Kids living abroad? Trust distributions will now be taxed differently

In South Africa, trusts are often used for estate planning, asset protection, and tax planning. One of the features of South African income tax law is the "conduit pipe principle" which, when applicable, determines how trust distributions should be taxed. Its application can have significant implications for both the trust and the beneficiaries.

During the trust’s tax year, income earned by it (such as interest, dividends, or rental income), can either be retained by the trust or distributed to its beneficiaries. The conduit pipe principle provides that if the trust distributes the income earned during the year to the beneficiaries in the same year, the income retains its nature and is taxed in the hands of the beneficiary (at the beneficiary's marginal rates). If the trust retains the income, it is taxed in the hands of the trust at a fixed rate of 45%. The tax residency of the beneficiaries does not come into play.

It's important to note that until recently, and in terms of the promulgation of the Taxation Laws Amendment Act, No. 17 of 2023, it was possible to distribute income to non-resident beneficiaries without paying tax in the trust (at 45%) but in the hands of the non-resident beneficiary (at their marginal tax rates).

Capital gains work similarly to income, except the tax residency of the beneficiaries did come into play. If a trust realised a capital gain and distributed it to South African tax resident beneficiaries in the same tax year, the gain would have been taxed in the hands of the beneficiaries at their individual capital gains tax rates (up to a maximum of 18%). If the trust did not distribute the capital gain, it would have been taxed within the trust at the rate of 36%. Furthermore, if a capital gain was distributed to a non-South African tax resident beneficiary, it would also have been taxed within the trust at a rate of 36%.

Changes to the Income Tax Act, No. 58 of 1962 , effective from 1 March this year, align the tax treatment of income distributions with the tax treatment of capital distributions made to non-South African tax resident beneficiaries. Therefore, effective from 1 March 2024, the Income Tax Act was amended to limit the flow-through principle only to distributions made to South African tax resident beneficiaries.

Reasons provided by the government for these amendments include that the flow-through of amounts by South African trusts to non-residents places SARS in a difficult position to collect income tax from those beneficiaries. Since they may not be taxed on foreign-sourced amounts, tax recovery actions may be difficult and, in the case of non-resident trusts that are beneficiaries, SARS may not have information on the persons in whom the foreign trusts vest the income.

Therefore, if you have children in offshore jurisdictions or you are a non-South African tax resident beneficiary, it’s critically important to ascertain their or your tax residency status and whether or not they or you may have inadvertently ceased South African tax residency – without proper planning, the aforementioned amendment could have significant implications when distributions are made by South African trusts.

Lastly, it’s important to keep in mind that these changes could also affect trusts created in terms of a will, i.e., a testamentary trust. In this regard, make sure that you seek advice before providing for a testamentary trust in your will if your children have, or are likely to relocate abroad and cease their South African tax residence, since this could have unintended tax implications in future if such trust would look to distributing to such non-resident beneficiaries.

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