Many high net-worth South African residents form offshore trusts due to the manifold benefits of such arrangements, among which are asset protection, flexibility and tax planning. From a taxation perspective, several statutory provisions potentially apply to foreign trust structures and the tax treatment of foreign trusts with South African resident founders or beneficiaries has become more complex due to recent legislative changes designed to tackle tax avoidance. This article considers the interplay between sections 7(8), 7C, 31 and paragraph 72 of the Eighth Schedule to South Africa’s Income Tax Act in relation to a trust structure often encountered in practice.
South African residents usually select a discretionary foreign trust and company structure, whereby the nonresident discretionary trust, established for the benefit of the founder’s family members, holds all the shares in a nonresident company, which holds the offshore assets. Distributions of income or capital gains from a foreign trust to a South African tax resident beneficiary are generally taxed in the hands of the beneficiary based on the nature of the income or gain. The financing of a discretionary trust arrangement typically commences with the granting of a loan by the South African founder of the offshore trust.
A loan is usually preferred to a donation as a means of financing a foreign trust arrangement, mostly because a donation results in an immediate tax liability in the form of donations tax at a rate of 20% or 25%, depending on the amount involved. A loan may be denominated in rands or foreign currency and may be interest-free or interest-bearing. In these circumstances, the potential application of the above provisions must be considered:
From a practical perspective, the reach of the terms ‘by reason or in consequence of’ and ‘attributable to’ is often unclear. Both are suggestive of the legal concept of proximate causation, which has been followed in South African jurisprudence. If, in the above example, the foreign trust had provided the funding required by the foreign company by subscribing for shares in the latter, would all the income derived by the foreign company be ‘by reason or in consequence of’ the founder’s loan to the trust? This is arguably not necessarily the case. Depending on the facts, the proximate cause of the income accruing to the company could partly be the founder’s loan and partly other factors (e.g., decisions taken by the foreign company’s board). There would clearly be difficulties in apportioning income amongst the competing causes in these circumstances, which are not addressed in the legislation.
One possible interpretation is that due to the application of the deeming provisions, section 7(8) and paragraph 72, which will likely result in an inclusion in the founder’s income, section 31 does not apply to the above loan at all. However, this interpretation is not favoured by the South African Revenue Service (SARS). It is worth noting that the definition of a ‘tax benefit’ includes the avoidance, postponement or reduction of any liability for tax. As this definition includes the postponement of the founder’s liability for tax, even if these deeming provisions may apply to tax the founder in later years of assessment, the founder would still have enjoyed the benefit of a postponement of liability for tax by not charging a full arm’s length rate of interest for this year and hence section 31 should apply as a form of ‘top up’. If, determined on an annual year of assessment basis, section 7(8) and paragraph 72 result in a lesser inclusion in the founder’s taxable income than would an arm’s length interest, the difference becomes a section 31 adjustment, which is known as a primary adjustment.
The effect of the application of section 31 is two-fold: the primary adjustment, levied through section 31(2), in the form of the inclusion in the founder’s taxable income of the top-up amount and a secondary adjustment essentially to compensate the government for the loss of the additional accretions to the founder’s estate for purposes of wealth taxes (donations tax and estate duty) because an arm’s length interest did not accrue to the founder. The secondary adjustment is levied through section 31(3) in the form of a deemed donation for donations tax purposes in the same amount as that of the primary adjustment. Donations tax is often referred to as ‘estate duty payable in advance’ and is levied at the same rates as applies to estate duty. Donations tax on the secondary adjustment would have to be declared and paid within seven months after the end of the relevant year of assessment. Both the primary and secondary adjustments would have to be accounted for on an annual basis.
To avoid the uncertainties and difficulties associated with the deeming provisions, taxpayers often charge full market-related interest on their loans in these circumstances, which means that none of the deeming provisions will apply (unless the official interest rate is higher than an arm’s length rate and section 7C applies, as discussed above).
Although the interest income is subject to income tax in the founder’s hands and grows their estate from an estate duty perspective, by and large the same tax result is achieved by the deeming provisions. However, the actual charging of an arm’s length interest by the founder decreases the reserves of the trust, which means that there is less to distribute and tax when the accumulated reserves of the trust are vested in South African resident beneficiaries.
David Warneke
BDO in South Africa
Common Structures and Application Provisions
South African residents usually select a discretionary foreign trust and company structure, whereby the nonresident discretionary trust, established for the benefit of the founder’s family members, holds all the shares in a nonresident company, which holds the offshore assets. Distributions of income or capital gains from a foreign trust to a South African tax resident beneficiary are generally taxed in the hands of the beneficiary based on the nature of the income or gain. The financing of a discretionary trust arrangement typically commences with the granting of a loan by the South African founder of the offshore trust.A loan is usually preferred to a donation as a means of financing a foreign trust arrangement, mostly because a donation results in an immediate tax liability in the form of donations tax at a rate of 20% or 25%, depending on the amount involved. A loan may be denominated in rands or foreign currency and may be interest-free or interest-bearing. In these circumstances, the potential application of the above provisions must be considered:
- Section 7(8): Section 7(8) is an anti-avoidance provision that applies where ‘by reason of or in consequence’ of a ‘donation, settlement or other disposition’ by a resident, an amount is received by or accrues to a nonresident, which would have constituted income had the nonresident been a resident. The non-charging of interest on a loan falls in the ‘other disposition’ category and is caught by this wording to the extent of the founder’s generosity (up to an arm’s length interest on the loan). In the structure outlined above, the trust income would usually be in the form of dividends declared by the foreign company out of its profits. As discussed below, it is somewhat unclear whether income that accrues to the foreign company would also be hit by this provision, assuming the foreign company’s source of funding was indirectly the interest-free loan by the trust founder. Arguably, to include both the income of the foreign company and foreign dividends declared out of the same income in the founder’s hands would give rise to double taxation.
