700 - Estate duty and the succeeding usufruct

This article examines a variation of the bare dominium/usufruct arrangement employed by estate planners to avoid estate duty. It involves the creation of a succeeding usufruct for a limited period after the death of the second-dying spouse who is the initial usufructuary.

SECTION 4(q) OF THE ESTATE DUTY ACT

Most readers will be aware of section 4(q) of the Estate Duty Act, 1955. It grants a deduction from the net value of the estate of the first-dying spouse for assets bequeathed to the surviving spouse. The basic bare dominium/usufruct arrangement makes partial use of section 4(q). Typically, the testator bequeaths the bare dominium to a discretionary family trust, while the usufruct is bequeathed to the surviving spouse.

The bare dominium will be included in the net value of the estate of the deceased with potential estate duty consequences. But depending on the age of the surviving spouse, its value might still be relatively small and might even be covered by the R3,5 million abatement under section 4A. The deceased will pay no estate duty on the value of the usufruct because of the deduction under section 4(q).

However, sooner or later the fiscus will want its pound of flesh in respect of the roll-over of the value of the usufruct that was enjoyed by the first-dying. That moment of reckoning will come when the surviving spouse dies.

TAXING THE CEASING USUFRUCT

Section 3(2)(a) of the Estate Duty Act includes as property of an estate

“(a) any fiduciary, usufructuary or other like interest in property (including a right to an annuity charged upon property) held by the deceased immediately prior to his death;”.

Next, section 5(1)(b) states how the ceasing usufruct must be valued:

“5. Determination of value of property

(1) The value of any property for the purposes of the inclusion thereof in the estate of any person in terms of section 3 or the deduction thereof in terms of section 4, determined as at the date of death of that person, shall be –

. . .

(b) in the case of any such fiduciary, usufructuary or other like interest in property as is referred to in paragraph (a) of section 3(2), an amount determined by capitalizing at twelve per cent the annual value of the right of enjoyment of the property in which the deceased held any such fiduciary, usufructuary or other like interest, to the extent to which the person who upon the cessation of the said interest of the deceased in consequence of the death of the deceased becomes entitled to any right of enjoyment of such property of whatever nature, over the expectation of life of such person, or if such right of enjoyment is to be held for a lesser period than the life of such person, over such lesser period: Provided that …”

It is actually the bare dominium holder who will be liable for the estate duty on the ceasing usufruct. Section 11 of the Estate Duty Act provides that it is “the person to whom any advantage accrues by the death of the deceased”.

In the absence of section 5(1)(b), the usufruct would simply run out and the surviving spouse would be left with no asset in his or her estate. The growth in value of the bare dominium would arise in the trust and the estate duty saving enjoyed by the first-dying spouse would be permanently lost to the fiscus.

Section 5(3) provides:

“(3) Where for the purposes of subsection (1) any calculation is required to be made over the expectation of life of any person, such calculation shall, in the case of a person who is not a natural person, be made over a period of fifty years.”

Thus, when the usufructuary dies and the bare dominium holder is a trust or company, the value of the ceasing usufruct for estate duty purposes will be determined at 12% a year for 50 years.

In ASA July 2021, “The aged usufructuary”, the option of an aged usufructuary disposing of the usufruct to the bare dominium holder in order to avoid the estate duty liability arising upon the death of the usufructuary was examined. That option involved comparing the sum of taxes payable as a result of such a disposal (transfer duty, CGT and donations tax) with the potential estate duty liability occasioned by the ceasing usufruct. Whether such a disposal is worthwhile will depend on the numbers; it is not a foregone conclusion that a tax saving will be achieved. The time value of money is also an issue because paying tax now rather than later has a cost. [To calculate the future value of a tax saving of, say, R100 at 10% a year for 10 years in Excel: =FV(0.1,10,,100). (Note that the double commas are not an error.)]

