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Treasury steps in to curb tax avoidance using trusts

Could trigger significant income tax where interest-free loans are extended.

JOHANNESBURG – A proposal by National Treasury, that aims to address the avoidance of estate duty by moving assets to a trust, could have significant tax implications for individuals involved.

The draft Taxation Laws Amendment Bill that was published for public comment in July, includes a provision that aims to make it detrimental for an individual to sell assets to a trust to which he or she is a so-called ‘connected person’ (typically family of the founder or beneficiaries of the trust) and extending a low- or interest-free loan to the vehicle.

Louis van Vuren, CEO of the Fiduciary Institute of Southern Africa (Fisa), says National Treasury has for some time held the view that South Africans move assets into trusts to avoid estate duty.

A common practice has been for individuals to sell their assets to a trust they have set up, but instead of the trust paying for the assets, the individual extends an interest-free or low-interest loan to the trust to enable the trust to finance the transaction.

Up until now, there have not been any problems with this type of structure. The common law position has always been that no loan bears interest unless interest is explicitly specified, he says.

But Treasury has argued that this makes it too easy for people to divest themselves from their assets by transferring it to a trust. This practice allows the assets to increase in value outside the estate of the original owner. When the individual eventually dies the only asset in the estate is the outstanding loan.

Van Vuren says this effectively pegs the value of the assets at the date of the sale, as there is no further growth of those assets in the estate of the founder.

“So what Treasury and the minister are saying is that this robs the State of estate duty, because those assets would have stayed in the estate and at death would potentially be susceptible or liable for estate duty,” he says.

The draft legislation proposes to curb this practice by charging income tax on deemed interest.

Should the new provisions take effect in their current form on March 1 2017 as proposed, 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 (currently 8% in terms of the Seventh Schedule of the Income Tax Act), 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) and the actual interest rate charged (in the case of an interest-free loan this will be 0%).

Thus, 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 a proposed new section 7C of the Income Tax Act.

The ‘sting in the tail’ 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, Van Vuren says.

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 exemption from donations tax and normal donations tax of 20% will be levied on any such donation.

Concerns

Van Vuren says at this stage it is unclear whether the new provision will only affect new loans or whether existing ones will also be included.

Fisa is also of the view that the official interest rate of 8% is inappropriate in these situations. This rate is usually applicable in situations where employers extend a loan to employees at a preferential rate. The difference between the official rate of interest and the interest rate the employee has to pay is deemed to be income in the hands of the employee and the employee is taxed on the amount as a fringe benefit.

Van Vuren says the official interest rate is not really appropriate for the trust situation. He argues that one should rather use the interest rate a private individual could earn on a money market or related investment – somewhere between 5% and 7%.

His biggest concern is that the proposal essentially wipes the common law position – that there is no interest on a loan unless specified – off the table for tax purposes.

Practically this means that if someone sets up a trust on behalf of his/her vulnerable child and a friend extends an interest-free loan to the trust, the friend will not be taxed on the notional interest as he/she is not regarded as a connected person to that trust. However, if the friend extends the same loan to a trust he/she sets up for his/her own child, the new provision will trigger income tax on the deemed interest.

Van Vuren says in practice, there are also situations where distributions to beneficiaries of a trust are held back until a later date (for example where the beneficiary is still completing tertiary studies). In practice, accountants often record these amounts as beneficiary loans to the trust.

This is not a true reflection of what actually happens under these circumstances. The withholding of the payment of such a vested distribution happens under powers extended to the trustees in the trust deed and this can never be a loan, as there is no requirement in the typical trust deed that the beneficiary must agree to this arrangement.

There is a concern that beneficiaries may now become liable for income tax on the deemed interest on these ‘loans’ because they are regarded as connected persons in relation to the trust, even though they had no say in the matter.

The new provision is one of the few, if not the only case, where one tax is used in order to enable the collection of another, he says.

* This content was sponsored by the Fiduciary Institute of Southern Africa.

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While on the subject of fairness in tax, one iniquitous tax is capital gains tax that is payable on both the inflationary growth plus any other growth of an investment. Tax on real growth can be defended but not tax on inflationary growth. A period of hyperinflation will make this very apparent. One will have to pay CGT even though one’s savings buy less. If not already included, this needs to be addressed during tax reform.

For the life of me, someone feels the same as I do. I hate CGT.

Agree but I also hate any transaction that puts money within reach of the thieving cadres. Would not mind paying tax if I knew it was channeled to specific application, not a pocket.

