Retirement fund contributions and Section 4q of the Estate Duty Act

RETIREMENT FUND PROCEEDS AND CONTRIBUTIONS

‘Pension interest’ from retirement funds, commutation, or part commutation from annuities due to past membership of a retirement fund, is not included as property for estate duty -Section 3(2) of the Estate Duty Act.

(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.

It is obvious then, if pension interest is free of duty,  to contribute as much as is required towards retirement funds in addressing retirement goals.

In taking advantage of this opportunity, a ”scheme” was devised where clients were encouraged, to save estate duty, to contribute as much as they could, towards their retirement funds. Imagine this scenario:  Client is 60, has R10 000 000 in an investment, he dies, 20% duty is payable = R2 000 000 duty if we ignore 4A abatement. This reduces the amount the heirs receive. If the client invests this entire amount in a retirement annuity, he immediately saves R2 000 000 as the proceeds are not dutiable. Yes – there is still lump sum tax but, think further. If client dies shortly after investing and, his beneficiaries commute 100%, tax calculation would be :  Lump sum R10 000 000 less disallowed contributions R10 000 000 = nil to be taxed.     Beautiful is it not? I saved 20% duty and there is no lump sum tax.  Awesome scheme indeed!

Not so fast says treasury who does not enjoy losing out on tax money even though we are working ”within the legislation”. Once they caught onto our brilliance, they changed legislation – of course!

The reason for the amendments to the Estate Duty Act 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)(3)(e) : for persons who died on or after 30 October 2019, so much of the contributions made on or after 1 March 2016 by the deceased to retirement funds and which were allowed as a deduction to determine the taxable portion of a lump sum, is included in DEEMED.

Ok, what does this mean?

Client invests R10 000 000 into a retirement annuity and two weeks thereafter dies. At this point, the client clearly has R10 000 000 contributions which he has not a yet utilised. The beneficiaries of the retirement fund decide to take the whole amount in cash. Lump sum tax will:   R10 000 000 proceeds, less R10 000 000 unused contributions = nil lump sum tax. What is the amount for estate duty?  The amount used to reduce the lump sum commuted – R10 000 000 was used to reduce the lump sum and hence R10 000 000 is deemed property for duty.

Let us change the scenario slightly. Say the beneficiaries opt to take R3 000 000 in cash and R7 000 000 into a living annuity.  The amount to be taxed is R3 000 000 less R3 000 000 (of the R10 000 000 contributions) contributions. What is the amount for estate duty? The amount used to reduce the lump sum = R3 000 000.

What if the beneficiaries opt to take the entire R10 000 000 in the form of an annuity? Well, is there a lump sum to be taxed? Nil . In this case was there any unused deductions to reduce a lump sum? Nil – there is no lump sum. Therefore the amount for estate duty is NIL.

It therefore makes sense to encourage the beneficiaries to consider a living annuity in place of commutation IF one is attempting to reduce the amount which will attract duty. But, think carefully and analytically for your client – saving estate duty is only but one minor little tax which could be covered by life insurance proceeds.

A living annuity will be taxed in the hands of the annuitant (the beneficiary) for his lifetime, increases his marginal tax rate  if the beneficiary has other income, which could end up in paying more tax during his lifetime vs estate duty.

Something to consider…. always do the calculations from all angles because if not, we may be creating a tax burden for the beneficiaries of the deceased!

The next question is,  if the spouse is the only heir and recipient of the retirement funds, will section 4Q apply. Remember, these are contributions SITTING in the retirement fund. It is not an asset in the deceased estate that can be bequeathed. Section 37C applies in terms of the distribution of funds on death of the member. Can one say who will receive the funds?

Not upfront we cannot. I would be hesitant to just assume that 4q would apply and would ensure sufficient liquidity to cover the duty – what danger is there in this? The beneficiaries would receive surplus!

But let us assume for the purpose of this article, that the spouse is the ONLY survivor and the retirement funds will be distributed to the spouse.

Treasury’s intention is to curb the avoidance of duty by investing in a retirement fund. They want the tax that you are attempting to avoid. They do not tax the lump sum, they want the duty.  I do not believe that they will allow a S4q deduction if the aim is to curb tax avoidance.

 

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—

 

Some poignant differences: property are assets in his estates which are bequeathed to his spouse. A life insurance with a spouse as a beneficiary 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

Duty                                                 R0

 

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.

Looking forward.