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STEP Mauritius Conference. 2019. Tax rates of a trust. A trust is the highest taxed entity in South Africa: Income tax rate-flat rate of 45%, no primary rebates CGT rate-flat rate of 36%, no rebates No interest rebate
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Tax rates of a trust A trust is the highest taxed entity in South Africa: • Income tax rate-flat rate of 45%, no primary rebates • CGT rate-flat rate of 36%, no rebates • No interest rebate It therefore makes no sense for a trust to take out any income generating investment • The conduit principle is often used to get round this problem, where income and capital gains are passed down to the beneficiaries in the same tax year, and the tax is then paid by them at their lower rate. BUT, problems with doing this: • Firstly, money has to come out of the trust to the beneficiaries; AND
Proposals to tax Trusts-Davis Tax Committee • Davis only a report, no legislation yet. However, some changes re trusts might happen. NB-not mentioned in 2018 budget apart from estate duty increase on estates above R30m! • Main change being discussed-any capital gain/income gains made in the trust will have to be taxed in the trust and not passed down. Example: • Trust sells a property. It makes a gain of R1m. Currentlyit could pass the gain down to beneficiaries and they would pay the CGT at a maximum rate of 18%. The proposals are that the taxable gain cannot be passed down and the trust would have to pay the CGT itself at the rate of 36% • The proposals will hit trusts hard if they make capital gains-they won’t be able to use the beneficiaries lower rates anymore. If they pass money down to the beneficiaries it will be after tax
Anti-avoidance laws relating to trusts | Section 7of the Income Tax Act 2) “Any income received by or accrued to any person married with or without community of property (hereinafter referred to as the recipient) shall be deemed for the purposes of this Act to be income accrued to such person's spouse hereinafter referred to as the donor) if— such income was derived by the recipient in consequence of a donation, settlement or other disposition made by the donor on or after 20 March 1991 or of a transaction, operation or scheme entered into or carried out by the donor on or after that date, and the sole or main purpose of such donation, settlement or other disposition or of such transaction, operation or scheme was the reduction, postponement or avoidance of the donor's liability for any tax, levy or duty which, but for such donation, settlement, other disposition, transaction, operation or scheme, would have become payable by the donor under this Act or any other Act administered by the Commissioner; or…”
Continued… 3) “Income shall be deemed to have been received by the parent of any minor child or stepchild, if by reason of any donation, settlement or other disposition made by that parentof that child- a) it has been received by or has accrued to or in favour of that child or has been expended for the maintenance, education or benefit of that child; or b) it has been accumulated for the benefit of that child.” 4) “Any income received by or accrued to or in favour of any minor child or stepchild of any person, by reason of any donation, settlement or other disposition made by any other person, shall be deemed to be the income of the parent of that child, if such parent or his or her spouse has made a donation, settlement or other disposition or given some other consideration in favour directly or indirectly of the said other person or his or her family.”
Continued… Section 7 (3) and (4) bring income back to the donor, if an interest free loan has been made by the donor for the benefit of his minor children [under 18], and that loan creates taxable income or capital gains.This includes a transfer to a trust Example- father loans R1m to a trust where the minor children are beneficiaries. Trust invests the moneyin a bank.The interest earned will be taxed back in the donor father’s handsin terms of this section. The same applies to capital gains earned, or any other taxable income. NB-overrules the conduit principle Therefore if a loan is made to a trust, and the trust buys a unit trust investment,the following tax issues arise: Trust fully taxed on all interest earned, no rebates Might be a section 7 clawback of interest and CGT earned back to the donor If try make use of the conduit principle, Section 7 might apply, or new proposals could catch the transfer if they eventually come in. Client at risk, as not certain if/when the new proposals could come in New Para 7C-discussed later
