Funders of trust structures, beware of tax changes
ALL ABOUT TRUSTS
It is well known that trusts and estates have been under the magnifying glass of the South African Revenue Service (SARS) for a while. This led to the introduction of an anti-avoidance measure (section 7C of the Income Tax Act) effective from March 1, 2017, whereby SARS accesses growth in a trust.
SARS wanted a way to access growth in assets, which people historically deliberately moved into a trust and thereby “froze” the value of the estate for estate duty purposes. For example, a farmer transfers into a trust his farm valued at R1 million and creates an interest-free loan for that amount to the trust. On his death, 30 years later, the farm in the trust may be worth R50m, but the loan of only R1m is reflected in the farmer’s estate. Sars could not access the growth in the value of the farm on his death, as the trust is a separate entity.
Section 7C cleverly assumes a growth rate at the official interest rate (now 7.25%) and treats it as an ongoing annual donation, which is taxed at the donations tax rate (20% of the amount of the donation if the aggregate of that amount and all previous donations during a person’s lifetime is up to R30m and 25% of the amount of the donation if the aggregate is in excess of R30m). This is if you do not charge interest on the loan to the trust.
If you do charge interest at at least the official interest rate, no donations tax will be payable, but the interest will be taxed in the hands of the lender and SARS will collect taxes in that way instead. This will be the case if the trust does not have taxable income from which its interest expense can be deducted and thereby neutralise the corresponding tax on the interest paid by the lender.
In many cases, trusts do not have taxable income, which will lead to a net tax payable on the interest by the lender. Whether the trust has the means to pay the interest or the interest is capitalised to the loan account, it will increase the estate of the funder, which SARS will tax on his or her death.
As the annual section 7C payments can be material amounts, people started implementing structures to prevent these unplanned annual payments to Sars.
Various structures have been introduced to circumvent section 7C, one of which is a preference share structure. In these structures, instead of advancing a “loan, advance or credit”, taxpayers subscribe for preference shares in a company owned by a trust, which is a connected person in relation to the natural person; for example, the lender is either a beneficiary or related to a beneficiary. In this case, the preference shares would not constitute a “loan, advance or credit” as envisaged in section 7C, thereby circumventing the relevant provisions. The minister of finance picked up on these schemes and announced in the Budget Speech last week that in order to curb this form of abuse, further rules preventing tax avoidance through the use of trusts would be introduced.
Are trusts still useful?
It is clear that SARS will keep attacking the use of trusts to “freeze” growth assets for estate duty purposes. People who have restructured their funding to trusts as preference shares to a company, held by a trust, will have to be aware of and be prepared for possible changes to be introduced by SARS. If the sole purpose of setting up a trust is the saving or avoidance of tax, it is no longer good advice to follow.
It is, however, not only about tax. A trust has the following unique benefits if used correctly:
- Protection of your assets. The number-one wealth preservation rule is to protect your assets. If you have your own business, sizeable investments and/or other assets, then you might want to pay attention. One of the most important reasons to consider a trust is that it will help you to separate your assets from your property investment debt, your business interests, and/or your other financial risks.
- Flexibility to cater for varying circumstances and events. A discretionary trust is extremely flexible and can be used to take into account any family, financial and legislative circumstances. This means that the trustees can manage the trust’s assets in the best interests of the beneficiaries, at any particular time, by taking into account all the relevant factors at that time. This flexibility caters for uncertainties such as divorce, insolvency, increase in family size or fortunes, and changes to tax legislation, provided the beneficiaries are defined and the trust deed is drafted in such a way as to anticipate these uncertainties.
- Family asset management. A trust can provide a centralised asset management structure, as well as controlled distributions for beneficiaries who are not in a position to manage assets themselves due to prodigality (excessive or extravagant spending). A trust can also provide for joint ownership of indivisible assets, such as holiday homes and farms.
- “Insurance” if something goes wrong with your mental health. Trusts can also be used to avoid the need to place a person under curatorship. This is particularly true for people who suffer from Alzheimer’s disease or simple senile dementia.
- Preservation of your wealth for future generations. If you bequeath your estate to individuals, it may become a case of “easy come, easy go”. For example, people who inherit, and/or their spouses, may not attach sentimental value towards the inheritance, and may put pressure on their spouses to liquidate the assets in order to go on an expensive holiday.
- Liquidity for your family after death. There is no estate freezing and no unnecessary triggering of capital gains tax (CGT). CGT is triggered only on the distribution or sale of an asset. For example, a family holiday home intended to be held for multiple generations would be better held in a trust. CGT on the growth of the asset would apply only when the asset is actually sold by 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 the founder of Trusteeze, a professional trust practitioner.