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Financial Planning

The ‘Loan Account Redemption Plan’ – a useful debt management strategy?

Advisors working within the business risk environment are sure to be familiar with the ‘Loan Account Redemption Plan’. Cynically, I have always viewed it as a solution suggested to clients as a means to earn more commission and not given with the client’s best interest at heart. However, I believe that such cynicism is unfair and some discussion and analysis of the plan, in order better to understand its workings and evaluate its usefulness, should prove helpful to us all when deciding whether or not to suggest it to our clients.

 

The plan has been described as: “…plan is used to release funds to the shareholder/ director/member…who has lent money to the company/close corporation… The funds are released in such a way that the company’s capital requirements are not affected.” ¹The idea seems to be that it is a means of avoiding the liquidity problems that often arise from settling a loan owed to the director.

For those readers who are perhaps less familiar with the plan, it can be set out as follows:

1. The company approaches a bank or other financial institution for a loan equal to the amount owed to the director in terms of the credit loan account.

2. The company uses the proceeds from this new loan to settle the loan account due to the director.

3. The director invests the cash received in terms of the repaid loan account in a five year investment policy with an insurance company. (Note the investment is made in the name of the director and not the company. The five year period is required to ensure that the income earned on the investment will be received by the director free from income tax in his hands.)

4. In order for the company to secure the loan from the financial institution the policy is ceded by the director to the bank as security for the loan.

5. During the period of the loan the company pays only the interest in terms of the loan agreement.

6. At the end of the loan period when the policy matures and the debt becomes due, the director once again lends an amount to the company, equal to the company’s debt to the bank, to enable the company to repay its loan to the bank.

7. The director’s loan account is accordingly reinstated and, in an ideal world, he has two options:

7.1. The balance of the proceeds of the policy on maturity thereof (assuming that positive growth was obtained) can be withdrawn; or

7.2. On maturity the balance of the proceeds of the policy can be left invested with the insurance company and capital withdrawals can be made therefrom.

1. Income tax and the ‘Loan Account Redemption Plan’

1.1. The misconception regarding the tax-free nature of the investment proceeds

The general structure of the plan requires that the proceeds received from the settlement of the original credit loan account to the director be invested for a five year term in an investment policy. Ostensibly, this is to ensure that the proceeds from the investment are received by the director free from Income Tax.

Clients and their advisors often make the mistake of thinking that the income on the policy investment remains untaxed. However, that is not so as the income on the policy investment is taxed in the Policy Holder Fund in terms of the ‘Four Funds Approach’ at a rate of 30% on the interest and rental income on the investment, that is, the proceeds are received by the director with 30% tax already deducted.

It is important, when considering whether or not to use the plan, to bear in mind the client’s marginal rate of tax as an investment in an investment policy would effectively have increased the client’s tax liability in instances where the client’s marginal rate of tax is less than 30%. In those circumstances, it may be better not to invest the funds in an investment policy. If we also bear in mind the individual’s interest and foreign dividend exemption then the individual will need to have a marginal rate of tax in excess of 30% to result in a tax liability equal to or higher than that paid in the policy holder fund.

 

1.2. The misconception regarding the benefit resulting from the interest deduction

 

It is said that the deductibility of the interest payments during the period of the loan is at the heart of the ‘Loan Account Redemption Plan’. From discussions with colleagues, it seems that many of them are under the impression that the tax deductibility of the interest payments mean that there is no cost to the company in regard to interest payments on the loan. This, however, is incorrect. The company is saving only in respect of that portion of the expense that would have been paid in tax should the expense not have been incurred.

For example: consider that the monthly cost of the loan, the interest, is R10 000. Now, if the company has an income of R100 000 for the month and its only expense is in respect of the interest then it will have made R90 000 profit and will be taxed at 28% on that profit, which tax will amount to R25 200 leaving the company with an after tax profit of R64 800.

On the other hand, should the company not have had the interest expense in respect of the loan, it would have made R100 000 profit which will be taxed at 28%, which tax will amount to R28 000, leaving the company with an after tax profit of R72 000. If we compare the company’s profits when taking the loan to that when not taking the loan, we can see that the cost of the loan to the company is R7 200 per month.

If this is the case, then the financial sense, or not, of the plan should be measured by comparing the return received on the investment policy over the five year term to that which could have been had, should the effective monthly expense of R7 200 in respect of the interest on the loan have been invested monthly for the duration of the plan.

