Tax law changes carry substantial implications based on where your heirs are situated around the world.

By: Elmie de Jager

02/11/2024

If you or any of your trust beneficiaries are considering emigrating, it is important to note that the taxation of distributions to non-residents has changed. These legislative changes may require many people to reassess their inheritance plans.

This includes section 10(1)(h) of the Income Tax Act, which took effect on 1 March 2024, and the fact that section 25B (which allows for growth distributions to beneficiaries through the conduit principle, where it is taxed in the hands of the beneficiaries rather than in the trust) no longer applies to individuals classified as non-residents.

So what does this mean in practical terms, and how does it affect you as a beneficiary or trustee of a local trust? Let’s begin by defining a “resident” as per section 4 of the Act. When an individual is considered a resident in both treaty countries, their residency status is determined as follows:

a) The person is deemed a resident of the country where they have a permanent home. If that is the case in both countries, the one with the strongest personal and economic ties is chosen.

b) If no permanent home can be determined, the country where the person has an ordinary residence is considered their country of residence.

c) If the individual has an ordinary residence in both countries or neither, they are considered a resident of the country of their nationality.

d) If they are a citizen of both or neither country, the authorities of the treaty countries will resolve the matter through mutual agreement.

If a beneficiary is classified as a non-resident (of South Africa), they will no longer be taxed in their personal capacity on trust distributions. Instead, the distribution will be subject to trust tax rates of 45% on interest and 36% (effective) on capital gains.

That is unfortunately not the end of the story. When non-residents receive the distribution, they may also face taxes on it in the country where they now permanently reside. Some countries may classify the full amount as income and it will be taxed according to their income tax tables, or they may treat it as a capital gain, depending on their local laws.

Here’s an example to illustrate:

A non-resident receives a distribution of R10 million from a local trust, where R5 million was the base cost and R5 million was capital gain. South African tax on the non-resident’s distribution would be calculated as follows:

• R5,000,000 capital gain taxed in the trust (since the beneficiary is a non-resident):
• R5,000,000 x 36% (80% inclusion rate x 45% tax rate) = R1,800,000
• Distribution to non-resident: R10,000,000 – R1,800,000 = R8,200,000.

If the U.S. considers this as income, the distribution places the individual in the 35% marginal tax bracket (ignoring any other U.S. income):

• R8,200,000 x 35% = R2,870,000 in U.S. tax.
• Net payout = R5,330,000.

Thus, the effective tax rate on this “inheritance” comes to 46.7%, meaning heirs effectively forfeit almost half of their inheritance due to taxes. And this is not the end of the process. Since transferring the funds is costly and complex, there will be additional fees for professional assistance.

What about a Double Taxation Agreement (DTA)? Unfortunately, in this case, a DTA offers little help because there are two distinct taxpayers: the trust and the beneficiary (non-resident).

Consequently, the other country will not consider the tax paid by the trust. Therefore, this situation is complex, and you may need to reconsider your structure, especially your inheritance plan if one or more of your beneficiaries has left the country permanently. Various solutions can help reduce taxes, but there is no one-size-fits-all solution, and each case must be evaluated individually.

When assessing the total value between a trust versus personal name, bear in mind that if the inheritance to the non-resident comes directly from you (rather than through a family trust), there would be estate duty implications between 20% and 25%, executor’s fees and the time required for estate settlement.

Capital gains, however, are realised in the deceased’s name at a maximum effective rate of 18%, instead of the 36% that would otherwise apply in the trust. If the non-resident receives an inheritance from an estate, it is classified as capital rather than income, which means they won’t incur additional taxes on it in their current country of residence.

This highlights the challenge of achieving a fair distribution of inheritance (after taxes) among children living in different countries such as South Africa, the U.S., and the U.K. It is a complex task that could lead to significant disparities if the tax implications are not carefully considered.

It is evident that the solution to this situation is not straightforward, and each scenario should be assessed on its own merits. The new legislation makes it less favourable for non-residents to be beneficiaries of a South African trust. As a trustee, it’s important to have a contingency plan for when a beneficiary plans to emigrate and to explore alternative investment vehicles to address these tax challenges effectively.

Elmie de Jager is a certified financial planner from Woodland. Contact her at info@woodlandwealth.co.za.