Changes to the tax treatment of trusts

In his budget speech on 27 February 2013, the minister of finance indicated that government will be changing the tax treatment of trust. The flow through or conduit pipe principal will no longer apply, but what does this mean for trustees and beneficiaries of trusts.

The reason for this change according to treasury, is to stop a practice of using trusts to avoid paying tax by distributing income to beneficiaries who have lower effective tax rates than the trust.

It is important to note that these new changes will not apply to trusts set up to provide for people with disability (called Special Trusts) and Testamentary Trust where the beneficiaries are minors younger than the age of 18 years. I effect the proposals will target Discretionary Trusts.

It is also important to consider why trusts are created. Often it is to protect assets for the benefit of a 3de parties. An example is a trust being created to hold the inheritance for children until they are perceived to be of an age to responsibility deal with the inheritance. Also to provide for a spouse after the testature’s death, without the risk of the assets falling into the hands of a new partner. Often the reason is not to avoid tax but it seems that the perception from government is that this is the main reason trusts are created.

Under the flow through principle income retains its form when it is distributed to beneficiaries. If a trust receive interest income and distribute it to a beneficiaries, the distribution will still be interest in the hands of the beneficiary and they will be able to claim their interest exemption against this interest received from the trust.  The effect of this change will be that the interest distributed to the beneficiary will now just be normal income and the interest exemption can no longer be used by the beneficiary.

Where this will have its most far reaching impact is on capital gain distributions. The trust may sell some shares it has been keeping for a long term. The capital gain will be included in the trust’s taxable income at 66% and taxed at a 40% normal income tax rate. This means an effective tax rate of 26.7% for the trust. If this capital gain was distributed to a beneficiary under the flow through principal, the beneficiary would pay tax on the same distribution at between 0% and 13.33%. The beneficiary could use the capital gains exclusion which may have meant a 0% tax rate. With the new rules a beneficiary who is paying the top tax rate will be taxed at 40%.

While there is some merit to the reasons for changing the way in which trusts are taxed, any tax payer has the right to structure his tax affairs in the manner that is most beneficial for him. Trustees of trusts also have the duty to act with care, diligence and skill. They must administer the trust assets to the maximum benefit of the beneficiaries. Is it then reasonable for government to see trustees making use of these rules, as avoiding tax?

What is also disturbing, is that many tax structures set up in the past will now become obsolete or to the disadvantage of the beneficiaries. For any country to have a well functioning tax base, there needs to be certainty regarding the rules. This change, along with the announcement that a whole review of the tax laws will be undertaken, means that there is no certainty and this does not encourage foreign investment.

As is clear from this article, these changes will have a major effect on trusts and especially beneficiaries of trusts. We recommend that all trustees make time to review their trust deeds and do adequate planing to adapt to these changes.