RETIREMENT FUND INTEREST
Payments from any retirement fund is not property for estate duty as provided for in Section 3(2) of the Estate Duty Act, does not include
(i) so much of any benefit which is due and payable by, or in consequence of membership or past membership of, any pension fund, pension preservation fund, provident fund, provident preservation fund or retirement annuity fund as defined in the Income Tax Act, 1962 (Act No. 58 of 1962), on or as a result of the death of the deceased.
If retirement fund interest is not dutiable, it makes sense to contribute as much as is needed to a retirement annuity address a person’s retirement objectives. This would be killing two birds with one stone, retirement needs addressed and estate duty reduced.
A popular practice surfaced over the years specifically with clients who had sizeable estates and who were generally above the age of 55. To immediately save estate duty, clients were recommended to transfer money from any cash investment that they may have held at the time and ‘’contribute’’ same to a retirement annuity. The added bonus was the fact that the client was 55 or older which allowed immediate access to the funds invested in the retirement annuity.
In effecting these transfers, clients save estate duty overnight as well as, sitting with a sizeable amount of retirement fund contributions which could be used to reduce taxable income (including exempting compulsory annuities). Any contributions made to a retirement fund that exceeds the allowed annual limit (currently R350 000) is carried forward to the following year of assessment and the cycle continues until contributions are exhausted. However, with these transactions we enter into, given the client’s natural life expectancy, disallowed contributions will possibly not exhaust during their lifetime. This does not present a problem either as, any disallowed contributions at the time of death (or retirement or a withdrawal) is used to reduce the lump that has to be taxed.
Let us pause here for a second and see a simplified example of the tax saving when these transactions are used in planning:
Assumptions: Client is older than 55, focusing only on a cash investment for the purpose of this example, has no other property / deemed property, ignore any other taxes including the R3 500 000 abatement. This is a simplified example:
Client has R50 000 000 held in a bank account, dies today:
Estate duty on the first R30 000 000 x 20% = R6 000 000
Estate duty on the amount that exceeds R20 000 000 x 25% = R5 000 000.
R11 000 000 in estate duty.
Client transfers R50 000 000 into a retirement annuity and dies the day thereafter:
Estate duty: R0! An immediate saving of R11 000 000 in death taxes.
To take this further, we need to understand that when a client’s dependents decide to withdraw retirement funds at the death of the member, these amounts are taxed according to the Retirement Lump Sum tax tables. The cash amount withdrawn is however reduced by the amount of contributions that have been previously disallowed (para 5 and 6 of the Second Schedule to the Income Tax Act)
In our scenario, what would the lump sum tax be?
Dependents draw cash of R50 000 000
Reduce by contributions disallowed: R50 000 000
Amount to be taxed R0
A brilliant plan for retirement purposes, for dependents on death of the member who have 100% access to tax free lump sums and no death taxes!
Of course, it was obvious that once Treasury caught onto this scheme, although allowed within the framework provided for in the Income Tax Act, they would pull the plug and put a stop to the bleeding of taxes escaping their basket. And, so they did.
The reason for the change was to specifically limit the practice of avoiding estate duty through excessive retirement fund contributions which can pass onto the deceased’s members beneficiaries free from tax.
The Estate Duty Act was amended to include Section (3)(2)(bA) which included disallowed contribution at the time of death as PROPERTY for the purpose of Estate Duty. This only applies to contributions made on or after 1 March 2016. The way the Act read at the time was the inclusion of the total disallowed contributions at the time of death.
If we apply it to our example used above.
Client invests R50 000 000 into a retirement annuity and two weeks thereafter dies. He has contributions of R50 000 000 that has been disallowed at the point of death. The amount to be included in property is R50 000 000! No more savings. We are back to paying R11 000 000 in estate duty but, without the liquidity to do so!
The Estate Duty Act was then amended in October 2019 to include in property only contributions that are used to reduce the lump sum. It reads:
|so much of the amount of any contribution made by the deceased in consequence of membership or past membership of any pension fund, provident fund, or retirement annuity fund, as was allowed as a deduction in terms of paragraph 5 of the Second Schedule to the Income Tax Act, 1962 (Act No. 58 of 1962), to determine the taxable portion of the lump sum benefit that is deemed to have accrued to the deceased immediately prior to his or her death.|
Let us apply this new amendment:
Client invests R50 000 000 into a retirement annuity. For 3 years that the client is alive thereafter, the client utilizes the maximum deduction of R350 000 which is allowed every year to reduce taxable income.
On the 4th year the client dies. At this point the client has disallowed contributions of
R48 950 000 as he has used R1 050 000 (350 000 x 3)
We assume that the investment remained at R50 000 000. The beneficiaries opt to draw the whole amount in cash.
