First published in Taxation Today.
Issue 48, February 2012
Inland Revenue recently released a draft Interpretation Statement1 concerning whether income deemed to arise under tax, but not trusts law, can give rise to beneficiary income. The conclusions reached by Inland Revenue in the draft are likely to be a cause of concern for many practitioners.
The issue discussed in the Interpretation Statement will be relevant to the trustees of many trusts. Deemed income can arise in several ways under the tax legislation, including as a result of the foreign investment fund (FIF) rules and the financial arrangements rules. Trustees of trusts with FIF investments, or investments in bonds or other instruments which are financial arrangements for tax purposes, may be deemed to derive taxable income from those investments without receiving a corresponding cash return. An effect of the financial arrangements rules, for example, is that the taxable income treated as having been derived by the holder of a financial arrangement in an income year can differ from the income actually received in cash, or in accounting terms, in that year.
The trustee of a trust in such circumstances may wish to distribute that deemed income to trust beneficiaries, notwithstanding the absence of a cash receipt. If correct, the conclusions drawn by the Inland Revenue in the draft Interpretation Statement impose significant fetters on the trustee's ability to do so.
Inland Revenue's conclusion
Inland Revenue concludes that income deemed to arise for tax purposes cannot of itself be vested in, or paid to, a trust beneficiary. However, if the trust has an actual (non-deemed) amount (of income or capital) that can be vested in, or paid to, the beneficiary under the terms of the trust, Inland Revenue concludes that the deemed income can be passed to a beneficiary as beneficiary income, and taxed in the hands of the beneficiary rather than the trustee. The relevant trust deed must either adopt the tax law definition of income, and/or permit the trustee to distribute capital at its discretion to the beneficiaries.
It is worth summarising Inland Revenue's reasoning in this regard.
Tax and trusts law principles
Inland Revenue's conclusions are based on principles of both tax and trusts law. The draft Interpretation Statement discusses the meaning of "beneficiary income" in the Income Tax Act 2007 (the ITA 2007) and examines in some detail the requirement in subss HC 6(1)(a) and 6(1)(b) that beneficiary income "vests absolutely in interest" in a beneficiary or is "paid to a beneficiary". The draft notes the wide interpretation to be given to "paid" in this context and confirms that no change of meaning has been effected by the omission of the words "or applies" from the current definition, wording which appeared in the previous definition in s OB 1 of the Income Tax Act 2004.
The draft refers to the Court of Appeal judgment in Commissioner of Inland Revenue v Ward  NZLR 1 and notes that that judgment establishes that a trustee is able to apply an amount to a beneficiary simply by way of a declaration - no actual payment is needed. The draft cites the more recent case of Commissioner of Inland Revenue v Albany Food Warehouse Ltd (2009) 24 NZTC 23,532 (HC) as support for the proposition that the expanded definition of "pay" in the current tax legislation is broad enough to cover the concepts previously covered by "applies", discussed in Ward.
The draft Interpretation Statement then refers to the first instance decision of the High Court in Hadlee and Sydney Bridge Nominees Limited v Commissioner of Inland Revenue (1989) 11 NZTC 6,155. Inland Revenue notes that the decision is authority for the proposition that where income is future property, or an expectancy, the vesting of that income will not be effective until the income is received or receivable. From that decision Inland Revenue then draws the conclusion that trustees are not able to pay to beneficiaries amounts which are future property.
Inland Revenue then notes in the draft that there are no clear policy indications or principles which would lead to the conclusion that a rule exists in the tax legislation prohibiting a trustee from distributing deemed income to trust beneficiaries. Rather, the draft continues, s HC 5 of the ITA 2007 suggests the contrary. Section HC 5 provides that income derived by a trustee is either beneficiary or trustee income. Section HC 5(2) confirms that if a trustee is treated as having an amount of income that is not derived under ordinary concepts, then the amount is treated as derived in the income year. The draft Interpretation Statement notes that the rule in s HC 5(2) applies for the purposes of s HC 6 (which establishes what income is income in the hands of a trust beneficiary), and concludes that "[t]his is an indication that deemed income can be beneficiary income" (at paragraph 77).
So far, most practitioners would probably agree.
The discussion in the draft Interpretation Statement of trusts law principles which are relevant to the conclusion that deemed income may be distributed to trust beneficiaries is more brief. The draft notes the importance of the distinction between income and capital receipts in the trust context and stresses that trustees are under a fiduciary duty to ensure that trust beneficiaries receive all that they are entitled to under the terms of the trust, and no more. A trustee must, the draft states, act within the powers given to it in the relevant trust deed. The power to distribute deemed income will be found in that deed. The draft states that "[i]f under the trust deed trustees are able to distribute amounts that are more than the trust law definition of income, trustees may be able to vest or pay amounts equating to deemed income" (at paragraph 25).
