Loans between related parties are a common occurrence in the SME business environment. These loans arise due to various reasons, such as assets being sold on loan account; money being drawn out, trust distributions made or dividends declared on loan account; funding provided by stakeholders, or even loans arising in a similar way to a trading account. Loans that may initially seem simple in principle, could lead to some unforeseen tax and legal consequences.
In this article we will provide a brief overview of the most common scenarios resulting in loans between related parties that we tend to encounter and look at what the key tax and legal considerations are. It is not our intention to provide a fully comprehensive list of all the forms that loans between related parties can take, neither do we propose the tax and legal considerations listed to be all inclusive. It is intended to provide a helpful summary of some key considerations to loans commonly found in the accounting records of SMEs. Loans by companies
In instances where companies make loans to shareholders, who are not companies, bearing interest at a rate lower than the SARS official rate of interest (currently 7.75% p.a.), a deemed dividend exists in terms of the Income Tax Act. The value of the deemed dividend is the difference between the interest charged and what interest would have been charged at the SARS official rate of interest. Where the loan is made to an individual, dividend tax at 20% of the calculated value of the deemed dividend is to be declared and paid to SARS.
Section 45 of the Companies Act permits financial assistance provided by a company (for example through providing a loan) to directors, or related parties to the directors, only if it is pre-approved by the shareholders (by means of a special resolution), and by the directors after ensuring that immediately after providing the financial assistance the company is both liquid and solvent, that the company’s Memorandum of Incorporation has been complied with, and the financial assistance is at terms that are fair and reasonable to the company. If Section 45 of the Companies Act is not complied with, the loan is considered void and the directors could be held liable for losses incurred as a result.Loans to trusts
Loans to trusts often exist due to assets being sold to trusts on loan account. Historically most trusts charged no interest on these loans.
Section 7C of the Income Tax Act introduced legislation whereby a deemed donation exists on loans to trusts if no interest is charged, or if interest is charged at a rate lower than the SARS official rate of interest. The value of the deemed donation is the difference in interest between the amount charged on the loan account (if any) and what the interest would have been at the SARS official rate of interest.
The donation is taxed at 20% in the hands of the donor (in this case the party making the loan). Natural persons are allowed to utilise their annual donations tax exemption (first R100,000 of amount donated) against the deemed donation.Loans between individuals
A common pitfall of loans between individuals is that the terms of the loan are not clearly agreed in writing between the parties, especially in the case of loans between family members. It is well advised to ensure that a proper loan agreement is drafted and signed between the parties, inclusive of key terms to the loan such as repayment terms, security offered and interest charged.
Some important considerations are:
Loans to employees
- If it is the intention of the parties that the loan would never be called or settled, the full value of the loan should be treated as a donation by the party giving the loan. This would attract donations tax at 20%. Natural persons are allowed to utilise their annual donations tax exemption against the donation.
- If it is the intention that the loan will be repaid, it remains part of the estate of the person providing the loan in the event of his/her death. It will attract estate duty at 20%.
- If it is agreed that interest would be charged, the requirement to register as a credit provider in terms of the National Credit Act should be considered.
A loan to an employee bearing no interest, or bearing interest at a rate lower than the SARS official rate of interest leads to a taxable benefit in the hands of the employee. The value of the taxable benefit is the difference in the amount of interest charged compared to what interest would have been charged at the SARS official rate. The 7th Schedule to the Income Tax Act further requires that this taxable benefit be taken into account when calculating the employee tax (PAYE) to be deducted from the employee’s salary.
In the event of interest being charged on loans to employees, the requirement to register as a credit provider in terms of the National Credit Act should be considered.Charging interest
Where interest has been charged on loan accounts, the general principle is that the interest is taxable in the hands of the party receiving the interest (note that natural persons currently have an interest exemption of R23,800 if aged below 65 years and R34,500 if older). The interest is not always deductible by the party paying the interest.
In addition to the tax treatment of charging interest, there are other legal complexities to consider. Section 40(1) of the National Credit Act requires that a person must apply to be registered as a credit provider if the total principal debt owed to that credit provider under all outstanding credit agreements exceed the prescribed threshold which has been R nil since 11 May 2016. Failure to register as a credit provider could result in the credit agreement being declared void. There are exceptions to the application of the National Credit Act which should be considered.When loans become irrecoverable
The legal and tax consequences of loans becoming irrecoverable as well as the requirements and implications of the prescription of debt are complex and could vary significantly from case to case. It is worth obtaining professional advice when considering writing off or waiving significant loans with related parties.Donations tax and estate duty
Throughout this article we have referred to donations tax being levied at 20%. This only applies to the first R30 million after which it increases to 25%. The same applies for estate duty where applicable. Donations tax must be paid to SARS by the end of the month, following the month in which the donation was made. Deemed donations due to interest being charged at a rate lower than the SARS official rate of interest are deemed to have been made on the last day of the relevant year of assessment.Conclusion
Loans between related parties often lead to legal and tax consequences not fully considered at the inception. It is well advised to properly consider all tax and legal aspects, and if necessary, obtain professional advice before entering into a loan agreement with a related party.