Conclusion Trust owned endowments will not be affected-the tax is all in the endowment portfolio! This means that the following tax problems are avoided: • Section 7 clawback- there is no taxable income to clawback • New tax proposals- there is no need to use the conduit principle, as the endowment pays out after tax money, which remains after tax if it is passed down to beneficiaries • High tax rates on a trust-the trust pays no direct tax, as all the tax is paid in the portfolio by the insurance company NB-Para 7C is NOT avoided if there is a loan account
Donations Tax Donations tax paid at the rate of 20%by the donor on any donation made • R100 000 per annum is exempt for a natural person, R10 000 exempt for a non-natural person in any tax year (Note public Company is exempt) • No donations tax paid on donations between spouses only. Note spouse is widely defined here for tax purposes. [Section 56 of the Income Tax Act] • No donations tax on charitable donations made to registered charitable organizations • No donations tax payable in respect of “so much of any bona fide contribution made by the donor towards the maintenance of any person as the Commissioner considers to be reasonable”[56 (2) (c)
Continued… • Section 58 of the Act - “Where any property has been disposed of for a consideration which, in the opinion of the Commissioner, is not an adequate consideration, that property shall, for the purposes of this Part, be deemed to have been disposed of under a donation...” • Section 59 - “The person liable for donations tax shall be the donor; Provided that if the donor fails to pay the tax within the period prescribed....the donor and the done shall be jointly and severally liable forthe tax” • Section 60 - “Donations tax shall be paid to the Commissioner within three months or such longer period as the Commissioner may allow from the date upon which the donation in question takes effect” • NB-remember change in 2018 budget for donations over R30m
Donations Tax Exemption Plan • Tax year ends 29 February 2020-many clients have not used their R100 000 donations exemption. Remember, its use it or lose it! • Idea is to use this exemption in a manner which is tax efficient, AND assists with their estate planning, in ensuring the investment is not an asset in their estate. We also want to use this in a manner which gives an effective marketing opportunity • Section 56 (2) (b) of the Income Tax Act allows every natural person to donate R100 000 free of donations tax per tax year. NB-this is not tax deductible! • Section 56 (1) (b)- there is no donations tax on donations between spouses. This is without limit
The Donations Tax Exemption Plan Husband and wife should therefore donate R200 000 per year as a couple, to a trust. The money belongs to the trust, without a loan account, so para 7C not triggered NB-don’t take short cuts-the money must come from each one of their bank accounts separately Trust invests money in a 5 year endowment policy to avoid tax problems: • Avoids tax on interest earned, or application of Section 7 • Avoids any CGT in the trust’s hands if units sold • Also avoids any consequences if the proposed changes to the taxation of trusts as per theDavis Report are ever implemented
Benefits R 200 000 per annum is removed from the donor’s estate. Growth takes place in the trust.A nest egg is built up for the family, free of estate duty The policy belongs to the trust and there is no loan account to attack Note-the trust must take out the policy from inception, so no 2nd hand policy problems. Trust must be set up first. No policy must be ceded to the trust, or else there will be double CGT-in the portfolio, and again when it pays out There should not be a life assured on the policy, as if there is the policy will pay out on that person’s death, and become a deemed asset Owning an endowment policy avoids changes in trust tax legislation
Deemed Asset Section 3 (3) (a) of the Estate Duty Act reads as follows: “Property which is deemed to be property of the deceased includes- a) so much of any amount due and recoverable under any policy of insurance which is a “domestic policy”upon the life of the deceased as exceeds the aggregate amount of any premiums or consideration proved to the satisfaction of the Commissioner to have been paid by any person who is entitled to the amount due under the policy, together with interest at six per cent per annum calculated upon such premiums or consideration from the date of payment to the date of death...”
