The recent history of the taxation of trust income in South Africa

Abstract

It has been 30 years since South Africa held its first democratic election. This article investigates how the taxation of trust income has changed since the dawn of democracy in South Africa. These changes are also evaluated, keeping in mind the perspectives of both the government and the taxpayers. It is argued that some of the changes are positive and necessary from both points of view. However, other changes, especially after 2013, seem to have been made simply to discourage taxpayers from using trusts. What does this mean for the future of trusts?

INTRODUCTION

South Africa recently celebrated the 30^th anniversary of its first democratic elections.¹ It is, therefore, appropriate to consider and assess the policy choices and laws made by its democratically elected government over this period. The purpose of this article is to investigate how the taxation of trust income by South Africa has changed over the last approximately 30 years and to evaluate these changes. The evaluation will keep the perspectives of both the government and the taxpayers in mind. Although this article is about South Africa, the influence of global trends and views will be apparent throughout. One example is globalisation and its influence on tax systems, including the campaign against base erosion and profit shifting (BEPS). Another is the perception that trusts are used mainly for tax avoidance or even evasion.²

By way of background, South Africa has, what is known as, a mixed legal system. This means that, although the basis of South African law is Roman-Dutch law (namely, it is based on civilian principles), English law has influenced it considerably.³ This led to South Africa developing a unique trust law that is quite unlike the law governing the traditional common law trust.⁴ In terms of the ownership of trust property, the courts in South Africa have held that the legal ownership of the property lies in the hands of the trustees, who have no beneficial interest in it. They are, however, bound to hold and apply the trust property for the benefit of a person(s) or for some other purpose.⁵ A trust is not a juristic person and does not have juristic personality, except as provided for in statute.⁶ As discussed below, South Africa’s Income Tax Act (ITA) regards a trust as a person, but it is not taxed in the same way as corporate entities.⁷

In South Africa, like in many countries around the world, trusts are known for their flexibility and the wide variety of purposes that they may serve.⁸ Cameron et al describe the trust as an ‘all-purpose institution’ that has ‘come to be employed for a wide variety of purposes over a long period of time’.⁹ Examples of the uses to which trusts have often been put are to protect assets, to run a business, or to cater for the needs of minors, incapacitated persons, or charities. More recently, trusts in South Africa have also been used, for example, in corporate restructurings and black economic empowerment transactions.¹⁰ These applications of trusts prove that they remain useful and relevant in the democratic era.

The investigation into the taxation of trust income by South Africa started in 1991, just before the dawn of its democracy. Two important changes to the ITA took place that year, namely the introduction of section 25B, which, to date, regulates the income taxation of trusts, and the amendment of the definition of a ‘person’ in the ITA to include a trust. Another watershed year for the taxation of trust income was 2013, when the Minister of Finance announced that the taxation of trusts would be reviewed to ‘control abuse’.¹¹ This budget speech displayed the perception of the National Treasury (South Africa’s Ministry of Finance) of trusts as anti-avoidance tools. It is submitted that this perception, which has persisted over the years,¹² has influenced many of the amendments after 2013.

In 2013, the Minister of Finance also announced the formation of the Davis Tax Committee, which investigated matters related to the taxation of trusts. In 2015 and 2016, the Davis Tax Committee released two reports that contained several significant recommendations in relation to the taxation of trusts.¹³ Some of the problematic areas highlighted by the Davis Tax Committee were addressed in subsequent legislation.¹⁴ Other recommendations were partly implemented¹⁵ or have not been implemented (yet).¹⁶ Only the recommendations that were implemented in legislation are addressed in this article.

GENERAL INCOME TAX

As mentioned above, a trust was included in the definition of a ‘person’ in the ITA.¹⁷ This amendment was significant because, before this date, the revenue authority’s practice was to tax the trustee as a representative taxpayer of the trust on any undistributed income.¹⁸ However, the court in Commissioner for Inland Revenue v Friedman¹⁹ decided that the trust was not a ‘person’ within the ITA and could therefore not be taxed. Furthermore, the trustees could not represent the trust, since they could not represent a non-existent person. This decision²⁰ prompted the amendment of the ITA to include a trust in the definition of a ‘person’. Thus, it is the trust itself that is (potentially) liable to tax in terms of the ITA.²¹ Although the definition of ‘person’ has been amended from time to time, it still includes a trust.

