The Income Tax Effects of Members’ Debit Loan Accounts A lecture

The Income Tax Effects of Members’ Debit Loan Accounts A lecture presented by Professor Phillip Haupt to the South African Institute of Professional Accountants (Western Cape) Cape Town www.hedron.co.za 23 August 2008 [email protected]

What is a member’s debit loan account? A member’s debit loan account arises when a close corporation makes a loan (or an advance which is subsequently converted into a loan) to a member of that close corporation. The loan is shown as an asset in the books of the close corporation. It is a liability in the hands of the member. The principles set out here apply equally to a loan which a company makes to its shareholder.

What can the income tax effects of a members debit loan be? The loan could have one or more of the following results: – The loan could be treated as a fringe benefit in the hands of the member – The loan could be treated as a “dividend declared” by the corporation (i.e. a distribution to members) – The loan could be treated as an unproductive asset in the hands of the close corporation and lead to the add-back of expenditure

Are there any anti-avoidance provisions in the Income Tax Act? Fringe benefit – This can arise whether the loan is made by the company or by someone else, and whether it is made to the employee or someone else. Dividend – This can arise whether the loan is made to the member or to a person connected to the member. The detail in respect of the above is set out later.

Are there any exemptions, exceptions or exclusions? Fringe benefits exclusions– these usually arise where the loan is made by virtue of membership and not by virtue of employment, or where the loan bears more than a certain rate of interest. Where the member uses the loan to produce income, he obtains some relief against a double tax. Dividend exclusions – there are a number of exclusions contained in section 64C of the Act. The detail is set out later.

Fringe benefits tax Paragraph (i) of the gross income definition in section 1 of the Income Tax Act includes in gross income – (i) the cash equivalent, as determined under the provisions of the Seventh Schedule, of the value during the year of assessment of any benefit or advantage granted in respect of employment or to the holder of any office, being a taxable benefit as defined in the said Schedule, and any amount required to be included in the taxpayer’s income under section 8A Although the provision refers to the holder of an office, this is not enough to trigger the fringe benefits provisions

What is the holder of an office? The Income Tax Act does not define office or office holder. The Close Corporations Act defines an ‘officer’ as any manager or secretary of the CC, whether or not such manager or secretary is a member. The Companies Act defines an ‘officer in relation to a company’ as including any managing director, manager or secretary of the company. The Income Tax Act defines a director as follows: “director”, in relation to a close corporation, means any person who in respect of such close corporation holds any office or performs any functions of a director of a company other than a close corporation

Is a member a holder of office? A member can be a holder of office in a close corporation, but he need not be. Section 46(b) of the Close Corporations Act provides that every member shall have equal rights in regard to the management of the business of the corporation. This does not mean that a member does manage or is a manager of the close corporation. This is a question of fact and can be varied by the association agreement between the corporation and the members from time to time.

Seventh Schedule – Fringe benefits Taxable benefits are set out in paragraph 2 to the Seventh Schedule to the Income Tax Act. The preamble to paragraph 2 is important, i.e. 2. For the purposes of this Schedule and of paragraph (i) of the definition of “gross income” in section 1 of this Act, a taxable benefit shall be deemed to have been granted by an employer to his employee in respect of the employee’s employment with the employer, if as a benefit or advantage of or by virtue of such employment or as a reward for services rendered or to be rendered by the employee to the employer—

What is important here is that a fringe benefit does not arise only because of the fact that a benefit is given to an office holder (i.e. a member who manages the close corporation). It must be given as a reward for services rendered or to be rendered as an employee, or It must be given by virtue of the member’s ‘employment’. There has to be a clear link (nexus) between the benefit and the employment.

Paragraph (2)(f) - Loans The operative provision of paragraph 2 is sub-paragraph (f), for loans, i.e. – “( f ) a loan (other than a loan for purposes of the payment by the employee of any consideration in respect of any qualifying equity share contemplated in section 8B to comply with the minimum requirements of the Companies Act, 1973 (Act No. 61 of 1973), or the payment of any stamp duties or uncertificated securities tax payable in respect of that share, or a loan in respect of which a subsidy is payable as contemplated in subparagraph (gA)) has been granted to the employee, whether by the employer or by any other person by arrangement with the employer or any associated institution in relation to the employer, and either no interest is payable by the employee on such loan or interest is payable by him thereon at a rate of lower than the official rate of interest”

The official rate of interest is set by the Minister of Finance in the Gazette from time to time and can be accessed on the SARS website ( www.sars.gov.za). The current rate is 12% per annum (with effect from 1 March 2008). Therefore, if a loan is made to a member by virtue of his employment or as a reward for services rendered, and interest at an annual rate of 12% is charged on the loan, no fringe benefit arises. As the interest rate changes, the interest on the loan has to change. Usually this is in March and September each year.

