Trusts have become an increasingly popular mechanism in South Africa, particularly as a means to reduce estate duty when you die. The problem facing wealthier South Africans is that anything over R1 million in your estate is taxed at 25 percent (with the exception that no duty is payable if assets are left to a spouse).
Over the years, inflation has made the R1 million increasingly meaningless with even the average ranking executive or professional person building up R1 million in assets fairly rapidly.
The problem can be reduced by placing assets in a trust. You are effectively transferring ownership of the assets and they are no longer included in your estate. You must however be aware that tax authorities internationally are moving to shut down the use of trusts as a tax dodge. At this stage it is not clear whether the introduction of capital gains tax in South Africa will affect offshore trusts.
You can transfer any asset to a trust with one exception: you cannot put any investment bought with your R750 000 foreign allowance into a local trust without specific Reserve Bank approval; neither can you use assets in the trust to k invest offshore. The options open to you are:
* Hold the assets in your own name;
* Create or buy offshore companies; or
* Create an offshore trust.
All three choices have both upsides and downsides.
Holding assets in your own name
* No trust advantages: You lose many of the advantages of holding assets in a trust. In particular, you do not receive the estate planning advantages. When you die, the value of your offshore holdings will be included in your estate and will be subject to estate duty. Those investments will also be valued in rands for estate duty purposes; so, if the rand continues to depreciate against other major currencies, the growth in value could be more rapid;
* Tax: South Africa traditionally taxed on a source basis but, with the relaxation in exchange control, two new sections were introduced to bring "investment income" into the tax net. You need to be careful when investing to ensure that the investment made does not produce interest, rental income, royalties or annuities as these will be deemed to be from a South African source and taxed accordingly. You also need to take account of the introduction of capital gains tax.
* An offshore will: This also has its problems as the winding up of an estate offshore is likely to be far more complex and expensive than in South Africa. A process called probate has to take place to ensure that the terms of the will are properly adhered to and all creditors are paid out and all assets collected.
* Potential for double estate duty: Your estate could be taxed twice on your foreign assets after your death, depending on the tax regime of the jurisdiction where your assets are held. There is some relief in this event in the local legislation (Estate Duty Act), but there may be time delays because of the process.
Creating or buying a company
In many ways owning an offshore company which houses your foreign investments is a halfway point between owning the assets in your own name and in a trust. Effectively, you are buying or creating what is known as a shell company. All you are doing is placing your assets in that company. You need to take a number of issues into account. These include:
* Choosing a jurisdiction: You will need to choose a tax efficient jurisdiction, which will require expertise;
* Estate planning: There are estate planning advantages as the company can live after you, but the way in which you hold the shares and issues, such as directorships, need to be taken into account; and
* Costs: The costs of setting up the company and administering it may be high, undermining the returns you receive on your investments.
Paul Roper, of Absa Offshore, who has written a book on offshore investments and asset holding structures, says you need to establish such things as company regulations; your anonymity as a beneficial owner; and liability limitation in the case of a problem.
* Vulnerability: A company could be vulnerable to changes in local regulations and legislation.
Trusts
There are two major additional advantages you gain from an offshore trust over a local trust. These are:
* You remove the money from the ambit of South African exchange controls; and
* Although you, as an individual, must pay tax on any income generated anywhere in the world, an offshore trust is not yet a taxable entity in South Africa. But you should obtain advice to ensure that the trust structure you set up does not become what is called a "controlled foreign entity" which could have income tax consequences.
Other issues that affect offshore trusts that you need to take into account include:
* Transfer of assets: In South Africa, you can make interest-free loans to and from trusts as well as make tax-free donations of R25 000 a year to a trust to repay a loan.
However, this does not apply to offshore trusts. In terms of income tax legislation, there is a section which governs what is called transfer pricing.
Barry Short, tax expert at Nedbank Investment Bank (NIB), says transfer pricing was introduced in the early nineties to stop companies from transferring activities from one country to another to pay out profits where there were lower tax rates.
What this means is if you give a loan to a trust, the trust will be deemed to be paying you interest (whether or not it does so), on which you will have to pay income tax in South Africa. The rate of interest is normally based on the London Interbank Offered Rate (Libor). The rate of interest will depend on the currency in which the loan is made. If the loan is in rands, an arm's length rate will be up to prime plus two percent over Libor. If the loan is in another currency, the appropriate rate would be the relevant interbank rate up to four percent over Libor.
* Costs: There are initial set-up and on-going costs with offshore trusts. It will probably be in your best interests to use professional trustees. As with local trusts, you need to be wary of off-the-shelf trusts which do not take account of your peculiar circumstances. Trusts, for cost purposes, can be divided into "dormant" trusts, in which you effectively place an investment and leave it to grow; and "active" trusts, where you are actively trading investments.
Lloyd Jones, who is based at NIB's Isle of Man office, says costs can vary between the two. A trust in which all the investments are through NIB International products can be set up for P300, with an annual charge of P300. A more complex "full" trust set-up fee starts at about P1 000 with an annual fee of P1 250. On top of this, the professional trustee charges about P85 an hour for work done on the trust.
