The Income Tax Effects of Members Debit Loan Accounts

1
The Income Tax Effects of Members Debit Loan
Accounts

• A lecture presented by Professor Phillip Haupt
  to the South African Institute of Professional
  Accountants (Western Cape)

Cape Town 23 August 2008 www.hedron.co.za
books_at_hedron.co.za
2
What is a members debit loan account?

• A members debit loan account arises when a close
  corporation makes a loan (or an advance which is
  subsequently converted into a loan) to a member
  of that close corporation.
• The loan is shown as an asset in the books of the
  close corporation.
• It is a liability in the hands of the member.
• The principles set out here apply equally to a
  loan which a company makes to its shareholder.

3
What can the income tax effects of a members
debit loan be?

• The loan could have one or more of the following
  results
• The loan could be treated as a fringe benefit in
  the hands of the member
• The loan could be treated as a dividend
  declared by the corporation (i.e. a distribution
  to members)
• The loan could be treated as an unproductive
  asset in the hands of the close corporation and
  lead to the add-back of expenditure

4
Are there any anti-avoidance provisions in the
Income Tax Act?

• Fringe benefit This can arise whether the loan
  is made by the company or by someone else, and
  whether it is made to the employee or someone
  else.
• Dividend This can arise whether the loan is
  made to the member or to a person connected to
  the member.
• The detail in respect of the above is set out
  later.

5
Are there any exemptions, exceptions or
exclusions?

• Fringe benefits exclusions these usually arise
  where the loan is made by virtue of membership
  and not by virtue of employment, or where the
  loan bears more than a certain rate of interest.
  Where the member uses the loan to produce income,
  he obtains some relief against a double tax.
• Dividend exclusions there are a number of
  exclusions contained in section 64C of the Act.
• The detail is set out later.

6
Fringe benefits tax

• Paragraph (i) of the gross income definition in
  section 1 of the Income Tax Act includes in gross
  income
• the cash equivalent, as determined under the
  provisions of the Seventh Schedule, of the value
  during the year of assessment of any benefit or
  advantage granted in respect of employment or to
  the holder of any office, being a taxable benefit
  as defined in the said Schedule, and any amount
  required to be included in the taxpayers income
  under section 8A
• Although the provision refers to the holder of an
  office, this is not enough to trigger the fringe
  benefits provisions

7
What is the holder of an office?

• The Income Tax Act does not define office or
  office holder.
• The Close Corporations Act defines an officer
  as any manager or secretary of the CC, whether or
  not such manager or secretary is a member.
• The Companies Act defines an officer in relation
  to a company as including any managing director,
  manager or secretary of the company.
• The Income Tax Act defines a director as follows
  director, in relation to a close corporation,
  means any person who in respect of such close
  corporation holds any office or performs any
  functions of a director of a company other than a
  close corporation

8
Is a member a holder of office?

• A member can be a holder of office in a close
  corporation, but he need not be.
• Section 46(b) of the Close Corporations Act
  provides that every member shall have equal
  rights in regard to the management of the
  business of the corporation.
• This does not mean that a member does manage or
  is a manager of the close corporation. This is a
  question of fact and can be varied by the
  association agreement between the corporation and
  the members from time to time.

9
Seventh Schedule Fringe benefits

• Taxable benefits are set out in paragraph 2 to
  the Seventh Schedule to the Income Tax Act.
• The preamble to paragraph 2 is important, i.e.
• 2.   For the purposes of this Schedule and of
  paragraph (i) of the definition of gross income
  in section 1 of this Act, a taxable benefit shall
  be deemed to have been granted by an employer to
  his employee in respect of the employees
  employment with the employer, if as a benefit or
  advantage of or by virtue of such employment or
  as a reward for services rendered or to be
  rendered by the employee to the employer

10

• What is important here is that a fringe benefit
  does not arise only because of the fact that a
  benefit is given to an office holder (i.e. a
  member who manages the close corporation).
• It must be given as a reward for services
  rendered or to be rendered as an employee, or
• It must be given by virtue of the members
  employment.
• There has to be a clear link (nexus) between the
  benefit and the employment.

