How do people still use trusts as tax planning vehicles?

The advantages of proper tax planning in a well-structured trust are clearly defined in the tax legislation. Even minor beneficiaries can enjoy tax-friendly distributions. Estate planners use the following principles in structuring their financial affairs to enjoy maximum benefit:

Conduit Principle, but subject to anti-avoidance provisions 

Unlike companies or close corporations, the trustees can decide to pay the Income Tax (45%) or Capital Gains Tax (36%) in the hands of the trust or distribute the tax liability to the beneficiaries at their marginal rate of tax (Income Tax 18% to 45% or Capital Gains Tax 7.2% to 18%), thereby paying much less tax.

Income and capital gains generated within the trust can be distributed to the beneficiaries where they will be paying tax based on their own personal income tax rates. Any income or capital gain paid to or vesting in a beneficiary will be taxed in the hands of that beneficiary. 

The Income Tax Act goes even further, giving trustees the power to vest purely capital growth in a beneficiary, without awarding any assets to the beneficiary. The caveat is that the growth awarded then becomes part of the estate of the beneficiary.

The Conduit Principle also applies to the source of income from a trust. Dividends, which are tax-free, remain tax-free as they pass through the trust to a beneficiary. Distributions therefore retain their nature for tax purposes, provided they are distributed in the same tax year that the trust received them; otherwise they will be taxable in the trust.

Many trusts empower the trustees to award income and capital gains from different sources to different beneficiaries, which creates good planning opportunities. So, for example, dividend income can be awarded to one beneficiary, and interest income can be awarded to another. Consider the opportunity to award interest income (which is taxable) to children with no other source of income (and are not yet paying any taxes), and the dividend income (on which no further taxes are payable) to parents with other sources of income (and already paying tax at the 45% marginal tax rate).

There may be circumstances where it is necessary to create a trust that retains all of its income, resulting in it paying tax at punitively high rates. In these circumstances, it is best to rather invest the trust capital in endowments, equities and preference shares, which pay after-tax or tax free dividends, so as to make the receipts in the trust non-taxable.

Bear in mind that once the trustees distribute large amounts of income and/or capital gains to beneficiaries in order to save tax, the estates of these beneficiaries will be inflated in value, and Estate Duty will become payable on their death on any amounts distributed, plus any growth thereof.

Bear in mind, the Income Tax Act contains specific anti-avoidance provisions, which will tax such distributions in the donor’s/funder’s hands if a donation or a soft loan was made to the trust by him/her, and income was generated as a result of this donation or soft loan. Similarly, capital gains made by the trust are attributable to the person who made a donation or interest-free loan to the trust. This means that during the donor's/funder’s lifetime, the capital gain is taxable in his/her hands at his/her rate of tax, and not at the higher rate attributed to trusts. This is actually a beneficial provision because it saves tax. This amount of Income Tax has to be claimed back from the trust by the donor/funder, otherwise it will be deemed a donation to the trust, on which Donations Tax will be payable (20%). Section 91(4) of the Income Tax Act states that “So much of any tax payable by any person as is due to the inclusion in his income of any income deemed to have been received by him or to be his income, as the case may be, in terms of subsection (3), (4), (5) or (6) of section seven, may be recovered from the assets by which the income so included was produced”.

If after the death of the donor/funder of the trust the higher Capital Gains Tax cannot be avoided (as the trust may become liable for tax after the donor’s/funder’s death), the trustees must ensure that they delay the payment of Capital Gains Tax until they are able to make an award to a beneficiary in terms of the Conduit Principle. Alternatively, by investing in unit trusts, rather than a bespoke portfolio of shares, trustees can delay Capital Gains Tax until they sell the units, leaving the unit trust manager to switch the underlying shares at will, without attracting Capital Gains Tax on each sale.

Income Splitting

Trustees can use the Conduit Principle and distribute income to various beneficiaries, who do not earn enough to pay tax. Individuals who earn up to R 78 150 income per year, do not pay tax. Trust income can therefore be split among a number of beneficiaries who earn up to this threshold, resulting in them paying no or very little tax on trust income. 

By using the trust as a conduit, the trustees can pay the school fees of the grandchildren of the donor/funder (the person who donated the income bearing assets to the trust, or who sold the income bearing assets to the trust at interest-free or soft loans) and have the income taxed in the grandchildrens’ hands. Each grandchild will not be liable for tax until his/her income exceeds R 78 150. The same principle applies to distributions to children, as long as the income generating assets were not donated or sold at an interest-free or soft loan to the trust by the parent, as this will trigger the anti-avoidance provision discussed above. The same is true for the major children of the donor/funder and for the minor children of a deceased donor/funder. For each child receiving R 78 150 per annum, a tax saving of R 35 167.50 (R 78 150 x 45%) will be achieved. So if you distribute R 78 150 to 5 of these qualifying people, you will save R 175 837.50 (R 35 167.50 x 5) in tax. 

Although income spplitting is a great tax planning tool, be mindful of the anti-avoidance provisions, where the parents may be taxed on trust income in the event that they have donated these income generating assets to the trust, or sold it to the trust on an interest-free or soft loan.

Donations tax

Assets in a trust can be distributed to the trust beneficiaries without incurring Donations Tax. If, during your lifetime, you wish to assist a child in purchasing a property, the trust can distribute trust capital (the assets that the trust owns and any retained income on which the trust already paid tax) to the child, without having to pay Donations Tax. 

If you used your own funds to contribute towards the house, you would be liable for Donations Tax (at 20%) on so much of the donation as exceeds R 100 000 (the annual Donations Tax exemption applicable to individuals) for that tax year. If, for example, you donate R 1m rand to your child to purchase a house, you will be liable for R 180 000 Donations Tax {(R 1m – R 100k) x 20%}.

Conclusion

Although there remains tax advantages using a trust, it should never be the motivating factor for registering a trust, as the South African Revenue Service is taking a very close look at trusts and the abuse thereof, so unless one can commercially justify why certain transactions were done by a trust, it will be attacked.