Implications of local trusts with foreign beneficiaries

South African families who have created South African trusts may be living all over the world. It is important to understand the tax rules and other implications for foreign beneficiaries.

Where do trusts pay tax?

Trusts are taxed in South Africa if they are formed or established in South Africa. They are also taxed in South Africa if they are foreign trusts, but managed in South Africa. If a foreign trust holds assets – such as a property – in South Africa, the trust is required to register with the South African Revenue Service for tax purposes. Foreign trusts, therefore, are taxed on a “source” basis; on such income and not on a “residence” basis. These rules may lead to trusts - both South African and foreign trusts - being taxed in more than one jurisdiction. South Africa has entered into treaties with various countries, in order to agree in which one country a trust will pay tax. The place of effective management of the trust will in most instances determine where the trust will pay tax.

According to the Income Tax Act, a South African registered trust is defined as a South African resident. The OECD (Organisation for Economic Co-operation and Development) treaty takes this one step further and states that if a trust is registered in South Africa but conducts its business or earns its income and capital gains offshore, it is still deemed a resident of South Africa and will be taxed in South Africa. Furthermore, and conversely, the OECD treaty states that if the trust is managed in South Africa, even if it is registered offshore, it is deemed a South African resident and will be taxed in South Africa. South Africa is one of the many non-member economies with which the OECD has working relationships in addition to its 34 member countries.

How are South African residents taxed on income distributions to foreign beneficiaries? 

• A local trust distributing income in the same year to a foreign beneficiary, where such income is generated from a donation, settlement or other similar (gratuitous) disposition made by a South African resident

If an amount is distributed by a South African discretionary trust to a non-resident beneficiary, as a result of a donation, settlement, or other similar (gratuitous) disposition - such as a soft loan - made by such South African resident, and such amount would have been included in his/her income had he/she been a resident, such amount will be deemed to be income of such South African resident donor/funder and included in his/her income.

Even if an asset is disposed of for less than its market value, the difference between the selling price and the market value will be deemed a donation. The resultant income on the difference between the selling price and the market value will be treated the same as per the above paragraph.

Where there is an expense, allowance or loss that the foreign beneficiary could have claimed as a deduction from the income (had he/she been a resident), such expense, allowance or loss is deemed to have been incurred by the donor/funder, but limited to the amount. As a result, a loss cannot be created from such deductions. Should a non-resident have paid foreign tax on the same amount (which actually accrued to him/her), the South African donor/funder may deduct a rebate equal to such foreign taxes paid.

How are South African residents taxed on capital gains distributions made to foreign beneficiaries?

• A local trust distributing a capital gain in the same year to a foreign beneficiary, and such capital gain is generated from a donation, settlement or other similar (gratuitous) disposition made by a South African resident

Where a capital gain is distributed by a South African discretionary trust to a non-resident beneficiary, then the South African resident donor/funder who made the donation, settlement or other similar (gratuitous) disposition (such as a soft loan) will be taxed on the capital gain resulting from such a disposition, and not the non-resident.

Should a non-resident have paid foreign tax on the same amount (which actually accrued to him/her), the South African donor/funder may deduct a rebate equal to such foreign taxes paid.

Other tax implications

It is important to understand if other countries may tax foreign beneficiaries on South African trust income, other than those discussed above. Trustees need to do a proper assessment of beneficiaries to understand and plan for any possible negative international tax consequences.

Exchange Control implications

A South African trust runs the risk of being classified an “affected person”, if it has foreign beneficiaries. An affected person is a body corporate, foundation, trust or partnership operating in South Africa, or an estate in respect of which either:

• 75 per cent or more of its capital, assets or earnings may be utilised for payment to, or to the benefit in any manner of, a non-resident, or
• 75 per cent or more of its voting securities, voting power, power of control, capital, assets or earnings, are directly or indirectly vested in, or controlled by or on behalf of, a non-resident.

“Affected persons” may obtain financial assistance in South Africa, only subject to certain restrictions. Financial assistance includes the taking up of securities, granting credit, lending of currency, discounting, factoring and the guaranteeing or acceptance of any obligation. In other words, if the trust needs to borrow money, it may be restricted.

A possible way to counter the negative effect of a trust being labelled an “affected person”, trust deeds could contain a clause stipulating that should the participation in allocations, payments or application for the welfare of a beneficiary under the trust, of a person who is not for the time being a resident of the Republic of South Africa, for the purposes of the Exchange Control Regulations, result in the trust or any company or other entity, in which it has any direct or indirect interest, being classified as an “affected person” for the purposes of the Exchange Control Regulations, the trustees may, by unanimous decision, limit the extent of the participation in allocations, payments or application for the welfare of a beneficiary under the trust, to such person, so as to avoid such classification, treatment, preclusion or restriction, with the right to reinstate such person’s participation when the restrictions are no longer necessary or operative.

It is important to be aware of the tax and other implications of non-resident beneficiaries of South African trusts. Always use the services of a professional to draft your trust deed, and it may also be wise to appoint an independent trustee who can guide the other trustees on technical issues such as those described above.