I came across the following interesting question raised during 2015 on the SAIT website and responded to by SAIT technical (link below) and thought the reply posted below merits some further thought.
“We would like some clarification on the following subject as we are of a differing opinion than some of our colleagues. A trust sold some of its investments (listed shares) during the financial year. The trust has held the shares for more than five years. The transaction led to capital gains tax in the trust that was subsequently distributed to the beneficiaries and taxed in their personal capacity. The trust had no taxable income. Some of the beneficiaries were “income beneficiaries” and some were “capital beneficiaries as described by the trust deed. We are of the opinion that the above capital gains should only have been distributed to “capital beneficiaries” as described in the trust deed and not to “income beneficiaries” as the nature of the distribution was capital in nature and thus the “income beneficiaries” could not receive such a distribution. Our colleagues are of the opinion that both “income” and “capital beneficiaries” are allowed to receive capital gains distributions. Your opinion would be greatly appreciated.”
And the reply was:
“In our view this is a trust law matter and not a tax matter as paragraph 80 Eighth schedule of the Income Tax Act does not differentiate as to the beneficiaries right to the distribution but merely deals with whether factually it was distributed (para 80(2) refers to a beneficiary who has a vested right in the capital gain but not in the asset. You would have to determine if the trust deed defines “capital” or “income” and determine whether the relevant capital gain distributed by creating an entitlement to trust assets (i.e., by cash payment or loan account) is settled/distributed by capital or income from the trust as defined by the trust deed.”
Let us first look at the nature of a trust. It has been accepted in our law that a trust is governed by the laws of contract and more precise, the stipulatio alteri, i.e., the contract in favour of a third party, thus, where not in contradiction to any statute, the rules governing the administration of a trust are strictly what is written in the contract, i.e. the trust deed and the principles laid down in decided case law;
The second aspect to consider is the fiduciary duty of the trustee not to prejudice the income beneficiaries over the capital beneficiaries and vice versa and in the decades past, this was often achieved by simply splitting the investment of the trust assets in a ratio between growth assets like equities and income producing assets like stocks, bonds and fixed deposits so as to generate sufficient income to meet the needs of the income beneficiary and where the ratio started to exceed 50% capital growth to 50% income generating assets, simply to adjust the asset split to maintain the same ratio. With the excellent returns equities have achieved in the past decades, trust investment portfolios are now structured with a greater bias toward equities…. but where does this leave the income beneficiary, as equities generate less income than other types of investment?
If a trust asset has been sold and the resultant gain not distributed, it would be taxed in the hands of the trust as income, but it is a capital asset that has been realised, so can that gain really be distributed to an income beneficiary?
It is here that the wording of the trust deed becomes crucial, not only as to the definition of “income,” but also as to the vesting of the rights of both capital and income beneficiaries.
Fortunately, most inter vivos trust deeds are discretionary in nature and a well drafted deed will have a clause authorising the trustees to determine what is of a capital nature and what is of an income nature when a distribution is made…something along these lines: “ to determine whether any surplus on realisation of any asset or the receipt of any dividends, distribution- or bonus- or capitalisation shares by the Trust to be regarded as income or capital of the Trust” This authority should be sufficient for the trustees to elect to distribute a realised capital gain to an income beneficiary.
But what of a Will Trust?
Where a Will Trust does not have the same discretion referred to above, then the capital is due to the capital beneficiaries and the income to the income beneficiaries. Any realised capital gain, although treated as income for taxation purposes, will remain capital for purposes of distribution from the trust and should be retained for eventual distribution to the capital beneficiaries and should be accounted for as capital by the trustees.
And vesting?
The term “vesting,” or a “vested right” can have different meanings.
Firstly, it may refer to ownership. A person owning property has a vested right, for example the beneficiaries in a bewind trust. (A trust where the assets are vested in the beneficiary, but merely administered on his/her behalf by the trustees)
Secondly, it refers to the difference between a certain (vested) or an uncertain(contingent) right. A vested right would form part of a deceased’s estate, but a contingent right, such as a right to receive a bequest at a certain age, is a right dependant on the beneficiary surviving to the stipulated age and only vests in him once he reaches that age.
