Capital gains tax (CGT) and trusts was the subject of this week's meeting of the ipac/Personal Finance Investors Club in Johannesburg. Brian Eaton discussed how to structure your trust to cope with the introduction of CGT.
It's up to you to decide how you want your trust to be taxed once CGT is introduced, Brian Eaton, managing partner at accountants Betty & Dickson, says.
Eaton says you have plenty of choice about the impact of CGT on your trust.
Your trust will survive the implementation of CGT. But you will have to give some attention to the way you want to structure it.
According to the current CGT proposals, capital gains in a vesting trust - a trust where the benefits to which the beneficiaries are entitled are laid down by the settlor - will be taxed in the hands of the beneficiaries.
In a discretionary trust, on the other hand - where trustees have discretion about the payment of benefits to beneficiaries - if the trustees do not exercise this discretion, any capital gain will be taxed in the trust. If they do, any gains will be taxed in the hands of the beneficiaries.
Individuals are to be taxed on 25 percent of their capital gains, while trusts, as is the case with companies, are to be taxed on 50 percent of the gains, so the way you structure your trust will have significant tax consequences for you.
Individuals pay tax on capital gains at their marginal income tax rate, so even an individual paying the top marginal rate of 42 percent will never pay more than 10.5 percent in tax on a capital gain (25 percent of 42 percent).
Trusts, on the other hand, pay income tax at 32 percent on income up to R100 000 a year and 42 percent on the rest, so trusts will pay tax at between 16 percent and 21 percent on a capital gain (50 percent of 32 percent and of 42 percent).
(Special trusts, set up to benefit physically or mentally disabled people, are a special case and pay tax on only 25 percent of capital gains, as is the case with individuals.)
But you shouldn't restructure your trust just to reduce CGT, Eaton warns. No tax should ever be the first consideration in setting up a trust.
"CGT in a vesting trust will be taxed in the the hands of individual beneficiaries, thus avoiding the high inclusion rates. In a discretionary trust, if gains are awarded to beneficiaries, they will be taxed in the hands of the beneficiaries.
"On the other hand, if you have to award profits to beneficiaries, what was the point of setting up the trust? Probably the original plan was to keep profits in the trust.
"The point is, though, that you have a choice."
You should start getting ready for CGT now, Eaton says, although you should not take any action yet.
"CGT is not going to go away and there's still enough time to deal with the issues properly. But don't do anything until the legislation is published - and don't let anyone persuade you to do anything."
Case study: The story of Mr L
At 50, Mr L had R1 million in unit trusts and R1 million in his provident fund. He came to financial adviser Lionel Karp, of Hemmes, Karp & Associates, for help.
The advisers suggested Mr L form a trust, liquidate the unit trust portfolio and invest the money in an endowment policy held in the trust, Karp told the investors club.
By the age of 60, when he retired, Mr L had R5 million in his provident fund. He was advised to deduct the tax-free portion of R120 000 and use the rest of the provident fund money to buy a living annuity.
The endowment policy in the trust, which was now worth R4 million, was left intact.
Three years later, Mr L died. On his death, the endowment policy in the trust was worth R6 million. Mr L's living annuity was worth R5 million, and this was free of any estate duty.
He'd spent the R120 000 tax-free withdrawal from the provident fund on a world cruise and on his children.
There was a R1 million loan account which had been put into the trust at age 50. But since there is no estate duty on any amount up to R1 million, Mr L's estate was not liable for estate duty at all.
Had CGT been in force, the advice would have been not to pay CGT in the trust - at a 21 percent rate - but rather to transfer the gain directly to Mr L's beneficiary, who would have had to pay capital gains tax at 10.5 percent.
The moral of the story, according to Karp, is:
* Use trusts as a vehicle for efficient tax and estate planning; and
* Be selective about the assets you place in a trust.
Keeping those bits of paper will save you hassles later
Keeping records of your assets is your responsibility as a taxpayer, Brian Eaton says.
Once CGT is implemented, it will be up to you to prove the valuations of your assets, including assets in a trust. So it's a good idea to retain any documents which might be useful - even if you don't know when you'll have to use them.
CGT is only payable on gains made after the tax takes effect on October 1. So assets which you - or the trust - acquired before that date must be valued as at October 1, the base date which will be taken into account when you sell the asset.
If the asset is shares listed on the JSE Securities Exchange, the shares will be valued as an average of the buying and selling prices for the five days before October 1 2001.
If the asset is shares on a foreign exchange, the valuation will be based on buying and selling prices on the last day's trading before October 1.
In the case of unit trusts, the valuation will be based on the buying price of the units over the last five days before October 1.
For unlisted shares in a company, you will have to get a valuation which must take into account the company's underlying assets.
For a house, you can use a professional valuer or an estate agent's estimate. You can deduct costs of some improvements - not repairs - to the house from the profit you make when you sell it, so keep invoices showing how much you have spent.
Remember, you will have to be able to justify your valuations when the time comes to pay tax, Eaton says. "If you can't, it's your problem."
And remember, too, that you are obliged to keep documents relating to the asset for five years after you have sold it.
Trust checklist
Take advantage of the time left before CGT is implemented to make sure your trust works the way you want it to, Brian Eaton suggests.
Here's a checklist:
Trust deeds:
Is your trust still achieving the aims you set? Look at this from all perspectives, not just from the tax point of view;
Valuations:
Have you had thought about valuations for all the assets in the trust?
Residential property:
Have you considered transferring any residential property held in the trust to an individual so as to take advantage of lower CGT rates? Remember, you can do this without paying transfer duty if you do it before the end of September 2002. But think this one through - if you transfer the property out of the trust into the name of the settlor, you may be creating a financial burden for the settlor;
Structure of investments:
Get advice on how best to structure your investments from the tax point of view;
Estate plan:
Revisit your will and estate planning to add the CGT implications. Remember, estate duty will be cut from 25 percent to 20 percent when CGT is implement-ed in October.
Definition
A trust is created when a person, the settlor, provides capital to be looked after by trustees for the benefit of beneficiaries.
There are two kinds of trusts: Testamentary trusts are created through a will and deal with the disposal of assets after the death of the settlor. Inter vivos trusts are created before the death of the settlor.
Inter vivos trusts can be of two sorts: Vesting trusts, in which beneficiaries are entitled to benefits; and discretionary trusts, in which the benefits provided to beneficiaries are at the discretion of the trustees.
Tip
Don't set up a trust merely to avoid income tax - you will be sorely disappointed, Brian Eaton says. In the short term, savings in income tax should not be the main object of your trust.