Recent amendments to the Income Tax Act 58 of 1962 (the Act), as a result of the Taxation Laws Amendment Act, No 23 of 2018, came into effect on 1 March 2019 and are set to have far reaching effects on the distribution of income and capital gains from foreign trusts to South African (SA) tax residents. The amendments will have the effect that any income or capital gains, which would previously have been exempt from tax, will now be taxed in either the SA resident donor hands or in the hands of SA resident beneficiaries.
These changes come as a result of a push by the legislature to close identified loopholes in this space and seek to regulate SA resident individuals who have an indirect interest in a foreign company through foreign trusts, and who have previously sought to use trusts as a means to avoid tax or re-characterise the nature of income.
It is trite that foreign trusts are only taxed on income from a source or deemed source or on a capital gain from immovable property held within SA. In certain scenarios, it is the SA resident donor or beneficiaries who are taxed on income and capital gains accruing to the foreign trust.
The impugned provisions, amongst others, are the donor anti-avoidance provisions of section 7(8) and paragraph 72 of the Eighth Schedule (8th Schedule) to the Act as well as section 25B(2A) and paragraph 80(3) governing the taxation of SA resident beneficiaries of foreign trusts.
Up until 1 March 2019, the operation of these provisions were as follows:
- Section 7(8) may attribute the income of a foreign trust to an SA tax resident donor. The resident donor would have been taxed on accruals by the trust provided that amount would have constituted income had that trust been an SA tax resident. However, where the income was derived as a result of foreign dividends from a foreign company, such dividends would not have constituted income had the trust been a resident through the application of the section 10B(2) participation exemption.
- Similarly, paragraph 72 provided for the attribution of a capital gain arising in a foreign trust, to a resident donor, which would have constituted a capital gain had that trust been an SA resident. However, where the capital gain arose as a result of the sale of foreign shares and the requirements of the participation exemption in terms of paragraph 64B had been met, that gain would not have constituted a capital amount had the trust been a SA resident.
Distribution of capital to SA resident beneficiaries
- In terms of section 25B(2A), where a capital distribution is made to an SA resident beneficiary from a foreign trust and that amount would have constituted income as defined had the trust been resident in SA, then that beneficiary would have been taxed on such an amount. However, where the capital distribution was as a result of receipt of foreign dividends by the foreign trust, such dividends would not have constituted income by virtue of the participation exemption.
- Paragraph 80(3) of the 8th Schedule deals with capital gains of a foreign trust vesting in a SA resident beneficiary and provides that where a resident acquires a vested right to a foreign trust's capital gain that would have constituted a capital gain had that trust been an SA resident, then that beneficiary would be subject to capital gains tax on that distribution. Again, should the amount have arisen from the sale of foreign shares, then that amount would not have been included as a capital gain on account of the participation exemption.
In the abovementioned instances, resident donors and beneficiaries would have been safeguarded from liability through the application of the relevant participation exemptions. However, from 1 March 2019 the participation exemptions as previously applied are to be disregarded where notably, amongst others, the foreign trust holds more than 50% of the total participation rights (as defined in section 9D(1) of the Act), or of the voting rights in that company, being directly or indirectly held or exercisable by the trust or any connected persons to that trust.
Disregarding the participation exemption has the effect that even if the income or capital gain would have been exempt in terms of the applicable participation exemption if the foreign trust had been an SA resident, that income or capital gain would, where the trust is not liable for taxation, be attributable to either the SA resident donor or beneficiaries.
These changes are applicable to all distributions and disposals occurring on or after 1 March 2019 and the consequent impact of the proposed changes should be carefully considered by SA residents with an interest in foreign trusts.
This article was co-written by Matthew Tout, Candidate Attorney, Baker McKenzie Johannesburg.