Paragraph 11 Paragraph 11 of the Seventh Schedule contains the detail in respect of the fringe benefit. The fringe benefit is the difference between the official interest rate and the (lower) interest rate paid by the member/employee. There are two exclusions, one dealing with casual loans not exceeding R3 000 per employee and loans to enable an employee to further his or her own studies. It is not likely that a loan to a member will be seen as a casual loan

Deemed expense – para 11(5) Where the taxpayer uses the proceeds of the loan for the purposes of producing income, the amount of the fringe benefit is deemed to be interest actually incurred – for section 11(a). Note that interest is now deducted under section 24J and so the paragraph should be updated to replace the reference to section 11(a) with ‘section 11(a) or section 24J’. Example: Mr X borrows R300 000 from his close corporation to fund his farming business. The loan is interest free and the fringe benefit is therefore R36 000 for the year. Mr X’s tax effect is: Fringe benefit R36 000 Deemed interest expenditure (36 000) Net tax effect Nil

Anti-Avoidance – para 16 Paragraph 2(f) operates whether the loan is made by the employer, or by arrangement with the employer or by an associated institution (see above). Paragraph 16 takes the anti-avoidance even further, however, i.e. – BENEFITS GRANTED TO RELATIVES OF EMPLOYEES AND OTHERS 16. (1) For the purposes of this Schedule and of paragraph (i) of the definition of “gross income” in section 1 of this Act, an employee shall be deemed to have been granted a taxable benefit in respect of his employment with an employer if as a benefit or advantage of or by virtue of the employee’s employment with the employer or as a reward for services rendered or to be rendered by the employee— (a) the employer has granted a benefit or advantage (whether directly or indirectly) to a relative of the employee, other than a benefit or advantage in respect of which paragraph 10 (2) (d) applies; or (b) anything is done by the employer under any agreement, transaction or arrangement so as to confer any benefit or advantage upon any person other than the employee (whether directly or indirectly), and such benefit or advantage, if it had been granted directly by the employer to the employee, would have constituted a taxable benefit contemplated in paragraph 2. (2) The provisions of this Schedule shall apply in relation to the taxable benefit so deemed to have been granted as though the taxable benefit had in fact been granted to the employee.

Deemed dividends Currently, distributions made by a close corporation to its members are treated as dividends subject to 10% STC (secondary tax on companies) for income tax purposes. The reason is as follows: – The Income Tax Act defines a company as including a close corporation. – The definition of ‘dividend’ includes any amount ‘distributed by a company to its shareholders’ – A shareholder is defined in relation to a close corporation as ‘a member of such corporation’ All of these definitions are contained in section 1 of the Income Tax Act.

Section 64C Section 64B of the Income Tax Act provides for a 10% tax to be paid by a company (close corporation on all dividends declared to its shareholders (members). Therefore if a close corporation makes a distribution of R100 000 to its members, it has to pay to SARS, STC of R10 000 by the end of the next month. This payment is declared on an IT56 form. Section 64C sets out the circumstances under which a dividend is deemed to be declared for the purpose of section 64B. This is an anti-avoidance section to prevent members from taking funds out of the close corporation without paying the 10% STC. Its application is automatic.

Section 64C(2)(g) is the operative provision in regard to loans and states: (2) For the purposes of section 64B, an amount shall, subject to the provisions of subsection (4), be deemed to be a dividend declared by a company to a shareholder, where— (g) any loan or advance is granted and made available to that shareholder or connected person in relation to that shareholder A connected person is as defined in section 1 of the Income Tax Act. There is no specific exclusion if the loan is also a fringe benefit unless it is part of a scheme available to employees who are not members (see s64C(2)(e)). The result is that if a loan to a member is subject to fringe benefits tax it is likely to be subject to STC as well. It does not mean that a loan subject to STC is subject to fringe benefits tax, however, as it may not be given as a reward for services rendered.