Furthermore, section 25B was introduced.²² This section has been amended several times since its introduction, but its basic premise has remained the same, namely that an amount that is received by or accrued to a trust is deemed to have accrued to a beneficiary. If that beneficiary is ascertained, the beneficiary has a vested right to the income and the amount has been derived for their benefit. In such a case, the beneficiary is liable to tax on the relevant amount and the trust is not taxed on that amount at all. However, an amount that is received by or accrued to a trust is taxed in the hands of the trust if there is no ascertained beneficiary, for whose benefit the amount was derived, with a vested right to that income. In such a case, only the trust will be taxed and not any beneficiary. In the case of a discretionary trust, the exercise by the trustee of his or her discretion in favour of the beneficiary will result in the beneficiary acquiring a vested right to an amount received by or accrued to a trustee during that year of assessment.²³ Therefore, if the trustee of a discretionary trust exercises his or her discretion in favour of a beneficiary during a particular year of assessment, the beneficiary will be regarded as having a vested right to the relevant income and will, consequently, be taxed on that income. The trust will, therefore, not be liable to tax in respect of the income distributed to such a beneficiary.

According to Olivier, the aim of certain later amendments to section 25B was ‘presumably to make the use of trusts so unattractive that from an income tax point of view, they will no longer be used as a tool for tax planning’.²⁴ For example, several subsections were added to section 25B in 1998, to prevent trusts from distributing their losses to taxpayers.²⁵ The object of these subsections is to limit the amount of the deduction to which beneficiaries are entitled, thereby trapping the deductions in the trust and making them unavailable to the beneficiaries.²⁶ In 2020, the section was also amended to state explicitly that the section only applies to amounts of a revenue nature.²⁷

A common law principle that is still relevant, even if section 25B is applied, is the ‘conduit pipe’ principle. The Ministry of Finance was of the view that section 25B was introduced ‘merely to confirm the conduit principle’.²⁸ In terms of this principle, income accruing to a trust retains its nature until it reaches the beneficiaries in whose hands it will be taxed. The trust is therefore a mere ‘conduit pipe’ through which income flows.²⁹ Thus, in the case of a trust where the income is deemed to accrue to the beneficiary during the particular year of assessment in terms of section 25B, the income will retain its nature in the hands of the beneficiary and be taxed as such.³⁰ Accordingly, the rules regarding the source of income will be applied to the specific item of income distributed to the beneficiary to determine where it is sourced.³¹ For example, income that is not from a South African source will retain its nature and be treated as such when it is distributed in the same year of assessment that it was received or accrued. However, if income is retained in the trust,³² the income will be taxed in the hands of the trust and, when distributed to the beneficiaries in a subsequent year of assessment, will not be subject to income tax in their hands.

In 2023, the Ministry of Finance announced in the Budget documentation that section 25B would be amended so that an amount flowing into a resident trust and distributed to a non-resident beneficiary would be taxed in the hands of the trust and no longer in the hands of the non-resident beneficiary.³³ The Income Tax Act has been amended accordingly.³⁴ The reasons for the amendment advanced by the Ministry of Finance are that the treatment of income flowing through the trust should be aligned with the treatment of capital gains in trusts and

[t]he flow through of amounts by South African trusts to non-residents places SARS [South African Revenue Service] in a difficult position to collect income tax from those beneficiaries as they may not be taxed on foreign-sourced amounts, tax recovery actions may be difficult and in the case of non-resident trusts that are beneficiaries, SARS may not have information on the persons in whom the foreign trusts vest the income.³⁵

Whether the reasons given by the Ministry of Finance are sound will not be addressed in this article, but what can be said is that the consequences of the amendment are far-reaching. It will result in the conduit pipe being ‘turned off’ in respect of non-resident beneficiaries.³⁶ In other words, income flowing into the trust to which an ascertained non-resident beneficiary has a vested right will no longer flow through the trust and be taxed in the non-resident beneficiary’s hands. Rather, the trust will be taxed on this income. This rule will apply, even if the income is not from a South African source. Previously, a non-resident beneficiary would not have been taxed on income from a source outside South Africa. The mere fact that the income flows through the trust to the non-resident beneficiary means that it will, in terms of the amendment, be taxable in South Africa. While it was settled law that the income distributed to a non-resident beneficiary (whether from a South African source or not) would retain its nature in the hands of the beneficiary, after the amendment, it is doubtful whether the income will retain its nature. It is an open question what the nature of the income received by the beneficiary would be.³⁷