Van Vuren says in practice, there are also situations where distributions to beneficiaries of a trust are held back until a later date (for example where the beneficiary is still completing tertiary studies). In practice, accountants often record these amounts as beneficiary loans to the trust.

Yeah, I’m sorry – but b******t. The distributions are made because the trustees want to pay no tax on the income, but retain the cash in the trust. If it genuinely was about investing the money for the benefit of the beneficiary, you would make no distributions and only allocate the funds when the beneficiary is ready to receive them.

I agree that an interest rate of prime might be a little excessive, but if you really cut down to the nuts and bolts of most of this argument, it boils down to “Waah waaah don’t you dare take away my tax avoidance tool”.

Carmen, it is unfortunately not as simple as that. Distributions to beneficiaries who are not yet ready to receive cash are done and then kept back in the trusts for reasons other than tax avoidance as well. For example, trustees may sell an asset and morally be bound to, or decide to, distribute the proceeds to three beneficiaries. One of these may regarded as too young, not finished with studies yet, or financially not mature or sophisticated enough to receive the distribution in cash. The prudent trustee(s), fulfilling his/her fiduciary duty properly, will then have to consider to keep the amount due to this beneficiary back in an accumulation account for the benefit of that beneficiary, if the trust deed/will extends that power to the trustee(s). It can never be a loan as a loan is a bilateral legal arrangement, while under these circumstances there cannot be the required consensus between trustee and beneficiary because the beneficiary has no choice in the matter. Some accountants incorrectly treat these situations as loans in trust financial statements.

Hi Louis. So if I follow your argument correctly, you’re saying that where the beneficiary doesn’t take the cash from the distribution, the trust should effectively treat this as “assets managed on behalf of beneficiaries”?

The reality is though, that this “non distribution”, if it was genuinely being treated as the beneficiaries asset, it would still be earning a return in the trust, along the lines of monies kept in trust by attorneys and real estate agents. So there should still be income being generated on the money that is being kept in the trust. Most trustees though do not separate the “assets under management” from the other earnings, which should then be allocated to the beneficiary. So even if you argue that it’s not a “loan”, it doesn’t change the fact that there is a return on that asset that is currently not being correctly treated. Those assets under management will have tax consequences.

My point exactly Carmen. These cases are currently not treated correctly by some accountants. To treat it as a loan can never be correct. Once it is vested, the funds/assets belong to the beneficiary. Once vested, always vested. If the trust deed provides for a trustee’s discretion to hold back the vested funds, it remains vested in the beneficiary and any income generated by those funds belongs to the beneficiary and should be taxed in the hands of the beneficiary. The way in which it is invested will then determine the amount of the taxable income generated and to be taxed in the hands of the beneficiary and not some inappropriate, notional interest rate arbitrarily determined by legislation.

@Carmen @LoiusvV. Louis you used the word “vested” in your response earlier. My family trust specifically says that all loans to beneficiaries do not vest, are not repayable and are interest-free. Does the “vesting” point still hold true? I admit to getting a bit lost with all this new legislation coming forward.

@Phil99

A discretionary trust has full ownership of the assets of the trust. They are managing them for the benefit of the beneficiaries, but legal tile is with the trust. A trust deed or a trustee (dependant on set up) may have the discretion to vest the right in the asset with a beneficiary. Once the asset is vested, then it means that the legal right to that asset has now transferred to the beneficiary. It could be that the trust has still has the asset in it’s name, but it is now acting as an agent of the beneficiary with regard to that particular asset. Once this has happened, then effectively any income earned by that trust and any future capital gains belong to the beneficiary and not the trust in the same way that any asset you own generates income for you.

With respect to your question then – I presume that the reason the vesting paragraph is in there is to confirm that it is the trust that holds the right to the loans, not any of the beneficiaries. Simply put – it protects the beneficiaries from having the loans made payable by anyone other the trustees.

@Carmen in response to your @phil99. (I wish MW would allow more down-comments).
Thank you for your reply. You are clearly very clued up about trusts, so may I expand on my earlier question. Our trust has income in the form of dividends (net of DWT), capital gains (where we sell equities to pay for some expenses and may make a gain or a loss) and interest. To keep the tax in the trust at zero, we retain the dividend income as it is already taxed, but distribute the interest and any capital gain to the beneficiaries in whatever proportion we deem appropriate. Would this be deemed a “fiddle”? I do all the book-keeping myself and also produce financial reports and do the tax return. I’m also 75 and beginning to wonder if I should use an accountant, even though we cannot really afford such a luxury, and accountants (and lawyers) have this idea of charging on a percentage of the assets rather on a time and cost basis.