Exclusions – section 64C(4)(b) Section 64C(4)(b) states: (4) The provisions of subsection (2) shall not apply— (b)where the amount constitutes remuneration in the hands of the shareholder or any connected person in relation to that shareholder or the settlement of any debt owed by the company to the shareholder or connected person The ‘amount’ in this case is the amount of the loan (see s64C(2) on the previous slide). As the loan amount itself is not remuneration, this exclusion does not apply. The fact that the Seventh Schedule deems a notional interest amount to be a fringe benefit does not mean that the loan itself is remuneration. Interestingly enough, the provision does not refer to ‘remuneration’ as defined in the Fourth Schedule. Therefore the normal dictionary definition of remuneration applies.

Exclusions – section 64C(4)(e) Section 64C(4)(e) states: (4) The provisions of subsection (2) shall not apply— (e)to any loan granted to the shareholder or any connected person in relation to the shareholder if the shareholder or connected person is an employee of the company or an associated institution contemplated in paragraph 1 of the Seventh Schedule in relation to the company and such loan is granted under, and in compliance with the normal terms and conditions of, a loan scheme generally available to employees of the company or of the associated institution who are not shareholders This exclusion will not apply if there does not exist, in the close corporation, a loan scheme available to all employees who satisfy certain criteria. This confirms that even if a loan is a fringe benefit, it could still be subject to STC if no such loan ‘scheme’ exists.

Section 64C(2)(c) excludes – – “so much of any amount (other than an amount contemplated in subsection (2) (e)) as exceeds the company’s profits and reserves which are available for distribution, including any amount deemed in terms of the definition of “dividend” in section 1 to be a profit available for distribution: Provided that any prohibition or limitation on any such distribution contained in the company’s memorandum and articles of association or founding statement or any agreement shall be disregarded in the application of this paragraph” This means that if a corporation does not have profits or reserves, the amount of the loan cannot be deemed to be a dividend. The question arises as to where the company can get funds to make a loan if there are no profits or reserves. The funds could come from members’ contributions, or from borrowings. If there are reserves and the funds come from borrowings, the exclusion will not apply.

Profits The term ‘profits’ in section 64C(2)(c) includes unrealised profits per the dividend definition in section 1., i.e. - – Provided further that for the purposes of this (dividend) definition “profits” includes realised and unrealised profits of a company whether or not those unrealised profits have been recognised in the financial records of the company Therefore, to work out the profits, one has to look at the profits in the financial statements, plus the excess of the market value of the assets on hand over their book values.

Example A close corporation has the following balance sheet: Assume that it borrows funds and lends these free of interest to the member (qua member) and then has the following balance sheet:

Although the corporation has no realised reserves, it does have unrealised profits of R200 000, being the difference between the market value of the building and its cost. Assume the following balance sheet of ABC Close Corporation: Equity and liabilities Assets Member’s contributions R50 000 Land and buildings Retained income 120 000 Market value is R575 000 Non-distributable reserve 180 000 Cash 200 000 Loan from subsidiary B 850 000 Interest-free loan to trust 600 000 R1 200 000 The trust is the family trust of the member. R400 000 R1 200 000

The total profits and reserves are as follows: Amount Market value of asset R575 000 Book value of asset (400 000) Retained income 120 000 Non-distributable reserve 180 000 R475 000 A provision has to be made for STC as the deemed dividend declaration and STC are automatic. The provision is 10/110 of R475 000 Reserves subject to STC (43 182) R431 818 Therefore, the loan of R600 000 to the trust (a connected person in relation to the member) is deemed to be a dividend or R431 818, and so subject to STC of R43 181,80.

Exclusions - Section 64C(4)(d) Section 64C(4)(d) states: (4) The provisions of subsection (2) shall not apply— (d) to any loan granted in respect of which a rate of interest not less than the “official rate of interest”, as defined in paragraph 1 of the Seventh Schedule is payable by the shareholder or any connected person in relation to the shareholder This exclusion is the most common one. Not only does it avoid STC, but also avoids fringe benefits tax. The problem is that the interest is taxable in the hands of the corporation, and not usually deductible in the hands of the member. It also leads to an increase in the reserves of the corporation.

