SOME US/SA TRUST TAX ISSUES FOR SA TRUSTEES

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SOME US/SA TRUST TAX ISSUES

FOR SA TRUSTEES

© Webber Wentzel 2012

Presentation to STEP South Africa Conference 2012

by Professor Michael Honiball

Partner, Webber Wentzel

29 May 2012

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South African Exchange Control for Emigrants;

What is a US Trust?;

US Grantor Trusts and Foreign Grantor Trusts;

Some General US Tax Principles;

US Check-the-box: General Principles;

US Passive Foreign Investment Company (PFIC);

US PFIC Example and Comments on Example;

SA/USA/DTA Tax treatment of SA Trusts;

DTA Example and Comments on Example;

Conclusion on DTA Treatment of Distributions from SA Trusts which are

Grantor Trusts;

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Some US/SA Trust Tax Issues Overview of Presentation

Introduction

According to US statistics, more than 1 200 000 immigrants in the USA are of

South African origin;

Many were relatively affluent when they left, and therefore were or are

beneficiaries of local and offshore trusts;

This presentation is mainly directed at the trustees of South African trusts;

As will become apparent, there is an important interaction between South

African exchange control laws applicable to trusts of emigrants, and US tax

laws;

There is also an important interaction between US tax law applicable to

individuals, South African tax law applicable to trusts, and the US/SA tax

treaty.

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• Exchange control restrictions only recognise three types of trusts for emigrants: own-asset trusts, blocked trusts, and deceased funder trusts:

o “Own-asset” trusts: the emigrant is deemed to own the trust assets directly, and can therefore remit the income and capital gains arising from those assets, outside of South Africa;

o “Blocked trusts”: no distributions are remittable to any emigrant but local distributions may be made; o “Deceased founder/funder trusts”: distributions are freely remittable to emigrants as so-called “legacies”;

• A special application must be made for own-asset status, which is not automatically granted: US Grantor Trust status can impact on own asset trust status and vice versa

• It is possible to obtain “own-asset” status for a beneficiary percentage, e.g. if there are 5

beneficiaries, then application can be made for them to be deemed to own 20% each. This may help (or not!) the US tax attribution position, for trust ownership of a PIFC;

• Generally, restrictions are imposed by the FinSurv Department of the SARB in respect of all three of the above categories of trusts if any beneficiary or the founder or funder is an emigrant,

including:

o Majority of trustees must always be South African residents; o Trust Deeds may not be amended without SARB/FinSurv consent;

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Some US/SA Trust Tax Issues for SA Trustees

What is a US Trust?

• A trust is a US Trust if:

o US court exercises primary supervision over trust administration; and

o US persons control all substantial decisions of the trust.

• A Foreign Trust for US purposes is any trust that is not a US trust;

o A trust with US governing law, US trustees, US assets and US beneficiaries can be a foreign trust with a non-US protector (if a non-US Protector controls some or all of the substantial decisions).

Taxation of US Trusts?

• The taxation of a US Trust is primarily dependent on whether the trust is a Grantor or a Non-Grantor Trust but is also dependent on whether the trust is a US Grantor Trust or a Foreign Grantor Trust;

• Of most relevance for SA emigrants to the USA, is a Foreign Grantor Trust, which is generally regarded as beneficial. Why?

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• US or foreign trust which is disregarded (“fiscally transparent”) for US income tax purposes;

• Grantor is considered to “own” the property held by the trust;

• Income, gains, losses, deductions, all for the Grantor, not the trust;

• Who is the Grantor? Various tests: funder; founder; spouse of founder or funder, if the income can be distributed to him without the consent of an adverse party (section 677);

• Section 679: immigrants to US – will be treated as Grantor of a foreign trust if funded within five years of becoming resident;

• Various other complicated rules;

• Pre-immigration Grantor Trusts are primarily set up for US estate duty (40%) planning and for US gift tax (35%) planning;

• Additional benefit: “normal” US tax treatment for the emigrant (US Grantor) if PFIC rules do not apply.

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Some US/SA Trust Tax Issues for SA Trustees

Foreign Grantor Trusts

• A non-resident Grantor (for US tax purposes) is not treated as the owner of a trust unless:

o The Grantor retains the power to revoke the trust; or

o Distributions may be made only to the Grantor or his/her spouse during the Grantor’s lifetime;

• this may be determined by the trust deed; or

• this may be determined by applying a “facts and circumstances” test.

