Can trustees apply and apportion expenses in such a way as to experience the greatest tax advantage?

Because the South African Revenue Service (SARS) has begun to view trusts as a means of structured tax avoidance, a number of measures have been introduced over the years resulting in the income of trusts being taxed at 45% —the highest rate applicable to individuals—and capital gains being taxed 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). Therefore, trustees will generally attempt to minimise taxes payable by the trust; this is after taxable income and/or capital gains have been attributed to a funder/donor resulting from a donation or sale of such income/capital gain producing asset on an interest-free or soft loan by the funder to the trust, and after the distribution of income/capital gains to beneficiaries through the application of the conduit principle. The conduit principle is a principle that allows income and/or capital gains to be taxed in the hands of the beneficiaries, instead of in the hands of the trust, through a decision of the board of trustees.

If a trust makes a combination of taxable income (for example rental) and tax exempt income (for example a dividend), trustees would naturally want to apply most of the trust expenses against the taxable income in an effort to reduce tax. Section 11 of the Income Tax Act permits the deduction of expenses from income in the calculation of tax, but Section 23(g) of the Income Tax Act limits these expenses to amounts incurred for the purpose of trade; in other words, for producing taxable income. As such, trustees would be required to prove to SARS that the expenditures deducted from the taxable income were incurred during the production of such income. Expenses paid by a trust will therefore not automatically qualify as a deduction against taxable income. Purchasing a flight ticket for your child to take a vacation abroad may be difficult to label as an expense incurred in the production of income, as opposed to interest paid being deducted from rental income received on properties owned by the trust. Clients are often under the impression that expenses paid by a trust, such as school fees, maintenance of one’s primary residence held by the trust, in which one lives rent-free, are all automatically deductible from income generated by the trust for tax purposes. This is clearly not the case.

It may also be difficult to prove that all trust expenses were incurred while producing, for example rental income, if, for example, the trust also holds an investment portfolio that only produces non-taxable dividends, especially when it is clear from the trustees’ behaviour that most of their effort and trust expenses, such as professional advisor costs, were incurred on the investment portfolio.

Although SARS is not prescriptive as to how expenses should be apportioned between taxable income (for example rental income) and exempt income (for example income from dividends), the onus is on the trustees to prove that they have applied their minds and that the ultimate apportionments are fair and reasonable. It does, however, appear that SARS favours apportionment on the basis of gross income. This means that expenses will be apportioned in the same proportion as taxable income to non-taxable income. The trustees will, however, be required to supply proof that the apportionment basis was fair and reasonable.