|The taxation of trusts and trust beneficiaries |
by Richard Thornton
01 Nov 2005
Relevant to Paper 2.3(MYS), Paper 3.2(MYS)
The taxation of trusts and trust beneficiaries is a wide-ranging and rather complicated topic, and comes under Part 4 of the syllabus, Taxation of Special Persons. Heading (a) refers to trusts and settlements. Unit trusts and property trusts, which are referred to under heading (b), will be covered in a future article.
The recommended reference text is Malaysian Trust Law by Mary George (ISBN 9 679 78691 9). It is not necessary for candidates to know the law in detail, but an understanding of the basic concepts is required when tackling questions on this topic.
For all practical purposes there is no difference between a trust and a settlement. In referring to ordinary taxation of ongoing trusts and their beneficiaries, the word 'trust' is used in this article. The word 'settlement' will only be used in referring to the anti-avoidance provisions of Section 65 of the Income Tax Act 1965 ('The Act').
What is a trust?
Unlike a company or a co-operative, which are brought into existence and registered under the provisions of a specific law, a trust has no separate existence in law. The Act contains detailed provisions dealing with the taxation of trusts but it does not define a trust. The concept is recognised under Malaysian law but we still need to use English law to find out what a trust is, and to gain an understanding of some of the terminology used.
A trust can be defined as: 'An equitable obligation, binding a person (who is called the trustee) to deal with property over which he has control (which is called the trust property) for the benefit of persons (who are called the beneficiaries or cestuis que trust) of whom he may himself be one, and any one of whom may enforce the obligation.' (Underhill, quoted with approval in Green v Russell (1959) 2 Q.B.226)
In short, it means that legal control of some property is given to the trustee (or trustees if more than one) to look after for somebody else for a time. Normally the trustee will have no right to take it or use it for himself.
A trust can be created in a number of different ways. Usually it will be made during the lifetime of the person who gives the property (called the settlor) but it might come into existence on a death, by the operation of law or under a will, or it might be created by some other law.
The terms of a trust will usually be set out in a written document (called the trust deed). Trust provisions can vary widely but two basic aspects are important: certainty as to what is the trust property, and certainty as to the intended beneficiaries. Beneficiaries might be named specifically or as a class of persons. Frequently, a beneficiary will be given a right to income only, and the capital will pass to somebody else.
In addition to unit trusts and property trusts, there are several other different kinds of trust used in Malaysia. A common form is the quasi-public trust or foundation, often established by a state government or a government body. This form of trust carries on business activities and may be wholly or partly benevolent in nature. We are more concerned with trusts established by, or for, private individuals to benefit family members for a term of years, and which invest the trust property for income and/or capital gain. We need not concern ourselves with what is called a 'bare trust'. Such a trust is really no more than a nominee for the person owning the property.
Method of taxing
The Act, in Sections 61-63, sets out specific rules for taxing the income of trusts. These cover the trust body itself and the beneficiaries, who are assessed and charged to tax separately from the trust body.
From time to time the trustees are known as 'the trust body' and, as such, are regarded as a single and separate person for all tax purposes (except the penalty provisions).
Trusts, whether carrying on business or not, have to comply with the self-assessment system in the same way as companies.
Taxing the income of the trust body
The first step in dealing with the tax position of the trust body and of the beneficiaries is to ascertain the total income of the trust body computed in accordance with Section 44 of the Act.
The normal rules for computation of income, including the source rules, continue to apply. Income of the trust body consists of income from any source comprising property of the trust, including a trustee's share of any partnership income which is also trust income.
Deductions can be made from income gross in ascertaining the adjusted income from each source, but these follow the normal rules of deduction under Section 33 etc, of the Act. Capital allowances may also be available where the trustees carry on a business activity. Any expenses would have to qualify in relation to a particular source of income. There is no general deduction for administration expenses, such as trustees' fees. Cash and other gifts specified under Section 44 of the Act can be deducted in ascertaining the total income of the trust.
Subject to one important exception (see below), the trust body is assessed and charged to tax by reference to the whole of its total income.
