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Why trust reform will affect your tax planning

04 April 2013 Fiona Zerbst
Fiona Zerbst, FAnews Online Editor

Fiona Zerbst, FAnews Online Editor

You may have noticed Minister Pravin Gordhan’s comment during this year’s budget speech that the taxation of trusts will come under review to “curtail tax avoidance”. Ho-hum, you may have thought – we have been warned about this before. Besides, it’s hard

You may agree in principle that trusts need to be scrutinised because tax planning around them has been more aggressive than the legislation ever intended it to be. In truth, it has not always been transparent, so SARS has rightly been concerned. But what will change now?

According to Di Seccombe, Head of tax training and presentations at Mazars, there’s no way to be sure of when the changes proposed in the budget speech will be enacted – but it’s likely that, because the Minister fired a warning shot across the bow in the budget speech, proposed tax changes could come sooner rather than later. Bear in mind that tax recovery is low and Treasury has made clear its intention to focus on the tax compliance of a particular segment of the population – namely high-net-worth individuals and their trusts – so it would not be unexpected if Minister Gordhan brought out the first round of proposed amendments mid-year.

A little background on trusts

For the purposes of this article, it is necessary to have a little background on trusts. Trusts are set up for a number of reasons, including preserving family assets over time; protecting assets from any poor business dealings and debt on the part of the founder; taking care of beneficiaries after the founder’s death; maintaining a spouse or child after a divorce; and so on.

A trust deed sets out the terms of trusteeship – the founder is obliged to appoint trustees who will manage the trust to the advantage of its beneficiaries. In a discretionary trust trustees can, in terms of the trust deed, exercise their discretion and distribute income or capital (in the form of an actual asset or a capital gain) from the trust to a beneficiary or beneficiaries. When the income or capital of a trust is distributed out of the trust, the amounts will no longer be subject to tax in the trust, but taxed in the hands of the recipient beneficiary.

According to the ‘conduit ’ or ‘flow-through ’principle, if a trust receives an amount in the form of dividends from shares held by the trust, for example, and distributes these to a beneficiary, the dividends retain their identity, and the beneficiary will receive dividends. The same principle would apply if the trust received interest, or if the trust made a capital gain and the trustees distributed these amounts to the beneficiaries.

The amounts would retain their identity and the beneficiaries would receive interest or a capital gain. As already stated, these amounts – the dividend, interest or capital gain – would then be subject to tax in the hands of the beneficiary and not the trust.

The ‘conduit principle’ and the fact that identifiable amounts distributed out of the trust are taxed in the hands of the recipient beneficiary, and not the trust, is the main reason why trusts can be used efficiently for tax purposes.

The trust as taxpayer

A trust, as a taxpayer in its own right, pays tax at the highest rate of tax for both capital gains tax (an effective tax rate of 26.6%) and on other taxable income at a flat rate of 40%. As a trust is not regarded as a natural person taxpayer, the trust does not qualify for any tax rebates and does not qualify for any of the capital gains tax exclusions available to a natural person taxpayer, for example the annual exclusion of R30000.

When trustees exercise their discretion (by means of valid and timeous trustee resolutions) and distribute specific amounts out of the trust, if those amounts vest in a beneficiary who is an individual for example, the amounts (which have retained their identity) will be taxed in the hands of the beneficiary.

Capital gains could be reduced by the R30 000 annual exclusion and then taxed at the maximum effective capital gains tax rate of 13.3%. Any local interest received could be reduced by the general interest exemption (R23 800 for taxpayers under 65 and R34 000 for taxpayers 65 and over) and finally the tax rebates would be set off against any tax liability of the individual.

From an Estate Duty perspective, trusts are efficient because a trust is not regarded as a ‘person’ in terms of the Estate Duty Act, and as such assets placed in a valid trust will not attract estate duty (essentially payable at 20% on the net value of the estate that exceeds R3.5million).

The Capital Gains Tax picture

Some of the proposed changes could make trusts inefficient tax vehicles, particularly when it comes to Capital Gains Tax (CGT), so although CGT was not hiked this year it is possible that Treasury will still get their piece of the CGT pie, albeit by different means. How is it proposed that this will be achieved?

The proposals actually seek to prevent the application of the ‘conduit principle’ to trusts by ensuring that discretionary trusts will only be able to distribute ‘taxable income’. The net effect of this is that when a trust distributes an amount, the amount will now be ‘taxable income’ and no longer retain its original identity.

It’s important to note, though, that once an amount of taxable income has been distributed out of the trust, the amount of taxable income will be subject to tax in the hands of the recipient beneficiary (at the relevant beneficiary’s rate of tax, for example between 18 and 40% in the case of an individual) and not in the trust at the flat rate of 40%.

Seccombe says that although at the outset it feels little has changed, the devil, as is so often the case with tax, lies very much in the detail.

