The debate around the taxation of trusts

Some say there were very few developments in the National Budget Speech on 27 February and that it’s ‘business as usual’. I beg to differ.

The revised SARS estimates reflect that tax collections for the 2012/13 fiscal year are currently R16 billion below target, compared with being spot-on for 2011/12. The implications of this have been substantially underplayed in the media. In years gone by, immediate steps would have been taken to increase taxes across the board and recover the position.

But Finance Minister Pravin Gordhan resisted any temptation to implement austerity measures and has, correctly or incorrectly, increased South Africa’s borrowing level to 5,1% of GDP for the 2012/13 fiscal year. Only time will tell if the international rating agencies will accept this, and, with the Reserve Bank steadfastly refusing to increase interest rates, the rand must be vulnerable.

Gordhan is tacitly accepting that the ‘big three’ taxes (corporate tax, personal tax and VAT) are almost ‘fully mined’ and that growth in tax collections is now largely dependent on growth and inflation rates. Increasing income tax rates will achieve little and a VAT increase is effectively blocked by COSATU and looming elections next year.

The only realistic means now of raising tax collections to achieve the targets of the National Development Plan has to be a fourth major tax. Hence the announcement that carbon emission taxes will be implemented from 1 January 2015 at R120 per carbon-emission ton. We will have to wait until the National Treasury’s proposals are released before more can be said in this regard.

As for the rest of South Africa’s tax future, Gordhan has referred the problem to a commission of enquiry lead by Judge Dennis Davis. The suggestions of the commission will probably result in change only in 2015.

The remaining tax proposals contained in the 2013/14 National Budget Speech were very limited in effect. That is, except for the proposed amendments relating to the taxation of trusts.

The existing regime for the taxation of trusts

The existing regime has been around for years. The provisions are extensive and potentially very complicated, but can be summarised as follows:

Enquiry 1 

Enquiry 1 is applied to identify the beneficiaries with a ‘vested interest’ in the trust income by applying section 25B.

If enquiry 1 is successful, the income from the trust arrangement is taxed in the hands of the beneficiary, usually an individual taxpayer.

Enquiry 2

Enquiry 2 is applied if enquiry 1 is inconclusive and attempts to establish the identity of the donor/settlor of a donation, disposition or settlement giving rise to the income. The tests are contained in the deeming provisions of section 7 of the Income Tax Act.

If both enquiry 1 and 2 are inconclusive, the income is taxed in the hands of the trust at the flat rate.

There are instances of ‘special trusts’, but these are very limited in number.

Tax arbitrages inherent to the taxation of trusts

Following the National Budget Speech, the maximum rates of tax for the commonly encountered taxpayers in South Africa are summarised below:


The above table ignores all exclusion amounts in the case of individuals.

Trusts incur a flat rate of tax of 40% on revenue income and 26,6% on capital income. Trusts are thus, prima facie, tax inefficient.

However, by applying the attribution provisions of sections 7 and 25B, the income can easily be shifted to the donor/settlor or beneficiary, thereby resulting in taxation at a lower marginal rate (unless the taxpayer has income exceeding R638 601 from other sources).

When it comes to capital gains tax (CGT), the 8th schedule to the Act allows the gain to be attributed to the donor or beneficiary (usually an individual taxpayer) at the lower CGT inclusion rate of 33,3%, thus avoiding the CGT exposure attributable to trusts.

In addition to the above, trusts effectively freeze the value of a donor/settlor’s estate, leading to substantially reduced estate duty exposure. As a result, estate duty collects only about R1 billion today as a contribution to a budgeted tax collection of R898 billion for 2014.

All of the above has been far too good to last. Some tax commentators have been expecting substantial changes to the trust tax regime for some years.

The proposal

The announcement finally arrived in the 2013/14 Budget Speech to the effect that the attribution provisions will be withdrawn/amended with effect from the 2014/15 year of assessment. Thereafter, if income accrues to a trust, it will be taxed within the trust.

The details are very vague and we will have to wait for this year’s draft income tax amendment bill to find out more.

Meanwhile, speculation started immediately after the National Budget Speech, the first question being: ”Is now the time to terminate all trust arrangements as a matter of urgency?’

A cautionary note

A trust cannot simply be terminated owing to a change in tax legislation. The first requirement is that trustees observe the termination requirements and the conditions relating to termination, as contained in the trust deed. Above all, the trustees must act in the beneficiaries’ best interests at all times.

The trustees will have to make the distinction between the best interests of the donor/settlor and the beneficiaries. Simply terminating a trust and returning the assets to the donor/settlor may well not be in the best interests of a beneficiary, even if it makes good sense from a tax perspective.

Remember, when terminating a trust, a disgruntled beneficiary can cause far more damage than the most prudent SARS official.

The premature termination of a trust arrangement may require the alteration of the trust deed. This may require the consent of all the trustees and/or the beneficiaries.

The next consideration will be the CGT implications pertinent to the termination of a trust. In most instances this will constitute a ‘disposal’ of all the assets of the trust, triggering CGT to be charged on all capital appreciation within the trust. The disposal value will be determined at current market value. If the trust assets consist of shares or immovable property, this could lead to an unforeseen cashflow problem.

Conclusion

It is certainly premature to consider the termination of a trust based on an announcement contained in the Budget Speech. The complex legislation required to effect this change will have to be drafted and then debated through the parliamentary process. The result may well be very different when the legislation is finally promulgated.

At worst, the new legislation will be promulgated in late 2013 or early 2014 and applied from 1 March 2014. There will be no retrospective effect.

The complex issues relating to the taxation of trusts may well be referred to the Davis Commission, in which case the new tax regime may be delayed until 2015.

Finally, a lobby group must surely emerge that will propose the granting of an opportunity to taxpayers to undo their trust arrangements while enjoying a CGT rollover. This would be an extension of the concepts contained in paragraph 51A of the 8th schedule of the Act relating to the closure of trusts and companies owning residential property.

But, ultimately, it is a case of ‘watch this space for details‘. We are going to have to eat this elephant one bite at a time.

Alternatives

South Africans have enjoyed a love affair with trusts for many, many years. But today, even before the anticipated amendments, there is no trust arrangement that can offer a tax deduction on investment, tax-free growth while invested and a CGT and estate duty exemption on exit.

Perhaps the retirement annuity fund will become the preferred estate planning vehicle of the future. Only time will tell.

This article originally appeared in The debate around the taxation of trusts in glacier by Sanlam, The {Inside} Story


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