Taxwise: Rules unclear when trusts give to trusts

By Denham Martin

Much media attention has been given to the new tax legislation on debt forgiveness. You discussed this in your column in May. While your article commented on persons forgiving debts owed by trustees where there are charities and companies as beneficiaries of the trust, I am uncertain as to the position taken in relation to trusts with other trusts as beneficiaries.

My family trust includes in the beneficiary classes trusts that I have set up for each of my children. I am also uncertain what would happen if I decided to resettle my trust on to another trust for one reason or another. I would be interested in your comments.

PW

Ponsonby

Under the new legislation, people are able to forgive debts owed to them by trustees, without income tax consequences, where the trust was established "primarily to benefit" charities and/or natural persons for whom the person forgiving the debt has natural love and affection.

But to the extent that distributions from the trust are subsequently made to persons other than those in the above two categories, the distributions are treated as gross income of the trustees and are therefore taxable.

While it is clear that distributions to companies as beneficiaries would be outside the above two categories, and therefore deemed to be gross income of the trustees, the position in relation to distributions to other trusts as beneficiaries is not so clear.

One view expressed is that a distribution to another trust, including by way of resettlement, is actually a distribution to the ultimate beneficiaries of that trust. So provided that the person forgiving the debt has natural love and affection for those ultimate beneficiaries, or those beneficiaries are charities, such a distribution would not be taxable.

Adopting this view, however, would require a mechanism in the legislation which would allow a "look through" the trustee relationship to the ultimate beneficial owners.

The relevant paragraph of the legislation contains no such express mechanism.

Another view, and this is the one I favour, is that in certain circumstances a distribution to another trust is not a "distribution" as contemplated by the new legislation.

The term "distribution," as defined in the Income Tax Act, contemplates that where property is being settled on to another trust, it will be treated as a distribution in situations where it would be beneficiary income or a taxable distribution if paid out to a beneficiary.

"Beneficiary income" is a defined term describing income that is passed out of a trust which either vests in a beneficiary or is dealt with on his or her behalf during the year of receipt or within the following six months.

Therefore, distributions of income to other trusts that are made in the year the head trust received the income or six months after, would potentially be "distributions."

"Taxable distribution" is a defined term relating to distributions from certain trusts where the trustees are not liable for tax on all trustee income (for example, where the settlor is not a New Zealand resident for tax purposes).

Accordingly, it appears that distributions of retained income or capital may not be within the terms of the definition of "distribution" and would not therefore be assessable income of the trustees of the head trust.

It remains to be seen whether the uncertainty surrounding this matter will ultimately be removed by subsequent legislation or by Inland Revenue issuing a policy statement.

* Denham Martin is the principal of Denham Martin & Associates, lawyers specialising in advice on taxation and related matters.