THE CAPITAL GAINS TAX CONSEQUENCES OF RESIDENT TRUSTS
Author: Dr Hendrik Coetzee CA (SA) H Dip Tax Law MCom DCompt
When one considers creating a trust regard must be had, not only to the reason why a trust is chosen as a vehicle as apposed to a partnership, company or close corporation, but also to the provisions relating to capital gains tax, income tax, donations tax, value added tax (VAT), estate duty, and transfer duty. The introduction of Capital Gains Tax (CGT) on 1 October 2001 complicated the use of trusts from a fiscal point of view.
The following issues are discussed in this article:
Effective CGT rates of trusts;
Vesting and non-vesting trusts;
Disposals of capital assets in the context of a trust and the liability to pay CGT;
Donations to a trust;
Loan accounts with trusts;
The concept of value shifting and trusts;
Non-resident trusts; and
Primary residences and trusts.
EFFECTIVE CGT RATES APPLICABLE TO TRUSTS
The CGT inclusion rate for all trusts other than special trusts is similar to that of companies, namely 50%. Special Trusts are those that are established to manage the financial affairs of persons who suffer from a mental illness or physical disabilities. It means that if a trust disposes of a capital asset, 50% of any realised capital gain will be subject to CGT and will be taxed at the trust’s income tax rate.
In respect of all years of assessment starting on or after 1 March 2002, trusts, other than special trusts and testamentary trusts with minor children as beneficiaries, will be taxed at a flat income tax rate of 40%. This results in an effective CGT rate of 20% in respect of all other trusts, both inter vivos and testamentary.
Special trusts are subject to income tax and CGT at the rates applicable to individuals. Thus only 25% of any capital gain will be subject to CGT. Consequently the effective rate at which capital gains would be subject to CGT taxed would vary between 4.5% and 10%, that is, between 25% of 18% and 25% of 40%.
Only special trusts qualify for the annual R10 000 exclusion from CGT pertaining to individuals.
VESTING AND NON-VESTING TRUSTS
A non-vesting trust, sometimes also referred to as a discretionary trust, is a trust where the trustees of the trust have a discretion to deal with trust property as they deem fit in terms of the provisions of the relevant trust deed.
Generally, a beneficiary of a discretionary trust has no vested right in relation to trust property other than a hope that he/she may benefit by the decision of the trustees to exercise their discretion in their.
A vesting trust is a trust where trust property vest in the beneficiaries in terms of the relevant trust deed. The beneficiary has a right to specific assets and normally the trust deed provides that he/she may not take possession of trust property until the expiry of some period of time. Thus, trust property belongs to the beneficiaries subject to the terms of the trust deed, albeit that normally they may not take possession until the happening of some event, such as the expiry of a certain period of time.
The difference between these two kinds of trusts is important when considering their CGT consequences.
DISPOSALS OF CAPITAL ASSETS BY TRUSTS TO RESIDENTS AND THE LIABILITY TO PAY CGT
A trust may dispose of property in the following four manners:
Disposal of assets by a discretionary trust to a resident third party who is not the founder, trustee or beneficiary of the trust concerned;
Disposal of assets by a vesting trust to a resident third party who is not a founder, trustee or beneficiary of the trust concerned;
The vesting of a trust asset by the trustee in a beneficiary; and
The distribution of such a vested asset by the trustee to the beneficiary in whom it vests.
Disposal of assets by a discretionary trust to unrelated resident third parties
A capital gain would be realised when the proceeds received on disposal of an asset exceed the base cost of the asset. A capital loss would be incurred when the base cost of the asset exceeds the proceeds realised on disposal of the asset.
The base cost represents such costs as the cost of acquiring, creating and valuing the asset. The proceeds are the amounts received by or accruing to or in favour of a person as a consequence of disposing of an asset.
If the capital gain realised by the trust on the disposal of the asset that vests in the hands of the beneficiary the capital gain accrues to the beneficiary and not the trust. It is possible that such a beneficiary has a CGT liability while he/she has not yet received the gain in terms of the relevant trust deed.
Disposal of assets by a vesting trust to unrelated resident third parties
A capital gain or loss will be realised by the beneficiary and the beneficiary will have to account for CGT on any capital gain. A capital loss realised by the beneficiary may be utilised to reduce the beneficiary’s capital gains for that or a future year of assessment.
Again, it is possible that such a beneficiary has a CGT liability while he/she has not yet received the gain in terms of the relevant trust deed.
The vesting of a trust asset in a beneficiary
The vesting of a trust asset in a beneficiary is included as a “disposal” for the purposes of CGT. Thus, in the case of a discretionary trust, the trust will be deemed to have disposed of an asset when such asset is vested in a beneficiary in terms of their discretionary powers under the trust deed. Any capital gain realised when an asset is vested in a resident beneficiary will accrue to the beneficiary concerned and not the trust. This is the case even where the proceeds do not in terms of the relevant trust deed vest in the beneficiary until the happening of a certain event such as the passage of time.
