A new era in taxation commenced on 1 October 2001 for all residents (including trusts) and, in some instances, also non-residents, with the introduction of capital gains tax (CGT) in the Taxation Laws Amendment Act 5 of 2001 on 20 June 2001 in the Income Tax Act (“the Act”). Certain consequential amendments are effected to the Income Tax Act and an eighth schedule containing the CGT stipulations are introduced to the Act. This paragraph on capital gains tax reflects the position of the Income Tax Act with all its amendments until May 2004.
The explanatory memorandum on the Taxation Laws Amendment Bill 2001 at 105 describes the position with regard to trusts as follows:
“The disposal of an asset to or by a trust, for example by vesting it in a beneficiary of the trust, is as a general rule subject to the proposed general principles governing disposals, base cost and proceeds as well as to the general anti-avoidance and loss limitation rules. The disposal of an asset to a beneficiary is, for example, subject to the connected persons rule in the proposed paragraph 38 while a disposal to a trust might be subject to the ‘clogged losses’ rule in the proposed paragraph 39. It is proposed that a capital gain arising from the disposal of a trust asset will be taxable either in the hands of the trust or where an attribution rule applies, in the hands of a beneficiary or a person who made a donation, settlement or other disposition to the trust”.
Who is liable to pay CGT?
Because a trust is defined in the Act as a “person” (see B21.1.1 supra) for income tax purposes, it is, in terms of section 26A of the Income Tax Act, liable to include in its taxable income for the year of assessment its taxable gain for that year of assessment as determined in terms of the Eighth Schedule. As will be indicated below, subject to the anti-avoidance rules finding application or not, under certain circumstances the beneficiaries can be liable for the tax on a capital gain. Where the anti-avoidance rules do find application, persons such as the founder and others who, for the purposes of these rules, qualify as donors, can be liable for the capital gains tax in the form of income tax.
A “special trust” for the purposes of certain CGT stipulations means a trust contemplated in paragraph (a) of the definition of “special trust” in section 1 of the Act. Therefore, unless specifically referred to, the testamentary special trust is excluded. (See par 1 Eighth Schedule and B21.1.1 supra.)
Tax rates and annual exclusions
Where a person (trust) has determined a net capital gain for the current year of assessment, such amount is multiplied by the inclusion rate to determine that person’s taxable capital gain, which is to be included in that person’s taxable income for the year of assessment. The inclusion rate of a trust other than a unit trust (which is exempt) or a special trust as defined in section 1 of the Act (therefore including a testamentary special trust, which is 25%) is 50%. When the inclusion rate is multiplied by the statutory income tax rate, the effective rate of a trust is 20% for trusts other than unit trusts, and, in the case of special trusts, the effective rate is nil–10% (Eighth Schedule pars 4–10).
The annual exclusion of a natural person and a special trust, as defined in the (a) part of the definition (see B21.1 supra), in respect of a year of assessment is currently R17 500; for 2009, R16 000 and for 2008 R15 000 and since 1 March 2006 it has been R12 500 (until 28 February 2006 it was R10 000) of the total capital gain for that year of assessment. This exclusion does not apply to other trusts (Eighth Schedule pars 5–7).
The disposal of an asset triggers liability for CGT. “Asset” is defined in the Eighth Schedule par 1 as including property of whatever nature, whether movable or immovable, corporeal or incorporeal, excluding any currency, but including any coin made mainly from gold or platinum, and a right or interest of whatever nature to or in such property.
“Disposal” inter alia includes any event, act, forbearance or operation of law which result in the creation, variation, transfer or extinction of any asset such as a donation or sale of an asset, the vesting of an interest in an asset of a trust in a beneficiary or the decrease in value of a person’s interest in a trust as a result of a value-shifting arrangement (Eighth Schedule par 11(1)).
“Value shifting” means an arrangement by which a person retains an interest in a trust, but following a change in the right to or entitlements of the interest in that trust (other than as a result of a disposal at market value as determined before the application of par 38), the market value of the interest of that person decreases and (a) the value of the interest of a connected person in relation to that person held directly or indirectly in that trust increases; or (b) a connected person (see B27.6 infra) in relation to that person acquires a direct or indirect interest in that trust (Eighth Schedule par 1). The time of disposal is the date on which the interest vests or the date on which the value of a person’s interest decreases (Eighth Schedule par 13). A specific formula applies in the calculation of the base costs in the event of value shifting (Eighth Schedule par 23).