1.3. The deductibility, or not, of the interest payments

Another risk for the client in availing himself of the “Loan Account Redemption Plan” is that the deductibility of the interest in respect of the loan is not the foregone conclusion that some proponents would have you believe. In fact the deductibility, or not, of the interest depends on a number of factors. Furthermore, for the plan to have any hope of success, it will be necessary to show that the interest in respect of the original loan would have been deductible.

It can be noted that, in the case of Burgess v CIR², where the details of the scheme was remarkably similar to the structure proposed in the “Loan Account Redemption Plan”, the court did indeed allow the deduction of the interest expenditure. However, this case should not be taken to mean that the interest expenditure will be allowed as a deduction in all cases where a similar structure is used.

If you wish to deduct any expenses from your gross income, which is not specifically permitted in terms of the Income Tax Act³ then, in order for that expense to qualify for deduction, you have to meet the criteria contained in the general deduction provisions. These provisions are contained in sec 11(a), which tells you what qualifies for deduction, and is in turn limited by section 23(f) and (g), which details what may not be deducted:

“For the purpose of determining the taxable income derived by any person from carrying on any trade , there shall be allowed as deductions from the income of such person so derived-

 

i. Any expenditure and losses;

ii. Actually incurred during the year of assessment;

iii. In the production of income (as defined by the Act);

iv. Provided such expenditure and losses are not of a capital nature.”⁴

No deductions shall in any case be made in respect of the following matters, namely-

 

f) Any expenses incurred in respect of any amounts received or accrued which do not constitute income as defined in section one;⁵

g)        any moneys, claimed as a deduction from income derived from trade, to the extent to which such moneys were not laid out or expended for the purposes of trade;”⁶

All the above need to be present before the interest payment will qualify as a deduction.

The court, in the well-known case of Port Elizabeth Electric Tramway Co. Ltd.⁷, has determined that “actually incurred” requires the existence of an absolute and unconditional legal liability to pay. In the same case, the court has determined what is required for expenditure to qualify as being “in the production of income”. The court says that: “…income is produced by the performance of a series of actions and attendant upon them are expenses. Such expenses are deductible expenses provided they are so closely linked to such acts as to be regarded as part of the cost of performing them.”

Similarly, the question whether or not an “expenditure and loss” is of a “capital nature” and not deductible, as opposed to being of a “revenue nature” and deductible, is also not defined in the act. Here we have to look at the case of George Forest Timber Co Ltd⁸ for a test to distinguish capital from revenue. In this case, the court was of the opinion that money spent in creating or acquiring an income-producing concern or source of future profit is capital expenditure, whereas money spent working that source would be revenue expenditure.

From the above two requirements, it should be clear that it is no easy matter to comply with these requirements. It should be considered, before deciding to make use of the ‘Loan Account Redemption Plan’, what the origin of the director’s credit loan account was, before it is possible to determine whether or not the expense in respect of which the loan was incurred was of a capital nature and therefore deductible or of a revenue nature and therefore not deductible.

If the loan account, for example, came about as a result of a dividend being credited thereto, then the interest in respect thereto will in most cases not be deductible for an example where such interest was not allowed – refer to the case of Ticktin Timbers⁹. Also, as can be seen in the case of Borstlap¹⁰, so called pre-production interest, interest incurred in respect of an asset before it is brought into use in the tax payer’s trade, barring certain exclusions contained in section 11(bA)¹¹, is not deductible. As it is incurred in respect of an acquisition or equipment, which will be a source of future profits, it is of a capital nature and is not deductible.

Many other scenarios are possible where the origin of the debt is such that a deduction of the interest payments in respect thereof will not have been possible in respect of the original debt owed to the director and will as a result not be deductible once the old debt is exchanged for the new. In order to ensure compliance with suitability requirement for advice contained in section 8 of the FAIS General Code of Conduct¹² I would suggest that advisors be wary of suggesting the ‘Loan Account Redemption Plan’ before a suitable due diligence in respect of the debt, its origin and ability to be deducted under the general deduction provisions has been done. I would further suggest that the complexity of the issues involved would require a tax specialist and would suggest the use of one to avoid potential personal liability due to negligence.

2. Capital Gains Tax

The general idea in respect of the “Loan Account Redemption Plan” is that if structured correctly, the investment proceeds will be received by the director free of income tax and that there will be no Capital Gains Tax implications. However, seeing as Capital Gains Tax in the hands of an individual is a maximum of 10%, as opposed to 28% income tax, should the advisor not be advising the director to structure his investments in such a way as to have it fall within the Capital Gains Tax net rather than the Income Tax net? This idea can be expanded upon to place some funds in interest bearing investments to use the interest deduction that is available in terms of the Income Tax Act and in this way further lower the average rate of tax on the investment.