Al disposals by a trust to a beneficiary will be deemed to take place at market value because the parties are related under the Income Tax Act.
The distribution of such a vested asset by the trustee to the beneficiary in whom it vests
The distribution of a trust asset to a beneficiary with a vested right in that particular asset is not considered to be a “disposal” for CGT purposes. Thus, when the trustee distributes such an asset to the beneficiary with a vested right in the asset, no CGT becomes payable.
DONATIONS TO A TRUST BY A RESIDENT
A trust is an arrangement between the founder of the trust and the trustees to the effect that certain assets will be held and be administered by the trustees for the benefit of certain beneficiaries.
Sometimes the founder makes a donation to an inter vivos trust upon creation. Where such donation is in the form of a capital asset it will be regarded as a disposal for the purposes of CGT. When such a donation takes place, the affect will be that the donor will be deemed to have disposed of the asset for proceeds equal to the market value thereof and in consequence will realise a capital gain or loss depending on the base cost of the asset. A donation of a capital asset could have both a donations tax and a CGT implication for the donor.
The trust, on the other hand, will be deemed to have acquired the capital asset at a cost equal to its market value. Should the capital asset thereafter be vested in a specific individual beneficiary, the individual beneficiary would be liable for CGT on 25% of the capital gain of that asset. If the trust should dispose of that asset to a resident unrelated third party, it will have to pay CGT on 50% of the capital growth of that asset.
LOANS TO TRUSTS
Sometimes, for the purpose of an estate plan, a person would sell an asset to a trust on loan account and thereafter reduce the loan account, or waive a portion thereof with an amount equal to the amount that may annually be donated free from donations tax, currently R30 000 per year per individual.
A waiver or reduction of a loan is regarded as a disposal for CGT purposes. Thus if, say, R30 000 of a loan account is waived the trust would be regarded to have received a capital gain of R30 000 because it was relieved of a debt, resulting in a taxable capital gain of R30 000 in the hands of the trust.
If the founder who waived or reduced a portion of the loan account is also a beneficiary or a relative of a beneficiary of the trust, the capital loss realised by the founder on the partial reduction or waiver of the loan will be ring-fenced. This means that such a capital loss may only be utilised against capital gains realised from disposals by the founder to the same trust.
Something to take note of is that an interest free loan may be deemed to be an ongoing donation as far as the amount of interest that was waived is concerned.
THE MEANING OF VALUE SHIFTING AND TRUSTS
Value shifting is the shifting of value between connected persons in a way that would otherwise not have been a disposal for CGT purposes and would therefore not have triggered the payment of CGT.
For an arrangement to qualify as a value-shifting arrangement, it has to meet the following requirements:
It must be an arrangement by which a person retains an interest in a company, trust or partnership, but following a change in the rights or entitlements of the interests in that company, trust or partnership (other than a result of a disposal at market value), the market value of the interest of that person decreases and –
The value of the interest of another person held directly or indirectly in that company, trust or partnership increases; or
Another person acquires a direct or indirect interest in that company, trust or partnership.
If a value shifting arrangement took place in the context of a trust, resulting in a disposal for the purpose of CGT, the market value of the interest of the person who retains an interest in the trust after the arrangement, should be deducted from the market value of his/her interest before the arrangement to determine his/her proceeds from the disposal. Expressing the difference in the market value of his/her interest before and after the arrangement as a percentage, and reducing the base cost of the disposed interest by that percentage determine the base cost.
Trusts established outside South Africa and not effectively managed by the trustees from within the country will qualify as a non-resident trust.
If a resident beneficiary should acquire a vested right to a capital amount in a non-resident trust that were not previously subject to capital gains tax in South Africa, and would have been subject to CGT had the trust been a resident, the amount must be subjected to CGT in the hands of the resident beneficiary. This will be so, irrespective of whether the amount has actually been distributed to the resident beneficiary by the trustees.
PRIMARY RESIDENCES AND TRUSTS
Capital gains realised on the disposal of a primary residence registered in the name of a natural person or special trusts are exempt from CGT up to the first Rl million. A primary residence is a residence, owned by a natural person or special trust, that is resided in by that natural person or beneficiary of the special trust as a main residence, and that is used by that natural person or beneficiary of the special trust mainly for domestic purposes. Note that this exemption does not apply to other trusts, companies or close corporations.
The use of trusts, from a tax point of view, is becoming more complicated by the day. Many persons have made use of trusts without sound reasons. The first question to ask oneself when considering the possibility of creating a trust is: Why would I need a trust – why not a company or close corporation? A point to keep in mind is that in some instances a trust could be preferred due to reasons other than tax avoidance.
There seems to a lot of ignorance surrounding the use of trusts. Thus my advice: Consult a qualified professional before creating a trust – you may be better off without one!