Certain disposals of an asset are specifically excluded, such as disposals by a trustee in respect of the distribution of an asset of the trust to a beneficiary who has a vested interest in that asset prior to distribution, and disposals by a trustee in respect of a change in ownership in an asset as a result of the termination of the appointment of a trustee or the appointment of a new trustee (Eighth Schedule par 11(2). See also B27.6 infra).
Base costs and capital gain
Where an asset is disposed of in a particular year of assessment the capital gain for a year of assessment (in respect of the disposal of an asset during that year) is equal to the amount by which the proceeds received or accrued in consequence of that disposal exceed the base costs of that asset. The reverse constitutes a capital loss. Base costs, therefore, play an important role in CGT and are determined according to the rules prescribed in Eighth Schedule part V (pars 20 to 34).
Despite paragraph 38(1)(b) a person’s interest in a discretionary trust must be treated as having a base cost of nil (Eighth Schedule par 81). This can have an effect in the case of the “sale of a trust” (see par 24.5.2 supra). Where for instance an individual beneficiary disposes of his interest in a discretionary trust to another person, the full value of the interest will be regarded as a gain. It is, however, extremely difficult to determine the full value of an interest where a group of individual beneficiaries (persons) in a fully discretionary trust disposes of their contingent right to another group of persons. Williams RC Capital Gains Tax: A Practitioner’s Manual at 24–25 and 250 expresses his doubts as to whether this spes or expectancy in the case of a discretionary trust is an “interest in or to property” of the kind contemplated in paragraph (b) of the definition of “asset”, and concludes that a mere right in personam against the trustee which such a beneficiary possesses (after acceptance of the benefits) does not constitute an “asset” in this sense.
The value of the interest of the vested beneficiary will, according to Meyerowitz on Income Tax par 39.16.10, depend upon the net value of the trust, but unless the beneficiary pays for his interest he will have no base cost. The same authors further maintain that in the case of what may be called a trading or commercial trust, a beneficiary would be contributing directly to the trust and thereby establish a base cost for his interest so that in the event of the sale of his interest his gain would be the difference between the proceeds from the disposal on the one hand and his costs in acquiring and retaining his interest on the other.
When the trustees vest a trust asset in a beneficiary, the base cost of the beneficiary’s interest in the trust must be increased by his cost of acquisition of the asset, which is the base cost of the asset to the trust. Therefore the base cost of the trust “migrates” to the beneficiary (De Koker par 24.129).
Capital gain attributed to a beneficiary
Where a capital gain or loss is determined in respect of the vesting by a trust of an asset in a trust beneficiary (who is a resident), that gain or loss must, subject to the anti-avoidance rules in paragraphs 68, 69, 71 and 72, be disregarded in the hands of the trust but must be treated as that beneficiary’s gain who then pays CGT (Eighth Schedule par 80(1)). It may happen, however, that a beneficiary does not acquire a vested interest in the asset itself but holds, or may acquire, a vested interest only in a capital gain on the disposal of the asset. This vested interest in the capital gain may be conferred by the trust deed or may arise as a result of the trustees’ exercising of their discretion to distribute only the gain (in the form of cash) to the beneficiary. The capital gain which in this way vests in the beneficiary will, subject to the anti-avoidance rules in paragraphs 68, 69, 71 and 72, be taxed in the hands of the beneficiary (who is a resident) rather than the trust. (pars 80(2) and B27.8 infra). Should the asset be distributed to a non-resident beneficiary or be disposed to a third party, and the gain not distributed to the resident beneficiary, any capital gain on the asset (value at date of distribution minus base costs) will be taxable in the hands of the trust (trustees as representative taxpayers) at 20% – the effective flat rate of tax for a trust. There are differing views on the tax liability of a distribution of a capital gain to a non-resident beneficiary namely that the coduit principle apply also in such an instance (where par 80(2) only makes mention of a resident beneficiary) and that the capital gain shall be taxable in the hands of the non resident. (See Clegg D “Capital Gains Tax-Non-Resident beneficiaries of a trust and the coduit principle” The Taxpayer February 2008 at 7).
