A recent SCA judgement has clarified that a capital gain distributed from one trust to a second and then to a natural person beneficiary must be taxed in the hands of the second trust, not the natural person.
The question whether a capital gain can flow through multiple discretionary trusts has finally been settled by the Supreme Court of Appeal (SCA).
This is important because, in practice, the following situation could arise. Discretionary Trust 1 sells an asset, realises a capital gain of ZAR 100 and vests it in discretionary Trust 2 in the same tax year. Trust 2 vests the ZAR 100 in John, one of its beneficiaries, in the same tax year. John is on the maximum marginal rate of 45%. If the gain could flow to John, he would pay tax of ZAR 18 (ZAR 100 × 40% inclusion rate × 45% marginal tax rate) (ignoring the annual exclusion of ZAR 40 000). But if the gain could travel only as far as Trust 2, it would be taxed at an effective rate of 36% ((80% inclusion rate) × 45% flat rate) and the tax would be ZAR 36.
In C: SARS v The Thistle Trust, 10 vesting trusts (collectively the ‘Zenprop Group’) carried on business as property owners and developers. In the 2014 to 2016 years of assessment, these ‘tier 1’ trusts disposed of capital assets, giving rise to capital gains which vested in The Thistle Trust in the same year of assessment. The Thistle Trust in turn vested the capital gains in its natural person beneficiaries in the same year of assessment, and they declared the capital gains.
SARS raised additional assessments for the years in question on The Thistle Trust as well as an understatement penalty of 50% plus s 89quat interest. In the Tax Court (ITC 1941 (2021) 83 SATC 387 (G)), Wright J found in favour of the taxpayer, ruling that the capital gains were correctly taxed in the hands of the natural person beneficiaries of The Thistle Trust under s 25B, para 80(2) of the Eighth Schedule of the Income Tax Act and the conduit principle.
On appeal by SARS to the SCA, the SCA held that s 25B did not apply because the Eighth Schedule had a self-contained rule for dealing with capital gains in the form of para 80(2). Para 80(2) required the capital gains to be disregarded by the tier 1 trusts and to be taken into account by The Thistle Trust. What was vested in the natural person beneficiaries of The Thistle Trust was simply a sum of money that did not give rise to a capital gain capable of attribution. The conduit-pipe principle formulated in the Armstrong and Rosen cases did not apply.
The lesson from this case is that multiple discretionary trust structures are inefficient for capital gains tax (CGT) purposes because they prevent gains from being taxed in the hands of natural person beneficiaries at the lower of 0% to 18% CGT effective rate. Instead, the capital gains are taxed in the tier 2 trust at 36%.
By implication, the case also puts paid to the argument that capital gains can be distributed to non-resident beneficiaries by resident trusts through the conduit principle.
It would be interesting to know whether the assessments of the natural person beneficiaries will be reduced or whether they have prescribed.
The taxpayer at least enjoyed success in one area. The court found that it was not liable for the understatement penalty of 50% because it had relied on a legal opinion. But the trust still had to pay the interest due on the underpayment of provisional tax.
(This article first appeared in the Davey’s Locker newsletter (November 2022) and is reproduced with permission.)