South African residents can now invest up to R2 million abroad, and a question that is often asked is: What are the tax and exchange control consequences where the foreign investment allowance is placed in an offshore trust? Furthermore, the 2003 exchange control and tax amnesty attracted some 43 000 applications. The window period for applying for amnesty has long passed, but the tax consequences arising out of the applications submitted to the authorities are complex and are often misunderstood. This article attempts to identify some of the issues that need to be considered when reviewing the tax consequences arising out of funds owned by an offshore trust, for which the donor applied for and received amnesty as well as the consequences facing an investor in South Africa investing their foreign investment allowance in an offshore trust.
The exchange control and tax related amnesty allowed donors in South Africa to obtain amnesty in respect of tax and exchange control violations in moving funds from South Africa to a trust located in a foreign jurisdiction. The applicant was required to apply for amnesty and declare the assets owned by the trust as at 28 February 2003. Where the assets were retained abroad, an exchange control levy of 10% of the value of the assets located abroad was payable to the authorities. In addition, a domestic tax levy of 2% was payable on those amounts on which income tax or donations tax should have been paid, but was not paid over to the authorities. The amnesty thus allowed for the legitimisation of funds held abroad by offshore trusts created at the instance of South African donors.
A major concern facing amnesty applicants was whether the assets owned by the offshore trust for which they were seeking amnesty would fall into their estate for estate duty purposes on their death. The amnesty provided that the assets were deemed to belong to the donor applying for amnesty for income tax purposes only, and did not result in those assets becoming legally owned by the donor personally. To secure the amnesty, the applicant was required to pay the 2% domestic tax levy, which expunged the liability for donations tax that would have otherwise been payable on the moneys remitted from South Africa to the offshore trust. The fiscal authorities confirmed during the amnesty process, that the assets held by the offshore trust would not fall into the estate of the amnesty applicant on their death. Thus, the offshore trust remains an attractive vehicle for owning the offshore assets where the donor applied for amnesty.
It is important though that the offshore trust is properly constituted with independent trustees and that the donor in South Africa does not, in reality, control the assets owned by the offshore trust. Under section 3(3)(d) of the Estate Duty Act, the assets owned by a trust may in certain cases be regarded as being owned by the deceased, where the deceased was competent to dispose of the assets owned by another entity for their own benefit. Thus, if the offshore trust does not constitute a separate entity that acts independently of the donor in South Africa, and the donor retains the right to direct to the trustees, how the assets of the trust are to be dealt with, and whether they should be made over to the donor, the estate duty advantage sought will not be available. It is important therefore, that the offshore trust is properly and independently managed such that the donor in South Africa has no control over the assets such that they can direct how the assets are to be dealt with and particularly cannot direct that those assets be made over to the donor or for their benefit in South Africa or elsewhere.
Income Tax and Capital Gains Tax ("CGT")
By applying for amnesty, the applicant accepted that the assets owned by the trust located offshore are deemed to belong to the donor with effect from 1 March 2002. Thus, any income derived from the assets owned by the offshore trust in the form of interest, rentals and dividends therefore constitute income in the hands of the donor which is liable to tax in South Africa as normal income. This deeming rule, contained in the amnesty legislation, applies until the amnesty applicant passes away or until the offshore trust disposes of the assets subject to amnesty relief.
If the offshore trust disposes of any assets, it is necessary to ascertain the capital gains arising therefrom to determine the CGT payable in South Africa. A point that is often overlooked is the fact that the assets owned by the foreign trust are deemed to belong to the donor for income tax purposes with effect from 1 March 2002. Thus, it was important to establish the market value of the assets owned by the offshore trust at 1 March 2002, and not the date on which CGT introduced on 1 October 2001, which would be the date on which market value would ordinarily be important.