The tax rate at which trusts were taxed should also be examined. In 1991, trusts were taxed on a sliding scale, at a similar rate to some categories of individuals.³⁸ However, in 1998, a special dispensation was created for trusts. They were taxed at 35 per cent on the first R100 000 and at 45 per cent in respect of all amounts exceeding R100 000. Individuals continued to be taxed on a sliding scale, with a maximum marginal tax rate of 45 per cent at that stage.³⁹ When the maximum tax rate for individuals was lowered to 42 per cent in 2000, a corresponding reduction in the rates for trusts was introduced, namely 32 per cent on the first R100 000 and 42 per cent on amounts exceeding R100 000.⁴⁰ However, since 2002, trusts have been taxed at a flat rate equal to the maximum rate for individuals.⁴¹ The reason given for the change in 2002 was to prevent ‘the current practice of income splitting through the use of multiple trust structures’.⁴² The tax rate at which trusts are taxed has kept pace with the marginal rate for individuals. Thus, for example, in 2016, the flat rate at which trusts were taxed was increased from 40 to 41 per cent and was increased to 45 per cent in 2018. It is quite clear that the change in the rates for trusts, from a sliding scale to a staggered flat rate and, eventually, to only one flat rate, resulted in trusts becoming far less attractive from a tax perspective. If one also bears in mind that, since 2002, trusts have been taxed at the maximum tax rate for individuals and that trusts do not qualify for many of the rebates or exemptions to which individuals are entitled,⁴³ it is clear that trusts are subject to exceptionally high real rates of income tax.

However, the opportunity to distribute trust income to beneficiaries with a lower tax rate than the trust (‘income splitting’) remained after the introduction of section 25B and still remains for resident beneficiaries. Thus, income accruing to a discretionary trust may be distributed in the year in which it accrues to several beneficiaries (typically minors) who have little other income and therefore lower tax rates than the trust. Thereby, the overall tax burden is lowered. At the current tax rate of 45 per cent for trusts, the opportunity to use income splitting remains one of the trust’s most appealing features from an income tax point of view. However, the 2023 amendment to section 25B ended the possibility of income splitting in relation to non-resident beneficiaries.

PERSONAL SERVICE PROVIDER

In 2000, provisions were introduced in the ITA to prevent taxpayers from using trusts (and companies) to avoid falling under the employees’ tax regime. These provisions created the concept of a ‘personal service trust’, which was included in the definition of an employee.⁴⁴ Therefore, if a trust met the requirements of a personal service trust, it would be regarded as an employee and any employer paying remuneration to such a trust would be obliged to deduct employees’ tax. Simultaneously, a limitation was placed on the amounts that a personal service trust could deduct in the calculation of its taxable income.⁴⁵ In 2008, the concept of a personal service trust was replaced by the concept of a ‘personal service provider’, a concept which encapsulates both trusts and companies.⁴⁶ Academics are of the view that ‘the statutory criteria for a personal service provider go far beyond criteria to unmask a disguised contract of service’.⁴⁷ Thus, if a trust qualifies as a personal service provider, employee’s tax will be deducted from the remuneration paid to it and its deductions will be limited. It will be taxed at the same rate as any other trust, that is, at a flat rate. The combination of these provisions makes the prospect of falling within the definition of a personal service provider particularly unappealing. Thus, the legislation has probably curbed the use of trusts to avoid employees’ tax. But at the same time, it could limit the use of trusts in a commercial setting, since individuals would be worried about falling within the wide definition of personal service providers.

SPECIAL TRUSTS

The concept of a special trust⁴⁸ was introduced in 2000. Special trusts are trusts created for certain vulnerable individuals and are, generally speaking, taxed in the same way as other trusts.⁴⁹ However, special trusts are taxed on the same sliding scale as individuals and not at the flat rate applicable to other trusts, and the inclusion rate for capital gains tax (CGT) purposes is the same as those of individuals.⁵⁰ Yet, these trusts do not qualify for the rebates applicable to natural persons⁵¹ or for the basic interest exemption.⁵²

Initially, only trusts created for the benefit of persons suffering from mental illness or serious physical disability, where the illness or disability resulted in the person not being able to earn enough income for his or her maintenance or managing his or her own financial affairs, were included.⁵³ This definition was extended in 2002 to include trusts created in terms of the will of a deceased, solely for the benefit of beneficiaries who are relatives of the deceased and alive on the date of death of the deceased, where the youngest beneficiary is on the last day of the year of assessment of the trust under 21 years of age.⁵⁴ Although the definition of a special trust has been refined several times, the gist of the definition remains the same.

Generally speaking, special trusts are spared the harsh income tax treatment suffered by other trusts. Their special regime makes them attractive vehicles, provided that the trust can be brought within the ambit of the definition.

INTERNATIONAL ASPECTS

In 2000, the policy decision was made to change South Africa’s mainly source-based system of taxation to a mainly residence-based system. Naturally, trusts were also impacted by this change. Thus, following this change, resident trusts are generally taxed on their worldwide income, while non-resident trusts are generally taxed only on their income from a South African source.⁵⁵ Similarly, a resident beneficiary is taxed on their worldwide income, which would include income from a non-resident trust. Previously, a non-resident beneficiary was usually taxed only on income from a South African source, but this was changed in the 2023 amendment discussed above.