Trust owned endowment with a life assured | ERROR! • Trust owns an endowment policy. A has donatedR100 000 per annum to the trust to pay for the policy. There is therefore no loan account or asset inA’s estate • The endowment policy has a life assured in error • When the life assured dies, the policy will pay out. That will trigger estate duty in the deceased estate, because of Section 3 (3) (a) .... • Answer-a trust owned endowment shouldNOT have a life assured
Diagram of Donations Plan Husband Wife Trust R100 000 DONATION Remains after tax money R100 000 DONATION Beneficiaries Policy matures (After tax money) Endowment Policy
Specimen Trust resolution to take out the investment Resolution passed by the Trustees of the ABC Trust,IT number at on the Resolved: The ABC Trust be and is hereby authorised to invest in an endowment policy/life policy with Discovery Life/Discovery Invest That Discovery Life/Invest be permitted to debit the bank account of the ABC trust/OR The trust shall make a lump sum contribution from its bank account to fund the abovementioned investment That [NAME OF TRUSTEE] is hereby authorised to sign all relevant documentation in respect of the above investment on behalf of the other trustees Signed [NB-MUST BE SIGNED BY ALL THREE TRUSTEES]
Para 7C | interest free loans to trusts • “This section applies in respect of any loan, advance or creditthat- • a) a natural person; or • b) at the instance of that person, a company in relation to which that person is a connected person in terms of paragraph (d) (iv) of the definition of connected person, directly or indirectly provides to - • (i) a trust in relation to which - • (aa) that person or company; or • (bb) any person that is a connected person (i.e. a beneficiary of a trust, any relative of such beneficiary, any other beneficiary of such a trust)) in relation to the person or company referred to in item (aa), is a connected person; or
Continued… (ii) a company if at least 20% of- (aa) the equity shares in that company are held, directly or indirectly; or(bb) The voting rights in that company can be exercised, by a trust referred to in subparagraph (i) whether alone or together with any person who is a beneficiary of that trust or the spouse of abeneficiary of that trust or any person related tothat beneficiary or that spouse within the second degree of consanguinity.“ Comment: stops all those schemes where a loanwas made to a company instead, where the sharesare owned by the trust! Note amendment wasmade retroactive!
Continued… (1A) “If a person acquires a claim to an amount owing by a trust or a company in respect of a loan, advance or credit referred to in subsection (1), that person must for purposes of this section be treated as having provided a loan, advance or credit to that trust or company- On the date on which that person acquired that claim; or If that person was not a connected person on that date in relation to- that trust; or the person who provided that loan, advance or credit to that trust or company, on the date on which that person became a connected person in relation to that trust or person, that is equal to the amount of the claim so acquired.” Comment- can’t transfer loan to another party to avoid the section!
Continued… (3) If a trust or company incurs- no interest in respect of the loan, advance or credit; or interest is incurred at a lower rate than the official rate of interest, (contemplated in paragraph 1 of the Seventh Schedule to the Income Tax Act - currently 7.75%), “an amount equal to the difference between the amount incurred by that trust or company during a year of assessment as interest in respect of that loan, and the amount that would have been incurred by that trust or company at the official rate of interest must.. be treated as a donation made to that trust, by the person who made that loan to the trust, on the last day of that year of assessment of that trust. “
NB-consequences where section applies The loan, advance or credit will be a deemed donation: • Example: Mr. X makes a loan to his trust of R5m which was used by the trust to buy an endowment policy. He charges interest at 2.75% • Donation: R5m x (7.75%-2.75%) = R250k • Donations Tax calc: Donation of R250k • Less Annual Exemption of R100k [if available] • Therefore, R150k taxable at 20% • Donations Tax = R30k. • Note this is payable every year
Continued… Commencement date: • The section came into operation on the 1st of March 2017and applies in respect of any amount owed by a trust in respect of a loan, advance or credit provided to the trust before, on or after that date • The annual Donations Tax exemption of R100k will apply to the deemed donation defined in this section, if it is still available • NB-in effect, the section is retroactive, as it catches all loans to a trust, no matter when they were made. The tax itself though is only payable for tax year starting1 March 2017
Exemptions The provisions do not apply if: a) The trust or company is a Public Benefit Organisation approved by the Commissioner in terms of section 30(3) of the Act; [NB-Local only] b) The loan, advance or credit was provided to the trust by a person by reason of, or in return, for a vested interest held by that person in receipts and accruals and assets of that trustand; The beneficiaries of the trust hold in aggregate a vested interest in all the receipts, accruals and assets of the trust; No beneficiary can in terms of the trust deed hold or acquire an interest in the trust other than a vested interest as envisaged above The vested interest of each beneficiary is determined solely with reference and in proportion to the assets, services or funding contributed by that beneficiary to the trust and; None of the vested interests held by the beneficiaries is subject to a discretionary power conferred on any person in terms of which that interest can be varied or revoked