Taxation of Foreign Grantor Trust?

o Global income and gains are taxed directly to the Grantor;

o Trust itself is only taxable on income from a US source;

o Distributions can be made to other US beneficiaries free of tax in the US, subject to certain conditions/restrictions.

Foreign Non-Grantor Trust?

o Trust only taxable on income from US source;

o But, undistributed income is subject to interest charges so that overall US tax cost could even equal the distribution;

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Ordinary individuals income tax progressive tax rates: up to 39.6% for 2011

onwards;

Foreign dividends tax rate: 15% (until December 31, 2012);

Foreign capital gains tax rate: 15% (until December 31,2012 – certain gains

up to 20%);

State taxes are paid additionally to the above;

All South African discretionary and vesting trusts are “look through” for

purposes of determining US CFC and US PFIC status, as well as for purposes

of US tax credits, etc.

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Some US/SA Trust Tax Issues for SA Trustees

US Check-the-box: General Principles

Entity to non-entity election (and vice versa);

Election changes the US tax treatment of the foreign company;

Benefits of making the election:

o

Enables flow-through of foreign company tax credits (e.g. company to

partnerships);

o

Uplifts the cost basis of shares for CGT;

o

Eliminates the application of anti-deferral rules under the CFC or PFIC

regimes;

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Complicated for companies held by trusts: need to understand both US trust

tax rules, and the US PFIC rules;

The election results in a deemed liquidation of the South African company

resulting in a capital gain trapped in the ownership trust, and unless amount

equal to the gain is distributed in full in same year (US tax year), it is

re-characterised as ordinary income. The same excess rule as for a PFIC then

applies in any subsequent year;

Earnings/profits become accumulated income in the trust if not distributed

in the same tax year;

Important to first determine if a company/entity is a US PFIC, then decide

whether an election must be made in respect of such PFIC for the above

benefits.

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Some US/SA Trust Tax Issues for SA Trustees

US Passive Foreign Investment Company (PFIC)

• There are three alternate taxing regimes which are applicable to PFICs; o First regime: Qualified Electing Fund:

• The relevant company is required to make financial disclosures on an annual basis; or

o Second regime: Mark-to-Market:

• This regime is only available for public companies; or o Third regime: Excess Distribution and Interest Charge:

• This regime is triggered by a distribution or disposal of an interest; • An excess distribution is a distribution exceeding 125% of the average

distribution for the last three years;

• The entire gain derived upon a disposal is deemed to be an excess distribution; • It is the third regime which can be detrimental to trust beneficiaries and must therefore

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• When is a company a PFIC? Extremely complicated rules;

• Generally, when 75% or more of a company’s gross income is passive income (e.g. dividends) or 50% or more of the value of its assets are passive assets (e.g. shares in other companies), then it will be a PFIC;

• There is no minimum US ownership threshold but a look-through rule applies for 25% or more shareholding;

• 125% 3-year average rule applies – what is this?

• If a US taxpayer receives an amount (dividend or capital gains), from a PFIC that exceeds 125% of previous three year’s average, the excess is characterised as ordinary income and retroactively taxed with interest charges over the taxpayer’s holding period. The balance is taxed as ordinary income;

• Once a PFIC, always a PFIC (except for a limited start-up exclusion);

• Problems with certain types of income e.g. rentals – passive or active?

• Trust ownership is attributed to beneficiaries in proportion to their interests. (What is a qualifiable proportionate interest in a discretionary trust? All facts and circumstances are considered).

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Some US/SA Trust Tax Issues for SA Trustees

US PFIC Example

A + B Rental of office block USA RSA 100% 40% SA Co1 Controller SA Co3 SA Co4 SA Co2 SA Co5 Non-emigrant resident A Bank interest Opco Invest co SA Co6 Opco Opco Opco 100% 100% 25% 20% Various passive investments Emigrant US tax resident B 50% 50% bank interest passive investment income operating income rental income operating income

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• SA trust is look-through for US tax purposes, 50% deemed attribution to Person B;

• SA Co 2 is a passive investment of SA Co 1 due to 25% rule not being met, despite being an Opco, while all the other companies are active investments of SA Co 1;

• Rental income from office block for SA Co 4 would be a problem in theory due to 25% rule;

o If actively managed by SA Co 4, rentals are active income; or

o If part of a syndicate/passive investment, rentals are passive income;

• Passive income of SA Co 5 would potentially be a problem for SA Co 1, but active income of SA Co 6 could counter-act;

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Some US/SA Trust Tax Issues for SA Trustees

Comments on US PFIC Example, cont.