11
Paragraph (2)(f) - Loans

• The operative provision of paragraph 2 is
  sub-paragraph (f), for loans, i.e.
• ( f ) a loan (other than a loan for purposes of
  the payment by the employee of any consideration
  in respect of any qualifying equity share
  contemplated in section 8B to comply with the
  minimum requirements of the Companies Act, 1973
  (Act No. 61 of 1973), or the payment of any stamp
  duties or uncertificated securities tax payable
  in respect of that share, or a loan in respect of
  which a subsidy is payable as contemplated in
  subparagraph (gA)) has been granted to the
  employee, whether by the employer or by any other
  person by arrangement with the employer or any
  associated institution in relation to the
  employer, and either no interest is payable by
  the employee on such loan or interest is payable
  by him thereon at a rate of lower than the
  official rate of interest

12

• The official rate of interest is set by the
  Minister of Finance in the Gazette from time to
  time and can be accessed on the SARS website
  (www.sars.gov.za).
• The current rate is 12 per annum (with effect
  from 1 March 2008).
• Therefore, if a loan is made to a member by
  virtue of his employment or as a reward for
  services rendered, and interest at an annual rate
  of 12 is charged on the loan, no fringe benefit
  arises. As the interest rate changes, the
  interest on the loan has to change. Usually this
  is in March and September each year.

13
Paragraph 11

• Paragraph 11 of the Seventh Schedule contains the
  detail in respect of the fringe benefit.
• The fringe benefit is the difference between the
  official interest rate and the (lower) interest
  rate paid by the member/employee.
• There are two exclusions, one dealing with casual
  loans not exceeding R3 000 per employee and loans
  to enable an employee to further his or her own
  studies.
• It is not likely that a loan to a member will be
  seen as a casual loan

14
Deemed expense para 11(5)

• Where the taxpayer uses the proceeds of the loan
  for the purposes of producing income, the amount
  of the fringe benefit is deemed to be interest
  actually incurred for section 11(a).
• Note that interest is now deducted under section
  24J and so the paragraph should be updated to
  replace the reference to section 11(a) with
  section 11(a) or section 24J.
• Example Mr X borrows R300 000 from his close
  corporation to fund his farming business. The
  loan is interest free and the fringe benefit is
  therefore R36 000 for the year. Mr Xs tax
  effect is

15
Anti-Avoidance para 16

• Paragraph 2(f) operates whether the loan is made
  by the employer, or by arrangement with the
  employer or by an associated institution (see
  above).
• Paragraph 16 takes the anti-avoidance even
  further, however, i.e.
• BENEFITS GRANTED TO RELATIVES OF EMPLOYEES AND
  OTHERS
• 16.   (1)  For the purposes of this Schedule and
  of paragraph (i) of the definition of gross
  income in section 1 of this Act, an employee
  shall be deemed to have been granted a taxable
  benefit in respect of his employment with an
  employer if as a benefit or advantage of or by
  virtue of the employees employment with the
  employer or as a reward for services rendered or
  to be rendered by the employee
• (a) the employer has granted a benefit or
  advantage (whether directly or indirectly) to a
  relative of the employee, other than a benefit or
  advantage in respect of which paragraph
  10 (2) (d) applies or
• (b) anything is done by the employer under any
  agreement, transaction or arrangement so as to
  confer any benefit or advantage upon any person
  other than the employee (whether directly or
  indirectly),
• and such benefit or advantage, if it had been
  granted directly by the employer to the employee,
  would have constituted a taxable benefit
  contemplated in paragraph 2.
• (2)  The provisions of this Schedule shall apply
  in relation to the taxable benefit so deemed to
  have been granted as though the taxable benefit
  had in fact been granted to the employee.

16
Deemed dividends

• Currently, distributions made by a close
  corporation to its members are treated as
  dividends subject to 10 STC (secondary tax on
  companies) for income tax purposes. The reason is
  as follows
• The Income Tax Act defines a company as including
  a close corporation.
• The definition of dividend includes any amount
  distributed by a company to its shareholders
• A shareholder is defined in relation to a close
  corporation as a member of such corporation
• All of these definitions are contained in section
  1 of the Income Tax Act.

17
Section 64C

• Section 64B of the Income Tax Act provides for a
  10 tax to be paid by a company (close
  corporation on all dividends declared to its
  shareholders (members). Therefore if a close
  corporation makes a distribution of R100 000 to
  its members, it has to pay to SARS, STC of R10
  000 by the end of the next month. This payment
  is declared on an IT56 form.
• Section 64C sets out the circumstances under
  which a dividend is deemed to be declared for the
  purpose of section 64B. This is an
  anti-avoidance section to prevent members from
  taking funds out of the close corporation without
  paying the 10 STC. Its application is automatic.

