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The benefits of using trusts for tax planning

Trusts and Taxes 

Is a Trust an effective tax planning vehicle? 

Given its perceived advantages when it comes to taxes, the popularity of trusts, especially inter vivos trusts, continues to grow. 

It is not surprizing then that there have been several recent legislative amendments which have far-reaching consequences for trusts, particularly the inter vivos trust, as tax planning instruments.  

Why would you want to set up a trust?

You may need a trust if:

  • your assets (including life policies) exceed R3.5m; 
  • Your assets consist of capital appreciating items; 
  • You have minor children; 
  • You want to control how / which assets are passed on to your heirs (especially in blended families); or 
  • You need asset protection planning. 

There are various types of trusts, including: 

  • Living Trusts (in South Africa called inter vivos trusts); 
  • Testamentary Trusts - Are created as a means to clarify how to handle a deceased person’s estate. This is stipulated in the deceased person’s Will; or a  
  • Bewind Trusts - These are created as trading vehicles providing trustees with limited liability and certain tax advantages. 

The two main advantages of placing assets in a trust are: 

  • Asset protection from creditors

If assets held by the trust aren’t owned by the trustees or beneficiaries, the creditors of the trustees or beneficiaries can have no claim against the trust (with few exceptions). 

  • Continuity

Since a trust can span multiple generations. When a trustee dies, the trust and any assets owned by it remain unaffected. 

Upon the death of a beneficiary, only the portion of the trust assets that vests in that beneficiary upon the date of death would form part of the beneficiary’s estate for estate duty purposes. 

Tax considerations

In South Africa living trusts are considered tax payers. To which there are two types of tax that apply: 

  1. Income tax - payable at a flat rate of 45% (individuals pay according to income scales), and
  2. Capital Gains Tax (CGT) – payable at the rate of 36%

Estate duty – A trust is not obligated to pay estate duty (which is the tax payable by a deceased estate). Trusts are however obligated to pay back outstanding loans to a deceased estate, in which the loan amounts are taxable with the deceased estate. 

How does a trust acquire assets? 

There are two ways in which assets can be transferred into the living trust:

  • Selling it to the trust (through a loan granted to the trust) or
  • Donating cash or other assets to it (any person can donate R100 000 per year tax free; 20% donations tax applies to further donations within the year).

Tax legislation clearly defines the advantages of proper tax planning in a well-structured trust. It is possible for even minor beneficiaries to have enjoyed more tax-friendly distributions.  

Estate planners often use the following principle to structure financial affairs to enjoy maximum benefit:

The Conduit Principle, but subject to anti-avoidance provisions.

The rules differ from companies to trustees: 

Trustees can decide to pay the income tax- which is 45%, or capital gains tax- 36% in the hands of the trust. 

Or they may decide to distribute the tax liability to the beneficiaries at their marginal rate of tax. Income tax is 18% to 45% or capital gains tax 7.2% to 18%, thereby paying much less tax. 

The income and capital gains that are generated within a trust can be distributed to the beneficiaries, where they will pay tax according to their personal income tax rates. 

Any income or capital gain which is paid to or is vested in a beneficiary will be taxed in the hands of that beneficiary. 

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

The conduit principle also applies to the source of income from a trust. The dividends, which are tax-free, remain so as they pass through the trust to a beneficiary. 

Therefore distributions 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 trustees to award income and capital gains from different sources to different beneficiaries, which in turn helps create a platform for positive planning opportunities. 

For example: 

The dividend income can be awarded to one beneficiary, and the 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 do not yet pay taxes). Then the dividend income, on which no further taxes is payable, goes to parents with other sources of income (and pay tax at the 45% marginal tax rate). 

There may also be circumstances where it is necessary to create a trust that retains all its income, resulting in it paying tax at severely high rates. 

In such circumstances, it would be wise 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. 

Donations

It is important to note that the Income Tax Act contains specific anti-avoidance provisions, which will tax such distributions in the donor’s (also known as a 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 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 proves to be a beneficial provision as 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”.

After the death of the donor of the trust, it may not be possible to avoid the higher capital gains tax (as the trust itself may become liable for tax after the donor’s death). The trustees must then 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. 

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 R78150 income per year do not pay tax. Therefore, the trust income can 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 (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 grandchildren’s hands.

Liability

Each grandchild will not be liable for tax until his/her income exceeds R78150. 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 and for the minor children of a deceased donor. 

