CGT implications of distributions to beneficiaries of a second trust from vesting trusts

Background

The Zenprop Group conducts the business of property owners and developers. The group is comprised of ten vesting trusts (“Tier 1 Trusts”).

Thistle Trust is a beneficiary of some of these Tier 1 Trusts.

In the 2014, 2015 and 2016 tax years the Tier 1 Trusts disposed of certain capital assets and realised capital gains. The capital gains realised were distributed, inter alia, to the Thistle Trust in the same tax year as the capital gains were realised. The Thistle Trust, in turn, distributed the amounts it received to its beneficiaries (in whose hands the capital gains were sought to be taxed).

The South African Revenue Service (“SARS”) raised an additional assessment, dated 21 September 2018, which subjected these capital gains to capital gains tax in the hands of the Thistle Trust.

SARS imposed understatement penalties and levied interest on the assessed liabilities.

Objection

The Thistle Trust objected on the basis that the capital gains should have been taxed in the hands of its beneficiaries having regard to section 25B of, and paragraph 80(2) of the Eighth Schedule to, the Income Tax Act (“Act”).

SARS disallowed the objection.

Appeal to the Tax Court

The tax court agreed, in essence, with Thistle Trust’s objection (the capital gains fell to be treated in terms of sections 25B(1) and 25B(2) read with paragraph 80(2) of the Eighth Schedule to the Act and therefore ought to have been taxed in the hands of its beneficiaries).

Legislative provisions

Section 25B, in so far as is relevant, provides as follows:

“(1) Any amount (other than an amount of a capital nature which is not included in gross income …) received by or accrued to or in favour of any person during any year of assessment in his or her capacity as the trustee of a trust, shall, …, 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.

(2)?Where a beneficiary has acquired a vested right to any amount referred to in subsection (1) in consequence of the exercise by the trustee of a discretion vested in him or her in terms of the relevant deed of trust, …, that amount shall for the purposes of that subsection be deemed to have been derived for the benefit of that beneficiary.”

The effect of the above provision is that amounts (other than those excluded) are taxable in a beneficiary’s hands if the beneficiary concerned has a vested right (including one in consequence of the exercise by the trustee of a discretion vested in him) to the amount in question during the tax year in question.

Section 26A of the Act provides as follows:

“‘There shall be included in the taxable income of a person for a year of assessment the taxable capital gain of that person for that year of assessment, as determined in terms of the Eighth Schedule.”

The effect of the above provision is that taxable capital gains are computed separately (in terms of the provisions of the Eighth Schedule to the Act) from normal taxable income. Such capital gains are then included directly in a person’s taxable income.

Paragraph 80 of the Eighth Schedule to the Act provides as follows:

“80(1) ?… where a trust vests an asset in a beneficiary of that trust . . . who is a resident, and determines a capital gain in respect of that disposal …

(a)?????????that capital gain must be disregarded for the purpose of calculating the aggregate capital gain or aggregate capital loss of the trust; and

(b) ????????that capital gain … must be taken into account as a capital gain for the purpose of calculating the aggregate capital gain or aggregate capital loss of the beneficiary to whom that asset was so disposed of.

80(2)?????…where a trust determines a capital gain in respect of the disposal of an asset in a year of assessment during which a beneficiary of that trust (other than any person contemplated in paragraph 62 (a) to (e)) who is a resident has a vested right or acquires a vested right (including a right created by the exercise of a discretion) to an amount derived from that capital gain but not to the asset disposed of, an amount that is equal to so much of the amount to which that beneficiary of that trust is entitled in terms of that right—

(a)?????????must be disregarded for the purpose of calculating the aggregate capital gain or aggregate capital loss of the trust; and

(b)?????????must be taken into account as a capital gain for the purpose of calculating the aggregate capital gain or aggregate capital loss of that beneficiary.”

The effect of paragraph 80(2) above is to subject amounts derived from capital gains to tax in a resident beneficiary’s hands (instead of in the hands of the disposing trust) where its requirements are satisfied.

Supreme Court of Appeal- contentions

SARS’s contentions, at the Supreme Court of Appeal[1], were as follows:

• ????????section 25B was not applicable as its provisions apply to amounts of an income nature (not of a capital nature);
• ????????capital gains tax is exclusively dealt with in the Eighth Schedule;
• ????????paragraph 80(2) of the Eighth Schedule to the Act applied exclusively to the amounts in question;
• ???????The Thistle Trust acquired a vested right to the capital gains distributed to it but no vested right to the capital assets disposed of by the Tier 1 vesting trusts (which meant paragraph 80(2) applied in respect of the capital gains vested in The Thistle Trust from the Tier 1 Trusts);
• ????????The Thistle Trust simply on distributed the amounts, received from the Tier 1 Trusts to its beneficiaries without determining a capital gain in respect of the disposal of its assets – this meant that paragraph 80(2) of the Eighth Schedule to the Act could not apply to the distribution by The Thistle Trust to its own beneficiaries.

