HOW TO MINIMIZE CAPITAL GAINS TAX USING THE FLOW-THROUGH PRINCIPLE, AND DOES YOUR TRUST PROVIDE FOR IT?
- AN INTRODUCTION TO CAPITAL GAINS TAX IN TRUSTS
- Since a trust is not a natural person, 80% of any capital gain arising from a disposal of an asset by the trust must be included in the trust’s taxable income if the amount is retained in the trust (subject to the attribution rules mentioned below). Where the capital gain is attributed to the trust, the effective rate of tax on a capital gain is 36%. Where a trust is a special trust, only 40% of the capital gain is included in the taxable income with an effective tax rate similar to that of an individual, but discretionary family trusts do not qualify as special trusts.
- There are however ways in which this tax can be minimised. A capital gain that arises as a result of the disposal of a trust asset can either be attributed to the trust or to someone else, such as the donor or a beneficiary. Paragraphs 68 – 72 of Schedule 8 of the Income Tax Act stipulate certain attribution rules and allow for capital gains arising in a trust to be taxed in the hands of the trust donor, wholly or in part if very specific requirements are met. As will be seen from this discussion, it may also be possible to vest the capital gain in a beneficiary who is a natural person and have it taxed in their hands.
- Where the capital gains are taxed in the hands of a donor or beneficiary as an individual, 40% of the capital gain arising from a disposal is included in his or her taxable income and the effective rate of tax on the capital gain is between 0% and 18%, depending on which tax bracket he or she falls in.
- TRUST DISPOSALS GIVING RISE TO CAPITAL GAINS TAX
The following disposals by a trust will give rise to a capital gain or loss being generated by the trust:
- Where a trust asset or interest in an asset is vested in a South African resident beneficiary (Paragraph 11(1)(d) of Schedule 8 of the Income Tax Act); or
- Any other disposals, such as the sale of an assets by a trust to a third party (Paragraph 11 of Schedule 8 of the Income Tax Act).
- FLOW-THROUGH PRINCIPLE
- The flow-through principle allows for capital gains that are realised inside a trust to “flow through” and be distributed to the beneficiaries of a trust whilst still retaining the nature of a capital gain. These amounts are then taxed in the hands of the beneficiary and not in the trust itself. Thus, where a capital gain is vested in a beneficiary, the trust will not be taxed on such gain.
- The beneficiaries, as natural persons and individual taxpayers, are allowed a yearly exclusion of R40 000.00 of any gains in that year and R300 000.00 in their year of death, and will only include 40% of the capital gain for income tax purposes and the gain will be taxed at their specific marginal rate of between 18% to 45%.
- The following example can be used to illustrate this benefit:
- A trust sells a property it owns for R1 million and makes a capital gain of R600 000.00;
- If this capital gain is retained and taxed in the trust, the capital gains tax payable will be R216 000.00;
- If however this capital gain is distributed in equal shares to 3 of the beneficiaries (each taxed at the highest marginal tax rate), the following will happen:
- Each beneficiary receives R200 000.00 which is regarded as a capital gain realised in their hands:
R200 000.00 – R40 000.00 (Annual exclusion for natural persons)
= R160 000.00
40% of R160 000.00 is included in the taxable income of the individual
= R64 000.00
This amount is taxed at that individual’s marginal tax rate:
45% x R64 000.00
= R28 800.00 income tax payable by each of the beneficiaries
Total capital gainst tax payable where flow-through principle is used: R86 400.00
This constitutes a saving of R129 600.00 in taxes.
- In order to effectively use this flow-through principle it must be noted that the capital gain must be allocated to a beneficiary who is a natural person and is resident in the Republic, and it must take place in the year the capital gain was realised by the trust.
- DOES YOUR TRUST PROVIDE FOR THE FLOW-THROUGH PRINCIPLE?
- In order for the flow-through principle to be applied in a trust, the trust deed must specifically authorise trustees to distribute the capital gains of the trust and vest it in beneficiaries.
- If your trust deed does not specifically provide for this, please contact us for a review and update of your trust deed.
Should you further be uncertain about your estate planning, please feel free to contact our office to consult with one of our experienced fiduciary specialists.
LLB; LLM (Estate Planning)
Fiduciary and Commercial Department
Phone: 012 361 9823