Over the years, changes to anti-avoidance provisions which deal with, inter alia, the controlled foreign company rules and the attribution of income from foreign structures have resulted in some uncertainty as to the correct application of section 7(8) when read together with section 25B(1) of the Act.
On 2 March 2021, the South African Revenue Service (SARS) published Interpretation Note 114 (IN) to clarify the interaction and application of sections 7(8) and 25B(1) to provide taxpayers with guidance on how to correctly apply the aforementioned provisions.
Section 7(8) and section 25B(1) apply when income received by or accrued to a foreign trust by reason of or in consequence of a donation, settlement or other disposition by a South African tax resident, is vested in a South African tax resident beneficiary by the trustees of the foreign trust.
When a foreign trust derives income in consequence of a donation, settlement or other disposition by a donor and the trust vests that income, or a portion of it, in a resident beneficiary, a conflict arises because the amount is potentially economically taxed twice – herein lies the uncertainty as to how the provisions interact with each other.
Section 25B(1) provides that –
Any amount received by or accrued to or in favour of any person…in his or her capacity as the trustee of a trust, shall, subject to the provisions of section 7, to the extent to which that amount has been derived for the immediate or future benefit of any ascertained beneficiary who has a vested right to that amount during that year, be deemed to be an amount which has accrued to that beneficiary, and to the extent to which that amount is not so derived, be deemed to be an amount which has accrued to that trust.
SARS states in the IN that the words “subject to the provisions of section 7” can be read to have the effect that if there is a conflict, inconsistency, or incompatibility between section 25B(1) and section 7(8), section 7(8) is given dominance and must prevail.
It accordingly becomes critical to correctly assess whether there is indeed a conflict, inconsistency or incompatibility between the provisions in order to understand whether section 7(8) must prevail (in the instance both provisions potentially apply), or whether section 25B(1) can be applied without regard to section 7(8).
By way of example, in the instance where a South African tax resident has advanced an interest free loan to a foreign discretionary trust, and the foreign trust has utilised the loan to make an interest bearing investment, vesting that interest income in a South African resident beneficiary (in the same tax year of assessment), then the tax consequences are as follows according to the IN (assuming the interest derived by the foreign trust is fully attributable to the interest free loan) and considering only how sections 7(8) and 25B(1) would apply in this context –
- as the trust is a separate person for income tax purposes, a determination needs to be made whether the interest derived by the trust is taxable in South Africa;
- consideration must be given to whether section 7(8) and section 25B both apply;
- in this instance, both provisions may potentially apply because for purposes of –
- section 7(8), an amount has, by reason of or in consequence of a donation, settlement or other disposition by a donor, been received by a non-resident and had that non-resident been a resident the amount of interest would have constituted income as defined; and
- section 25B, an amount has been received by a trust, which section 25B(1) potentially deems to accrue to the trust or to a beneficiary.
- a conflict therefore arises in this example as both provisions potentially apply and, if both sections are applied, the amount is potentially economically taxed twice given that –
- section 7(8) requires that any amount received by or accrued to the foreign discretionary trust, which would have constituted income had the trust been resident, be included in the donor’s income; and
- section 25B(1) deems the amount vested in the beneficiary to have accrued to the resident beneficiary and therefore it would be included in the resident beneficiary’s gross income.
In a scenario like the example above, the IN provides that section 7(8) must be applied in the first instance. Therefore, section 25B(1) is disregarded to the extent that the amount is attributable to a donation, settlement or other disposition and is included in the donor’s income despite the fact that it may, subsequent to its receipt or accrual, have been vested in a resident beneficiary in the same year of assessment in which it was received by or accrued to the foreign discretionary trust.
In the instance that no conflict arises, (i.e. when the amount derived by the trust is not attributable to a donation, settlement or other disposition) the remaining amount must be dealt with under section 25B(1).
The position set out in the IN ensures that no economic double taxation occurs in the event that the trust has vested the relevant amount of income in a South African resident beneficiary, because to the extent that section 7(8) applies, section 25B(1) will not apply. In other words, to the extent that the amount of income has been attributed to the donor, it is not taxed in the hands of a resident beneficiary in whom it has been vested.
South African taxpayers with foreign trusts should take cognisance of the guidance issued by SARS to avoid any unintended tax consequences. To the extent that South African taxpayers do not apply the provisions in accordance with the IN, it may create future tax issues that will potentially be costly and time-consuming to rectify.