South Africa: Far-Reaching Proposed Changes To The Taxation Of Foreign Trusts

Last Updated: 23 August 2018
Article by Jenny Klein and Sheryl Kunaka

Most Read Contributor in South Africa, September 2018

The South African Draft Taxation Laws Amendment Bill, 2018 (the "Draft Bill"), which was published by the Minister of Finance on 16 July 2018, introduces many of the tax proposals announced in the 2018 Budget Review earlier this year.

Consistent with the general trend of combatting perceived areas of tax avoidance, among the tax changes contained in the Draft Bill are proposed amendments to the provisions in the Income Tax Act, 1962 (the "Act") dealing with foreign trusts that hold the majority of the shares in an underlying foreign company. The Explanatory Memorandum on the Draft Bill states that the proposed amendments are intended to close the loophole in the current tax legislation regarding the use of trusts to defer tax or recharacterise the nature of income.

The current position is that the controlled foreign company ("CFC") rules in the Act do not apply to foreign companies that are held by interposed foreign trusts or other foreign foundations that have South African resident beneficiaries.

In 2017, the CFC rules were extended to South African resident companies having an indirect interest in a foreign company through a foreign trust or foreign foundation whose financial results form part of the consolidated financial statements of a group of which the parent company is a South African resident.

The proposed amendments in the Draft Bill will expand the ambit of the donor attribution rules for South African resident donors of a foreign trust and the taxation of capital distributions from a foreign trust in the hand of the South African resident beneficiaries.

Donor attribution rules

The proposed amendments apply to section 7(8) of the Act and paragraph 72 of the Eighth Schedule to the Act and are summarised below.

Section 7(8) of the Act may attribute the income of a foreign trust to a South African resident who has made a donation, settlement or other disposition (including a loan that incurs interest at less than a market-related rate) to a foreign trust. The resident donor is currently subject to tax on the accruals of the trust which would have constituted income (as defined) had the trust been a resident and which are attributable to that donation/disposition. However, where the income of the foreign trust comprises foreign dividends from a foreign company, all the shares that are held by that trust, such foreign dividends may not have constituted income (as defined) had the trust been a resident because of the participation exemption in section 10B(2)(a) of the Act.

Section 10B(2)(a) exempts foreign dividends received by or accrued to a person that holds at least 10% of the total equity shares and voting rights in the foreign company declaring the foreign dividend. As a result, such foreign dividends accruing to the foreign trust would not be attributed to the resident donor in terms of section 7(8).

The amendment to section 7(8) proposes that the participation exemption must be disregarded in determining the amount that would have constituted income had the trust been a resident, where the foreign trust, or any one or more connected persons in relation to the trust, holds more than 50% of the total participation rights or voting rights in the foreign company, and the South African resident donor (or any relative of the donor or any trust of which the donor or relative is a beneficiary) is a connected person in relation to the foreign trust (eg, a beneficiary or a relative of a beneficiary). It is proposed that this amendment will come into operation on 1 March 2019 and will apply to amounts received or accrued on or after that date.

However, it is not clear from the wording of the proposed amendment whether the South African resident donor would still benefit from the partial tax exemption that applies to all foreign dividends in terms of section 10B(3) of the Act or whether the full amount of the foreign dividend would be included in the income of the resident donor in these circumstances. It seems that the partial exemption should apply in these circumstances.

Paragraph 72 of the Eighth Schedule to the Act is similar to section 7(8) and provides for the attribution of a capital gain arising in a foreign trust (including an amount which would have constituted a capital gain had the trust been a resident) to a South African resident who has made a donation, settlement or other disposition to that foreign trust. However, where a gain arises from the disposal by a foreign trust to a third party of shares held in a foreign company and the requirements of the participation exemption in paragraph 64B of the Eighth Schedule are met, the gain would not have constituted a capital gain had the trust been a resident.

Paragraph 64B of the Eighth Schedule provides a capital gains tax exemption for any capital gains or losses that arise from the disposal of equity shares in foreign companies subject to certain requirements being met, including that the person held an interest of at least 10% of the equity shares and voting rights in that foreign company and that the interest in the foreign company was disposed of to a non-resident (other than a connected person). If the paragraph 64B exemption applied to the trust had it been a resident, such gain would not be attributed to the resident donor in terms of paragraph 72.

