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Beneficiary income, Beneficiary income, Trustee income

Deemed income – beneficiary income or not?

Inland Revenue has released Interpretation Statement 12/02: Income tax – Whether income deemed to arise under tax law, but not trust law, can give rise to beneficiary income.

Interpretation Statement 12/02 (IS12/02) confirms the Commissioner’s view (outlined last year in IS1110: see Tax law review of whether deemed income is beneficiary income) that in some circumstances, deemed income can give rise to beneficiary income under s HC 6 of the Income Tax Act 2007 (“the Act”).

This question as to whether deemed income can give rise to beneficiary income arises because there is no necessary symetry between tax law and trust law.

Where deemed income can be paid as beneficiary income for tax purposes, the income will be taxed at the beneficiary’s marginal tax rate, rather than as trustee income, regardless of the fact that there is no actual cash flow.

The main points from IS 12/02 can be summarised as follows:

  • Deemed arises under the Act but where there may not be any actual cash flow.  Examples include attributed CFC income, FIF income and LTC income.
  • The Act does not prevent deemed income giving rise to beneficiary income. However, income must vest absolutely in interest in, or be paid to, a beneficiary before it can be beneficiary income for income tax purposes. The terms of the trust deed and general trust law bind how a trustee may deal with the trust fund. For an amount to vest absolutely in interest in, or be paid to, a beneficiary, the trust deed must provide for such vesting or payment, either by express provision in the trust deed or through appropriate powers of the trustee.
  • The Commissioner considers that an amount of deemed income cannot automatically vest in or be paid to a beneficiary. This is because there is no actual income and the income does not exist for trust purposes. This means that trust must have an actual (non-deemed) amount in the trust fund available to be distributed that can be vested absolutely in interest in, or paid to, a beneficiary.
  • It is not problematic of itself if trust law income is the same as, or exceeds tax law income, provided that an equivalent amount of trust law income is actually vested absolutely in interest in, or paid to, a beneficiary. 
  • Deemed income will be beneficiary income only to the extent to which is it reflected by an actual amount vested absolutely in interest in, or paid to, a beneficiary by the trustee or under the terms of the trust deed. Whether this is possible will depend on the terms of the relevant trust deed. Accordingly, it will be necessary for a trustee to resolve that the actual amount from the trust fund is being treated as the vesting or payment of deemed income for tax purposes. If an actual amount from the trust fund is used to vest or pay the deemed income for tax purposes, the amount of deemed income will meet the definition of “beneficiary income”, and will be taxed at the beneficiary’s marginal tax rate.

IS 12/02 contains examples of three types of trust deeds in a situation where the tax law income of a trust exceeds its trust law income in a particular income year:

  • The trust deed does not define income. The tax law income and trust law income of a trust are different. Under the trust deed, the trustee can only vest absolutely in interest or pay income of the trust according to trust law concepts of capital and income. Therefore, trustees will not be able to vest absolutely in interest or pay an amount that equates to deemed income. The deemed income will be treated and taxed as trustee income. This would be the case in any income year.
  • The trust deed defines trust law income as income calculated for income tax purposes. The tax law income and trust law income of a trust are the same. Under the trust deed, the trustees can vest absolutely in interest or pay income of the trust to beneficiaries according to tax law. To the extent that there are sufficient amounts available in the trust fund, trustees may vest or pay amounts that equate to deemed income. The deemed income will then give rise to beneficiary income.
  • 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. The tax law income and trust law income of a trust are different, but the trustees have the power to vest or pay amounts that are more than trust law income to income beneficiaries. To the extent the trustees actually vest absolutely in interest or pay amounts equating to deemed income, the deemed income will give rise to beneficiary income.

History

Prior to the release of IS 12/02, the Commissioner released a draft Interpretation Statement (INS0111) for discussion purposes.  The Law Society made submissions regarding INS0111 suggesting that a clear outcome could be achived  by:

  • “(a) allowing deemed income to be treated as beneficiary income by way of a simple tax election by the trustee; or
  • (b) allowing deemed income to be taxed to beneficiaries in the same proportion as trust law income is distributed to them. The Law Society understands that the law in Australia is along these lines (though the extent of litigation in Australia on the issue of whether trust income has been distributed suggests that it may not be an entirely straightforward approach either)”.

These points have not been adopted by IS12/02.  However, wider discussion around deemed income and when it can be treated as beneficiary income may be warranted in the interests of greater certainty for trustees. 

As matters stand, any trustee in receipt of deemed income for tax purposes, who wishes to distribute that income to a beneficiary, will need to ensure that the distribution of deemed income is permissible in accordance with the terms of the deed of trust.

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