The trust body of ABC Trust is resident in Malaysia. Accounts are made up to 30 June each year. The trust had the following amounts of income for the basis period 1 July 2003 to 30 June 2004. This forms the total income of the trust body for the year of assessment 2004:
Subject to any set-off for tax paid by instalments, the trust body will have the following liability to tax due for payment no later than 31 January 2005:
Taxing the income of a beneficiary
A beneficiary entitled to income from a trust is deemed to have a source of income in relation to the trust. This is equivalent to the total income of the trust for the year of assessment concerned or, in the case of several beneficiaries, a fraction of the total income equal to his fractional entitlement to the distributable income in the basis year for the year of assessment concerned. This is known as his ordinary source. Distributable income means the actual income available for distribution by the trustees. That is not necessarily the same as the total income for tax purposes. The basis year is a calendar year but it is not necessarily the same as the basis period. In the case of ABC Trust in Example 1, the basis period for the year of assessment 2004 is the year to 30 June 2004, but the basis year is the year to 31 December 2004.
The beneficiary is allowed a credit under Section 110 for the amount of tax chargeable on the chargeable income of the trust body, or for a proportion of it if he is entitled to less than the whole of the distributable income. This proportion is calculated by dividing his ordinary source income from the trust for the year of assessment concerned by the total income of the trust for that year. Note that the tax chargeable on the trust is not necessarily the same as the tax payable by the trust.
Continued from Example 1. Beneficiary D, a Malaysian resident, is entitled to 50% of the distributable income of ABC Trust for the basis year to 31 December 2004. Assuming he is a single man with no other income or deductions to claim, his tax position for the year of assessment 2004 is:
In fact, there is no need for the ABC Trust to make any tax payment in respect of D's share of the total income. The Director General has a power, which is usually exercised in such cases, to deduct the income entitlement of a resident beneficiary in ascertaining the chargeable income of a trust body.
Continued from Examples 1 and 2. Assuming that D's share of the total income of the trust, but not that of the other beneficiaries, is allowed to be deducted in ascertaining the chargeable income of ABC Trust, the position for the year of assessment 2004 would be as follows:
When the fractional entitlement of a beneficiary changes during the basis year, the total income is apportioned between the different periods on a time basis. A beneficiary's entitlement is then calculated separately for each time period and his ordinary source income for the year is the aggregate of the fractional entitlements.
Continued from Examples 1 to 3. Beneficiaries E and F were each entitled to 25% of the distributable income of ABC Trust until 31 March 2004 when E passed away.
F then became entitled to a full one-half share. Apportionment of total income:
E's ordinary source income 1/4 x RM6,000 = RM1,500
F's ordinary source income 1/4 x RM6,000 + 1/2 x RM18,000 = RM10,500
Note: For simplicity, the apportionments have been calculated by reference to months rather than days.
Trusts intended to benefit minors frequently provide that income is to be accumulated by the trustees for a period of time, rather than being distributed year by year. The trust will bear any tax attributable to the income. On subsequent distribution, such income is not treated as income of the recipient. Where some of the income is to be accumulated and some distributed, an appropriate part of the total income of the trust body will be disregarded in calculating the share of income of a beneficiary entitled to income distribution.
Note: The full amount of tax payable by the trustees is RM6,720 but only the amounts in the third column are taken into account in respect of beneficiaries D, E and F.
This example is continued from Examples 1 to 4 and is shown above. In fact, in ABC Trust, one-third of the trust income was being accumulated for a minor during the basis year 2004, and only the distributable income is revealed in Examples 1 to 4.
The full amount of the trust total income for the year of assessment 2004 is RM36,000. The full position is shown above.
Residence and non-residence
The trust body, as a separate person, is distinct from its beneficiaries, and the residence position of each is determined independently. The taxability of a beneficiary will usually be affected by his own residence position and, to some extent, by the residence position of the trust body. On the other hand, the residence position of the trust body has little or no effect on its own taxability.
