Trust move ignores basic principles

By DENHAM MARTIN

The Government's Budget paper Towards a Stronger, Fairer Tax System included the announcement that it will introduce legislation to tax distributions of income from trusts to minors at the 33 per cent trustee rate.

Clearly, the purpose of the proposal is to limit the benefits of income-splitting that can arise by making distributions to children whose marginal tax rate could be as low as 19.5 per cent.

However, one extraordinary aspect of this proposed legislation is that minor beneficiaries are the sole focus of the proposal.

It would still be possible to income-split by the trust making distributions to other beneficiaries whose marginal tax rates are less than 33 per cent (for example, retired parents or spouses who are not working).

The proposal, like the proposed attribution rule discussed in this column recently, demonstrates that this Government is prepared to adopt anti-avoidance legislation that is ill-conceived and not founded on basic tax principles.

It is prepared to adopt wide-ranging and untargeted measures to stop a limited area of tax avoidance (the "sledgehammer to crack a nut" approach).

The alternative, and cynical, view of the proposal is that it is simply another attempt to impose a tax on those who are supposedly wealthy.

A principle of income tax in New Zealand is the marginal tax rate approach for individuals.

In other words, a taxpayer is taxed at differing rates as the income earned crosses various thresholds (effectively, 19.5 per cent to $38,000, then 33 per cent to $60,000 and 39 per cent thereafter).

As a basic principle, the source of that income to the taxpayer is not relevant to the rate of tax to be applied - it is the total income earned that is the key.

The proposed legislation falls foul of this principle as it infers that a minor (anyone unmarried under 20) who receives income from a trust must pay tax on that at the 33 per cent rate, even though the taxpayer's total income may be less than the threshold for that rate to apply.

A real-life example of this relates to a trust that was set up for two children whose parents were killed in an accident.

The children will be taxed at the 33 per cent rate on every dollar of income from the trust, even though they may not have any other income whatsoever - hence, for minors, the title could read, Towards a Senseless, Unfairer Tax System.

The proposed legislation also ignores the basic principles of trust law.

It presupposes that the parents (the likely settlors of the trust) have a right to the income such that they should be taxed on it.

The whole basis of trust law is that the beneficiaries of the trust have the right to the property of the trust, including the income.

To identify what the proposed legislation should do requires that the problem be properly analysed.

In my view, the problem arises where a trust is used to provide for a minor the things that the parent would otherwise have to provide, such that the parent is relieved of making that provision and, thus, benefits from the trust.

The child does not benefit as (s)he receives nothing more than (s)he would have otherwise got from the parents.

This was illustrated in Case S43, where private expenditure allocated to the minor beneficiaries included items incurred in the upbringing of children (e.g. food, clothing, state school fees and other household costs).

The judge concluded that the income should be treated as trustee income (and taxed at the higher rate) as the trustees had not turned their mind to the manner in which the income had been applied for the benefit of the beneficiaries.

This case shows that there is the ability under the law as it stands to deal with the income-splitting problem.

Conversely, where trustees exercise a proper discretion to pay income to minor beneficiaries (i.e. the minor benefits from the income) and the trustees comply with both the trust law and tax law requirements, there is no tax being avoided. The parents were never entitled to the income and, thus, are not avoiding any tax on it.

Under the existing law, it may be difficult to ascertain who is really benefiting from the income paid to minor beneficiaries. If this is the problem to be addressed, the answer should be to require that trustees keep sufficient records to demonstrate the point, with a failure to keep adequate records leading to the tax rate being increased.

The answer is not adopting the proposed amendment with its far-reaching effects on validly constituted trusts (including fixed trusts, where only the minor can benefit, as is common under a testamentary trust).

The proposed amendment needs rethinking.

However, taxpayers and advisers must also rethink the use of trusts, if they have not done so over the past few years, and appreciate that the real value in trusts is in creditor protection and wealth retention within families and not in income-splitting.

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