Tax efficient offshore investment within a SA trust

A trust has long been the darling of every affluent South African family. A sign that you have accumulated sufficient wealth to preserve for the generations to follow. However, the prestige has waned over the last couple of decades for the following reasons:

• Considerable change in family dynamics. It is now common for a family of four to be split across different countries.
• The investment options available to South African investors have increased dramatically. Offshore investments in a unit trust, shares and even physical property have become the norm. All these asset classes are out of reach for a South African trust.
• Legislative changes have reduced the tax benefits of trusts.

Due to the historic popularity of trusts, various individuals or families have trusts containing considerable capital gains, thus the only route to alternative investment options involves triggering capital gains.

For example, suppose the trust invested in shares listed on the JSE (as various trusts have done in the past) in March 2002. A R300 000 investment, split evenly across SA stalwarts Sasol, Nedbank and Shoprite would’ve grown to roughly R4 million today (a return of 13.83%). In order to bank those profits and deploy capital elsewhere, the trust will cough up R1 332 238 in capital gains tax.

Source Table 1: Brenthurst Wealth

The conduit principle allows for trust income and capital gains to flow through to the beneficiaries and be taxed in their individual capacity. At first glance, this seems sufficient to neutralise the tax inefficiencies of a trust, as individuals have a 40% inclusion rate vs the 80% inclusion rate of a trust. Ultimately, the objective of a trust is to preserve wealth for future generations by protecting it against capital gains tax and estate duty. Distributing all income and gains to beneficiaries proves counter-intuitive when keeping the objective of intergenerational wealth in mind:

• Family trusts would rather keep capital within the trust’s name to build long-term growth, where it could be under the supervision of the trustees and not in the hands of individual beneficiaries.
• Considering the profiles of individuals with large family trusts, distributing earnings to individual beneficiaries is likely to push up their marginal tax rates, nullifying some of the tax savings made through the implementation of the conduit principle as these individuals are already in high tax brackets.
• By removing capital from the trust and placing it in the name of individual beneficiaries, the capital is once again exposed to estate duty.

Solution: Sinking fund

The ideal product for a trust to invest in is called a sinking fund. A sinking fund is similar to an endowment policy, except a sinking fund does not require life assureds. This means the investment can continue in perpetuity without advisors and trustees having to re-appoint new life assureds (endowment policies are realised if the last life assured passes away).

Tax is levied within the sinking fund, meaning earnings are not taxed in the name of the trust. Within a sinking fund, income is taxed at a flat rate of 30% and capital gains at a flat rate of 12%. Keeping in mind that large family trusts are generally a tool for the wealthy, the following comparisons can be drawn.

Source Table 2: Sars, Brenthurst Wealth

The beneficial tax rates make a huge difference when measured over a long time period, which is the investment horizon of a typical trust. For example, we assume a trust invests R1 million in the Ninety One Equity Fund in 2000 and fully disposes of the investment every five years to show the effects of CGT. The below graph illustrates the difference in outcomes between a normal discretionary investment in the trust’s name and a sinking fund investment in the trust’s name. The tax benefits of the sinking funds lead to a difference of R4 691 083 after 20 years.

Source Figure 1: Morningstar, Ninety One

South African trusts are prohibited from making direct offshore investments. A significant drawback for the wealthier segment of society, who generally desire to use the diversification that offshore investments provide. Although not directly offshore in another jurisdiction, a sinking fund does allow for offshore allocation within the underlying investments. This means the trust can gain exposure to offshore growth assets and exchange rate movements – useful tools to have when trying to build long-term wealth.

Although the first prize would be to externalise assets directly in an offshore jurisdiction, many wealthy families have deep roots in South Africa and have significant enterprises operating within the country with no imminent plans to emigrate. For these individuals, a sinking fund is especially attractive.

It is advisable to engage with an experienced, qualified financial advisor to structure investment strategies suited to the investors’ specific circumstances and financial goals.