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Beneficial Interest In A Trust: What happens if you want to go?

Sunday, 01 July 2007   (0 Comments)
Posted by: Author: Peter O'Halloran
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Beneficial Interest In A Trust: What Happens If You Want To Go?

The sale of discretionary trust interest could pose a problem when it comes to capital gains tax (CGT).

Consider the following case study: A client is a beneficiary in a discretionary trust.His siblings are involved in the day to-day business of the trust that conducts farming operations.In a planning exercise, the founder decides that the client should no longer be a beneficiary because he wishes the benefits of the trust or capital on dissolution to devolve upon the beneficiaries who actually work on the farm.The client is offered a certain asset, with a certain value in exchange for the relinquishment of his beneficial interest in the trust.

From this case study the question emerges: What is the CGT effect of such a sale of a discretionary interest by the client? At present the answer to this question seems to be uncertain as the Income Tax Act and eighth schedule provide such terms as are reproduced below, but do not provide any formulas to ascertain the values to be used.


The relevant definitions and paragraphs of the eighth schedule are as follows:Value-shifting arrangement means an arrangement by which a person retains an interest in a company, trust or partnership, but following a change in the rights or entitlements of the interests in that company, trust or partnership (other than as a result of a disposal at market value as determined before the application of paragraph 38), the market value of the interest of that person decreases and- 

(a) the value of the interest of a connected person in relation to that person held directly or indirectly in that company, trust or partnership increases; or

(b) a connected person in relation to that person acquires a direct or indirect interest in that company, trust or partnership.

The definition of an  asset is of vital importance as CGT is not triggered until an asset is disposed of. The word is widely defined to include all forms of property and all rights or interest in such property. Currency is excluded as it is dealt with in part XIII.In Jones v Skinner 5 LJ Ch 90 the word was interpreted as the most comprehensive of all terms that can be used and is indicative and descriptive of every possible interest a party may have. 

When it comes to the definition of disposal the act states that a disposal is any event, act, forbearance or operation of law which results in the creation, variation, transfer or extinction of an asset.It includes the sale, donation, expropriation, conversion, grant, cession, exchange or any other alienation or transfer of ownership of an asset, as well as the decrease in value of a person's interest in a company, trust or partnership as a result of a value shifting arrangement.

When it comes to capital gain, the act states that a person's capital gain for a year of assessment, in respect of the disposal of an asset during that year, is equal to the amount by which the proceeds received or accrued in respect of that disposal exceed the base cost of that asset.

Also significant in this regard is time of disposal.The time of disposal of an asset by means of the decrease of a person's interest in a company, trust or partnership as a result of a value shifting arrangement, is the date on which the value of that person's interest decreases. 

The act states that a person's interest in a discretionary trust must be treated as having a base cost of nil.The result is that the capital gain made by a beneficiary disposing of his or her interest in a discretionary trust will be calculated with reference to the full proceeds, without taking any base cost into account.The same rule will apply to a subsequent disposal of the interest by the purchaser.When it comes to  proceeds from disposal, subject to subparagraphs (2), (3), and (4), the proceeds from the disposal of an asset by a person are equal to the amount received by or accrued to, or which is treated as having been received by, or accrued to or in favour of, that person in respect of that disposal.The amount of the proceeds from a disposal by way of a value-shifting arrangement is determined as the market value of the person's interests to which subparagraph 11(1)(g) applies immediately prior to the disposal less the market value of the person's interests immediately after the disposal, which amount shall be treated as having been received or accrued to that person.

An interest in a discretionary trust

In his book Stein on Capital Gains Tax Stein asks the question: "But what is an interest  in a discretionary trust?” According to him there is no definition in the schedule or the act as to what constitutes such an interest. Further his submission is that when the trust is a discretionary trust, it must be assumed that the interest as contemplated is the 'right' that a person will enjoy to benefit from the trust in the event of the exercise by the trustees of their discretion to make an award of capital or income to that person as a "discretionary” beneficiary of the trust.In the absence of any indications to the contrary, Stein’s assumption, although practical and reasonable, cannot in law be supported and for the following reasons:

Firstly, the judgment in CIR v Sive's Estate1955 (1) SA 249 (A) is authority for the fact that, under a trust, a discretionary beneficiary has no rights as such, but merely a contingent right .(Spes).Consequently such beneficiary has no interest save as is specifically allocated to him by the trustees of the trust.

