Section 7C of the ITA is a trust anti-avoidance provision aimed at limiting the tax-free transfer of wealth to trusts using low or interest-free loans, advances or credit arrangements, including cross-border loan arrangements. Since its inception, section 7C has been plagued by uncertainties that have led to multiple amendments aimed at clarifying and expanding the ambit of its application.

The most recent amendment to section 7C took effect on 1 January 2025 and was introduced by section 4(1)(b) of the Taxation Laws Amendment Act 42 of 2024, with the objective of limiting the exclusion of an ‘affected transaction’ as defined under section 31(1) of the ITA from the scope of section 7C.

Before we deal with what the amendment entails and the implications for taxpayers, it is useful to recap the anti-avoidance measures contained in section 7C and section 31 of the ITA.

Section 7C and its anti-avoidance objective

In terms of section 7C, when a South African resident who is a connected person in relation to a trust makes a loan (including a cross-border loan) to that trust and either does not charge interest or charges interest at a rate that is lower than the official rate of interest, the shortfall amount of interest that would have been applied as per the official rate of interest will be deemed to be an ongoing annual donation to the trust by the resident lender. This deemed donation is subject to South African donations tax as may be applicable from time to time.

The official rate of interest is defined in the ITA to mean: 

·        in the case of a debt denominated in the currency of the Republic, a rate of interest equal to the South African repurchase rate plus 1%; or 

·        in the case of a debt denominated in any other currency, a rate of interest that is the equivalent of the South African repurchase rate in that currency plus 1%.

For example, consider a situation where a loan of GBP 1 million is made by a South African resident to a connected person foreign trust (on an arm’s length basis) against an interest rate of 4,75%. With the official interest rate currently at 5,75% (based on the Bank of England base rate of 4,75% plus 1%), the difference of GBP 10,000, representing the forgone interest, would be deemed to be a donation under section 7C. At an exchange rate of GBP 1 = ZAR 23, this amounts to ZAR 230,000, which would be subject to donations tax.

Section 31 transfer pricing adjustments

Section 31 of the ITA contains anti-avoidance measures (also known as the transfer pricing rules) that apply to certain ‘affected transactions’, which include but are not limited to cross-border loan arrangements between connected persons. 

In terms of section 31, if an ‘affected transaction’ has terms and conditions that deviate from those that would exist in an ‘arm’s length’ agreement between independent parties, certain transfer pricing adjustments must be made, which in turn may result in an increased tax liability in the hands of the South African residents.  

For purposes of this article we focus only on cross-border loan arrangements that would qualify as ‘affected transactions’ under the transfer pricing rules. In such instances, the provisions of section 31 would require the following transfer pricing adjustments to be made:

·        primary adjustment (section 31(2)): the lender must include the difference between the arm’s length interest rate and the actual interest charged (if any) in its taxable income; and

·        secondary adjustment (section 31(3)): 

·        where the lender is a company, then the amount of the primary adjustment is deemed to be a dividend consisting of an asset in specie declared and paid by the resident lender to the non-resident borrower; or

·        where the lender is a natural person, the amount of the primary adjustment is deemed to be a donation made by the resident lender to the borrower, thereby potentially incurring a donations tax liability at the donations tax rate as may be applicable from time to time.

Historical interaction between sections 7C and 31 of the ITA 

Previously, to avoid double taxation in instances where the application of sections 7C and 31 intersect, section 7C(5)(e) excluded cross-border loans classified as ‘affected transactions’ under section 31 from the ambit of section 7C. 

The 2024 budget announcement highlighted the concern that the 7C(5)(e) exclusion (as worded at that point in time) inadvertently created a loophole allowing for the avoidance of donations tax where the arm’s length interest rate determined in terms of section 31 was lower than the official rate of interest under section 7C. 

For instance, imagine Y, a South African resident, advanced an interest-free loan of R5 million to a connected non-resident trust. The arm’s-length interest rate (market-related rate) was 6%, resulting in interest of R300,000, while the official interest rate applicable under section 7C was 8,75%, equating to R437,500.

As this is a cross-border loan between connected persons, it falls within the scope of section 31’s transfer pricing rules and accordingly would have been excluded from section 7C (under the previous wording of section 7C(5)(e)). Under the transfer pricing rules, Y would have been required to: 

·        make a primary adjustment by including the difference between the arm’s length interest (R300,000) and the actual interest charged (R0) in their taxable income; and 

·        secondary adjustment: if Y was a company, the R300,000 would have been deemed to be a dividend in specie and subject to South African dividends tax, or, if Y was a natural person the R300,000 would have been deemed to be a donation and subject to donations tax. 

Had section 31 not applied, the transaction would have been subject to section 7C. In that case, the deemed donation would have been based on the shortfall between the official interest rate (8,75%) and the actual interest charged (0%), resulting in a deemed donation in the amount of R437,500 (R5 million × 8,75%).

Therefore, the section 7C(5)(e) exclusion in its previous form would have reduced the deemed anti-avoidance tax amount declared by Y by R137,500.

In the Explanatory Memorandum on the Draft Taxation Laws Amendment Bill, 2024, National Treasury relied on a similar example and referred to the loophole as an “unintended anomaly in the interaction between the trust anti-avoidance measures and transfer pricing rules”, which inadvertently created structuring opportunities that had the potential to lead to the erosion of the tax base. 

The amendment

The section 7C5(e) exemption was duly amended and now reads as follows:

“
…(e) that loan, advance or credit constitutes an affected transaction as defined in section 31(1) to the extent of an adjustment made in terms of section 31(2)”. (own emphasis added)

Practically, this amendment introduces a ‘further section 7C adjustment’ in as far as qualifying cross-border loan arrangements are concerned. 

The exemption under section 7C(5)(e) now only applies to interest subject to a section 31(2) adjustment. Where the arm’s length interest rate under section 31(2) is lower than the official rate, the difference is no longer be excluded from section 7C, leading to an additional donations tax liability.

Using the earlier example, the implications of the amendment are illustrated in terms of Y’s tax liabilities as follows:

·        primary adjustment (section 31(2)): Y is required to include the R300,000 of forgone interest in their taxable income; 

·        secondary adjustment (section 31(3)): 

·        if Y is a company, the amount of the primary adjustment (R300,000) is deemed to be dividend in specie, or 

·        if Y is a natural person, the amount of the primary adjustment (R300,000) is deemed to be a donation; and

·        a further 7C adjustment: the balance of the interest up to the official rate of interest (R137,000) is deemed to be a further donation under section 7C. 

The report of the Standing Committee on Finance on the Taxation Laws Amendment Bill, 2024, dated 19 November 2024, indicates that numerous submissions called for exclusions for arm’s length transactions with lower interest rates from the ambit of section 7C. National Treasury, however, dismissed these proposals, citing the anti-avoidance purpose of section 7C and asserting that the new amendment adequately addresses the gaps in the interaction between the trust anti-avoidance provisions and transfer pricing rules.

This amendment to section 7C(5)(e) therefore underscores the legislature’s commitment to ensuring that anti-avoidance measures are robust and effective. Taxpayers engaging in cross-border trust structures must carefully evaluate their compliance with the amended provision, as they may now face anti-avoidance tax liabilities under both sections 31 and 7C. Consulting with tax professionals is essential to navigate the complexities of these rules and avoid unintended tax consequences.