The rise of the discretionary family trust has long seemed inevitable. It appears to provide unparalleled commercial and fiscal flexibility to achieve multi-generational wealth transfer, asset protection, estate planning and other objectives.
While family trusts with vested rights for beneficiaries with particular needs do have their place, beneficial owners generally believe that a discretionary family trust, in combination with an appropriate letter of wishes, allows them to adapt to changes in circumstances and to have peace of mind about access to trust assets when required. This may be achieved without compromising income splitting and other benefits associated with an elective flow-through tax dispensation.
Unsurprisingly, the regulatory and fiscal tide seems to have turned against trusts, particularly, discretionary trusts.
The changing fiscal landscape
In South Africa, initiatives to impose onerous tax treatment on trusts and their beneficiaries have become an established trend.
- Trusts have historically been taxed at the maximum personal tax rate on income and the highest rate on capital gains.
- In 2013, the National Treasury proposed to restrict the flow-through principle and that distributions of capital gains by a trust to natural persons would in future be taxed at income tax rates and not at capital gains tax rates but these proposals were not enacted.
- In 2015, the Davis Tax Committee recommended that:
- All distributions by offshore trusts to SA resident beneficiaries should be taxed as income and;
- Local trusts should be taxed as separate taxpayers at a flat rate of tax. This would mean that the conduit principle for local trusts would be removed so that the income of local trusts could no longer be taxed in the hands of beneficiaries or the donor at individual marginal tax rates as opposed to the higher flat rate of tax in the trust.
Fortunately, these proposals were not implemented.
- In 2016, anti-avoidance measures were introduced that treat the interest benefit on low-interest or interest-free loans provided by or at the instance of natural persons to trusts and certain companies related to trusts as a deemed donation.
- In 2018, amendments were made to disregard the participation exemption under certain circumstances, to preclude tax-free capital distributions by offshore discretionary trusts out of dividends that would have been exempt had the trust been a South African tax resident.
- In 2021, the anti-avoidance rules relating to funding of trusts and related companies by low-interest or interest-free loans were extended to preference share funding.
- Late in 2023, the conduit principle was terminated for distributions of income by local trusts to non-resident beneficiaries. Existing legislation does not cater for the application of the conduit principle to capital gains that are vested in non-resident beneficiaries by local trusts.
Regulatory changes
Internationally, transparency of beneficial ownership of trusts increased significantly following the introduction of the Common Reporting Standard and the resulting Automatic Exchange of Information between various revenue authorities around the world.
The South African Revenue Service ("SARS") recently introduced detailed disclosure requirements to record the beneficial owners of trusts to comply with the Financial Action Task Force requirements.
Trustees are also obliged to lodge and keep up-to-date records of the beneficial ownership of the trusts of which they are trustees, and to record comprehensive data regarding beneficial ownership of trusts with The Master of the High Court.
Funding challenges
Trusts are generally funded by donations or loans. Both methods involve tax costs for a South African resident funder.
Donations by South African residents are subject to donations tax of 20% or 25% to the extent that donations in aggregate exceed R30m (subject to an annual exemption of R100 000 donated by natural persons). In addition, capital gains tax ("CGT") may apply to a donation of assets that fall within the CGT net.
As indicated above, the interest benefit of low-interest or interest-free loans to trusts is subject to deemed donations or, in the case of cross-border loans to a connected person, transfer pricing provisions. Interest earned on interest-bearing loans constitutes the gross income of a South African resident lender.
In addition, attribution rules may tax income and capital gains attributable to donations and non-arms-length loans in the hands of the donor.
Vested rights in respect of trusts
In the current dynamic tax and regulatory environment, providing certain vested rights to beneficiaries may offer unique solutions.
The potential to create a hybrid trust instrument which has both discretionary and vested features makes the structuring opportunities particularly attractive. In this scenario, vested rights can co-exist within the framework of a discretionary trust.
Historically, vesting trusts have often been regarded as less effective than discretionary trusts for reasons such as tax inflexibility, the inclusion of vested rights as property for estate duty purposes and the exposure of vested rights to creditors.
Beneficial owners are beginning to reassess the apparent drawbacks of vested rights compared to potential funding and other benefits.
For example, while vested rights may indeed be exposed to creditors, it must be recognised that the rights of the creditor remain subject to the terms of the trust instrument. This opens the door for creating an instrument that provides protection without having to rely on the non-vesting of some of the rights of beneficiaries.
Careful structuring of the terms of the relevant vested rights in the trust may enable funding of the trust through a contribution that does not constitute a donation for donations tax purposes.
This outcome not only precludes donations tax but also becomes the defence against the application of the attribution rules to resultant income and capital gains derived by the trust.
Of course, careful planning is required to achieve a contribution that remains outside the ambit of a donation yet does not fall within the provisions that would treat it as an interest-bearing instrument. Should this requirement be overlooked and a contribution to a trust constitutes an interest-bearing arrangement, a funder may well have to face tax liabilities without any cash flow to fund the tax.
Even if the above guidelines and requirements are observed, a beneficial owner may well be concerned about the estate duty impact of such vested rights. This enquiry must be addressed bearing in mind that donations (in this case to a trust) would constitute deemed property for estate duty purposes and that a loan to a trust constitutes property. The challenge is to structure an arrangement that achieves the above-mentioned objectives and mitigates the estate duty exposure of the funder.
It should be noted that contributions made by a resident to an offshore trust which exceeds ZAR10 million, where such resident has or acquires a beneficial interest in the offshore trust, are reportable to SARS within 45 business days. Consideration should be given to when the relevant resident acquires such beneficial interest in the offshore trust. This may not be at the time that the relevant contribution is made to such trust.
Conclusion
The changing environment of an increasing fiscal clamp-down on trusts may well spur a new generation of vested rights in respect of trusts that could challenge the perceived axiomatic superiority of purely discretionary family trusts.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.