A recent change to the taxation of foreign trusts will have far-reaching effects on the distribution of income and capital gains to South Africans.
According to tax executives, it may just be the final push for South Africans with a large asset base offshore to join their assets rather than repatriating them and paying a maximum of 20% tax.
In terms of the Taxation Laws Amendment Act, any income or capital gains that would previously have been exempt from tax will now be taxed from March 1 this year.
Baker McKenzie’s legal and tax experts Matthew Tout and Arnaaz Camay say these changes came as a result of a push by the legislature to close identified loopholes associated with foreign trusts and seek to regulate SA resident individuals who have an indirect interest in a foreign company through foreign trusts.
Participation exemption removed
Keith Engel, CEO of the South African Institute of Tax Professionals, says SA allowed for a “participation exemption” in 2002 in order to be internationally tax-competitive.
This exemption meant that if a South African tax resident owned shares in a foreign company, they were exempt from tax on dividend and capital distributions.
The European and British legislature allowed for a participation exemption so as not to discourage their tax residents from repatriating money from a foreign source.
“In the US they are taxing the money that is coming home, so people tend to keep it offshore longer,” says Engel, who was at National Treasury in 2002 when the participation exemption was introduced.
SA basically followed the European and British models, but this has now changed. All distributions from a foreign trust to a South African tax resident made after March 1 2019 will be taxed.
Johan Troskie, an international tax and commercial lawyer, says the amendment had been hinted at earlier – effectively to tax foreign companies held by interposed offshore trusts, the so-called look-through principle.
Tax avoidance concerns
Offshore trusts have long been seen by the South African Revenue Service as part of various measures to avoid tax in SA.
“My difficulty is that tax legislation in SA is often so blindly aimed at tax avoidance that we miss the opportunity of good tax law,” says Troskie. “Why would SA beneficiaries not enjoy the participation exemption of a foreign trust in a foreign company?”
This look-through principle may further contribute to driving much-needed investment capital from SA at a time when we definitely cannot afford it.
“The people and families who this measure is aimed at are the very people who start new ventures and employ people in SA – we should welcome them, not drive them away.”
Engel says in most instances distributions are only made when the South African tax resident wants to bring the money back to SA. But with a maximum tax rate of 20% for individuals, it becomes expensive.
The people who are affected are those who set up offshore trusts but did not want to keep the money offshore indefinitely.
“It will not hit the super-rich because they never intended to bring the money back,” says Engel. “People who set up offshore trusts as part of their expatriate planning will also not be too bothered.”
The people who do care are those with lower levels of wealth, or who have greater income needs in SA than they anticipated.
It is these people who may want to repatriate the money. It is also people who wanted to build up some offshore reserves but had no intention of leaving SA.
“Although it [the amendments] want to devalue offshore trusts as a whole, it really only devalues the repatriation. It will hit people who have assets of around R20 million to R40 million.”
Wealthier people are increasingly making the decision to leave the country, and sometimes tax becomes a make-or-break point.
“People say tax became the turning point for them,” says Engel, “if they are already half in and half out, the tax aspect pushes them to leave.”
It is similar to the limitation on foreign income tax exemption, where only R1 million of the foreign income will be exempt from South African tax.
Theoretically, the foreign trust charge does have merit. However, whatever gain SA gets in taxing the repatriated income or capital gains in the short run, it will lose from the tax base in the long term, adds Engel.