Directors Loan Account Traps: Section 7C and Dividends Tax

The directors loan account is the most common finding in owner managed company financial statements in South Africa, and the least understood. It is rarely created by a decision. It appears because the company paid a school fee, a medical bill, a car instalment or a home renovation, and the bookkeeper had nowhere else to put it.

That is fine until the balance grows, or until SARS, a bank or a buyer looks at it. This guide explains which direction the balance runs, what the tax rules do about it, and how to clean one up without creating a bigger problem.

Which way does the balance run

A credit balance is the healthier position, and it is often the cheapest form of funding a small company has. It still needs an agreement, particularly where a bank or an auditor asks whether the loan is repayable on demand, because a demand loan can affect the solvency and liquidity assessment.

Why a debit balance is a tax problem

The tax system takes the view that a company distributes value to its shareholders through dividends, and that dividends carry dividends tax. If a shareholder can simply borrow money from the company indefinitely and pay nothing for it, the benefit has been extracted without the tax. Two mechanisms close that gap.

• Deemed dividend on low interest loans. Where a company makes a loan to a shareholder or a person connected to a shareholder, and the interest charged is below the official rate of interest, the shortfall can be treated as a deemed dividend in specie and taxed accordingly. The charge recurs for as long as the loan stays outstanding.
• Fringe benefit on an employee loan. Where the director is also an employee and the loan relates to employment, the low interest benefit can instead fall into the Seventh Schedule as a taxable fringe benefit, with PAYE consequences on the payroll.
• Companies Act restrictions. Financial assistance to a director or a related company requires board approval, a solvency and liquidity test, and a special resolution or authority in the memorandum of incorporation. Without those, the loan can be void.

Where section 7C fits in

Section 7C is a separate anti-avoidance rule and it is frequently misapplied in conversation. It targets loans, advances and credit provided to a trust, interest free or below the official rate, by a connected natural person or by a company connected to that person. The forgone interest is treated as an ongoing donation by the lender, with donations tax consequences year after year.

It matters here because so many South African owner managed structures place the shares, the property or the family assets in a trust. A loan account that looks like a simple director balance can, once the trust is in the chain, sit squarely inside section 7C. If your structure includes a trust, get the loan reviewed rather than assumed.

How the balance builds without anyone deciding

1. 1Personal expenses on the company card. Groceries, travel, school fees and home costs coded to the loan account because there is no other home for them.
2. 2Drawings instead of salary. Money taken monthly with no payroll and no dividend declaration behind it.
3. 3Assets bought in the wrong name, most often a vehicle registered personally but paid for by the company.
4. 4Unsupported reimbursements, where a director is repaid for costs with no invoices behind them, so the amount is posted to the loan.
5. 5Prior year adjustments dumped to the loan account because the difference could not be explained at year end. This is the one that turns a small balance into a large one.

In an owner managed company the loan account is a diary of every decision nobody wrote down. Reading it honestly is usually the first step to fixing the structure.

Rishen Narsing, CA(SA)

How to clean up a debit loan account

There are only four real routes, and the right combination depends on your marginal tax position, the company's cash and the size of the balance. Model them before you choose, because the cheapest one on paper is not always the one the company can afford.

Whichever route you take, reconstruct the account first. Pull every entry for the period, categorise each one, and separate genuine business costs that were miscoded from actual personal extraction. A surprising share of most loan accounts is simply misposted expenses, and correcting those is free. The same reconciliation is what the ITR14 company tax return and the annual financial statements will need anyway.

What it costs you later

An unexplained loan account slows down everything that follows it. It extends the annual financial statement preparation because the reviewer cannot sign off a balance nobody can explain. It is a standing question in an independent review or an audit. Banks read it as owner extraction when assessing serviceability, and buyers price it into a deal.

How Synergy helps

We reconstruct and reconcile loan accounts, quantify the deemed dividend or fringe benefit exposure at the current rates, and design the clean-up under tax services. Where a trust is in the structure and section 7C is in play, we work through the position with your attorney before anything is posted. The ongoing fix, a documented remuneration policy and correctly coded owner expenses, sits under process and policy.