Blurred lines – will foundations liberate or domesticate?

We’ve been fielding lots of queries recently about the use of foundations instead of trusts, especially for South African beneficiaries.  In our previous articles What in the tarnation is a foundation? and Can an offshore Foundation be a useful tax planning tool? we highlighted some of the positives that a foundation has to offer, as it could be seen as a mix between a company and a trust.  However, although it sounds great to achieve the pros of a company, in terms of e.g. tax-free dividend receipts, and the pros of a trust, e.g. breaking the ownership link, we advise caution. Today we explore the potential pitfalls that can arise in practice when these blurred lines can potentially get very nasty.

So, in terms of basics, the SA Income Tax Act defines the terms “company” and “trust”, but not the term “foundation”. Because foundations are not recognised under South African corporate or tax law, applying the tax provisions can only work if they are regarded as either a company or a trust. SARS generally aims to follow the foreign countries’ legal and tax treatment of the foundation in South Africa. In essence, if the foreign country views the foundation in a specific way, SARS generally follows suit.

What if the Foundation is treated as a company?

If the foreign country classifies the foundation as a company (e.g. if the foundation is an incorporated entity), SARS would likely treat the foundation as a foreign company for South African purposes as well.

This classification creates quite a conundrum when determining the tax treatment of distributions. Foundations generally have no “shares” and therefore distributions by the foundation cannot fall under the South African definition of “Foreign Dividends”. An argument could possibly be made that the distribution is a return of capital, but what happens when all the capital has already been returned?

In addition, should SARS treat the foundation as a company, it could argue that the foundation is a controlled foreign company (“CFC”) and all income and gains in the foundation should be imputed to the South African beneficiaries and taxed in their hands, unless a particular exemption applies.

Finally, under normal circumstances, the shares in foreign companies would fall into the estate of a deceased South African shareholder. But now there are no shares…..

What if the Foundation is treated as a trust?

If the foreign country treats the foundations as a trust, SARS could attempt to mimic this classification. This could create another list of difficulties for the “settlor” and “beneficiaries” of the “trust”.

In practice, the founder of the foundation would have quite a bit of control over the decision-making by the Council of the Foundation. If the foundation is seen to be effectively managed from South Africa by the founder, the foundation will be deemed to be a South African tax resident and will be subject to tax on its worldwide income.

Secondly, if the founder (the settlor) of the foundation is still alive, and the foundation was funded through a donation or low or no-interest loan, all the income and capital gains could be attributable to the founder and taxed in his hands as and when it irises in the foundation.

Another awful option…

The burden of proof to show SARS that an amount is not taxable rests on the taxpayer. As a result of all the uncertainty around the treatment of distributions received by South African beneficiaries from foundations, SARS might decide to take the draconian route and tax receipts from foundations at the maximum tax rate, namely as income of up to 45%.

The uncertainty and possible administrative risk of proving to SARS that the distributions are not taxable at the sliding scale income tax rates might not be worth using foundations as any kind of structuring tool.

So, in summary, if something sounds too good to be true, it probably is.  And we advise that, until South Africa has clarified its position on the taxation of foundations, extreme caution is exercised.

If you’d like to learn more, contact us.

Associated enterprises

How can we help?

How you structure your business is a critical question as you expand globally.  The right structure will protect your assets, improve your currency position, support your business operations, facilitate future business expansion and changes, and optimise your overall tax rate. Trying to unscramble a sub-optimal structure entered into in haste or without full consideration of relevant facts is complex and expensive, so it’s important to plan upfront.

Structuring an international business is both a science and an art – this is our specialist area of expertise. Regan van Rooy is an international tax and structuring advisory firm focussing on Africa. We have offices in South Africa, Mauritius and Ireland and we can help you with any international tax or structuring query.