The “conduit-pipe” principle is often relied on when tax on vested benefits from a trust is in issue. The desired result from the taxpayer’s point of view is mostly that the beneficiary of the trust who acquired a vested right to a trust benefit should be taxed on the taxable value, rather than the trust itself, because of a more favourable tax rate. In Commissioner, SARS v Thistle Trust (516/2021)  ZASCA 153, the South African Revenue Service (SARS) challenged the application of this principle to tiered trust structures in the context of capital gains tax.
The Thistle Trust was a beneficiary of various trusts, referred to as the Tier 1 Trusts. The Tier 1 Trusts comprised a group of ten vesting trusts conducting the business of the Zenprop Group, a property investment and development group.
In the 2014 to 2016 years of assessment, the Tier 1 trusts disposed of capital assets resulting in capital gains which vested in The Thistle Trust in the year of assessment in which the disposals occurred. The Thistle Trust in turn, in the same year of assessment, vested the capital gains in its resident natural person beneficiaries, who declared the capital gains as income taxable at the rate applicable to natural persons (0 -18%).
SARS, however, raised an additional assessment for the relevant tax period, taxing the amounts received by the Thistle Trust as taxable in its hands at the rate of 36% applicable to trusts.
The Thistle Trust filed an objection to the additional assessment, relying on section 25B of the Income Tax Act 58 of 1962 (“the ITA”) and paragraph 80(2) of the Eighth Schedule to the ITA (“the Eighth Schedule”) for the argument that the Thistle Trust was not liable for capital gains tax, because the capital gains were properly taxable in the hands of the Thistle Trust’s beneficiaries as the ultimate beneficiaries of the proceeds of the sale of properties by the Tier 1 Trusts.
The tax court found in favour of the Thistle Trust, holding that the capital gains were taxable in the hands of the natural person beneficiaries of the Thistle Trust under section 25B and paragraph 80(2), based on the “conduit-pipe principle”.
The issue before the Supreme Court of Appeal (“the SCA”) was whether the capital gains in question were taxable in the hands of the Thistle Trust, or in the hands of the Thistle Trust’s beneficiaries to whom those gains were distributed.
The conduit-pipe principle:
The Thistle Trust relied on the “conduit-pipe” principle as first applied in Armstrong v Commissioner, Inland Revenue  AD 343 and embedded in South African law in Secretary, Inland Revenue v Rosen  (1) SA 172 (A). This principle allows income received by a trust and immediately passed on to a beneficiary in the same year in which it was received, to be regarded as income which accrued to the beneficiary and not to the trust. On this principle the trust is no more than a conduit for the amount in question to flow through to the beneficiary.
However, where proceeds from capital assets are concerned, it has always been unclear whether only paragraph 80 to the Eighth Schedule to the ITA is applicable, or both section 25B of the ITA and paragraph 80.
Section 25B of the ITA:
Section 25B of the ITA in summary provides that any amount (other than an amount of a capital nature which is not included in gross income) received by or accrued to or in favour of any person (trust) during any year of assessment, shall to the extent to which the amount has been derived for the immediate or future benefit of any ascertained beneficiary who has a vested right to that amount during that year, be deemed to be an amount which has accrued to that beneficiary, and to the extent to which that amount is not so derived, be deemed to be an amount which has accrued to that trust.
The section also provides that where a beneficiary has acquired a vested right to any amount referred to above in consequence of the exercise by the trustee of a discretion vested in him or her in terms of the relevant deed of trust, that amount shall be deemed to have been derived for the benefit of that beneficiary.
Paragraph 80 of the Eighth Schedule:
Paragraph 80 of the Eighth Schedule states that (1) where a trust vests an asset in a beneficiary who is a resident, and determines a capital gain in respect of that disposal:
(a) that capital gain must be disregarded for the purpose of calculating the aggregate capital gain or aggregate capital loss of the trust; and
(b) that capital gain or the amount that would have been determined as a capital gain must be taken into account as a capital gain for the purpose of calculating the aggregate capital gain or aggregate capital loss of the beneficiary to whom that asset was so disposed of.
Subparagraph (2) further states that where a trust realises a capital gain from the disposal of an asset in a year of assessment during which a beneficiary of that trust who is a resident has a vested right or acquires a vested right (including a right created by the exercise of a discretion) to an amount derived from that capital gain, but not to the asset disposed of, an amount that is equal to so much of the amount to which the beneficiary of that trust is entitled to in terms of that right:
” (a) must be disregarded for the purpose of calculating the aggregate capital gain or aggregate capital loss of the trust; and
(b) must be taken into account as a capital gain for the purpose of calculating the aggregate capital gain or aggregate capital loss of that beneficiary.”
The SCA’s decision
The SCA decided that when the proceeds that gave rise to the capital gain were received by the Thistle Trust, they were received as a capital amount and not as income. Therefore, the Thistle Trust could not rely on section 25B of the ITA, because this section only applies to income received by a trust and vested in a beneficiary.
Because the proceeds from the sale of assets by the Tier 1 Trusts were not income received by the Thistle Trust, the SCA decided that the beneficiary was liable for capital gains tax under paragraph 80(2) of the Eighth Schedule.
The SCA further held that paragraph 80(2) of the Eighth Schedule only applies to proceeds from the disposal of capital assets and in this instance the Tier 1 Trusts vested the capital gains in the Thistle Trust. The Thistle Trust itself did not dispose of any capital asset nor realised a capital gain that was distributed to its beneficiaries. Instead, it distributed monies that vested in it as of right. In these circumstances, the ‘conduit-pipe principle’ does not apply.
In terms of this ruling of the SCA the benefit of having the capital gains taxed in the hands of natural person beneficiaries at a lower rate (0% to 18%), cannot be achieved where one trust is a beneficiary of another trust and has a vested right to, and receives, a capital gain from the other trust. The result is that the capital gains will be taxed in the hands of the trust, at 36%.
The SCA’s interpretation and application of the “conduit-pipe” principle in this case has extensive implications for commercial structures involving the layers of multiple discretionary trusts.