Family Trust Investments and Tax – Part 2

2.2 Loan accounts

A loan account is an asset in the planner’s estate. As such, it is generally advisable to reduce the loan account where estate duty is a concern. This can either be done during the planner’s lifetime, or through structuring his will or life assurance correctly.

During the planner’s lifetime, the loan account may be reduced

  • through the use of donations that are beneath the threshold for donations tax (although this may face scrutiny from the Commissioner for SARS in terms of the tax avoidance provisions); (10) or
  • where beneficiaries for example require to live off trust investments (for example pensioners), through carefully planned distributions by the trustees in repayment of the loan account. In this regard, no tax is payable where it constitutes repayment of a loan account, whereas tax may otherwise have been payable on the trust distribution at the beneficiaries’ marginal rate of tax. Care should be taken not to simply write off loan accounts, as this is a CGT event, which may result in CGT being payable. Where a debt is written-off, or reduced for no consideration, the Eighth Schedule(11) deems the debtor to have acquired a claim to a debt with a base cost of nil and the proceeds deemed to be equal to what was written off. That is, the whole amount written-off is subject to capital gains tax, in the debtors’ hands. An alternative is for the planner to consider one of the following methods to reduce the loan account on his death.

2.2.1 Life assurance

The family trust is the contracting party and the planner is the life assured. The proceeds are received by the trust, which uses the proceeds to repay the loan account to the planner’s estate.

The costs associated with this option are the premiums (although the benefit is the added liquidity in the planner’s estate pursuant to repayment of the loan account).

Although the policy is deemed property in the planner’s estate (12), there would be no estate duty liability for the planner where the trust and the planners’ spouse are beneficiaries and the amount received by the trust is capped at an amount equivalent to the abatement (R3,5 million, assuming the loan account is not greater than R3,5 million) with the planner’s spouse receiving the residue (13). Provision would have to be made for executor’s fees in respect of the loan account as an asset in the estate. Should the loan account be greater than R3,5 million, the value of the policy can be increased to take into account the estate duty payable (Initial cover required/1 – 0.2). (14)

2.2.2 Testamentary bequest

Bequeath an amount “equivalent” to the outstanding value of the loan account to the trust. The wording used should be carefully chosen so as to avoid a CGT event pursuant to the “writing-off” of a loan. Note that where the outstanding value of the loan account is greater than the estate duty abatement at the time (currently R3 500 000), there is likely to be estate duty levied on the balance (because whereas the planner may, for example, have had a spousal deduction in terms of section 4(q), this would not be available where the bequest is to the trust).

An example of wording which may lead to CGT on the basis that the debt has been written off is:

  • I bequeath the balance of the loan account due to me by the XYZ Family Trust No IT 111/2001 to the trustees of the said trust to be held and administered in accordance with the stipulations of the said trust deed.

Whereas the following wording could possibly prevent such a CGT liability:

  • I bequeath a cash amount equal to the amount, if any, due to me by the XYZ Family Trust No IT 111/2001 up to a maximum amount of R3 500 000 (three and a half million Rand) to the trustees of the said trust to be held and administered in accordance with the stipulations of the said trust deed.

There is no consensus, however, as to whether the above wording would be open to attack under the general anti-avoidance provisions in the Income Tax Act (“the Act”), (15) and one would also need to review the will in the event of an increase in the abatement. It is suggested that one should conservatively use the life cover option (see 2.2.1) in preference. SARS (16) even take the view that leaving assets/cash to an heir to be used to repay a debt due could, depending on the facts of the case and the intention of the parties during the deceased’s lifetime, lead to the application of paragraph 12(5). (17)

Note further that this alternative requires liquidity. Should this be an issue, bridging finance could be considered. The executor of the deceased estate would approach an institution for a loan equivalent to the outstanding loan account (which is assumed to be less than an amount equivalent to the estate duty abatement of R3 500 000).

The executor would thereafter pay this amount to the trust in terms of the will. The family trust would then use this amount to settle the loan account, and the executor would then repay the institution. The main costs involved are generally a fee of about 1% of the value of the loan account, and interest at prime (possibly less 1% or 2%). A period of at least a month is often used to lend legitimacy to the scheme. However, at the end of the day this remains a scheme, the main purpose of which is to avoid tax, and is open to attack by the Commissioner for SARS.

By way of example, were the trust’s loan account R1 500 000, bridging finance costs at 1% would be R15 000, and interest at an assumed rate of 15,5% for 30 days would be R19 375, bringing the total estimated costs to R34 375.

This can be compared to the costs of “writing off” the debt as follows (the debtor is deemed to have acquired the debt):

This is clearly the least favourable option [although the planner could, however, claim a loss in terms of paragraph 56(2)].

Where liquidity is an issue and bridging finance is not an option, the planner could use life cover with the planner as contracting party and the life assured. This would, however, result in additional executor’s fees and would be deemed property in the deceased estate. If life cover is to be used, it is suggested that it is structured as discussed in 2.2.1.

