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Cape Town - If Budget 2016's "cryptically worded proposals" relating to the taxation of trusts are enacted in conjunction with the proposal of the Davis Tax Committee that income and capital gains be taxed in the hands of the trust rather than that of the donor or the beneficiaries, the taxation consequences will be disastrous for trusts, cautioned David Warneke, tax partner at BDO SA.
"Trusts are a popular planning vehicle in SA and a great deal of comment was elicited last year by the release of the Davis Tax Committee’s discussion document on estate duty. The Davis Committee document proposed fundamental changes to the taxation of trusts," said Warneke. The timing of the Budget 2016 proposals is, therefore, surprising to him in the absence of an updated version of the Davis Tax Committee document.
For Warneke the nub of the proposals relating to trusts is contained in Finance Minister Pravin Gordhan's statement that "to limit taxpayers’ ability to transfer wealth without being taxed, government proposes to ensure that the assets transferred through a loan to a trust are included in the estate of the founder at death, and to categorise interest-free loans to trusts as donations". Gordhan added that further measures to limit the use of discretionary trusts for income-splitting and other tax benefits will also be considered.
The proposal relates to the transfer of growth assets into trusts by individuals on loan account, a transaction of a type routinely carried out on the advice of tax and estate planners.
"This transaction is often considered primarily for reasons of estate protection and ease of estate administration rather than tax savings. For example in the event of the death of the disponer, income from assets held in a trust may continue to be received by the disponer’s dependants," explained Warneke.
"Too often trusts are simply viewed as tax avoidance arrangements whereas in many cases the tax consequences are of secondary importance."
He gives the following example to illustrate how savings in estate duty and capital gains tax may result from the transfer of growth assets into a trust:
Say a portfolio of shares with a market value of R4m is sold into a trust by an individual on interest-free loan account. (The sale of the portfolio may trigger capital gains tax in the hands of the individual.)
As a result the loan of R4m becomes an asset in the estate of the individual. However, if the loan is free of interest, then it does not grow in value over time. In fact, dividends and capital profits from the portfolio may be used to reduce the outstanding balance of the loan.
On the other hand, growth in the portfolio accrues to the trust and not the individual. This means that on the demise of the individual, it is only the outstanding balance of the loan and not the value of the shares that will form part of the individual’s estate.
There will be no capital gains tax payable on the deemed disposal of the loan (for purposes of capital gains tax, an individual is deemed to have disposed of his or her assets to his or her estate at market value upon death) since the base cost of the loan should not be less than the market value of the loan.
In this manner the growth in the value of the portfolio, represented by the increase in the value of the portfolio over the initial balance of the loan, is also protected from the estate duty which is levied at 20 per cent on the net value of an individual’s estate.
Error in the wording?
"I presume there is an error in the wording of the proposal in that it meant to say that it is the disponer of the assets who would be taxed, rather than the founder of the trust," said Warneke.
"The effect of the proposal may be that any growth in the asset from the date of initial transfer into the trust will form ‘deemed property’ in the estate of the deceased for purposes of estate duty."
This may result in the value of such growth, together with the outstanding balance of the loan at the date of death of the disponer, forming part of the dutiable estate of the disponer for estate duty purposes.
So in the above example, if the market value of the portfolio had grown to R10m on the demise of the disponer and the outstanding balance of the loan at that date is R3m, then in addition to the loan of R3m, R6m (being the market value of the portfolio at the date of death - R10m - less the market value of the portfolio when it was first transferred to the trust - R4m - would be included in the dutiable estate of the disponer.
"On the other hand, the proposal may have the effect that the full market value of the asset will be included in the dutiable estate of the deceased and that the loan will be disregarded as an asset in the hands of the disponer," said Warneke.
"In either of the above possibilities, one wonders whether an adjustment is envisaged if an asset was only partly financed by a loan from the disponer, for example 70% financed by a loan from a financial institution with the remainder financed by a loan from the disponer."
To him, presumably, despite the growth in the asset or the asset itself forming part of the dutiable estate of the disponer for purposes of estate duty, the asset will remain that of the trust for income tax purposes (including capital gains tax).
"If the proposal of the Davis Tax Committee to tax all revenue and capital gains in a trust is enacted in conjunction with this proposal, the overall taxation effect would be disastrous," warned Warneke.
"The full market value of the asset would be exposed to estate duty at 20% and if the asset is sold by the trust any resulting capital gain would be taxed at 32.8%. This contrasts with estate duty at 20% and a maximum capital gains tax rate of 16.4% for assets held by individuals."
Constitutionality challenged
As an alternative to the above treatment from the perspective of capital gains tax, the proposal has the effect that any growth in the value of the asset from the date of initial transfer into the trust to the date of death will form part of the deemed disposal that arises at market value on the death of the deceased (in the hands of the deceased), explained Warneke.
In this case he would expect the trust to obtain a stepped up base cost equal to the market value that was taken into account in determining the capital gain in the hands of the deceased.
"The timing of the effective date of the proposed legislation will also be important to monitor. If the proposal becomes effective for assets disposed of to a trust on or after a given future date then it will not have retrospective effect," he said.
"If it simply applies to trusts on or after a given future date then it will have retrospective effect in that it will apply so as to tax unrealised gains in assets already held in trusts. The constitutionality of such a proposal may well be challenged."
The proposal to categorise interest-free loans to trusts as donations is also cryptic, in his view.
"Presumably it is the non-charging of interest that would be regarded as a donation rather than the entire capital amount of the loan. To regard capital lent as a donation is inconsistent with the meaning of the word donation, as it is an amount that has to be repaid," he said.
"However, if a loan is free of interest then, depending on the terms of the loan, the non-charging of interest may give rise to a donation or a deemed donation for purposes of donations tax."
In his view, the proposal may be formulated in such a way that, regardless of the terms of the loan, the non-charging of interest will be regarded as a donation for purposes of donations tax. One possibility is that donations tax will be levied annually at the rate of 20% on a market-related interest rate applied to the outstanding balance on the loan.
"If this is what is envisaged, then the proposal is also interesting in view of the recommendation in the discussion document released by the Davis Tax Committee on Estate Duty that transfer pricing not be applied to interest-free loans to trusts," said Warneke.
One of the recommendations contained in the Davis Tax Committee’s discussion document is that income should be taxed in the trust and not in the hands of the beneficiaries. The reference to limiting the use of discretionary trusts for income-splitting may be an indication that this recommendation will be enacted, according to Warneke.
"We will have to wait for the release of the draft taxation laws amendment bill of 2016, probably in June, to know exactly what the Budget 2016 proposals entail," he said.
"It is, however, certain that the proposals will have far-reaching implications for the use of trusts."
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