Are you aware of possible double taxation as a result of trust distributions? - 30 May 2024

Many trustees are advised to distribute all trust income and capital gains to beneficiaries to escape the high tax rates in trusts. Even though a trust carries the highest Income Tax rate (a flat rate of 45%) and Capital Gains Tax rate (a flat rate of 36%), when trust distributions are considered, cognisance is not taken of the ‘knock-on’ effect of potential further taxes that it may trigger.

Section 7C Donations Tax (actually a ‘prepayment’ of Estate Duty)

One of the major changes, to date, in trust tax law – in terms of combatting the postponement or avoidance of Estate Duty – was the introduction of Section 7C of the Income Tax Act. This section taxes loans with interest below the variable official rate of interest (repo rate plus one percent – currently 9.25%) as a ‘deemed donation’. Donations Tax is payable on the interest that should have been charged on the loan. This is taxed in the hands of the funder – the tax is 20% of the amount of the ‘donation’ if the aggregate of that amount and all other donations during a person’s lifetime (on or after 1 March 2018), excluding all exempt donations during the same period, is less than or equal to R 30 million, and 25% of the amount of the ‘donation’ if the aggregate of that amount and all previous donations during a person’s lifetime (on or after 1 March 2018), excluding all exempt donations during the same period, exceeds R 30 million. The rationale is that Donations Tax and Estate Duty are both charged on a gratuitous disposition (during your life and at death) at the same rates. The issue with the application of Donations Tax and Estate Duty is that no apportionment is allowed between the two tax brackets (20% or 25% explained above). Therefore, if the aggregate donations/estate is pushed above the R 30 million threshold, the entire donation/estate will be taxed at 25%, and no portion will be taxed at 20%.

SARS, through this provision, attacks the age-old method, whereby people transfer their assets to ‘their’ trusts on interest-free loan accounts, which never got repaid. The effect of this arrangement was that the person’s estate got ‘pegged’, and all the growth happened in the trust. No Estate Duty would therefore be paid on the growth of the asset upon a person’s death.

Section 7C now ensures that a person pays tax during their life to make up for this ‘loss’ to the fiscus by assuming a growth rate on trust assets. For example, if you sold a building to the trust for R 3 million on an interest-free loan account, you would pay R 35 500 tax (R 3 million x 9.25% (current official rate of interest) – R 100 000 (the annual Donations Tax exemption applicable to each South African resident individual)) x 20% (Donations Tax; if cumulative donations did not exceed R 30 million)} annually, subject to changes in the variable official rate of interest and the cumulative amount of donations after 1 March 2018.

Distributions

A trust has unique tax treatment in that others may pay tax on income and capital gains generated in the trust rather than the trust itself. For example, the ‘Conduit Principle’ allows trustees to shift the tax burden from a trust to its beneficiaries, thereby paying tax at the individual’s marginal tax rate. In many cases, this may be lower than the trust’s tax rates listed above. Therefore, one can legally use this mechanism as part of one’s tax planning, and achieve better tax efficiency. One can also apply the ‘Income Splitting’ (and capital gain splitting) principle to reduce the effective tax rate on income or capital gains generated in a trust, by distributing income and capital gains to multiple beneficiaries who pay tax at low rates. This in many instances is the sole reason for trustees to move all the net income and capital gains generated in the trust during a year to beneficiaries. This is often done in such an ‘automatic’ fashion (just to save tax) that the compulsory application of the ‘attribution rules’ of the Income Tax Act, whereby all or some of the trust income and capital gains are to be attributed to the donor or funder for them to pay tax on income and capital gains generated as a result of their donation or soft funding, are overlooked. Given the South African Revenue Service’s (SARS) renewed focus on the ‘attribution rules, such behaviour may trigger penalties and interest on the incorrect treatment of trust income and capital gains. As a result of the introduction of Section 7C (discussed below), it is hard enough to get assets into a trust, so it may not be wise to ‘bleed’ growth out of a trust that was set up as a generational wealth transfer trust through making distributions just to save tax that year. Following the example above, if the trustees sell the building after 10 years and make a capital gain of R 5 million, they may distribute it to a beneficiary to save tax of R 900 000 {R 5 million x [36% (Capital Gains Tax rate for a trust) - 18% (maximum Capital Gains Tax rate for an individual)]}, which seems a great incentive for trustees to distribute the amount to a beneficiary. This is exactly what SARS wants, as the amount will then fall within the estate of the beneficiary concerned, which will attract Estate Duty.

Estate Duty

Estate planners and trustees should be mindful that once distributions are made to beneficiaries, such amounts or assets have to be unconditionally vested in those beneficiaries to qualify for the more favourable tax treatment discussed above. Distributions could either be physically paid to beneficiaries or left in the trust as amounts payable to beneficiaries. In both instances, these amounts are included in and inflate beneficiaries’ estates. It may even push a beneficiary’s estate over the R 30 million mark, which triggers an additional 5% Estate Duty upon the person’s death, as explained above. Any future income and growth on these amounts (whether the amounts are physically paid out to the beneficiary concerned or retained in the trust for them) also vest in these beneficiaries’ hands, which will inflate their estates.

Potential double tax

After Section 7C was introduced as a ‘prepayment’ of Estate Duty on assumed growth, SARS has made no provision for any rebates on amounts already paid annually (since 31 March 2018) on the assumed growth explained above, against the calculated Estate Duty upon the deaths of beneficiaries who have received distributions during their lifetimes. Following the example above, applying the current rates, double taxation (Estate Duty and Section 7C Donations Tax) will be paid on R 355 000 (10 years x R 35 500).

Conclusion

When trustees consider distributions, detailed calculations should be performed to understand the total tax consequences resulting from distributions. Each beneficiary’s estate should also be taken into consideration, as one would want to avoid the extra 5%Donations Tax and/or Estate Duty as a result of any transaction or distribution. If trustees blindly distribute trust income and capital gains to avoid paying higher taxes only for that year, they may trigger other unintended tax consequences. When free cash is available after a trust asset has been sold, it may be wiser to rather repay a loan attracting Section 7C Donations Tax, as it will forever attract Section 7C Donations Tax, even if it is bequeathed to a family member after the death of the original funder.