The taxation of trusts and trust income from a South African perspective
May 2013 | EXPERT BRIEFING | CORPORATE TAX
Trusts have traditionally been a convenient tool for tax planning purposes. Even though it also provides the additional benefit of separating the assets of a taxpayer from an insolvency perspective, trusts also enabled taxpayers to potentially avoid estate duty and to reduce the effective rate of interest to the extent that income was diverted to lower income earners.
Even though the English principle of equitable ownership as distinct from legal ownership is foreign to South African law, the use of a trust was introduced in South African law through usage without specific legislative intervention. In Estate Kemp & Others v McDonald’s Trustee 1915 AD 491 it was for instance indicated: “The underlying conception in these and other cases is that while the legal dominium of property is vested in the trustees, they have no beneficial interest in it but are bound to hold and apply it for the benefit of some person or persons or for the accomplishment of some special purpose. The ideal is so firmly rooted in our practice, that it would be quite impossible to eradicate it or to seek to abolish the use of the expression trustee, nor indeed is there anything in our law which is inconsistent with the conception.”
Currently a trust is defined widely in the South African income tax legislation as meaning any trust fund consisting of cash or other assets which are administered and controlled by a person acting in a fiduciary capacity, where such person is appointed under a deed of trust or by agreement or under the will of a deceased person.
Over a number of years the South African Revenue Service (SARS) started to shift its focus to the tax position of trusts and how the perceived tax avoidance can be curbed. A number of measures have been introduced over the years, resulting in the income of trusts currently being taxed at the highest rate applicable to individuals, being 40 percent in circumstances where capital gains are taxed at the highest effective rate applicable to any taxpayer, being 26.7 percent. No rebates are also claimable by a trust as opposed to rebates that can be claimed by natural persons from a tax perspective.
However, the fundamental basis pertaining to the taxation of trusts, being the so-called conduit or flow through principle, remained the same. This conduit principle has the effect that income and gains will flow through to the beneficiaries of a trust on the basis that the income would also have retained its character. For instance, in a South African context dividends are exempt from tax. Should dividends be vested in a beneficiary during the same year of assessment that it has accrued to the trustees, the dividends would retain their character in the hands of the beneficiaries and thus also be exempt. From a dividends tax perspective (being levied at the rate of 15 percent in respect of dividends received), SARS has also indicated that it will be the beneficiary that is deemed to be the beneficial owner of the dividends and thus liable for dividends tax to the extent that the beneficiary has a vested right to the dividends or in circumstances where the dividends may be vested in the beneficiary by the trustees during the same year of assessment.
There are two ways in which a beneficiary can obtain a vested right to income and/or the assets of a trust. In terms of a vesting trust the assets and income of the trust are vested in a specific beneficiary, who is then entitled by law to such income and/or assets. In terms of a discretionary trust, the trustees have the discretion whether and how much of the income or assets of the trust can be vested in a specific beneficiary on the basis that a beneficiary has merely a contingent right or so-called spesto the trust income or capital. It is especially the use of a discretionary trust that created a concern on the part of SARS as the trustees would effectively be offered a choice as to which taxpayer is liable for the income or capital gains of the trust. For instance, if the income or gains are vested in a beneficiary, the beneficiary would be liable for the tax. If no vesting takes place, the trust (as a taxpayer) would incur the tax liability even though it is not a legal person in a South African context.
In another attempt to curb the potential abuse associated with the use of trusts, it has been indicated that the conduit principle does not apply to losses or expenditure that may be incurred by a trust. Losses and expenses are therefore ring-fenced and a beneficiary can only claim a deduction or allowance to the extent that an amount has accrued to the beneficiary. Losses can therefore not be transferred to a beneficiary so as to shift the tax burden.
From a capital gains tax perspective a novel principle has also been introduced in the sense that it is possible to vest a capital gain (and not an asset) in a trust beneficiary who is a South African tax resident. It is therefore not necessary to vest an asset in a beneficiary, but the trustees can decide to protect the capital in a trust and only vest the capital gain in a beneficiary. In such instance the capital gains tax is to be accounted for by the beneficiary.
Over years the use of offshore trusts has also been the subject matter of legislative intervention. Essentially income and capital gains will be taxable in the hands of a South African resident to the extent that the resident acquires a vested right to the income or capital of a foreign trust in circumstances where the income or capital gains have not been subjected to tax in South Africa previously. To the extent that, in the context of capital gains, the capital of the trust thus arose from a capital gain or an amount that would have constituted a capital gain of the trust had the trust been a South African tax resident, the vesting thereof in the beneficiary would then result in a capital gains tax liability.
In the recent round of legislative proposals National Treasury indicated that a number of fundamental changes will be made to the taxation of trusts. Not only will the use of trusts to avoid estate duty be reviewed, but it appears that the use of trusts by high net worth individuals has not been targeted by the legislature. In particular, discretionary trusts will no longer act as flow through vehicles. The income, capital gains and losses of the trust will now be calculated at the trust level on the basis that distributions will be allowed as a deduction from a trust perspective to the extent that these distributions are funded out of current taxable income. The effect is that a separate calculation will have to be made to determine the tax position of a trust on the basis that distributions will be allowed as a deduction. To the extent that a beneficiary becomes entitled or receives a distribution, such distribution will be: (i) taxable to the extent that the distribution has been deducted by the trust; and (ii) tax free to the extent that no deduction has been made by the trust.
It is important to appreciate that capital gains will be converted into revenue gains on the basis that the distributions by a trust to natural persons will in future be taxed at income tax rates and not at capital gains tax rates, being 40 percent.
A trading trust will also be taxed as a separate trust on the basis that distributions will be deductible by this type of trust. The trust will be regarded as a trading trust if it either conducts a trade or if the beneficial ownership interests in these trusts are freely transferable.
In a further attempt to curb international tax avoidance, foundations will also be included under the concept of a trust. Distributions from offshore foundations will also be regarded as ordinary revenue and be taxed accordingly.
It is expected that substantial restructuring will take place in the context of trusts. In the process one should appreciate that donations to trusts will result in the donor being liable for the income or capital gains of the trust. An interest free loan is also regarded as a donation to the extent of the interest free element. It would therefore not assist a taxpayer to merely donate an amount to a trust (whether locally or internationally) as the income or capital gains will still have to be accounted for by the donor.
Emil Brincker is a director and National Head of the Tax practice at DLA Cliffe Dekker Hofmeyr Inc. He can be contacted on +27 (0)11 562 1063 or by email: firstname.lastname@example.org.
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