To coincide with South Africa’s change to a mainly residence-based taxation system, section 25B was amended by the addition of section 25B(2A).⁵⁶ According to Olivier, this section was inserted into the ITA to ‘counter the use of offshore trusts for tax planning’.⁵⁷ In other words, it was foreseen that residents could arrange their affairs in such a way that their income-producing assets would be held in non-resident trusts. If these assets produced income that was not from a South African source, South Africa would not be able to tax these amounts, which could be distributed to South African resident beneficiaries in further years of assessment as distributions of a capital nature. Accordingly, section 25B(2A) was enacted to counter such planning.⁵⁸ In terms of this section, certain amounts are included in a resident beneficiary’s income, if that beneficiary had in a previous year of assessment a contingent right to an amount that would have been income had the trust been a resident and the beneficiary acquired a vested right against a non-resident trust to that amount in the current year of assessment.⁵⁹

The aim of countering the use of offshore trusts for tax planning was further achieved by the addition of subsections (8) to (10) of section 7, which Olivier describes as ‘[a]nother nail driven into the coffin of offshore trusts’.⁶⁰ Section 25B is subject to section 7, which deems certain amounts, received by or accrued to the trust, to be that of another person (typically the founder). Therefore, if section 7 applies, section 25B will not apply. Of particular relevance is section 7(8), which provides that where by reason of or in consequence of any donation, settlement or other disposition made by any resident (typically the founder), any amount is received by or accrued to any person who is not a resident (eg, a non-resident trust), which would have constituted income had that person been a resident, there shall be included in the income of that resident so much of that amount as is attributable to that donation, settlement, or other disposition.⁶¹

However, amounts that constitute exempt income will not be part of the amounts that would have constituted income had the trust been a resident. Therefore, most dividends received from South African resident companies by a non-resident trust would be exempt and therefore not attributed to the South African resident donor or beneficiary in terms of section 25B(2A) or 7(8). Similarly, dividends received from a non-resident company that would have been exempt had the trust been a resident are also exempt and therefore not attributed to the South African resident donor or beneficiaries.⁶²

The change from a mainly source-basis of taxation to a mainly residence-basis of taxation brought about other opportunities for tax avoidance. To curtail these, controlled foreign company (CFC) legislation was introduced, broadly speaking, to impute some of the income of a non-resident company controlled by a South African resident to that South African resident.⁶³ For a non-resident company to qualify as a CFC, a South African resident(s) must hold, directly or indirectly, more than 50 per cent of the total ‘participation rights’ in that company, or a South African resident(s) must be able to exercise, directly or indirectly, more than 50 per cent of the voting rights in that company.⁶⁴ There are several provisos to this general rule and these, as well as the applicable definitions, will not be discussed here.

Generally,⁶⁵ a non-resident trust will not qualify as a CFC, since a trust is not a company.⁶⁶ However, the following structure has given rise to a debate. Say a South African resident is the only beneficiary of a non-resident discretionary trust. The non-resident discretionary trust holds more than 50 per cent of the participation or voting rights in a non-resident company. Can it be said that the resident beneficiary indirectly holds the required number of participation rights or is able to exercise the required number of voting rights in the non-resident company for it to qualify as a CFC in relation to the South African resident? Some authors have argued that the resident does not,⁶⁷ but it is a matter that has clearly been a concern for both the Davis Tax Commission, as part of their response to BEPS Action 3,⁶⁸ and SARS.⁶⁹ Therefore, in 2017, the CFC legislation was amended to include within the definition of a CFC any foreign company where the financial results of that foreign company are reflected in the consolidated financial statements, as contemplated in IFRS 10, of any company that is a resident. Therefore, if the non-resident trust and the non-resident company are part of the same group and consolidated by the South African tax resident for financial reporting purposes under IFRS 10, the foreign company will be regarded as a CFC. Hence, an amount equal to some (or all) of the CFC’s receipts and accruals will be attributed to the resident company in accordance with the provisions of section 9D.

