Just when wealthy South Africans thought they’d absorbed all the blows, hidden in the fine print of SA’s Budget 2017 was a bombshell that is about to hit creators of offshore trusts really hard. BDO’s David Warneke explains the SARS version of a poison pill which adds significantly to the risks of those who are involved with offshore trusts. And it goes way beyond the recent legislation on transfer pricing. – Alec Hogg
This special podcast is brought to you by BDO, whose David Warneke joins us now on the line from Cape Town. David, good to talk to you. There was a lot in the budget for people like yourself to digest, but one of the shocks you wrote on BizNews this week was the taxation of offshore trusts. Now, how prevalent are offshore trusts among South Africans?
I think it’s fair to say that a lot of wealthy South Africans have offshore trusts. I don’t have an exact number for you, but I think it is quite prevalent within South Africa, that’s my impression, not nearly as prevalent (I dare say) as local trusts, but certainly, there are a good number of wealthy South African families that have offshore trusts.
What would the incentive be to have a structure like that?
It’s quite a good question, actually, because it’s not as straight-forward as it seems from the point of view that it’s not simply a question of that a South African residents can set up an offshore trust in a place like Mauritius or wherever it is, which would then hold shares in a company (typically, that’s the way that the structure works) and do investments through the company. The basic tax problem that arises, (which I don’t know if anybody out there appreciates), is that we have transfer pricing legislation in our Income Tax Act. In other words, the way of transferring those assets into a trust would typically be by way of the offshore allowances, assuming it was all done legally (and hopefully, it is), would be by way of using the offshore investment allowance.
Then the question is how do you divest yourself of the money that you’re putting into the trust and normally what happens then is people don’t donate it to those trusts because there is a donations tax implication. Normally what happens is that they make a loan, they advance a loan to the trust. Usually they end up being connected persons in relation to the trust from an income tax point of view. That’s where the problem comes in because you’ve got this Transfer Pricing Legislation that says if you have a transaction between a resident and a non-resident, you are connected personally with the sign in the Act, in relation to one another, that the transaction must be on arm’s length terms and conditions and if it’s not, then it’s deemed to be an arm’s length terms and conditions.
In this type of situation the trick is really that loan that’s made interest-free is actually deemed to be interest bearing as an arm’s length interest rate and that interest is supposed to then be declared by the South African lender in their tax return. That’s the problem and I think what often has happened is that people don’t know about that or they conveniently overlook it and therefore, that interest ends up not being charged, which would obviously undermine the tax effectiveness of the whole scheme.
David, just so that I can understand it, maybe from a practical perspective, if as a wealthy South African you have an offshore trust and you get all the approvals from the exchange control for R10m for argument’s sake and that trust then invests in equities in other parts of the world, at this point, is it necessary to charge interest or for that trust to pay interest to the South African taxpayer who has actually set it up?
Yes, provided that the taxpayer or that person that set it up or any of his relatives or any connected person in relation to him is a beneficiary of the trust, which invariably is the case because one would set it up such that your immediate family would be discretionary beneficiaries usually, of such a trust. In that case, they are connected persons, the trust is connected in relation to you, or the person setting it up and therefore, if lower than an arm’s length interest rate is charged on the loan and if the money does go in as a loan as opposed to a donation, for example, then the interest is deemed to accrue to you, whether you’ve charged it or not, an arm’s length rate of interest.
How high is that, what rate of interest is that?
The enquiry would really be, at what rate could the trust have borrowed from an external, unconnected third party such as the bank, for example, on the strength of this balance sheet and that would then be the rate.
The fact being that most people, I guess would not be charging the trust interest, because they don’t want to increase their tax liability, but they could be fined for that emission in future or now.
That is the problem with that and yes, I think many people, as I say, don’t realise that that provision is listed and they just don’t charge interest and they go about their business, but actually there’s definitely a tax issue there.
What else was there in this budget that would worry you about offshore trusts?
In this particular budget, if you look at the statement made regarding offshore trusts, it was particularly that structure that I’ve just described now, where you have an offshore trust which holds shares in an offshore company. For example, let’s just use Mauritius again as an example, we have a trust set up there and we have a company set up there and the trust holds all the shares in that company and South African residents have set that trust up with that structure. The announcement that was made, was not entirely clear, but what it seems to be saying is that there is going to be an attempt to deem the company that is held by the trusts to be what’s called a controlled foreign company from the South African tax point of view.
Basically with the controlled foreign company then, in proportion to whatever their participation rights are in the company, South African residents would have to include the net income of that underlying company in their own income tax returns, almost as if they held the shares in that company directly and you were looking straight through the company at whatever its underlying income was. So, it’s difficult to see how that’s practically going to work because obviously those individuals who might have set that structure up, don’t actually hold the shares in the company, the offshore trust holds the shares in the company.
