The Oxford online dictionary defines a thistle as a widely distributed herbaceous plant of the daisy family, which typically has a prickly stem and leaves and rounded heads of purple flowers. On 7 November 2022 the Supreme Court of Appeal (SCA) delivered judgment in C: SARS v The Thistle Trust,1 overturning the tax court’s decision and confirming that capital gains cannot flow through multiple discretionary trusts. For the taxpayer, this was ironically, a prickly decision because it resulted in the gains being taxed at twice the rate in the trust instead of in the hands of its natural person beneficiaries.
In June 2021 I examined Case 24918, since reported as ITC 19412 and concluded that the tax court’s decision was incorrect and should be approached with caution.3 The matter was subsequently taken on appeal by SARS to the SCA in C: SARS v The Thistle Trust, which upheld the appeal except for the 50% penalty which SARS had imposed, which the court directed be remitted. At the time of writing this article, the taxpayer’s counsel was hoping that its client would seek leave to appeal the decision to the constitutional court.4
Facts
The Thistle Trust is a beneficiary of various trusts that comprised the Zenprop Group (‘the tier 1 trusts’). These trusts were a group of ten vesting trusts that conduct the business of the Zenprop Group, a group of property owners and developers. In the 2014 to 2016 years of assessment, the Tier 1 Trusts disposed of certain capital assets. The capital gains so realised were distributed, amongst others, to the Thistle Trust in the same years of assessment. The Thistle Trust, in turn, in the same years of assessment, distributed the amounts it received to its beneficiaries. It treated the proceeds received as taxable in the hands of its beneficiaries.
SARS raised additional assessments for the years of assessment under review, taxing the capital gains in the Thistle Trust. SARS also imposed an understatement penalty on the Thistle Trust and required it to pay interest on the assessed liability.
The trustees of the Thistle Trust lodged objection on the basis that the trust had no taxable income, since the capital gains had been accounted for by the trust’s beneficiaries. The tax court found that the vesting trusts, that is, the Tier 1 Trusts, had disposed of capital assets and made capital gains. It held that the capital gains distributed to the Thistle Trust and subsequently passed on to its beneficiaries, constituted ‘amounts’ that fell within the purview of section 25B(1) and (2), and paragraph 80(2) of the Eighth Schedule to the Income Tax Act 58 of 1962 (Act).
Accordingly, the tax court concluded that the distribution to the beneficiaries of the Thistle Trust was a distribution of capital gains taxable in the hands of its beneficiaries and set aside the additional assessments.
The statutory framework
Under paragraph 80(2) of the Eighth Schedule a capital gain that is vested by a discretionary trust in a resident beneficiary must be disregarded by the trust and taken into account by the beneficiary of that trust. In other words, the gain can be attributed only to the beneficiary of the trust that disposed of the asset and cannot flow further through multiple discretionary trusts. The position with income is different under section 25B(1) which has no such restriction.
The SCA noted that the taxation of trusts came about as a result of the decision in CIR v Friedman and Others NNO5 in which the court held that a trust was not a legal persona nor a taxable entity. The practice had been that the trustees, as representative taxpayers, were subject to the tax imposed on trust income that accrued to the trust. The court found that since a trust was not a legal person and not a taxpayer, the trustee could not be a representative taxpayer of the trust. Following this judgment, the Act was amended to include a trust in the definition of ‘person’ in section 1.
The court continued:
‘Subsequently, section 25B was included in the ITA. The introduction of the section was to provide for the taxation of income accrued to trusts and their beneficiaries. The qualifier was that the trust or beneficiary concerned would only be taxed if it had a vested right in the “amount” received or accrued. Put differently, in terms of section 25B, the trust or beneficiary had to have a vested right in the “amount” received or acquired, otherwise the amount would be taxable in the hands of the trust.’