Since a natural person’s effective rate of tax (nil–10%) is lower than that of a trust and since a natural person qualifies for the annual exclusion of R17 500, which exclusion is not, save for a special trust in terms of paragraph 1 of the Eighth Schedule (excluding a testamentary special trust), available to a trust, tax will be saved if an asset or a gain, as set out above, is awarded to a beneficiary who is a resident. If an asset or gain is allocated to more than one resident beneficiary, it will be possible to reduce the rate of tax further, if the beneficiaries have little other income and, therefore, pay low marginal rates of tax because each will be entitled to the annual exclusion of R17 500, unless it is already absorbed by their other gains (par 5(1), Stein M 2001 Capital Gains Tax Principles and Planning at 37 but contra De Koker par 24.127).
The above is also confirmed by the explanatory memorandum at 106 where it is stated that the attribution of a capital gain to a donor or beneficiary, who is a natural person or a person other than a trust, will, therefore, result in a lower effective rate in respect of the gain. Capital losses determined in respect of the disposal of trust assets will, however, be trapped in the trust (Eighth Schedule pars 8, 9 and 39). Therefore, where capital losses are arising on the vesting of trust assets in a beneficiary, these losses may not be “shifted” from the trust to the beneficiary, but remain in the trust and must be treated in terms of paragraph 39, because paragraph 80(1) and (2) only refer to “assets” and “gains” and not to “losses” (De Koker par 24.127).
The date of vesting is the date of disposal to a beneficiary (par 11(1)(d) read with 13(1)(d)) and the distribution of an asset to a beneficiary who has a vested right is not a disposal (par 11(2)(e)).
Where, during any year of assessment, any resident acquires a vested right to any amount representing capital of any trust which is not a resident, which capital arose from a capital gain of that trust determined in any previous year of assessment during which that resident had a contingent right to that capital or any amount which would have constituted a capital gain of that trust, had that trust been a resident, and that capital gain has not been subject to tax in the Republic in terms of the provisions of the Income Tax Act, that amount must be taken into account for the purposes of calculating the aggregate capital gain or aggregate capital loss of that resident in that year of assessment (Eighth Schedule par 80(3)). Other than a vesting in a public benefit organisation or a foreign entity where a resident of the Republic has made a donation to a trust and there is a capital gain attributable to the donation vesting in or treated as vesting in a non-resident (other than a controlled foreign entity in relation to the resident), the gain is to be taken into account in determining the aggregate gain or aggregate capital loss of the resident (Eighth Schedule par 72 and Meyerowitz on Income Tax par 39.16.7).
Special rules apply when an asset is disposed of to a trust which is a connected person of the person making the disposal. “Connected person” is defined in section 1 of the Income Tax Act as “in relation to a trust – (i) any beneficiary of such trust; and (ii) any connected person in relation to such beneficiary” and as “in relation to a connected person in relation to a trust… includes any other person who is a connected person in relation to such trust”. In this definition “beneficiary” means “any person who has been named in the will or deed of trust concerned – (i) as beneficiary; or (ii) as a person whom the trustee of the trust has the power to confer a benefit from such trust”. Where an asset is disposed of to such a trust for a consideration that does not reflect an arm’s length price, the disposal will be deemed at market value and the trust will be deemed to have acquired it at a cost equal to the same value (Eighth Schedule par 38; see also B27.3 supra).
A person must, when determining the aggregate capital gain or aggregate capital loss of that person, disregard any capital loss determined in respect of the disposal of an asset to any connected person in relation to that person. For the purposes of this paragraph (39), a connected person in relation to a natural person does not include a relative of that person other than a parent, child, step-child, brother, sister, grandchild or grandparent of that person. Furthermore, a person’s capital loss which is disregarded in terms of these stipulations may be deducted from that person’s capital gains determined in respect of disposals of assets during that year or subsequent years to the same person to whom the disposal giving rise in that capital loss was made, if at the time of those subsequent disposals, that person is still a connected person in relation to that person (Eighth Schedule par 39(1), (2) and (3)). In terms of section 1 of the Income Tax Act “spouse” in relation to any person means
“a person who is a partner of such person –
in a marriage or customary union recognised in terms of the laws of the Republic;
in a union recognised as a marriage in accordance with tenets of any religion; or
in a same-sex or hetrosexual union which the Commissioner is satisfied is intended to be permanent, and
‘married’, ‘husband’ or ‘wife’ shall be construed accordingly: provided that their marriage or union contemplated in paragraph (b) or (c) shall, in the absence of proof to the contrary, be deemed to be a marriage union without community of property”.
