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February distributions to reduce tax: a good idea or not for trustees?

Published Feb 21, 2022

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ALL ABOUT TRUSTS

Phia van der Spuy

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It is again that time of the year (the end of February) that trustees have the opportunity to make distributions to beneficiaries to shift tax liability away from the trust (which pays a income tax at a flat rate of 45% and capital gains tax at 36% from the first rand of gains realised) to beneficiaries paying less or no tax at all (such as minor beneficiaries). This is a tool that has been used by accountants and tax advisers for years in a (legal) attempt to pay less tax on trust income and capital gains. The question is: is it that effective to just attempt to minimise the tax payable on this year’s return?

The trust is the taxpayer of last resort

Many people believe that trusts are no longer a vehicle to be used in estate planning, as trust income and capital gains are taxed at the highest rates in South Africa. It is actually not true and not that simple.

First, when trusts paid tax at a lower rate than individuals (believe it or not), the South African Revenue Service introduced anti-avoidance provisions to prohibit people from moving income or capital gains away from themselves by donating assets to a trust or selling them to the trust on an interest-free or soft loan basis. In this instance, income or capital gains generated on assets donated to the trust are deemed to accrue to the donor. Similarly, income or capital gains generated on assets financed via loans at below-market interest rates are taxed in the hands of the funder, limited to the notional amount of interest calculated on the loan at a market-related interest rate. These provisions override any other provisions that aim to tax trust income or capital gains. Although SARS may not motivate or remind you about these provisions (as in most instances they will be better off by ignoring them), they are now beneficial provisions to be effectively utilised in tax and estate planning.

Second, if no deeming provisions (resulting in income or a capital gain being taxed in the hands of the donor or funder, as explained above) can be applied to income or a capital gain realised in the trust, the beneficiary (excluding distributions to a foreign resident beneficiary) will be liable for the tax on amounts vested in them through trustees applying their discretion, utilising the Conduit Principle. This is the provision that most accountants and tax advisers use in an attempt to minimise the tax liability on trust income and capital gains every year.

Finally, the trust will pay tax on any income or capital gains realised in the trust that has not been taxed already in terms of the two above instances. The trust is, therefore, the taxpayer of last resort.

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The above makes it clear that a blanket statement that the most tax is paid on income generated or capital gain realised in a trust is simply not true. With a trust being the taxpayer of last resort, planning opportunities present themselves, which are not available to any other taxpayer, whether it is an individual or company. Accountants and tax advisers often forget, or are not aware of, the benefits of the attribution rules described above. One, however, needs to actively manage the trust, and have proper paperwork and accounting and record-keeping systems, and consider the various options in order to minimise taxes paid. Material estate planning benefits can be materialised over the long term from the application of the attribution rules, but you can only do that if you keep proper account of the relevant numbers.

The decision has a long-term effect

It is clear from the Income Tax Act that it is not a requirement that cash should flow – hence the reference to “vest”. A “vested right” is defined as a “right accrued to a possessor with no conditions”, the legal definition being “a right belonging completely and unconditionally to a person as a property interest which cannot be impaired or taken away without the consent of the owner.” A vested right cannot be conditional – or else it would never have existed in the first place. A vested personal right to claim payment or transfer of the benefit will form part of the estate of the beneficiary. It cannot just be taken away. By including it in the estate of the beneficiary, a huge benefit of growing and retaining value in a trust is undone by making such distributions for tax purposes only. The end result is that after estate duty, the effective tax rate payable to SARS will be higher than the rate at which you would have paid tax in the trust by not making distributions (the third option described above). We all know by now how difficult and costly it is to get assets into a trust today.

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In addition to the undoing of the estate planning benefits in a trust, the amounts vested in the beneficiaries will now be exposed to their creditors. Not a wise decision of trustees to do that only to save tax in the short term.

Conclusion

Trustees, accountants, tax advisers and financial advisers can add great value to assist a family to build generational wealth in a trust and not advise clients to undo the benefits of accumulating assets in a trust over time (which is hard work) by making distributions every year, at all cost. And the answer lies in proper systems to keep track of the numbers that you will have to convince SARS about.

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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.

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