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Whether deemed income can give rise to beneficiary income

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 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.

Trust law can require trustees to treat income and expenditure in a way that may not be aligned with the treatment of the same under the Act.

If deemed income does give rise to beneficiary income for tax purposes, the income will be taxed at the beneficiary’s marginal tax rate, regardless of the fact that there is no actual cash flow.

IS 12/02 provides that:

  • Deemed income for the purposes of IS12/02 is income deemed to arise under the Act but where there may not be any actual cash flow.  Examples include attributed CFC income, FIF income and LTC income.
  • “Beneficiary income” is defined by the Act in s HC 6 as income derived by a trustee that either vests absolutely in interest in a beneficiary, or has been paid to the beneficiary, within the time limits imposed by s HC 6(1B).
  • The Act does not prevent deemed income giving rise to beneficiary income. However, s HC 6 requires an examination of what has happened within the trust. This is because s HC 6 requires income to actually vest absolutely in interest in, or be paid to, a beneficiary before it can be beneficiary income. 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 itself be vested absolutely in interest in, or paid to, a beneficiary. This is because there is no actual income to vest or pay to a beneficiary. The income is only deemed to arise for tax purposes and 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. Such an amount must actually vest absolutely in interest in, or be paid to, a beneficiary in a way that is effective for trust law. An actual cash payment does not necessarily have to be made to a beneficiary at the time of the vesting or payment.
  • 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.  However, for that vesting or payment to be effective for trust law purposes, the deemed income will be beneficiary income for tax purposes and taxed at the beneficiary’s marginal tax rate.
  • The Commissioner’s position is that 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 Commissioner considers that 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 noting amongst other things that it:

  • … does not wish to comment on the correctness or otherwise of the proposition that in order for deemed income derived by a trust to give rise to beneficiary income, the trust must have an actual (non-deemed) amount to distribute. However, it believes that some of the language in the draft that expresses this proposition could be made clearer …”.

The Law Society  suggested that the points addressed could be achieved 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.

One Response

Chris Lindsay on July 8, 2012 at 7:58 pm

S HC 6(1) requires that an amount “vest” or be “paid” before it can be beneficiary income. These words must surely mean that actual amounts vest or are paid. It is stretching interpretation to say that a deemed income amount can either vest or be paid. I would argue that it is never possible to either “vest” or “pay” an amount that is notional. It seems to me that the IRD are forcing an interpretation to get the practical outcome they want and the legislation should be amended to explicitly provide for deemed income to become beneficiary income. I note S HC 5(2) appears to get us part of the way there, but seems to only allow notionally derived amounts to be treated as trustee income, without extending it to beneficiary income.

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