What, if any, are the tax consequence of an interest free loan to a company? Taxpayer is a South African Private Company, with only director who is also the sole shareholder. His uncle, who is not part of the company, made a loan to the company at no inte
Important:
This answer is based on tax law for the year ending 28 February 2020.
Answer:
There is no legal, from a tax point of view at least, requirement that interest must be charged. The decision to, or not to, charge interest in respect of debt is not a tax related issue. In this instance it is clear that the agreement between the directors, the company in essence, and the person providing the finance, didn’t provide for interest to be levied on the amount outstanding from time to time.
The Income Tax Act doesn’t ‘force the parties to charge interest’.
Note that the mere granting of a loan interest free, does not give rise to a donation, as no right to earn interest is waived (definition of donation in section 55(1)). If a loan agreement grants the lender a right to charge interest, then the waiving of that right is a “donation” as defined in section 55 of the Income Tax Act and subject to donations tax.
Refer to Interpretation Note 58 (issue 2) dated 4 October 2012: The Brummeria case and the right to use loan capital interest free. This interpretation note discusses when an interest free loan can result in an inclusion in gross income, being the interest “saved” by the borrower.
It is true that Judge Froneman, in CSARS v RM Woulidge said, “as long as the capital remains unpaid the failure to charge interest represents a continuing donation…” At issue before the court then was section 7 of the Income Tax Act. You referred to section 7C - it deems a donation to arise when an interest free loan is made to a trust or a company by a person connected to the trust (under certain circumstances). This does not apply in this case because all the shares are held.
Where the agreement between the parties provides for interest to be incurred by the company, the principle is that the amount of interest incurred during a year of assessment, must be deducted from the income of that person (the company) derived from carrying on any trade, if that amount is incurred in the production of the income. See section 24J(2) of the income Tax Act in this regard.
The interest will accrue to the holder of the instrument - see section 24J(2) of the income Tax Act in this regard – and be accounted for as gross income.