It will be noticed that the above amendment only applies when the South African resident is a company. But what if a South African resident individual is the only beneficiary of the trust? The amended legislation will not apply to cause the non-resident company to become a CFC in relation to the individual. If one assumes that the non-resident company is then not a CFC and declares a dividend to the trust, it will form part of the trust capital if it is not distributed in the same year of assessment in which it is received. If the capital is distributed in a later year of assessment, section 25B(2A) will apply. However, an amount must only be included in the resident beneficiary’s income if the trust capital arose from any receipts or accruals that would have constituted income if such trust had been a resident. Dividends declared by a non-resident company are exempt if the recipient holds at least 10 per cent of the total equity shares and voting rights in the relevant company.⁷⁰ Thus, the dividends received by the non-resident trust would not constitute income and would therefore not be included in the resident individual’s income during the relevant year. To curb what the National Treasury called ‘this loophole’,⁷¹ the legislation was amended. A new provision was added to the legislation to ensure that this⁷² dividend exemption will no longer apply in these circumstances where the dividend was paid by a non-resident company and more than 50 per cent of the total participation or voting rights in that company are directly or indirectly held or exercisable by the trust (or together with a connected person).⁷³ This new provision will not apply if the amount has already been included in the resident’s (or connected person’s) income.⁷⁴

Therefore, in the case where the South African resident is a company, holding shares in a non-resident company via a non-resident trust, the tax position of the resident after the 2017 amendments is more or less similar to the case where the shares are held via a non-resident company: in both instances CFC legislation will apply. Trusts were therefore stripped of their advantage over companies in this scenario. In the case where the South African resident is an individual holding shares in a non-resident company via a non-resident trust, the exemption in respect of dividends received by the trust and distributed in a later year of assessment is no longer available, making this use of the trust less attractive.

A fairly similar provision to the one described above in section 25B(2B) was added to section 7(8) of the ITA. In determining whether an amount would have constituted attributable income had the non-resident trust been a resident, section 10B(2)(a) must be disregarded, if the trust (alone or with a connected person) holds or is able to exercise more than 50 per cent of the total participation rights or voting rights in the company declaring the dividend and the resident, who made the donation, settlement, or other disposition (or a connected person), is a connected person in relation to the trust. Once again, the exemption of section 10B(2B) applies to the extent that the foreign dividend is included in the income of the resident who made the donation, settlement, or other disposition (or connected persons). In the situation where section 7(8) applies, trusts were made even less appealing by the removal of the exemption.

CAPITAL GAINS TAX

A major change regarding the taxation of trusts took place with the introduction of CGT in 2001. In terms of the Eighth Schedule to the ITA, a capital gain will either be taxed in the trust or in the hands of the beneficiary. However, the gain may also be attributed to another person (typically the founder) under circumstances similar to those described in section 7.⁷⁵

At the outset, it is important to note that the inclusion rates for trusts have always been high, making its effective tax rate for CGT purposes the highest of all taxpayers.⁷⁶ Thus, initially, the inclusion rate for capital gains by a trust was 50 per cent. This was increased to 66 per cent in 2012.⁷⁷ In 2016, the CGT inclusion rate for trusts was increased to 80 per cent. Thus, for the 2016 tax year, the effective CGT rate for a trust was 32.8 per cent. After the increase in the income tax rate of trusts to 45 per cent, the effective tax rate of a trust sits at 36 per cent. This increase in the inclusion rate, coupled with the increase in the tax rate, has made trusts rather unappealing. By comparison, the effective tax rate for companies is currently 21.6 per cent in respect of capital gains. Furthermore, trusts do not qualify for much of the CGT relief available to individuals, such as the annual exclusion,⁷⁸ and the exclusion in respect of personal use assets.⁷⁹

It should further be noted that some of the rules in the Eighth Schedule specifically deal with trusts.⁸⁰ These provide that capital gains are taxed in the hands of the beneficiary, rather than in the hands of the trust under certain circumstances, thereby allowing the lower inclusion rate and progressive rates applicable to individuals to be used. Thus, similar to income splitting, capital gains are spread to beneficiaries, who have the benefit of their annual exclusion and low inclusion rate. These factors allow for substantial savings. Hence, a gain made by the trust in respect of the vesting by the trust of an asset in a trust beneficiary who is a resident is disregarded in the hands of the trust and taken into account in the hands of the beneficiary to whom the asset was disposed.⁸¹ Likewise, a capital gain made in respect of the disposal of an asset by a trust in a year of assessment during which a trust beneficiary who is a resident has a vested interest or acquires a vested interest (including an interest caused by the exercise of a discretion) in that capital gain but not in the asset is disregarded in the hands of the trust and taken into account in the hands of the beneficiary.⁸²

According to SARS, these rules apply only if the beneficiary is a resident.⁸³ Thus, if a resident trust vests an asset in a non-resident beneficiary, it is the trust that will realise the capital gain or loss. Similarly, if a resident trust determines a capital gain (typically by the sale of an asset to a third party) in respect of which only a non-resident beneficiary has a vested right, the trust will have to account for the gain.

