The R1 million capital gains tax exemption on profits from the sale of privately-owned primary residences was not enough to persuade many taxpayers with residences owned by companies, close corporations and trusts to transfer ownership into their own names. But since Finance Minister Trevor Manuel tweaked the tax laws in the recent Budget, it's time to reconsider.
A basic principle of the capital gains tax (CGT) system that came into effect on October 1 last year was that every South African should be allowed to own a home (a primary residence, to use the jargon of CGT) without fear of paying CGT if it is sold.
Two conditions must be present for a property to qualify as a primary residence in terms of CGT:
- An individual or special trust must own an interest in the property. (A special trust is established to provide for an individual who is mentally or physically handicapped and financially not self-sufficient); and
- The property must be used for residential pur-poses only.
If both conditions apply, the first R1 million of the capital gain resulting from the sale of the property is exempt from CGT.
But this concession left many taxpayers out in the cold. For a variety of reasons, some South Africans own their homes through private companies, close corporations (CCs) and trusts.
So, to be fair to all taxpayers, the South African Revenue Service (SARS) created a window period during which you can transfer a property owned by a private company, CC or trust into your name without paying transfer duty or CGT. This period expires on September 30, 2002. The option is open to any taxpayer whose property was registered in the name of a company, CC or a trust before April 5, 2001 - the date on which this legislation was first tabled in Parliament.
It sounds very fair, but in reality few taxpayers have found this concession worth taking advantage of. Here is why:
- The primary concession cannot be worth more than R100 000 per sale of a primary residence. (That is, R1 million profit, multiplied by the individual's CGT inclusion rate of 25 percent, multiplied by the maximum marginal rate of tax of 40 percent.)
- Some taxpayers, rightly or wrongly, do not want to draw the attention of SARS to their estate planning mechanisms. This would occur if they accepted the concession.
- Residential properties are held in companies, CCs and trusts as a way of minimising exposure to estate duty. The rate of estate duty is 20 percent of the value of the estate - far more than the potential rate of CGT. Thus there is still greater incentive to hold the property in a company, trust or CC.
- Some residential properties have been held in companies, CCs or trusts for many years. In such cases, the pain of losing the primary residence concession is alleviated somewhat by the fact that CGT is charged only on profit earned after the tax's introduction on October 1 last year. Most profit on such properties would have been earned pre-CGT and therefore would not be taxed.
- Saving tax is not always the main reason for setting up a trust. Many taxpayers form trusts to exclude assets from their estates in the event of liquidation or divorce, or simply to have an efficient holding mechanism when they die.
- A property held in a company or a CC can be sold without the involvement of the Deeds Office or the imposition of transfer duty.
So, to sum up, although the SARS concession looked quite good on paper, it was often not worth the hassle for a potential R100 000 saving. At least that was the position until Manuel presented the Budget in February 2002.
Budget's low blow
During the build up to the implementation of CGT in October last year, many commentators predicted that Manuel would increase the rates in 2002. That didn't happen. In fact, he lowered the super tax rate to 40 percent on taxable income over R240 000, which, in turn, lowered the maximum rate of CGT for individuals from 10.5 percent to 10 percent.
But there is more than one way to skin a (fat) cat. A lesser-known detail of the Budget was the announcement that the current exemption on dividends paid from the capital reserves of a company on liquidation or deregistration would probably be withdrawn.
So how does this effect your decision on ownership of your primary residence?
Consider a company or CC that makes a capital gain and then liquidates:
- Step 1
will be to pay CGT on the capital gain. Assuming that the asset was acquired in the CGT era, the corporate CGT inclusion rate of 50 percent, coupled with the corporate tax rate of 30 percent, will give a CGT charge of 15 percent. This will leave R85 out of R100 distributable to the shareholder.
- Step 2
is the liquidation dividend that will become subject to Secondary Tax on Companies (STC). Take the remaining R85 and multiply it by the STC tax fraction of 12.5/112.5. Result: STC of R9.44, which leaves R75.56 distributable to the shareholder. This is an effective tax rate of 24.4 percent on corporate capital profits. If the capital gain was made last year, it is tax-free. And the official corporate tax rate on revenue profits is 30 percent!
The immediate consequence of this is that taxpayers have to reconsider their decision to keep their properties in companies and CCs. If you now face paying a cocktail of CGT and STC - resulting in a potential tax rate of 24.4 percent - you may well be better off paying the maximum CGT rate for individuals: 10 percent. And the R1 million primary residence concession can soften the tax blow even further.