Short says that the costs would probably exclude most people with only their R750 000 foreign allowance. These people should rather structure their local affairs to reduce their local assets to a minimum, allowing them to use the R1 million abatement on estate duty for their foreign investments.
Roper, who warns against off-the-shelf trusts, says that a trust can be made cost efficient by combining the foreign investment allowances of a spouse and other relatives to make a more substantial sum.
* Differences: There are a number of differences between offshore and local trusts. The regulation in the main reputable offshore centres tends to be tighter than in South Africa.
Legislation and court precedents require high standards from professional trustees while trusts which do not set up an arm's length relationship between you and the trust are frowned upon. Short says you also need to be aware of anomalies. For example, the trust will continue to be taxed on any benefits paid to a non-resident major child.
* Jurisdiction: You have to decide where to locate the trust. The most popular choices are the Isle of Man and the English Channel Islands of Jersey and Guernsey. Roper says you not only need to choose a tax-free jurisdiction but also one that has a strong tradition of enforcing trusts. Jones believes the Isle of Man is best suited while Roper favours Jersey in the Channel Islands because of the body of trust case authority which creates a level of certainty in dealing with trusts.
Who should set up an offshore trust
An offshore trust for a R750 000 foreign investment allowance is probably not very cost-effective. However, NIB's Barry Short says there are many people living in South Africa who could take advantage of an offshore trust. These groups include:
* People who inherit substantial sums offshore. This money should be transferable into an offshore trust without any tax consequences; and
* Emigrants and immigrants to and from South Africa. This would protect emigrants from tax consequences in their new country of residence and immigrants from tax consequences in South Africa; and
With the tax changes in the South African 2000 budget on offshore earnings from tax-free, source-based to taxed, resident's-based tax the trust advantages are now limited. Previously the money could be donated tax free to a trust.
The pros and cons of setting up an offshore trust
ADVANTAGES
* Estate planning: This is the primary advantage, allowing for proper management and control of your assets after you die;
* The freezing of value: It is possible to "freeze" the value of your estate at present value. The growth in the value of your assets will occur in the trust, limiting the net value of your estate. This is advantageous under inflationary conditions, with tax of 25 percent being payable after the first R1 million;
* Tax planning: Alarm bells should ring if tax planning is the primary motive for a trust, as there are many provisions in the Income Tax Act that will deem income to be taxed in your hands if the taxman believes you are avoiding tax;
* Preservation of assets after death;
* The on-going management of your assets, including contractual arrangements. This is particularly useful in a business arrangement, where value could be lost by selling off a business share;
* Protection of assets from creditors. Your personal liability is limited to the assets in your name. Assets in your trust cannot be accessed by your creditors;
* Protection from spendthrift children who will not be able to go on a spending spree reducing the assets to nil;
* Protection of a vulnerable spouse after your death, particularly in the case of a second marriage;
* Protection of minor and/or vulnerable children, particularly if a child is retarded in some manner;
* Income tax splitting: Under some circumstances, income from a trust can be split between a couple, reducing tax liability. For example, say one spouse has a marginal rate of 42 percent and the other of 30 percent, there is an advantage to the spouse on the lower marginal rate being the recipient of the income from the trust;
* Assuring rapid access to income and capital after your death. Payment to beneficiaries can be delayed for up to a year in the winding up of your estate. A trust avoids many of the complications and delays if your assets are held in a trust, with beneficiaries receiving benefits immediately;
* Multi-ownership of assets: It is not easy to divide some assets, such as a business, a farm or other property, between heirs. By placing the asset in a trust, it can be held intact with your heirs being the beneficiaries to the income generated by the asset;
* Impartiality: You can expect the decisions of a third party (professional) trustee to be impartial, not favouring any one beneficiary, particularly after your death;
* Confidentiality: On your death, your will becomes a public document. However, because a trust does not become part of your estate, the assets held in the trust remain confidential;
* Flexibility: Trusts provide wide choices, giving flexibility if the tax, political or economic situation changes significantly; and
* Cost saving: The assets in the trust are not subject to any of the executor fees or costs of winding up an estate.
Disadvantages
* Perceived and actual loss of control: You no longer have total control of your assets. Your protection lies in the wording of the trust deed. A trust created under one set of conditions can become a monster under others, say, following a divorce. The result could be worse than any tax due under estate duty. Although a trust can take over all your discretionary investments, you can still manage these assets directly without the involvement of the trustees, through a power of attorney;
* A trust is an entity which is registered and may, under certain circumstances, be accessed by the authorities. But trusts cannot easily be attacked by the authorities, as they would not easily become aware of the trust. In most offshore jurisdictions, disclosure of confidential information carries a criminal sanction;
* Bad choice of trustees: If trustees are rival heirs, there can be problems. This is why you need an independent party as a trustee; and
* Possible future regulatory changes: Laws and regulations can change both here and offshore affecting trusts.
Health Warning
Offshore trusts are extremely complex and come in a number of different guises. You must get proper advice from an expert, preferably a cross-border organisation, based or with a representative office in South Africa and a representative office in the jurisdiction where you intend to establish the trust.