Soon after the introduction of the Eighth Schedule, a further paragraph was added to paragraph 80 to introduce a provision comparable to section 25B(2A). Therefore, if a non-resident trust distributes an amount from its capital to a resident beneficiary who obtained a vested right to that amount during that particular year and that capital arose from a capital gain (or an amount that would have constituted a capital gain had the trust been a resident) made in a previous year during which a beneficiary had a contingent right to that capital and the capital gain has not been taxed in South Africa, the capital will be taxed in the hands of the resident beneficiary.⁸⁴

Many of these provisions have undergone some relatively minor amendments from time to time. Furthermore, in 2008, the time of disposal rules were amended to ensure that a disposal (namely the distribution of an asset to the beneficiary with a vested interest) will take place on the date that the interest vests in a beneficiary.⁸⁵

The provisions described above deal only with capital gains. Capital losses always remain in the trust and cannot be distributed to the beneficiaries. Furthermore, the clogged loss rules may apply, which would mean that a ‘loss arising from the vesting of an asset in a beneficiary may be set off only against capital gains arising from transactions with that same beneficiary’.⁸⁶

Trusts are, like other entities, allowed to make use of the participation exemption found in paragraph 64B. This provision, was introduced in 2003 as the twin of the participation exemption for dividends, both of which are aimed at encouraging capital inflows and the repatriation of foreign dividends.⁸⁷ Paragraph 64B provides that, subject to certain exclusions, a person must disregard any capital gain or loss on the disposal of equity shares in any non-resident company, if the person (or together with another forming part of the same group of companies) held a certain percentage of the equity shares and voting rights (currently 10 per cent) in the non-resident company and satisfied certain other requirements.

The position of non-resident trusts should also be considered. Initially, when a non-resident trust vested an asset in a resident beneficiary, only limited types of assets were previously subject to CGT.⁸⁸ These gains were disregarded in the trust’s hands but included in the beneficiary’s capital gains calculation.⁸⁹ Similarly, it was only when a non-resident trust disposed of one of the limited types of assets to a third party that the gain was included in the CGT calculation of a resident beneficiary with a vested right to the gain. The trust did not take the gain into account.

In terms of a fairly drastic amendment in 2018,⁹⁰ a non-resident trust that vests an asset in a beneficiary must determine a capital gain as if it had been a resident. Therefore, all of the non-resident trust’s assets that are vested in the beneficiary are subject to CGT. Likewise, a non-resident trust that disposes of an asset must, after the amendment, determine the capital gain on the disposal as if it were a resident and this gain is then included in the beneficiary’s hands if he or she had a vested right to the gain. Therefore, the gain on all of the non-resident’s assets that are disposed of will be included in the vested resident beneficiary’s hands.⁹¹

The explanatory memorandum that accompanied the relevant bill gave no explanation or policy reason for this change.⁹² One can, therefore, only speculate as to the reasons for this change, but the frequent statements in the explanatory memorandum that the use of trusts to avoid tax must be discouraged gives a clue to the mindset of the National Treasury. What is troubling about this amendment is that there is no requirement that the beneficiary must have any sort of control over the trust. Had the trust been a company and South African residents held more than 50 per cent of the participation rights or voting rights, the company would have constituted a CFC. Thus a capital gain realised by the CFC would have formed part of its net income and an appropriate amount would have been included in its net income.⁹³ Had South African residents not held the requisite participation or voting rights, no capital gain would have been attributed to them, since the company would not have constituted a CFC.⁹⁴ However, as the legislation currently reads, if a non-resident trust vests an asset in a resident beneficiary, the beneficiary is simply taxed on that gain. Or, if a non-resident trust disposes of an asset, the beneficiary with a vested right to the gain is taxed on the gain. Therefore, the trust and its beneficiary are treated in the same way as a CFC and the resident in relation to which it is a CFC. However, a crucial difference between the two situations is that a beneficiary typically does not control a trust.⁹⁵ In fact, in the words of Judge Cameron, ‘[t]he core idea of the trust is the separation of ownership (or control) from enjoyment’.⁹⁶ Consequently, it does not make sense to apply the same rule to trusts as to CFCs.