The proposed amendment to paragraph 72 is that the participation exemption in paragraph 64B must be disregarded in determining the amount which would have constituted a capital gain had the trust been a resident. Disregarding the participation exemption would mean that, even if a gain from the disposal of equity shares in a foreign company would have been exempt in terms of the participation exemption if the trust had been a resident, that gain would still be attributed to and taxed in the hands of the resident donor. It is proposed that this amendment will come into operation on 1 March 2019 and will apply to amounts vesting on or after that date.

Capital distributions to South African resident beneficiaries

In terms of section 25B(2A), capital distributions to a South African resident beneficiary of a foreign trust, which arose from prior year's receipts and accruals of the trust which would have constituted income (as defined) if the trust had been a resident, may be taxable in the hands of the resident beneficiary.

The current position is that capital of a foreign trust arising from a prior year's foreign dividends derived from the foreign company, the shares in which are held by that trust, would have been exempt from tax if the trust had been a resident in terms of the participation exemption in section 10B(2)(a) of the Act. Therefore, a capital distribution to a South African resident beneficiary of capital arising from such foreign dividends would not be taxable in South Africa in the hands of the beneficiary on the basis that no amount of income (as defined) would have arisen for the trust had it been a resident.

The proposed amendment to section 25B(2A) is that the participation exemption in section 10B(2)(a) must be disregarded in determining the amount received or accrued to the foreign trust consisting of a foreign dividend if more than 50% of the total participation rights or voting rights in the foreign company are held/exercisable by the trust or by any one or more connected persons in relation to the trust. Accordingly, capital distributions by a trust which are derived from such foreign dividends would be taxable in the hands of the South African resident beneficiary. It is proposed that this amendment to section 25B(2A) will come into operation on 1 March 2019 and will apply in respect of any year of assessment commencing on or after that date.

However, as is the case with the proposed amendment to section 7(8), it is not clear whether the South African resident beneficiary would still benefit from the partial tax exemption which applies to all foreign dividends in terms of section 10B(3) of the Act or whether the capital distribution would be taxed in full in these circumstances. It seems that the partial exemption should apply in these circumstances.

Capital gains are dealt with in paragraph 80 of the Eighth Schedule to the Act and the proposed amendments to paragraph 80 will significantly expand its scope to include foreign trusts.

Paragraph 80(1) provides that if a trust vests an asset in a resident beneficiary, the beneficiary would be subject to capital gains tax in respect of this capital gain. Paragraph 80(2) provides that if a trust disposes of an asset and vests the resultant capital gain in a resident beneficiary in the same tax year, the beneficiary would be subject to capital gains tax in respect of the capital gain. It seems that these provisions do not currently apply to foreign trusts unless they hold assets that are subject to South African capital gains tax (eg, South African immovable property). However, the proposed amendments will extend the ambit of these provisions to include gains made by foreign trusts that would have constituted capital gains if the foreign trust had been a resident.

Paragraph 80(3) provides that if a foreign trust vests an amount of capital arising from a prior year's capital gain (or what would have been a capital gain if the foreign trust had been a resident) in a South African resident beneficiary, the beneficiary would be subject to capital gains tax on this capital distribution. Similar to the amendment proposed to paragraph 72, it is proposed that the participation exemption in paragraph 64B of the Eighth Schedule must be disregarded in determining the amount which would have constituted a capital gain had the trust been a resident.

It is proposed that these changes to paragraph 80 will come into effect on 1 March 2019 and will apply in respect of disposals on or after that date.

Conclusion

The proposed amendments are in draft and are subject to change. The due date for comments from the public is 16 August 2018. However, given the potentially adverse tax effects for South African resident individuals with interests in foreign trusts, the impact of the proposed changes should be carefully considered before the expected effective date of 1 March 2019.

Sheryl Kunaka is a candidate attorney in ENSafrica's tax department.

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.

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