Death of beneficiary of a special trust
When a beneficiary of a special trust (see par B21.1.1 and the definition in Eighth Schedule par 1) dies, the trust must continue to be treated as a special trust for the purposes of CGT until the disposal of all assets held by it or until two years after the date of death of the beneficiary, whichever comes first (Eighth Schedule par 82). A special trust, defined in the (a) part of the definition (not applicable to a special testamentary trust for minors), also qualifies for the annual exclusion and exclusion in respect of primary residence (Eighth Schedule par 45(1)), personal use assets (Eighth Schedule par 53(1)), and compensation for personal injury, illness or defamation of a beneficiary of that trust (Eighth Schedule par 59).
1 Donations and disposals not at arm’s length
See paragraph B27.6 supra and Eighth Schedule paragraphs 38 and 39.
2 Attribution of a capital gain that is subject to conditional vesting
Where a person (a) has made a donation settlement or other disposition (see par B21.4.2 supra) which is subject to a stipulation or condition imposed by such person, or any other person, to the effect that a capital gain or portion thereof shall not vest in the beneficiaries until the occurrence of some event (such as the exercising of a discretion by trustees of a trust), and (b) when a capital gain has arisen as a result of a donation during the year of assessment but has not vested in any beneficiary, and (c) when the person who made the donation has been a resident throughout the same year of assessment, the capital gain will be taken into account in determining the aggregate capital gain or loss of the person who made the donation, settlement or other disposition and will be disregarded in the determining of any other person’s aggregate capital gain or capital loss (par 69 of the Eighth Schedule). These provisions are similar to those of section 7(5) as discussed in B21.5 supra.
If the donation, settlement or other disposition has been made by a natural person, the deeming provisions will cause less tax to be payable because the natural person’s effective rate will be lower than the effective rate of a trust (Stein Capital Gains Tax 42).
3 Attribution of capital gain that is subject to conditional vesting and distributed to certain beneficiaries
When a person makes a donation, settlement or other disposition to a trust under the circumstances described in B27.8.2, above, and the trustees of a trust which is a connected person distribute or allocate the capital gain to –
a spouse of the person who makes such a donation, settlement or other disposition, where the provisions of paragraph 68 apply, the said gain will be attributed to the spouse who makes the donation, etc. The requirements for such an attribution are that:
a donation, settlement or other disposition was made; and
it was carried out mainly for the purpose of reducing, postponing or avoiding liability for any tax (Eighth Schedule par 68 as well as the definition of “spouse” referred to in par B27.6 supra);
a minor child of the person who makes the donation settlement or other disposition, where paragraph 69 applies, the said gain will be attributed to the parent who makes the donation, etc. The requirements are similar to those of section 7(3) and 7(4) discussed in B21.6 supra.
4 Assessed capital losses
The Commissioner may deny a trust from setting off a capital loss when he is satisfied that the proceeds of the disposal of an asset have been derived by the trust on the disposal of an asset as a direct or indirect result of:
an agreement affecting the trust;
a change in the trustees or beneficiaries of the trust;
if such an agreement or change was entered into solely or mainly for the purpose of using it in order to avoid liability of tax.
The onus is on the taxpayer to show that the intention was not to avoid tax (s 103(2) and 103(4)).
5 Attribution of income as well as of capital gain limited
Where an amount of income, as well as a capital gain, has been derived from or attributable to a donation, settlement or other disposition made by a person, the amount of that income, as well as that capital gain, may be subject to the attribution rules embodied in section 7 and paragraphs 68 to 72 of the Eighth Schedule respectively. This may result in the taxation of both amounts in the hands of the donor (the person who made the donation, settlement or other disposition). Paragraph 73 limits the total amount of the income and gain that can be taxed in the hands of the donor to the amount of the benefit derived from the donation, settlement or other disposition by the person to whom it was made (the donee). The quantified benefit to the donee from, for example, an interest-free or low-interest loan will, therefore, determine the extent to which any resulting income and capital gain can be attributed to the donor (explanatory memorandum at 98). The value of a benefit in the case of an interest-free loan is equal to the amount of interest expenses saved by the trust as a result of the loan. Assuming that the trust would have been able to obtain a loan from a financial institution at an interest rate of, say, 12,5% per annum, the trust saves an amount during the first year equal to the amount of interest that would have been payable at this rate.
The trust would not have been able to distribute the full amount of any trust income and the full market value of any trust asset to the trust beneficiaries had it been obliged to pay the interest. Any income would have had to be applied to pay the interest charged and can, therefore, (according to the explanatory memorandum at 110) be treated as having arisen by reason of the donation made by the donor. Therefore, income that was vested in, for example, the donor’s minor child can be taxed in the donor’s hands in terms of section 7.