• Apply asset value test to SA Co 1? under the 50% test, you need to value all its active assets (SA Co 3, SA Co 4 (assume)), SA Co 6, and then compare with the value of all passive assets (bank deposit in SA Co 1, shares in SA Co 2 and passive investment of SA Co 5), then attribute 50% of the total to emigrant Beneficiary B;

• Or: Apply the income test to SA Co 1? passive income is as follows: bank interest, SA Co 2 dividends, and SA Co 5 passive income. Active income: all Opco’s income except SA Co2. What if all the Opco’s are making losses? Apply on a gross income basis and then attribute 50% to emigrant Beneficiary B;

• If not a PFIC, based on the above calculations, 15% tax on current year distributed dividends. If a PFIC, 35% tax with no tax credits, unless a check-the-box election is made;

• If not a PFIC, full US tax credits are available for tax paid by the trust (but not paid by the underlying company).

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• New South African dividends tax? 15% tax paid by the trust or by the company? Withheld by Co, levied on trust, so probably creditable in the USA under both DTA and US domestic law.

• New SA Dividends Tax replaced STC wef 1 April 2012 and is withheld by the SA

resident company declaring the dividend. However, the liability for tax is that of the shareholder;

• Does not apply between SA-resident companies, but does apply to all dividends declared to SA resident individuals and SA resident trusts at 15%;

• In the case of a SA vesting trust, flow-through will apply and the beneficiary will suffer the tax liability;

• Dividends Tax rate is 15% but DTA relief could apply in favour of non-resident

individuals (e.g. for US residents, the 15% rate could be reduced to 5%, depending on the shareholder percentage, etc).

• Generally, US tax resident individuals will obtain a US tax credit for any Dividends Tax paid.

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Some US/SA Trust Tax Issues for SA Trustees

SA treatment vs. US treatment vs. DTA treatment

• Interaction between SA, USA and DTA tax principles is complicated in relation to

trust distributions to emigrant beneficiaries;

• In South Africa, discretionary trusts are taxed as follows:

o Section 25B: Income of trusts and beneficiaries of trusts – flow through, or not;

o Paragraph 80: Capital gains attributed to beneficiary – flow through, or not;

o Paragraphs 80(1) and 80(2) only apply to distributions by resident trusts to resident beneficiaries, and only where none of the relevant “tax-back” or attribution rules apply. There are no specific provisions which expressly apply to distributions by resident trusts to non-resident beneficiaries. The so-called “conduit principle” (which has been recognised in case law) may be relevant in this regard;

o All of the above only applies to the extent that the section 7(8)/Para 72 attribution rules do not apply to tax the donor/founder/settlor.

• Vesting trusts are not taxed and instead the vested beneficiaries are taxed in the

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The relevant provisions of the US/SA DTA are the following:

o Article 4 – Residence

1. For the purposes of this Convention the term "resident of a Contracting State" means:

… (d) in the case of an item of income, profit or gain derived through an entity that is

fiscally transparent under the laws of either Contracting State, that income shall be

considered to be derived by a resident of a State to the extent that the item is treated for purposes of the taxation law of such Contracting State as the income, profit or gain of a resident (emphasis added).

o Article 13 – Capital gains

… 5. Gains from the alienation of any property other than that referred to in the preceding paragraphs shall be taxable only in the Contracting State of which the

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Some US/SA Trust Tax Issues for SA Trustees

SA treatment vs. US treatment vs. DTA treatment, cont.

o Article 4 – Residence Commentary (IRS Explanatory Memorandum) Commentary on Paragraph 1 of Article 4

… Subparagraph (d) addresses special issues presented by fiscally transparent entities such as partnerships and certain estates and trusts. In general, subparagraph (d) relates to entities

that are not subject to tax at the entity level, as distinct from entities that are subject to tax,

but with respect to which tax may be relieved under an integrated system. This subparagraph

applies to any resident of a Contracting State who is entitled to income derived through an entity that is treated as fiscally transparent under the laws of either Contracting State.

Entities falling under this description in the United States would include … Grantor Trusts. … Subparagraph (d) provides that an item of income derived by such a fiscally transparent entity will be considered to be derived by a resident of a Contracting State if the resident is treated under the taxation laws of the State where he is resident as deriving the item of income (emphasis added).

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o Article 4 – Residence Commentary (IRS Explanatory Memorandum) Commentary on Paragraph 1 of Article 4 cont.

