In brief
The Supreme Court of Appeal issued a judgment on 07 November 2022 dealing with a trust and tax law principle called the conduit pipe principle. Essentially, this principle requires that amounts realized by a trust, where a beneficiary has a vested right to the amount, must be taxed in the hands of the beneficiary and not the trust.
In this case, the Supreme Court of Appeal held that the conduit pipe principle does not apply to income flowing through layered trust structures to beneficiaries, triggering the need for layered trust structures to be tested for continued tax efficiency without relying on the conduit pipe principle. However, there are a number of technical flaws in the matter, and it is likely that the decision will be appealed to the Constitutional Court of South Africa — the highest court in the country.
This article appears in the first edition of the Private Wealth Newsletter 2023.
Background
The conduit pipe principle was brought into South African common law from English tax cases in 1938 and it has since been codified into legislation. Under the conduit pipe principle, trusts are not taxed on revenue amounts received or capital gains they realize, where the beneficiaries have a vested right to the trust's income or underlying assets — whether as a result of an exercise of a discretion by the trustees or if they are beneficiaries of a vested trust. Instead, the income or capital gains are taxed in the hands of these vested beneficiaries.
The Supreme Court of Appeal recently issued a judgment that limits the application of the conduit pipe principle in the context of layered trust structures.
The taxpayer in the case is a second-tier trust, which was a beneficiary of first-tier trusts that operated a real estate business and owned certain capital assets. The taxpayer had vested rights to the income and capital of the first-tier trusts and the taxpayer's beneficiaries in turn had vested rights to the taxpayer's capital and income.
Following the disposal of the capital assets by the first-tier trust, the South African Revenue Service (SARS) taxed the taxpayer (a second-tier trust) for the capital gains realized by the first-tier trusts. The taxpayer objected to this, arguing that its vested beneficiaries ought to have been taxed on these gains, which would be taxed at a lower rate.
The taxpayer appealed to the tax court and then to the high court, following these appeals, the SARS appealed to the Supreme Court of Appeal. The case may still be appealed to the Constitutional Court of South Africa.
Case findings
- The court held that the amount received by the taxpayer and distributed to its beneficiaries was capital in nature.
- It was also held that the amount received and distributed by the taxpayer did not constitute an asset, which would be subject to capital gains upon distribution by the taxpayer. Rather, it was an amount received that was capital in nature.
- Therefore, the taxpayer did not realize a capital gain that could be taxed in the hands of its beneficiaries, because the conduit pipe principle legislative provisions for capital amounts did not make provision for the pass through of capital amounts, but only capital gains realized.
- Further, as distinct provisions implemented the conduit pipe principle for capital and revenue amounts, and the income provisions expressly excluded application to capital amounts, the taxpayer could not rely on the income provisions to be deemed a conduit of the capital amount it had received.
- Therefore, the taxpayer's appeal was dismissed and it was taxed on the capital gain realized by the first-tier trusts.
