Offshore Trusts: Selected, and Sometimes Overlooked Pitfalls
01 September 2010
Posted by: Author: Tanya Cohen
Offshore Trusts: Selected, and Sometimes Overlooked Pitfalls
There are many potential benefits for both the settlor and his chosen beneficiaries in setting up a trust. These include: estate planning, succession, asset protection and certain tax benefits.All the potential benefits of a trust established in South Africa will apply to an offshore trust, with the added benefits of (usually) a lower or nil tax regime in the chosen jurisdiction, together with the potential to invest in a hard currency and to diversify one’s investments.However, there are a number of complex issues that should be taken into consideration by South African residents (for tax and exchange control purposes) before a final decision to set up an offshore trust is made.Three such issues are discussed briefly below.
Risk 1: Is the trust valid? The risk of an invalid trust is that its assets may not be protected from creditors (business, divorcing spouse or SARS).
To avoid the question of whether a South African court would determine validity of an offshore trust under South African law or the law of the relevant foreign jurisdiction, the trust deed should allow the settlor to specify the applicable law of choice (Jersey often being preferred).In addition, he should ensure that the trust (the way it is established and managed) is valid in terms of the laws of the country that may be called upon to interpret it or in respect of which taxation principles will be applied, in our case, South Africa.To be valid in terms of South African trust law, the following two important criteria (among others) must be met:
•The settlor must actually intend to create a valid trust.
•Ownership of the trust property must actually be transferred to the trustee (to be administered in terms of the trust deed and for the benefit of the beneficiaries).
Many settlors purport to transfer property to trustees, but continue to treat and manage the assets as if they were still his own – providing evidence that neither the settlor nor the trustee intended the funds to pass out of the settlor’s de facto ownership.In South African law this is commonly referred to as a ‘sham trust’.In such a situation it is arguable that the trust, even though ostensibly duly formed, never came into existence at all, leaving its assets susceptible to attachment by creditors or taxation in the settlor’s hand.
Risk 2: Tax residence of the trust
One of the benefits of establishing a trust in a low tax jurisdiction would involve the mitigation of both source and residence-based taxation and the relief of double taxation.To maintain these benefits, the trust must not only be established in the chosen jurisdiction, but it must also be effectively managed there. If it is effectively managed by persons residing in South Africa, it will become tax resident South African at the higher marginal rates for trusts. Risks arise in a number of possible scenarios: (a) at set up stage – when granting specific powers to a South African protector or settlor, such as the powers to control aspects of the administration of the trust; (b) in the ongoing management of the trust’s affairs, or (c) the ‘offshore’ corporate trustee itself, is not effectively managed outside of South Africa. Additionally, if for example the trustees appoint a South African investment adviser to invest and manage the trust’s share portfolio (being its only asset), it may be difficult to argue that the (offshore) trustee is effectively managing the trust, in that they may not have applied their minds to the trust’s affairs at all in any particular annual period.
Risk 3: Tax and estate planning consequences of the chosen funding method
Funders of offshore trusts are often advised to transfer funds on an interest-bearing loan account, at a market-related rate of interest.The purpose is to ensure that the anti-avoidance provisions in section 7(8) and paragraph 72 of the Eighth Schedule to the Act do not apply, on the one hand; and on the other, to ensure compliance with the transfer pricing provisions of both sections 31 of the Income Tax Act and the South African Reserve Bank (i.e. for exchange control purposes). Two issues arise:
(a) How does one determine a market-related rate of interest? A number of issues should be taken into consideration.For example, SARS Practice Note 7 suggests that one should look to ruling interest rates in South Africa and the country of the borrower.However, the currency of the loan must also be relevant to provide the lender with currency stability. The lender (usually the settlor) should consider the rate of interest he could get if he placed the funds on deposit with a bank and the period of the loan.
(b) Whatever rate is agreed, the trustee runs the risk that a lower rate of return is generated by the trust’s underlying investments than the interest payable to the settlor/lender, which would leave the trust technically insolvent.The settlor on the other hand will be obliged to pay tax on the interest accruing to him in terms of the loan agreement, regardless of whether the trust is able to pay him.
(c) Even if the trust is not actually required to pay over the interest, the effect of the obligation will be to increase the settlor’s loan claim against the trust.From an estate planning perspective, this is counter productive, as the long-term objective of establishing a trust is, over time, to increase the trust’s own assets and reduce the personal assets of the planner.
Readers will have heard this advice before – trusts should never be established only to gain a tax advantage.Before deciding to set up an offshore trust, settlors must attain an in-depth understanding of the unique benefits available in the trust and decide whether they will be advantageous to the ultimate beneficial owners, with the tax consequences being only one of the factors to take into account.
Source : By Tanya Cohen (TaxTALK)