Exclusions - Section 64C(4)(f) Section 64C(4)(f) states: “(4) The provisions of subsection (2) shall not apply— (f) to any loan or credit granted to a shareholder of the company or any connected person in relation to the shareholder during any year of assessment of the company granting the loan or credit, if— (i) such loan or credit is repaid or otherwise extinguished by not later than the end of the immediately succeeding year of assessment; (ii) the amount thereof is not included in any subsequent loan or credit granted to the shareholder or any connected person in relation to the shareholder; and (iii) the provisions of this paragraph have not been applied in the case of the company in any previous year of assessment”

This is to help those corporations which made interest-free loans to the members in ignorance of the provisions of section 64C. The loan can be extinguished by being repaid or being used to settle a debt created by a dividend or salary to the member. This is only a once-off relief. It cannot be used in respect of a loan that has been outstanding for a longer period, even if the loan bore interest in the earlier period. It also cannot be extinguished by ceding the loan from a member to his wife, or trust, for example as these are connected persons in relation to the member.

Exclusions – section 64C(4)(i) This is included for completeness, i.e. Section 64C(4)(i) states: “(4) The provisions of subsection (2) shall not apply— (i) to any loan or credit granted to a trust by a company to enable that trust to purchase shares in that company or the controlling company in relation to that company with a view to the resale of those shares by that trust to employees of that company, under a share incentive scheme operated by the company for the benefit of those employees” Note that in all cases, the word ‘company’ includes a close corporation.

Repayment of loan If a loan is deemed to be a dividend declared and the 10% STC has been paid, any repayment of the loan by the member or connected person is deemed to be a dividend received by the corporation – s64C(5). From an STC point of view this means that the corporation obtains an STC credit. A dividend is deemed to be declared on the date the loan is made, and it is deemed to be received on the date that the loan is repaid.

Connected person - Note that one is looking at who is connected to the member, not who is connected to the close corporation In relation to a member of a close corporation, section 1 deems the following to be connected: – Any relative of the member – Any trust of which the member or a relative is a beneficiary, or any other person or entity connected to the trust – Any partner of the member – Any company in which the member holds (directly or indirectly) at least 20% of the equity share capital or voting rights (either alone or which a connected person)

Example Assume the following structure: Mr X 100% Loan of R1 million ABC Close Corporation Members interest R1 000 Reserves – R1 million Cash R1 000 Loan to XYZ R1 million 50% XYZ (Pty) Ltd

Mr X is a connected person in relation to X (Pty) Ltd as he indirectly holds 50% of the equity share capital of X (Pty) Ltd The fact that the close corporation is also connected to X is irrelevant. The loan to X is therefore a deemed dividend declared by ABC Close Corporation. As X (Pty) Ltd is not part of the same ‘group’ as ABC, there is no STC relief.

Assume the following structure: Mr X 100% Loan of R1 million ABC Close Corporation Members interest R1 000 Reserves – R1 million Cash R1 000 Loan to XYZ R1 million 70% XYZ (Pty) Ltd

In this case the loan will not be subject to STC due to exclusion (l) in section 64C(4), i.e.“(4) The provisions of subsection (2) shall not apply— (l) to any amount contemplated in subsection (2) (a), (b), (c), (d) or (g) distributed, transferred, released, relieved, paid, settled, used, applied, granted or made available by a company for the benefit of any controlled group company in relation to that company.” A controlled group company is defined in section 1 as follows: “group of companies” means two or more companies in which one company (hereinafter referred to as the “controlling group company”) directly or indirectly holds shares in at least one other company (hereinafter referred to as the “controlled group company”), to the extent that— (a) (b) at least 70 per cent of the equity shares of each controlled group company are directly held by the controlling group company, one or more other controlled group companies or any combination thereof; and the controlling group company directly holds at least 70 per cent of the equity shares in at least one controlled group company;

Unproductive asset An interest free loan to a member is an unproductive asset, unless it is given to him or her as a fringe benefit. If it is an unproductive asset, any costs incurred in making the loan cannot be deducted for tax purposes. Therefore, if funds are borrowed at interest and on-lent to the member interest-free, the interest on the borrowing will not be tax deductible.