As a result of the current economic situation (where many people are not financially secure), borrowing money from friends or family can be a means of survival, or to cover unforeseen expenses. In a previous article we mentioned that the National Credit Act does not apply:

• to credit agreements involving loans between family members, partners and friends on an informal basis, and
• between a stokvel, and a member of that

But please be aware, there are two things to consider:

• whether the National Credit Act will apply, and
• what the income tax implications

One must determine whether such a loan is made on an arm’s length basis.

An Arm’s length transaction means that the terms of the transaction are equivalent to market-related terms and conditions of a transaction completed by two (unrelated) parties, acting freely and independently of each other. It is likely that these parties have equal bargaining power and are not subject to undue pressure or influence from the other party.

The Court considered this question in Beets v Swanepoel. In this case, the mother granted a loan to her daughter at a favourable interest rate. The daughter failed to honour her part of the agreement and the mother approached the court to claim the outstanding balance of the loan.

The daughter argued that her mother (the lender) ought to have been registered as a credit provider as required in terms of the Credit Act and that her failure to do so renders the loan agreement invalid. Based on these facts, the Court ruled in the daughter’s favour and held that the credit agreement was at arm’s length despite the mother-daughter relationship and for that reason, the loan agreement was found to be invalid.

But what are the income tax implications of such loans?

In general, one would normally find interest-free loans in the case of family members or very close and trusted friends. Such borrowings tend to be informal, and non-repayment or partial repayment is common.

An interest-free loan by a person to another person resident in South Africa has no tax effect unless the borrower is the spouse or minor child of the lender. If the borrower is the spouse or child, then section 7(2) of the Income Tax Act could apply if the loan was made for tax avoidance or income splitting, as motivation behind such a loan. If that is the case, the result would be that the lender is taxed on the value of the “benefit” that the borrower got for not having to pay interest.

Where tax avoidance or income splitting is not the drive behind these loans, it is nevertheless recommended that a loan agreement be put in place, especially for larger sums. This formalises the arrangement and makes repayment more likely, particularly if either party should die.

In the event of a loan where interest is charged, the rule states that all amounts received by or accrued to a taxpayer (in cash or otherwise) that are not of a capital nature and are capable of being valued, should be included in the taxpayer’s gross income and are therefore subject to income tax.

Section 10(1)(i), however, provides for an exemption of interest received from a source in the Republic. The exemption applies to interest up to,

• R23 800 for taxpayers below the age of 65 years,
• R34 500 for taxpayers aged 65 years or older, and
• R23 800 in the case of the estate of a deceased

It must be remembered that the absence of a loan agreement could be misinterpreted as a donation.

If you are the “lender” you could be subject to 20% donations tax on any “loans” in excess of R100 000 a year. There is an exemption for situations where you make genuine contributions towards the maintenance of a person, to the extent considered reasonable by SARS. This would apply to persons who are dependent on you, even if they are not legally your “dependants”, and should cover amounts paid to another person in your close circle to cover their necessary expenses, within reason.

On a personal note, even though you are dealing with family, setting up an official loan agreement or contract in which the outstanding debt is formally recognised, is a crucial part of the success of the arrangement. Everyone must know their obligations and agree to them formally.

Bear in mind that an outstanding loan will remain an asset in your hands when you die. At that stage such a  loan will generally be recognised as an asset in the estate and could therefore attract estate duty.

 

Article by BH Groenewald
Director (Tax),
BVSA Chartered Accountants (Pty) Ltd
bennieg@bvsa.ltd