Secondly, there can be no talk of "value” of a discretionary beneficiary's contingent right as any benefit to him or her is left to the discretion of trustees.Such contingent right furthermore cannot be divided.It is simply not possible to divide a contingent right. If the trustees have an unfettered discretion, as soon as a limit is placed thereon the discretion is lost.It is consequently impossible to sell a portion of a contingent right.

One can no doubt sell the contingent right in its entirety.Although here we are on extremely treacherous ground because placing a value on such a contingent right would imply that one is dealing with something that can possibly have a value, whilst we know well that a contingent right is impossible to value.

The market value of a right that is given up in exchange for an asset or amount of money will, of course, in terms of paragraph 35(1) be the value of the asset or the amount of money concerned.The sale of such a contingent right, in my view, is not truly a sale of the right as such but merely a gesture of conciliation on the part of a planner who wishes to appease a potential benefit holder or heir.

To compensate or not think of a farming property in trust.Unless the farm is large enough to support multiple families, the siblings of the beneficiary who will continue to farm are often removed as beneficiaries in this manner, prior to vesting.There is no reason in law to compensate such children of the planner for their loss of the contingent rights that they might have had in future prior to vesting because they, in theory at least, have lost nothing of value. 

Should the sale of a trust be in issue as was the case in the past where trusts were sold containing fixed property, my submission is that these were not trusts as such, but merely took the form thereof for the sake of tax avoidance.The person/s to whom the income accrued would be thus identified as the true owner/s whilst the so-called trustees would have been agents for that person, doing the bidding of that person as is the wont of agents who are employed by a principal or principals.

Those to whom the capital accrued on completion of the sale of the trust should thus rightfully be liable for transfer duty under the ordinary rules pertaining to the sale of a fixed property by an individual or a partnership.

Transfer Duty 

Transfer duty is not in my view payable in the event of one or more beneficiaries in a discretionary trust being substituted or removed.The Transfer Duty Act makes provision under section 9 for the exemption from transfer duty under circumstances pertaining to the change in administration of the trust, provided that no consideration is payable.The act is silent on the removal or substitution of discretionary beneficiaries.As explained above, a contingent right has no value and thus, no transfer duty can possibly be levied on a change of discretionary beneficiaries.

For transfer duty to be payable, the consideration paid for the renunciation of the contingent right should be paid to the erstwhile beneficiary by the remaining beneficiaries in terms of section 9(4)(b) of the Transfer Duty Act.If the planner is thus a beneficiary, then the exemption, in my view, will cease to operate in favour of such planner and transfer duty will be payable, with the amount of consideration being the only value that can possibly be used to measure the value of the contingent right.As the rights are rights to the trust and not in the trust, transfer duty should be payable on the natural person's scale, the purchaser being responsible for payment.

Should the planner not also be a beneficiary, then the above scenario will not come about and no transfer duty can then be paid, as aforesaid.I do submit, however, that CGT is payable in circumstances where an erstwhile beneficiary gains an asset or a sum of money as quid pro quo for his or her giving up the rights to receive any benefit from a trust in future.The "sale” of the beneficiary's interest is distinguished from the concept of a value shifting arrangement, because there cannot be any value shifting where the "entire contingent right” is disposed of in this manner.As explained above, one cannot part with a fraction of a contingent right in any event.

No CGT generated It seems obvious then, that, if a beneficiary renounces his or her right under a trust in line with the wishes of the planner or for any other reason, and such erstwhile beneficiary receives nothing in return for his renunciation, then there cannot be any question of CGT being generated. 

This is, I submit, because the interest cannot have a value unless an asset or amount of money is exchanged for it.Should such asset or amount of money be exchanged for the interest, then the value, in terms of paragraph 35 of the eighth schedule, will be such value of the asset or amount of money.

The calculation regarding CGT will be fairly simple in this event as the base cost will be NIL in terms of the provisions of paragraph 81.The entire value of the quid pro quo (value of the asset or amount of money exchanged for the renunciation) will be a capital gain.It is then included in the taxable income of the individual by operation of the normal formula.

Source: By Peter O'Halloran (TaxTALK)



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