Answer
The current rules contain provisions
relating to the forgiveness of debts in consideration of natural
love and affection for the beneficiaries of a trust.
Basically, there are no adverse tax consequences for a trust where:
1. the client is a natural person who
forgives the debt owing by a trust (whether in a will or otherwise);
and
2. the trust was established primarily to benefit:
Where a trustee makes a distribution to a beneficiary that does not come into any of the above categories, the trustee is deemed to have gross income to the extent that the distribution is less than or equal to the total amount of debts forgiven by the creditors. The gross income should be returned in the year the distribution is made.
This means that debt forgiveness gives rise to tax consequences only to the extent that distributions are actually made to beneficiaries outside the categories above.
Therefore, in the current situation, you must look at whether the trust is established primarily to benefit the persons described above. Some trust deeds may have a specifically designated category of "primary beneficiaries". However, many do not. In the absence of guidelines in the legislation, this issue becomes rather uncertain. Perhaps trustee minutes on formation or a memorandum of wishes (if one exists) of the settlor could be helpful in ascertaining the primary beneficiaries.
The IRD issued public ruling BR Pub 99/7, which relates to debt forgiveness in consideration of natural love and affection. In the ruling a distinction is no longer made between "primary" and "minor" beneficiaries. All beneficiaries for whom a creditor can have natural love and affection are accepted as qualifying for the concessionary treatment.
To the extent that distributions are made only to close family members and charitable trusts, the client's trust will not have a problem. However, it may still be a safe course of action to spell out the circumstances in the gift statement. In the consideration segment, the statement could provide that the release of $x owing is:
"in consideration of natural love and affection creditor A has for B, C and D, being primary beneficiaries of the Z Trust".
If there is going to be a problem in terms of the new legislation or if the boundaries of relationships are uncertain, the client (settlor) could organise for a cash gift to be made to the trust. The trustees then use the cash to repay the existing debt.
Example
A trust has an existing debt of $50,000. The settlor gifts cash
of $27,000 (which is within the annual gift duty exemption). The
trustee uses the cash to repay $27,000 of existing debt. The result
is:
1. no gift duty; and
2. no accrual income.
The difficulty with this option is that it relies on the settlor having the cash to gift to the trust and the trust having a bank account. The settlor may need to organise an overdraft facility. This option should also be considered and implemented carefully to ensure that it is not considered to be a form of avoidance.
Are past debt forgiveness arrangements safe?
The new rules apply to debt forgiveness made after 19 May 1999. The commentary on the Bill (as it stood just before it was passed) noted that if "problems" were to emerge, the legislation could be amended to make the change retrospective to when the accruals rules were first enacted.
Income Tax Act 1994, ss EH 4,
EH 5, EH 45, EH 47, EH 52.
Tax Administration Act 1994, s 22B.
Public binding ruling BR Pub 99/7.
2001 New Zealand Master Tax Guide, 6-240.
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