‘Taxable income’ is a specifically defined concept for income tax purposes. A taxpayer’s tax liability is based on the taxpayer’s taxable income in a year of assessment. To calculate taxable income, all the receipts and accruals of a taxpayer are taken into account. Depending on the nature of the taxpayer, some of the receipts and accruals may be exempt from tax, like local dividends. The taxpayer will also claim all expenses which the taxpayer is entitled to.

This is where one has to pay attention – just before a taxpayer’s taxable income is finalised, the taxpayer must include into taxable income a taxable capital gain. That is, the portion of any net capital gain made by the taxpayer from the disposal of assets during the year that will be included into taxable income. In the case of a trust, the trust must take 66.6% (the inclusion rate) of any net capital gain and include that portion of the net capital gain into the taxable income of the trust.

Calculating taxable income for individuals and trusts

An important comparison at this point is to look at the calculation of taxable income in the hands of an individual taxpayer, and where this may differ from a trust.

First, as we’ve seen, an individual enjoys more exemptions than a trust does, for example the local interest exemption. Secondly, when calculating a net capital gain in the hands of an individual, the R30000 annual exclusion has been taken into account. Most importantly, only 33.3% of the remaining net capital gain is included in the taxable income of an individual (not the 66.6% inclusion rate, as in the case of a trust).

By ensuring that only taxable income may be distributed by a trust, the proposal would force all capital gains in a trust to be taxed at the trust’s inclusion rate for CGT (66.6%). Only once the taxable capital gain has been included into taxable income can the trust’s taxable income be distributed to a beneficiary, to be taxed at the relevant rate of tax paid by the beneficiary on the amount of taxable income.

What is clear is that keeping assets in a trust for tax purposes would become extremely tax inefficient. The gain from the disposal of an asset’s not being taxed in the hands of a trust would effectively be undone.

Trusts are already the most expensive tax vehicle we have

As stated, trusts are expensive tax vehicles, but administered correctly they have nevertheless been extremely useful tax vehicles. If there are no tax breaks to be had and one can’t use a trust for tax planning in respect of CGT, will people shy away from setting them up?

This may or may not be the case, but Seccombe notes that some taxpayers have been holding off purchasing new properties into their trusts because they are nervous of what the future may hold. High-net-worth individuals may feel, quite correctly, that they are being squeezed from all sides, with the new caps on retirement annuities (RAs) and other disincentives.

The new withholding tax of 15% on interest paid to foreign creditors (investors) in respect of private companies and trusts could well have a knock-on effect on local business and a number of local trusts that own businesses, for example. If foreign investors no longer get tax-free interest on the money they loan to local business, there is little incentive for them to invest – and if local trusts are the recipients of these loans, they will essentially have to renegotiate their lending arrangements. (By contrast, government is all for incentivising foreign investors to look at government bonds. from which the investor will continue to receive interest free from the 15% withholding tax, which will be another great revenue source for government.)

The 15% withholding tax was set to be implemented from 1 July 2013, but it seems from the Budget Speech the Minister may push this date forward to 1 March 2014.

Editor’s thoughts:
At this stage, the situation with regard to trusts and CGT is unchanged, but it should be clear why trusts and beneficiaries need to worry. We know that a great many trusts have been set up in such a way that they are, in effect shams. It often happens that founders make it look like they have legally given away ownership and control of the assets in that trust, but they have not in fact done so and still have complete control over them. Much of this comes to light in divorce cases, where trusts have been found to contain hidden assets. Trusts do need to get their houses in order, because it’s almost certain that government will not let this state of affairs continue for much longer. SARS is going back to the letter of the law, so if you haven’t been keeping your paperwork up to date (valid trust deeds and valid timeous trustee resolutions), or you’ve been claiming expenses in trusts that don’t belong there, for example, you’ll likely be the focus of government’s wrath. Do you think trusts are likely to be faced with tax amendments this year? Comment below or email fiona@fanews.co.za.

Comments

Added by nawaazgani, 14 Apr 2013
interesting article on trusts and other well informed
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Added by Gotcha, 09 Apr 2013
I'm in the throes of divorce: am discovering a plethora of my husbands financial secrets. 1) He has completed my tax returns for years - effectively filing without my permission or agreement 2) In his Trust, he has written off substantial CGT by false distributions to me (not even sure I was ever a beneficiary 3) Undeclared offshore assets 4) Variety of business entities about which I had no knowledge previously ......And on it goes. The hard part is to stay patient and focussed Any advice?
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Added by Cuban, 04 Apr 2013
The abuse of the "conduit" principle is wide. The non-compliance with the Trust Property Control Act is also rife. Once again it's the people complying with the spirit of all the laws that is going to feel the pinch because of the abuse of a few others. Changes will definitely be introduced, however I doubt whether it will be this year.
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Added by Five, 04 Apr 2013
The other question, assuming the changes happen as assumed above, will the TRUST option under 4 fund tax (Life Insurance policy) still be of any value? I guess not for the reasons stated above.
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