Tax: beware of ‘deeming’
This article was first published in the 4th-quarter 2015 edition of Personal Finance magazine.
There are a number of provisions in the tax legislation that “deem” certain amounts to be part of your income in a given year and that require you to include them in your tax return, although you did not actually receive them. Similarly, when a company transacts with its employees and shareholders, there may be unforeseen tax consequences, particularly in owner-managed businesses. Often, these consequences arise when loans are made between an individual and connected parties. A few of the most common tax pitfalls of this kind are described below.
Spouse “working” in your business
If your spouse is on the payroll of your business, but his or her salary is excessive in relation to the work actually being done (in other words, it is more than you would pay a third party for the same services), the South African Revenue Service (SARS) will deem the excessive portion to be your income and taxable in your hands. Even if pay-as-you-earn (PAYE) tax was deducted from your spouse’s salary, it is likely to have been less than you (as the higher earner) would have paid on the same income, because income is taxed at a progressive rate.
The deeming provision is designed to prevent you from using your business as a vehicle for splitting your income to reduce your tax liability.
When it comes to the tax calculation for the business, SARS can also reject the deduction of the portion of your spouse’s salary it regards as excessive.
Donations to your spouse or children
If you are thinking of donating income-producing assets to your spouse or minor children in the hope of splitting the income and paying less tax, because your spouse or children are taxed at lower tax rates, think again. If the donation is made with the aim of avoiding tax, the income is deemed to be yours and will be included in your tax calculation, so you would gain nothing and face penalties and interest.
Although donations to a spouse do not attract donations tax, a donation to a child above the donation exemption limit (R100 000 in total a year per individual taxpayer) will also give rise to donations tax of 20 percent.
In owner-managed businesses, fringe benefits, such as interest-free loans, the use of a company car and payments for health care and/or life cover, are often overlooked when it comes to submitting tax returns. These benefits give rise to taxable amounts in the hands of the recipients, and PAYE should be deducted. Because these benefits arise monthly, if the tax is not correctly calculated, the impact of penalties and interest can be significant over a number of years.
Interest-free loans from your company
If you are a shareholder of a company or a member of a close corporation (CC), a loan to you from the company or CC at no or low interest can give rise to dividends withholding tax of 15 percent. The deemed amount is calculated by applying the “official rate” of interest to the loan, and if the interest payable on the loan is lower, the difference will be regarded as a dividend, with DWT owing to SARS.
The “official rate” is linked to the prime rate and therefore changes from time to time. With effect from August 1, 2015, it is seven percent.
Similar provisions apply if the company or CC makes the loan to a “connected person” – for example, a spouse, sibling or child – or to a trust of which you are a beneficiary.
Controlled offshore company
Globalisation has made it much easier to set up and operate offshore companies and trusts, but there are numerous tax implications to navigate if you venture off South Africa’s shores.
If you, either alone or together with certain connected parties, own more than 50 percent of an offshore company, the controlled foreign company (CFC) rules could apply to you. Unless an exemption applies (and the exemption conditions are onerous), SARS can “look through” (or, in layman’s language, ignore) the offshore company and include the net income of the company in the South African shareholder’s taxable income, where it will be subject to South African tax.
A credit should be available for foreign taxes paid by the offshore company, but the credit may be negligible if the company was set up in a low-tax jurisdiction.
Another factor to consider with foreign companies is where the operations, management and control of the company are situated. Even if a company is incorporated in a foreign jurisdiction, if the company is effectively managed from South Africa, it could be regarded as tax-resident in South Africa and therefore subject to tax in this country, even though it might also pay tax in its country of incorporation. In that case, the CFC rules (imputing income to the shareholders, as described above) would not apply, because the company as a whole would pay South African tax.
The CFC rules are complex and involve consideration of South African tax law, foreign law and, possibly, double-taxation agreements, depending on the jurisdiction. Therefore, it is strongly recommended that you obtain comprehensive tax advice before setting up company or trust structures offshore.
Transactions with non-residents
Transactions with non-resident connected persons are subject to “transfer pricing” rules. One of the most common such transactions is a loan to an offshore trust of which you are a beneficiary, or a loan to your offshore company. If the terms of the loan are more favourable than the offshore entity could have obtained from an independent lender transacting at arm’s length, a transfer pricing adjustment may be required. This could result in an additional amount of income being included in your taxable income, representing interest that would have been earned if the transaction had taken place on arm’s-length terms. Besides being inefficient from a tax perspective, you would be faced with a tax liability in your personal capacity for income you never received.
A transfer pricing adjustment may also be necessary if goods or services are provided to or from a connected non-resident at prices that differ from the open market value. To protect the South African tax net, SARS will adjust the South African taxpayer’s income upwards, or reduce allowable expenditure, to reflect an arm’s-length price for the goods or services. One of the difficulties is that a market-related arm’s-length price or interest rate may not be readily available, so choosing an appropriate transfer price is not clear cut.
The transfer pricing rules can also give rise to dividends withholding tax or donations tax, making this an area that needs careful consideration.
Settling amounts on a trust
A “donation, settlement or other disposition” to a trust, whether local or offshore, can give rise to complicated deeming provisions.
A donation gives rise to donations tax, which is why assets or cash are often settled on a trust via a loan account. However, a loan that is interest-free, or is given at an interest rate lower than an arm’s-length rate of interest, is regarded as a disposition, and, in various circumstances, the income that arises in the trust as a result of the transfer through a loan account can be imputed to you and included in your taxable income. Because you have not actually received the income, paying the tax would be an unplanned cost to you personally.
A typical example is where you, as a South African resident, make an interest-free loan to a local discretionary trust of which you are a beneficiary. If the trust earns taxable income from investing those loan funds, that income is not taxed in the trust, but must be included in your tax calculation.
An even more complicated situation can arise if you lend to an offshore trust of which you are a beneficiary. The deeming rules are similar to those that apply to local trusts, but you must also consider the transfer pricing rules in relation to the interest rate charged.
The tax legislation also covers any distribution to a South African resident out of income that has arisen in an offshore trust in a year prior to the distribution.
The interaction of the deeming provisions related to no- or low-interest loans, the transfer pricing rules and the taxation of future distributions need to be thought through carefully to avoid the possibility of effective double taxation on portions of the income.
Ad hoc loans to family or friends
A feature of the current South African economic environment, in which many people are not financially secure, is borrowing from family or friends as a means of survival, or to cover unforeseen expenses.
Such borrowings tend to be informal, and non-repayment or partial repayment is common. Tax avoidance or income splitting is not the motivation behind these loans. It is recommended, however, that a loan agreement be put in place, especially for larger sums. This formalises the arrangement and makes repayment more likely, particularly if either party should die.
In the absence of a loan agreement, the transaction could be viewed as a donation. If you are the “lender”, you could be subject to 20-percent donations tax on any “loans” in excess of R100 000 a year. There is an exemption for situations where you make genuine contributions towards the maintenance of a person, to the extent considered reasonable by SARS. This would apply to persons who are dependent on you, even if they are not legally your “dependants”, and should cover amounts paid to another person in your close circle to cover their necessary expenses, within reason.
Most of the tax pitfalls described in this article occur when transactions between connected people are executed on favourable terms. Most of the pitfalls can be avoided if you apply arm’s-length principles whenever you transact with a connected person. If you would have transacted on different terms and conditions with an independent third party, you need to consider carefully whether any of the anti-avoidance or deeming provisions might apply to your situation and act accordingly.
* Kari Lagler is a registered tax practitioner and an independent tax consultant.