ALTERACIONES DEL AGUA

At the time of inception of a trust, only the founder will typically have a loan account due to him or her by the trust as a result of the initial sale of assets to the trust at market value (unless the assets were donated to the trust).

Distributions on loan account

If any distributions are made by the trustees to the beneficiaries in any year, such

distributions can either be paid out in cash from cash reserves in the trust or such amounts can be kept on a loan account due to each beneficiary while the income earned is

reinvested in the trust thereby achieving greater potential growth in the trust. The latter option will result in loan accounts due to beneficiaries that will increase over time as distributions are declared but not paid out in cash. For founders and beneficiaries other than a founder who sold the initial assets to the trust on loan account, this loan account will start from Rnil whereas, for a founder who sold assets to the trust on loan account, this practice will increase the initial loan account over a period of time.

Regular distributions to beneficiaries are commonly done to obtain a tax advantage through the working of s 25B of the Income Tax Act (conduit principle) by having trust income and gains vest in the hands of beneficiaries and therefore taxable at the lower effective tax rates applicable to individuals (as opposed to the high tax rates applicable to trusts)338_{. In order to avoid a depletion of trust assets through regular cash distributions,}

such distributions are then often kept on loan account and reinvested in the trust to ensure maximum capital growth of the trust assets.

Such loan accounts due by the trust will be an asset in each of the estates of the founder and beneficiaries. These loan accounts are consequently open for attachment by third parties to the beneficiaries, like creditors or former spouses in divorce cases. Therefore, if such loan accounts are allowed to become sufficiently large compared to the value of the trust assets, the protection of wealth initially achieved through the use of a trust will effectively be partially undone. If a third party manages to attach a beneficiary’s loan account by means of a court order, the trustees may have to liquidate some of the trust’s assets in order to pay out such loan account to such third party on behalf of the relevant beneficiary. A significant reduction of trust capital may hamper the growth of trust assets in future years, affecting all other beneficiaries’ potential distributions.

Large remaining loan accounts of the founder or beneficiaries will also attract a large estate duty liability on death which may undo the short-term income tax savings achieved from regular annual distributions in the past.

Cash distributions to beneficiaries on a regular basis (as opposed to keeping such amounts on loan account or within the trust) will likewise form part of such beneficiaries’ personal estates and, if not consumed for living expenses, could also result in the undoing of the protection of wealth achieved by use of a trust as well as being subject to excessive estate duty on the death of the beneficiaries.

Interest-free loan accounts

As transfer pricing will not be applicable between connected persons who are residents339

(for instance, the founder and the trust), there is no taxation requirement for the loan account to a resident trust to carry an arm’s length interest rate. Interest-free loans are therefore the norm as any interest earned by the trust would merely have been distributed as income to the various beneficiaries in order for such income to be taxed at the

individual’s marginal tax rate. This would also create an additional accounting and administrative burden.

Even though an interest-free loan is not seen as a donation itself340_{, it has been argued that}

the interest foregone constitutes a continuing, common law donation and that s 7 and paras 68 to 73 of the Eighth Schedule may therefore apply to the amount that would have accrued to beneficiaries as a result of such interest amounts foregone341_.

Reducing loan accounts

A portion of each distribution made by trustees to beneficiaries could be made in cash in order to assist in paying the taxes due on such distributions in the hands of the various beneficiaries or if to be used to finance living expenses, while the rest of the distribution remains on loan account.

The founder and other beneficiaries will also typically opt to reduce their loan accounts annually by using their R100,000 annual donation free of donations tax342_{. The reduction}

of debt will not have any capital gain consequences in the trust as para 12A of the Eighth Schedule, which governs the calculation of capital gains in these cases, exempts debt

339 _{Per the working of s 31 of the Income Tax Act}

340 _{That is, the interest foregone does not fall within the statutory definition of ‘donation’ per s} 55(1) of the Income Tax Act which would have attracted donations tax (De Koker & Williams 2015:para 12.27).

341 _{De Koker & Williams 2015:para 12.27; Foster et al. 2015:9 (para 2.2.3)} 342 _{Section 56(2)(b) of the Income Tax Act}

reductions which occurred by way of donation343_{. Prior to 1 January 2013, the application}

of the now-repealed para 12(5) of the Eighth Schedule to the Income Tax, may have resulted in such annual donations being viewed as the reduction a debt for no

consideration344 _{which could have been considered as a deemed disposal attracting capital}

gains in the trust in those years of assessment345_.

A retired beneficiary (for instance, the founder) could furthermore start to draw down on their loan account in order to supplement retirement income thereby reducing his or her remaining loan account more rapidly which will result in less estate duty payable on this asset in their estate on death.

