The importance of having a flexible trust deed

Inland Revenue has released an interpretation statement outlining whether income deemed to arise under tax law, but not trust law, can give rise to beneficiary income.

Deemed income exists only under tax law and does not usually correspond to an actual cash flow. Consequently, deemed income cannot itself be vested absolutely in the interest of or paid to beneficiaries, and so the Commissioner of Inland Revenue (the Commissioner) will only regard deemed income as being beneficiary income when:

• Trustees can vest or pay amounts which equate to deemed income to income beneficiaries; and
• There is an explicit link between an amount of deemed income for tax purposes and the amount vested absolutely in the interest of or paid to a beneficiary.

When deemed income amounts for tax purposes exceed the trust law income of the trust, the trustees' ability to make a payment equating to deemed income will depend on the terms of the particular trust deed, the trustees' actions and having sufficient amounts available in the trust fund to distribute to beneficiaries.

The need for an explicit link between an amount of deemed income and the amount vested or paid will require a trustees' resolution, or a provision in the trust deed itself, which clearly specifies that an amount being vested absolutely in interest or paid to a beneficiary is a payment of a deemed income amount. In the absence of an explicit link, the Commissioner may regard the amount paid or vested as a payment of trust capital or corpus.

The Commissioner's interpretation statement also includes a number of examples which illustrate the concepts noted above.

For more information please see below (quite technical). Alternatively please contact our Tax Team:

Phil Barlow
Tax Director
T + 64 9 414 5444
E phil.barlow@hayesknight.co.nz

Shelley-ann Brinkley
Senior Tax Manager
T +64 9 414 5444
E shelley-ann.brinkley@hayesknight.co.nz

A more indepth look...

Trusts continue to form an important role in the wealth management strategy of many Kiwis. Beside the need to ensure that your trust can adapt to stay true to its purpose, a recent statement from the Commissioner of Inland Revenue further highlights the importance of having a flexible trust deed.

Inland Revenue has released an interpretation statement outlining whether income deemed to arise under tax law, but not trust law, can give rise to beneficiary income.

The thing with deemed income

In the view of the Commissioner, there is some conflict between:

• How the annual income derived by a trust is measured for tax purposes, which may vary from the trust law measure of income because of deemed income amounts; and
• The method of allocating tax law income between trustee(s) and beneficiaries for an income year, which method is based wholly on trust law concepts.

Practically however, deemed income for tax purposes should only be problematic when it causes the tax law measure of income in a particular income year to exceed the corresponding trust law measure of income.

Examples of deemed income amounts include attributed controlled foreign company income, foreign investment fund income, and look-through company income based on an owner's effective look through interest.

Deemed income for tax purposes is by default trustee income, unless it is beneficiary income under section HC 6 of the Income Tax Act 2007 (the ITA).

To qualify as beneficiary income under section HC 6, an amount of income derived by a trustee in an income year must:

• Vest absolutely in interest in a beneficiary of the trust in the income year; or
• Be paid to a beneficiary of the trust in the income year or within the time limits specified by section HC 6(1B).

The concepts of "vesting absolutely in interest" and "paid" are unconstrained and can be as simple as a trustees' resolution that the amounts be held in the name of the beneficiaries. However, a trustee can "vest absolutely" or "pay" only existing property (i.e. the income must not be future property or an expectancy).

The time limit specified by section HC 6(1B) is the later of the date that falls within 6-months of the end of the income year and the due date for filing the trustees' tax return (or the date on which the trustee's return is filed if earlier than the due date).

Because the two limbs of section HC 6 are based on trust law concepts, the Commissioner considers such provisions require something to have happened within the trust before a vesting absolutely in interest or payment of deemed income to beneficiaries will be effective. However, because deemed income amounts exist solely for tax law purposes and may not correspond to an actual cash flow or an accretion to the trust, deemed income cannot itself be vested absolutely in interest in, or paid to, a beneficiary as a matter of trust law.

Despite this impediment, the Commissioner will recognise deemed income as beneficiary income in an income year if an equivalent actual amount from the trust fund is vested absolutely in interest or paid to beneficiaries within the specified statutory time limit.

Vesting absolutely in interest or payment of amounts equating to deemed income

Whether it is possible to vest absolutely in interest or pay to beneficiaries amounts equating to deemed income will depend on a combination of the terms of the particular trust deed, the trustees' actions and having sufficient amounts available in the trust fund to distribute to beneficiaries in accordance with the trust deed.

For instance, the trust deed indicates what each beneficiary is entitled to receive, and if the trust deed distinguishes between income and capital beneficiaries, trustees may be unable to distribute amounts which are capital for trust law to income beneficiaries (to comply with their fiduciary duties).

On the other hand, particular flexible trust deeds may permit such actions by defining income for trust law purposes as being tax law income (in which case tax law income and trust law income will be the same) or by providing the trustees with a discretion to distribute trust capital, or corpus, to income beneficiaries.

When trustees are uncertain as to whether, in a particular income year, their trust deed permits them to vest absolutely in interest or pay amounts from the trust fund equating to deemed income, the Commissioner recommends them to seek legal advice.

Examples of when deemed income will (or will not) be recognised as beneficiary income

The Commissioner provides three examples in his interpretation statement to demonstrate when deemed income will or will not be recognised as beneficiary income in an income year. These examples are outlined below.

Each example assumes that tax law income exceeds trust law income by a deemed income amount:

• The trust deed does not define income

Because the trust deed is silent on how income must be measured, the trustee must distinguish between trust capital and income using trust law concepts. As the trust law income is calculated using ordinary concepts and is less than the tax law measure, the trustee will not be able to vest absolutely in interest or pay an amount to income beneficiaries that equates to the deemed income. The deemed income will be included and taxed in trustee income. This outcome would be the case in any income year.

• The trust deed defines trust law income as income calculated for income tax purposes

If the trust deed defines trust income as being "income calculated under the ITA", the trust law and tax law measure of income would be the same. To the extent there are sufficient amounts available in the trust fund, the trustees can vest absolutely in interest or pay amounts to income beneficiaries that equate to deemed income after making the appropriate resolutions.

• The trust deed defines income using trust law concepts of capital and income, but the trustees have the power to distribute trust capital to income beneficiaries

Although the tax law and trust law income of a trust are different, the trust deed provides the trustees with a discretion to vest or pay amounts that are more than trust law income to income beneficiaries.

To the extent that the trustees actually vest absolutely in interest or pay amounts equating to deemed income, the deemed income will give rise to beneficiary income, but only if there is an "explicit link" between the amount of deemed income for tax purposes and the amount vested or paid. If there is no such link, the amount paid or vested may be regarded by the Commissioner as a payment of trust capital or corpus.

An "explicit link" will exist if the trustees' resolution (or the trust deed itself) clearly specifies that the actual amount being vested absolutely in interest or paid to a beneficiary is a payment of a deemed income amount. For example, the trustees may resolve that they are paying an amount to a beneficiary because the amount of tax income exceeds the amount of trust income.

Not just deemed income

Although the focus of the interpretation statement is on deemed income amounts, the Commissioner acknowledges that a mismatch between tax law income and trust law income can also arise for tax law income amounts that correspond to an actual cash flow.

For example, timing mismatches can arise under the financial arrangement rules which cause amounts to be included in taxable income in a different income year than the year in which income is recognised under trust law. Tax law may also treat some receipts differently than under trust law, such as amounts derived on the disposal of land, which can be characterised as income for tax purposes but as being on capital account by a trust.

The Commissioner considers that the same reasoning as for deemed income amounts can also apply to such mismatches.