The court’s statement that section 25B was introduced after the addition of a trust to the definition of ‘person’ is incorrect. Section 25B was inserted by section 27 of the Income Tax Act 129 of 1991 and deemed to have come into operation as from the commencement of years of assessment which commenced or commence on or after 1 March 1986. The definition of ‘person’ in section 1 was amended by section 2(1)(b) of the same amending act to insert a ’trust fund’, and the effective date under section 2(2)(a) provided for an identical effective date as section 25B. The fact that the two amendments were made simultaneously is important because it supports the view that section 25B was necessary in order for the conduit principle to continue. Once a trust was made a person, it could not simply be deprived of its income after accrual during the same year of assessment under the common law conduit principle.
The SCA then cited section 25B(1) as it currently reads rather than as it read during the years of assessment under review. On the face of it this is a basic error, since it is always the legislation that prevailed during the years of assessment under review that must be applied. There were two important differences between the legislation as it read in 2014 to 2016 and currently. The first was that during 2014 to 2016 the heading read ‘Income of trusts and beneficiaries of trusts’ while in the current legislation it reads ‘Taxation of trusts and beneficiaries of trusts’. Secondly, the current version contains the words ‘(other than an amount of a capital nature which is not included in gross income …)’ after the words ‘any amount’ and these bracketed words were absent in the 2014 to 2016 years of assessment. While section 25B in its 2014 to 2016 guise did not exclude amounts of a capital nature, it was evident from the heading that the section was concerned with income and not capital gains. In the tax court Wright J had taken the view that the insertion of the words in brackets was evidence that the previous wording did in fact include amounts of a capital nature. But a subsequent clarifying amendment can also shed light on the way in which the legislation ought to be interpreted.6 There were many indicators in section 25B that it dealt with income and not capital gains: the heading; the fact that the words ‘any amount’ used to read ‘any income’ and were changed in 2004 because of the introduction of the residence basis of taxation;7 the reference to section 7 which deals with attribution of income to donor; and in section 25B(3), (4) and (5) which limit ‘deductions or allowances’ to income. Yet, the SCA did not deal with the impact, if any, of the subsequent amendment.
The court stated the following on applying section 25B as a whole:
‘[19] When examining sections 25B(1) and 25B(2) to determine what “any amount” constitutes, the sections must be read as a whole. Section 25B(3) provides insight into the amount that the legislator was concerned with in the application of this section. That amount was the “taxable income derived by way of any amount”.
‘Section 25B, read in its entirety, demonstrates that the amount is of a taxable income nature and not of a capital gains nature – “any amount” will thus not include capital gains.’
The statement that ‘any amount’ is of a taxable income nature and not of a capital gains nature if taken literally does not make sense because a taxable capital gain is also included in ‘taxable income’ under paragraph (b) of that definition. The court was no doubt simply confirming that the type of taxable income contemplated in section 25B(3) was of the nature derived from income as in paragraph (a) of the definition of ‘taxable income’ and did not include a taxable capital gain.
The court continued:
‘[20] It bears mentioning that section 25B was introduced by the legislature in 1991, while capital gains tax came into existence in 2001. Logically, if capital gains did not exist, section 25B could not have been intended to apply to capital gains. Further, the insertion of “other than an amount of a capital nature which is not included in gross income” in the section after any amount, which came about after capital gains was introduced, is yet another indicator that this section does not apply to an amount of the nature of a capital gains (sic).’
The statement that the words in brackets came about after capital gains were introduced is not wrong but they were inserted only in 2020,8 some 20 years after CGT was introduced. Nevertheless, the court was quite correct to point out that section 25B was introduced some 10 years before the introduction of CGT, and thus did not even contemplate capital gains.
The court cited this passage from Milnerton Estates Ltd v C: SARS in support of its view that section 25B found no application to capital gains:9
‘the determination of the amount of any capital gain falling to be included in the taxpayer’s taxable income is a matter dealt with in the Eighth Schedule to the Act . . . and on its face the Schedule seems to provide a self-contained method for determining whether a capital gain or loss has arisen.’
