Deferring tax by using unit trusts

Investors in shares are able to defer capital gains tax (CGT) using unit trusts. The deferral works as follows: Section 42 of the Income Tax Act, No 58 of 1962 (IT Act) allows a taxpayer to transfer listed shares to a company free of immediate tax consequences if certain requirements are met.

30 Sep 2016 3 min read Tax and Exchange Control Alert Article

One requirement is that the shares must be transferred in exchange for “equity shares” in the transferee company.

If the requirements are met the taxpayer suffers no CGT or securities transfer tax (STT) in relation to the shares transferred. The taxpayer must account for CGT in future when it disposes of the equity shares it has acquired in exchange for the assets.

Under s41 of the IT Act, for purposes of s42 of the IT Act, the term “company” includes “any portfolio of a collective investment scheme in securities”.

Under s1 of the IT Act a “portfolio of a collective investment scheme in securities” means “any portfolio comprised in any collective investment scheme in securities contemplated in Part IV of the Collective Investment Schemes Control Act, 2002 [CISC Act] or carried on by any company registered as a manager under and for purposes of section 51 of the CISC Act for purposes of [Part IV of the CISC Act]”.

The CISC Act, among other things, governs unit trusts in South Africa which invest in listed shares.

Under s41 of the IT Act, for purposes of s42 of the IT Act, the term “equity shares” includes a participatory interest in a “portfolio of a collective investment scheme in securities”.

So, if a taxpayer, say, transfers her listed shares to a unit trust in exchange for units in the unit trust, then the transfer will not give rise to CGT or STT (provided the unit trust meets the requirements under the CISC Act and the transfer meets the requirements under the IT Act).

The benefit of this course of action is the following: A unit trust pays no CGT on the disposal of an asset (paragraph 61(3) of the Eighth Schedule to the IT Act). The unit holder pays CGT when he disposes of his unit in the unit trust. So, a long-term investor could realise shares, or chop and change his share portfolio in the unit trust without incurring CGT. If he held the shares in his own name he would pay CGT as and when he realised shares, even if he promptly reinvested the net proceeds.

Does the transfer of shares to a unit trust in the manner set out above constitute impermissible tax avoidance as it effectively defers the CGT each time a share portfolio is realigned? In my view the answer is: No.

Section 42 of the IT Act in so many words allows a taxpayer to transfer assets to a unit trust free of immediate tax consequences, thereby allowing a taxpayer to take advantage of the favourable regime available if assets are held in a unit trust portfolio. It would be anomalous if the IT Act allowed a taxpayer to structure her affairs in a way that is tax beneficial, only to deny her the benefit once she has done so. Fortunately, it appears that this is also the view of the South African Revenue Service, see:

While the above course of action has tax benefits, taxpayers should take into account the practical and commercial effects. Taxpayers should ensure that the unit trust is properly regulated under the CISC Act. They should also ensure that the transaction is properly planned and implemented. The unit trust manager will charge fees for managing the portfolio. Finally, once the portfolio has been transferred to the unit trust, the taxpayer will lose control over the portfolio which will be managed by the manager.

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