Trust Tax Troubles: Why Your Trust-Within-a-Trust Structure Might Need a Rethink

The Constitutional Court delivered a significant judgment on October 2, 2024, Thistle Trust v Commissioner for the South Africa Revenue Service (CCT 337/22) [2024] ZACC 19, addressing two key issues: whether the “conduit principle” applies to capital gains distributed through multiple trusts in the same tax year, and whether an understatement penalty was warranted for the Thistle Trust’s tax treatment. The case arose when the Thistle Trust, an inter vivos discretionary trust, received capital gains from ten vesting trusts of which it was a beneficiary from 2014 to 2016 and then distributed these gains to its beneficiaries in the same tax years. The Trust didn’t declare these gains in its tax returns, operating under the belief that the beneficiaries should pay the tax. In response, SARS assessed the Trust for the gains and imposed a 50% understatement penalty, along with interest on the outstanding tax liability.

The matter proceeded through various courts, with the Tax Court initially ruling in favour of Thistle Trust, finding the conduit principle that applies to dividends was equally applicable to capital gains. The Supreme Court of Appeal then reversed the Tax Court’s decision on tax liability but upheld the objection to the penalty, leading to the Constitutional Court appeal.

Throughout this process, the Thistle Trust maintained that it was merely a conduit for the movement of gains to its beneficiaries which, under both common law and the Income Tax Act at the time, meant the gains were taxable only in the hands of the beneficiaries. The Thistle Trust presented two key arguments: first, that section 25B of the Income Tax Act should be interpreted to include capital gains. Second, paragraph 80(2) of the Eighth Schedule to the Income Tax Act, which specifically addresses the conduit principle for capital gains, should allow capital gains to flow through multiple layers of trusts to be taxed in the hands of the final beneficiaries, rather than at intermediate trust levels.

SARS argued that the common law conduit principle only applies where it is specifically incorporated into the Income Tax Act. They maintained that section 25B was not applicable to capital gains distributed through trusts, as these are exclusively governed by paragraph 80 of the Eighth Schedule. Furthermore, SARS contended that paragraph 80 does not permit trusts to escape tax liability on capital gains received from other trusts merely by distributing these gains to their own beneficiaries.

Regarding understatement penalties, SARS argued that the Thistle Trust lacked reasonable grounds for its tax position and disputed the Supreme Court of Appeal’s finding that the filing was an inadvertent error or innocent misstatement. The Thistle Trust defended its position, claiming that any understatement was a bona fide inadvertent error as it had relied in good faith on senior counsel’s opinion. The Trust maintained that the fact that it had deliberately taken this tax position was not relevant.

Constitutional Court Judgement

The Constitutional Court’s majority judgment found the matter raised an important point of law regarding section 25B, paragraph 80(2), and the conduit principle, which would affect capital gains tax liability for tiered trust structures up to 2021. On the conduit principle, the Court held that while it was originally introduced when tax statutes didn’t address trust taxation, statutory interpretation now takes precedence since the Income Tax Act specifically addresses trust taxation.

The Court found that section 25B (introduced in 1991) was not intended to apply to capital gains, as capital gains tax did not exist in South Africa at that time. Section 26A and the Eighth Schedule, particularly paragraph 80(2), were the relevant provisions governing the taxation of capital gains realised by trusts. The Court, however, determined that the Thistle Trust had not “disposed” of an asset as required in terms of the wording of paragraph 80(2). It accordingly held that paragraph 80(2) only applies to the first beneficiary trust in multi-tiered structures, rejecting the Thistle Trust’s “robust common sense” argument as it would undermine the legislative intent to tax trust capital gains at higher rates.

Regarding the understatement penalty, while raising an important legal issue, leave to appeal was refused because lower courts hadn’t addressed the interpretation issue and SARS had no sustainable case for penalties, with the Court noting that taking a position based on legal advice, even if incorrect, provided reasonable grounds. On costs, the Thistle Trust was not ordered to pay appeal costs due to the Biowatch principle, while SARS was ordered to pay cross-appeal costs as Biowatch didn’t apply to them as an organ of state.

The minority judgment (dissenting) took a different view. They found significant ambiguities in paragraph 80(2) of the Eighth Schedule, evidenced by varying interpretations among tax experts and academics. The minority argued that the provision could reasonably be interpreted to allow the conduit principle to apply fully, enabling capital gains to be taxed in the hands of ultimate beneficiaries in multi-tier trust structures. This interpretation was preferred as it avoided arbitrarily stopping the conduit principle at second-tier trusts. The judgment emphasised constitutional-era statutory interpretation principles, requiring consideration of text, context, and purpose while preserving constitutionality and avoiding arbitrary or irrational outcomes. Importantly, they invoked the contra fiscum rule, which requires ambiguous fiscal legislation to be interpreted in the taxpayer’s favour. The minority found their interpretation aligned with both the provision’s purpose (applying the conduit principle to capital gains) and its context, noting that section 25B already embodied the conduit principle for other monetary accruals. They argued it was illogical to have different approaches to the conduit principle within the same statute, particularly without SARS providing a rationale for this distinction. Based on these interpretive principles, they would have upheld Thistle Trust’s appeal.

What to take from this judgement?

The Constitutional Court judgment provides several crucial takeaways for taxpayers and practitioners. Most significantly, it establishes that the conduit principle only applies to the first beneficiary trust in multi-tiered structures, meaning capital gains cannot be “streamed” through multiple discretionary trusts to ultimate beneficiaries, and intermediate trusts must declare and pay tax on capital gains they receive as beneficiaries. The judgment also clarifies that when tax legislation specifically addresses an issue, statutory interpretation takes precedence over common law principles, though the significant disagreement over paragraph 80(2)’s interpretation highlights the complexity of tax legislation. On penalties, the judgment confirms that taking a tax position based on professional legal advice, even if ultimately incorrect, can protect against understatement penalties, and SARS cannot impose penalties merely because a taxpayer didn’t follow SARS’ interpretation. Practically, this means trust structures should be reviewed for compliance, professional advice should be documented, and multi-tiered trust arrangements need to factor in the tax implications at each level.

Meet the author: Kendra Saunders

Kendra Saunders is an admitted attorney and senior international tax consultant at RvR, based in Cape Town. Contact Kendra at [email protected].