Many South Africans use trusts, companies and other family structures as part of their wealth and estate planning. However, transactions between related parties are subject to connected persons tax rules, which are some of the most important anti-avoidance provisions in the Income Tax Act. These provisions are designed to prevent taxpayers from shifting wealth, income, losses, or assets between related parties on non-commercial terms to obtain a tax advantage. Understanding these rules is essential before transferring assets, providing loans, restructuring investments or implementing family wealth strategies.
What is a “connected person”?
Section 1 of the Income Tax Act defines connected persons broadly and covers various relationships between individuals, trusts, companies and partnerships. Examples include:
Individuals
- A natural person and their relatives, including spouses, parents, children, siblings and extended family members.
- Any trust in which that person or a relative is a beneficiary.
Trusts
- A trust and its beneficiaries.
- A trust and any person connected to that beneficiary.
Partnerships
- A partner is connected to every other partner.
- Persons connected to those partners.
Companies
- A company and individuals or entities that directly or indirectly hold a significant equity interest or voting rights.
- Other companies within the same group.
- Persons who, together with connected persons, hold at least 20% of the equity shares or voting rights.
In practice, most family-owned companies, family trusts and related investment structures are connected to the same persons.
Why does this matter?
The SA Revenue Service (SARS) assumes that connected persons may not always transact at arm’s length. An arm’s-length transaction is one in which the parties involved are acting independently and in their own best interests, as if they are unrelated and have no relationship that could influence the terms of the transaction.
Unlike unrelated parties who negotiate purely on commercial terms, connected persons may:
- Sell assets below market value.
- Charge little or no interest on loans.
- Shift profits to lower-taxed entities.
- Transfer wealth to family members.
- Create artificial losses.
Consequently, sections of the Income Tax Act contain special rules whenever connected persons are involved, and SARS may adjust the tax outcome to reflect what would have occurred between unrelated parties.
Key tax consequences
1. Market value substitution for capital gains tax
One of the most important consequences is that SARS may ignore the actual price at which any transaction is done, disregard the actual transaction price and apply the market value instead. The capital gains tax (CGT) is then calculated at the market value of the asset, not the price it is sold for.
For example, A parent sells shares worth R10mn to their child for R1mn. SARS may treat the transaction as having occurred at R10mn, meaning CGT could apply based on the market value rather than the amount received.
2. Losses may be ring-fenced
Where an asset is sold at a loss to a connected person, the capital loss is generally deferred until the connected person disposes of the asset to an unconnected party.
3. Interest-free and low-interest loans
Loans between connected persons, especially interest-free or low-interest loans to trusts,can trigger several provisions and require careful consideration.
Potential consequences include:
- Donations tax implications.
- Deemed donation rules.
- Trust attribution rules.
- Section 7C trust rules.
This is one of the most significant connected-person rules affecting estate planning. Consequently, for estate planning purposes, trust funding arrangements should be structured carefully and reviewed regularly.
On interest-bearing loans, SARS would consider whether the interest rate is ‘market-related’.
How is this defined? SARS does not prescribe a single fixed “market-related” interest rate that applies in all circumstances. Instead, SARS generally considers a market-related rate to be: The rate that independent parties dealing at arm’s length would have agreed upon, having regard to the borrower’s creditworthiness, security provided, currency, term of the loan, and the interest rate that would normally apply to similar transactions.
Practical SARS benchmarks
In practice, SARS often uses certain benchmark rates as indicators:
- Official rate of interest
- Generally linked to the SA repo rate plus a prescribed margin.
- This is not necessarily a market rate for all transactions.
- Section 7C loans
- For interest-free or low-interest loans to trusts (and companies connected to the trust), SARS primarily uses the repo rate plus 1% to calculate any deemed donation.
4. Offshore structures and transfer pricing
Where connected persons transact across borders, transfer pricing rules may apply if:
- A SA company deals with a foreign connected person, and
- the transaction is not at arm’s length.
SARS may adjust taxable income to what it would have been had independent parties transacted. Examples include:
- Excessive management fees.
- Interest-free offshore loans.
- Artificially low pricing of goods or services.
Additional penalties and interest can apply if transfer-pricing adjustments are made.
5. Donations tax
Transactions between connected persons often attract scrutiny under the donations tax provisions. Examples include:
- An asset transferred below market value.
- Debt waived without adequate consideration.
- Interest-free funding arrangements.
SARS may treat the value given away as a donation.
6. Estate planning structures
Connected-person rules are particularly relevant where:
- Family trusts hold investments.
- Family companies own assets.
- Parents fund trusts.
- Offshore trusts are used.
Many traditional estate-planning techniques are affected by:
- Section 7 attribution rules.
- Section 7C.
- CGT market value rules.
- Donations tax provisions.
- Transfer pricing rules
As a result, structures must be carefully designed and documented.
Practical examples
Example 1: The sale of property to a family trust
A property worth R15mn is sold to a trust for R8mn.
The potential consequences are:
- CGT may be calculated based on the R15mn market value.
- Possible donations tax on the R7mn difference.
- SARS scrutiny of the valuation.
Example 2: An interest-free loan to a trust
A R30mn loan is provided to a family trust.
The potential consequence:
- SARS may apply section 7C deemed donation rules annually.
Example 3: Selling shares to a family company
Shares are sold to a company owned by family members.
The potential consequences are:
- Market value substitution.
- Possible CGT exposure even where little cash changes hands.
- Possible increased anti-avoidance SARS scrutiny.
Why is it particularly important for offshore structures
For South Africans using:
- Offshore trusts,
- Offshore foundations,
- Offshore holding companies,
the connected-person rules interact with:
- Section 31 transfer pricing rules
- Controlled foreign company (CFC) rules,
- Section 7 attribution rules,
- Section 25B trust rules,
- Section 7C loan rules.
A structure that appears commercially sensible can produce unexpected SA tax consequences if connected-person relationships are overlooked.
Conclusion
The connected-person rules do not prohibit transactions between related parties. However, these transactions must be carefully structured and supported by the appropriate documentation, as they often cause SARS to disregard the actual terms of the transaction and substitute arm’s-length or market-value outcomes. The main consequences are:
- Market-value substitution for CGT.
- Deferred or denied capital losses.
- Donations tax exposure.
- Section 7C deemed donations on trust loans.
- Transfer-pricing adjustments for offshore transactions.
- Increased SARS scrutiny and documentation requirements.
For someone implementing a SA/offshore trust structure, connected-person analysis should be performed before any share transfer, loan funding, trust funding, debt waiver or restructuring transaction is undertaken. This ensures that those structures continue to work effectively as tax rules, family circumstances and investment objectives evolve.
If you wish to discuss this further, please contact Di Haiden – di@rcinv.co.za
