The Davis Tax Committee (DTC) has released its First Interim Report on Estate Duty addressing the role and relevance of estate duty, as well as its interaction with other taxes. Whilst the recommendations included in the report address a number of proposed amendments aimed at increasing tax collections, one of the most topical aspects is the manner in which trusts may be subject to tax in the future. It is also important to remember that the recommendations included in the report are not yet law, so care may need to be exercised in taking any decisions regarding your personal estate and trust matters in response to this information until certainty exists regarding the changes. The report is open for public comment until 30 September 2015.
The highlights of the report may be summarised as follows:
Collections from estate duty
The terms of reference given to the DTC were to inquire into “The progressivity of the tax system and the role and continued relevance of estate duty to support a more equitable and progressive tax system. In this inquiry, the interaction between CGT and the estate duty should be considered.”
The significant reason behind the research was a result of the decline in collections from estate duty over the past 20 years. This may largely be attributed to estate planning exercises conducted by individuals to avoid or limit their exposure to the estate duty on their passing.
The contributions to National Revenue from estate duty represent approximately 0.1% of total tax collections, much lower than the levels of contributions by many other countries. The previous Katz Commission had suggested a targeted tax contribution of between 1 to 1.5% of tax revenues from this tax, which could amount to about R10 to R15 billion per annum. That would be argued by the lawmakers to make a substantial contribution to a reduction in the national debt level.
The DTC has noted that estate duty, coupled with donations tax, are the only direct wealth taxes in South Africa, and as such they cannot justify a repeal of these taxes without introducing some other form of a wealth tax. It has also been acknowledged that to introduce an entirely new form of tax, such as Capital Transfer Tax or a Net Wealth Tax, would be far too onerous and complex, and would defeat their intentions. As a result, the DTC has recommended that the estate duty system should remain in place, however with some modification.
The DTC has also noted that they do not view Capital Gains Tax (CGT) as a wealth tax, but rather an income tax on capital income. This clarification has been included by them to counter any argument that an individual is exposed to double taxation on death, namely the imposition of CGT on the deemed disposals at date of death as well as the estate duty.
It must always be kept in mind that there should be legitimate reasons for the establishment of a trust, such as the protection of the underlying assets. Despite that comment, the use of a trust to house growth assets will result in the capital growth of the assets accruing to the trust and not the donor, thus resulting in that growth falling outside of the individual’s hands for estate duty purposes.
In the absence of any specific anti-avoidance provisions in the laws, there is little to prevent the use of a trust as an effective tool to reduce exposure to the estate duty.
Even though trusts have the highest rates of tax (41% on income and effective rate of 27.306% on capital gains) the provisions of sections 7 and 25B of the Income Tax Act are often (validly) used to vest the trust income in the hands of a beneficiary, resulting in those amounts being taxed in the hands of that beneficiary. With appropriate planning, the effective rates of tax on that income and capital gains in the hands of the beneficiary are generally lower than the rates that may have resulted in the trust. In light of this position, the DTC claims that the attribution rules in section 7, which were originally introduced as an anti-avoidance measure, are now being used to avoid tax.
In order to better understand the history of section 7, those provisions were introduced at a time when the personal income tax rates were higher than that of a trust. As an anti-avoidance measure, when taxable income was retained in the trust, they would attribute that income back to the donor for tax purposes.
In addition, section 25B states that when income is vested in the hands of a beneficiary, that income will be deemed to have accrued to or have been derived for the benefit of that beneficiary, and thus taxable in the hands of that beneficiary. That section also goes on to provide that any deduction or allowance in terms of the Income Tax Act as incurred in the production of that income must be allowed as a deduction in the hands of that beneficiary in the determination of the taxable income derived by that beneficiary.
As mentioned above, with careful planning on the use of section 7 and 25B, they create the ability for income to be taxed at lower effective tax rates when taxable income is channelled to a natural person beneficiary. Furthermore, the underlying assets are held by the trust with the inherent benefit on limiting the growth of the estate of the donor.
Further to the role that trusts have played in the collection of taxes from the estate duty system, the DTC has made the following recommendations:
Retain the flat rate of taxation for a trust at the existing levels, currently 41%.
Repeal the provisions of section 7 and 25B insofar as they relate to South African resident trusts.
Retain the deeming provisions of section 7 and 25B insofar as they relate to non-resident trusts.
Trusts should be taxed as separate taxpayers.
The only relief to the rules should be for a “special trust” as defined in the Income Tax Act. That is a trust created solely for the benefit of one or more persons with a disability.
