Taxing beneficiary income of minors at 33% rate

This measure will apply from the start of the 2001-2002 income year.

• Beneficiary income distributed to a minor will be taxed at a final rate of 33% when that income is derived from property which was settled on that trust by a relative or guardian of that minor or a person associated with a relative or guardian. (Section HH 3A-3B of the Income Tax Act 1994)
• A minor for the purposes of this rule is defined as a person under the age of 16 years. (Section HH 3A)
• Beneficiary income will be excluded from the rule in certain circumstances. (Section HH 3B)
• The rule will not apply if beneficiary income is $200 or less in an income year. (Section HH 3A)
• Beneficiary income subject to this rule will be taxed at the trust level (on behalf of the beneficiary). (Section HH 3A)

The Government announced in the 2000 Budget that it would introduce legislation this year to require distributions of beneficiary income to minors to be taxed at a rate of 33%. These distributions are currently taxed at the marginal rate of the minor beneficiary, which may be as low as 19.5%. The Government has consulted on this proposal by means of an issues paper outlining the proposal in more detail and seeking public submissions.

The purpose of the minor beneficiary rule is to support the Government’s objective of distributing the tax burden equitably through a progressive tax system. Family expenses are normally met from income earned by the parents which has been taxed at their marginal tax rates. However, by placing income-earning assets in a trust and distributing the income to the children as beneficiary income, some families are able to meet their costs out of income taxed at the marginal tax rates of the children. Although this situation undermines the progressiveness of the taxation system, it will often not be within the ambit of the existing anti-avoidance legislation.

The incentive to place income-earning assets in a trust has increased since the current trust taxation rules were introduced, in 1988. The difference between the lowest marginal tax rate and the highest has increased, especially with the introduction of the 39% tax rate earlier this year.

The example illustrates how trusts can be used to achieve a lower tax rate on family income. Income that would have been earned by the parents and taxed at their marginal tax rates is instead distributed to a child as beneficiary income and is consequently taxed at the child’s marginal tax rate.

Therefore the family with a trust has an extra $6,599 with which to meet the family’s expenses, even though it has identical income from identical sources as the family without a trust.

The minor beneficiary rule is not aimed at all situations in which a minor receives beneficiary income, but rather at the particular situation where families can gain a tax advantage by use of a trust. Consequently, the rule will only apply when the beneficiary income of a minor is derived from property which was settled on that trust by a relative or a guardian of that minor or a person associated with a relative or guardian.

The existing definition of a "relative" in section OB 1 of the Income Tax Act 1994 will be adopted for this purpose. Under this section, individuals are regarded as relatives when they are connected by:

• blood relationship (which includes persons within the fourth degree of relationship);
• marriage (which includes not only persons married to each other but also those with a blood relationship to their spouse); and
• adoption.
• Including settlements made by a person associated with a relative or guardian ensures that settlements made by a family company, for example, are included within the rule.

For the purposes of this rule, the existing definition of "settlor" in section OB1 is being amended to ensure that a relative, guardian or his or her associate who provides services to the trust is not deemed to be a settlor. An example would be where damages for the benefit of the child are settled on a trust and the parent of the child provides free accounting services.

The minor beneficiary rule will apply to beneficiary income distributed from both discretionary and fixed trusts. It will also apply to beneficiary income distributed from a qualifying, non-qualifying or foreign trust.

The rule will apply only to children under the age of 16 years.

In determining whether the rule applies the trustee will look at the child’s age as at the balance date of the trust. If the minor is under the age of 16 throughout the income year, the rule will apply to all income derived in that year. If the minor turns 16 in that income year, the rule will not apply to any income derived in that income year.

There are a number of exceptions from the ambit of the rule to ensure that the rule focuses on particular situations where a family can gain a tax advantage by having income distributed as beneficiary income to a child. These include:

• beneficiary income derived from property if the settlor received that property as agent for the beneficiary from someone other than a relative, guardian or his or her associate;
• beneficiary income derived from property when the settlor has been ordered by a court to pay damages or compensation to the child;
• beneficiary income derived from property settled on the trust under the terms of a will, codicil, intestacy or any variation of these by a court, if the minor was alive within twelve months after the date of the settlor’s death;
• beneficiary income from a group investment fund;
• beneficiary income distributed to a non-resident minor;
• beneficiary income distributed to a disabled minor for whom the Child Disability Allowance is paid under the Social Security Act 1964; and
• beneficiary income distributed to minors from the Maori Trustee and Maori authorities.

If beneficiary income would otherwise be subject to this rule but is $200 or less in an income year, the minor beneficiary rule will not apply. If that income is over $200, all of that beneficiary income will be subject to the rule.

Beneficiary income subject to this rule will be taxed at the trust level at a final tax rate of 33%, on behalf of the beneficiary. Consequently, beneficiary income subject to this rule will not be included when calculating the minor’s final tax liability.

The trustee is required to take all reasonable steps to ascertain whether the minor beneficiary rule applies. If it clearly does apply, or if doubt exists, the trustee must withhold tax on the beneficiary income of that minor at 33% on behalf of the beneficiary. The trustee is required to include the tax withheld on this income in his or her provisional tax payments.

If a trustee fails to deduct at 33% from beneficiary income that is subject to the rule, the trustee will be liable for this tax, and penalties will potentially lie with the trustee. If the minor is mistakenly taxed at 33% when he or she should have been taxed at 19.5%, the minor can claim a refund for this additional tax in his or her return.

This discussion paper was prepared by Inland Revenue Department's Policy Advice Division.

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