In a recent article tax expert Matthew Lester looked at the Davis Tax Committees interim report around estate duty. The report seeks public comment but suggests that estate duty is in dire need of modernisation. In a follow up article, Lester looks at the implications of some of the recommendations, and what could mean for people with trusts and proposed tax changes, if the Finance Minister signs off on them.
by Matthew Lester
The taxation of trusts is a contentious subject that, along with estate duty, is in dire need of modernisation. This process has now started with the release of the first interim report of the Davis Tax Committee on estate duty (July 2015: Available on taxcom.org.za)
Estate duty was implemented in South Africa in 1955 and its overall contribution has now declined to negligible proportions, a mere R1 billion out of total tax collections of R1.1 trillion. There are various reasons for this including longevity, poor enforcement and the unlimited inter-spouse abatement.
But it cannot be denied that the wealthy are able to dispense with their potential estate duty liability by transferring their wealth into trusts that endure indefinitely, irrespective of the death of the founder.
The Katz Commission of Enquiry briefly looked at estate duty back in 1997 and recommended that it be replaced by Capital Transfer Tax (CTT).
CTT is awfully complex as it involves the periodic measurement and taxation of wealth. The moment that valuations come into tax there is plenty of scope to manipulate. Even if this could be controlled the difficulty arises, ‘where does the cash come from to pay the tax when the underlying asset has not yet been sold?’ Furthermore the international experience is that CTT does not yield handsome revenue streams. For all these reasons the DTC recommended that CTT is not the answer for RSA.
When it comes to trusts, taxpayers are allowed to have his cake and eat it. Not only is estate duty hit to leg, but the trustees can manipulate the income of the trusts to be taxed in the hands of the donor or the beneficiary using sections 7.25B and the 8th schedule of the income tax act. These provisions are often referred to as the attribution or conduit principles.
When it comes to the capital gains of trusts this allows the taxpayer to cause the capital gains to be taxed at personal CGT rates and thus vastly reduce CGT liability. Although both trust and individuals have the same top marginal tax rate (41%) individuals enjoy the lower progressive tax rates up to taxable income levels of R701,300.
The DTC went back into the history of the taxation of trusts and found that the attribution/conduit principles were promulgated at a time when personal income tax rates were substantially higher than trust rates. Thus the provisions effectively operated as anti-avoidance measures.
But, with the passing of time, trust tax rates now exceed personal income tax rates, particularly when it comes to capital gains. So the provisions have evolved into pro-avoidance provisions.
Thus the DTC is recommending that trust income is taxed within a trust at the flat rate, currently 41% for revenue income and 27.3% for capital income.
This is wonderful stuff for tax nerds but what does it mean for the donor or beneficiary of a trust.
The DTC is not suggesting the imposition of a wealth tax on trusts. Nor is it even suggesting that a form of transfer pricing be implemented to cover the use of interest free loans used when forming trusts. No bad news there!
The sting comes when on the income tax profile of the trust. Tax on revenue income will be imposed at the flat rate (currently 41% for revenue income and 27.3% for capital income).
Some may say that trusts will receive a full frontal tax lobotomy. Perhaps this should be viewed as bringing trusts more in line with the taxation principles applied to companies. If you want to use these structures you must accept the tax consequence of the structure.
Today capital assets can be transferred into trusts almost willy-nilly. That stays the same. When the donor dies estate duty is diminished. No change there either. But when the asset is sold the CGT profile of the trusts will be far higher – 27.3% more than the current maximum personal CGT rate of 13.6%.
These are broad recommendations made by the DTC to the minister of finance. The first question is ‘ will they be accepted?’ Only time will tell. Then will come the thorny process of designing the raft of amendments needed to implement the proposals.
Taxpayers are advised to be wary of the knee-jerk reaction to dissolve their current trust arrangements. Firstly one must consider whether dissolving a trust is in the best interests of the beneficiaries, irrespective of the tax consequences. Secondly, dissolving a trust may well lead to a substantial and immediate CGT liability.