Another advantage of drawing down on a loan account is that such amounts will be cash distributions free from additional taxation (assuming that such withdrawals are paid from cash reserves in the trust and no sale of trust assets, resulting in taxable capital gains, is required). Distributions kept on loan account were taxed in the hands of the beneficiary in the years of assessment when these distributions were made and the withdrawal of cash from these loan accounts in later years will therefore have no additional tax implications for the beneficiary at that time.

Treatment of trust loan accounts on death of beneficiary

As stated above, a loan account due by a trust to a beneficiary will be regarded as an asset in the estate of such beneficiary and on death, the remainder of such loan account will therefore be included in his or her estate and subject to estate duty of 20% on the net estate exceeding the s 4A estate duty abatement (currently at R3,500,000) 346_.

An excessive estate duty liability as a result of large remaining loan accounts on death due to distributions in excess of the living expense requirements of a beneficiary can therefore undo the previous short-term income tax benefits achieved by distributing income to beneficiaries each year.

A further arrangement that could be considered is for the founder to donate the remaining loan account due by the trust back to the trust via a donatio mortis causa (donation in contemplation of death). Such a donation will be exempt from donations tax per s 56(1)(c)

343 _{Para 12A(6)(b)(i) of the Eighth Schedule to the Income Tax Act.}

Even though no donations tax would be payable, this sub-paragraph only refers to donations as defined in s 55(1) of the Income Tax Act and no reference is made to donations tax to have been levied in order for this exemption to apply.

344 _{Per the now-repealed para 12(5)(a)(i) of the Eighth Schedule to the Income Tax Act applicable} prior to 1 January 2013

345 _{De Koker & Williams 2015:para 24.132} 346 _{Foster et al. 2015:9 (para 2.2.3)}

of the Income Tax Act but will be regarded as deemed property in the estate of the founder on death per s 3(3)(b) of the Estate Duty Act and therefore liable for estate duty. Even though such a loan account will remain in the founder’s estate for estate duty calculation purposes, no executor’s fees will be due on such a loan account (typically charged at the statutory maximum of 3.99% of the estate’s gross asset value, inclusive of VAT347_{) as it}

will no longer form part of the deceased estate to be managed by the executor. The founder’s deceased estate will therefore save up to a maximum of 3.99% of the

outstanding loan account in expenses which would otherwise have been payable by the estate. For sufficiently large loan accounts such a saving may not be insignificant which may make this option worth considering.

With regard to CGT consequences to both the trust and the founder, the donation of the founder’s loan account to the trust via a donatio mortis causa amounts to a reduction of debt (due by the trust) which is governed by para 12A of the Eighth Schedule to the Income Tax Act. If this reduction of debt fell into the provisions of para 12A, then it would have resulted in a reduction of the base cost of any assets held in the trust

purchased as a result of the reinvestment of the loan amounts due to the founder348_{. This}

would have resulted in an additional capital gain equal to the loan amount to be recognised on the eventual sale of such assets by the trust. Even though no donations tax was due on the donatio mortis causa, the amount by which the debt is reduced by the deceased estate of the founder (that is, the full loan account amount) forms part of the property of the deceased estate for the purposes of the Estate Duty Act349 _{and therefore the donation of the}

loan account to the trust falls outside the provisions of s 12A350 _{so it is submitted that there}

will be no CGT consequences for the trust as a result of the reduction of this debt. As the founder is a connected person to the trust by virtue of being a beneficiary of the trust351 _{it is furthermore submitted that the capital loss in the founder’s estate as a result of}

the disposal (via donation) of the loan amount to the trust will be ring-fenced per para 39(1)(a) of the Eighth Schedule to the Income Tax Act. Additionally, as the trust was not required to reduce the base cost of assets in the trust per para 12A, it is submitted that the exceptions to the ring-fencing of capital losses contained in para 56 of the Eighth Schedule

347 _{Per Regulation 8(1)(a) promulgated under s 103 of the Administration of Estates Act, No. 66 of} 1965 the executor’s remuneration equals 3.5% on the gross value of estates. This is the amount exclusive of VAT, therefore if an executor is registered as a VAT vendor, an amount of 3.5% x 1,14 = 3.99% will be due.

348 _{Para 12A(3) of the Eighth Schedule to the Income Tax Act} 349 _{Per s 3(3)(b) of the Estate Duty Act}

350 _{Para 12A(6)(a) of the Eighth Schedule to the Income Tax Act}

will also not apply352_{. The donation of the founder’s loan account to the trust via a donatio}

mortis causa will therefore neither result in a capital gain being recognised in the trust nor a capital loss being recognised in the founder’s estate.