This article was first published in the second quarter 2017 edition of Personal Finance magazine.
Many trusts are established for bona fide estate-planning purposes, such as, among many others, the protection of assets from creditors, protection against spendthrift beneficiaries, flexibility, continuity, or aiding a benevolent purpose (through a trust known as a public benefit organisation or PBO).
Typically, the estate planner would transfer growth assets to the trust, often set up as a discretionary trust, and then invest those assets. The assets held in a discretionary trust do not belong to the creator of the trust (also known as the founder, settlor or donor), nor do they belong to the beneficiaries. Instead, the beneficiaries may benefit only once the trustees have exercised their discretion. The beneficiaries, therefore, have a hope of receiving something, rather than an automatic right to benefit in any way whatsoever.
The tax motive
Let us assume the founder or estate planner has only one growth asset, with a value of R10 million. On good advice, he or she creates a discretionary trust with an initial cash donation of R1 000 and becomes one of five potential discretionary beneficiaries.
The founder is also one of three trustees (one being an independent trustee) and the trust is managed in accordance with their fiduciary duties and responsibilities.
For the purposes of this illustration, we will ignore all other potential taxes that might be payable as a result of the transfer or sale of the growth asset, including capital gains tax, VAT, transfer duty and securities transfer tax. The founder sells the growth asset to the trust for the fair market value – in this case, R10 million.
However, the trust does not have sufficient cash reserves, or other financial means, to pay for the asset. The seller or founder now enters into a loan agreement with the purchaser (the trust).
The terms of the agreement are negotiated so that (i) the purchase price becomes due and payable when the seller issues a written demand for payment and (ii) the outstanding purchase price will bear interest as determined by the parties from time to time. The parties promptly agree that the outstanding purchase price will bear no interest. This all happens in year one.
Let us assume that in year 20 the trust’s market value is R39 million. However, it is obliged to repay the debt of R10 million to the founder. Thus, the trust’s net asset value is R29 million (R39 million – R10 million loan).
What are the fiscal benefits? The founder has pegged the value in his estate at R10 million – the value of the outstanding loan. The loan is the only asset that will attract estate duty in the event of the founder’s death because all further growth will accrue within the trust. Since a trust is not a natural person (but a legal person or entity) for estate duty purposes, no estate duty can be levied on assets held by a trust. The Estate Duty Act deals only with assets that were owned by the deceased, or that are deemed to be part of the deceased’s estate.
The estate duty saving in this example, therefore, is R29 million (the growth within the trust) x 20 percent (the estate duty tax rate), which equals R5.8 million.
Because of the disposal and funding mechanism used (an interest-free loan), the founder is also not liable for donations tax. Had the founder instead donated the growth asset outright to the trust, donations tax in the amount of R1 980 000 would have become pay-able, calculated as follows: R10 million – R100 000 (the amount not subject to donations tax) x 20 percent (the donations tax rate).
In summary: the total of R5.8 million estate duty, plus R1 980 000 donations tax, is saved over a period of 20 years in this example.
As this example demonstrates, one of the many benefits that discretionary trusts offer is the minimisation of estate duty. Additionally, by funding the trust through an interest-free loan agreement, donations tax is avoided. Eradicating these benefits, it would seem, is the main driver behind the proposed new section 7C to the Income Tax Act.
During the Budget Speech of February 24, 2016, the then Minister of Finance, Pravin Gordhan, said the government proposed to “limit taxpayers’ ability to transfer wealth without being taxed” by ensuring that assets “transferred through a loan to a trust would be included in the estate of the founder at death” and by categorising interest-free loans to trusts as donations.
However, after that speech, the Davis Tax Commisson, chaired by Judge Dennis Davis, made the following recommendations in its Second Interim Report on Estate Duty and Trusts: “National Treasury should consider the possibility of extending the provisions of section 3(3)(d) of the Estate Duty Act to include deeming provisions that identify ‘deemed control’ of a trust through a loan account between a trust and a ‘connected person(s)’, where the loan is not subject to interest, or is subject to interest at below the official rate. In these circumstances, the loan provides the lender with de facto control over the trust.”
