Capital gains tax and trusts: is there a pipe?

Rene Magritte (1898 – 1967), the Belgian Surrealist artist, painted a smoking pipe and below it the words “Ceci nest pas une pipe” (“This is not a pipe”). And, of course, the painting of the pipe isnt a pipe; it is an image of a pipe.

In South African tax law (which may also seem surreal at times) there is the common law principle of a conduit pipe. The principle is that the trustee of a trust is a conduit in certain circumstances. For instance, if a company declares a dividend in respect of shares held by a trust, and the trustees promptly distribute the dividend to the beneficiaries, the dividends retain their nature in the hands of the beneficiaries (see Secretary for Inland Revenue v Rosen 32 SATC 249).

As far as income tax is concerned, the conduit pipe principle has to an extent been codified in section 25B of the Income Tax Act, 1962.

The question arises whether it also applies to capital gains tax (CGT).

For example, Sigmund and Salvador are beneficiaries of a trust formed in South Africa (SA) by their late father. Sigmund is tax resident in SA. Salvador is tax resident in Spain.

The trustees sell some shares listed in SA which were held as a long-term investment. The trustees promptly vest the profit in Sigmund and Salvador.

Paragraph 80(2) of the Eight Schedule to the Income Tax Act, 1962 says that if a trust makes a capital gain and vests that gain in a trust beneficiary who is tax resident in SA, the gain is subject to CGT in the hands of the beneficiary, and not in the hands of the trust.

Often, the application of that provision results in a lower effective tax rate: the effective CGT rate of a trust is 20%; the effective CGT rate of a natural person varies between 0% and 10%.

Now, CGT was introduced in SA in 2001. Since that time, many people assumed that, because of the wording of paragraph 80(2), if a trustee distributed a capital gain arising on the disposal of an asset by a trust to a beneficiary who was not tax resident in SA, the capital gain would in all cases be subject to CGT in the hands of the trust.

So if we applied paragraph 80(2) to the example above, Sigmund would pay CGT on the capital gain distributed to him while the trust would pay CGT on the capital gain distributed to Salvador because he is not tax resident in SA.

Some commentators say this is all wrong. They say that paragraph 80(2) simply codifies the common law conduit principle in relation to SA tax residents; it does not alter the principle generally or in relation to beneficiaries who are not tax residents in particular (see, for instance, the authorities listed in the South African Revenue Service’s (SARS) Comprehensive Guide to Capital Gains Tax (Issue 3) (Guide) at page 443).

If this position is correct then Salvador in our example above will, in fact, pay no CGT in SA when the trustees distribute the capital gain to him. Generally, persons who are not tax resident in SA only pay CGT in SA in respect of immovable property in SA and assets of a permanent establishment in SA.

Not surprisingly, SARS sees the matter differently. SARS says that the conduit principle does not apply where a trust distributes a gain to a non-resident beneficiary mainly because the “legislative intent” in respect of paragraph 80(2) was to limit the conduit principle to resident beneficiaries (see page 443 of the Guide).

So does the pipe exist or not? Does the conduit pipe principle apply where a trust distributes a capital gain to a non-resident beneficiary?

Unfortunately, there is no clear answer to the question. We will need to wait for the courts or legislature to guide us. In the meantime, trustees should take advice before they make capital distributions to non-resident beneficiaries.