CC clarifies the tax treatment of multi-tiered trust structures
A recent (2 October 2024) Constitutional Court (CC) judgment, Thistle Trust v Commissioner for the South African Revenue Service (Thistle Trust and the SARS), clarified the application of the conduit principle to capital gains distributed through a multi-tiered trust structure. The Court also remarked on the meaning of 'no reasonable grounds for tax position taken' and 'reasonable care not taken in completing return'. These terms are used for the purposes of levying understatement penalties.
Capital gains tax
The Thistle Trust was a beneficiary of ten vesting trusts (the Zenprop Trust Group). The Zenprop Trust Group disposed of assets and distributed the proceeds to the Thistle Trust. The Thistle Trust then distributed these proceeds to its beneficiaries.
Based on advice given to them, the Thistle Trust interpreted section 25B of the Income Tax Act 58 of 1962 (ITA) as read with paragraph 80(2) of the Eighth Schedule and the common law conduit principle, to mean that only the ultimate beneficiary in a multi-tiered trust structure is liable for capital gains tax on capital gains distributed through its structure. The conduit principle provides that the trust itself is not taxed on the income that vests in the hands of its beneficiaries. Instead, the income merely flows through the trust and retains its nature.
Based on the wording of section 25B of the ITA read with paragraph 80 of the Eighth Schedule, the CC had to determine if it is the Thistle Trust or its beneficiaries which are subject to capital gains tax on the gain derived by Zenprop Trust Group. Section 25B of the ITA, as it read at the time (the section has been amended with effect from 1 January 2021 to apply to all tax years from 2021 onwards), provided that any amount received by or accruing to a trust for the benefit of a beneficiary with a vested right will be deemed to be an amount accruing to the beneficiary. At the same time paragraph 80(2) provided that 'where a capital gain is determined in respect of the disposal of an asset by a trust in a year of assessment during which a trust beneficiary . . . has a vested interest or acquires a vested interest ... in that capital gain but not in the asset' it is the beneficiary which is taxed on that gain and not the trust.
The Tax Court held in favour of the Thistle Trust on the basis that section 25B applied to capital gains, and as a result the beneficiaries of the Thistle Trust, and not the Thistle Trust itself were liable for capital gains tax. The SCA however agreed with SARS and held that paragraph 80(2) regulated the capital gains tax liability of trusts to the effect that the Thistle Trust, and not the beneficiaries of the Thistle Trust, were liable for the capital gains tax.
In agreement with the SCA the majority judgment in the CC, held that section 25B does not apply to capital gains distributed by a trust, and that the conduit principle as codified in paragraph 80(2) of the Eighth Schedule only applies to the first beneficiary trust in a multi-tiered trust structure. Therefore, the first beneficiary, even if that beneficiary is a trust, will be liable for capital gains tax in respect of the disposal of an asset if the proceeds of the disposal are vested in such trust as a beneficiary.
In rejecting the Thistle Trust's argument that the phrase 'in respect of the disposal of an asset' in paragraph 80(2) should be read as being parenthetical, and that paragraph 80(2) therefore did not apply solely to the first beneficiary in a multi-tier trust structure (where such beneficiary is a trust), the majority stated 'If a statute is not framed in a form that lends itself to the interpretation desired by a litigant, they cannot ask the Court notionally to perform linguistic surgery on the statute by adding or removing commas until the desired interpretation is achieved'.
The majority confirmed that limited weight and reliance can be placed on explanatory memorandums to interpret legislation. They took into account the relevant explanatory memoranda when interpreting paragraph 80(2) as both the Thistle Trust and SARS relied thereon, and it accepted that it is a well-established practice to use explanatory memorandums to determine the purpose of revenue statues. The minority judgment agreed with the Thistle Trust and highlighted that the text, purpose and contextual factors of a provision must be considered in determining its meaning. Even though minority judgments have little persuasive value, the approach adopted in determining the meaning of a provision is valuable.
Understatement penalties
The Tax Court did not consider the issue of understatement penalties as it upheld the Thistle Trusts' position on the capital gains tax. In the SCA, SARS conceded that the understatement was a bona fide and inadvertent error, and that SARS was therefore not entitled to levy an understatement penalty. As such, the SCA did not reach the issue of understatement penalties.
The CC did not grant leave to the cross-appeal regarding the understatement penalties, as it would have to do so without a preceding judgment on the issue. The CC however considered whether it was in the interests of justice to consider the cross-appeal by evaluating if SARS had a strong case for penalties. If so, the CC would have granted leave to appeal. SARS argued for levying understatement penalties based on the grounds that of 'no reasonable grounds for tax position taken' and 'reasonable care not taken in completing return' as contemplated in section 223 of the Tax Administration Act 28 of 2011. The CC clarified that 'no reasonable grounds for tax position taken' could not apply, even though the CC found the tax position to be incorrect because Thistle relied on legal advice when adopting its tax position.
The SARS further argued that reasonable care was not taken in completing a return, as Thistle was aware that SARS held a contrary view to the view of the legal advisors. The CC made it clear that SARS is not an elevated authority who can demand the only reasonable interpretations of tax legislation and SARS' argument was found to be untenable.
The CC held that SARS' claim for understatement penalties failed on both grounds of 'no reasonable grounds for tax position taken' and 'reasonable care not taken in completing return'.
The CC's approach provides persuasive arguments as to the meaning of 'no reasonable grounds for tax position taken' and 'reasonable care not taken in completing return' when SARS intends to levy understatement penalties on a taxpayer.
Taxpayers which form part of multi-tier trust structures should take note of the judgment. The reasoning is also valuable for taxpayers against whom understatement penalties have been levied. It further highlights the benefit of obtaining proper tax advice prior to implementing a transaction, as the mere act of obtaining advice could alleviate the burden of understatement penalties being levied. Finally, taxpayers should be careful to place reliance on explanatory memorandums during a dispute with SARS as it could be bound by such reliance should a matter proceed to Court.
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.