I may be wrong here but Carmen and Phil99 seem to me to be at cross purposes.

The discussion thread is really about the accounting presentation and correct tax treatment of the situation where a distribution by a trust to a beneficiary is not actioned with an actual transfer of assets.

So loans TO beneficiaries are off topic. My first reaction to the wording in Phil99’s trust is that if it’s not repayable [at all], it can hardly be a loan. Not repayable and not vested are surely mutually exclusive ? Perhaps all it’s meant to do is cover the situation where funds advanced in anticipation of a distribution prove excessive, and the overpayment (described rightly or wrongly as a loan) is carried through to be offset or adjusted in the next accounting period without having to be refunded immediately.

@phil99:
I certainly agree about the nested replies!

The methodology you are using is completely correct with regards to taxable income within the current framework of the law. The problem that your approach would result in under the new dispensation is that where those distributions are not matched with a physical outflow of cash, then you end up in the loan/assets under management argument that Louis and I were having.

I would however like to add that the legislation currently refers to “loans, advances and credits” and while I agree with Louis on the loans, I struggle to see how these distributions would not be credit. But that’s a side point.

@cheetah58 I agree that loans from a trust to a beneficiary are not impacted by this particular piece of legislation, but most people don’t really understand what vested means. Don’t see how it’s irrelevant in the context of trusts to explain the difference.

@carmen

Explanation of terms is never irrelevant ! I just thought Phil99 might have the wrong end of the stick, no matter.

So what is the problem in avoiding paying excesive tax, particularly in SA where taxpayers get so little for their tax payments?

Then at least be honest about it and don’t try to justify it by arguing something else.

Can you please comment on the situation where the trusts sole assets are as a result of donations by trustees within the tax laws of currently R100 000 per tax payer. I.E. NO interest free loan and NO donations in excess of the tax allowance.

Fully agree with LouisvV, that there is a real practical issue in not distributing trust income to benficiaries in the case where one wants to build funds for tertiary education. The student can then maybe pay fees off trust income.

Despicable how the collaborators and too many commentators seem to regard high tax as a good thing; a standard to be strived for. Tax s/be minimal in all instances.

This law is just another unethical tax grab. Sies.

pacraratc – in that case the normal section 7 attribution rules would still apply. There would be no section 7C imputed interest though.

MW your comments section is a blerrie disaster. Comments just disappear after the post button is pushed.

So again:

Can someone comment: what is the case if ALL trust assets are as a result of donations within the R100 000 per person tax limit. NO interest free loans involved.

Thanks.

Hi John.
Some comments are automatically referred for moderation and that is why they “disappear”. We try to moderate as soon as possible, but sometimes there may be a delay. Once approved, these comments will “reappear”. I apologise for this, but the racist and defamatory nature of many comments make this necessity.
Regards
Ryk

This is going to be hell on wheels if it goes through in its present form. There are “unintended consequences” here, though the ANC rulers may well decide that these are admirable and will add gravy. To make the legislation retroactive would be, IMHO, “unconstitutional”, given that everyone has had the right to order their affairs in order to minimize their tax liability. This is tax avoidance, which is not illegal as in the case of evasion. I see that from last year, SARS asked for a list of all loans to beneficiaries and other interested parties. This year, the whole list has disappeared and one has to complete the whole lot again. There is something sinister afoot here. I have no problem with new loans after 1/3/2017 (except for the obvious flaws in the draft). We have already had the insistence on independent trustees, following the SCA case of Parker, (which is the seminal work on the subject). Now people trying to order their affairs in accordance with the law are faced with the prospect of common law being overthrown for what I consider to be political reasons.

@ Carmen.

The trust I am involved in pays tax at 41% on taxable income earned, whether distributed or not. What is the problem then?

Nothing “passed through” yet.

I’m not sure I understand. If the trust is distributing the income, then the tax should be paid by the beneficiary, not the trust. The only way that the trust is paying the tax is if they are distributing the trust capital rather than the income.

What happen if the trust does no distributions at all? That is our idea: to build up capital to eventually have enough income to fund education.

The trust still earns income on it’s investment income and the rate is the top marginal rate of 41% at present.

The “pass through option ” will come to and end under proposed legislation. Trusts then get taxed at the full 41% on income. Obviously if no income then no tax.

If any different would appreciate more info.

Thanks.

