Trusts And Tax Planning: An Unmitigated Disaster
23 January 2011
Posted by: TaxFind™
Trusts And Tax Planning: An Unmitigated Disaster
When words become vital…
Trust are a favourite tool of the rich and the mega-rich to shield the family's wealth from generational taxes, such as estate duty; to keep the ostensible income of individual beneficiaries low whilst giving them access to money and assets held by friendly trustees; and to ensure that the "black sheep” of the family cannot squander what has been built up over generations.
Wealth normally buys expert tax planning. But not in the case of the taxpayer in ITC 1840 (2009) 72 SATC 79 where the monumental blunders of the tax advisers cost the trust nearly R80 million in donations tax—which could have been totally and legitimately avoided by the addition of a few words to the trust deed, and by a few expeditious decisions when flaws in the tax plan came to light.
Principle: A trust can make distributions only to its beneficiaries
The core principle highlighted in this case can be briefly stated. If a trust distributes trust income or capital, gratis, to someone who does not fall within the class of beneficiaries defined in the trust deed, then it is a donation and is subject to donations tax. This particular case involved two trusts. The first ("the X Trust”) was established in 1973 when one S made a donation to the trustees for the benefit of six named children.
In 1981, the original trust deed was substituted by a new deed, in terms of which the assets in the trust were divided between six equal sub trusts (that is to say, sub-divisions within that same trust), one for each of the six children.
In 1994 six new trusts ("the children's trusts”) were created for the benefit of each of the six children. The trustees of the X Trust then proceeded to sell capital assets of that trust to each of the six trusts at market value, with a portion of the selling price left outstanding on interest-free loan account. Consequently, each of the children's trusts was in debted to the X Trust in an amount of R52 million.
In 1996, the X Trust awarded each of the children's trusts an amount of R52 million and, by agreement, these amounts were set off against the amounts owing on loan account by the children's trusts to the X Trust. However, the trustees of the X Trust had made the award of the R52 million to the children's trusts in the bona fide but mistaken belief that they had the power, under the trust deed of the XTrust, to make such awards, and the awards had been accepted by the children's trusts.
In 2006, the trustees were advised that those awards to the children's trusts may have been ultra vires, in that the trust deed of the X Trust did not state that the children's trusts were beneficiaries.The assessment to donations tax and the dispute in the tax court The Commissioner, acting in terms of Sections 54 and 56 of the Income Tax Act 58 of 1962, assessed the X Trust to donations tax in the amount of R78million (that is to say, at the then prevailing rate of 25% of the value of the donations), plus interest of R93 million, based on the 1996 awards by the X Trust to the children's trusts.
The X Trust objected to the assessment on the grounds that no property had been disposed of, alternatively that there had been no donation, alternatively that, if there had been a donation, it was exempt from donations tax.
A crucial issue in the resultant
Tax Court litigation was whether the awards made by the X Trust to the children's trusts had been made
out of "pure liberality or disinterested benevolence”—the touchstone of a donation for purposes of donations tax. The court held that the 1996 awards by the X Trust to the children's trusts were ultra vires
because the latter trusts were not beneficiaries of the X Trust. The court stated that making those awards without power or authority to do so is clear evidence that such awards were motivated by pure liberality or disinterested benevolence, because the trustees intended to benefit the 1994 children's trusts, which they wrongly regarded as beneficiaries.
The court also went on to say that "even if the 1996 awards were made in the bona fide but mistaken belief that the 1994 children's trusts were beneficiaries [of the X Trust] ... these were donations as contemplated by the legislature”.
As to whether the donations were exempt from donations tax, the court held that "there can be no question of such a donation being exempt from payment of donations tax, because the property was not disposed of under or in pursuance of the trust”. In other words, the awards to the children's trusts were outside the scope of the beneficiary clause of the X Trust and, in that sense, were not made "under or in pursuance of” that trust.
The court therefore ruled that "whether or not the transaction was void inter partes is irrelevant. Consequently, if a void transaction can give rise to liability for income tax, there is no reason why a transaction can also not give rise to liability for donations tax (see MP Finance Group CC (in liquidation) v Commissioner, South African Revenue Services 2007 (5) SA 521(SCA) at 523 B-C)”.
The court thus concluded that the X Trust "by its conduct either waived or renounced its right to reinstate the 1994 loan debts, and its inaction amounted to a donation giving rise to donations taxbecause, on its own version, the ultra vires point came to the attention of the trustees on or after 14 February 2006 and not later than 21 June 2006, the date of the [X Trust's] objection in which it relied on the fact that the 1996 awards were a nullity. In my [the judge’s]view, once the error was brought to the attention of the trustees, it was incumbent upon them to reinstate the loan debts in the financial statements.
"Inaction on their part amounted to a waiver or renunciation of their right to reinstate the loans. It should have been clear to the trustees ... that ... to do nothing ...and proceed to sign the financial statements of 2006 and 2007 ....constituted a waiver or renunciation of rights.
"I conclude therefore that [the X Trust] is liable for donations tax in respect of the 1996 awards, notwithstanding the fact that they may have been void as between the parties to the (illegal) agreement. It does not mean that if the award is not valid there is no donation.Validity is not a requirement for donation in terms of the Act.”
A succession of pitfalls
The timeline in this matter shows that the advisers to the trust, and the trustees themselves, fell into a succession of pitfalls. Firstly, if stated individuals are to be the beneficiaries of a trust, it is elementary draftsman ship to include, as further beneficiaries in the beneficiary clause, any trust of which those individuals are beneficiaries. Secondly, before making the distribution of the R52 million to each of the children's trusts, the professional advisers should have taken the elementary precaution of checking to see whether the recipients fell within the scope of the beneficiary clause of the X Trust. Thirdly, when it came to light that a distribution had been made to recipients who were not beneficiaries, that distribution ought to have been immediately revoked.
It is interesting that the tax court seems to have assumed that such a retrospective revocation would have been effective, for it is far from clear that this would have been so. As a matter of principle,once a transaction has been entered into, its tax and other consequence are fixed and cannot be undone, unless the transaction is voidable on one or other of the accepted legal grounds for voidability and is then set aside.
Source: By PricewaterhouseCoopers’ (Taxbreaks)