Johann Jacobs, Director and National Head of the Trusts and Estates practice, Cliffe Dekker Hofmeyr
The first interim report on estate duty to the Minister of Finance by the Davis Tax Committee (Committee), which was made public on 13 July turned its focus squarely on trusts.
Given the Committee’s mandate, this is to be expected as trusts have for some time been viewed with much mistrust by the state as a mechanism for the affluent to protect their wealth and avoid paying their fair share of tax.
While not advocating the abolishment of trusts, or the introduction of capital transfer tax, the Committee is of the view that a substantial amount of income tax is lost through the distribution of income and gains to trust beneficiaries at a lower tax rate.
The Committee has thus made certain far-reaching recommendations with regard to taxation of local trusts, which will cause those individuals who were primarily motivated by tax advantages, to reconsider their reliance on trusts.
These recommendations should not come entirely as a surprise, as there were precursors in the 2013/2014 Budget Speech, when the Minister announced that the Government was planning to put an end to trusts acting as a conduit and that the flow of income should be calculated at trust level.
Repeal of s25B and s7 of the Income Tax Act
The Committee recommends that s25B and s7 of the Income Tax Act, No 58 of 1962 (Act) be abolished.
To comprehend the impact of this, an analysis of the workings of these two sections is necessary:
Section 25B essentially codified the conduit principle and provides that if income accruing to a trust is distributed in the same tax year it retains its nature and is taxed at the individual’s tax rate, as opposed to the Trust’s.
Based on this principle, trusts have been used as a means to effect so-called income splitting, where an initial amount that would have been taxed at the higher tax rate of the trust, is split and paid to natural persons at a lower income rate (or at worst the same rate), while also enjoying the benefits of rebates, which are limited to natural persons.
The so-called attribution rules, which are contained in s7 of the Act, were initially introduced to discourage the distribution of income to beneficiaries, at a time when the tax rates of trusts were different. Effectively any income distributed by a trust in certain circumstances is attributed back to the donor of the trust and taxed in his or her hands.
This deeming provision, introduced as an anti-avoidance measure, however morphed into an attractive device for the avoiding of both Income and Capital Gains Tax, when the respective tax rates of trust and individuals were changed subsequent to its initial promulgation.
The Committee’s thesis is that by the abolishment of these two sections, a substantial amount of further tax may be collected by the South African Revenue Services, but more importantly, it will operate as a deterrent for the creation and continuing existence of trusts with the primary purpose of saving on tax.
In the context of capital gains tax – which is included as taxable income in terms of the Eighth Schedule of the Act – the tax savings is even more impressive and it is thus likely that paragraph 68 (and following), as well as 80, will similarly be repealed.
Tax rate for trusts
One of the Committee’s other recommendations is that the flat rate of taxation for trusts, should be maintained at the existing level.
Currently the rate for income tax is 41% from the first rand, with no rebates. This is as opposed to an incremental marginal rate starting at 18% and going up to 41% with various exemptions and rebates (where applicable), available to individuals.
Trusts to be taxed as separate taxpayer
The Committee recommends that each trust should be taxed as a separate tax payer.
This is a curt recommendation, but a logical extension of the thinking which envisages the scrapping of s25B and s7 of the Act.
The effect of this will be that a trust will be taxed as a primary taxpayer and not as a secondary or default taxpayer (should distributions have been made to beneficiaries).
The workings of such a tax regime can only be speculated upon, but it seems that income may be taxed in the hands of the trust, with the possibility of a deduction in respect of any distribution to a beneficiary.
Whether the income received by the beneficiary will retain its nature or whether it will be subject to an exemption will become apparent in the details.
It is telling to note that SARS has introduced a new tax return which calls for much greater disclosure by taxpayers in alignment with the Committee’s proposal.
Interest free loans
On the positive side, the Committee is not making any adverse recommendation on the use of loan accounts in the establishment of trusts.
In most instances – to avoid the consequences of paying donations tax – a founder will capitalise a trust by means of an interest free loan.
This allows a founder to peg the value of the loan, in his or her name, while the sold asset can continue to grow in the trust, while neither forming part of his or her estate, nor being subject to estate duty, on death.
Surprisingly, this marvel is not being challenged and the Committee specifically recommends that no attempt must be made to implement transfer pricing in the event of financial assistance or interest free loans being advanced to trusts.
This is a wonder that planners can thus continue to employ to enhance and protect their wealth.
Special trusts and testamentary trusts
The Committee recommends that the definition of special trust contained in s1 of the Act be retained.
Thus the Committee’s proposals will not affect special trusts and testamentary trusts, so a planner can still provide for the security of a minor or person with disability through a trust without losing the benefits of rebates and a lower personal tax rate where applicable.
It has never been good advice to create a trust for the purpose of avoiding estate duty or for income tax savings. Individuals who created trusts for sound reasons will continue to enjoy the benefits thereof as part of a holistic estate planning structure, despite the potential adverse income tax consequences.
As those individuals who created trusts primarily for tax considerations may now consider dissolving those trusts. But they will have to be cognisant of the terms of the trust deeds, the rights of beneficiaries and the potential capital gains tax that may be triggered by such a transfer.
The Committee is not in favour of a blanket concession concerning the dissolution of trust arrangements.
Needless to say, individuals who elect to dissolve trusts will lose all the other, more fundamental benefits and protections that a trust would have afforded the beneficiaries.
However, planners must be mindful that the Committee’s recommendations are but a first step and that a consultative process will follow before any of the proposals are incorporated into legislation.