Any income derived by the offshore trust directly or by a company wholly owned by the offshore trust, will fall to be taxed in the hands of the donor applicant and must be reflected in their tax return submitted to the Commissioner: South African Revenue Service. Once the donor passes away, the income will not fall to be taxed in South Africa unless the income derived by the foreign trust is awarded to a beneficiary that is resident in South Africa. On the donor's death, the donor is deemed to have sold the assets owned by the trust at the current market value thereof. The donor will thus be liable to CGT on the assets owned by the trust on the difference between the market value at date of death and the base cost, being the actual cost of assets acquired after 1 March 2002 or alternatively market value of the assets at 1 March 2002, where a valuation was undertaken in the prescribed manner. It must be remembered that to rely on the market value method of determining base cost for CGT purposes, it was required to undertake a valuation of assets owned by the offshore trust before 30 September 2004 and to retain proof of that valuation. If the valuation of the assets exceeded R10 million, it was necessary to submit the valuation to the Commissioner: SARS in the first tax return submitted after 30 September 2004. Where a taxpayer has failed to submit a valuation timeously to the Commissioner: SARS, it is now possible to seek condonation of the late submission of the valuation in accordance with the recent amendments introduced to the legislation.
Investment Of The Foreign Investment Allowance
Where a South African resident utilises the foreign investment allowance of R2 million and places the funds in an offshore trust on an interest-free loan account, income tax problems arise. This is by virtue the thin capitalisation and transfer pricing rules contained in section 31 of the Income Tax Act, no. 58 of 1962, as amended (the "Act"). The effect of section 31 is that the investor in South Africa will be deemed to have received interest on the funds placed in the offshore trust equal to a market related rate of interest that could be derived from those funds. In deciding to place funds offshore, it is important that careful consideration is given as to exactly how the investment is to be made. Where an investor in South Africa chooses to acquire listed shares or immovable property directly abroad, no problems arise because if there is any income derived from those assets, it will fall to be taxed in South Africa in the normal course. The complication arises where the South African investor wishes to place foreign investment loans in a trust with a view to the offshore trust making investments in various assets, thereby shielding the growth in the assets from the South African resident's estate for estate duty purposes.
If the investor donates the foreign investment allowance to a foreign trust, donations tax of 20% is payable on the donation made to the trust.
The offshore investment must be structured carefully to manage the income tax consequences that may arise from the transaction. It may be possible for the South African investor to acquire preference shares in a foreign company, where the ordinary shares are wholly owned by an offshore trust. This may alleviate the problems that would otherwise arise if the South African investor advanced funds, free of interest, directly to an offshore trust.
Awards Made By The Offshore Trust To South African Resident Beneficiaries
If the offshore trust makes awards to South African residents on which income tax was previously paid in South Africa under the deeming rules applicable to amnestied trusts, no further tax will be payable in this country. The trustees should award trust capital to beneficiaries in South Africa where that capital arose prior to 1 March 2002, on the basis that such amounts will not on any basis be liable to tax in South Africa. The amnesty, against payment of the domestic tax levy sought to exclude such amounts from income tax in future years of assessment.
It is important that the trustees of the offshore trust identify the nature of the award made to the beneficiaries resident in South Africa, so that they can properly account for the award in their tax return in South Africa. Where the award comprises of amounts of income derived by the offshore trust, after the death of the donor, such amounts will fall to be taxed in South Africa's normal income, unless they constitute capital gains, in which case those gains will be taxed as capital gains, subject to a maximum tax rate of 10% in South Africa.
Sale Of Assets By The Trust
Where the offshore trust disposes of assets, the donor in South Africa will be liable to CGT on the difference between the proceeds received on the sale of the assets and the base cost thereof. Where the assets were held by the trust at 1 March 2002, and the assets owned by the trust were valued in the prescribed manner, the market value will constitute the base cost. If the assets were acquired by the offshore trust after 1 March 2002, the donor will have to take account of the actual cost incurred in acquiring the asset and deduct that amount from the proceeds received on the sale of the assets and by the trust.
