Trust-to-trust: Can you end up paying tax on a trust distribution which you have not yet received?
I recently received a phone call from a lady in her early twenties who was desperate for help.
When she was a minor her parents registered her as a taxpayer and as trustees of their family trust distributed, but never paid, trust income to her in an attempt to avoid paying tax at a higher rate in the trust.
Unfortunately, they never paid the tax over to SA Revenue Service (Sars) on behalf of their minor child.
When she started working after completing her university studies, she went to Sars to register herself as taxpayer, unaware that her parents have registered her years ago as taxpayer. She was confronted by Sars with a huge outstanding account of approximately R 5 million, consisting of outstanding taxes, penalties and interest.
Although she has ever since tried to convince Sars that she was not the culprit, Sars insists that she owes the money to the organisation.
This causes her a lot of anxiety, as the family is no longer communicating to one another, her parents got divorced and the trust’s funds are depleted.
There is no prospect that she will ever receive any cash from the trust in the form of distributions made to her, which remains payable to her. Sars keeps her liable for the outstanding amount. According to her, her parents “ruined her life”.
As a general rule, income received by, or accrued to, a discretionary trust will be taxed in the hands of the trust, unless it is distributed before the trust’s financial year end (February each year) to a South African resident beneficiary, in which case it will be taxed in the beneficiary’s/ies’ hands, even though it may not have been physically paid to the beneficiaries and remains payable at the end of the financial year it has been distributed or vested.
In terms of Section 7(1) of the Income Tax Act income distributed or vested, but not yet paid in cash to a beneficiary, which:
- remains due and payable to them;
- has been credited to them;
- has been reinvested, accumulated, or capitalised in their name or on their behalf; or
- has been otherwise dealt with in their name or on their behalf;
- is deemed to have accrued to the beneficiary and will be taxed in their hands (ITC 1328 case of 1980), subject to the other anti-avoidance provisions - Section 7(2), 7(3), 7(4), 7(6), or 7(8) of the Income Tax Act). That means that one would have to first establish whether any of these other anti-avoidance provisions apply. If so, then this provision will not apply.
Section 25B of the Income Tax Act, which is the principal taxing section relating to trusts provides that (subject to Section 7 of the Income Tax Act) the income of a trust is taxed either in the trust or in the hands of the beneficiary as follows:
If the income vests during the year in a beneficiary, that beneficiary is taxed on it
If the income does not vest in the beneficiary, then the trust is taxed on it
Section 25B of the Income Tax Act (for trust income) and Paragraph 80(2) of the Eighth Schedule of the Income Tax Act (for trust capital gains), read together with Section 7(1), essentially codified the Conduit Principle first articulated in South African common law. The Conduit Principle is unique to trusts and allows trustees to distribute income and capital gains to beneficiaries together with the tax payable thereon, in order for the beneficiaries to pay less tax than would have been paid on the same income or capital gains in the trust.
Be mindful to classify the distributions due correctly in the financial statements to avoid being caught under the provisions of Section 7C of the Income Tax Act which taxes interest-free loans.
Trustees should timeously communicate income or capital gains distributed to beneficiaries so that they can include that in their respective tax returns. Beneficiaries should also be mindful when such distributions are made to them, without receiving any cash from the trust, as they may not have the cash to pay the taxation relating to such distributions. It will be prudent of trustees to pay at least enough cash to the beneficiaries to cover their tax obligations to Sars.
Phia van der Spuy is a Chartered Accountant with a Masters degree in tax and a registered Fiduciary Practitioner of South Africa®, a Master Tax Practitioner (SA)™, a Trust and Estate Practitioner (TEP) and the founder of Trusteeze®, the provider of a digital trust solution.