Binding private ruling (BPR) 342 dated 30 April 2020 'Donation by a resident to a foreign trust of property received from another foreign trust' is particularly interesting because it revealed a novel way, at least to me, of avoiding capital gains tax (CGT).
The applicant was a resident beneficiary of Trust A which was resident in Country X. Trust A had been settled in 2012 by the applicant's son. The beneficiaries on the date of settlement were the applicant's son, the applicant's daughter-in-law, as well as any children or grandchildren of the applicant's son and such other persons or class of persons or any charitable institution which the trustees may add under the trust deed. The applicant was appointed a beneficiary of Trust A in 2019. The purpose of the arrangement was to transfer the net assets of Trust A to Trust B, which was resident in Country Y. Trust A would firstly revalue its assets and credit the revaluation surplus to its capital account. It would then vest this surplus plus the settled trust capital in the resident beneficiary on loan account. The beneficiary would then donate the resulting loan account in Trust A to Trust B. Finally, Trust A would transfer its net assets to Trust B in settlement of the loan account.
At this point readers might be wondering why it was necessary to involve the resident beneficiary in the arrangement, since the beneficiary had nothing to gain from the transaction. One can only speculate, but it seems likely that the transaction may have been structured in order to avoid tax in a foreign jurisdiction.
The following rulings were made:
- The award by Trust A to the SA beneficiary will not constitute ‘gross income’ as defined in section 1(1) for the beneficiary, as it will constitute a receipt of a capital nature. Subsequent to this ruling, section 25B(1), which gives effect to the conduit principle, was amended on 20 January 2021 to exclude amounts of a capital nature that are not included in gross income.
- On the award of the amount by Trust A to the beneficiary, no amount must be included in the taxable income of the beneficiary under section 26A read with the Eighth Schedule, as the beneficiary will not have disposed of any asset. This raises the question whether a beneficiary gives up a right to claim the amount in exchange for the vested right. But given that paragraph 20(1)(h)(vi) establishes the base cost of the vested claim, there is a necessary implication that underlying exchanges of rights are disregarded.
- On the donation by the beneficiary to Trust B, no amount must be included in the taxable income of the beneficiary under section 26A read with the Eighth Schedule, as the disposal of the beneficiary's right to receive the award will not result in any capital gain, as the market value of the claim will be equal to its base cost. As mentioned above, paragraph 20(1)(h)(vi) establishes the base cost of the claim. It provides that a person that acquires an asset from a non-resident by way of donation is treated as having acquired the asset for a cost equal to market value on the date of acquisition. The proceeds on disposal of the claim to Trust B would be equal to the same market value under paragraph 38.
- Section 25B(2A), read with section 25B(2B), will not apply to the award to the beneficiary. This is merely confirmation that no part of the vested claim originated from trust capital comprising previously untaxed income. Since the vesting originated from the settled capital of the trust and the unrealised surplus, this would be the position.
- No asset of Trust A will have been disposed of, nor will any asset or right to any asset have been vested in the beneficiary, so that neither paragraph 80(1) nor paragraph 80(2) will apply to the award made to the beneficiary. This is where the CGT avoidance arises because the unrealised surplus does not represent the disposal of an asset, which would be a prerequisite for a capital gain
- Paragraph 80(3), read with paragraph 80(4), will not apply to the award made to the beneficiary. Again, this is similar to section 25B(2A), and merely confirms that no part of the trust capital built up in prior years of assessment includes an untaxed capital gain or an amount that would have been a capital gain had the trust been a resident.
- The donation by the beneficiary to Trust B will be exempt from donations tax under section 56(1)(g)(ii). Section 56(1)(g)(ii) exempts from donations tax any property ‘if such property consists of any right in property situated outside the Republic and was acquired by the donor … by a donation if at the date of the donation the donor was a person (other than a company) not ordinarily resident in the Republic ‘. The resident beneficiary had acquired the claim through vesting from Trust A, which was not ordinarily resident in South Africa, and so the beneficiary was able to donate it free of donations tax.
The part of the arrangement that caught my attention was the revaluation of the trust assets shortly before disposing of them and the vesting of this unrealised surplus on loan account in the resident beneficiary.
The donation by the beneficiary to Trust B will be exempt from donations tax under section 56(1)(g)(ii). Section 56(1)(g)(ii) exempts from donations tax any property 'if such property consists of any right in property situated outside the Republic and was acquired by the donor … by a donation if at the date of the donation the donor was a person (other than a company) not ordinarily resident in the Republic '. The resident beneficiary had acquired the claim through vesting from Trust A, which was not ordinarily resident in South Africa, and so the beneficiary was able to donate it free of donations tax.
