Trusts: New law creates many new problems

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People with a discretionary family trust need to look at their gifting programmes following recent changes to the law.

Monday, May 31st 1999, 12:00AM

by Philip Macalister

If you have formed, or are the beneficiary of, a discretionary family trust, you need to know about recent developments concerning the making of gifts to such trusts. Often such gifts are made in the form of the forgiveness or writing off of debts owed by the trustees to the originators of the trust eg: unpaid purchase price for acquisition of assets from those originators.

Background
Last year the Commissioner of Inland Revenue released a draft ruling, detailing the department’s views on how such debt forgiveness operates within the context of the Income Tax Act’s accruals rules. These rules govern the taxation of debt instruments such as loans.

The principle is that normally the writing off of a debt results in taxable income to the debtor. An exception, however, is where the creditor has "natural love and affection" for the debtor and the gifting or writing off is made in that context. Thus when a settlor forgives part of a debt owing by a trustee out of natural love and affection for the beneficiaries of the trust, that has normally been accepted as falling outside the accruals rules and not giving rise to a tax liability to the trustee.

The recent IRD ruling, however, suggested a considerable restraint on that principle if the trust in question include as beneficiaries persons other than the immediate family of the creditor. In situations where the beneficiaries could include other trusts, family companies, or charities (often included as a residuary beneficiary) or where there is a power to add beneficiaries, the accruals rules exemption therefore might not apply.

This draft ruling has caused a great deal of concern, since there are many family trust deeds in existence which are in that category.

The Select Committee

The Finance and Expenditure Select Committee was persuaded to look at the issue in the context of the current Remedial Tax Bill in respect of debt forgiveness made in consideration of natural love and affection.

The bill, which was passed largely unaltered on May 18, creates as many new problems as it cures. Because of the act all persons with family trusts and either past or intended gifting programmes in place, will need to review their legal position and trust administration as a matter of some urgency.

The legislation does several main things:

1. it clarifies that forgiveness of debt may be made to family trusts with a broader range of beneficiaries free of implications under the accruals rules, provided the Trust was established primarily to benefit persons for whom the creditor has natural love and affection. This in itself is laudable, and removes a number of doubts. It should preserve tax-free debt forgiveness programmes, even for trust deeds which have the power to appoint further beneficiaries, have the ability to make distributions to other family trusts, companies and charities and so on, so long as it is clearly documented who the primary beneficiaries are and that they are close family members (which will generally be the case);
2. however, if a distribution is later made to any person (other than a charity) for whom any creditor who forgave a debt owed by the trust at any time does not have "natural love and affection", the distribution in question will be treated as taxable income to the trust at that later time. A separate family trust (even if for the benefit of the same set of beneficiaries), a family company, or a more distant relative or friend may not qualify as a person for whom you have natural love and affection. This tax treatment applies whether the distribution in question would be taxed to the beneficiary under the normal trust taxation rules or not, arguably leading to at least one level of double taxation. More seriously, this rule applies whether or not the original debt forgiveness was treated as taxable to the trustee (see (a) above). This means double taxation will occur in those cases, there being no apparent remedial provision to deal with that.
3. because of the taxation link between any debt forgiveness and future distributions, all trustees are now required to keep records for as long as the trust exists in order to ascertain exactly who receives a distribution and what the level of "forgiven" debt is at the time of any distribution. For accrual tax purposes, that level will be determined in accordance with a special statutory formula.

At the time of any distribution from a trust it will have to be ascertained whether all creditors who have forgiven debt to the trustees could have had "natural love and affection" for the beneficiary who receives the distribution. Depending upon the Inland Revenue Department’s interpretation of the class of persons for whom one can have natural love and affection (a task for which the IRD is not at first sight particularly well qualified and which they shied away from in last year’s draft ruling) there could be considerable difficulty at that time - especially if distributions are to be made to a wider class of family members, in-laws or nieces and nephews etc.

Retrospectivity
Regrettably, these rules seem to apply whether the debt forgiveness in question has taken place prior to or after the introduction of this legislation even though the introductory commentary to the bill as reported back from the Select Committee does suggest that these provisions are only meant to have effect from the commencement of the Act. Unfortunately, the wording of the bill itself does not seem to bear out this intention.

A common problem will arise when it is intended to re-settle a trust on to a new trust in which case there would appear to be taxable income for the original trust equal to the amount of the distribution (up to the maximum amount of debts forgiven to the original trust), if such a transaction is treated as a "distribution".

What does this mean in practice?
The main points above highlight the problem of continuing with a traditional gifting programme involving forgiveness of debt. However, it suggests that in the interim no further gifts by way of forgiveness of debt should be undertaken if there is any question at all that a future distribution (whether of capital or of income) might be made by the trust to a person for whom any creditor (usually an original settlor of the trust) might not be considered to have "natural love and affection". Examples would be distributions to:

(a) any new family trust, whether by way of resettlement or otherwise
(b) a company
(c) distant relatives or in-laws
(d) community organisations which are not charities such as sports clubs
(e) business associates.

Rather than use the forgiveness of debt method of gifting, there are other gifting techniques (with straight cash payments being the simplest, assuming there is sufficient cash available to substantiate the gift) which may reduce the impact of the legislative change. Indeed, the simple form of forgiveness of debt which has been a feature of estate planning for many years may go the same way as the dodo and first past the post politics.

The Taxation (Accruals Rules and Other Remedial Matters) bill was passed into law on May 18.

People with trusts should now be looking at how they will deal with these new rules.

Graham Tubb and David Ireland are partners with law firm Kensington Swan in Wellington.

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