Ovenstone, should be determined on the basis of what the trust, as borrower, would have paid had it borrowed the funds on normal commercial terms. If either of these approaches are accepted, then the donation – if it is a demand donation – should fairly be valued over the life expectancy of the donor as per the provisions of the aforementioned sections.

In conclusion - Interest-free loans, vested rights in trust property and section 82:

This article set out to illustrate that a frequently encountered error in accounting records could conceivably lead to an increased liability for Income Tax. In order to do this, time was spent distinguishing loans from trust capital that is vested in one or more beneficiaries. Although the debtor in terms of the loan and the beneficiary with a vested right in trust capital are frequently the same people, it was said that these amounts should be accounted for separately in the trust’s books of account.

Having distinguished loans from vested trust capital, the taxation of trusts and interest-free loan accounts were discussed and it was attempted to show that there is a very real chance that interest-free loans, as they are frequently used with trusts in estate planning exercises, could attract unexpected donations tax or income tax. If this is indeed so then I suggest that a failure to separately account for interest-free loans and vested trust capital is likely to lead to trustees incorrectly accounting to beneficiaries for trust income and capital gains, resulting in incorrect tax returns. Such errors will be compounded should SARS at any stage dispute one of the trusts tax returns. It should be borne in mind that section 82 places the burden of proof on the taxpayer to prove why a specific amount/deduction/exemption should be treated or not treated by SARS in a specific manner. It would seem reasonable then that SARS, without evidence to the contrary, would treat the vested rights to trust capital and income and the interest-free loans as one and the same. Needless to say it will be time-consuming and expensive at that stage to amend the trust’s books of account to correctly reflect the situation. And this without even taking into account the trustee’s personal liability resulting from a failure to sufficiently differentiate between interest-free loan capital and trust capital in which beneficiaries have a vested right. 

This article first appeared on the November/December edition on Tax Talk.



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