A new world
The world of offshore trusts is now more dynamic than ever. The benefits of trusts as effective tools for the preservation of assets for future generations has been commonly known and accepted for decades. Globally, the trust environment is changing due to the introduction of the Common Reporting Standards and the resulting Automatic Exchange of Information between various revenue authorities around the world. The original settlement and current beneficial ownership of trusts is now largely transparent.
In addition, some jurisdictions view offshore trusts as transparent vehicles with potentially significant tax implications for the funder and beneficiaries of these vehicles. This increased transparency has made beneficiaries more aware of their rights against trustees and their entitlement to information relating to the management and administration of the trusts.
An intricate range of tax provisions can apply to South African residents’ relationship with offshore trusts. Foundations are also increasingly used which may have different tax consequences. The tax treatment of the funding of and distributions from offshore trusts has been the subject of debate for a number of years, culminating in the most recent amendments which were promulgated in the Income Tax Act, 1962 (“Act”) in 2018.
In essence, the Act provides for the taxation of income and capital gains distributed to South African resident beneficiaries. The funding of these vehicles can also trigger a donations tax liability and resulting attribution rules can apply to include income and capital gains in the hands of the donors. Where a person connected to the trust sells assets to the trust on loan account, interest is required to be charged.
The amendments brought about fairly fundamental changes relating to the payment of dividends and the use of the participation exemption in circumstances where trusts held shares in underlying companies.
Below, we consider some highlights of the amendments relating to the participation exemption.
Donors may be taxed on income received by or accrued to the offshore discretionary trust if such income was received by or accrued to the offshore trust by way of donation, settlement or other disposition made by the resident, provided that such income would have been included in the offshore trust’s income had the trust been a resident. Interest-free loans or low-interest loans granted to the offshore trust are also covered by these provisions.
Previously, this rule could have excluded dividends distributed to a non-resident trust by a foreign company. Such a foreign dividend would not have constituted income had the trust been a resident, by virtue of the participation exemption in section 10B(2)(a) of the Act.
The participation exemption applies to foreign dividends received by or accrued to a person that holds at least 10% of the total equity shares and voting rights in the foreign company declaring the dividend. Such foreign dividends are exempt from tax.
The amendment to section 7(8) of the Act states that, when determining whether an amount constitutes income, the participation exemption must be disregarded in respect of a foreign dividend and amounts derived directly or indirectly from a foreign dividend that were received by or accrued to a non-resident such as an offshore trust where, among other requirements, more than 50% of the total participation or voting rights in the foreign company are held or exercisable by the offshore trust, and where the resident is a connected person, as defined, in relation to the trust.
South African resident donors are still able to benefit from the partial tax exemption that applies to all foreign dividends in terms of section 10B(3) of the Act, in which case the dividends will be taxed at a maximum rate of 20%.
These rules will not apply to interest bearing loans. These require an arm’s length rate of interest to be charged in terms of the transfer pricing provisions set out in section 31 or in terms of section 7C of the Act, which specifically regulates the charging of interest where assets are sold to a trust on loan account.
Previously, a capital distribution to a South African resident beneficiary by an offshore trust arising from a prior year’s foreign dividends derived from a foreign company, would have been exempt from tax if the trust would have qualified for the participation exemption. Therefore, such a capital distribution would not have been taxable in South Africa in the hands of the beneficiary on the basis that no amount of income (as defined) would have arisen for the trust if it had been a resident.
Similar to the discussion above in respect of the attribution rules, the participation exemption must be disregarded under the same circumstances as discussed above, when determining the extent to which capital distributions will be taxed in the hands of the South African resident.
Capital distributions by an offshore trust that are derived from such foreign dividends would consequently be taxable in the hands of the South African resident beneficiary. However, South African residents would also still be able to benefit from the partial tax exemption applicable to foreign dividends.
Amendments to distributions of capital gains
Prior to the amendments below, paragraph 80(1) of the Eighth Schedule to the Act (“Eighth Schedule”) provided that if a trust vested an asset in a resident beneficiary, the beneficiary would be subject to capital gains tax in respect of the related capital gain determined by the trust in respect of the disposal of the asset. Paragraph 80(2) of the Eighth Schedule provides that if a trust disposes of an asset and vests the resultant capital gain in a resident beneficiary in the same tax year, the beneficiary would be subject to capital gains tax in respect of the capital gain. Previously, these provisions appeared to not be applicable to offshore trusts. Subsequent to the legislative amendments, the resulting capital gain in respect of a disposal of an asset vested in a South African beneficiary of a trust is to be taken into account in determining the aggregate capital gain or loss of the resident beneficiary to whom the asset was disposed. This provision is now applicable to offshore trusts as well.
Remittance of offshore distributions to South Africa
South African exchange control residents may use their annual foreign investment allowances to fund offshore trusts.
The South African Reserve Bank’s Currency and Exchange Control Guidelines do not impose any restrictions on the remittance of distributions from offshore trusts to resident beneficiaries.
Some arrangements in respect of offshore trusts may need to be reported to the South African Revenue Service unless they are excluded in terms of the Tax Administration Act, 2011. Such reportable arrangements include contributions made by a resident to an offshore trust which exceed ZAR10-million, and where such resident has or acquires a beneficial interest in the offshore trust. These arrangements must be reported to the South African Revenue Service within 45 business days.