INCREASE IN THE OFFICIAL INTEREST RATE
Annexure C to the 2018 National Budget reveals a proposed increase in the “official rate of interest” as set out in the Income Tax Act.
Increasing the official interest rate increases taxes to be borne by individuals. This includes discouraging low interest loans from employers, and creating significant extra tax on loans to trusts to facilitate estate planning. The most concerning impact is in relation to loans to trusts which are seen as deemed donations.
The official rate of interest is currently set at the repurchase rate plus 100 basis points (7.75%). The proposed increase would bring this up to the prime lending rate (currently set at 10.25%), representing an increase of 2.5%. Tax based on a rate of 10.25%, rather than tax based on a rate of 7.75%, reflects a tax increase of 32%.
Tax situations involving the official rate of interest
The official rate of interest is used in various situations relating to tax including quantifying the:
- Taxable fringe benefit, which arises out of certain low interest rate and interest-free loans provided by employers to employees. A higher “official rate of interest” would result in higher employees’ tax payable by employees receiving low- or no-interest loans from their employers.
- Amount of a deemed dividend where there is a loan from a company to a shareholder who is an individual. A higher “official rate of interest” would result in higher dividends tax payable in relation to low- or no-interest loans from a company to its individual shareholders.
- Value of the deemed donation which arises from a low interest or interest-free loan made to a trust by a connected person in relation to that trust (or in certain circumstances a company controlled by a trust). This is in terms of section 7C of the Income Tax, a new provision which is already contentious. A higher “official rate of interest” would result in higher donations tax payable in relation to low- or no-interest loans from individuals.
Reason for increase does not hold true for loans to trusts
The reason for the proposed increase is explained as: “Given that interest rates lower than prime are now uncommon, it is proposed that the official rate be increased to a level closer to the prime rate of interest. This would allow the benefit of lower rates to be measured with reference to a rate that approximates the rate offered by commercial banks to low-risk clients.”
This reasoning may be logical insofar as borrowing by individuals is concerned, which would be the employees’ tax and dividends tax implications of the official rate of interest.
However, this is not a reasonable conclusion in relation to loans by individuals, which is the case in relation to section 7C loans to trusts. In this situation, it would be more relevant to consider the investment return the individual could otherwise earn, which presumably would be substantially below prime.
Section 7C already a concerning tax provision, now triggering higher taxes
Section 7C of the Income Tax Act (which came into effect on 1 March 2017) creates a deemed donation where a trust is granted an interest-free loan or a loan at a lower rate of interest than the official rate by a connected person to the trust.
This deemed donation is equal to the difference between the official rate of interest and the lower or zero rate, multiplied by the amount of the loan owing from time to time. This donation is deemed to be made to the trust on the last day of the tax year (i.e. the last day of February), which is subject to donations tax at the rate of 20%. The first donation in terms of these provisions will accordingly be triggered on 28 February 2018, with the donations tax due by 31 March 2018.
There have been several criticisms levelled at section 7C of the Income Tax Act. These include concerns that and that section 7C impacts on legitimate estate planning as well as preventing tax avoidance schemes. In addition, there are concerns regarding the practical implementation of section 7C and the impact this will have on trust administration, bearing in mind that trust financial statements are often only finalised several months after year end and that trustees’ decisions (including regarding vesting amounts in beneficiaries) would impact on the amount of any loans.
An increase to the official interest rate would significantly increase the amount on which donations tax is payable. While section 7C is arguably necessary to target tax avoidance, the deemed donation also negatively affects taxpayers seeking to transfer assets into a trust for legitimate estate planning purposes, such as the protection of personal and family assets from creditors or placing assets in trust for minors or other individuals with limited legal capacity.
Article by Julia Moore, associate in our Tax Practice.