Family Trusts: IRD to investigate gifting transactions
Recent comments by the Inland Revenue Department will have far-reaching and significant implications in the area of gifting, particularly to family trusts. Guardian Trust business development manager Mark Cassidy explains the latest developments.
Tuesday, September 29th 1998, 12:00AM
There are effectively two ways to transfer assets to the trustees of a family trust namely, by way of immediate gift or by way of sale for fair or market value.
To adopt the first approach would, if the gift was in excess of $27,000 (either on its own or cumulatively with gifts within the preceding 12 months) give rise to gift duty under the Gifts and Estate Duties Act 1968.
To avoid this it has been common practise for the settlor(s) to sell their assets to the trustees at their market value and for the trustees to acknowledge their indebtedness to the settlor(s) by way of a Deed of Acknowledgment of Debt. The resulting debt back to the settlor(s) is systematically forgiven at the rate of $27,000 per annum by the settlor.
It is clear that this is a practise that has to date been acceptable to the Inland Revenue Department (IRD) and if conducted properly can effectively shift assets out of the settlor's estate.
The primary draw back however has been that the programme takes time to complete to be fully effective for asset and creditor protection purposes. This can have significant consequences particularly where the value of the assets are high and the settlors are getting on in years.
In addition the programme itself also requires an understanding of the requirements of the relevant provisions of the Estate and Gift Duties Act and what is required to perfect the gift or forgiveness of debt (whether wholly or in part).
It was with some alarm that in early August I read a communication issued by the IRD to all practitioners entitled "Duties Investigation" that began, "Inland Revenue investigators recently began investigating gifting transactions. As a result a number of cases have been forwarded to the Police".
The IRD went on to say that it appears a considerable number of gifting documents had been backdated, "either to correct a planned gifting programme omission, or accelerate an existing or new gifting programme".
The IRD indicated that as from the September 1 it will widen its investigation programme to include full investigations of gifting transactions and that it views the practise as an offence under the Tax Administration Act.
IRD has indicated that this is such a serious matter that full investigation will, in appropriate cases, involve forensic examination of the documents.
It would appear this is often far from necessary as there have been cases of several Deeds of Forgiveness being submitted at the same time to the IRD purporting to relate to up to four consecutively preceding years.
The less forgiving might take the view that such action is deliberately fraudulent and indeed in some cases this might be so. However, it is worth considering the point that gift duty is in effect a voluntary tax and that provided that the programme is commenced early, correctly established and properly implemented such difficulties can legitimately be avoided.
Failure to make the gifts due to either procedural failure or lack of understanding of the formalities necessary to perfect the gift can be avoided.
There is a strong argument for the gifting programme to be carried out by trust professionals who can ensure that what may in the past have been perceived as a simple and straight forward procedure does not give rise to disastrous and unintended consequences.
These consequences have been spelt out very clearly by the IRD and include:
- Assessing the correct duty using the actual date the documents were signed (note that the insertion of the incorrect date in the document of itself will not invalidate it).
- Charge of use of money interest ( currently 14.69 per cent)
- Possible imposition of shortfall penalties up to maximum of 150 per cent against the donor (the settlor)
- Possible criminal prosecution of the donor and/or any person who aids or abets the donor
- Publication of the persons name in the New Zealand Mercantile Gazette where criminal prosecution or shortfall penalties are imposed
The potential financial costs can be very high. For example in a current case one couple is facing the possibility of having to pay a sum in excess of $40,000.
It is also worth noting that it is not only the donor who can be penalised, but also the trustees (and their professional advisers). Neither are free of risk both financially and in respect of potential criminal prosecution (as aiders or abetters).
The trustees will in most cases be a party to the incorrectly dated document, which will almost certainly amount to a breach of trust and may prevent them from relying on any indemnity from the assets of the trust.
The sleeping independent trustee, whether a friend or professional, may now seriously think twice about taking on such a role in view of the risks involved.
Just when you thought you were safe
Having comforted yourself with the knowledge that your gifting programme is in order and that there is no potential liability for unpaid gift duty there suddenly appears on the horizon another curve ball.
In a draft Public Ruling (Ref PU0009) the commissioner raises the spectre of a potential income tax liability.
On the face of it this seems somewhat unusual, particularly bearing in mind that most Deeds of Acknowledgment of Debt are expressed to be interest free, or carry interest only if demanded (the Marshall Clause).
To appreciate the significance of the draft ruling it is necessary to consider the provisions of section EH4 of the Income Tax Act 1994 which relate to base price adjustment calculations in respect of financial arrangements upon inter alia a remission of that arrangement.
It is not within the scope of this article to examine the provisions in detail, suffice to say that the acknowledgment of debt is a financial arrangement and that the forgiveness of debt amounts to a remission within the meaning of the section.
Generally under section EH4 any principal, interest or other amount payable on a financial arrangement that is "remitted" is gross income to the issuer.
In the context of a trust, the issuers are the trustees and on the forgiveness of the debt or part of it the trustees of the amount remitted treat the remission (amount forgiven) as a receipt of income.