3. Return on investment

It would seem however, from the point of view of return on investment/expense that the “Loan Account Redemption Plan” may not be the best use of its money for the company as, after the five years of payments, it is in the same position as it was at the start thereof.

To be successful and have funds available for the re-loan required to settle the loan from the bank the company and its director cannot risk negative growth on the policy investment. As such the investment has to be made in a “Growth Plan” with a guaranteed return. Unfortunately, this guarantee comes at the expense of growth with the result that better returns can be had from other investments, albeit with no guarantee and the possibility of negative growth.

In other words, in order to judge the quality of the investment a comparison should be made between the returns from an investment in the “Growth Plan” and that of other forms of investment – such as a collective investment scheme (hereafter referred to as unit trust).

The results of any calculations in this regard will inevitably hinge on the assumptions that are made with regards to the growth obtainable in the different types of investments and the interest payable on the loan. The rates of the “Growth Plan” are easily obtainable and since it is a guaranteed product no assumption will be needed in this regard. However, the interest rate on the loan will depend on the financial institution forwarding the loan and is liable to change from time to time. Also, returns on an investment in a unit trust will vary, i.e. it will be a fluctuating return and not linear, so the best we can do is to take an average performance over a period of time in order to get some idea of what performance can be expected. This of course is not a guaranteed return.

It should also be remembered when doing any calculations in this regard, that the expense in respect of the interest will through the effect of the tax deductibility thereof, discussed above, be “partially funded” by SARS and this effect needs to be incorporated in the calculation.

Lastly, the cost aspect of the investment policy will also have to be considered, as all costs incurred in respect of administration costs to the insurer and commission payable to the broker will in turn reduce the returns.

 

4. Conclusion:

After consideration of the plan I am, for the following reasons, still not convinced that it is such a “great idea”.

i. While it is so that the plan has not in any way required from the company to reduce its Income Producing capital, it seems to me that the plan still fails to meet its stated objective, namely to release funds to a director, shareholder or member to whom the company/CC owes money. Yes, indeed on obtaining the replacement loan the company does settle the debt in respect of the credit loan account, but the plan does not however stop there. The plan requires that the director take the payment received and immediately reinvest it in order to have capital available in 5 years time, when the new loan needs to be settled, to once again lend money to the company and in doing so re-creating the first scenario. So we see that effectively the director has not in fact received the funds in a form useful to him during the duration of the scheme.

ii. At the conclusion of the scheme we have once again returned to the original status quo – barring potential growth on the investment. This growth on the investment comes at the cost of a monthly payment of interest to the bank. As shown above this interest payment is tax free in respect of 28% thereof, but the other 72% thereof comes out of the company’s pocket. As a large number of loans from directors/shareholders and members seem to be interest free it should be remembered that the scheme, in those situations, is creating a monthly expense where before there was none. Remember that this is still an expense that needs to be paid by the company, impacting its cash flow, before it receives a tax deduction in respect thereof at a later stage. A deduction which, as discussed above, is not at all certain.

Nevertheless, even if the loan account should be drawing interest the relevant interest rate of the old versus the new loan should be borne in mind especially as the company after five years of paying the probably higher interest rate to the bank is back in the same position as it was at the beginning of the scheme.


 

¹Premiums and Problems Exam edition no. 101 for 2010 at D42.

² Burgess v CIR 1993 (4) 161 (A)

³ Income Tax Act 58 of 1962

⁴ Section 11(a) of the Income Tax Act 58 of 1962

⁵ Section 23(f) of the Income Tax Act 58 of 1962

⁶ Section 23(g) of the Income Tax Act 58 of 1962

⁷ Port Elizabeth Electric Tramway Co Ltd v CIR 1936 CPD 241

⁸ CIR v George Forest Timber Co Ltd 1924 AD 516

⁹ Ticktin Timbers CC V CIR 1999 (4) SA 939 SCA

¹⁰ Borstlap v SBI 1981 (4) 836 (A)

¹¹ Section 11(bA) of the Income Tax Act 58 of 1962

¹² General Code of Conduct for authorised Financial Services Providers and their representatives in terms of Section 15 of the Financial Advisory and Intermediary Services Act No. 37. of 2002.







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