… The taxation laws of a Contracting State may treat an item of income, profit or gain as

income, profit or gain of a resident of that State even if, under the taxation laws of that State, the resident is not subject to tax on that particular item of income, profit or gain … These principles also apply to trusts to the extent that they are fiscally transparent in either

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Some US/SA Trust Tax Issues for SA Trustees

SA treatment vs. US treatment vs. DTA treatment, cont.

o Article 13 Commentary

Commentary on Paragraph 5 of Article 13

Paragraph 5 grants to the State of residence of the alienator the exclusive right to tax gains from the alienation of property other than property referred to in paragraphs 1 through 4. For example, gains derived from shares … may be taxed only in the State of residence of the alienator, to the extent such income is not otherwise characterized as income taxable under another article …“ (emphasis added).

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• Application of the above to SA trusts? 3 potential scenarios:

1. Income distributed to US resident beneficiary;

2. Asset (in specie) distributed to US resident beneficiary;

3. Capital gain distributed to US resident beneficiary.

• All three scenarios have very different tax treatment in respect of the income and gains of a SA trust which has US Grantor Trust status;

• Trustees of such SA trusts must obtain professional tax advice prior to making any distributions to any US tax persons.

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Some US/SA Trust Tax Issues for SA Trustees

DTA Example

o SA discretionary trust (SA Trust), which is tax resident in SA and is an own-asset trust for emigration purposes, owns 9% of the shares in a foreign company (Company A);

o SA Trust has two emigrant, US resident beneficiaries, Mr and Mrs X;

o SA Trust is a US Grantor Trust in relation to Mr X and an own-asset trust for SA exchange control purposes in relation to Mr X;

SA Trust Company A (UK) Mr X US resident 9% Mrs X US resident SA tax resident trust UK tax resident company

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o SA Trust wants to dispose of all the shares in Company A and distribute the gain to Mr X;

o SA Trust has also received a dividend of R100 from Company A during May 2012 (2012 US tax year, 2013 SA tax year);

o The purchaser of the shares in Company A is tax resident in Switzerland;

o The Trustees of the SA trust have three options:

• they could dispose of the shares and then distribute the capital gain to Mr X; or • they could distribute the shares in specie to Mr X who could thereafter sell them

himself; or

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Some US/SA Trust Tax Issues for SA Trustees

Comments on Example

What is the tax treatment of the dividend received by SA Trust?

o The foreign dividend received by SA Trust from Company A will not be exempt from SA income tax under Section 10B as the shareholding is below 10%;

o If the trust retains the dividend, the trust itself will normally be taxable thereon at 15%, while if it distributes the dividend in the current tax year, normally the resident beneficially will be taxable thereon at 15%;

o In this case, as the SA Trust will be considered a fiscally transparent entity for US tax purposes under the US/SA DTA (because it is a Grantor Trust), South Africa will have no taxing rights, irrespective of whether the trustees distribute the dividend or not. The dividend will therefore be subject to US tax in the hands of Mr X only, at a US rate of 15% (until December 31, 2012).

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What is the tax treatment of the sale of shares in Company A by SA Trust?

o The Para 64B CGT exemption will not apply as the shareholding in Company A is below the qualifying threshold of 10%;

o Therefore, SA Trust would normally be liable for CGT at an effective rate of

26.7% (if the trust retains the gain) or the beneficiary will be taxable at 13.3% (if a resident who is a natural person);

o However, Mr X is subject to tax only in the US on the capital gain derived, because of the fact that SA Trust is fiscally transparent (by virtue of being a Grantor Trust), as under article 13(5) of the US/SA DTA, Mr X will be deemed to be the “alienator” of the shares – (no DTA tax credit required);

o This SA tax position applies irrespective of whether the trustees distribute the capital gain to Mr X in the same tax year, or in a subsequent tax year, while if the distribution is made in a subsequent tax year, certain negative US tax implications will arise.

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Some US/SA Trust Tax Issues for SA Trustees

Comments on Example, cont.

