Taxation of Trusts in SA
The "conduit principle", established in Armstrong v Commissioner for Inland Revenue 1938 AD 343, provides that income or capital gains received by a trust retain their character and are taxed in the beneficiaries' hands (not the trust) if vested in such beneficiaries within the same year of assessment. Initially a common law doctrine, it is now codified in the Income Tax Act, 58 of 1962 ("ITA"), under section 25B for income and paragraph 80 of the Eighth Schedule to the ITA (“the Eighth Schedule”) for capital gains.
This principle ensures that income and capital gains distributed to (or vested in) beneficiaries are typically taxed at the beneficiary level, rather than the trust level. However, the specific tax treatment depends on the type of trust and the beneficiaries' rights.
Types of Trusts in SA
In SA, in broad terms, trusts are generally classified by the rights granted to beneficiaries, with each type having unique tax implications:
- Bewind Trust: The beneficiaries own the trust assets, while the trustees merely manage the assets on behalf of the beneficiaries. Any income and gains attributable to the assets are automatically taxed directly in the beneficiaries’ hands as they own the assets.
- Vested Trust: The beneficiaries do not own the trust assets but have an irrevocable right to the trust’s income and/or capital. Income earned by the trust is taxed in the beneficiaries’ hands by virtue of their vested rights to such amounts, with trustees exercising limited discretion over distributions.
- Discretionary Trust: A discretionary trust grants trustees the power to decide on income and capital distributions to beneficiaries. Retained income within the trust is taxed at the trust level, but income distributed may be taxed in the beneficiaries' hands through the conduit principle as envisaged in the ITA.
Thistle and its implications
Thistle, which progressed from the Tax Court to the highest court in SA, the Constitutional Court, has sparked debate regarding the application of the conduit principle, especially in multi-tiered trust structures involving capital gains.
Summary of the facts
In Thistle, the Commissioner of SARS contested the tax treatment of capital gains within a multi-tiered trust structure. Ten vesting trusts (“the Property Trusts”) held and disposed of capital assets, realising capital gains which vested in their beneficiaries, which included the Thistle Trust (“the Trust”), a discretionary trust. The trustees of the Trust, in turn elected to vest the gains, in the same year of assessment, in the Trust’s natural person beneficiaries, who declared and paid the tax on these gains.
SARS, however, issued an additional assessment, taxing the capital gains in the Trust at the Trust’s effective tax rate on capital gains of 36%, dismissing the Trust’s reliance on the conduit principle.
The Tax Court ruled in favour of the Trust, but SARS appealed. The Supreme Court of Appeal (“SCA”) held that paragraph 80 of the Eighth Schedule requires a trust to "determine a capital gain in respect of the disposal of an asset" for the conduit principle to apply. As the Trust in this case was not a bewind trust and had not disposed of any asset, and had therefore not determined any capital gain in respect of the disposal of an asset (it had merely received a capital gain by virtue of the vesting by the Property Trusts), the SCA ruled that the gains were taxable in the hands of the Trust and not the Trust’s beneficiaries.
The Constitutional Court upheld the SCA’s decision, affirming that paragraph 80(2) of the Eighth Schedule does not allow the conduit principle to extend beyond the first trust in a multi-tiered structure of this nature. Paragraph 80(2) of the Eighth Schedule limits the application of the conduit principle to the trust that realises the capital gain by disposing of an asset, precluding its extension to subsequent beneficiary trusts.
Implications
The Constitutional Court majority judgment clarified that the legislative framework of the ITA, particularly paragraph 80(2), overrides the common law conduit principle in multi-tiered trust structures. Therefore, if a vesting trust or a discretionary trust determines a capital gain from the disposal of an asset and vests such capital gain in another trust, the capital gain must be taxed in the hands of that beneficiary trust at the effective rate of 36%, even if the beneficiary trust has subsequently vested the capital gain in its natural person beneficiaries.
Conclusion
The Thistle decision clarifies the treatment of capital gains arising in multi-tiered trust structures.
Tax planning strategies, such as broadening the scope of a trust’s beneficiary clause or vesting the right to a capital gain prior to accrual thereof to ensure that capital gains are taxed directly in the hands of natural person beneficiaries, can be valuable tools in mitigating the tax burden associated with the Thistle decision. These approaches may help preserve the benefits of the conduit principle and provide flexibility in managing the tax implications for trust beneficiaries.
For assistance with your trust matters, or any other tax-related inquiries, please reach out to your local Moore firm HERE.