Continued… | Exemptions • The trust is a special trust as defined in paragraph (a) of the definition of a special trust (i.e. a trust solely for the benefit of one or more persons who are persons with a disability, as defined, where such disability incapacitates such person or persons from earning sufficient income for their maintenance, or from managing their own financial affairs); • The trust or company used the loan wholly or partly for purposes of funding the acquisition of an asset, and – • the person referred to in subsection (1)(a) or the spouse of that person used that asset as a primary residence as contemplated in paragraph (b) of the definition of “primary residence” in paragraph 44 of the Eighth Schedule throughout the period during that year of assessment during which that trust or company held that asset; and • (ii) the amount owed relates to the part of that loan, advance or credit that funded the acquisition of that asset;
Continued… | Exemptions The loan, advance or credit constitutes an affected transaction as defined in section 31(1) that is subject to the provisions of that section (transfer pricing provisions related to an offshore trust); The loan, advance or credit was provided to the trust or company in terms of an arrangement that would have qualified as a sharia compliant financing arrangement as contemplated in section 24JA, had that trust or company been a bank as defined in that section; or The loan, advance or credit is subject to the provisions of section 64E(4) (i.e. where the loan was made to the trust by a company and is deemed to be a dividend by that company to the trust in terms of the said section) The trust was created solely for purposes of giving effect to an employee share incentive scheme…
Comment The annual Donations Tax exemption of R100 000 will apply to the deemed donation defined in this section. This means this 100k annual exemptions is most important and needs to be used carefullyin planning From 1 March 2017 donations tax will have to be paid on all loans above R1 290 000. [7.75% x R1 290 000 =R99 975, which is below the donations tax exempt amount, assuming it is available.] Clients should not panic and take rash decisions to close their trusts and distribute the assets, or sell some/all the assets and pay off the loan. Remember, that selling off assets or distributing them out of the trust will create an immediate CGT event on which CGT will have to be paid. Also, paying back the loan or distributing assets will transfer assets back into the planner’s estate, and create an estate duty problem going forward
Continued… • Clients need to carefully consider what was the reason for creating the trust. If that reason is still there-for example-to protect minors or vulnerable people-then they should consider keeping the trust • Most importantly, client’s need to do the maths. They must calculate what it will cost them every year to pay the donations tax on the loan account, as opposed to what it will cost them in upfront CGT and future estate duty to repay the loan or close the trust. They must seek specialist advice • Clients must also remember that if the trust has an endowment policy, and they cede it out of the trust to a third party, then that policy becomes a second hand one. This will mean that when it finally matures, CGT will be paid on any gain in the investor’s hands, in addition to the tax in the portfolio
Continued… • Clients should also be aware that if the trust has a large amount of taxable income, it might be worthwhile, depending on the facts of the case, to actually pay interest on the loan at the official rate. That would remove the loan from the provisions of para 7C, and allow the trust to deduct the interest paid against its other taxable income. Off course, such interest would be taxable in the planner’s hands, but the planner would be able to use the interest rebate against this, and might have a low tax rate or deductions [like a RA] in their personal capacity. Again, this will all depend on the facts ofthe case • Finally, please be aware that the interest is calculated on a daily basis, so it is not possible to avoid the paragraph by paying back the loan shortly before the end of the tax year, and then reinstating it shortly after the start of the new tax year
Continued… • NB-the R100k annual donations exemption is most important! • NB-if minor beneficiaries are credited in the trust books, but not paid out,don’treflect this in the financials as a loan, or else para 7C kicks in. Reflect it as a vested benefit not yet paid out • NB-if you are going to pay out to kids who are beneficiaries, or do things like pay the kid’s schools fees, just make sure the resolutions are properly done-dated correctly, and specifically mention the transactions. SARS looks for any gaps in the resolutions. They do ask to see them!
Conclusion • Planning for South African clients with local trusts is extremely complex if the trusts are funded by wayof loans • Since 1 March 2017 these loans could trigger donations tax as well as the other penal provisionsof para 7 • Most advisors have never worked with donations tax before-need to upskill on it and how it works in practice • NB-don’t let your clients panic, but there should be a good reason now to justify having a trust. That in itself is a positive development!
