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QUESTION THREE (30 MARKS)

Dom Kop suffers normal tax at the maximum marginal tax rate of 45% on all his additional earnings. He has a 19-year-old son who is fulltime university student. He is wholly responsible for the maintenance of his son while he is a fulltime student. During the 2024 year of assessment, he spent R180 000 on maintaining his son. This was in addition to providing him with accommodation.

Both Dom Kop and his son are residents of the Republic.

Acting upon the advice of his accountant, Dom Kop and his son carried out the following transactions:

On 28 February 2023 Dom Kop sold a rent-producing property at its market value of R3 000 000 to his accountant.
On 1 March 2023 he lent R3 000 000 from his sale to his son, interest free.
On the same day his son used R3 000 000 to purchase the same rent-producing property from his father’s accountant.
During the 2024 year of assessment net rentals of R180 000 accrued to Dom Kop’s son for the rent-producing property that he had purchased. This amount was the sole amount that accrued to him for the year.

Besides providing his son with accommodation in his home, Dom Kop made no other contributions towards his son’s maintenance during the 2024 year of assessments.



YOU ARE REQUIRED TO:

Discuss whether the Commissioner could successfully use any of the provisions contained in the Income Tax Act to stop this tax-saving arrangement. Show all relevant calculations.

1 answer

In this scenario, Dom Kop engaged in a series of transactions that could be scrutinized by the South African Revenue Service (SARS) under the Income Tax Act. We'll analyze the transactions and relevant provisions that may apply to stop the tax-saving arrangement.

Overview of the Transactions

  1. Sale of Property:

    • Dom Kop sold a rent-producing property at its market value of R3,000,000.
    • He sold it to his accountant (unknown if at market value).

  2. Loan to Son:

    • Dom Kop lent R3,000,000 interest-free to his son.

  3. Son's Purchase:

    • His son used the R3,000,000 to buy the same rent-producing property from the accountant.

  4. Rental Income:

    • Dom Kop's son accrued net rental income of R180,000 during the year.

  5. Dom's Maintenance Expenses:

    • Dom spent R180,000 maintaining his son, in addition to providing accommodation.

Potential Issues

1. Tax Avoidance or Evasion

SARS could argue that these transactions were structured primarily to avoid tax. The application of the General Anti-Avoidance Rule (GAAR) in Section 80A of the Income Tax Act could be relevant here.

  • Section 80A defines a tax avoidance arrangement as any transaction involving a contrived or artificial arrangement designed to avoid tax. Specifically, if the main purpose of the transactions was to evade taxation, the Commissioner may disregard those transactions.

2. Transfer Pricing and Market Value

  • The market value of R3,000,000 ties into transfer pricing rules. If the property sold to the accountant was significantly undervalued compared to the market rate, it may attract scrutiny under Section 31, which relates to the deductibility of interest and the valuation of transactions.

3. Interest-Free Loan

  • The loan from Dom to his son was interest-free. Under Section 7, which deals with the taxation of loans to minor children, there could be implications if the transaction is deemed to have not been conducted at arm's length, especially concerning how this impacts the allocation of taxable income.

4. Income Tax Implications for the Son

  • The son earned R180,000 in rental income, which would be subject to tax. His taxable income would need to be calculated based on that rental income and any allowable deductions. However, his status as a full-time student may allow for certain exemptions or lower tax rates under Section 10(1)(c), the taxation of students.

Calculation of Tax Impact

Considering Dom Kop's marginal tax rate of 45%:

  1. Tax on Son's Income:
    • Rental Income: R180,000
    • Assuming no deductions for simplicity:
    • Tax = R180,000 * 45% = R81,000 (if taxed at Dom's rate).

Conclusion

It appears that the transactions between Dom Kop and his son can be considered artifice aimed at avoiding tax. The Commissioner could invoke the General Anti-Avoidance Rule if he determines that the transactions were primarily aimed at reducing Dom's tax liability and preserving wealth within the family unit.

The provision of interest-free loans and the sale of property could also fall under scrutiny for potential undervaluation or non-arm's length treatment if not handled correctly.

Ultimately, while Dom’s son will be liable for tax on the rental income, the arrangement’s design could lead SARS to challenge the legitimacy of the transactions under the noted provisions. An in-depth review of the facts and perhaps consultations with SARS on each transaction may be warranted to reduce exposure to any serious challenges.