The other consequence is that companies and CCs will be stigmatised as tax traps. This could result in potential buyers preferring to pay transfer duty on a purchase, rather than face paying CGT and STC when they come to sell the property.
The future of trusts
The way in which tax on trusts has been determined has always been complicated. Basically, tax is imposed in terms of a pecking order that runs as follows:
- Target 1: The donor.
The taxpayer who creates the trust pays tax in terms of a range of provisions contained in Section 7 of the Income Tax Act.
- Target 2: The beneficiary.
If Section 7 does not apply because a donor cannot be identified, Section 25B seeks to identify the beneficiary with a vested (guaranteed) interest in the income and capital of the trust. Where this is achieved, the beneficiary is taxed on all income distributed by the trust, plus income retained in the trust to which the beneficiary has a vested interest.
- Target 3: The trust.
Where sections 7 and 25B do not catch the donor and the beneficiary, the trust pays the tax. Before the latest Budget, the tax rates were reasonably attractive:
Income 0 to 100 000: Tax rate 32 percent
Income R100 000 and over: Tax rate 42 percent
In Budget 2002, the sliding tax scale that applied to trusts was abolished in favour of a flat rate of tax of 40 percent - unless the trust is established for minor children or physically or mentally handicapped persons. In such cases, the individual tax rates will apply.
At present, the flat rate only applies to so-called discretionary trusts because Section 7 and Section 25B pass off the income to the donor or beneficiary. So in many cases no harm has been done as yet.
But will this last? I don't think so. The problem is that applying the provisions of sections 7 and 25B can be very complicated. Every trust deed has to be interpreted separately. If this is enough to confuse postgraduate tax students, just imagine what can happen when an ordinary taxpayer has a dispute with SARS.
Furthermore, many trusts have been structured to convey a vested interest on minor children who have no other income. The tax savings achieved by using the lower marginal tax rates of children, compared to the maximum marginal tax rate of their parents, have been very attractive and widely exploited. But, as with all good things in life and tax, sooner or later they must come to an end.
SARS has stated that its goal is to simplify the tax system. So why would it want to carry on with three potential taxpayers every time a SARS official picks up a trust file? It must be obvious to SARS that life would be much simpler if the provisions of sections 7 and 25B were amended to make all trusts pay tax at a flat rate of 40 percent.
If this does come to pass, the CGT implications for a trust holding a primary residence will be frightening.
Trusts already have a CGT inclusion rate of 50 percent, compared to the individual inclusion rate of 25 percent. When this is coupled with a flat rate of tax of 40 percent, an effective CGT rate of 20 percent results. That is double the individual rate.
Wrapping it up
I don't think it was the intention of SARS, in imposing CGT, to make a fortune out of individuals - not at a rate of 10 percent. Perhaps the only purpose of CGT is to make you declare all your gains in the hope of flushing out the revenue that should be subject to tax at the full rate. The political flak that Manuel would take from increasing an individual's effective CGT rate should make him think twice.
On the other hand, it is companies that make the really big capital gains. These are the worthwhile targets, where Manuel can get his slice of the tax action and contain the flak to being condemned at the South African Chamber of Business's annual convention.
All companies and CCs fall under the same definition in the Income Tax Act. So if you are looking for a sexy corporate structure to warehouse your wealth, you are treading in the very area where Manuel has trained his sights.
As far as trusts are concerned, I don't think Manuel is going to grant them much latitude, other than to provide dispensations that will help minor children and those afflicted with mental and physical handicaps. Other trusts will probably be treated like corporates and land up with an effective tax rate on capital income of 20 percent or more.
Currently, we are in a position to play some tricks to minimise the tax damage, particularly with trusts. But doors will continue to close. And the costs of properly administering corporate and trust structures will continue to rise.
In the past, every man and his dog could use corporate and trust vehicles to gain some tax efficiency.
Those days are over for most of us. As the tax advantages decline, corporates and trusts will develop a reputation as danger zones. Taxpayers who thought that placing a property in a trust would be a selling point when they came to sell it, may well find themselves sitting with a liability.
However, there are concessions that will soften the blow for those who have already set up their structures and, in many cases, it is not worth bailing out. But be careful, the road ahead is confusing.
For those who want to work on the well-worn adage of when in doubt, form a company or trust, forget it - unless you are really wealthy. The days of the widespread use of corporates and trusts in personal financial planning are over for most of us.
Matthew Lester is a professor of tax studies at Rhodes University in Grahamstown.
This article was first published in Personal Finance magazine, 3rd Quarter 2002. See what's in our latest issue