There has been a trend to deal with trading stock, allowance assets and capital gains in the main body of the Act in order to kill three birds with one stone but when this happens, it is obvious from the language of the sections concerned, and in most instances, there was evidence of a deliberate move out of the Eighth Schedule, as for example, section 9H (cessation of residence) formerly in paragraph 12(2)(a), section 9HA (death) formerly in paragraph 40, section 9HB (roll-over between spouses) formerly in paragraph 67, section 40C (capitalisation shares) formerly in paragraph 78 and a few new provisions such as section 24BA and section 40CA (assets acquired through issue of shares). But in the instant case, section 25B has always dealt with income because paragraph 80 of the Eighth Schedule had self-contained provisions dealing with the attribution of capital gains.
On the conduit principle which had been firmly established in SIR v Rosen,10 and which was found to be applicable in the tax court, the court stated in paragraph 24:
‘Trollip JA cautioned in Rosen that while the principle was applicable for general application in our tax system, it ought only to be applied in appropriate circumstances to be determined on a case-by-case basis.’
The italicised words were not those of Trollip JA but were added by the court.
The court concluded:
‘[25] The facts of this case do not support the application of the “conduit pipe principle”. The Tier 1 Trusts vested the capital gains in the Thistle Trust which accordingly held a vested right therein. The distribution to it of the accrued gains resulted in it receiving those gains as of right. The Thistle Trust did not dispose of any capital asset nor determine a capital gain that was distributed to its beneficiaries. Instead, it distributed monies that vested in it as of right. In these circumstances, the “conduit principle” does not apply.’
It is a pity that the court did not come out unequivocally and state that the conduit principle fell away with the amendment of the definition of ‘person’ to include a trust.
I would take issue with the statement that the Thistle Trust did not dispose of a capital asset. A debt claim, including a bank account, is a capital asset, but the court was correct that the disposal of such a claim did not give rise to a capital gain.
The understatement penalty and interest
An understatement penalty is imposed under section 222 of the Tax Administration Act 28 of 2011 in accordance with the table in section 223 unless the understatement arose from a bona fide inadvertent error. The court noted that SARS had correctly conceded that the understatement indeed arose from such an error because the taxpayer had relied on a legal opinion. The taxpayer was, however, liable for interest on the underpayment of provisional tax under section 89quat(2).
Conclusion
While the court’s reasoning could have been better expressed in places, its conclusion that section 25B and the conduit principle were inapplicable was in my view correct. The judgment also puts paid to the argument that capital gains can be distributed to non-resident beneficiaries under the conduit principle.
It would be interesting to know whether the tax paid by the natural person beneficiaries can be transferred to the Thistle Trust. It is likely that their 2014 to 2016 assessments have prescribed. Taxing both the trust and its beneficiaries on the same amount would be harsh.
Tax planners will have to look at flattening their trust structures to avoid capital gains being taxed in the trust at 36% instead of at the effective rate applicable to natural persons of 0% to 18%.
This article was first published in ASA February 2023
Editors note: The Thistle Trust v Commissioner for the South African Revenue Service (Case 337 / 2022) was heard at the Constitutional Court of South Africa on 8 February 2024. Judgment is pending.
1 - (516/2021) [2022] ZASCA 153 (7 November 2022), since reported as 2023 (2) SA 120 (SCA), 85 SATC 347.
2 - (2021) 83 SATC 387 (G).
3 - (June 2021) Integritax ‘Superimposing s 25B and the conduit principle on para 80 of the Eighth Schedule’ at 119.
4 - (November / December 2022) 71 The Taxpayer.
5 - 1993 (1) SA 353 (A) at 371D-F, 55 SATC 39.
6 - C: SARS v United Manganese of Kalahari (Pty) Ltd 2020 (4) SA 428 (SCA), 82 SATC 444 at 455 in [24].
7 - The Revenue Laws Amendment Act 32 of 2004 changed ‘income’ to ‘amount’.
8 - Taxation Laws Amendment Act 23 of 2020.
9 - 2019 (2) SA 386 (SCA), 81 SATC 193.
10 - 1971 (1) SA 172 (A), 32 SATC 249 at 267.
