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A most effective tax-saving strategyThere is no obligation on a lender to charge a market-related interest rate - or any interest at all ONE OF the most effective tax avoidance strategies that will remain - even if and when the government implements the Katz Commission proposals to tax the capital of trusts - will be the interest-free loan. Let's take a simple example. A father lends his adult son R1-million, free of interest, to develop his business. The capital value of the business grows at 20% a year. After 10 years the business is sold, and out of the profit the son repays his father's loan. The interest the father would have lost of, say, R2.7-million over that period, would have been taxed at, say, 45%, leaving an effective loss of R1.5-million. For this sacrifice, the father would have made it possible for the son to realise a tax-free capital gain of R5.2-million. Is such a strategy tax-effective? There are two potential dangers - of income tax being assessed on the father on grounds of diversion of income, and of donations tax being imposed on either, based on the value of the interest sacrificed. However, says well known tax adviser Costa Divaris: "The general principle of taxation is that there is no obligation resting upon a lender to charge interest or, if he or she does so, to charge a market-related rate of interest. "Very often a family transaction will be financed by means of an interest-free loan representing either the purchase price of some transferred asset, or moneys advanced for the independent acquisition of an asset. "In practice it is probably true to say that vast amounts of interest-free finance underpin family transactions. "Under the income tax law there is no provision deeming interest to accrue on such a loan. Nor does such a loan involve a donation for donations tax purposes. Specific legislation would be required to change this position, whose validity is widely accepted." The only provision for taxing no- or low-interest loans clearly established by law is where there is an employer/employee relationship. Where the loan is in excess of R3 000 the employee is taxed on the fringe benefit, which is determined as the difference between the rate of interest charged and the official rate set for this purpose. Divaris says a loan within a family might be considered as diverting taxable income from one taxpayer to another. "The valid question to be asked is whether one of the specific or general anti-avoidance provisions of the income tax law will thereby be brought into play." If you make an interest-free loan to your spouse which has the effect of diverting income to her or him, the value of the interest sacrificed could be subject to tax in your hands - but not if there is a genuine commercial basis for the disposition. For example, suppose you sell your car to your spouse for R100 000 and give her or him three years to pay you, interest-free. Failing to charge interest on an outstanding debt arising out of a sale is a normal commercial practice and may even be perceived by the seller as a kind of discount on the selling price. In any case, the anti-avoidance provisions of section 7 of the Income Tax Act, which encompass diversion of income to minor children as well as to spouses, are rarely applied. Eleven years ago the Margo Commission recommended: "Interest-free or low-interest loans, and other means of financing … to transfer real wealth for inadequate consideration" should be subject to the capital transfer tax it proposed. But nothing was done about it. More recently it was the turn of another tax reform team. The Katz Commission commented: "In its research into the position in foreign jurisdictions, the commission found that effective action against interest-free loans is relatively rare. "The US has made endeavours in this regard, which have resulted in horrendous complexity with questionable effectiveness." In this case there is an imputed benefit on an annual basis in respect of interest-free demand loans. But Katz commented: "An attempt to follow this precedent can only encourage the use of a range of derivative instruments designed to circumvent the legislation, hence necessitating complex legislation. "For these reasons, the commission has decided against a recommendation of specific legislation to remedy the problem of interest-free loans." And so this powerful tax-saving strategy remains intact, providing it is not used with minor children or employees, and is used with caution with a marriage partner.
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