For those who have trusts and for those contemplating the creation of trusts, the question of the high tax rates associated with these entities is, more often than not, a nagging one.A typical inter vivos discretionary-type trust is taxed at 40% on its taxable income and, since the last Budget, at 26.7% on any capital gains. But are trusts really the tax nightmare they appear to be?The Income Tax Act and its Eighth Schedule contain important provisions which, if applied correctly, can ameliorate the ostensible high tax rate situation.
1.This article focuses specifically on inter vivos discretionary trusts, and does not deal with the taxation of special trusts, vested trusts and the like.
2.Hereinafter referred to as "the Act.”
3.Needless to say, this is just a simple example.One could for instance distribute or award more of the gain to beneficiaries with a lower capital gains tax rate.
4.Unless the Trust Deed requires audited financial statements, then statements reflecting income and expenditure, assets and liabilities, will suffice.
5.Lack of proper administration can also lead to the Trust being seen as an alter ego of the Founder and/or Trustees leading assets being then deemed to fall into the personal estates of these individuals.
The Provisions of the Income Tax Act 2 : The Conduit Principle
Section 25B of the Act pertains to income earned by a trust and Paragraph 80 of the Eighth Schedule to the Act deals with the taxation of any capital gain made by a trust.The Act and Eighth Schedule recognise the application of the so-called conduit principle in terms of the income or gain, instead of being retained by the trust, and taxed at the rate of the trust, can be distributed, or awarded to a beneficiary of the trust, at his or her income or capital gains tax rate, in the same year that the income is received or accrued, or the gain made. In these circumstances, the income retains its nature when it is distributed or awarded to the beneficiary.For example, if dividend or interest income is earned in the trust, when the conduit principle is applied, it will retain its nature as dividend or interest income in the hands of the beneficiary.
In addition, we can go further and split the income or gain to various beneficiaries as opposed to just a single beneficiary.By so doing, we can apply the tax thresholds, deductions, exemptions and rebates applicable to individuals, in respect of income, and the annual exclusion applicable to individuals, in respect of capital gains, to each beneficiary to whom the income or gain is distributed or awarded by the application of the conduit principle.By way of a simple example, if a trust makes a R300 000 capital gain, we could split the gain to three of the beneficiaries at say a R100 000 each.
Each beneficiary would then be able to subtract the R30 000 annual exclusion from the capital gain of R100 000, thus making the taxable gain in each of their hands R70 000.Assuming each beneficiary is on the highest capital gains tax rate of 13.3%, the net effect of this would be 13.3% of R210 000 as opposed to distributing or awarding the gain to only one beneficiary, where the net effect would be 13.3% of R270 000.
The conduit principle is unique to trusts and affords a certain amount of tax efficiencies and flexibility to the tax planner, which opportunities are not available in other entities, such as companies and close corporations.The tax efficiencies created by the conduit principle may be compromised, in the event of the application of the anti-avoidance/deeming provisions, as contained in Section 7 of the Act, when it comes to income, and paragraphs 68 to 73 of the Eighth Schedule, when it comes to capital gains.
It is important to bear in mind that we should, ideally, not use a trust to run a business.From a tax point of view, it would be far better to run a business in a close corporation, or a company, the members’ interest or shares of which can be held by a trust. If we were to run a business in a trust, we would pay 40% tax on taxable income as opposed to the 28% in a corporate entity.Trusts are better suited to protecting assets and effective estate planning.In this context we may wish to contemplate the creation of a well-considered trust structure, versus a single trust, in order to optimise the aforementioned benefits.
The Real Tax Nightmare: Non - Compliance
Perhaps it can be argued that the real tax nightmare surrounding trusts is not the high tax rates but the lack of proper administration and compliance.Failure to, inter alia, register the trust for tax, to submit returns, and to prepare financial statements can cause the benefits of the trust to be compromised and further lead to penalties, interest and other sanctions in terms of the Act.SARS’s recently issued Compliance Programme: 2012/13 – 2016/17 has highlighted the intention of SARS to focus on wealthy South Africans and their trusts, and their lack of compliance.
Trusts afford a certain amount of tax efficiencies which are not available in other entities and this, notwithstanding the high tax rates applicable to trusts.Trusts are therefore not the tax nightmare that they are so often perceived to be.Much depends on what we are utilising trusts for and whether we have a well-managed and considered trust structure in place which is compliant in all respects.
Source: By Heather Pretorius (TaxTALK)