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Interest-bearing loans to family companies and family trusts have, to the present, been very tax effective.

Exempt interest from family companies and trusts is under threat.

The Draft Explanatory Memorandum on the Taxation Laws Amendment Bill, 2010 foreshadowed a significant amendment to the exemption presently accorded by the Income Tax Act to interest derived by an individual taxpayer.

In order, inter alia, to encourage saving, the Income Tax Act grants an exemption from income tax to interest earned by individual taxpayers, up to a specified amount, beyond which any further interest is taxed as ordinary income.

This interest exemption is capable of being exploited, and many taxpayers have done so.

For example, where a family company carries on a business, it can (instead of raising the necessary start-up capital by issuing shares) borrow money from its members or directors and pay them interest on the borrowed funds. The interest will be a tax-deductible expense for the company, and will be exempt from tax in the hands of the lender up to the statutory threshold, thus providing a tax benefit for both parties. This arrangement also works with a close corporation or a family trust that carries on a business and earns income.

The proposed amendment

SARS has proposed that the Income Tax Act be amended to provide that the interest exemption should be applicable only to "savings that flow into the general economy" (as distinct from loans to closely-held companies and family trusts), and that the exemption should apply only to interest-bearing products listed on the JSE, interest paid by government, and interest paid by a bank, friendly society, registered medical scheme, collective investment scheme or from a dealer or brokerage account.

In other words, the proposal is that there would be no exemption from tax for interest received from one's own family company, close corporation or trust. The interest outlaid by these entities would remain tax-deductible if they used the borrowed funds to produce income, but the interest would not be exempt from tax in the hands of the individual lenders who received it.

Many taxpayers were relieved to find that this proposal was dropped from the Explanatory Memorandum in its final form and that it does not feature in this year's tax amendments as contained in the current Taxation Laws Amendment Bill of 2010. Whether the proposal will be revived in future years, remains to be seen. It seems likely that the proposed amendment has just been temporarily shelved for further consideration and refinement by SARS, since it is clearly in an advanced stage of planning, and it seems that, in principle, a decision has probably been taken to introduce this amendment.

Taxpayers would be well advised to plan their affairs on the basis that the proposed anti-avoidance amendment in relation to exempt interest will indeed become law in the near future.


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