Important considerations when setting up an off-shore trust

With South Africa's economy struggling and the political future of the country very unstable, many people are considering investing off-shore. Despite scandals such as the recent "Panama Papers" coming to light, the off-shore trust remains popular among high net-worth individuals in South Africa. 

What many people forget, however, is that the South African Income Tax Act contains specific anti-avoidance provisions in regard to "donations, settlements or other dispositions" made by South African tax residents to non-residents (which would include off-shore trusts).

Section 7(8) of the Income Tax Act provides that income arising from a "donation, settlement or other disposition" made by a South African resident (A) to a non-resident (B Trust) will be taxed in the hands of A, if such income would have been taxable in the hands of B Trust, had B Trust been a South African tax resident.

Section 7(8) is referred to as an attribution section or a "tax-back" section.

South African Courts and academic writers have interpreted the words "by reason of…" as requiring a direct link and have applied a causation test. Furthermore, the courts have determined that a narrow interpretation should be followed. What this means, is that any income arising in the hands of B Trust (to use the example set out above) by reason of the initial start-up capital donated to B Trust by A (who is a tax resident) can be included in the hands of A in terms of section 7(8).

For example, if A donates an amount of US$100 000 to B Trust and B Trust uses the capital to invest in immovable property, the rental income arising from such immovable property is clearly linked to and arises as a result of the initial start-up capital donated to B Trust by A.

However, where B Trust re-invests the rental income in another investment, for example shares in a company listed on a foreign stock exchange, and earns income from such investment (in the form of dividends), A should be able to argue that such income earned by B Trust from the listed shares is not attributable to the initial start-up capital donated by him to B Trust, as such dividend income is attributable to a profitable employment of the rental income earned on the immovable property investment. A should further be able to argue that such subsequent act of investment by B Trust severed the link between the donation of the initial start-up capital and the eventual earning of dividend income.

A further example is the provision of an interest-free or low interest loan by a South African resident to an off-shore trust. The South African courts have found that the difference between the amount of interest that was charged and the amount of interest that should have been charged can be treated as an ongoing donation. In such circumstances, the ongoing donation will also constitute a "donation, settlement or other disposition" for purposes of section 7(8) of the Income Tax Act and may also cause income earned by the off-shore trust by reason of the donation to be included in the South African resident's income.

The abovementioned examples are obviously very simple and most real life situations may be significantly more complicated and, as such, it would be prudent for taxpayers considering this course of action to obtain professional advice prior to setting up any off-shore structures.

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