The recent introduction of section 7C to the Income Tax Act brought the taxation of trusts, and the funding thereof specifically, under the spotlight again. Briefly, section 7C seeks to levy donations tax on loans owing by trusts to connected parties (typically beneficiaries or the companies they control). To the extent that interest is not charged, a donation is deemed to be made by the creditor annually amounting to the difference between the interest actually charged (if at all), and interest that would have been charged had a rate of prime – 2.5% applied.
What many lose focus of is that interest free (or low interest) loans have income tax consequences too, over and above the potential donations tax consequence arising by virtue of section 7C. Section 7 of the Income Tax Act is specifically relevant. This section aims to ensure that taxpayers are not able to donate assets away and which would rid themselves of a taxable income stream.
In broad terms, section 7 deems any income that accrues to a trust or beneficiary to be the income of the donor if the income accrues from an asset previously the subject of a “donation, settlement or other disposition”. In other words, where a person donates a property to a trust, the rental income generated will not be taxed in the hands of the beneficiary or the trust, but in the hands of the donor. Section 7 therefore acts as an anti-avoidance provision to ensure that taxpayers do not “shift” tax onto persons subject to less tax through donating income producing assets out of their own estates.
It is interesting to now consider what an “other disposition” would amount to. Various cases have confirmed that an interest free loan would be treated as such and that, to the extent that interest is not charged, this would amount to a continuing donation. The implication thereof is this: assume the funder of a discretionary trust sells a property to that trust on interest free loan account. Any rental earned would ordinarily have been taxed in the hands of the trust or the beneficiary, depending on whether distributions will have been made. However, since section 7 will apply to the extent that no interest was charged on the loan account, a portion of the rental income will now be taxable in the hands of the trust funder.
The take-away is that donations to trusts have income tax implications for the donor too, over and above a donations tax consequence. This will also be the case where interest free loans are involved.
This article is a general information sheet and should not be used or relied on as legal or other professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Please feel free to contact Brian Kahn for further information or specific and detailed advice. Errors and omissions excepted (E&OE)