After much debate, the final legislative outcome was the introduction of the new section 7C of the Income Tax Act. The salient features of the section are as follows.
1. Section 7C applies to any loan, advance or credit made by a natural person (or by any company to which that person is connected) to a trust to which that person or company is connected, IF no interest, or low interest, is incurred by the trust.
2. In such a case, an amount equal to the difference between the interest incurred by the trust and the official rate of interest (currently eight percent) will, at the end of the year of assessment, be deemed to be a donation to the trust made by the natural person.
3. The annual donations tax exemption (currently R100 000) may be used to offset the deemed donation to the trust.
4. The section 7 deeming provisions and paragraphs 70 and 72 of the attribution rules of the Eighth Schedule still apply:
• No deduction, loss or allowance will be claimable by the natural person or company upon the disposal of the loan;
• Loans by companies made by more than one person will be deemed to have been donated pro rata to their shareholding; and
• The effective date was March 1, 2017 and applies to amounts provided to a trust before, on or after that date.
What about exemptions?
Section 7C will not apply to the following:
• PBO trusts.
• Section 30C trusts. These trusts are created to assist with the funding of small businesses, also known as small business funding entities.
• Vesting trusts. With this kind of trust, the loan, advance or credit is provided to the trust by a person with a vested interest in the receipts, accruals and assets of that trust.
• Special trusts.These are solely for the benefit of one or more persons who, for reasons of disability, are unable to earn enough to support themselves and/or are unable to manage their own financial affairs.
• Primary resident trusts. Here, a loan to a trust is wholly or partly used to fund the acquisition of an asset – a property – which is used, throughout the year of assessment, by the person who granted the loan, or the spouse of that person, as a primary residence.
• Transfer pricing, section 31. If transfer pricing is applicable, no deeming of donation will apply – in other words, there is no “double taxation” on the same event.
• Financing structures that are shariah-compliant.
• Deemed dividend, section 64E(4). The loan was made to the trust by a company and is deemed to be a dividend by the company to the trust.
What did section 7C achieve?
Although Gordhan proposed in his budget speech “to ensure that the assets transferred through a loan to a trust are included in the estate of the founder at death”, no such proposals were tabled. Rather, section 7C seeks to categorise interest-free loans to trusts as donations. In this regard, it should be borne in mind that estate duty and donations tax are complementary. The intention is to subject the transfer of assets to either donations tax (transfers made during the donor’s lifetime) or estate duty (transfers on death), not both. Section 7C, therefore, addresses this and ensures that the benefit of an interest-free or low-interest loan to a trust is subjected to donations tax.
Referring back to the example, assuming the same facts and all things being equal, does the fiscus gain when you compare the position before section 7C with the new position on estate duty? The growth within the trust remains exempt from estate duty and the estate planner still achieves a saving of R5.8 million.
However, from a donations tax point of view, the fiscus gains about R2.8 million over the 20-year period, calculated as follows: R10 million x 8 percent – R100 000 x 20 percent x 20 years.
This demonstrates that implementation of section 7C will have negative consequences for interest-free loans to trusts. We strongly advise individuals who find themselves within the ambit of section 7C to seek professional advice before making any hasty decisions.
Each case must be judged on its own merits and facts to establish an appropriate plan of action. Any aggressive estate structuring in an attempt to minimise the negative consequences of section 7C must be weighed against the General Anti-avoidance Rule.
Trusts are still valuable estate planning vehicles, but now it is important to consider how trusts can be “funded” going forward.
Finally, tax should not be the primary driver of estate planning strategy. If a trust is appropriate, the founder needs to consider the fiscal consequences of the chosen structure and take appropriate measures to
address any liquidity constraints.
Jan Coetsee is the head of PwC’s estates and trust division. This article has been adapted from the January/February 2017 edition of TaxTalk, published by the South African Institute of Tax Professionals, which can be accessed via www.taxtalk.co.za