No plans should be made to implement any transfer pricing adjustments in the event of financial assistance or interest-free loans being advanced to trusts.
All distributions from foreign trusts should be taxed as income.
The DTC has concluded that taxpayers should be able to “make use of trusts when it makes sound sense to do so in the pursuit of a commercial benefit, as opposed to an estate duty benefit.” However, in that case, the taxpayer may need to accept any potential adverse tax consequences.
With a proposal to repeal the provisions of section 7 and 25B in respect of a South African resident trust, that would result in the taxable income being taxed in the hands of the trust at the higher effective rates of tax. This would represent the adverse tax consequence on the use of a trust as mentioned by the DTC.
In the opinion of the DTC, if their recommendations are followed in respect of the tax regime for trusts, it will act as a deterrent to estate planning practices without the need to introduce alternate complex taxes. The DTC goes on to state that taxpayers who wish to postpone the estate duty via the use of a trust will remain at liberty to do so, but the eventual sale of the assets will result in a higher rate of tax in the trust, which will compensate for the estate duty loss.
The DTC has anticipated that there may be a call for taxpayers to be allowed a period to dissolve their existing trust arrangements, however they are not in favour of that approach because:
the dissolution of a trust arrangement must be achieved in terms of the provisions of the trust deed, irrespective of the tax implications
it would be inequitable to allow a trust to “bank” its accumulated estate duty savings
it would be extremely complicated for both SARS and the taxpayer.
Section 4(q) of the Estate Duty Act provides a deduction from the value of an estate, subject to estate duty, in respect of property that accrues to the surviving spouse.
On the basis that there is no intellectual justification for this exemption, and because no amount of refinement to the definition of a “spouse” can cater for the diverse circumstances in South African families, the DTC has recommended that the principal of inter-spouse exemptions and roll-overs should either be withdrawn completely or subjected to a specified limit.
In terms of section 56(1)(a) and (b) of the Income Tax Act, there is an exemption from donations tax in respect of property disposed of to a spouse. The DTC is of the view that the donations tax system is open to manipulation due to the potential wide interpretation of a spouse. For that reason the DTC has recommended that the inter-spouse exemptions be retained, but the section 56(1)(b) exemption should be amended so as to exclude all interests in either fixed property or companies.
There is also an exemption from donations tax in section 56(1)(c) in respect of donations made in anticipation of death. The DTC has suggested that in order to prevent the diminution of an estate in anticipation of death that this exemption be removed.
Another exemption in the donations tax rules that has come under scrutiny is the provisions of section 56(2)(c) related to bona fide contributions made towards the maintenance of any person that the Commissioner considers reasonable. The DTC views this as a loophole for the taxpayer to diminish an estate. On the basis that it is extremely difficult to determine what constitutes “reasonable expenditure”, it is suggested that the extent of what is considered to be reasonable expenditure be limited to certain categories of expenditure only.
The DTC noted its concern regarding the impact on estate duty collections of an apparent wide-spread practice marketed by the financial planning industry. This practice involves making large lump sum contributions to a retirement annuity fund in anticipation of death. The rationale behind this practice is that although no tax deduction may be claimed on contributions exceeding the allowable deduction limits, the contribution effectively reduces the exposure to estate duty through the existing exemptions.
The DTC has therefore recommended that to stop this practice, all contributions made to retirement funds on or after 1 March 2015 in excess of the amounts allowable as a deduction for normal tax should be included in the estate duty computation.
Abatements and rates of estate duty
It was highlighted that there has been no increase in the estate duty abatement since 2007 when it was increased to R3 500 000. The DTC therefore recommends that the primary abatement be increased to R6 million per taxpayer.
With regards to the rate of estate duty, it has been recommended that the current rate of 20% be retained.
There are a number of potentially far reaching matters that have been raised in the draft report. However, it is cautioned not to take any drastic steps at this stage. It must be noted that this document is still open to public comment until the end of September 2015. In addition, the extent of amendments to the Income Tax Act and Estate Duty Act to give effect to these proposals is significant, and that will have a bearing on the ultimate effective date if they are to be implemented.
All taxpayers should revisit their personal estate planning positions as well as reconsider the appropriate use of any trust structures in place. It should always be kept in mind that a transaction or scheme should not be carried out solely for a tax benefit, but rather for valid commercial or practical reasons.
You are welcome to contact us should you wish to address any of these aspects at further length or to assist in reviewing your potential exposures based on the contents of the DTC report.
Tax and Trust Partner, Johannesburg