Should the offshore trust transfer its assets into an insurance policy that will constitute a disposal of a foreign company asset for CGT purposes. CGT will become payable even though the trust may not receive any cash on the transfer of trust assets into an insurance policy. As and when the trust receives any payments from the insurance policy, those payments or part surrenders of the policy, will constitute proceeds for CGT purposes on which CGT will become payable. It must be noted that the deeming rules contained in the amnesty legislation will apply until the donor dies or the assets are disposed of by the trust.
Once the deeming rules contained in the amnesty legislation cease to operate, the deeming provisions contained in section 7 of the Act are resuscitated and causes the income derived by the trust to be taxed in the hands of the donor.
The foreign trustees may recommend that the offshore trust transfers all of the assets owned by it to a new trust in accordance with the pour over provisions, often contained in foreign trust deeds. Such event would cause CGT to become payable in the hands of the donor as a result of the deemed disposal of assets previously owned by the first trust. The question that arises is whether the deeming rules contained in the amnesty legislation continue to apply to the assets, now owned by a new trust. Furthermore, will the income derived by the new trust will fall to be taxed in the hands of the donor in South Africa on the basis that section 7 of the Act deems that income to belong to the donor? The disposal of assets owned by the amnestied trust must therefore be considered carefully as the tax consequences are complex.
It must be noted that under the existing exchange control regulations, an offshore trust cannot invest in South African assets. This is on the basis that the Exchange Control Department of the South African Reserve Bank will treat such investment as a contravening Regulation 10(1)(c) of the Exchange Control Regulations. During the amnesty process, a number of applicant were able to regularise prior breaches of exchange control, including the unwinding of so-called loop structures. Those structures comprised an offshore entity owning South African assets for the benefit of a South African resident. It is therefore, not lawful for an offshore trust to acquire South African shares, fixed property or other assets where that trust has South African resident beneficiaries.
The income derived by the amnestied trust can be retained abroad under current Exchange Control Regulations. Likewise, a South African resident utilising the foreign investment allowance is free to invest in whatever asset they choose, so long as it is not an investment, directly or indirectly, acquiring South African assets, and can retain the income derived from the offshore assets abroad.
From an estate duty point of view, it makes sense for the South African resident to settle the income tax liabilities on the foreign income derived by the foreign trust out of South African assets, thereby reducing the estate in South Africa for estate duty purposes, as opposed to remitting funds from the offshore trust to South Africa to settle those liabilities.
Disclosure And Income Tax Returns
The donor of the assets to the amnestied trust must disclose the income derived by the offshore trust in their personal tax return. It must be remembered that the assets owned by the offshore trust do not belong to the donor personally, and should therefore not be included in the donor's statement of assets and liabilities submitted to the Commissioner: SARS. Previously, beneficiaries of a trust were required to disclose the fact that they were beneficiaries of the offshore trust and had to disclose the name of the trust, the place where it was located and also to state whether they had received any awards therefrom. The 2007 income return only requires the donor and beneficiaries of an offshore trust to indicate the income derived by them from the offshore trust. It would appear that it is no longer necessary to state that a taxpayer is a beneficiary of a trust located abroad.
Amnestied foreign trusts therefore remain effective for estate planning in South Africa because the assets owned by such trust do not belong to the donor on death for estate duty purposes. It is important though, that it can be shown, if required to do so, that the offshore trust is a genuine one and that it cannot in any way be said to be the alter ego of the deceased. Failure to ensure that the trust is genuine may result in the donor forfeiting the estate duty advantages sought.
The income tax and CGT rules relating to the income derived by the foreign trust subject to the amnesty provisions are complex, and those rules are often overlooked in completing the donor's tax return in South Africa. A resident wishing to utilise the foreign investment allowance of R2 million, must structure the investment made abroad carefully and should avoid advancing the funds to a foreign trust on an interest-free basis, failing which, the thin capitalisation and transfer pricing rules contained in section 31 of the Act will apply.
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.