Where the usual $27,000 is forgiven this could give rise to an income tax liability falling on the trustees of some $9,000. The income tax act does however provide relief in the form of section EH4(6) that provides;
" where an amount owing under a debt (including any amount accrued and unpaid at the time of forgiveness) is forgiven by a natural person in consideration of natural love and affection, the amount forgiven, shall for the purposes of the qualified accruals rules, be deemed to have been paid when the amount is forgiven".
Put simply this means that in the context of the gifting programme where the settlor is a natural person (not a company) and forgives the debt or part of it in consideration of natural love and affection. It is treated as if the trustees have paid it to the settlor and therefore it does not come within section EH4 and no income tax implications will arise for the trustees.
Practitioners have for sometime expressed concern about the implications of these provisions in relation to the application of section EH4(6) in respect of Family (Discretionary) Trusts. The Commissioner in BR Pub 96/4 ruled that inter alia EH4(6) could apply to:
- A debt forgiveness between near relatives, such as father and child, brother and sister, husband and wife, and de facto parents; and
- A debt forgiveness by a trust settlor or creditor to a family trust being a discretionary trust where the creditor has or would have had a relationship of natural love and affection with all, or all the primary trust objects or potential beneficiaries; and
- A partial debt forgiveness.
The commissioner makes it clear in his analysis of the public ruling that although the term natural love and affection is not further defined in the Income Tax Act his view is that it exists between near relatives (see above) and between lifelong friends (although not ordinary friends or colleagues).
In respect of Family Trusts although conceding the position is less clear confirms that section EH4(6) can apply when either all or all of the primary, trust objects or potential beneficiaries are persons for whom the creditor has or would have natural love and affection.
The ruling creates at least three problems namely;
- What are primary and minor beneficiaries?
- What is the situation where there is a power to vary and add beneficiaries who may not be considered near relatives or lifelong friends?
- What is the position if companies, other trusts, superannuation schemes or charities are potential beneficiaries?
The commissioner at the time accepted that charities being minor beneficiaries would not preclude the subsection applying but went on to say that the department did not propose to issue guidelines on the distinction between primary and minor beneficiaries and suggested the issue could be considered on a case by case basis.
Although these issues have existed for sometime it had been hoped that as a result of representations made by practitioners a clarification of the issues would be forthcoming.
The draft public ruling extends the definition in the earlier public ruling in so far as it relates to family trusts to include those classes of beneficiaries previously referred to and "... qualifying beneficiaries or a combination of these". Qualifying beneficiaries are:
- A superannuation scheme that is a trust established specifically by its deed to provide retirement benefits to near relatives or close friends of the creditor or to the qualifying beneficiaries or a combination of these; or
- A fixed trust where all the beneficiaries are near relatives or close friends of the creditor or are qualifying beneficiaries or a combination of these; or
- A discretionary trust where all, or all the primary, trust objects or potential beneficiaries are near relatives or close friends of the creditor or are qualifying beneficiaries or a combination of these.
The commissioner reiterates in his commentary much of the current binding ruling but in addition deals with comments from practitioners and gives various examples as to how the ruling would apply.
There is still considerable debate between professionals as to the implications of the earlier binding ruling because of the uncertainties that at least for the present still remain.
It is of course debateable if the accrual rules should apply at all in such circumstances which do not sit comfortably with the exemption for gifts under section of the Estate and Gift Duties Act.
No doubt representations will be vigorously made to the commissioner. This is particularly so as it is widely anticipated that there may be legislative changes in the future in relation to the particular section of the Income Tax Act in question.
In summary the current position would appear to be as follows;
- The primary beneficiaries of a family trust have to be confined to near relatives or close friends or superannuation schemes fixed or discretionary trusts whose primary beneficiaries are near relatives or close friends.
- Where there is an ability to add primary objects (beneficiaries) who are not near relatives, close friends or qualifying beneficiaries then section EH4(6) will not apply and an income tax liability will fall on the trustees in respect of debts (or partial debts) forgiven by the settlor.
- Charities can be included but only as a minor beneficiary.
- Companies are not included within the meaning of "qualifying beneficiary" and should not therefore be a primary beneficiary
- The past history or intention in respect of future distributions by the trustees are irrelevant.
As many modern family trust deeds will already include as trust objects primary beneficiaries for whom natural love and affection cannot exist in the view of the commissioner there is some concern as to whether a gifting programme should be continued in such situations. In addition the power to add beneficiaries would in most cases almost certainly bring the trust outside the scope of section EH4(6).
It should be noted however that the latest ruling is only in draft form at this stage and that such rulings are binding on the commissioner not the taxpayer.
Various suggestions as to how to deal with the problems created by the commissioner's view of section EH4(6) have been put forward including:
- The assignment of any existing debt to a "safe trust" where the primary beneficiaries are close relatives, near friends or qualifying beneficiaries.
- The repayment of the loan through such means as cheque swaps etc
No doubt over the coming months more solutions will be proffered ranging from the simple and straightforward to the elaborate and exotic. For the time being it would be prudent, before creating a trust or embarking on or continuing a gifting programme to seek advice from a trust professional. Failure to do so may prove to be very costly indeed.
Mark Cassidy is a business development manager with New Zealand Guardian Trust. He can be contacted by email at NZGT-WN@xtra.co.nz
You can read Philip's blog here: http://www.goodreturns.co.nz/blog/
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