STC and Dividends Tax on interest-free loans

Dear Client,

STC and Dividends Tax on interest-free loans

Although Secondary Tax on Companies (STC) was replaced by Dividends Tax on   1 April 2012, many companies have recently been receiving unexpected STC assessments from SARS, often for quite substantial amounts of tax and with an extra punch in the form of interest.  On closer analysis, it seems that in many cases, the levying of the STC by SARS is in fact justified in terms of the Income Tax Act – much to the surprise of the companies and their owners!

The STC liability arises because the scope of the deemed dividend provisions under the STC rules was, in fact, very wide.  This article explains why STC has been applied, how the deemed dividends arose, how the STC liability is calculated and how interest-free loans are treated under the new Dividends Tax.

Dividends declared by a company to its shareholders up until 31 March 2012 were subject to 10% STC.  The liability on actual dividend distributions is obvious but the Income Tax Act also contains provisions to circumvent tax avoidance transactions that enable a shareholder to benefit in some way even though no cash dividend was actually declared.  Under these provisions, certain types of transactions give rise to deemed dividends with the result that STC becomes payable.

Section 64C(2) of the Income Tax Act lists 8 different circumstances that will give rise to a deemed dividend and s 64C(4) then lists certain exemptions from the deemed dividend rule.  As far as interest-free loans are concerned, s 64C(2)(g) states that an amount is deemed to be a dividend declared by a company to a shareholder where a loan or advance is granted and made available to that shareholder or connected person in relation to that shareholder.  Two exemption provisions are relevant:

  1. The deemed dividend rule will not apply if interest has been charged on the loan at a rate at least equal to the ‘official rate of interest’ for fringe benefits tax purposes (s 64C(4)(d)).  This rate is currently 6% per annum.
  2. The deemed dividend rule will not apply if the loan is repaid or otherwise extinguished by the end of the following year of assessment (i.e. the year following the year in which the loan is advanced) (s 64C(4)(f)).
  3. For example, assume ABC CC advanced an interest-free loan of R500 000 to its member, Joe Bloggs, on 1 May 2010.  ABC CC’s financial year ends on the last day of February each year.  The loan has not yet been repaid.
  4. Result: The financial statements of ABC CC for the years of assessment ended 28 February 2011 and 29 February 2012 will reflect a loan to Joe Bloggs of R500 000.  The loan does not carry any interest, was advanced during the year ended 28 February 2011 and has not been repaid by the end of the following year, i.e. by 29 February 2012.  The full amount of the loan is therefore a deemed dividend under s 64C(2)(g) and STC is payable on the loan at the rate of 10%.  ABC CC therefore has a STC liability of R50 000 (R500 000 x 10%).
  5. Where the deemed dividend provision applies as a result of an interest-free loan, the dividend is deemed to have been declared by the company on the date that the loan was made available (s 64C(6)).  Under the STC rules, the dividend cycle ended on this date and the STC was due and payable by the end of the following month.  Interest will be charged by SARS on any STC liability that remains unpaid after the due date for payment.
  6. In the above example a dividend of R500 000 was deemed to be declared in May 2010 and the STC should therefore have been paid by 30 June 2010.  Assuming SARS raises an assessment for STC of R50 000 in April 2013, interest will also be payable on the R50 000, calculated at the prevailing interest rate (currently 8.5%) from 1 July 2010 until 31 March 2013.  This would result in an interest charge of more than R12 000!

Loans to connected persons

An often overlooked aspect of this deemed dividend provision is its application to loans made by a company to any connected person in relation to its shareholders.  In other words, the scope of the provision is broader than merely loans from a company to its shareholders.  This has particular relevance for horizontal structures where an individual owns a number of companies and/or close corporations.  To fully appreciate the implications of the connected party rule, one would need to examine the definition of ‘connected person’ in s 1 of the Income Tax Act.  Briefly, in the context of closely held companies the following part of the definition of ‘connected person’ is relevant:

  • Any member of a CC is a connected person to that CC.
  • A non-company shareholder of a company other than a CC is a connected person to the company if he owns (either alone or together with any connected person in relation to himself, e.g. any of his relatives) at least 20% of the shares in that company.
  • A company that owns at least 20% of the equity shares in another company is a connected person to that other company if there is no majority shareholder in the company.