2.2.3 Bequest of loan account

Finally, the loan account, as an asset in the estate of the deceased, can simply be bequeathed to a family member, or to another trust. Whilst there is a deemed disposal to the estate on death there is no CGT as this is treated as cash and there is therefore a nil gain.

Where the loan account is greater than an amount equivalent to the estate duty abatement, this option could be combined with the option of bequeathing a cash equivalent. That is, the “cash equivalent” bequeathed to trust is capped at R3 500 000, and the balance of the loan account is left to the spouse (who could continue to donate an amount equivalent to the annual amount exempt from donations tax, to reduce the loan account) or another trust.

2.3 Deemed distribution of capital gains

A trust is often used for tax arbitrage, and in particular trust distributions are utilised to minimise the effect of CGT within the trust. This should not, however, be the primary objective for forming a trust.

If, for example, an ordinary discretionary trust makes a switch in a collective investment scheme (unit trust) investment, this is a CGT event. If a gain has been made, CGT will be payable.

Where an interest-free loan to the trust has been used, the gain may be attributed to the person who made such loan in terms of the attribution rules contained in the Act. (18)

The question is whether the trust can take this notional gain, which has arisen for example on a switch within the trusts unit trust portfolio, and distribute it to the beneficiaries. The effect, were this possible, would be that the beneficiaries are each entitled to their annual exclusion (currently R17 500 – 2009/2010 year of assessment), and 25% of the deemed gain distributed to each of them would be included in their taxable income subject to taxation at their marginal rate of tax. The objective is therefore to save CGT through distributing the gains of a trust by utilising each beneficiary’s exclusion rate, inclusion rate and marginal tax rate rather than having the gains taxed in the trusts hands using a 50% inclusion rate and a marginal rate of tax of 40%.

One cannot, however, simply distribute “deemed” gains. It is, however, possible to distribute an amount equivalent to the actual gain made by the trust on the investment, to the beneficiaries. So as not to have to liquidate the units, the “gain” could, in turn, be loaned back to the trust in terms of a loan agreement. One should take care in doing so not to negate any estate planning objectives of the trust and to ensure that the distribution takes place in the same year of assessment that the gain arose. The distribution can, however, be used to the planner’s advantage, as any future distributions (he may, for example, wish to live off) from the trust, will be in repayment of the loan account, and therefore tax-free.

Paragraph 80(2) of the Eighth Schedule (19) states that, subject to the attribution rules

… where a capital gain arises in a trust in a year of assessment during which a trust beneficiary who is a resident has a vested interest or acquires a vested interest (including an interest caused by the exercise of a discretion) in that capital gain but not in the asset, the disposal of which gave rise to the capital gain, the whole or the portion of the capital gain so vested–

  1. must be disregarded for the purpose of calculating the aggregate capital gain or aggregate capital loss of the trust; and
  2. must be taken into account for the purpose of calculating the aggregate capital gain or aggregate capital loss of the beneficiary in whom the gain vests.

The whole or a portion of the gain may therefore be distributed to beneficiaries and will be taxed not in the hands of the trust, but in their hands. The more beneficiaries to whom the gain is distributed, the greater the potential savings in CGT (20). This is, however, subject to the possible application of the attribution rules (21).

However, it should be cautioned that there is a possibility, although remote, that where the amount equivalent to the gains are simply loaned back to the trust, such a scheme could face scrutiny by the Commissioner for SARS in terms of the general anti-avoidance provisions (22).

3. Trust Investments: Unit Trusts vs Endowments/Sinking Funds

It should be stressed that decisions as regards whether to structure an investment such that the planner is the owner, or alternatively the trust, should be taken on a case-by-case basis, only after having gathered and analysed all the necessary information (including the trust deed). In this regard a needs analysis is essential (23).

3.1 Unit Trusts

Income generated from a collective investment scheme (unit trust) investment, as opposed to an endowment, is taxed in the hands of the owner.

Assuming, by way of example, that an ordinary discretionary family trust currently holds a unit trust investment and that since inception of the investment, no distributions have been made to the beneficiaries, all growth on the investment would currently be taxed in the hands of the trust. (24) Capital gains tax is also payable by the trust on the sale of units. It would be expected that the trust has deducted the expenses of the unit trust investment against the income of the trust, to reduce the tax liability.

The current scenario, however, exposes the investment to income tax at 40% (on the interest) and to CGT at an effective rate of 20% (50% of any gain is included in the trusts’ taxable income which is then taxed at 40%). Consideration should therefore be given to investment in an endowment, whilst bearing in mind the CGT consequences arising from the sale of the unit trusts in order to invest in the endowment.

With regard to the current investment in unit trusts and the current tax burden, one alternative is for the trust to distribute trust income to the beneficiaries during the same year it accrues to the trust, resulting in that income being taxed not in the hands of the trust but in the hands of the beneficiaries. This, however, would affect the tax position of the beneficiaries and the beneficiaries marginal tax rates should furthermore be compared to the rate of 30% (four funds taxation) within the endowment.

