High net worth families used to rely on creating a trust as a tax-efficient vehicle for growing their assets and passing wealth from generation to generation. But tax authorities and governments around the world have tightened up laws and regulations to prevent the affluent from using trusts to shield their income and capital gains from taxation.
Under South Africa’s current tax regime, income in a trust is taxed at 45%, which is the same as the highest tax bracket for individuals. What’s more, the government has in recent years introduced new rules that mean local loans used to fund a trust now accrue interest in the settlor’s hands, payable each year. This is less of a challenge if the interest is earned offshore where interest rates are low, but it does dampen one of the traditional benefits of trusts.
You can mitigate against the punitive taxation rates by attributing income and capital to beneficiaries, but it is important to keep track of any new tax regulations and laws that may come down the line in later years. The Davis Commission has recommended sweeping changes as part of its proposals for revamping South Africa’s tax system, so change is probably on its way.
From an international perspective, countries such as Australia do not recognise trusts, while others such as the US and some European jurisdictions tax their proceeds more punitively than they do personal or corporate income or capital gains. When setting up a trust, it is thus important to consider where the beneficiaries will be based and to get international legal and tax advice for those jurisdictions.
Now that many of the tax loopholes are closed, what are the benefits of trusts? Though we focus on tax efficiency in this article, it is worth noting that trusts have several key advantages when it comes to succession planning and protecting your assets from personal bankruptcy. When it comes to tax efficiency, trusts are still suitable for growing long-term assets such as new entrepreneurial ventures, or leveraged fixed property investments, where the capital introduced to the trust is minimal relative to the long-term value to be created.
The reason for this is that growth in the trust falls outside the settlor’s assets for estate duty and capital gains tax purposes (there’s also a significant saving on executor’s fees), if the funding of the trust is structured correctly. Over the long-term, the compounding of returns can be substantial, with a 20-25% saving on estate duties and an up to 18% saving on capital gains tax.
There are also important benefits in passing trusts from one generation to the next. Without a trust, estate duties and capital gains tax are levied as the assets pass between each generation. With a trust, the settlor pays taxes on the initial investment, but there is no further tax with each subsequent generational change.
As this article shows, there is no simple way to sum up whether a trust will be tax-efficient for you and your family. There are many nuances to consider, especially if the beneficiaries of the trust live across multiple tax jurisdictions. As an added point, a trust needs to be large in scale as administration costs can wipe out the tax benefits if the asset base is too small.
Given all the complexities and constantly changing regulations, we urge clients to approach us for a professional review of their existing trusts, or for advice if they are contemplating setting up a local or offshore trust.
In our next post in this series, we will look at tax considerations around endowment policies.
Here are the links to the other articles in our series on tax-efficient investing:
Part 4 – Tax Impacts of Trusts (current article)