Major concerns over minor tax issue

By BRIAN FALLOW

WELLINGTON - The Government has stirred up a wasp's nest with its plans to fix what it sees as a tax rort - the use of trusts to split income with children.

The Government said in the Budget that it would legislate to tax distributions from trusts to minors at 33c in the dollar, instead of their marginal tax rate, which is typically 19.5 per cent.

It has now given more details of the proposal in an issues paper, outlining exceptions for trusts which arise from bequests or which are set up for the disabled. Submissions are sought by July 24.

Income-splitting involves taxpayers allocating income to other family members who have lower tax rates, in order to achieve tax savings.

This may involve transferring income-producing assets to a trust, but sometimes the income arises from trading ventures such as a farm or a professional practice.

"Trust beneficiary income that is claimed to be income of children is, in substance, often not theirs," Revenue Minister Michael Cullen said.

"Oh, yes it is," says PricewaterhouseCoopers tax partner John Shewan.

"Income distributed by the trustees to beneficiaries is their [the beneficiaries'] income at law and should be taxed accordingly.

"The whole thing is based on a flawed assumption, and the consultation is clearly going to be limited to playing at the margin."

Mr Shewan said it was illogical to look at income-splitting with children, but not spouses.

The issues paper recognises that income can be allocated to low-income spouses to produce tax benefits, but says it is not proposed to extend the new rule to spouses.

"A spouse's income is more likely to be in substance income of that spouse," it says, invoking again the troublesome form-versus-substance distinction.

"In the 1998 income year," Dr Cullen said, "about 3500 children under the age of six received a total of more than $27 million in beneficiary income from things like business activities. This figure excludes interest and dividend income distributed by trusts.

"It is absurd to argue that an average of $7700 in income attributed to these very young children should qualify for tax rates meant to apply to people on low incomes."

But as things stand, case law already places some limits on the ability to income-split with children.

A parent who appropriates minor beneficiary income to pay for the basic necessities a parent is obliged to provide, such as food, clothing and shelter, is liable to face a challenge from the Inland Revenue.

However, it seems to be okay, under the present law, to pay out of beneficiary income for things like holidays and school fees.

The area can get very grey: shoes are essential, but what about designer label shoes?

How much tidier, in the minds of tax policy mandarins, to tax it all at grown-up rates.

The extra tax revenue to be had from the law change is estimated to be between $10 million to $15 million.

Financial planner Murray Weatherston said there had been an explosion in the use of trading trusts as a business vehicle, where people might once have set up companies.

"I think we have every right to say distributions to children from testamentary trusts be exempt from the new tax, and that investment income be exempt, but why should personal effort income be able to be diverted via a trading trust to infant beneficiaries?"

Mr Shewan said grandparents who gave $5000 to a trust established for the benefit of their grandchildren would find distributions to those children taxed at 33 per cent.

Had they gifted the $5000 directly and invested it on their behalf, the income would be taxed at 19.5 per cent.

Income arising in a trust and applied to beneficiary children's tertiary education fees would also suffer tax at 33 per cent rather than 19.5 per cent.

"You could debate the subtleties of trust law until the cows come home," Mr Shewan said, "but there are far more fundamental questions to ask.

"Is it reasonable to tax at 33 per cent investment income paid to children? Is it reasonable that their very first dollar of investment income be taxed?

"Unlike virtually all developed countries, New Zealand imposes high rates of tax on all investment income with no concessions or relief of any kind. Is this sending the right kind of signal to savers?"