The lump sum to be taxed: 50 000 000
Less contributions disallowed at this point (48 950 000)
Amount to be taxed R1 050 000 to be taxed according to the
lump sum tax table.
Of the amounts above, it is the amount that is used to reduce the lump sum which is estate dutiable. The amount used to reduce the lump above is R48 950 000 which is included in property. This is more accurate as this is the amount that the beneficiaries have benefited from which will not attract lump sum tax, but will attract duty.
To fully understand the amount that is dutiable, let us change the scenario slightly. We assume that by the time the client dies, the market has taken a negative turn and the lump sum value has dropped to R41 900 000.
Lump sum to be taxed 41 900 000
Less contributions disallowed to this point (41 900 000)
Amount to be taxed R0
Amount to be included in estate duty R41 900 000
Even though the client does have R48 950 000 disallowed contribution at this point, it is limited to
the lump sum that has to be taxed. The difference of R7 050 000 is thrown into the bin. It is not used by the deceased member and it is most definitely not passed onto the beneficiaries.
Of course, if beneficiaries opt to take the full annuity income and no cash, then there is not contributions which are dutiable.
The last amendment made to the Estate Duty Act was effective on 20 January 2021 where
the provision was moved from Property to Deemed property. This is, S3(2)(bA) was repealed and, the provision was moved to S3(3)(e). The contributions that are dutiable are now no longer property but deemed to be property for estate duty purposes.
Before moving on, we need to consider whether making a recommendation to transfer a sizeable amount (or any amount) to a retirement annuity to specifically save estate duty is still worthwhile considering the possible tax burden. There is no on size fit’s all solution here and one has to analyse each client’s situation.
Section 4q deduction
Firstly consider the objective of the inclusion of retirement fund contributions, it was to circumvent the situation where estate duty was avoided and the beneficiaries benefiting from tax free amounts. In short.
Section 4q of the Estate Duty Act provides
|so much of the value of any property included in the estate which has not been allowed as a deduction under the foregoing provisions of this section, as accrues to the surviving spouse of the deceased: Provided that—|
Yes, it does make reference to ‘’so much of the value of any property’’ but, I do not want to read much into the word ‘’property’’ and would not want to apply it literally. The reason for my thinking is that a domestic policy is deemed property and yet, a section 4q deduction is provided by the mere fact that the spouse is a beneficiary. Let me therefor argue further as I want to see if I can cover all the bases for my thinking.
There are however some differences between a life insurance policy with a spouse as a nominated beneficiary and a pension fund interest. One is that the life insurance policy actually ‘’accrues’’ to the spouse and the other is that the insurer, the contract being a third party contract, will pay the proceeds to the spouse as the nominated beneficiary. There is no doubt about this. The beneficiary nomination was also appointed by the deceased himself.
Can one say the same about retirement fund contributions? Do the retirement fund contributions which is a mere ‘’accounting’’ (nominal amount) transaction, be said to accrue to the spouse? On what basis does contributions accrue to anyone?
Some argue that it does ‘’accrue’’ as the contributions form part of the lump sum payment. Ok, let us debate this further.
Section 37C of the Pension Fund Act provides for the discretion of the Trustees to decide on an equitable share. (Retirement fund interest never form part of a deceased estate unless of course there are no dependents nor nominated beneficiaries). Perhaps with most of our clients we only have a spouse but I am sure some have more dependents and not just a spouse. There is no guarantee that a spouse will benefit. It depends on whether the retirement interest accrues to a spouse or a dependent, this is however all up to the trustee’s discretion. It is not the deceased spouse that specifically bequeathed anything to his surviving spouse unlike an insurance policy.
Let us add more to this. If one believes that because the contributions ‘’sit in the lump sum’’ which is awarded to the spouse, it is not the contribution that is being awarded but the pension interest itself? Which does not constitute property and therefore cannot be afforded a deduction.
I can argue in circles but, let us end in this manner as an example always explains it better.
The reason for Treasury introducing the inclusion of retirement fund contributions was to circumvent the avoidance of estate duty and the lack of tax that would result when beneficiaries receive pension interest.
If Treasury grants a Section 4q deduction on the same contributions it is attempting to tax, then we are back to square one:
Save R11 000 000 in duty by transferring R50 000 000 to a retirement fund.
Client dies. Lump sum R50 000 000 payable to spouse
Less disallowed contributions R50 000 000
Lump sum to be taxed R0
Contributions for estate duty R50 000 000
Section 4q R50 000 000
I cannot see this being the intention of the legislator!
The above is very simplified and welcome any other views that you may have. I would not bet on a Section 4q deduction and my advise to clients in these instances is to ensure that liquidity is available to settle 20%/25% duty on a notional amount. It is not liquidity either!
There have been some other changes leading from this but, that is for another time altogether.