Trusts: A tax nightmare?
18 July 2012
Posted by: SAIT Technical
By Heather Pretorius (TaxTalk)
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 the Eighth Schedule thereto, contain important provisions which, if applied correctly, can ameliorate the ostensible high tax rate situation.
THE PROVISIONS OF THE INCOME TAX ACT : 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 thereto, recognise the application of the so-called conduit principle in terms whereof 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 to the aforegoing, one can go further and split the income or gain to various beneficiaries as opposed to just a single beneficiary. By so doing, one 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 000-00 Capital Gain, one could split the gain to three of the beneficiaries at say a R100 000-00 each. Each beneficiary would then be able to subtract the R30 000-00 annual exclusion from the Capital Gain of R100 000-00, thus making the taxable gain in each of their hands R70 000-00. 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 000-00 as opposed to distributing or awarding the gain to only one beneficiary, where the net effect would be 13,3% of R270 000-00.
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 one should, ideally, not use a Trust to run a business in. 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 one were to run a business in a Trust, one would pay 40% tax on taxable income as opposed to the 28% in a corporate entity. Trusts are better suited to protecting one's assets and to effective estate planning. In this context one 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 the lack of compliance in respect of said Trusts.
As can be seen from the above, 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. It is submitted that Trusts are not therefore the tax nightmare that they are so often perceived to be. Much also depends on what one is utilising one's Trust/s for and whether one has a well managed, and considered Trust structure in place which is compliant in all respects.