Tax risks for Trusts
02 January 2012
Posted by: Author: Carin Grobbelaar
Tax Risks For Trusts
The use of family trusts has, for many years, been extremely popular for estate planning purposes and to achieve other financial benefits. These benefits include the protection of assets against creditors,the protection of assets against market risks, the protection of the beneficiaries, the flexibility and continuity that a trust offers, as well as potential tax benefits.
However, the use of a trust can also create potential tax risks. Many trust founders find it difficult to accept that the trust, represented by the trustees, is a separate entity and often attempt to retain control over the trust assets, either through the appointment of so-called puppet trustees who may be a spouse and a major child of the founder, or through the provisions of the trust deed. Examples include provisions in terms of which the founder retains a veto right or in terms of which the founder retains the authority to appoint and dismiss trustees and to vary the provisions of the trust deed. For a valid trust to exist, the founder must give up control over the trust property.
Under the well-known substance over form principle, effect will be given to the substance of an arrangement rather than its form if that arrangement does not reflect the true intention of the parties involved. In the context of a trust, this means that where the parties never really intended to form and give effect to a trust, our courts will not uphold its existence and the parties will be taxed accordingly.This would result in the forfeiture of any planned tax benefits.
This does not mean that the founder, as a trustee of the trust, cannot exercise some form of control over the trust assets, provided that all the trustees act jointly after proper consultation and subject to the provisions contained in the trust deed. Even where the trust deed reserves some form of control for the founder, or where the founder makes use of a letter of wishes, a valid trust may still be created. It is important though that the founder should not treat the trust as his alter ego.
Another tax risk is the application of the anti-avoidance measures contained in section 7 of the Income Tax Act. Section 7 contains a number of provisions that are directed at transactions in which a taxpayer seeks to achieve tax avoidance by donating or disposing of income producing assets to or in favour of another party under specified conditions or circumstances, thereby diverting related income away from himself. These provisions seek to ensure that if an amount accrues to a trust or to a beneficiary of a trust as a result of some donation, settlement or other gratuitous disposition, the donor (or founder) will be taxed on that receipt. Section 7 will therefore not apply if there has been a commercial arms-length transaction. However, where the consideration given for the assets is minimal, the whole disposal will be regarded as gratuitous. This could also have serious donations tax implications.
In order avoid the application of section 7 (and donations tax) founders often transfer their assets at their true market value to the trust on loan account. However, in many cases interest is not charged on the loan. In CIR v Woulidge (2002 SCA), shares were sold by the founder to a trust at their market value on an interest-free loan account. The Supreme Court of Appeal held that for section 7 to apply, there had to be a disposition wholly or to an appreciable extent, gratuitously out of liberality or generosity. The court held that in this case, the disposition contained both appreciable elements consideration, i.e. the sale of shares at market value.In such a case, the court held that an apportionment should be made between the two elements for the purposes of determining the income deemed to have accrued to the donor under section 7. In this case, the interest that should have been charged on the loan account was regarded as the portion of the income deemed to have accrued to the donor within the meaning of section 7.
Although section 7 should not deter prospective founders from establishing trusts, as the other tax benefits could still outweigh this disadvantage, there is a serious risk that the provisions contained in section 7 may be overlooked. This could lead to incorrect disclosures in the tax returns of the founder,the trust and the beneficiaries.
One of the benefits of a trust is the fact that it is a mere ‘conduit’ through which income flows to the beneficiaries.As a result, subject to section 7, the income is taxed in the hands of the beneficiaries who receive a vested right to that income. This means that the income is taxed at the beneficiaries’ respective tax rates and not in the trust at the tax rate of 40%. In terms of paragraph 80 of the Eighth Schedule to the Income Tax Act, this attribution principle also applies to capital gains tax (CGT). This allows the trustees to avoid the effective CGT rate of 20% if the capital gain should be taxed in the trust by distributing the gain to the beneficiaries who would pay a maximum effective rate of 10% CGT. However, there are two situations where the attribution rules do not apply: where the capital gain is distributed to a non-resident beneficiary and where the gain is distributed to another trust which is a beneficiary of the original trust. In these two circumstances, the capital gain will be taxed in the trust making the distribution at the effective CGT rate of 20%.Trustees should keep this in mind when making decisions regarding the distribution of income and capital gains to beneficiaries.
It is clear that there are many benefits to be gained from the use of a trust. It is important, however, to be aware of and avoid the associated risks.
Source: By Carin Grobbelaar ( TaxTALK)