Another technique for dealing with a ceasing usufruct is to provide for a succeeding usufruct for a limited period of, say, one year, following the death of the usufructuary. But the “one-year wonder”, as it has become known, requires some advance planning as it cannot be implemented after the death of the testator.

Set out below are two examples illustrating the estate duty consequences for a married couple making use of the section 4(q) deduction. To keep matters simple, the CGT payable on death by the first-dying under section 9HA(1) of the Income Tax Act, 1962, has been ignored.

Example 1 – Single usufruct created on death of first dying

Facts:

At the time of his death, John owned a property worth R10 million. He bequeathed the bare dominium in the property to the John Family Trust and the usufruct to his wife Sally. At the date of his death Sally would have been 60 at her next birthday. The property has a value of R30 million at the later date of Sally’s death,

Result:

According to Table A [Tables A and B were published in regulations under the Estate Duty Act in GNR 1942 (GG 2533) of 23 September 1977. Table A sets out the expectation of life and the present value of R1 per annum for life capitalized at 12% over the expectation of life of males and females of various ages.] Sally's life expectancy was 18,78 years and the present value of R1 a year for life was 7,34135.

At the date of death, the value of the usufruct was R10 million ×12% × 7,34135 = R8 809 620. [The result can be checked using Excel: =PV(0.12,18.78,-1200000). The figure of R1,2 million is the annual right of enjoyment R10 million × 12%.] The value of the bare dominium was R10 million less the value of the usufruct, which is R1 190 380. The bare dominium forms part of the net amount of John’s estate but is covered by the R3,5 million abatement under section 4A. The usufruct portion bequeathed to Sally is covered by the deduction under section 4(q). John will therefore pay no estate duty.

On Sally’s death, the ceasing usufruct has a value of R30 million × 12% × 8,3045 = R29 896 200 under section 5(1)(b). [The trust has a deemed life expectancy of 50 years under section 5(3). Under Table B (“Present value of R1 per Annum Capitalized at 12% over Fixed Periods”), the factor for 50 years is 8,3045.] However, this may not exceed the difference between the current market value of the property (R30 million) and the value of the bare dominium when it was created (R1 190 380) = R28 809 620. [Further proviso to s 5(1)(b).] Sally’s estate duty liability will be determined as follows:

Value of ceasing usufruct (section 5(1)(b)) R28 809 620

Less: Abatement (John and Sally) R3,5 million × 2 (section 4A(2)) (7 000 000)

Reduced by portion used by John 1 190 380 (5 809 620)

Dutiable amount of estate 23 000 000

Estate duty @ 20% 4 600 000

The trust acquired the property at a base cost of R1 190 380 under section 25(3)

of the Income Tax Act. If it were to dispose of the property on Sally’s death, it would have a capital gain of R30 000 000 − R1 190 380 = R28 809 620. If the trust paid the CGT at 36%, it would have a CGT liability of R5 185 731. But if the gain is vested in the beneficiaries in the same year of assessment, they would pay CGT at a maximum of 18%, namely, an aggregate of R2 592 866 (disregarding the annual exclusion of R40 000 for each beneficiary). Sally would have a capital loss for her ceasing usufruct but this will have to be disregarded under paragraph 15

of the Eighth Schedule to the extent that it was not used in carrying on a trade. It would be beneficial only if she had other capital gains against which it could be offset.

Example 2 – Succeeding usufruct for one year

Facts:

The facts are the same as in Example 1 except that John provided for a succeeding usufruct to his two children for one year after Sally passed away.

Result:

The estate duty consequences for John are the same as in Example 1, that is, no liability.

The value of Sally’s ceasing usufruct is now based on a period of one year, R30 million × 12% × 0,8929 = R3 214 440 [Table B, factor for one year]. This amount is less than the available abatement of R5 809 620 (R7 million − R1 190 380) and so Sally has no estate duty liability.

The CGT consequences for the trust are the same as in Example 2.

Example 2 illustrates the substantial estate duty saving that is achieved through the use of the succeeding usufruct: no duty v R4,6 million.

