Holdco (Pty) Ltd has recently established a subsidiary company Subco (Pty) Ltd. As a new company, Subco is in need of a cash injection. Accordingly, Holdco provides a voluntary interest-free loan to Subco to help it out with some much-needed capital to help grow its business. But what are the tax implications of this interest-free loan, if any?
From a business perspective, an interest-free loan is a good way to obtain financing, especially in instances where a company is newly established and as such may use such a loan as working capital. However to determine potential tax implications, one must consider the intent of the loan and whether said loan can be regarded as gross income and therefore taxable in the hands of the borrower, or capital in nature and therefore not taxable.
A loan can be defined as an amount lent to someone, the borrower, where there is in turn a reciprocal duty on the borrower to repay the loan, and if the parties so agree, with interest accumulating on the loan amount. Importantly though, there is no duty on the borrower to charge interest on a loan advanced, but could the interest-free nature of the loan give rise to potential tax implications.
A loan may be regarded as gross income in the hands of the borrower in the event that such a loan is made quid pro quo (in return for) for goods or services, and furthermore where the loan is interest-free or at a low interest rate. The amount that would form part of gross income in the hands of the borrower would not be the full loan amount, but rather the benefit that arises because of the fact that the borrower does not have to pay interest.
However, it is also important to note that not all interest-free loans have a benefit that the borrower can derive which would result in said benefit being treated as gross income. It is generally understood that interest-free loans that are granted for financing purposes to help grow the business, and where the underlying purpose is capital in nature and not necessarily quid pro quo, should not have tax implications for the borrower.
Should your company consider the making of a loan to a subsidiary for legitimate business purposes, it may be advisable to obtain opinion beforehand as to whether the loan would be of a capital or a revenue nature, with the interest-free amount potentially treated as taxable accrual in the hands of the borrower depending on its nature.