This is a somewhat aggressive way of avoiding paragraph 80 of the Eighth Schedule, since had the assets first been disposed of and the resulting proceeds vested in the resident beneficiary, any capital gains would have been attributed to the resident beneficiary under pararaph 80(2A) or (3). But the unrealised surplus is not a capital gain arising from the disposal of an asset; it merely represents a distribution of trust capital, placing it beyond the reach of the
fiscus on a plain reading of paragraph 80. There is the danger that SARS could invoke section 80A to 80L (the general anti-avoidance rules), since revaluing the trust assets, vesting the surplus in the resident beneficiary, and then disposing of those assets shortly afterwards seems to serve no commercial purpose other than to obtain a tax benefit. The ruling did not cover this aspect. However, as indicated earlier, it seems that the transactions were not aimed at avoiding tax in SA but more likely in an offshore jurisdiction such as the settlor's country of residence.
One aspect that was not canvassed in the ruling was that any capital gains arising in Trust B would be attributable to the resident beneficiary under paragraph 72, since the acquisition of the assets from Trust A was funded by the donation from the resident beneficiary. This may not have been of concern for reasons not disclosed in the ruling. For example, if the beneficiary was at an advanced age, any attribution would cease upon the death of the beneficiary. Alternatively, if the beneficiary intended to cease to be resident, attribution would also not be of concern.
Trustees act in a fiduciary capacity, and vesting an unrealised surplus in a beneficiary could be viewed as reckless and prejudicial to other beneficiaries, particularly if the unrealised surplus cannot be sustained. In
Dimbula Valley (Ceylon) Tea Co Ltd v Laurie [1] it was held that a surplus on valuation of fixed assets is distributable by a company if
- the articles authorise it;
- the valuation is made in good faith by a competent valuer; and
- the surplus is unlikely to fluctuate in the short term.
- the surplus is unlikely to fluctuate in the short term..
One would hope that a prudent trustee would adopt equivalent principles when considering whether to distribute an unrealised surplus. Instead of articles of association, the trustee would need to ensure that the distribution is permitted by the trust deed.
This problem was seemingly not an issue in the BPR, since the sale of the assets was likely to have taken place soon after their valuation, and so the trustees would have been aware that the unrealised surplus would soon become realised.
An arrangement of this nature may backfire if the asset was originally funded by a donation, settlement or other disposition and the donor is a resident. The problem is that when the actual capital gain arises, it will be subject to attribution back to the resident donor under paragraph 72. Thus, one would need to ensure that the person who originally funded the purchase of the trust assets is not a resident. It can be inferred from the ruling that the resident beneficiary's son was a non-resident, otherwise the capital gains that arose on the disposal of Trust A's assets to Trust B would likely have been attributed to him.
Australians have been exploiting the unrealised surplus loophole in their own country with discretionary trusts for decades. In
Fischer v Nemeske Pty Ltd[2] the High Court of Australia held in a 3-2 decision that a valid debt was created for the beneficiaries when the trust vested a revaluation surplus in the beneficiaries. The Australian Council of Social Service in a policy briefing dated November 2017 stated that[3]
'Avoiding tax on capital gains (distributions of untaxed capital gains from the revaluation of assets within a discretionary trust to beneficiaries does not attract Capital Gains Tax, though it does for fixed trusts).'
It seems that a fixed trust under Australian law is the equivalent of a vesting trust under SA law. However, Australia has a specific disposal event (E4) that deals with the situation when non-assessable amounts are paid to beneficiaries. Section 104-70 of the Australian Income Tax Assessment Act, 1997 requires the 'cost base' (equivalent of base cost) of the asset to be reduced by such amounts and if the amount exceeds the cost base, a capital gain will arise. This treatment is similar to that found under paragraph 76B for returns of capital from companies.
With resident trusts, there seems to be little advantage to distributing an unrealised surplus to a resident beneficiary because the capital gain that will arise on realisation will be subject to CGT at the rate of 36% in the trust if it cannot be distributed. Trustees have other ways of achieving the same result, for example, by simply making a loan to the beneficiary.
Conclusion
Given that BPR 342 was issued on 30 April 2020, it is surprising that National Treasury has not yet acted to address the question of distributions by non-resident trusts out of unrealised surpluses.
This article was first published in ASA August 2023