In what proportion, if you have, let’s say, four or five beneficiaries of that offshore trust to South Africa, does one then just say, “Well, 25 percent of that is deemed to an individual one’s income, 25 individual two, three, four”, or is one just looking at the founder of that trust including 100 percent of the underlying company in that person’s income? It’s really not clear how that would be brought about.
What does seem to be clear is that the advantage that an offshore trust might have had is now being eliminated. Are there still any advantages in having this structure if these proposals go ahead?
Yes it might work for somebody who went overseas, worked overseas for a number of years, and wasn’t for a while a South African tax resident, then came back into South Africa, but before they came back they set the structure up. Possibly it might work for them. I think transfer pricing, in any case, would be a problem. I think even there, if there’s a loan outstanding between a South African resident and a non-resident, one could argue that the transfer pricing provisions would still deem a market-related interest rate to apply. I think that if SARS were to work with the provisions in the Act that are already there, namely the Transfer Pricing Provisions, I think that’s the main one in Section 7.8, if they were to work with those, there’s actually enough to make foreign trust arrangements, certainly on the whole, not beneficial from a South African tax point of view.
Alec, I might just add, sometimes what people do is that loan to the trust, they denominate it in a hard currency, where the rates of interest then are argued to be very low, in other words, an arm’s length, it’s an interest on a US Dollar denominated loan between the South African resident and an offshore trust might carry a fractional, a very low rate of interest so that the transfer pricing provisions at the moment, one might think that it’s still worth having that structure and suffering the tax on that rate of interest when you convert it back into Rands because it’s quite low to begin with, but one must also remember that over the time, the rates of interest are subject to fluctuation obviously, they might well go up. They’re low at the moment, but they’re unlikely to always be that.
Also then by having that loan denominated in hard currency, one’s actually creating a future estate duty problem because that loan is an asset in that lender’s estate for estate duty purposes and one would then have to convert that on their death back into Rands for purposes of calculation of estate duty, which then might make the estate duty liability worse down the line by having it in hard currency.
What’s the motivation behind all of this? It’s pretty complex stuff, but where are the tax authorities, what’s driving their intention?
Well, I think that tax authorities worldwide have been taking aim at offshore trusts. We have that situation in Europe, in America, and in Canada. They just don’t like residents to be beneficiaries or participants in offshore trust arrangements, I think largely because despite having transfer pricing and other legislation in place, what they have found is that people simply aren’t compliant with that legislation and historically it’s been difficult to get information on those offshore trusts, so that if people don’t declare those interests in the offshore trusts then the revenue authorities are none-the-wiser.
Historically, that’s been the case. Of course, now with the common reporting standards coming into play and worldwide transparency being enhanced, information sharing between revenue authorities and so on, I think that those days are largely over, but I think that it’s fair to say that it’s not just a South African peculiarity, I think largely offshore jurisdictions as well, take a dim view of trusts in the developed world.
Your advice to someone who does have an offshore trust, get some expert consultancy quick.
Well, for sure, yes, one does need to review that. One of the recommendations of the Davis Tax Committee as well, in their final report on the state duty, which also included trusts, was that SARS should very comprehensively investigate all offshore trust arrangements and I think that the reasoning behind that is that if one digs down into it, you might well find that it’s not properly set up. For example, one of the issues is that for the offshore trust arrangements to have any benefits at all, it would have to be a non- South African tax resident trust to begin with. For example, the usual thing is that you have an offshore trust company doing the management of the trust and you have trustees who are all offshore, you might have a South African one.
The problem though is, from an income tax point of view, our definition of ‘resident’ in the case of a trust would be basically, if the effective management of that trust is offshore as opposed to in South Africa. Then what would happen would be that one would have to look at where are the actual decisions regarding largely the strategic management of the trust are actually formulated, are they formulated offshore or are they formulated onshore and one might well find that although one almost has the veneer of these offshore trustees taking the decisions and minuting them and all the rest of it, that the actual underlying decisions are really made by the founder here in South Africa who just tells them basically what to do, in which case the trace of effective management of that trust is actually South Africa, which means that the offshore trust is actually a South African resident trust that’s, for tax purposes, not actually a non-resident to begin with.
So yes, I do agree with you. I think that people with those structures really need to have them reviewed as a matter of urgency to make sure that all the boxes are ticked and in terms of what they perceive the arrangement to be, that that does in fact hold water to begin with and then following on from that, even if the arrangement is what it’s purported to be, what are really the South African tax consequences of those arrangements, taking into account the transfer pricing provisions in Section 7.8, deemed income provisions and the other provisions in our Income Tax Act.
Well, not a very good budget for those who hold offshore trusts, David Warneke informing us there and this special podcast was brought to you by BDO.