The amount of income so deemed to be that of the donor must, in terms of paragraph 73, be deducted from the total amount of interest saved by the trust as a result of the interest-free loan extended by the donor. The remaining amount (total amount of interest saved minus the total amount of income) of, say, an amount of R262 500 deemed interest after deducting R52 500 income in the trust, namely R210 000, amounts to 60% of the capital gains of, say, R350 000 realised by the trust in respect of disposals during a particular year. The amount of R210 000 represents the maximum amount of the capital gain that may be attributed to the donor in terms of paragraph 73. (It represents the portion of the gains that would have had to be applied by the trust to pay interest at a market-related rate.)
6 Attribution of capital gain that is subject to revocable vesting
Where a donation, settlement or other disposition (donation) confers a right upon a beneficiary, who is a resident, to receive a capital gain attributable to that donation and where that right may be revoked or conferred upon another by the person who conferred it and where such capital gain has, in terms of that right vested in that beneficiary during a year of assessment throughout which the person who conferred that right has been a resident and has retained the power to revoke that right, the capital gain will be taken into account in determining the aggregate capital gain or loss of the person who retained the power of revocation and will be disregarded in the determination of the capital gain or loss of the beneficiary (par 71 which is similar to the provisions of s 7(6)).
9 Estate planning opportunities
The introduction of capital gains tax into the tax system of South Africa has the result of making, more than ever before, estate owners and estate planners adopt a holistic approach to the advantages and disadvantages of a trust.
The mere fact that the effective rate of capital gains tax applicable to a trust is substantially higher than that which is applicable to a natural person may cause one to reconsider the effectiveness of a trust as an estate planning tool. However, as indicated above, it is exactly these differences in effective rates that may cause an estate owner to have the capital gain attributed to him in terms of the attribution rules. This will not only cause less capital gains tax to be payable but may also cause the estate owner to diminish his estate more rapidly than would have otherwise been the case.
If the saving of estate duty is added to the holistic picture, together with the financial risk protection a trust can offer, the advantages of the trust substantially outnumber the disadvantages.
This can best be illustrated by the following example. Mr X has a sizeable estate in excess of R3,5 million, with no substantial deductions applicable. He inter alia owns a commercial property with a base cost of R1 million which, upon his demise, is valued at R1,6 million. The capital gain of R600 000 may, upon his demise, attract income tax in the amount of approximately R59 000 (10% on the gain after deduction of the annual exclusion). This amount must be added to the amount of estate duty the commercial property will attract in Mr X’s estate, namely 20% on R1,6 million which is R309 000. Thus, we arrive at a total tax and duty liability of R364 000. If Mr X had sold the property to his family trust for an amount of R1 million while the base cost was still R1 million, effectively creating a loan account in his favour of R1 million, the occurrence of his death will not attract capital gains tax if the loan account is still R1 million upon his demise and bequeathed to a spouse or a separate non-debtor trust or where a cash amount of R1 million or a cash amount which is to be calculated upon his demise as being equal to the amount of the loan is bequeathed to the debtor trust. In this way it cannot constitute a debt disposal in terms of paragraph 12(5) (see pars 56 read with 12(5), 3(b)(ii), 20(3), 38, 34, 40, 67 and 1 definition of “asset”.) However, in ITC 1793 (2007) 67 SATC 256, it was decided that if the loan itself (“Enige bedrag wat die B . . . Familie Trust onder leningsrekening aan my verskuldig mag wees, . . .”) is bequeathed to the debtor, such a bequest constitutes a debt disposal, subject to capital gains tax on the full amount of the loan. In ITC 1835 (2008) 71 SATC 105 the court came to an opposite conclusion (See also Meyerowitz D “Capital Gains Tax: Beware of Paragraph 12(5) of the Eighth Schedule” The Taxpayer September 2009 at 163. Upon the death of the testator, and assuming the R3,5 million abatement has been “used up” already, the loan account will attract estate duty in the amount of R200 000 in his estate if bequeathed to the trust as indicated above. Compared with R364 000 where no trust is utilised, the saving of R164 000 is substantial.
If the asset is subsequently sold by the trust for R1,6 million and if only the gain is distributed to, say, six beneficiaries, who are Mr X’s grandchildren, to pay for their studies while they themselves earn very little other income, no tax is payable on the capital gain. The R1 million retained in the trust can be re-invested by the trustees in another fixed property and the process can be repeated.