The Thistle Trust, on the other hand, contended as follows:

• ???????the word amount in section 25B included capital gains; and
• ???????paragraphs 80(1) and 80(2) were both applicable. The reason advanced was that “the capital gains that the Tier 1 Trusts distributed to the Thistle Trust amounted to an asset which, in fact, vested in its beneficiaries. Therefore, so it was contended, the Thistle Trust was no more than a conduit for the gain that flowed through it and is accordingly not subject to be taxed on the gain.”

Supreme Court of Appeal – reasoning

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The Supreme Court of Appeal reasoned, inter alia, as follows:

• ????????section 25B was introduced in 1991 at a time when capital gains tax was not imposed on capital receipts and accruals. Consequently, section 25B could not have applied to capital gains when 25B was introduced;
• ????????the words other than an amount of a capital nature which is not included in gross income came about after capital gains tax was introduced in 2001 and such words expressly exclude such amounts from falling within its ambit;
• ????????it has previously held[2] that the determination of the amount of any capital gain falling to be included in a taxpayer’s taxable income is dealt with in the Eighth Schedule to the Act (which on its face seems to provide a self-contained method for determining whether a capital gain or loss has arisen);
• ????????the scheme of the Act was that section 25B applied to the taxation of amounts of an income nature and the Eighth Schedule to amounts of a capital nature;
• ????????that the Rosen[3] case had cautioned that the conduit principle was to be applied in appropriate circumstances on a case-by-case basis (despite the principle applying generally in the tax system);
• ????????the conduit principle was not applicable to these particular facts as the Thistle Trust received the capital gains, as of right but did not dispose of any capital asset or determine a capital gain. The capital gains were distributed to the beneficiaries (The Thistle Trust distributed monies received by it as of right).

The Supreme Court of Appeal, therefore, concluded that the capital gains were correctly taxed in the hands of The Thistle Trust (on a proper interpretation of paragraph 80(2) of the Eighth Schedule to the Act).

SARS was therefore correct to raise the additional assessment on The Thistle Trust for the relevant tax years.

Understatement penalty

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SARS raised an understatement penalty of ZAR 1.46 million (on the basis of it being a standard case in circumstances where the taxpayer had no reasonable grounds for the position adopted).

An understatement refers to any prejudice to SARS or the fiscus as a result of, inter alia, an omission from a tax return. The applicable percentage penalty depends on the behaviour.

SARS initially took the view that because The Thistle Trust had relied on a legal opinion that another entity within the Zenprop Group had sought, the Thistle Trust had consciously and deliberately adopted the tax position it took.

In an argument before the Supreme Court of Appeal Counsel for SARS conceded (correctly in the view of the Supreme Court of Appeal) that the omission from its tax return was a bona fide inadvertent error as it believed section 25B of the Act also applied to it (it argued that though it erred, it did so in good faith and acted unintentionally).

SARS’ Counsel’s concession is at odds with SARS’ own expressed/published position in this regard. There the view is expressed that a bona fide inadvertent error refers to a genuine involuntary mistake - one that does not result from deliberate planning i.e., to qualify under the bona fide inadvertent error exclusion the omission, in the tax return, must not have resulted from genuine deliberate tax planning.

In essence, under the SARS published view, a bona fide inadvertent error refers to mistakes such as typographical mistakes if genuine and involuntarily made (after reasonable care has been taken).

The wording of section 222 of the Tax Administration Act seems to not support SARS’ published view (as the section refers to an understatement penalty not being applicable where the omission results from a bona fide inadvertent error. This suggests that the section’s emphasis is on the cause of the omission rather than what the omission is in fact.

For now, there is an authoritative view from the Supreme Court of Appeal albeit terse (the Court could have delved into this aspect more to explain the basis for agreeing that the SARS concession was a correct one).

It will be interesting to watch developments in this regard and/or to see whether case law will further refine the meaning thereof in the provision in question.

[1] The Commissioner for the South African Revenue Service v The Thistle Trust (516/2021) [2022] ZASCA 153 (7 November 2022)

[2] Milnerton Estates Ltd v CSARS [2018] ZASCA 155; 2019 (2) SA 386 (SCA) para 22

[3] Secretary for Inland Revenue v Rosen 1971 (1) SA 172 (A) at 190H-191A