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Taxation of trusts to be revisited

27 October 2015   (0 Comments)
Posted by: Author: Hanneke Farrand
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Author: Hanneke Farrand (ENS)

The recent Davis Committee Report on Estate Duty has revealed that SARS is concerned with the use of trusts for tax planning purposes. 

The Davis Tax Committee First Interim Report on Estate Duty (DTC Report) was released for public comment on 13 July 2015. The DTC Report, in essence, proposes that "many deficiencies of the current estate duty system be addressed by way of…simple yet fundamental amendments to the existing legislation.” 

The DTC Report deals, among others, with donations tax, estate duty and the taxation of trusts. We set out below our comments on the recommendations made in the DTC Report insofar as they are applicable to trusts. 

It is clear from the DTC Report that SARS is concerned with the use of trusts for tax planning purposes and, in particular, in the context of estate planning. 

The recommendations in the DTC Report are subject to consultation and will not necessarily find their way into draft tax legislation. In this regard, the DTC Report specifically 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.” 

In Broomberg on Tax Strategy it is stated that: 

"The common assumption is that trusts are some kind of tax panacea... Then, conversely, from a…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.” 

South Africa has well established rules and case law dealing with the taxation of trusts. SARS also recently introduced new tax returns for trusts that require far more detailed disclosures by taxpayers in accordance with these principles. It is hoped that the fact that these mechanisms are currently available will be considered during the extensive consultative process and that solutions can be found to the issues identified in the DTC Report without adopting all the proposed tax measures. 

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, i.e. the beneficiary has a right to trust distributions which cannot be defeated, and such right passes to his cessionaries or his estate upon his death even if the distribution is payable at some future date. 

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 No. 58 of 1962 (Income Tax Act), 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, i.e. 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 to a beneficiary before the fiscal year end of the trust, in which case it will be taxed in the beneficiary’s 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, where any person (including a South African tax resident) makes a gratuitous disposal to a domestic trust which is subject to a condition or stipulation which provides that the beneficiaries may not receive the income (or a portion thereof) until the happening of some event, section 7(5) may attribute the retained income derived by the trust from such gratuitous disposition to that person until the happening of the event or the death of that person, whichever first takes place. It is accepted that the exercise of their discretion by the trustees of a discretionary trust is regarded as being an "event” for purposes of this section. 

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. 

In the context of capital gains tax (CGT), the Eighth Schedule to the Income Tax Act contains similar attribution rules which attribute capital gains to the donor or settlor of a trust or to resident beneficiaries. 

Specifically, paragraph 70 deals with capital gains retained in the trust and is worded similarly to section 7(5). In this regard, where any person (including a South African tax resident) makes a gratuitous disposal to a domestic trust which is subject to a stipulation or condition which provides that the capital gain (or a portion thereof) attributable to such gratuitous disposal shall not vest in the beneficiaries until the happening of some fixed or contingent event, paragraph 70 may attribute the retained capital gains attributable to such gratuitous disposition to that person if the capital gains has arisen during a tax year throughout which the person has been a resident and the capital gain has not vested during that year in any resident beneficiary. The exercise of their discretion by the trustees of a discretionary trust will also be regarded as being an "event” for purposes of this paragraph. 

In terms of paragraph 80(2) of the Eighth Schedule to the Income Tax Act, in the event that the trust sells an asset and makes a capital gain, such gain will be taxed in the hands of the South African resident beneficiary if the gain (or a portion thereof) is vested in that beneficiary in the same tax year that it arises. In the event that the gain is vested in a non-resident beneficiary, the trust will be taxed on that capital gain. 

Where a South African resident made a gratuitous disposal to any person (including a South African trust) and a capital gain attributable to that gratuitous disposal has arisen during a year of assessment and has during that year vested in or is treated as having vested in any person who is not a resident, that capital gain will be attributable to that resident in terms of paragraph 72 of the Eighth Schedule to the income Tax Act. 

There is also a third trust type, i.e. the so-called bewind trust. In a bewind trust, ownership of the trust property vests in the beneficiary/ies. However, the trustees administer and control the trust property. Therefore, any income or capital gain arising by virtue of the use or disposal of the trust property will automatically vest in the beneficiary/ies and such income or capital gains will not be taxed in the trust.

Recommendations in the DTC Report 

The DTC recommends, inter alia, that the following amendments be made to the existing tax legislation: 

  • The flat rate of tax for trusts should be maintained at its existing level (i.e. 41 per cent). 
  • The provisions in terms of which trust income of South African resident trusts can be taxed in the hands of beneficiaries or a donor at individual marginal tax rates as opposed to the higher flat rate of tax in a trust, should be removed. This means that trust income will always be taxed at the flat rate of tax applicable to trusts
  • The attribution and distribution rules pertaining to offshore trusts should be retained. However, all distributions of foreign trusts to South African resident beneficiaries should 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. 

Attribution rules  

It is unclear from the DTC Report whether this recommendation is made in respect of all trust types, including a bewind trust. In that instance, this recommendation would, effectively, result in the bewind trust being liable for tax on income and/or capital merely flowing through such trusts by virtue of the assets it administers and controls for the benefit of its beneficiaries.

It is not specifically recommended in the DTC Report that the provisions in terms of which capital gains of South African resident trusts may be taxed in the hands of beneficiaries or a donor at lower individual marginal tax rate as opposed to the higher rate of tax in a trust, should be removed. 

Offshore trust distributions 

The recommendation in the DTC Report that all offshore trust distributions should 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 for South African resident beneficiaries. 

Separate taxpayers 

It is unclear how this recommendation would be implemented in practice taking into account the fact that, as mentioned above, South Africa has well established rules and case law dealing with the taxation of trusts. For example, how would distributions from a trust to its beneficiaries be treated for tax purposes in the event that all trusts are treated as separate taxpayers i.e. would they be deductible in the hands of the trust and/or subject to withholding tax in the hands of the beneficiaries? 

Interest-free loans 

The transfer pricing rules are applicable to "affected transactions” (as defined) which, essentially, mean that such 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 in any event be taxed in the South African trust. 

Corporate 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 specifically dealt with in the DTC Report, although it is stated that taxpayers must be allowed to make use of trusts when it makes sound sense to do so in the pursuit of a commercial benefit, as opposed to an estate duty benefit. A broad-brush amendment of established trust principles would, however, also impact these arrangements. 

If the recommendations contained 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 per cent and on capital gains at an effective rate of 27.31 per cent.

Once the scope of the legislative amendments to the tax treatment of trusts has been finalised, in our view, a period should be allowed for taxpayers to re-evaluate their interests and determine whether to continue with the current trust arrangement or to dissolve same prior to the implementation of the recommendations in the DTC Report.

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This article first appeared on the September/October 2015 edition on Tax Talk.    


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