PS. this what really irritates: Pass through to trustees that DONATE will be taxed at full 41% instead of their own marginal rate which is more ethical. Bad but probably too difficult as usual for the cancer guvmint.

@pacaratac

If the trust doesn’t distribute, then that tax is fully payable in the trust, you are 100% correct. As it stands, there has been no amendment to the ability of discretionary trusts to distribute the tax consequences to beneficiary if the distribution is made in the same year the income is earned.

Where this becomes problematic is that it still leaves us with how the funds got into the trust in the first place, which is where the real catch 22 occurs. You either need to be happy to pay the 20% donations tax up front, or you’re going to have this imputed interest on the loan. So new trusts are going to have a problem with how they fund their assets.

As for your last point: Under section 7, this deem back to the donor is already in the legislation and has been for YEARS. Most people who work with trusts just stick their head in the sand about it and pretend that section doesn’t exist…

Well, this stirred up quite the debate. Well I’ll throw in my 5 cents as well.

Can anyone tell me what the current government cost of living is for an individual. Let me explain what I mean: All the monies paid to some government institution by the average living person.

VAT, Income Tax, Fuel Levies, Road Levies, UIF, Carbon tax, sugar tax, a**h**e tax, property tax and don’t forget Eskom and their nasty price hikes as they are government controlled. All this nonsense that gets paid to different institutions of government.

Lets get a net figure here which we can use, and once you’ve calculated the net figure – do explain why you think it is justifiable to pay this to the state for the current services they don’t provide.

The fact remains although many people have used this gap to avoid tax, but so be it, that were the rules. But if you think anything’s going to get better with more taxes you’re fooling yourself. The same with economists and big financial advisers supporting “the government should raise taxes in order to save the country”. That is absolutely absurd there’s more than enough money to go around, we just need a capable government with values.

But what’s currently happening is the government is busy cutting off all the hands that’s feeding them. They anger the citizens month after month, destroying investments by making **cough nene** Professionals and other skilled individuals are fleeing the country and the rates of citizens leaving increase by the month.

Don’t get me wrong here with my following statement, but companies in America are literally poaching skilled individuals here. They don’t even make it difficult to move anymore.

People are sick of government costs constantly increasing. The individuals of the country will pay taxes and they will be willing to pay it and stop evading (illegal) taxes once they get some proper service for a change.

Regarding this change in legislation, the only thing that will happen is you will see a lot of cash start moving again.

Oh and of course – Don’t forget to vote ^.^

Easy question for a change. It depends who you are:
Category Cost of living
1. President – an unknown negative amount

2. Other govt politician and heads of SOE’s – zero

3. Govt employee – union dues only

4. The rest of us – Total govt revenue *( Total Population) / (Total category 1 + 2 + 3)

What if the loan is dollar denominated ? (Or some other currency where bank deposits pay no interest)

Under the current wordings – sucks to be you. Interest rate is set at the official rate of interest, currently 8,5%

So if you are invested in Yen, with negative interest rates, you still have to charge local official rates. Another reason this should not become legislation, but it probably will, as the ANC need more Bisto. G-d almighty!

@Phil99

Most pieces of legislation like this (such as transfer pricing) refer to market value rather than the official rate of interest. This means that where a loan is to be denominated in another currency, then you would use the appropriate interbank (repurchase/repo) lending rate of that particular currency to help determine the market value. The final bill may still have that amendment in it. I know most of the comments on the bill have been highly critical of this point.

The official rate is not linked to inflation. It is the repo rate plus 1%. Repo rate is currently 7.00%. Repo plus 1.00% is 8.00%, which is the current official rate.

as per @Carmen – and the long-term deterioration in the exchange rate results in a much higher rand value of the loan being subjected to estate duty later on.

If (big If) it’s feasible to denominate the loan in a chosen foreign currency, you should do it in a currency likely to weaken long-term against the rand (Zim $ would have been good) so that the rand value of the loan, and of the interest on it, dwindles over time.

Many thanks to Carmen, Cheetah58 and PeterJ for confusing me even more – no seriously, you have been very helpful and I now understand how to proceed. SARS may not be totally happy, but I can cover my tracks! 🙂

Reading cheetah58’s post I left wondering whether, within a particular jurisdiction, any laws (in particular taxation laws) exist that take into consideration other countries’s currencies.

yeah I was going to discuss the tax situation of trusts in aus (if funds distributed – then recipients pay the tax- if not the trust pays at top rate – 47%). BUT realised the issue is simply that the anc govt intends to tax everything and anything!

What is really shocking is the number of prominent people who happily collaborate with cancer.

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