Section 7C of the Income Tax Act, No. 58 of 1962 (“the Act”) was introduced with effect from 1 March 2017 as an anti-avoidance measure aimed at curbing the tax-free transfer of wealth to trusts through interest-free or low-interest qualifying funding arrangements.
The provision does not tax capital transfers directly. Instead, it taxes the economic benefit of funding, namely, the interest foregone when a connected person (as defined) allows a trust to use capital without paying a market-related return. By deeming that foregone interest to be an annual donation, section 7C of the Act (“Section 7C”), effectively converts what would otherwise be a once-off estate-planning step into a recurring donations tax exposure.
Overview of Section 7C
Broadly, Section 7C applies where a resident natural person, or a company acting at the instance of such a person, directly or indirectly provides a loan, advance or credit to:
- a trust that is a connected person (as defined) in relation to that individual; or
- a company in which at least 20% of the equity shares or voting rights are held (directly or indirectly) by such a trust.
Where the loan bears no interest or interest below the official rate, the difference between the interest actually charged, and the interest that would have been charged at the official rate, is deemed to be a donation, made on the last day of the trust’s year of assessment (in most cases the end of February). This deemed donation is subject to donations tax at 20% (or 25% where applicable), after taking into account the annual R100 000 donations tax exemption available to the resident lender. The related donations tax is due to SARS by the end of the following month i.e. 31 March.
The provision operates on a continuing, annual basis for as long as the loan remains outstanding.
The vested-rights dilemma: when retained distributions become “loans”
SARS has consistently interpreted Section 7C expansively. If an arrangement results in capital being left at the disposal of a trust on favourable terms, Section 7C is likely to find application (subject to a limited range of exemptions), regardless of the intention of the lender.
A long-standing area of uncertainty has been the treatment of vested rights that are not paid out in cash to beneficiaries and whether Section 7C applies in this regard.
In practice, trustees often vest income or capital in a beneficiary (thereby creating a vested right), but retain the amount in the trust for liquidity, investment or administrative reasons.
Historically, this raised the question: Does the retention of a vested amount constitute a “loan, advance or credit” by the beneficiary to the trust for purposes of Section 7C?
If answered in the affirmative, beneficiaries could unexpectedly be exposed to donations tax under Section 7C on amounts they never physically received.
The difficulty lies in distinguishing between:
- a unilateral trustee decision to retain funds, and
- the election by a beneficiary to leave funds in the trust.
Prior to the recently issued SARS Draft Interpretation Note on Section 7C (“Draft IN”), there was no explicit SARS guidance on where this line should be drawn.
The Draft IN and clarity on retained distributions
The Draft IN provides guidance on the scope and application of Section 7C, including clarification on the treatment of retained distributions.
Central to SARS’s analysis is the interpretation of the word “provide” in the phrase “loan, advance or credit provided to a trust”. SARS adopts the view that “provide” connotes a positive act or conscious decision, rather than mere acquiescence or inaction.
The Draft IN draws a distinction:
- No Section 7C exposure arises where:
- trustees vest an amount in a beneficiary; and
- the trustees unilaterally decide to retain that amount in the trust (for example, by crediting it to a beneficiary loan account), without any election, request or agreement by the beneficiary.
In these circumstances, although the beneficiary acquires a vested personal right against the trustees, the beneficiary cannot be said to have “provided” a loan to the trust.
- Section 7C may, however, apply where:
- the non-distribution of a vested amount results from a choice made by the beneficiary;
- the beneficiary requests that the amount not be paid out and instead be retained in the trust; or
- the beneficiary enters into an agreement with the trustees for the amount to be retained (for example, after attaining an age at which payment is due).
In such cases, the retained amount is treated as a loan, advance or credit provided by the beneficiary to the trust, potentially triggering Section 7C where no interest, or interest below the official rate, is charged.
SARS therefore reframes the enquiry in practical terms i.e. did the beneficiary cause the trust to retain the funds?
- Where the beneficiary has taken no action, the beneficiary cannot be regarded as having provided funding to the trust and Section 7C would not find application.
- Conversely, where the beneficiary elects to leave the funds in the trust, the beneficiary has made capital available to the trust, irrespective of how the arrangement is described, and Section 7C would find application.
This distinction avoids penalising beneficiaries merely because trustees defer payment, while capturing situations where beneficiaries intentionally allow trusts to use their funds on an interest-free basis.
Practical implications
The Draft IN elevates the importance of trustee conduct and proper documentation of decisions. The tax outcome no longer turns solely on whether an amount has vested, but on why it was not distributed.
In practice, to mitigate against an unintended application of Section 7C:
- Trustee resolutions and minutes should clearly demonstrate that the retention of vested amounts arises from an exercise of trustee discretion, and not pursuant to any request, election or agreement by a beneficiary.
- Language suggesting beneficiary “agreement”, “consent” or “instruction” to retain funds should be avoided, as it evidences the positive act contemplated by the Draft IN and may trigger Section 7C exposure.
- Where beneficiaries have an enforceable right to payment (for example, on attaining a specified age), particular care is required if amounts are retained thereafter, as such retention may readily be characterised as beneficiary elected.
SARS has effectively signalled that it will examine the substance of the trust’s decision-making process, rather than merely the accounting treatment.
A key consequence of the Draft IN is that trust administration and record-keeping have become determinative. Historic practices of recording amounts as “retained by agreement” or “left on loan account” are no longer tenable.
Going forward, it is prudent that:
- trustee minutes clearly record whether retentions arise from trustee discretion or beneficiary choice;
- beneficiaries avoid written or informal requests for non-payment unless an interest-bearing loan is intended; and
- advisors assume that SARS will scrutinise not only financial statements, but also trustee resolutions, minutes and correspondence when assessing Section 7C exposure.
Conclusion
The Draft IN reflects SARS’s stance on the application of Section 7C. While it provides welcome clarity on the treatment of vested rights, it simultaneously imposes a heightened evidentiary burden on trustees and advisors to demonstrate that retained amounts do not arise from a beneficiary’s election.
Moore’s private client, fiduciary and tax teams are well placed to assist with trust structuring, compliance reviews and SARS-related attendances to ensure that trust distributions and funding arrangements are implemented correctly and withstand scrutiny.