Tying these strands of tax and trusts law analysis together, then, the draft Interpretation Statement notes that as a matter of trusts law, a trustee can vest or pay to a beneficiary only an amount up to the amount of trust income. Traditional trusts which define trust income by reference to trusts law (or do not define it at all and leave the matter to an application of trusts law) will not, according to the draft, be able to distribute income which is deemed to arise for tax law, but not for trusts law, purposes.
However, the draft continues by stating that if the relevant trust deed adopts the income tax definition of income, the trustee thereunder will be able to vest or pay amounts "that equate to the deemed income" to the beneficiaries (paragraph 84). The trusts law concept of income and the tax law concept of income will be the same.
Actual amount needed?
The quoted words in the preceding paragraph are deliberately used in the draft Interpretation Statement. As noted above, Inland Revenue does not accept that actual deemed income can be distributed to beneficiaries. Rather, Inland Revenue notes in the draft (at paragraph 85) "that there needs to be an actual amount in the trust that can be vested or paid" in or to beneficiaries for deemed income to be able to be distributed.
The reasoning in the draft to support this significant caveat is not expressed in detail. The draft notes (at paragraph 85) that deemed income which arises under the tax legislation "exists only for tax law purposes; it will generally not correspond to actual cash receipts in the hands of the trustee and so cannot itself be vested in, or paid to, a beneficiary".
However, the statement that deemed tax income exists only for tax purposes can be regarded as support for the contrary proposition, that deemed income can in fact be vested in or paid to a beneficiary. The rules in the ITA 2007 relating to the taxation of trusts and trust beneficiaries exist without need for much interaction with trusts law. "Income" for the purposes of s HC 6 is an amount defined in the ITA 2007. Similarly, "beneficiary income" as defined in s HC 6 is a tax concept, existing for tax purposes. "Paid" as used in s HC 6 likewise has its own definition in s YA 1. Little or no recourse is needed to trusts law concepts in applying these concepts and determining what amounts are, for tax purposes, distributed by a trustee to a trust beneficiary.
Put another way, there does not appear to be anything in s HC 6 which requires that an actual amount exist in the trust which is capable of distribution to beneficiaries, to permit the distribution of deemed tax income.
The draft refers to the Hadlee decision as support for the proposition that the trust must have an actual (non-deemed) amount which can cover the amount of deemed income desired to be distributed. However, it is not clear that the decision in Hadlee is authority for this conclusion. The decision concerned a purported assignment by a partner in a professional partnership of part of his rights thereunder. The High Court held that the assignment was of future property or an expectancy. Arguably however, the Hadlee decision is not directly relevant to the issue discussed in the draft Interpretation Statement. Hadlee is not a trusts case and its facts are not analogous to the derivation of income (for tax purposes) by a trustee and the distribution of that income (for tax purposes) to a trust beneficiary.
The draft Interpretation Statement also notes (at paragraph 30) that "[u]nder trust law, the trustees cannot pay out more than is permitted by the trust deed and is represented by the trust's net assets. Otherwise, a trustee risks breaching their fiduciary duties". However, it is not clear that a distribution of an amount which only exists for tax purposes should cause an insolvency event for the relevant trust, for accounting purposes.
In this regard, the draft Interpretation Statement suggests that a trustee which has the power under the trust deed to distribute income and capital to beneficiaries as it sees fit will have greater flexibility to distribute income deemed to arise for tax, and not trusts, law purposes. The draft notes that "[i]n this situation, there is also potentially less of a problem with the difference between tax law and trust law measures of income because amounts of capital could be used to vest or pay deemed income to income beneficiaries" (at paragraph 27).
However, many trustees (and beneficiaries) would regard it as unsatisfactory to utilise trust capital to enable a distribution of deemed income to beneficiaries (particularly where the need for them to do so is questionable). This would also be an issue for trusts which may have limited trust capital or be more restricted in terms of which beneficiaries may receive income or capital distributions.
There is no doubt that the differences between tax income and income determined according to ordinary trusts (accounting) principles can give rise to difficult issues. The issues will be relevant to the trustees of many trusts. Submissions on the draft Interpretation Statement close on 17 February 2012. Debate of the issues discussed in the Interpretation Statement is worthwhile and hopefully will lead to greater clarity in relation to these issues.
This publication is necessarily brief and general in nature. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.