A further amendment to tighten the taxation of trusts dealt with the participation exemption. In terms of paragraph 80(4), which was inserted in 2018,⁹⁷ in determining whether an amount would have constituted a capital gain had the trust been a resident, the provisions of paragraph 64B (the participation exemption) must be ignored, if the disposer held more than 50 per cent of the total participation or voting rights in the company whose shares are being disposed of. However, the participation exemption will not be ignored if the amount is derived from an amount that will be included in the income of, or attributed to, the resident or a connected person. For example, T Trust is a non-resident discretionary trust and it holds 60 per cent of the shares in Company X, a non-resident. Individual A is a resident beneficiary of T Trust. If T Trust disposes of its shares in Company X and vests the gain in resident A, paragraph 80(2) will apply. Thus, the gain is to be determined as if T Trust were a resident and this gain is then included in beneficiary A’s hands. In terms of paragraph 80(4), even though T Trust is regarded as a resident, it will not qualify for the participation exemption since it holds more than 50 per cent of the equity shares in Company X. But what would have happened if T Trust were a company? In that scenario, if individual A holds all the shares in T Company and it holds all the shares in Company X, both T Company and Company X would be CFCs in relation to A. If T Company were to sell its shares in Company X, paragraph 64B (the participation exemption) would apply, assuming that all the other requirements of that paragraph were met.⁹⁸ Therefore, the capital gain or loss will not form part of T Company’s ‘net income’ that is attributed to A in accordance with section 9D. Why should the CFC, in this case, get the benefit of the participation exemption, but not the trust? No reasons were advanced by the National Treasury.

INTEREST-FREE LOAN ACCOUNTS AND THE PLAN TO SAVE ESTATE DUTY

Although this article deals with income tax, a little excursion into estate duty is required to explain a later income tax development. Estate duty is levied on the estate of every person who dies. It is charged on the dutiable amount of the estate calculated in terms of the Estate Duty Act 45 of 1955.⁹⁹ A person’s estate includes all of his or her property on the date of death and also certain assets deemed to be his or her property on the date of death.¹⁰⁰ Because estate duty is charged, and has been charged in the past, at a rate of between 20 and 25 per cent,¹⁰¹ many individuals have devised plans to reduce their exposure to this type of taxation.

A popular estate plan¹⁰² involved the transfer of a growth asset, for example, immovable property or shares, to a trust. The purpose of such a plan was to allow all future growth in the asset to occur in the trust and not in the hands of the individual transferring the asset (typically the founder). Since the trust is not liable for estate duty, the growth in the asset was not subject to any estate duty. Due to the 20 per cent donations tax charge, most assets were not donated.¹⁰³ Rather, the purchase price remained outstanding on the loan¹⁰⁴ account, typically interest free. Although the loan by the transferor to the trust formed part of the transferor’s estate for estate duty purposes, this amount usually became fairly insignificant, if the value of the asset (of which the trust was now the owner) increased substantially. Furthermore, the value of the loan may have been reduced by annually donating an amount equal to the amount exempted from donations tax to the trust. This amount is currently set at R100 000¹⁰⁵ and the loan account could, therefore, be reduced by that amount annually.

One of the concerns of the Davis Tax Committee was that trusts could be used to avoid estate duty, while at the same time allowing income splitting to take place.¹⁰⁶ Interestingly, the answer to this concern came in the form of an amendment to the ITA, rather than through an amendment of the Estate Duty Act. Section 7C was inserted into the ITA in 2016.¹⁰⁷ In its most basic form, the section provides that if a certain type of loan, advance or credit (loan) is made to a trust at no interest, or at an interest rate that is below the ‘official rate of interest’, an amount equal to the difference between the interest rate charged to the trust during the particular year of assessment and the official rate of interest must be treated as a donation made to the trust.¹⁰⁸ Thus, donations tax must be paid on this amount, subject to the exemptions available in respect of that tax. Furthermore, no loss, deduction or allowance may be claimed in respect of the disposal (including a waiver) or failure to claim for the payment of an amount owing in respect of the type of loan.¹⁰⁹

The type of loan affected by these provisions includes a loan made by a natural person to a trust in relation to which the natural person (or a connected person) is a connected person. Several loans are exempted from these provisions, for example, loans to trusts that are public benefit organisations or small business funding entities, loans to special trusts and certain Sharia-compliant loans. Further exemptions prevented overlap with other sections of the ITA, ensuring, for example, that sections 31 and 64E take precedence.¹¹⁰

Thus, if a natural person (typically the founder) made an interest-free loan to a trust, an amount equal to the official rate of interest on the loan will be regarded as a donation. However, due to the exemption of the first R100 000 donated,¹¹¹ only an amount exceeding R100 000 will be subject to donations tax. Even if a natural person could collaborate with a spouse so that they could both make use of the R100 000 exemption, they could only make a fairly limited interest-free loan to a trust¹¹² without attracting donations tax.

Many loopholes in the legislation, or plans devised to avoid the provisions of section 7C, were subsequently closed, or thwarted by amending legislation.¹¹³

Has section 7C been effective in addressing the popular estate plan against which it was aimed? Herbst submits that if interest rates are low, the tax liability that follows from the application of section 7C is considerably less than the liability for donations tax or even estate duty which would have been incurred, had the interest-free (or low-interest) loan not been made. He cautions that in a high interest rate environment, the situation may well be different.¹¹⁴ He also highlights that section 7C leads to economic double taxation.¹¹⁵ It may be deduced that section 7C has certainly influenced the use of one-time popular estate plan and estate planners have had to think twice about using interest-free loans. However, for some estate planners, it may still make sense to use interest-free loans.