18

• Section 64C(2)(g) is the operative provision in
  regard to loans and states
• (2)  For the purposes of section 64B, an amount
  shall, subject to the provisions of
  subsection (4), be deemed to be a dividend
  declared by a company to a shareholder, where
• any loan or advance is granted and made available
  to that shareholder or connected person in
  relation to that shareholder
• A connected person is as defined in section 1 of
  the Income Tax Act.
• There is no specific exclusion if the loan is
  also a fringe benefit unless it is part of a
  scheme available to employees who are not members
  (see s64C(2)(e)). The result is that if a loan
  to a member is subject to fringe benefits tax it
  is likely to be subject to STC as well. It does
  not mean that a loan subject to STC is subject to
  fringe benefits tax, however, as it may not be
  given as a reward for services rendered.

19
Exclusions section 64C(4)(b)

• Section 64C(4)(b) states
• (4)  The provisions of subsection (2) shall not
  apply
• where the amount constitutes remuneration in the
  hands of the shareholder or any connected person
  in relation to that shareholder or the settlement
  of any debt owed by the company to the
  shareholder or connected person
• The amount in this case is the amount of the
  loan (see s64C(2) on the previous slide). As the
  loan amount itself is not remuneration, this
  exclusion does not apply. The fact that the
  Seventh Schedule deems a notional interest amount
  to be a fringe benefit does not mean that the
  loan itself is remuneration. Interestingly
  enough, the provision does not refer to
  remuneration as defined in the Fourth Schedule.
  Therefore the normal dictionary definition of
  remuneration applies.

20
Exclusions section 64C(4)(e)

• Section 64C(4)(e) states
• (4)  The provisions of subsection (2) shall not
  apply
• to any loan granted to the shareholder or any
  connected person in relation to the shareholder
  if the shareholder or connected person is an
  employee of the company or an associated
  institution contemplated in paragraph 1 of the
  Seventh Schedule in relation to the company and
  such loan is granted under, and in compliance
  with the normal terms and conditions of, a loan
  scheme generally available to employees of the
  company or of the associated institution who are
  not shareholders
• This exclusion will not apply if there does not
  exist, in the close corporation, a loan scheme
  available to all employees who satisfy certain
  criteria. This confirms that even if a loan is a
  fringe benefit, it could still be subject to STC
  if no such loan scheme exists.

21

• Section 64C(2)(c) excludes
• so much of any amount (other than an amount
  contemplated in subsection (2) (e)) as exceeds
  the companys profits and reserves which are
  available for distribution, including any amount
  deemed in terms of the definition of dividend
  in section 1 to be a profit available for
  distribution Provided that any prohibition or
  limitation on any such distribution contained in
  the companys memorandum and articles of
  association or founding statement or any
  agreement shall be disregarded in the application
  of this paragraph
• This means that if a corporation does not have
  profits or reserves, the amount of the loan
  cannot be deemed to be a dividend. The question
  arises as to where the company can get funds to
  make a loan if there are no profits or reserves.
• The funds could come from members contributions,
  or from borrowings. If there are reserves and
  the funds come from borrowings, the exclusion
  will not apply.

22
Profits

• The term profits in section 64C(2)(c) includes
  unrealised profits per the dividend definition in
  section 1., i.e. -
• Provided further that for the purposes of this
  (dividend) definition profits includes realised
  and unrealised profits of a company whether or
  not those unrealised profits have been recognised
  in the financial records of the company
• Therefore, to work out the profits, one has to
  look at the profits in the financial statements,
  plus the excess of the market value of the assets
  on hand over their book values.

23
Example

• A close corporation has the following balance
  sheet
• Assume that it borrows funds and lends these free
  of interest to the member (qua member) and then
  has the following balance sheet

24

• Although the corporation has no realised
  reserves, it does have unrealised profits of R200
  000, being the difference between the market
  value of the building and its cost.
• Assume the following balance sheet of ABC Close
  Corporation
• The trust is the family trust of the member.

25

• The total profits and reserves are as follows
• Therefore, the loan of R600 000 to the trust (a
  connected person in relation to the member) is
  deemed to be a dividend or R431 818, and so
  subject to STC of R43 181,80.

26
Exclusions - Section 64C(4)(d)

• Section 64C(4)(d) states
• (4)  The provisions of subsection (2) shall not
  apply
• (d) to any loan granted in respect of which a
  rate of interest not less than the official rate
  of interest, as defined in paragraph 1 of the
  Seventh Schedule is payable by the shareholder or
  any connected person in relation to the
  shareholder
• This exclusion is the most common one. Not only
  does it avoid STC, but also avoids fringe
  benefits tax. The problem is that the interest
  is taxable in the hands of the corporation, and
  not usually deductible in the hands of the
  member. It also leads to an increase in the
  reserves of the corporation.