What is the tax treatment of the vesting or distribution of shares in specie to Mr X, whereafter Mr X disposes of the shares?

o In South African trust law, an asset of a discretionary trust can be “vested” in a

discretionary beneficiary, without actually distributing such asset “in specie” to such

beneficiary. The trustees retain control over such asset, but full economic value resides in the beneficiary;

o In effect, vesting creates a new trust, referred to as a “bewind trust”, which is a Roman-Dutch creation;

o South African CGT is payable upon vesting or upon a distribution of assets in specie, as both types of events are deemed disposals for CGT purposes;

o SA Trust is therefore liable for CGT at a rate of 26.7% upon the vesting of the asset, or the distribution of the asset in specie, as both events are deemed disposals for South African CGT purposes.

o No DTA relief, as the disposal is made by a fiscally transparent entity to a beneficiary thereof (i.e. for US tax purposes, Mr X is disposing of an asset to himself).

o There will be a CGT liability in the US later, in respect of the subsequent sale by Mr X to the Swiss resident;

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o The result is that both SA CGT at 26.7% and later US CGT at 15% (or 20%) will be payable;

o Will the US resident (emigrant beneficiary) receive a US tax credit?

• Definitely not under the US/SA DTA, as the SA deemed capital gain is not treated as a taxable capital gain in the hands of Mr X;

• However, Mr X could potentially claim a tax credit not under the US/SA DTA, but under US domestic tax law. Even though he may make an election to claim a US tax credit on an accrual basis, it is doubtful whether this election can be used in this case as for South African tax purposes the trust is not tax transparent (for this transaction), and therefore a different entity is being taxed on a different gain;

• If no US tax credit under US domestic law, this is therefore a classic example of economic double taxation in respect of which potentially no double tax relief is available.

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Some US/SA Trust Tax Issues for SA Trustees

Conclusion on US/SA DTA Treatment of distributions from SA Trusts which are

Grantor Trusts

• Distribution of current income to a US resident: conduit principle coupled with DTA

fiscal transparency treatment causes it to be taxable only in the USA;

• Distribution of a current capital gain to a US resident: according to SARS view,

taxable in SA trust under SA domestic tax law (26.7%) but taxable only in the USA if the USA/SA DTA applies (DTA relief);

• Capitalisation of a capital gain in the trust: normally SA CGT at 26.7% but overridden

by DTA if the US/SA DTA applies because Mr X is instead taxable on this gain in the USA. Subsequent distributions will, however, have negative US tax consequences for Mr X so distribution of all current year gains is preferable;

• Distribution of asset in specie to a US resident or vesting of asset: taxable in trust at

26.7% (SA tax) and no US tax consequence (distribution to yourself but later sale will cause US CGT with no DTA credit for SA trust tax under the DTA (therefore economic double taxation)). However, potentially arguable that later credit in US for prior SA tax paid, e.g if accrual election is made (under US domestic law).

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Overall Conclusion

US tax treatment of SA trusts gives both benefits and problems;

Clear interaction between US Grantor Trust status, and exchange control

own-asset trust status;

US Grantor Trust status may assist in obtaining ‘own asset’ trust status from

SARB and vice versa;

US tax issues may require SA trustees to make distributions of all current

year income and gains in certain cases;

Selection/decision by South African trustees about whether and when to

distribute income, gains or assets must be done having regard to US tax and

DTA principles, as consequences may materially differ!

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Tel: +27 11 530 5269 Fax: +27 11 530 6269

Email: michael.honiball@webberwentzel.com Websites: www.michaelhoniball.com

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Some Recommended US Advisors

Legal Notice: these materials are for training purposes only and do not constitute legal or other professional advice. Peter Rosenberg TerraNova Services, LLC 1900 Market Street Philadelphia PA 19103-3508 T +1 2156652006 www.terranovatrust.com Jerry Gumpel

Sheppard Mullin Richter & Hampton LLP

12275 El Camino Real Suite 200 San Diego, CA 92130-2006 T + 1 858 720 8900 www.sheppardmullin.com Christopher Uzpen Withers Bergman LLP 157 Church Street New Haven, Connecticut 06502-0426 T +1 2033024076 www.withersworldwide.com

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ETHIOPIA KENYA MALAWI MAURITIUS MOZAMBIQUE RWANDA SOUTH AFRICA TANZANIA UGANDA ZAMBIA

Legal Notice: these materials are for training purposes only and do not constitute legal or other professional advice.

www.webberwentzel.com

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10, 16 & 18 Fricker Road, Illovo Boulevard,

Johannesburg, 2196, South Africa PO Box 61771, Marshalltown, Johannesburg, 2107, South Africa T +27 11 530 5000

CAPE TOWN

15th floor, Convention Tower,

Heerengracht, Foreshore, Cape Town, 8001, South Africa PO Box 3667, Cape Town, 8000, South Africa T +27 21 431 7000

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