1587. Time of vesting of benefits
December 2007 – Issue 100
An established principle in relation to the taxation of trusts is the "conduit principle" in terms whereof trust income or capital that has been vested in beneficiaries is not taxed in the hands of the trust, but rather in the hands of the beneficiaries. This principle is codified in section 25B and paragraph 80 of the Eighth Schedule to the Income Tax Act, No.58 of 1962 (the Act). (For purposes of this article we leave aside the provisions of section 7 of the Act which in certain circumstances taxes the income of the trust in the hands of the donor of the trust assets.)
Section 25B provides that where a beneficiary has acquired a vested right to income in a trust, such income must be deemed to have accrued to that beneficiary. As has been established by the Supreme Court of Appeal (see Armstrong v CIR 1938 AD 343), trust income which is taxable in the hands of the beneficiary does not lose its identity because it first passes through a trust. Where dividends are declared to a trust and are subsequently vested in a beneficiary, such amounts which accrue to the beneficiary will retain their nature as a dividend and will not be "converted" into income of a different nature. Thus, whether an amount, in the hands of the beneficiary, constitutes revenue must generally be determined without reference to the fact that it passed through the trust first. Similarly, whether income is or is not exempt from tax must be determined in relation to the taxpayer to whom the income or capital gain accrues in any year of assessment, i.e. the beneficiary where amounts are distributed or the trust where amounts are not distributed.
A problem arises where the asset generating the income is held by a trust while the income accrues to the beneficiary (by virtue of a vesting), as certain exemptions in the Act link the exemption to the person holding the asset. Most trusts, with the exception of a bewind trust, operate on the principle that the trust owns the assets while the income and in some cases, certain capital, vests in the beneficiaries (in most cases at the discretion of the trustees). Accordingly, where the income is vested in a beneficiary who is not the owner of the assets, this leads to a position where the "conduit principle" has the effect of flowing the income, without the accompanying exemptions, through to the beneficiaries.
A good illustration of this is in relation to section 10(1)(k)(ii)(dd) which provides an exemption from normal tax of any foreign dividends accrued to a person where that person holds at least 20 per cent of the total equity share capital and voting rights in the company declaring the dividend. Where a trust holds the shares in the foreign company and the dividends declared in respect of those shares vest in the beneficiary, such dividends will not be exempt under this section, as the person seeking the exemption is not the holder of the shares. This is true irrespective of whether the trust holds at least 20 percent of the equity share capital and the beneficiary’s effective interest in the trust is at least an effective 20% interest in the shares held by the trust.
The Appellate Division of the Supreme Court (as the Supreme Court of Appeal was then known) in Brodie & Another v Secretary for Inland Revenue 1974 (4) SA 704 (A), dealt with a similar section, the now removed section 10(1)(k)(v) which provided amongst others for the exemption from tax of dividends that accrued to any person in respect of shares acquired by such person by donation from a foreigner. Here the court held that the conduit principle can not be extended so as to make it of application, not only to dividends passing through a trustee into the hands of the beneficiaries under a trust, but also to the ownership of the shares on which such dividends are paid. Such, it was held, would be contrary to the provisions of section 10(1)(k)(v) and the terms of the will which did not provide that the trustees held the shares on behalf of the beneficiaries, but on their own account. It seems therefore that where the shares are not held by the beneficiary himself, the conduit principle will not be of much avail, but rather to the detriment of the beneficiary in relation, inter alia, to the foreign dividend exemption.
In a case such as the above, the timing of the vesting of the dividend income in the beneficiaries is of utmost importance. Should the dividend income not be vested in the beneficiary, but retained in the trust for the year of assessment in which the dividend was declared, the exemption provided in section 10(1)(k)(ii)(dd) will be available to the trust, as it is the holder of the shares. When the already "taxed" dividend income is distributed to the beneficiary in a subsequent year of assessment, it will not be taxed in his hands again and should constitute a receipt of capital which would not give rise to any capital gains tax. A different set of rules applies to non-resident trusts.
Paragraph 80 of the Eighth Schedule to the Act provides a similar conduit mechanism to the one in section 25B. In terms of this paragraph where an asset is vested in a resident beneficiary, any capital gain or loss thereon must be disregarded in the hands of the trust, and taxed in the hands of the beneficiary. Similarly where a capital gain arises in a trust in a year of assessment during which a resident trust beneficiary has a vested interest in that capital gain, such gain must be disregarded in the hands of the trust and taken into account in determining the aggregate capital gain or loss of the beneficiary. Once again, the distinction between the beneficiary in whose hands the gain may vest, and the trust in whose hands the asset creating the capital gain or loss is owned, may be problematic as will be illustrated below.
Paragraph 55 of the Eighth Schedule to the Act provides that a person can disregard any capital gain or loss in respect of a disposal of any amount in respect of a policy (a policy with an insurer) where that person is the original beneficial owner of the policy, or persons within a certain relationship with such beneficial owner (such as his spouse or dependant). Where an insurance policy is acquired by a trust, the trust will be the beneficial owner of the policy. Should the proceeds on disposal or redemption be vested in a trust beneficiary, the capital gain exemption provided in the paragraph will not apply, as the beneficiary will not be the original beneficial owner of the policy and thus the exemption will not apply to the beneficiary albeit that the trust would have been entitled to the exemption.
Vesting should accordingly be extended until the following year of assessment, in order to have the proceeds under the policy taxed in the trust’s (who is the original beneficial owner under the policy) hands, thereby qualifying for the paragraph 55 exemption. Where the beneficiary is a non-resident, the conduit principle provided in paragraph 80 will in any event not apply as the paragraph applies only to resident beneficiaries. Accordingly, where the beneficiary is a non-resident, the vesting or not of the policy income is of no consequence, such gain being taxed in the hands of the trust and being subject to the exemption in paragraph 55.
As is illustrated above, the conduit principle does not necessarily create a situation where the provisions of the Act apply mutatis mutandis to beneficiaries or trusts, the only relevant distinguishing factors being who should carry the tax burden and the rates at which tax is levied. The exemption or otherwise of income may well depend on the person in whose hands it is taxed, making the time of vesting an important factor in tax planning. This once again serves to illustrate that a trust is a structure sui generis and the tax consequences may or may not deviate from those principles which we may comfortably apply to other entities, stressing the need to carefully consider the implications of each action when dealing with trusts.
Edward Nathan Sonnenbergs Inc.
IT Act:8th Schedule par 55, 80