But has section 7C gone too far? It is common for businesses to be funded, at least initially, by the persons starting the business and for them to charge little or no interest.¹¹⁶ However, conducting that business through a trust has become very unattractive because of section 7C and most entrepreneurs would prefer to use a company rather than a trust for business purposes. Although the legislation does exempt certain business trusts,¹¹⁷ very strict requirements must be met for this exemption to apply and many trusts used for business purposes may not qualify. Furthermore, there are many instances in which inter vivos trusts are used for purposes other than the avoidance of donations tax or estate duty. An example of such use is in black economic empowerment transactions, where the purpose would be to assemble points on the relevant scorecard. Herbst proposes the introduction of a ‘motive or purpose test’ to ensure that transactions that are not entered into to avoid tax will not be caught by the provision.¹¹⁸

CONCLUSION

Trusts have been used in South Africa for many years and continue to be used to this day. This valuable entity has proved itself to be adaptable and useful under democratic rule in South Africa. What must be evaluated is whether the changes to the taxation of trust income were judicious, bearing in mind the interests of both taxpayers and the democratic government.

The creation of the concept of a special trust should be commended and is a positive for both taxpayers and the government. These trusts are spared some of the severe tax consequences applicable to other trusts. However, special trusts have a limited reach since the concept applies only in two circumstances.

The ever-increasing tax rates to which trusts have been subjected and the limitations on deductions are, naturally, negatives for taxpayers. Whether these high effective tax rates will automatically result in a positive for the government, is not clear, since these high rates may well cause fewer trusts to be used. Furthermore, income splitting (and capital gains splitting) is still possible with respect to resident beneficiaries. If taxpayers use this technique, the extremely high tax rates applicable to trusts can be managed by having the income flowing through the trust taxed in the hands of the resident beneficiaries.

Trusts have been made subject to many anti-avoidance provisions specifically aimed at them and at first glance, these provisions may be seen as a negative for taxpayers. However, some of these anti-avoidance provisions may be justified. For example, sections 7(8) and 25B(2A) (before the latest amendments) prevent taxpayers from moving income-producing assets abroad and later repatriating the income without tax consequences in South Africa. Another example would be provisions that have closed loopholes, and/or countered opportunities for BEPS, such as the amendment of the CFC definition where IFRS 10 is used to measure whether there is effective control by a South African company.

However, other amendments seem to stem from the government’s view that trusts are anti-avoidance tools and that the parties to the trust should be taxed harshly to discourage their use. For example, in terms of the latest CGT amendments, a non-resident trust is now treated as if it were a resident when it vests an asset in a resident beneficiary, or when it disposes of an asset and a resident beneficiary with a vested right. The effect of this provision is that all the non-resident trust’s assets will be subject to CGT in South Africa if the trust has a resident beneficiary with vested rights. A further example is the participation exemption that no longer applies if a trust holds more than 50 per cent of the total participation or voting rights in the company whose shares are disposed of. Another illustration is the newest amendment to section 25B of the ITA, whereby income to which a non-resident beneficiary has a vested right will now be taxed in the trust and not in the hands of the non-resident beneficiary. The negative impact of these provisions on taxpayers must surely deter the use of trusts in South Africa, especially by (potential) foreign investors.¹¹⁹

Furthermore, some amendments may be too wide, hampering the use of trusts for commercial or non-tax-related purposes. An example is section 7C. Taxpayers can no longer fund trusts with an interest-free or low-interest loan without considering the possible tax consequences of doing so.¹²⁰

It is submitted that trusts (and the parties to them) have been made subject to increasingly harsh tax laws by South Africa since the dawn of democracy, especially after 2013. One wonders why trusts have been singled out for such harsh tax treatment. Undoubtedly, the government will point to trusts used for tax avoidance or even tax evasion. However, other entities, such as companies, are also used for these purposes, yet they are not subject to the same punitive tax measures as trusts. Ultimately, it seems as though the pendulum regarding the taxation of trusts by South Africa has swung too far in favour of the government. It is hoped that the balance will be restored soon before income taxation suffocates the trust in South Africa.

Author Biography

Dr Izelle du Plessis is a senior lecturer at Stellenbosch University, South Africa. She holds the degrees BCom (Law), LLB and LLD from Stellenbosch University and an LLM (Taxation) from the University of Cape Town. She has published journal articles and book contributions in the field of tax law and has a special interest in the taxation of trusts.

Footnotes