The appellate division established the conduit-pipe principle in 1938 in Armstrong v CIR and confirmed it in subsequent cases. If this principle applies, the beneficiary entitled to the trust income is liable for tax on the income. Section 25B of the Income Tax Act, which governs the taxation of trusts, contains a deeming rule with a similar effect in section 25B(1). There are, however, various exceptions to the conduit-pipe principle that taxpayers often overlook. This article considers some of these, including a recent amendment.
Attribution rules
Section 7 of the Income Tax Act deems certain income to accrue to someone other than the person who received it. These rules generally require that the income must have accrued to a person by reason of a donation, settlement or other gratuitous disposition. For example, section 7(3) deems income that accrued to, or for the benefit of, a minor child by reason of any donation, settlement or other disposition made by the child’s parent to have accrued to the parent. These rules counter the effect of various arrangements to shift income to persons who pay no or little (low rate) tax.
Section 25B(1) states that its deeming rule is subject to the attribution rules. If a person, therefore, makes a donation or gratuitous disposal to a trust and, as a result thereof, amounts accrue to a person to whom the attribution rules apply, the attribution rules rather than the conduit-pipe principle determine the person liable for the tax on the amount.
Capital gains
If a trust disposes of an asset, the resulting capital gain arises in the hands of the trust as the default position. SARS states that the capital gains tax rules relating to trusts intentionally deviated from the conduit-pipe principle. Paragraph 80 of the Eighth Schedule to the Income Tax Act, rather than the conduit-pipe principle, governs capital gains tax for trusts. The Supreme Court of Appeal in CSARS v The Thistle Trust and amendments to section 25B to exclude amounts of a capital nature from its ambit confirm this.
Flow-through taxation, therefore, applies to capital gains only to the extent that paragraph 80 provides for this. Importantly, it does not provide this treatment for assets or capital gains that vest in non-resident or tax-exempt persons. It also does not extend flow-through taxation to capital gains vesting to multiple layers of discretionary trusts, as the court confirmed in The Thistle Trust case.
2023 amendment
For years of assessment starting from 1 March 2024, the deeming rule in section 25B(1) only applies to amounts that accrue to a trust to which a resident beneficiary has a vested right. If a non-resident beneficiary has a vested right to such income, the income will be taxed in the hands of the trust. The National Treasury’s draft explanatory memorandum states that this change intends to align the taxation of income vesting in non-resident beneficiaries with that of capital gains. The change eases tax collection, which was often difficult where amounts vested in non-residents.
The amendment raises various concerns for non-resident beneficiaries. These include possible double taxation without relief. If the beneficiary is taxed on the vested amount in another jurisdiction, but the trust was liable for tax thereon in South Africa, the beneficiary may not qualify for relief for this South African tax. Affected beneficiaries would need to consider this more closely in their home jurisdictions.
