Author: Doria Cucciolillo (The SAIT)
According to the 2013/2014-budget review the National Treasury intends to amend current income tax legislation that relates to trusts. At present trusts function as flow-through mechanisms and therefore provide loopholes to avoid taxes. The proposed amendments aim to reduce the available tax saving schemes involving trusts, but will have no effect on so-called special trusts (established to take care of minor children and persons with disabilities). This article investigates the income tax consequences of the proposed changes.
Current tax saving schemes
The utilisation of trusts to gain income tax benefits has become a popular trend among taxpayers, especially wealthy individuals who wish to reduce potential estate duties. A method frequently used by taxpayers is the disposal of a growth-asset to a trust through a loan-account. Although the disposal may have immediate CGT-implications for the taxpayer (where 33.3% of the capital gain will be subject to normal income tax) and in some instances donations tax at a rate of 20%, he or she avoids paying taxes on any subsequent increase in the value of the asset. The asset will not be included in the person’s estate when he or she dies and no estate duty will be payable thereon. However, any increase in the asset’s value can be taxed (as part of a capital gain) if the trust disposes of the asset.
In order to save normal income taxes, the capital gain with disposal will normally be distributed to the beneficiaries of a trust. Since ordinary trusts are taxed on 66.6% of the capital gain at a rate of 40%, it will be more beneficial to distribute a capital gain to beneficiaries who fall within lower tax brackets, for example companies that are taxed at a lower rate of 28%. If the distribution is made to a natural person he or she may reduce the capital gain with an annual exclusion of R30 000 and only 33.3% of the remainder will be included in taxable income.
The above tax saving scheme is available due to the fact that a trust represents a flow-through mechanism. In other words, any income received by a trust will retain its nature when it is distributed to a beneficiary. As a result, the beneficiary may apply any tax exemptions or exclusions that relates to that specific type of income. For example: if the trust receives interest from an investment, and the interest is distributed to a beneficiary (who is a natural person) the beneficiary will be entitled to claim the monetary interest exemption whereas the trust will not be entitled to this exemption. The distribution may therefore result into tax savings if the natural person pays income tax at a lower marginal rate.
Treasury intends to put an end to the implementation of the above mentioned tax saving methods. In terms of the proposed adjustments trusts will no longer function as flow-through mechanisms and distributions to beneficiaries will be included in ordinary revenue. This means, for example, that a natural person will not be entitled to reduce a distribution of interest received from a trust with the monetary interest exemption since the income does not constitute “interest” in the natural person’s hands. As a result the beneficiary is taxed in full on the distribution received, while the trust will be granted a deduction for distributions made (provided that it does not result into an assessed loss). In contrast with current legislation distributions will form part of the beneficiary’s income (irrespective of its original nature) and may be subject to normal income tax if no deductions are available.
If a capital gain is distributed to a beneficiary, the full amount will be included in the beneficiary’s taxable income while the trust will receive a deduction for the distribution made. The capital gain will then be included in the taxable income of the beneficiary at a rate of 100% (without any annual exclusion).
Efficiency of proposed amendments
Although the above mentioned provisions are much more stringent if compared to current legislation, it does not combat tax avoidance in full. It will still be possible to avoid income tax in the trust (levied at a rate of 40%) through the distribution of income to beneficiaries who fall within lower tax brackets. In effect, the income of the trust can be shifted to beneficiaries who are taxed at lower marginal rates, while the trust is granted a deduction for these distributions and is therefore relieved from paying income taxes on these amounts.
It seems as if the amendments will be more effective in terms of avoidance schemes that involve the distribution of capital gains. Currently, a trust pays normal income tax on 66.6% of a capital gain and therefore the gain will rather be distributed to a natural person who is only taxed on 33.3% of the gain. If the proposed amendments are put into effect, these avoidance schemes can no longer be enforced. The distribution will not constitute a capital gain in the beneficiary’s hands and he or she will be taxed on 100% of such a gain.
The intended legislative adjustments may assist government to a certain extent in its efforts to combat tax avoidance, but at the same time it may discourage the creation of ordinary trusts. Not all trusts are created to avoid taxes and some have important social roles, for example to provide sustained financial assistance to an adult beneficiary while assets are secured in the trust. In essence, it may discourage the use of a trust as a safeguard for assets since trusts will become highly ineffective from a tax perspective.