A trust has historically been seen as an efficient vehicle to conduct a business due to its cost effective nature and its administrative efficiency. The onerous tax treatment of trusts may however outweigh the benefits associated with utilising a trust to conduct business. The Supreme Court of Appeal in the recent judgment of CSARS v The Thistle Trust (“Thistle”),[1] added to the burdensome manner in which trusts are taxed by holding that a capital gain earned by a trust, which has another trust as a beneficiary, cannot be distributed and taxed in the hands of the ultimate beneficiary of these trusts, but must be taxed in the hands of the beneficiary trust.
The facts of Thistle were as follows. The Thistle Trust is one of many beneficiaries of vesting trusts which make up the Zenprop Group. The trusts, referred to as Tier 1 Trusts, comprised a group of ten vesting trusts that conduct the business of the Zenprop Group, a group of property owners and developers. In the 2014, 2015 and 2016 years of assessment, the Tier 1 Trusts sold certain capital assets. The capital gains received from the disposal of those capital assets were distributed to the Thistle Trust in the same year of assessment in which they arose. The Thistle Trust then distributed the amounts it received to its beneficiaries and treated the proceeds received as taxable in the hands of its beneficiaries. SARS then raised additional assessments for the 2014, 2015 and 2016 years of assessment, taxing the amounts received by the Thistle Trust in its hands and not in the hands of its beneficiaries. SARS also imposed understatement penalties against the Thistle Trust and required it to pay interest on the assessed liability.
The Thistle Trust filed an objection to the additional assessments, which was rejected by SARS. The Thistle Trust then appealed to the Tax Court, which held that the capital gains distributed to the Thistle Trust and subsequently passed on to its beneficiaries, constituted ‘amounts’ that fell within the ambit of sections 25B(1), 25B(2), and paragraph 80(2) of the Eighth Schedule to the Income Tax Act 58 of 1962 (the “ITA”).
As a general rule, income and capital gains received by or accruing to a trust are subject to income tax and capital gains tax (“CGT”) in its hands, unless a beneficiary of the trust has a vested right to such amounts. Section 25B(1), as it read during the relevant years of assessment provided that ‘any amount’ which is received by or accrues to a trust shall be taxable in the hands of any beneficiary which has a vested right to such amount.
Accordingly, the Tax Court held that the distribution to the beneficiaries of the Thistle Trust was a distribution of capital gains, taxable in the hands of its beneficiaries and not in the hands of the Thistle Trust. The Tax Court also placed reliance on the well established conduit-pipe principle applicable to trusts, which provides that amounts which flow through a trust to a beneficiary retains their nature and is taxable in the beneficiaries hands.
The SCA in overturning the decision of the Tax Court reasoned that it is clear from a careful interpretation of the provisions of section 25B(1) that capital gains are not included in the phrase ‘any amount’ as used in section 25B(1). The Court further held that the conduit-pipe principle is not applicable in casu as the capital gains vested in the Thistle Trust and is therefore taxable in its hands, irrespective of whether the amounts which comprise such gain is distributed to its beneficiaries.
The SCA opined that as the income received from the disposal of the capital assets and distributed by the Thistle Trust to its beneficiaries were capital gains, such amounts are excluded from the ambit of section 25B and subject only to paragraph 80 of the Eighth Schedule. It is noteworthy that the Court relied on the current wording of section 25B of the ITA, which explicitly excludes amounts of a capital nature from the ambit of section 25B(1), in interpreting section 25B(1) as it read during the relevant period. During the years of assessment under review, the wording of section 25B(1) included no such exclusion.
A capital gain which accrues to a trust due to the disposal of an asset by that trust is therefore taxable in the hands of the beneficiary to which the amount which comprises such gain is distributed. It is irrelevant that this beneficiary is also a trust and has distributed the relevant amounts to its beneficiaries.
The effect of this decision is that the ITA does not make room for the distribution of capital gains through a multi level trust structure and the amounts received by the trust, which constitutes a capital gain should be taxed in the trust’s hands and not in the hands of the ultimate beneficiaries of the structure.
In relation to the understatement penalties levied by the SARS, the SCA reasoned that as the Thistle Trust relied on a tax opinion, addressed to another entity within the Zenprop Group, the understatement of its tax liability constituted a bona fide inadvertent error, which means that no understatement penalties could be levied.
This judgment provides useful guidance as to the manner in which capital gains which arise in a multi-level trust structure will be taxed. Amounts which constitute capital gains cannot be distributed to an ultimate beneficiary in a multi-level trust structure and this must be borne in mind when transactions which involves trusts are implemented.
A positive outcome arising from this judgment for taxpayers is that reliance on a tax opinion, even if addressed to another person, can form the basis of successfully disputing understatement penalties levied by the SARS, which means there is substantial benefit to a taxpayer from obtaining a tax opinion prior to implementing a transaction.
[1] (516/2021) [2022] ZASCA 153 (7 November 2022).
