South Africa - Trusts - Providing Vested Rights In Respect Of Discretionary Trusts (2024)

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The rise of the discretionary family trust has long seemedinevitable. It appears to provide unparalleled commercial andfiscal flexibility to achieve multi-generational wealth transfer,asset protection, estate planning and other objectives.

While family trusts with vested rights for beneficiaries withparticular needs do have their place, beneficial owners generallybelieve that a discretionary family trust, in combination with anappropriate letter of wishes, allows them to adapt to changes incirc*mstances and to have peace of mind about access to trustassets when required. This may be achieved without compromisingincome splitting and other benefits associated with an electiveflow-through tax dispensation.

Unsurprisingly, the regulatory and fiscal tide seems to haveturned against trusts, particularly, discretionary trusts.

The changing fiscal landscape

In South Africa, initiatives to impose onerous tax treatment ontrusts and their beneficiaries have become an establishedtrend.

• Trusts have historically been taxed at the maximum personal taxrate on income and the highest rate on capital gains.
• In 2013, the National Treasury proposed to restrict theflow-through principle and that distributions of capital gains by atrust to natural persons would in future be taxed at income taxrates and not at capital gains tax rates but these proposals werenot enacted.
• In 2015, the Davis Tax Committee recommended that:
  • All distributions by offshore trusts to SA residentbeneficiaries should be taxed as income and;
  • Local trusts should be taxed as separate taxpayers at a flatrate of tax. This would mean that the conduit principle for localtrusts would be removed so that the income of local trusts could nolonger be taxed in the hands of beneficiaries or the donor atindividual marginal tax rates as opposed to the higher flat rate oftax in the trust.

Fortunately, these proposals were not implemented.

• In 2016, anti-avoidance measures were introduced that treat theinterest benefit on low-interest or interest-free loans provided byor at the instance of natural persons to trusts and certaincompanies related to trusts as a deemed donation.
• In 2018, amendments were made to disregard the participationexemption under certain circ*mstances, to preclude tax-free capitaldistributions by offshore discretionary trusts out of dividendsthat would have been exempt had the trust been a South African taxresident.
• In 2021, the anti-avoidance rules relating to funding of trustsand related companies by low-interest or interest-free loans wereextended to preference share funding.
• Late in 2023, the conduit principle was terminated fordistributions of income by local trusts to non-residentbeneficiaries. Existing legislation does not cater for theapplication of the conduit principle to capital gains that arevested in non-resident beneficiaries by local trusts.

Regulatory changes

Internationally, transparency of beneficial ownership of trustsincreased significantly following the introduction of the CommonReporting Standard and the resulting Automatic Exchange ofInformation between various revenue authorities around theworld.

The South African Revenue Service("SARS") recently introduced detaileddisclosure requirements to record the beneficial owners of truststo comply with the Financial Action Task Force requirements.

Trustees are also obliged to lodge and keep up-to-date recordsof the beneficial ownership of the trusts of which they aretrustees, and to record comprehensive data regarding beneficialownership of trusts with The Master of the High Court.

Funding challenges

Trusts are generally funded by donations or loans. Both methodsinvolve tax costs for a South African resident funder.

Donations by South African residents are subject to donationstax of 20% or 25% to the extent that donations in aggregate exceedR30m (subject to an annual exemption of R100 000 donated by naturalpersons). In addition, capital gains tax("CGT") may apply to a donation ofassets that fall within the CGT net.

As indicated above, the interest benefit of low-interest orinterest-free loans to trusts is subject to deemed donations or, inthe case of cross-border loans to a connected person, transferpricing provisions. Interest earned on interest-bearing loansconstitutes the gross income of a South African residentlender.

In addition, attribution rules may tax income and capital gainsattributable to donations and non-arms-length loans in the hands ofthe donor.

Vested rights in respect of trusts

In the current dynamic tax and regulatory environment, providingcertain vested rights to beneficiaries may offer uniquesolutions.

The potential to create a hybrid trust instrument which has bothdiscretionary and vested features makes the structuringopportunities particularly attractive. In this scenario, vestedrights can co-exist within the framework of a discretionarytrust.

Historically, vesting trusts have often been regarded as lesseffective than discretionary trusts for reasons such as taxinflexibility, the inclusion of vested rights as property forestate duty purposes and the exposure of vested rights tocreditors.

Beneficial owners are beginning to reassess the apparentdrawbacks of vested rights compared to potential funding and otherbenefits.

For example, while vested rights may indeed be exposed tocreditors, it must be recognised that the rights of the creditorremain subject to the terms of the trust instrument. This opens thedoor for creating an instrument that provides protection withouthaving to rely on the non-vesting of some of the rights ofbeneficiaries.

Careful structuring of the terms of the relevant vested rightsin the trust may enable funding of the trust through a contributionthat does not constitute a donation for donations tax purposes.

This outcome not only precludes donations tax but also becomesthe defence against the application of the attribution rules toresultant income and capital gains derived by the trust.

Of course, careful planning is required to achieve acontribution that remains outside the ambit of a donation yet doesnot fall within the provisions that would treat it as aninterest-bearing instrument. Should this requirement be overlookedand a contribution to a trust constitutes an interest-bearingarrangement, a funder may well have to face tax liabilities withoutany cash flow to fund the tax.

Even if the above guidelines and requirements are observed, abeneficial owner may well be concerned about the estate duty impactof such vested rights. This enquiry must be addressed bearing inmind that donations (in this case to a trust) would constitutedeemed property for estate duty purposes and that a loan to a trustconstitutes property. The challenge is to structure an arrangementthat achieves the above-mentioned objectives and mitigates theestate duty exposure of the funder.

It should be noted that contributions made by a resident to anoffshore trust which exceeds ZAR10 million, where such resident hasor acquires a beneficial interest in the offshore trust, arereportable to SARS within 45 business days. Consideration should begiven to when the relevant resident acquires such beneficialinterest in the offshore trust. This may not be at the time thatthe relevant contribution is made to such trust.

Conclusion

The changing environment of an increasing fiscal clamp-down ontrusts may well spur a new generation of vested rights in respectof trusts that could challenge the perceived axiomatic superiorityof purely discretionary family trusts.

The content of this article is intended to provide a generalguide to the subject matter. Specialist advice should be soughtabout your specific circ*mstances.