This may involve distributing the income of the trust among family members in a tax-effective way over many years, or providing capital from the trust when it will most benefit the beneficiaries in the future - for example, when purchasing a home.
Distributions can only be made by the trustees to beneficiaries who are identified (by name) or identifiable (a class of beneficiaries) in the trust deed, otherwise a distribution will be regarded as a donation, which will trigger donations tax.
The trust deed will stipulate who the income beneficiaries and capital beneficiaries are.
The type of trust determines how trust assets and income are treated.
In a vested trust, income beneficiaries have a vested right to the income of the trust, and capital beneficiaries have a vested right to the assets and capital gains in the trust. The trustees have no discretion in terms of which beneficiaries receive distributions.
Generally, in a discretionary trust, the trust deed stipulates that trustees have full discretion to whom they make distributions, and that beneficiaries do not have to be treated equally when distributions are made. This enables the trustees to be objective in terms of whom the distributions are made to.
By distinguishing between income beneficiaries (those who only receive income generated by the trust) and capital beneficiaries (those who only receive capital or capital gains from the trust), the founder is able to distinguish between how the trust income versus the trust capital should be handled. The founder may, for example, want his or her spouse from a second marriage only to benefit from the fruits of the trust assets (the income), while keeping the trust assets in the existing family for generations to come.
Provisions pertaining to the distribution of income are usually broadly defined so that the trustees can award income benefits to the income beneficiaries as widely as possible. Provisions pertaining to the awarding of capital or capital gains among capital beneficiaries are also provided for in the trust deed.
Trustees have the ability to push the tax burden on trust income and capital gains to beneficiaries (rather than taxing it in the trust at higher tax rates) while making distributions to such beneficiaries through a principle called the conduit principle. The conduit principle can be used for taxing capital gains in the hands of the beneficiary only if the trust deed specifically gives the trustees the power to distribute a capital gain. Very specific wording is required to satisfy this requirement.
It is important trustees are aware of the various tax consequences resulting from distributions.
The Income Tax Act contains certain anti-avoidance provisions applicable to trusts which aim at taxing any income or capital gain as a result of a donation or a soft loan in the hands of such donor or lender, rather than in the hands of the trust or any beneficiaries.
These provisions were introduced after people abused trusts to push income or capital gains away from themselves, typically onto a child or spouse.
They are not concerned with who formed or created the trust (the founder), but rather with the person who transferred the assets into the trust: the donor or funder.
The provisions effectively seek to tax the donor/funder on the income and/or capital gains generated by those assets. Transactions that are specifically targeted through the anti-avoidance measures in the Income Tax Act are those “in consequence of” a donation, settlement or other disposition, resulting in:
- Distributions to spouses to save tax;
- Distributions to minor children (under 18);
- Income and capital gains retained in the trust;
- * Distributions to beneficiaries, where the trust deed gives the person who made the donation, settlement or other disposition certain powers for approval of distributions, for example a veto right; and
- Distributions to non-residents.
Be careful of selling assets to a trust at below market value. Should assets be sold to the trust at less than market value, the above provisions will apply to the difference between the market value and the sales price. The donor/funder - instead of the beneficiary - will be taxed on this income or capital gain.
When considering distributions, it is important to realise that a trust is a taxpayer of last resort. The following order should be followed in determining who will be liable for the payment of tax on trust assets:
- The trustees should apply the anti-avoidance provisions in the instance of a donor or funder of a soft loan and tax such donor or funder, instead of the trust, on any resulting income and/or capital gains.
- If the provisions do not apply, the trustees can decide whether they want to make use of the conduit principle to push the tax liability to the beneficiaries, along with a distribution, which decision has to be made before the tax year-end - the end of February each year.
- If the provisions do not apply and the trustees decide to retain the income and/or capital gains in the trust, rather than distributing it to the beneficiaries, only then will such income or capital gains be taxed in the trust.
Phia van der Spuy is a registered fiduciary practitioner of South Africa, a master tax practitioner (SA), a trust and estate practitioner and founder of Trusteeze, a professional trust practitioner.