For example, assume Jim Smith owns all the members interest in 3 CCs:

CCa, CCb and CCc.  If CCa advances an interest-free loan to CCb this will fall within the scope of ‘a loan made by a company to a connected person in relation to a shareholder’ because CCb is a connected person

in relation to Jim and Jim is a shareholder of CCa.  Therefore, the deemed dividend provision as described above will apply to this loan and CCa will have a STC liability plus a liability for interest on the late payment of that STC along the lines described in the earlier example.

 

What happens under the Dividends Tax regime?

STC applied to any dividend (including deemed dividends) declared on or before 31 March 2012.  Dividends Tax at the rate of 15% is levied on any dividend paid on or after1 April 2012, unless a specific exemption or lower-rate concession applies.  In considering the Dividends Tax implications for low-interest loans advanced to shareholders or their connected persons, four possibilities are considered:

 

1.       New loans advanced on or after 1 April 2012

The Dividend Tax rules contain a new deemed dividend provision for low-interest loans in s 64E(4).  This provision applies only where the following three conditions are present:

(i)                  The debtor is a person other than a company;

(ii)                The debtor is a resident; and

(iii)               The debtor is either a connected person to the company or a connected person to that connected person.

 

In these circumstances, the deemed dividend arises where the debtor owes an amount to the company ‘by virtue of a share held in that company’ during a year of assessment.  For example, a loan advanced to the son of a CC member by virtue of the father’s interest in the CC would fall within the scope of the provision if the son is a resident.  The loan from CCa to CCb in the example in above would not fall within the scope of this provision as the debtor is a company.

Where the deemed dividend rule applies, the amount of the deemed dividend is calculated by applying a notional interest rate to the loan account balance during the year.  The notional interest rate is the difference between the official interest rate (currently 6% as explained above) and the actual interest rate charged on the loan.  It is noteworthy that only the interest differential is a deemed dividend, not the capital amount of the loan.

Where the deemed dividend rule applies, the dividend is deemed to be paid on the last day of the year of assessment and the company must pay the Dividends Tax, calculated at 15% on the amount of the deemed dividend, by the end of the month following the year-end.  The dividend is deemed to be a dividend in specie, which results in the company bearing the cost of the dividends tax.

For example, assume XZY CC advanced an interest-free loan of R100 000 to its member, Sally Shabangu, on 1 April 2012.  The loan balance has remained unchanged.  XYZ CC’s financial year ends on the last day of February each year.

Result: XZY CC is deemed to have paid a dividend of R5 500 (R100 000 x 6% x 11/12) on 28 February 2013.  The Dividends Tax payable is R850 (R5 500 x 15%) and XYZ CC had to pay this amount to SARS by no later than 29 March 2013 (the last business day of the month) to avoid interest being charged.

 

2.       Loan in existence on 1 April 2012 remains unchanged

Although there is a loan in existence during the year of assessment, the deemed dividend rule described above does not apply to the extent that the debt has already been taxed as a deemed dividend under the STC provisions (s 64E(4)(e)).

 

3.       Loan in existence on 1 April 2012 increases thereafter

The increase in the loan from 1 April 2012 will give rise to the deemed dividend provision as outlined above.  The notional interest rate as explained in item 1. above will be applied to the loan balance excluding the portion of the loan that has already been subject to the STC provisions.

4.       Loans in existence on 1 April 2012 decrease thereafter

There is no further tax implication on the repayment of the loan.  The repayment does not give rise to a STC credit because the repayment is deemed to be a dividend that accrued to the company on the date the amount is repaid (s 64C(5)) and this date falls after 31 March 2012, the last day on which STC credits could be created.

 

Conclusion

Low-interest and interest-free loans advanced by a company could have expensive tax consequences.  Consult your accountant or tax advisor to ensure that you avoid any nasty surprises!

 

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