Are trusts taxed more punitively?

Many people deliberately set up trusts with a view to save or avoid tax. This is problematic because the South African Revenue Service (SARS) has, over the years, introduced many anti-avoidance provisions to combat the use of trusts for tax avoidance schemes. Trusts serve many purposes, but saving tax is not one of them. If you have set up a family trust to protect your assets from creditors, and if you have administered the trust properly, you have the advantage of saving Estate Duty upon your death, and SARS cannot attack your trust because of this.

Although a trust is not a legal entity, with the inclusion of a trust as a “person” in the Income Tax Act, SARS recognises a trust as a separate taxpayer. SARS requires that every South African trust be registered for Income Tax. This must be done as soon as you have successfully registered the trust with the Master of the High Court and you are in possession of a registration number. Failing to register for Income Tax is a jailable, criminal offence. If you do not end up behind bars, SARS will charge you penalties as high as 200%, if the trust were to pay tax. Trusts may also be liable for taxes such as VAT, payroll taxes, Donations Tax, Transfer Duty and Security Transfers Tax.

Because SARS has begun to view trusts as a means of structured tax avoidance, it now taxes income of trusts at 45% - the highest rate applicable to individuals - and capital gains at 36%, the highest effective rate applicable to any taxpayer (although the effective tax rate for a capital gain distributed to a shareholder in a company is now at a higher rate of 37.92% after the increase of the dividend tax rate in February 2017).

A trust is different to a company or a close corporation in that it is the trail of each transaction with the trust that will determine whether it is the trust that is liable for the payment of any tax on income or capital gains earned within the trust, or a person connected to the trust, such as a funder, donor, or beneficiary. It is incorrect to assume that trust income and capital gains are taxed at higher rates than that of individuals and companies, even though this is what the media advocates. In South Africa, the trust is actually the taxpayer of last resort.

Who pays tax on trust income and capital gains?

SARS does not tax amounts in excess of the total income or capital gains received by the trustees, and SARS does not tax more than one person on the same amount. Where income or capital gains are taxed in the hands of the trust, any subsequent distribution thereof will not attract tax in the hands of the beneficiary. Depending on the circumstances, trust income and capital gains can be taxed in the hands of the donor/funder, the beneficiary, or the trust.

The following order should always be followed in determining who will be liable for the payment of tax on trust assets:

• Firstly, SARS introduced anti-avoidance provisions to prohibit people from moving income or capital gains away from themselves by donating assets to a tust or selling it to the trust on an interest-free or soft loan basis. In this instance income or capital gains generated on assets donated to the trust or financed on an interest-free or soft loan, by a connected person in relation to the trust, is deemed to be accruing to such donor or funder. These provisions override any other provisions aiming to tax trust income or capital gains. 
• Secondly, if no deeming provisions can be applied to an income or capital gain that is vested in a beneficiary - resulting in it being taxed in the hands of the donor/funder - the beneficiary will, if decided by the trustees, in terms of the Conduit Principle (a mechanism which allows trustees to shift the tax burden from a trust to its beneficiaries, thereby paying tax at the individual’s marginal tax rate), be taxed on the income or capital gain vested in him/her. This is only applicable to South African residents. Trustees can also use the Conduit Principle and pay beneficiaries who are earning income below the tax threshold. Individuals who earn up to R 78 150 (if you are under 65 years), R 121 000 (if you are 65 or older, but under 75) and R 135 300 (if you are 75 years or older) income per year, do not pay tax. Trustees can also utilise the Conduit Principle to split income and capital gains amongst a number of beneficiaries who earn up to the thresholds listed above, thereby ensuring that little or no tax is paid on trust income and capital gains. This is referred to as “income splitting”, a benefit exclusively available to trusts. Income-splitting ensures that tax payable is reduced to an amount less than if the income had been taxed from one source. Should a distribution of interest be made to a number of beneficiaries, each beneficiary is permitted to utilise the annual interest exemption to reduce their taxes. This is contrary to the interest distribution only being available once to an individual who earns the same combined interest. Similarly, a capital gain distributed to a number of beneficiaries -  instead of an individual making the capital gain in his/her own hands - can benefit from multiple annual exclusions. This currently stands at R 40 000 per natural person, per year. It is important to note that any such distributions must be made before the end of February, otherwise the income or capital gain will be taxed in the trust. 
• Finally, the trust will pay tax on any income or capital gains, which has not been taxed already. The trust, therefore, is the taxpayer of last resort.

The above makes it clear that a blanket statement that the most tax is paid on income generated or capital gain realised in a trust is simply not true. With a trust being the taxpayer of last resort, planning opportunities present itself, which are not available to any other taxpayer, whether it is an individual or company. One needs to actively manage a trust and consider the various options in order to minimise taxes paid.