Over the years, a number of estate planning mechanisms have been employed by South African taxpayers for purposes of mitigating their liability to pay estate duty. These strategies fall into three broad categories, being spouse transfer, investment and estate freezing.
- Under the first strategy of transfers to spouses, taxpayers simply bequeath their entire estate to their spouses. Thus, in the calculation of the dutiable amount, the entire value of the bequeathed property would be deductible from the estate (in terms of section 4(q) of the Estate Duty Act, 1955), resulting in no estate duty liability arising.
- Under the investment strategy, taxpayers invest in products that provide growth and may be transferred to their heirs following their death with no/minimal estate duty implications. One such manner of executing this strategy is the conversion of dutiable property to non-dutiable property, for example, by making excessive contributions to retirement funds.
- In terms of the estate freezing strategy, taxpayers ensure that the growth of the value of their assets takes place in the hands of another person, thereby "freezing" the value of their estates. Trusts, in particular, are frequently utilised by taxpayers for this purpose, and have received attention from the South African Revenue Service ("SARS") as they have been used by taxpayers to escape or reduce the liability for estate duty.
Trusts may essentially be transparent for tax purposes. Where
the beneficiaries of the trust have a vested interest in the trust
(ie the trust is a vested trust), or where the trustees distribute
the capital of the trust or the income generated by the trust
assets to the beneficiaries (ie a discretionary trust), the
provisions of section 25B of the Income Tax Act and paragraph 80 of
the Eighth Schedule to the Income Tax Act would be
Section 25B(1) of the Income Tax Act provides that any amount received by or accrued to or in favour of any person during any year of assessment in his/her capacity as a trustee of a trust, to the extent to which such amount has been received for the immediate or future benefit any ascertained beneficiary who has a vested interest to that amount during that year, this shall be deemed to be an amount that has accrued to the beneficiary of the trust. Section 25B(2) of the Income Tax Act provides that where a beneficiary has acquired a vested right to any amount in consequence of the exercise by the trustee of a discretion vested in him/her in terms of the trust deed of the trust, agreement or will of a deceased person, that amount would be deemed to have been derived for the benefit of that beneficiary.
Therefore, in terms of section 25B of the Income Tax Act, the trust would be transparent for tax purposes, with any amounts to which the beneficiary has a vested interest, or amounts to which the beneficiary acquires a vested interest as a result of the exercise by the trustee of the discretion to vest the amount in the beneficiary, deemed to be amounts that accrue directly to the beneficiaries. The application of section 25B would result in the income being taxed in the hands of the beneficiaries at their respective tax rates, and not in the trust which is taxed at the rate of 41%. Where the beneficiary is not in the top tax bracket (ie is not subject to income tax at the maximum rate of 41%), this would result in a tax saving. The provisions of section 25B of the Income Tax Act are, however, subject to the anti-avoidance provisions of section 7 of the Income Tax Act.
Similarly, paragraph 80 of the Eighth Schedule to the Income Tax Act provides that where a capital gain is determined in respect of the vesting by a trust of an asset in a beneficiary who is a resident (other than persons contemplated in paragraph 62(a) to (e) of the Eighth Schedule, or a person who acquires the asset as an equity instrument as contemplated in section 8C(1) of the Income Tax Act), the gain must be disregarded for purposes of calculating the aggregate capital gain or loss of the trust, and must be taken into account for the purposes of calculating the aggregate capital gain or loss of the beneficiary to whom that asset was so disposed. Paragraph 80 of the Eighth Schedule to the Income Tax Act therefore has the effect of making the trust tax transparent and attributing capital gains and losses directly in the beneficiaries. The beneficiaries (assuming they are natural persons) would be subject to capital gains tax ("CGT") at a rate of 16.4%, as opposed to the trust being subject to CGT on the capital gain at an effective rate of 32.8%. This would also result in a tax saving.
Taxpayers often take advantage of the benefits provided by section 25B and paragraph 80 of the Eighth Schedule to the Income Tax Act. A mechanism often employed by taxpayers is to dispose of an asset to the trust for a consideration equal to market value left outstanding on loan account. No interest is charged on the loan. Following the sale of the asset, the purchase consideration owing by the trust is reduced every year by the taxpayer waiving ZAR100 000 of the loan. This waiver would be exempt from donations tax in terms of section 56(2)(b) of the Income Tax Act. In addition, no CGT implications would arise for the trust in terms of paragraph 12A of the Eighth Schedule to the Income Tax Act, as the debt would be reduced by way of a donation as defined in section 55(1) of the Income Tax Act, and thus, paragraph 12A would not be applicable in terms of paragraph 12A(6)(b) of the Eighth Schedule to the Income Tax Act.
In an effort to curb the avoidance of tax by utilising trusts, section 7 of the Income Tax Act provides several anti-avoidance measures, which deem someone other than the person who receives income or to whom income accrues, to be entitled to the income.
While the provisions of section 7 of the Income Tax Act nullify any income tax savings that could have been obtained by the taxpayer and the beneficiaries of the trust, this is, in practice, of little consequence to taxpayers, as the primary purpose of this arrangement is to freeze the growth of the assets in the taxpayer's estate for estate duty purposes. The income tax benefits would accrue to the beneficiaries of the trust after the death of the taxpayer, as the income received by the trust and distributed to them would be taxed in their own hands at their respective tax rates. Also, where there is more than one beneficiary, the arrangement has the effect of splitting the income received by the trust among the beneficiaries.
The estate planning mechanism utilising a trust is arguably a method of avoiding estate duty and donations tax, and the general anti-avoidance rules and the substance over form doctrine could arguably be invoked by the SARS to challenge these transactions (as could, potentially, the argument that the advance of an interest-free loan amounts to a continuing donation). However, these anti-avoidance tools have not been invoked by SARS to challenge these decisions to date. Instead, section 7C was introduced to the Income Tax Act by the Taxation Laws Amendment Act No. 15, 2017 (promulgated on 19 January 2017) for purposes of addressing situations where assets are disposed of to a trust on interest-free loan account.
Section 7C applies where a loan is made available to a trust, no interest is payable on the loan, or interest is payable at a rate lower than the official rate of interest contemplated in the Seventh Schedule to the Income Tax Act (currently 8%), and the loan is made available (whether directly or indirectly) to the trust by a natural person or a company that is a connected person in relation to that natural person, and the natural person or any person that is a connected person in relation to that natural person, is a connected person in relation to the trust. Section 7C comes into operation on 1 March 2017 and applies in respect of years of assessment commencing on or after that date.
The effects of the application of section 7C would be as follows:
- any interest forgone by the taxpayer in respect of the interest free or low interest loan would be treated as an ongoing and annual donation to the trust; and
- no deduction, loss, allowance or capital loss may be claimed by the taxpayer in respect of the interest free or low interest loan made to the trust.
The provisions of section 7C would therefore have a devastating effect on the use of trusts as an estate planning tool.
While the issues of taxpayers mitigating their liability to pay estate duty that section 7C seeks to address is clear and the intention of National Treasury is legitimate, the effects of section 7C may be draconian in several respects. Trusts are utilised by many taxpayers to protect assets from creditors on behalf of their family and facilitate the ease of estate planning, and not necessarily for the sole purposes of avoiding estate duty. The amendment is retrospective in that it would affect loans made by taxpayers to trusts preceding the legislation, resulting in the effective expropriation of the taxpayer's property.
The use of trusts for estate planning purposes may, therefore, have become less effective following the introduction of section 7C into the Income Tax Act and taxpayers should consider any estate planning structures currently in place in light of these amendments.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.