It never ends: Proposals to clarify the interaction between section 7C and transfer pricing rules in the context of low or interest-free loans

The current legal position

As we have discussed in many of our previous Tax & Exchange Control Alerts, section 7C is an anti-avoidance provision aimed at preventing the tax-free transfer of wealth to trusts using low or interest-free loans, advances, or credit arrangements, including cross-border loan arrangements. The mechanism through which it prevents anti-avoidance is by stating that if the interest rate charged on loans made by individuals to trusts and certain connected-person companies is lower than the official rate of interest, the difference between the interest charged and what would have been charged at the official rate of interest, will be treated as a deemed donation. The “official rate of interest” is defined as:

• In the case of a rand-denominated debt, the South African repo rate plus 100 basis points.
• In the case of a foreign currency denominated debt, a rate of interest that is the equivalent of the South African repo rate applicable in that currency plus 100 basis points.

For a rand-denominated debt, the official rate of interest is currently 9,25%. To illustrate the application of the section – if a person were to advance an interest-free loan of R1 million to a South African connected person trust, the difference between the interest charged (R0) and the interest that should have been charged in terms of the official rate of interest, being R92,500, is R92,500. The full amount is treated as a deemed donation in terms of section 7C.

However, section 7C(5) contains a list of exclusions to which section 7C does not apply. One of the exclusions is where the transfer pricing provisions in section 31 of the ITA apply to a cross-border loan or advance made by a South African resident to a non-resident. Section 31 applies to so-called “affected transactions”, which are broadly defined, but for purposes of this article, it is sufficient to state that a loan advanced by a South African resident to a non-resident, where the parties are connected persons, will be an affected transaction. This would include a situation where a South African resident is a beneficiary of a foreign trust and advances a loan to that trust. Section 31 states that one must consider whether the terms of an affected transaction, including a loan, adheres to the arm’s length principle.

SARS interpretation notes and debate

Given the wording of the exclusion in section 7C(5), there has always been some debate as to the interaction between sections 7C and 31 of the ITA. Some commentators have taken the view that given the wording of exclusion in section 7C(5) it was unclear whether section 7C could still apply where section 31 applied to a cross-border loan. The more commonly held view has been that if section 31 applies to a cross-border loan, section 7C does not apply. One needs to consider two SARS interpretation notes in this regard.

In SARS Interpretation Note 114 (IN114), published on 2 March 2021, an example is included of an instance where a South African resident makes an interest-free loan to a non-resident discretionary trust. Although IN114 was not intended to expressly deal with the interaction between sections 7C and 31, it provides some useful insight. In the example, SARS states that section 31 may apply on the basis that the loan to the non-resident trust is potentially an affected transaction. However, it continues to state that the South African resident should also consider the possible application of section 7C. While some interpreted the example to suggest that if section 31 applies to the loan, section 7C will not, it was not entirely definitive. The example did not address whether there would be an issue if the rate that applies in terms of section 31 were lower than the official rate of interest.

However, Interpretation Note 127 (IN127), published on 17 January 2023, seemed to clarify the issue. There, SARS uses an example where an interest-free loan is advanced by a South African resident to a non-resident discretionary trust, which is a connected person, and where the market-related (arm’s length) rate is 10%. It notes that the loan is used by the trust to earn rental income of R80,000, which is vested in the South African resident donor in terms of section 7(8) of the ITA. Considering that the arm’s length amount is R100,000 (10% of R1 million), a transfer pricing adjustment of R20,000 must be made that also constitutes a deemed donation under section 31(3). IN127 then goes on to state that considering the exclusion in section 7C(5) and that “the affected the transaction is subject to the provisions of section 31(2) and section 31(3) … section 7C(2) and section 7C(3) do not apply”. Pursuant to this, it seemed clear that section 7C would not apply where section 31 applies, although one should keep in mind that SARS interpretation notes are not binding.

Budget announcement and implication

Despite the above, and while acknowledging that the intention of the exclusion in section 7C(5) is “to avoid the possibility of an overlap or double taxation”, it states that:

“[the] exclusion does not effectively address the interaction between the trust anti-avoidance measures and transfer pricing rules where the arm’s length interest rate is less than the official rate on these cross-border loan arrangements. It is proposed that amendments be made to the legislation to provide clarity in this regard.”

It appears that there is a concern in the context of loans where the arm’s length interest rate, determined in terms of section 31, is lower than the official rate of interest that applies where section 7C applies and that this may result in avoidance. This issue is not addressed in IN127 example, although at the time that it was published, the official rate of interest was lower than 10% (being the arm’s length rate in the example). While it remains to be seen how the issue will be addressed, one can only hope that the proposed amendment will not have the effect of diluting the exclusion by stating that the official rate of interest should also apply to a cross-border loan to which section 31 applies. One should appreciate that IN127 set out detailed considerations that should be taken into account in determining an arm’s length rate. It is at least arguable that if the proper application of those IN127 considerations results in justifying an arm’s length rate that is lower than the official rate of interest, the official rate of interest should not apply. Although many countries currently have high interest rates compared to prior years, a foreign trust could potentially be able to borrow abroad at a lower rate than the official rate of interest.