The role of foreign trusts in the structuring of foreign affairs of South African residents is changing, says international family wealth manager Stonehage Fleming. Foreign trusts will always have a broad benefit for wealthy families with complex, international affairs and should not be used to mitigate tax, but rather to maximise the wealth protection and estate planning opportunities. Foreign trusts are no longer the only option for investors looking to remit funds from South Africa, due to a changing international tax environment coupled with the recent focus by SARS on both local and foreign trusts.
More specifically, with the implementation on March 1 2017 of Section 7C of the Income Tax Act, which addresses low or no interest loans to trusts, the 2018 tax year marks the first year where South African taxpayers are subject to a Section 7C liability. Additionally, it was proposed in the 2018 Budget Speech that the ‘official rate of increase’ (which is also the rate used to calculate Section 7C donations) be upwardly revised to be more aligned with a market-related rate. A change in this ‘official rate of interest’ will necessitate a review of whether the interest rate applicable to existing loans needs to be adjusted, and where Section 7C applies to a loan to a trust, it will also result in an increased donation and therefore donations tax liability.
Further developments include the rising costs of administration and management of foreign trusts due to heightened governance, compliance and reporting functions of trustees, as well as the growing trend of remitting funds offshore (over and above the R10 million available through the annual foreign investment allowance) by way of special applications to the South African Reserve Bank. These special application funds cannot be lent to a trust and must be invested in the name of the applicant, which may deem the costs of establishing and maintaining a foreign trust unwarranted to house only a small portion of the taxpayer’s foreign funds remitted from South Africa.
“In determining the tax implications of a foreign trust where a loan is in place which is not attracting interest at a market-related rate, the relationship between three primary tax principles must be considered – transfer pricing provisions, attribution rules and the new Section 7C,” says Elana Nel, senior associate in the tax advisory division at Stonehage Fleming in South Africa.
Typically, funding a trust by means of a donation is not a suitable option, due to an immediate 20-25% applicable donations tax charge, as well as the application of attribution provisions. Therefore, assuming funding is by way of a loan, estate duty will be payable on the value of the loan at the date of death, which will be affected by the currency denomination of the loan and increased with accumulated interest. Additionally, income tax will be payable on the interest charged on the loan; or where not charged, the application of attribution provisions, Section 7C and transfer pricing legislation must be considered.
“Purely from a tax perspective, foreign trusts lose their relevance when the combined estate duty on the loan and the tax paid on the interest earned on the loan constitutes a significant tax cost, which when added to the costs of establishing and managing the structure, are greater than if you invested the funds personally,” says Nel.
As alternatives to foreign trusts, Stonehage Fleming considers various options depending on each particular family’s circumstances and associated risk profiles. Personal investment saves on structural costs and offers greater personal control, while offshore life insurance products, which can be entered into by a foreign trust or an individual, may offer specific capital gains and income tax benefits. A ‘dry’ trust is a suitable vehicle for investors whose foreign funds have been externalised by way of special applications. It serves as a passive inter vivos foreign trust that is set up during the settlor’s lifetime with a nominal settlement but only becomes active once fully funded on the settlor’s death, when the settlor bequeaths his/her foreign assets to the trust in terms of a Will. With no loan in place during the resident’s lifetime, no interest is earned and thus no income tax is payable.
Nel says: “While there are still various scenarios where a foreign trust may be a necessary planning vehicle, the era is over where it is advised as an “automatic” ultimate solution to every investor remitting funds from South Africa. It is important to note that tax structuring should never be the sole or dominant reasoning behind arranging the structuring of your affairs through a foreign trust and with other options available that can be tailor-made to suit specific requirements, we advise that wealthy South Africa residents enlist the services of a tax specialist to re-assess their circumstances, as we are expecting greater scrutiny on trusts in the years ahead.”