For Example: 

For each child receiving R78150 per annum, a tax saving of R35167.50 (R78150 x 45percent) will be achieved.

So if you distribute R78150 to five of these qualifying people, you will save R175837.50 (R35167.50 x 5) in tax.

Although income splitting is a great tax planning tool, be mindful of the anti-avoidance provisions. These state where the parents may be taxed on trust income if they have donated the 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 an individual would like to assist a child in purchasing a property during their lifetime, the trust can distribute trust capital to the child, without having to pay Donations Tax. 

Trust capital is the assets that the trust owns and any retained income on which the trust has already paid tax.

If you used your own funds to contribute towards the house, you would be liable for Donations Tax (at 20percent) on so much of the donation as exceeds R100000 (the annual Donations Tax exemption applicable to individuals) for that tax year.
For Example:

If you donate R1 million to your child to purchase a house, you will be liable for R180000 Donations Tax (R1m - R100k) x 20%

The change in the law

The Taxation Laws Amendment Act, 2016 introduced section 7C.

Section 7C was promulgated on January 22 2017 and the section was deemed effective from the 1st of March 2017. The section was introduced specially to prevent trusts from being used as mechanisms to avoid or reduce estate duty and donations tax.

Which means this section is of vital significance to anyone who transferred assets to a trust without being paid for the asset.

It used to be quite common practice to sell assets to a trust on an interest-free loan basis, as a result of the trust not having liquidity or because the seller did not want to pay tax on the interest. 

The loan would then effectively be written off by the annual donations allowance of R100 000 per annum until the trust owned the asset in its entirety. The sale of the asset on this basis avoided both donations and income tax.

Donations tax is calculated at a flat 20% of the value of the asset above your allowable donation of R100 000 per annum payable by the donator.

The implications

Any individual who sells assets to a trust (in relation to which he or she is a connected person) and finances those assets by way of a loan at an interest rate that is less than the official interest rate, will be subject to income tax on the deemed interest.

The deemed interest will be the difference between interest on the loan at 8% (The official rate = at least the repo rate plus one) and the actual interest rate charged (in the case of an interest-free loan this will be 0%).
For Example: 

If an individual sells assets to the value of R10 million to a trust that he sets up and extends an interest-free loan to the trust to finance the assets, the individual will be taxed on R800 000 of deemed interest (8% of R10 million) even though this is a fictitious amount. This is the result of the new section 7C of the Income Tax Act.

The ‘cherry on top’ is that the annual interest exemption of R23 800 for individuals younger than 65 won’t apply. Moreover, no costs or other deductions could be offset against the interest.

The Income Tax Act allows individuals to donate R100 000 per annum to anybody without paying donations tax on it. A common practice among estate planners is to donate R100 000 to the trust every year to reduce the outstanding interest-free loan.

In terms of Treasury’s proposal, any reduction of the loan to a trust under these circumstances will not qualify for the R100 000 annual exemptions from donations tax and normal donations tax of 20% will be levied on any such donation.

These changes have been effected primarily because of SARS’s (often justified) belief that trusts are used solely as a tax planning tool.

It is therefore unwise to select a trust as an option merely for its possible tax benefits, because, with the changes in tax legislation, such benefits may have become invalid. 

Disadvantages Of A Trust

Additional expenses:

A trust is deemed to be a separate legal entity.  As such, there are many various lengthy and sometimes expensive requirements. 

The following are required annually:

  • Annual financial statements;
  • Annual income tax return; and 
  • Bi-annual provisional tax returns

Administrative requirements:

  • Keep all records (the first entry to financial statements) from the commencement of the trust to at least 5 years after the trust has been deregistered;
  • Trustees minutes and resolutions about all transactions to be drafted and retained;
  • Maintain a separate bank account for all trust cash flows; and 
  • Maintain an asset register

Relinquishment of control:

  • SARS may deem income back to the donor of the asset if there is not adequate relinquishment of control over the asset; and 
  • A court may look through the trust if there is not adequate separation of control between the trustees and the trust assets.

From the above it is evident that a trust is not suited for every individual, especially if one is planning to use a trust specifically for tax purposes. 

That is not to say that there are no remaining tax advantages to using a trust; however it should never be the motivating factor for registering a trust.

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, the motivation will be investigated.

Van Deventer & Van Deventer Incorporated - Tax Planning with Trusts

For expert legal advice contact Van Deventer & Van Deventer Incorporated.

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