The reasons for putting an investment in a child’s name may well be altruistic, but it could backfire when it comes to tax.
I can’t believe it’s been 13 years since my wife and I were thinking about our son starting high school. With me at seminary at the time, training to enter the Methodist ministry, the thought of how we would be able to cover his school fees was certainly front and centre.
Thankfully, although our stipend wasn’t much, the church did provide us with accommodation, enabling us to sell the house that we owned prior to me entering ministry. While the plan was to invest these funds, it was comforting to know that we did have money available should we need it.
As it turned out, we managed. Being stationed in a farming outpost halfway between Pietermaritzburg and Greytown meant there was little to tempt us as far as entertainment was concerned, but funding his future university education was another issue entirely!
What complicated matters was the itinerant nature of Methodist ministry, which meant that if we were to be redeployed elsewhere, there was no guarantee that this would be within striking range of a university.
Looking at options, one of the ideas we considered was to invest the proceeds from our house sale in a flat, which could then be rented out as student accommodation. Our son could then occupy the flat while he is studying, and then he could either continue to live in it, or it could revert to being a rental property.
While we ended up not going down that route (life happens), it seems that one of our readers is at a similar life stage to where we were when our son was in high school, and really wants to plan ahead (must be an actuary), judging by the following questions:
“I want to buy a flat for my daughter of 6 years. This is for her future. I therefore want to place the flat in her name and then rent the flat out to generate extra income. This income I want to invest in her name so she can one day use it for studies.
“Who will be taxable on the rental income from this flat? If my daughter, will she have to pay tax as this flat will be her only income?
“Will this flat be seen as a donation that I made to my daughter? If so, can I buy the flat for her, but have her – with a contract – have to pay it back via the rental income? Am I then allowed to donate R100,000 per year to her and subtract that from this loan?”
Firstly, I have to give 10 out of 10 to this caring and astute father who is thinking ahead for his daughter. Even if he uses a bond to finance the property, chances are good that by the time she goes to university, the property will be paid off, and she will have a place to live in during her studies and thereafter.
The accumulated rent will also fund her tuition. Should she then decide to buy a house once she is established in her career, the proceeds of her flat will make more than a decent deposit.
On the face of it, buying the property in the daughter’s name is a brilliant idea since the capital gains will accrue to her, not to her father, and any rents earned in the meantime would accrue to someone who – at the age of six – presumably does not have any other significant taxable income.
In theory, at least, this means that the overall tax bill would be significantly lowered because of the way the tax tables are structured.
However, as with most good ideas, there have been people who have used such structures to deprive the National Treasury of what it considers to be its rightful share, and so Section 7 of the Income Tax Act was enacted to prevent this form of tax avoidance.
Section 7(3) deals specifically with donations to minor children and essentially stipulates that if a parent donates an asset or amount to their minor child, any returns generated by such assets will be taxed in the hands of the donor parent.
The blow will be softened somewhat through the claiming of expenses against the property, such as maintenance, etc., but as rentals increase over time, the net taxable profit is likely to increase, especially if the property has been bought for cash, or once it becomes bond-free.
However, it gets even more complicated thanks to donations tax. If the parent is purchasing the property for cash, there is likely to be a substantial donations tax bill, in that any amount exceeding R100,000 (assuming no other non-exempt donations) will be subject to donations tax at 20%.
Our reader is obviously aware of this, since he has asked whether the transaction can be structured as a loan, which is repaid from both the proceeds of the rental and an annual donation (write-off) of R100,000 thereof.
However, without getting into the Capital Gains Tax (CGT) implications at this stage (this will be discussed in the next paragraph), the main problem from an income tax point of view would be that any loan payments would have to be made from after-tax money (i.e., the capital portion of loan repayments is not tax-deductible).
Turning now to the CGT issue, it would be quite interesting to see what impact Section 7(3) would have on who would be liable for the CGT once the property is sold – especially if the property is sold after the daughter turns 18.
My interpretation of Section 7(3) would be that the tax on the proportion of the capital gain accruing up to the age of 18 would lie with the father, while any capital gains thereafter would be taxed in the daughter’s hands.
However, the biggest problem is not likely to be a tax one but a legal one, in that a six-year-old does not have the legal capacity to enter into contracts. His daughter would therefore only be able to enter into such a contract when she turns 18.
In fact, she legally does not even have the capacity to enter into the purchase contract, or to sign any documents giving effect to the transfer of the property or the registration of the bond (if there is one).
So, what is the most tax-efficient solution in this case? To my knowledge, there is no real solution that will enable complete tax avoidance – i.e., there will be some tax paid at some point, but the following are two options that could be considered:
Scenario 1
- The property is purchased via a trust, with the father as donor and the daughter as beneficiary.
- The initial donation should be limited to R100,000, with the balance being provided as a loan. Such loan can then be amortised by means of an annual donation of R100,000 to the trust.
- The rentals will accrue to the trust, which will also be able to claim the expenses. However, the net profit (if retained by the trust) will be taxed at 45%.
- If any part of the profits is distributed to the daughter, Section 7(3) will most probably mean the father being taxed on such net rentals until the daughter turns 18. However, the daughter can receive the distributions in her own name after she turns 18, and pay tax thereon in her own right.
- If the property is then transferred to the daughter, a CGT liability may be payable by the trust (at an effective rate of 36%). The trust itself will also not be entitled to the R2 million primary residence exclusion.
Scenario 2
- The father purchases the property in his own name, and is taxed on the net rentals.
- On his daughter’s 18th birthday, the property is sold to her on a loan account, with such loan being amortised as an annual donation of R100,000.
- This sale will trigger a CGT liability in the father’s hands, but it will be lower than what the trust in Scenario 1 would have paid – the maximum applicable rate being 18% (45% marginal rate x 40% inclusion rate). He would also be able to claim the R40,000 annual exclusion if he had no other capital gains.
- Any further tax consequences to the daughter will be the same as for any property she then owns in her own right.
Scenario 1 is undoubtedly less tax-efficient than Scenario 2. Even if the father is on the maximum marginal tax rate of 45%, the income tax position and that of the trust are the same. The difference would be the CGT position, which clearly favours individuals over trusts.
However, there are legal matters to consider – for instance, whether going the trust route, or structuring a loan agreement that enables the father to transfer the property to his daughter without her having to raise her own finance (i.e., buying the property on loan account from her father).
There might also be pushback from SARS concerning such structures, and the documentation involved would need to be absolutely watertight. Therefore, anyone considering such a structure is thus strongly advised to obtain professional assistance, ideally from a tax practitioner who is also an attorney.
WRITTEN BY STEVEN JONES
Steven Jones is a retired tax practitioner and member of the South African Institute of Professional Accountants.
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