Thirdly, it could refer to the postponement of the right of enjoyment. A person may acquire a right to property on the death of a deceased (dies cedit), but due to an intervening right such as a usufruct, only acquire the right to enjoyment of it on the death of the usufructuary (dies venit).
Thus it is difficult to see that, where a trust beneficiary has acquired a vested right to an asset (such as in a vesting trust, i.e. where they have acquired incontestable rights to either assets, income or capital gains) , the realised gain of that particular asset may be distributed to some other party than the vested capital beneficiaries, unless there is some discretion granted to a trustee in the trust instrument, or will to do so, but the wording of the trust instrument or will would need to be carefully studied in order to do so. By way of example, a testator may create a vesting trust in his will where the capital vests in his children alive at the date of his death (i.e. it is not contingent on them surviving to the date of termination of the trust (usually the date of death of the income beneficiary, who is very often his spouse) and the right to the income immediately vests in his spouse on his death. If the trustees now realise an asset during the trust administration and decide to distribute that gain, as it is more tax efficient to do so, there are several scenarios:
One – They are given the power in the trust instrument to determine what constitutes capital and what constitutes income and because the gain is deemed income for tax purposes, they distribute it to the vested income beneficiary. Here they would be breaching their fiduciary duty to the capital beneficiaries, as it is after all part of a realised capital asset, to which the capital beneficiaries have already acquired a vested right, that they are distributing, even though they are given the power to determine that it is income.
Two – They have the same power, but distribute it to the capital beneficiaries, who already have a vested right to the bare dominium. This would be the correct distribution of the realised gain., provided the will grants them the power to do an early distribution.
Three – They have no power to determine its nature but decide that it is income because for income tax purposes it is deemed as income. This would be an incorrect decision by the trustees as they are changing the nature of the realised asset from capital to income without the power to do so.
Four – They have no power to determine its nature and decide to distribute it to the vested capital (bare dominium) beneficiaries. Here again, one needs to look at their fiduciary duty. The income beneficiary would be entitled to the income generated by all the assets, thus distributing a realised gain of a capital asset prejudices the income beneficiary in that she loses the income that could be generated by that asset. There should be no problem with distributing capital to capital beneficiaries, provided the trust instrument or will grants the trustees the power to do an early distribution and the income beneficiary consents to the distribution.
Lastly, if the Trust has been set up to gain the deduction afforded by section 4(q) of the Estate Duty Act 45/1955, one needs to consider the implications of the second proviso:
Section 4: The net value of any estate shall be determined by making the following deductions from the total value of all property included therein in accordance with section 3, that is to say –
(q) so much of the value of any property included in the estate which has not been allowed as a deduction under the foregoing provisions of this section, as accrues to the surviving spouse of the deceased: Provided that –
(ii) no deduction shall be allowed under the provisions of this paragraph in respect of any property which accrues to a trust established by the deceased for the benefit of the surviving spouse, if the trustee of such trust has a discretion to allocate such property or any income therefrom to any person other than the surviving spouse.
As can be seen from the second proviso, if the trust has been set up as part of estate planning, with a view to make use of the section 4(q) deduction, there is a real risk in scenario two and four of falling foul of the second proviso and losing a substantial benefit for the estate, should SARS foresee the possibilities of scenarios two and four, whilst scenarios one and three probably have an element of breach of the trustees’ fiduciary duty.
In summary, suffice it to say that a trust is a contract between the testator/founder and the trustees and all the trustees’ powers are derived from it, but have to be applied with equal benefit to both capital and income beneficiaries( this duty is not only limited to vested beneficiaries but extends to contingent(possible) beneficiaries as mentioned in the 2019 case of Griessel v de Kock) to fulfil their fiduciary duties and with the distribution of a realised capital gain, exceptional scrutiny and consideration has to be given to the wording of the trust deed or will which created the trust before deciding to whom to distribute it.
Sentinel International and its Trust Team can assist you with the drafting of your trust deed or review your existing trust deed to ensure that it is still fit for purpose.
While every reasonable effort is taken to ensure the accuracy and soundness of the contents of this publication, neither writers of the articles nor the publisher will bear any responsibility for the consequences of any actions based on information or recommendations contained herein. Our material is for informational purposes.
Author: Ulrich Hoffmann