27
Exclusions - Section 64C(4)(f)

• Section 64C(4)(f) states
• (4)  The provisions of subsection (2) shall not
  apply
• ( f ) to any loan or credit granted to a
  shareholder of the company or any connected
  person in relation to the shareholder during any
  year of assessment of the company granting the
  loan or credit, if
• such loan or credit is repaid or otherwise
  extinguished by not later than the end of the
  immediately succeeding year of assessment
• the amount thereof is not included in any
  subsequent loan or credit granted to the
  shareholder or any connected person in relation
  to the shareholder and
• the provisions of this paragraph have not been
  applied in the case of the company in any
  previous year of assessment

28

• This is to help those corporations which made
  interest-free loans to the members in ignorance
  of the provisions of section 64C. The loan can
  be extinguished by being repaid or being used to
  settle a debt created by a dividend or salary to
  the member.
• This is only a once-off relief.
• It cannot be used in respect of a loan that has
  been outstanding for a longer period, even if the
  loan bore interest in the earlier period.
• It also cannot be extinguished by ceding the loan
  from a member to his wife, or trust, for example
  as these are connected persons in relation to the
  member.

29
Exclusions section 64C(4)(i)

• This is included for completeness, i.e.
• Section 64C(4)(i) states
• (4)  The provisions of subsection (2) shall not
  apply
• to any loan or credit granted to a trust by a
  company to enable that trust to purchase shares
  in that company or the controlling company in
  relation to that company with a view to the
  resale of those shares by that trust to employees
  of that company, under a share incentive scheme
  operated by the company for the benefit of those
  employees
• Note that in all cases, the word company
  includes a close corporation.

30
Repayment of loan

• If a loan is deemed to be a dividend declared and
  the 10 STC has been paid, any repayment of the
  loan by the member or connected person is deemed
  to be a dividend received by the corporation
  s64C(5).
• From an STC point of view this means that the
  corporation obtains an STC credit.
• A dividend is deemed to be declared on the date
  the loan is made, and it is deemed to be received
  on the date that the loan is repaid.

31
Connected person- Note that one is looking at
who is connected to the member, not who is
connected to the close corporation

• In relation to a member of a close corporation,
  section 1 deems the following to be connected
• Any relative of the member
• Any trust of which the member or a relative is a
  beneficiary, or any other person or entity
  connected to the trust
• Any partner of the member
• Any company in which the member holds (directly
  or indirectly) at least 20 of the equity share
  capital or voting rights (either alone or which a
  connected person)

32
Example

• Assume the following structure

Mr X
100
ABC Close Corporation Members interest R1
000 Reserves R1 million Cash R1 000 Loan to XYZ
R1 million
Loan of R1 million
50
XYZ (Pty) Ltd
33

• Mr X is a connected person in relation to X (Pty)
  Ltd as he indirectly holds 50 of the equity
  share capital of X (Pty) Ltd
• The fact that the close corporation is also
  connected to X is irrelevant.
• The loan to X is therefore a deemed dividend
  declared by ABC Close Corporation.
• As X (Pty) Ltd is not part of the same group as
  ABC, there is no STC relief.

34

• Assume the following structure

Mr X
100
ABC Close Corporation Members interest R1
000 Reserves R1 million Cash R1 000 Loan to XYZ
R1 million
Loan of R1 million
70
XYZ (Pty) Ltd
35

• In this case the loan will not be subject to STC
  due to exclusion (l) in section 64C(4), i.e.-
• (4)  The provisions of subsection (2) shall not
  apply
• to any amount contemplated in subsection (2) (a),
  (b), (c), (d) or (g) distributed, transferred,
  released, relieved, paid, settled, used, applied,
  granted or made available by a company for the
  benefit of any controlled group company in
  relation to that company.
• A controlled group company is defined in section
  1 as follows
• group of companies means two or more companies
  in which one company (hereinafter referred to as
  the controlling group company) directly or
  indirectly holds shares in at least one other
  company (hereinafter referred to as the
  controlled group company), to the extent that
• at least 70 per cent of the equity shares of each
  controlled group company are directly held by the
  controlling group company, one or more other
  controlled group companies or any combination
  thereof and
• the controlling group company directly holds at
  least 70 per cent of the equity shares in at
  least one controlled group company

36
Unproductive asset

• An interest free loan to a member is an
  unproductive asset, unless it is given to him or
  her as a fringe benefit.
• If it is an unproductive asset, any costs
  incurred in making the loan cannot be deducted
  for tax purposes.
• Therefore, if funds are borrowed at interest and
  on-lent to the member interest-free, the interest
  on the borrowing will not be tax deductible.