INTEREST FREE LOANS WITH COMPANIES

A4bThe latest annual nation budget presented in Parliament proposed the dividends tax rate to be increased with almost immediate effect from 15% to 20%. The increased rate brings into renewed focus what anti-avoidance measures exist in the Income Tax Act[1] that seeks to ensure that the dividends tax is not avoided.

Most commonly, the dividends tax is levied on dividends paid by a company to individuals or trusts that are shareholders of that company. To the extent that the shareholder is a South African tax resident company, no dividends tax is levied on payments to such shareholders.[2] In other words, non-corporate shareholders (such as trusts or individuals) may want to structure their affairs in such a manner so as to avoid the dividends tax being levied, yet still have access to the cash and profit reserves contained in the company for their own use.

Getting access to these funds by way of a dividend declaration will give rise to such dividends being taxed (now) at 20%. An alternative scenario would be for the shareholder to rather borrow the cash from the company on interest free loan account. In this manner factually no dividend would be declared (and which would suffer dividends tax), no interest accrues to the company on the loan account created (and which would have been taxable in the company) and most importantly, the shareholder is able to access the cash of the company commercially. Moreover, since the shareholder is in a controlling position in relation to the company, it can ensure that the company will in future never call upon the loan to be repaid.

Treasury has for long been aware of the use of interest free loans to shareholders (or “connected persons”)[3] as a means first to avoid the erstwhile STC, and now the dividends tax. There exists anti-avoidance legislation; in place exactly to ensure that shareholders do not extract a company’s resources in the guise of something else (such as an interest free loan account) without incurring some tax cost as a result.

Section 64E(4) of the Income Tax Act provides that any loan provided by a company to a non-company tax resident that is:

  1. a connected person in relation to that company; or
  2. a connected person of the above person

“… will be deemed to have paid a dividend if that debt arises by virtue of any share held in that company by a person contemplated in subparagraph (i).” (own emphasis)

The amount of such a deemed dividend (that will be subject to dividends tax) is considered to be effectively equal to the amount of interest that would have been charged at prime less 2.5%, less so much of interest that has been actually charged on the loan account.

It is important to also appreciate that the interest free loan capital is not subject to tax, but which would also have amounted to a once-off tax only. By taxing the interest component not charged, the very real possibility exists for the deemed dividend to arise annually, and for as long as the loan remains in place on an interest free basis.

[1] 58 of 1962

[2] Section 64F(1)(a)

[3] Defined in section 1 of the Income Tax Act

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE)

MANAGING TAX RESIDENCE OF COMPANIES

A1_BLarger corporate groups often expand their operations beyond South Africa’s borders. To facilitate operations in these other countries, it is often preferable for such groups to set up separate subsidiary companies in those jurisdictions. The assumption is then that these companies are by default and by virtue of their incorporation not resident here.  This is a dangerous assumption to make though and not necessarily the case if not managed properly.

Tax residence is not solely determined with reference to a company’s place of incorporation – it is but one of many criteria in terms of which a company may be regarded as being South African tax resident. The Income Tax Act contains a variety of criteria on which legal persons’ tax residence may be determined, and this includes that entity’s ‘place of effective management’.  In other words, despite the fact that a company may have been incorporated in another country: if that company is managed from South Africa, that company will be tax resident in South Africa in terms of the South African Income Tax Act.

The above will naturally very often give rise to dual residence for tax purposes.  For example, the country of incorporation will regard the company to be tax resident there by virtue of the company’s incorporation in that country, while South Africa will also regard the company to be a tax resident of it as a result of it being managed from here.  If South Africa does not have a double tax agreement with the other country in question, this will obviously lead to the company being subject to tax in both countries.

This is not preferable, and also discourages international trade.  It is for instances such as these that South Africa has concluded a great number of double tax agreements with many countries.  Double tax agreements determine (where a company is considered to be tax resident in both countries by virtue of their respective domestic legislative framework, for example where a company is incorporated in one country but managed from another), in which country and under which conditions a person will be considered to be tax resident.  For companies, in most of these cases the determining test would be where the company’s place of effective management is.

It would quite often be tax beneficial for a company not to be tax resident in South Africa and therefore it would be important to ensure that the company’s board meetings and day-to-day management take place in the country where tax residence is purported to be.  This should be managed carefully, especially where the company may potentially also be considered to be tax resident in a country with which South Africa has not concluded a double tax agreement.

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE)