The strange legal nature of a trust makes the taxation of its income unique. In terms of common law, a trust is not a juristic person. For that reason, trust income has historically ‘flowed through’ a trust, retaining its ‘nature’ until it reached the beneficiary. In other words, trust income will be taxed as if it was earned directly by the beneficiary in which the income vests. Because of this, tax deductions can apply to the income earned from a trust.

For example, if a South African trust has a savings account in South Africa, the beneficiary may still make use of the interest exemption (the first R22 000 of interest is exempt from tax). This interest exemption only applies to natural persons, so the trust itself (not being a natural person), is not entitled to that exemption. This ‘flow through’ characteristic is described as a ‘conduit pipe’ for income flowing through the trust to its beneficiaries.

Restrictions on the conduit-pipe principle

In more recent years, this principle has been severely restricted to prevent abuse, and with the hope of increasing government revenue. Despite the common law status of a trust, the Income Tax Act, No. 58 of 1962 (“the Act”) deems a trust to be a juristic person for tax purposes. This means that trust income can be taxed in the hands of the trust or the trustees of the trust. Nevertheless, the conduit pipe principle still exists in South African law.

The conduit-pipe principle is further regulated by Section 25B of the Act, and capital gains are dealt with similarly in paragraph 80 of the Eighth Schedule to the Act. These provisions still allow income to flow through to a beneficiary without being subject to tax in the trust. But, for this provision to apply, the trust income must vest in the beneficiary within the same year of assessment in which the trust receives the income. That income will not be part of the trust’s taxable income, as long as it vests in a beneficiary within the same year it was received by or accrued to the trust.

“Vesting”?

‘Vesting’ in this context refers to a beneficiary becoming fully entitled to an amount, whether or not they choose to withdraw the amount. An amount can be vested in a beneficiary in two ways. A trust deed can provide for a right to automatically vest in a beneficiary. Or the trustees of a trust may grant a right to a beneficiary.

If the income is not vested in a beneficiary within the same year of assessment that is was earned in, section 25B provides that the trust will be taxed on the income.

Which is favourable?

It is generally unfavourable for an amount to be taxed within a trust. This is because the taxable income of a trust is taxed at a flat rate of 45%. Furthermore, unlike natural persons, trusts don’t get tax rebates and tax credits. As a result, the tax rate for trusts works out to be as high as the effective tax rate for natural persons in the highest tax bracket.

Thus, if the beneficiary has a lower effective tax rate, it is more favourable to make use of the conduit-pipe principle, and tax the income in the hands of the beneficiary.

South African tax residents

Recent amendments to section 25B have restricted the conduit-pipe principle even further. Now, ‘flow through’ only applies to a beneficiary who is also a South African tax resident. Income that vests in a non-resident beneficiary will always be taxed in the hands of the South African trust. This allows SARS to ensure that income earned in South Africa is taxed in South Africa, whether that income is taxed within the trust or as the income of the resident beneficiary.

These provisions have led to fears of economic double taxation, where non-residents are also taxed on their income from a trust, by the country in which they are resident. In view of this, For this reason, trustees and beneficiaries should reassess beneficiaries’ tax residency, to accurately determine the trust’s tax liability.

Being tax efficient is an important part of great financial management. In this blog, a group of South African tax experts at AJM Tax share their tips and explanations on tax issues. Learn everything you need to know about tax, from deductions you never knew about to retirement savings and capital gains. The first Tuesday of every month is Tax Tuesday.