In terms of the “conduit” principle (25), interest and dividends earned in respect of the unit trust investments would, however, retain their character as interest and dividends. The beneficiary in receipt of an interest distribution would be entitled to the annual individual interest exemption (26) (which the trust does not qualify for) and dividends will also remain taxfree in the hands of the recipient beneficiary (although note that a 10% withholding tax has been proposed to replace Secondary Tax on Companies). (27)

In the same way it is possible for a distribution of capital gains to take place, resulting in the beneficiaries to whom the distribution is made paying the CGT, rather than the trust. (28) In this way the CGT burden is spread, and the resultant CGT will be lower than that payable by the Trust. (29)

For example:

  • If the capital gains for a year of assessment as a result of a sale of an investment are R100 000, if the Trust retained this gain, CGT of R20 000 would be payable (50% of R100 000 = R50 000 ´ 40%).
  • If, however, there was a distribution of an amount equivalent to the gain to four beneficiaries with marginal tax rates of 30%, each beneficiary would start with again of R25 000, of which R17 500 can be excluded (2009/2010 annual exclusion for individuals), leaving a capital gain of R7 500, of which 25% (R1 875) is included in their taxable income, which assuming marginal rates of tax of 30%, would result in each beneficiary paying nominal CGT of R562,50. (That is, the cumulative CGT for all four beneficiaries is R2 250, as opposed to R20 000 which would have been payable by the trust).

Even in the event that all four beneficiaries had a marginal tax rate of the maximum of 40%, the CGT payable by each beneficiary would only be R750, with a cumulative CGT for all four beneficiaries of R3 000. This still represents a saving of R17 000. No rebates are applicable to a trust and the interest exemption does not apply to a trust. Again, it is important to bear in mind that tax savings should not be the main purpose of a trust, as SARS may disregard the existence of the trust under the general anti-avoidance provisions. (31)

3.2 Purchasing an endowment/sinking fund in the trust

Among the advantages of an endowment/sinking fund are that:

  • All growth is taxed within the fund (32) at a rate of 30%, not in the trust’s hands (which is 40% where the trust retains the income).
  • After the five-year “restriction period” (during which only one loan and one disinvestment is permitted and during which the premiums cannot exceed more than 20% of the premiums in the previous year without extending the restricted period) (33) the proceeds are “tax-free” (that is, they are not again taxed in the owner’s hands).
  • Where there are liquidity concerns, an interest-free loan facility could also be used by the trust to gain access to the capital and the trust could loan this capital to a beneficiary. This loan account will be a liability in the beneficiaries’ estate and will reduce the dutiable estate. The beneficiary could at some stage repay the loan to the trust, or the planner could donate the outstanding amount to the trust, which would then repay the interest-free loan back into the policy.
  • If, on maturity, distributions are made to beneficiaries after policy maturity, the payments retain their original nature and will be free of tax in the beneficiaries’ hands, as the trust acts as a “conduit”.

With pure endowment policies, estate duty can be avoided by adding additional life assureds. Should the policy then become payable on the death of additional life assureds, it will not be deemed property in the estate of the planner. Alternatively where the amount of the policy is under R3 500 000 being equivalent to the estate duty abatement, no estate duty is payable. The advantage of a sinking fund investment by a trust, is that it does not form part of the property of the planner where it is owned by the trust, as it has no life assureds.

A planner’s marginal rate of tax should be assessed to compare the income tax/CGT payable in terms of a unit trust investment or an endowment. For example, one would compare the income tax/CGT payable were unit trusts either:

  • held by the trust with capital gains distributed to beneficiaries to utilise a lower rate; or
  • held directly by the planner.

The annual exclusion for capital gains will be available in both scenarios. The first scenario offers opportunity for tax arbitrage depending on the number of beneficiaries and particularly where the planner has a higher marginal tax rate than these beneficiaries. For example, the effective rate of CGT were one to assume a marginal tax rate of 25% for one beneficiary of the trust is 6,25% and if one assumes the planner has a higher rate of CGT, at for example 30%, the effective rate of CGT in the planner’s hands is 7,5%).

One could also then compare the above analysis in respect of a unit trust investment to a sinking-fund being the chosen vehicle:

  • Sinking Fund: income tax and CGT would be payable within the fund at a rate of 30% and an effective rate of 7,5% respectively, with no annual exclusion applicable. Where held by the trust, the fund and all growth therein would fall outside of the planner’s estate, and switches would not be subject to CGT in the trust or the planner’s hands.
  • Unit trust investment: CGT payable with annual exclusion available to planner.

The circumstances of each client’s situation including his or her marginal rate of tax are clearly crucial. In the event that it is preferable given the facts of the case being dealt with to move from a unitised investment held by a trust to an endowment held by a trust, switches could be gradually phased-in across different tax years to reduce the CGT payable in any one year. A benefit of an endowment is that unlimited switching of underlying funds is generally permitted. In the event that a trusts risk profile changes,(34) it is therefore possible to switch into lower-risk funds without income tax/CGT consequences in the owners’ hands.


The article was initially published an Old Mutual Newsletter and we make reference to Stanley Tordiffe BCompt(Hons)CA(SA),
CFP (021 555 9300).

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