The Taxation of Interest Earned in Trust

Authored by: Jonathan Maphosa

Published: 2010/10/19

A brief analysis

It is imperative for the founders of trusts to be fully conversant with the tax implications of interest earned on funds donated to a trust. I will analyse one such common trend in South Africa in attempt to clarify the position. Quite often, a parent will set up an education trust by donating an interest earning investment of considerable value to the education trust.

For example Mr X donates R1 million to his daughter’s education trust that earns an interest of 10% a year. In terms of the provisions of the trust deed, the trustees’ are required to pay to the daughter an amount sufficient to cover all her university education costs and supply her with a reasonable monthly allowance to cover her university accommodation and living expenses. The trust deed also provides that interest in the trust will be capitalised and reinvested and when the daughter completes her studies, the trust will be dissolved and the capital and capitalised interest will be awarded to the daughter.

In whose income will the interest earned by the education trust be included for taxation purposes?

The distributions made by the trustees to the daughter for purposes of covering her university tuition, accommodation and allowance, if the daughter is a minor, will be taxed in the hands of the parent (aka trust founder Mr X), section 7(3) of the Income Tax Act 58 of 1962 (“the Act”) states that if, by reason of any donation, settlement or other disposition made by a parent, income has been received by or has accrued to or in favour of a minor child, has been expended for his maintenance, education or benefit or has been accumulated for his benefit, the income is deemed to have been received by or accrued to the parent of the minor child. The word ‘child’ is defined to include a stepchild, a legally adopted child but excludes grandchildren.

Therefore if a father donates an interest-bearing investment to his minor child, any interest derived on this investment will be deemed to be the income of the father.

In Kohler v CIR (T), 16 SATC 312, the court found that, upon a proper construction of the equivalent of section 7(3), it was only income derived in the first instance by a minor from sums donated by his parent that could be included in a parent’s income, and therefore that the provision did not apply to income received by the minor from the use of the income so derived.

By contrast, income from a donation made by a parent to a major child is taxable in the child’s hands, unless some other anti-avoidance provision is brought into effect, such as section 80A of the Act. For section 80A to apply the Commissioner for the South African Revenue Service (“the Commissioner”) must show:

•

that there is an “arrangement”, and

•

that there is a saving in a tax (a tax benefit) with the result the “arrangement” is an “avoidance arrangement”, and

•

if it is a “business” transaction, it was carried out for bona fide business purposes other than obtaining a tax benefit or has created abnormal rights or obligations, or it lacks commercial substance, in whole or in part, taking into account the provisions of section 80C, or it would result directly or indirectly in the misuse or abuse of the provisions of the Act (including the provisions of Part IIA of Chapter III (the general provisions) consisting of section 80A to section 80L inclusive), or if it is not a “business” transaction, it was entered into or carried out by means or in a manner which would not normally be employed for a bona fide purpose, other than obtaining a tax benefit, or it has created rights or obligations that would not normally be created between persons dealing at arm’s length, or it would result directly or indirectly in the misuse or abuse of the provisions of the Act (including the provisions of Part IIA (see above)), and

that the purpose of the scheme was to avoid a tax collected by the Commissioner (he is allowed to presume this requirement exists),

if the provisions of section 80A are proven to apply to the example set out above, the entire interest (R100 000) will be included in Mr X’s gross income. However, if Mr X can show that one (or more) of the above requirements is not met, then the raising of section 80A by the Commissioner will be invalid, and the Commissioner will be required to assess the taxpayers on the basis that the provisions of section 80A do not apply. As stated in SIR v Geustyn, Forsyth and Joubert (A), 33 SATC 113 at 120, “unless all four factors are present at the same time, it is impossible to attempt to invoke these anti-avoidance provisions”.

As far as the income retained in the trust reinvested for the “possible” benefit of Mr X’s daughter is concerned, the provisions of section 7(5) of the Act will apply, this section provides that the income retained in a trust cannot be taxed in the hands of the beneficiaries or trustees, but tax will be levied upon the person who made the donation to the trust. Where multiple donors exist, each donor will be taxed on the pro-rata income retained in the trust, which is attributable to the donation made by that donor to the trust [Silke on South African Income Tax, 2010]. It follows that Mr X will be liable for tax on the income retained by the trust as the income is accumulated for the beneficiary but will be paid to her only on the occurrence of an event – at this point in time the daughter does not have a vested right to the capital or the accumulated interest.

About the author

Jonathan Maphosa joined Adams & Adams in 2008 as a professional assistant in the Commercial Law department. He specialises in consumer protection law, corporate law, general commercial law, securities law, tax law, as well as estate planning and wills. Jonathan holds an LLB from the University of Kwa-Zulu Natal and Certificates in Advanced Corporate and Securities Law and Technology and Crimes from UNISA and the Abo Akademi University in Finland respectively. He also holds a Post-Graduate Diploma in Drafting and Interpretation of Contracts from the University of Johannesburg and is currently studying towards an LLM in Tax Law at the University of Pretoria. Jonathan is a member of the Law Society of the Northern Provinces and the Corporate Lawyers Association of South Africa.

Jonathan is currently a Fiduciary Specialist (Attorney) at BoE TRUST LIMITED t/a BoE Private Clients.

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The Taxation of Interest Earned in Trust

In whose income will the interest earned by the education trust be included for taxation purposes?