Taxation of trusts revisited
29 July 2015
Posted by: Author: Hanneke Farrand
Author: Hanneke Farrand (ENSafrica)
The Davis Tax Committee's First Interim Report on Estate Duty ("DTC Report”) was released for public comment on 13 July 2015. In essence, the DTC Report proposes that "a highly progressive tax that patches loopholes, helps provide equality of opportunity and reduces the concentration of wealth, must be implemented”.
The DTC Report was released in draft and is, therefore, open to comment. Following from this, it is clear that the recommendations in the DTC Report will not necessarily find their way into draft tax legislation. South Africa has well established rules and case law dealing with the taxation of trusts. The South African Revenue Service ("SARS”) recently introduced new tax returns for trusts that require far more detailed disclosures by taxpayers in accordance with these principles.
The DTC Report deals with, amongst others, donations tax, estate duty and the taxation of trusts. Below we set out our comments on the recommendations made in the DTC Report insofar as they are applicable to trusts.
We will send out further communications relating to the remaining recommendations made by the DTC.
Broomberg on Tax Strategy states that –
"The common assumption is that trusts are some kind of tax panacea... . Then, conversely, from a South African Revenue Service (SARS) perspective trusts are viewed with a degree of suspicion and mistrust. [T]he truth lies somewhere between these positions. Trusts are useful vehicles, but there is little tax magic that arises from the utilisation of a trust.”
The DTC report underlines SARS’s concerns with the use of trusts for tax planning purposes.
General principles relating to the taxation of trusts
In terms of South African tax law, essentially two different types of trusts exist; namely, a vesting trust and a discretionary trust. A vesting trust is a trust in which the beneficiary has a vested right to the income and/or capital thereof. A discretionary trust does not provide a beneficiary with a vested right to trust distributions. Instead, the trustees have a discretion to make distributions to beneficiaries.
Section 25B of the Income Tax Act 58 of 1962, read together with section 7(1), essentially codified the conduit-pipe principle first articulated in South African common law. In this regard, income received by, or accrued to, a vesting trust is taxed in the hands of the vested beneficiary/ies; ie, the trust is transparent for tax purposes. On the other hand, income received by, or accrued to, a discretionary trust will be taxed in the hands of the trust, unless it is distributed before the fiscal year end of the trust, in which case it will be taxed in the beneficiary’s/ies' hands.
The above income tax consequences may, however, be superseded by the deeming provisions relating to trust income as set out in section 7 of the Income Tax Act. In this regard, if a resident makes a gratuitous disposal to either a local or offshore trust, section 7 may attribute the retained income derived by the trust from such gratuitous disposition to that resident.
Where trust income is taxed in the hands of the trust on subsequent distribution to a beneficiary, such distribution is treated as capital in the hands of the beneficiary. However, section 25B(2A) provides that, in the context of offshore trusts, if the offshore trust distributes capital to a South African resident beneficiary, such capital may be taxed in that beneficiary’s hands as income, if certain requirements are met
In the context of capital gains tax ("CGT”), the Eighth Schedule to the Income Tax Act provides for attribution rules which attribute capital gains to the donor or settlor of a trust or to resident beneficiaries.
In the context of a loan from a South African resident beneficiary to an offshore trust, in our view, transfer pricing rules should be taken into account when determining the rate of interest to be charged on such loan.
Recommendations in the DTC Report
The DTC recommends, inter alia, that the following amendments be made to the existing tax legislation:
- The provisions in terms of which trust income can be taxed in the hands of beneficiaries or a donor at lower marginal rates, as opposed to the flat higher rate of tax in a trust, are to be removed. This means that trust income will always be taxed at the higher rate applicable to trusts.
- The attribution and distribution rules pertaining to offshore trusts are to be retained. However, all distributions of foreign trusts to South African resident beneficiaries are to be taxed as income.
- Trusts should be taxed as separate taxpayers.
- No attempt should be made to implement transfer pricing adjustments in the event of financial assistance or interest-free loans being advanced to trusts.
- Criminal action could be taken against taxpayers who fail to disclose their direct or indirect interests in foreign trust arrangements.
The transfer pricing rules are applicable to "affected transactions” (as defined), which essentially means that these rules are only applicable in a cross-border context. Therefore, as noted in the DTC Report, the transfer pricing rules are not applicable to loans between South African resident taxpayers.
In the event that the recommendation relating to the removal of the income attribution rules, insofar as they apply to South African trusts, is implemented, all trust income will be taxed in the South African trust. Essentially, whether or not the trust was funded by way of an interest-free loan would not be of relevance.
Offshore trust distributions
The recommendation in the DTC Report that all offshore trust distributions be taxed as income does not take into account the distinction between income and capital receipts. Repayments of loans or distributions of the original corpus of an offshore trust, in our view, should not be regarded as income distributions since such distributions should retain their nature as "capital”.
In our view, the rules applicable to the taxation of trust income and capital gains distributed by offshore trusts to South African resident beneficiaries are clear and can be substantiated if proper financial records are kept. To this end, the taxpayer carries the onus of proof to provide adequate records to substantiate the nature of the distributions. SARS could tax distributions from offshore trusts as income if the taxpayer could not prove that the distribution was made from the original capital or capital gains. Simply taxing all distributions from offshore trusts would have far-reaching and, in our view, unnecessary tax implications.
Commercial use of trusts
Trusts are not only used by individuals. In the corporate sphere, trusts are used to facilitate a portfolio of investments; for example, a collective investments scheme. These are not dealt with in the DTC Report. A broad-brush amendment of established principles would naturally also impact these arrangements.
If the recommendations in the DTC Report are implemented, then all South African resident trusts will be taxed as separate taxpayers. They will be taxed on income at a flat rate of 41% and on capital gains at an effective rate of 27.31%.
In respect of offshore trusts, all income derived by such offshore trusts by virtue of a donation from a South African resident would be taxed in the hands of the donor in terms of section 7(8) of the Income Tax Act. When the offshore trust distributes either capital gains or income to a South African resident, such amounts will be taxed as income in the hands of the South African resident beneficiary.
The DTC Report states that: –
"The repeal of the attribution provisions will have diverse and far-reaching implications ... . An extensive consultative process will have to follow … to identify and address the many issues involved.”
It is hoped that during this extensive consultative process, solutions can be found to the issues identified in the DTC Report without adopting the punitive tax measures contained therein.
This article first appeared on ensafrica.com.