- Paragraph 72 of the Eighth Schedule: Paragraph 72 is the capital gains tax counterpart to section 7(8). It would therefore apply if, for example, the foreign trust were to realise what would have constituted a capital gain had it been South African resident on the disposal of its shares in the foreign company. In that case, the founder would have to include what would have constituted the trust’s capital gain as its capital gain up to the extent of an arm’s length interest on the loan. As with section 7(8), the participation exemption no longer applies in determining the trust’s capital gain in these circumstances.
From a practical perspective, the reach of the terms ‘by reason or in consequence of’ and ‘attributable to’ is often unclear. Both are suggestive of the legal concept of proximate causation, which has been followed in South African jurisprudence. If, in the above example, the foreign trust had provided the funding required by the foreign company by subscribing for shares in the latter, would all the income derived by the foreign company be ‘by reason or in consequence of’ the founder’s loan to the trust? This is arguably not necessarily the case. Depending on the facts, the proximate cause of the income accruing to the company could partly be the founder’s loan and partly other factors (e.g., decisions taken by the foreign company’s board). There would clearly be difficulties in apportioning income amongst the competing causes in these circumstances, which are not addressed in the legislation.
- Section 31: Section 31 deals with transfer pricing and could potentially also apply to the above loan arrangement. The loan meets three requirements of this provision:
- It is between ‘connected persons’ (the founder and the trust would be connected persons in the above scenario);
- It is between a resident (the founder) and a nonresident (the trust); and
- Had the loan been provided to the trust by a lender on an arm’s length basis, interest would have been required and paid by the trust. The interest-free nature of the loan is thus a term that is different from that which would have applied in an arm’s length arrangement.
One possible interpretation is that due to the application of the deeming provisions, section 7(8) and paragraph 72, which will likely result in an inclusion in the founder’s income, section 31 does not apply to the above loan at all. However, this interpretation is not favoured by the South African Revenue Service (SARS). It is worth noting that the definition of a ‘tax benefit’ includes the avoidance, postponement or reduction of any liability for tax. As this definition includes the postponement of the founder’s liability for tax, even if these deeming provisions may apply to tax the founder in later years of assessment, the founder would still have enjoyed the benefit of a postponement of liability for tax by not charging a full arm’s length rate of interest for this year and hence section 31 should apply as a form of ‘top up’. If, determined on an annual year of assessment basis, section 7(8) and paragraph 72 result in a lesser inclusion in the founder’s taxable income than would an arm’s length interest, the difference becomes a section 31 adjustment, which is known as a primary adjustment.
The effect of the application of section 31 is two-fold: the primary adjustment, levied through section 31(2), in the form of the inclusion in the founder’s taxable income of the top-up amount and a secondary adjustment essentially to compensate the government for the loss of the additional accretions to the founder’s estate for purposes of wealth taxes (donations tax and estate duty) because an arm’s length interest did not accrue to the founder. The secondary adjustment is levied through section 31(3) in the form of a deemed donation for donations tax purposes in the same amount as that of the primary adjustment. Donations tax is often referred to as ‘estate duty payable in advance’ and is levied at the same rates as applies to estate duty. Donations tax on the secondary adjustment would have to be declared and paid within seven months after the end of the relevant year of assessment. Both the primary and secondary adjustments would have to be accounted for on an annual basis.
- Section 7C/Section 31(3) Overlap: Section 7C, in essence, deems low-interest or interest-free loans to trusts (or companies the shares of which are held by trusts) to be donations for donations tax purposes to the extent of a shortfall between the interest charged and the official interest rate and clearly overlaps with section 31(3) in these circumstances. It is worth noting that section 31(3) has an international flavour in that it requires at least one of the parties to the transaction or arrangement to be nonresident or have a permanent establishment outside South Africa, whereas section 7C is agnostic in this regard. The definition of the ‘official rate of interest’ depends on whether the loan is denominated in rands or a foreign currency (i.e., the South African repurchase rate plus 100 basis points or the foreign currency equivalent plus 100 basis points). Thus, if an arm’s length interest rate was 10% over a year of assessment and the official rate was 7%, the secondary adjustment in relation to the interest-free loan in terms of section 31(3) would give rise to a deemed donation based on interest calculated at the 10% rate, while section 7C would potentially also give rise to a deemed donation based on interest calculated at the 7% rate.
BDO Insight
To avoid the uncertainties and difficulties associated with the deeming provisions, taxpayers often charge full market-related interest on their loans in these circumstances, which means that none of the deeming provisions will apply (unless the official interest rate is higher than an arm’s length rate and section 7C applies, as discussed above).Although the interest income is subject to income tax in the founder’s hands and grows their estate from an estate duty perspective, by and large the same tax result is achieved by the deeming provisions. However, the actual charging of an arm’s length interest by the founder decreases the reserves of the trust, which means that there is less to distribute and tax when the accumulated reserves of the trust are vested in South African resident beneficiaries.
David Warneke
BDO in South Africa