The “one-year wonder” requires the will of the deceased to make provision for a succeeding usufructuary for a period of one year. Typically, this would be one or more of the children of the deceased, or it could be a public benefit organisation (PBO). There is a danger that if the succeeding usufructuary dies, the estate duty will be substantially increased. It may thus be prudent to provide for an alternative usufructuary such as a PBO.

While there may be a commercial reason for such an arrangement, such as ensuring that the property has an occupant while an executor is appointed, it does seem somewhat contrived and designed to obtain a tax benefit. The problem for SARS, however, is that the Estate Duty Act does not contain any general anti-avoidance provisions such as sections 80A to 80L of the Income Tax Act. The arrangement is not a sham because the one year succeeding usufruct is real and does not purport to be anything else than what it is.

National Treasury proposed in the Draft Taxation Laws Amendment Bill, 2009 (dated 1 June 2009), to put an end to the “one-year wonder” by deleting the following words in section 5(1)(b):

“or if such right of enjoyment is to be held for a lesser period than the life of such person, over such lesser period”.

The proposal was, however, withdrawn. The Final Response Document to the Taxation Laws Amendment Bills, 2009, stated:

“2.6.2 USUFRUCTUARY SCHEME

Comment (Clause 6; Section 5(1) of the Estate Duty Act): The envisaged aim of the proposal is to close down a scheme whereby testators avoid estate duty by bequeathing a usufruct to a spouse with the remainder first to a one-year trust (or other one-year holder), followed by another shift to the ultimate heir. However, this proposal unfairly penalises all usufructs, many of which have valid non-tax estate planning purposes. For example, a usufruct may be created in favour of a surviving spouse and then transferred to a minor child until such time as the minor reaches majority. Conversely, the proposal can also be misused (eg, through the use of public benefit organisations) to reduce the estate duty in an artificial way.

Response: Accepted. It is accepted that a usufruct created in a will can fulfil an important function in estate planning unrelated to the estate duty.

In acceptance of this concern, the amendment is withdrawn for reconsideration. Nevertheless, one-year schemes remain of concern and still warrant an appropriate remedy.”

To date no such remedy has surfaced and in practice SARS accepts the validity of the succeeding usufruct.

Other aspects that need to be considered include whether a lower rate than 12% a year for valuing the usufruct is appropriate [See Standing Committee on Finance – Report-Back Hearings, 25 August 2009] and whether “market value less 30%” is applicable (land on which a bona fide farming undertaking is being carried on). [Under section 5(2) the Commissioner can approve a lower rate if satisfied that the property could not reasonably be expected to produce an annual yield of 12%.] There is also the risk that the law may be amended along the lines proposed in 2009. If such an amendment were to occur after the testator had died, it would not be possible to amend his or her will and the surviving spouse would be left with a large estate duty liability. One would have to hope that the amendment would apply only to persons dying on or after the effective date of the amendment.

Implementing the bare dominium/usufruct arrangement when the usufructuary is at an advanced age will result in a higher estate duty exposure for the first-dying because it will increase the value of the bare dominium. Starting estate planning early in life can avoid the need for an arrangement such as the “one-year wonder”.

CONCLUSION

Estate planning is a complex multifaceted matter that needs to take into account all the various taxes and other circumstances facing a taxpayer. Nevertheless, the “one-year wonder” does offer significant estate duty savings in appropriate circumstances.

This article was first published in ASA May 2023

Duncan McAllister

Webber Wentzel

Acts and Bills

· Income Tax Act 58 of 1962: Sections 9HA(1), 25(3)(b) & 80A–80L; Eighth Schedule: Paragraph 15(c);

· Estate Duty Act 45 of 1955: Sections 3(2)(a), 4(q), 4A (specific reference to subsection (2)), & 5(1)(b) (specific reference to the further proviso to this provision), (2) & (3);

· Draft Taxation Laws Amendment Bill, 2009.