There is a special rule to ascertain the residence position of a trust body. In general, a trust body is resident for a basis year for a year of assessment if any one or more of the trustees is resident for that year. However, the trust body will not be resident for that year if:
The tax residence of a beneficiary is determined under Section 7 of the Act in the usual way, as is the residence of any individual trustee. The residence of a corporate trustee is determined in accordance with Section 8 of the Act.
Sources of income
For a trust body, whether resident or not, it is important to know the rules applicable to sources of income. Income which accrues in, or is derived from Malaysia, or is deemed to be derived from Malaysia, is income of the trust for tax purposes. Foreign source income is not within the scope of charge. Even if it is received in Malaysia, it is exempted by paragraph 28 of Schedule 6 of the Act.
Taken from Question 4(b) of Paper 11 for December 1998. A non-resident trust had the following income for a year of assessment (the basis period being the year to 31 December):
The Malaysian dividends constitute the total income of the trust body, which is deemed to be derived from Malaysia in accordance with Section 14 of the Act. The tax position of the trust is as follows:
Note: The foreign dividends are not part of the total income whether received in Malaysia or not.
In the case of a beneficiary, his share of the total income of a trust, determined in accordance with his fractional entitlement to the distributable income of the trust, is deemed to be a source of income for him and it is deemed to be derived from Malaysia. This applies whether the beneficiary is resident or not and whether the trust body is resident or not.
Continued from Example 6. Sam and Nick were entitled to one-third each of the income of the trust for the basis year concerned. The other one-third was accumulated under the terms of the trust. Nick was resident in Malaysia for that year but Sam was not.
Sam and Nick both have deemed income from the trust of RM10,000 (2/3 of RM30,000 x 1/2). Sam, as a non-resident, is liable to tax at 28% on his share of income. Nick is taxable as a resident according to his personal circumstances. They are both entitled to a Section 110 set-off for a proportion of the tax chargeable on the trustees in respect of the distributable income (RM8,400 - 1/3 = RM5,600/2 = RM2,800).
Further source income of a beneficiary
The Act provides for the matching of trust income actually received by a beneficiary during a basis year for a year of assessment with his ordinary source income, calculated in accordance with his fractional entitlement.
A beneficiary's income from his further source is defined as the excess of the following over his statutory income from his ordinary source:
Continued from Examples 6 and 7. Nick received the following amounts from the trust during the basis year concerned:
All of these amounts were remitted to Malaysia from overseas by the trustees. Without any exemption, Nick's further source income would be:
Note: Income disbursed by a trust body on behalf of a beneficiary is treated as being received by the beneficiary.
Paragraph 28 of Schedule 6 exempts income derived from a source outside Malaysia and received in Malaysia. The non-resident trust is a source outside Malaysia so the income received from the trust is exempt and can be ignored. As a result, there is no further source income. The same would apply if the trust income had been received by Nick outside Malaysia and then remitted to Malaysia. However, the ordinary source income remains in any case because the Act deems it to be derived from Malaysia. Although the further source is also deemed to be income of the beneficiary, there is no provision to deem it to be derived from Malaysia.
The further source concept applies to all trusts where the beneficiaries are entitled to the income or a share of it. A further source can arise due to the late distribution of income, or to the receipt of income which is not taxable.
A resident trust had a total income of RM20,000 for the year of assessment 2004. One beneficiary was entitled to all of the distributable income. The beneficiary received a payment of RM3,000 in respect of 2003 income in March 2004, and a payment of RM22,000 on account of 2004 income in November 2004. The beneficiary's deemed income for the year of assessment 2004 consists of:
The further source income of the beneficiary in Example 9 includes RM3,000 which relates to the year of assessment 2003. Provided that this was an ingredient of the beneficiary's ordinary source income for that year, the further source income can be reduced accordingly.
There is still an unexplained excess of income distributions of RM2,000. The reason might be that the trustees were able to distribute more income than the total income for tax purposes due to having received exempt income such as exempt dividends. Although Section 61(1A) provides for a 'two-tier' exemption for a unit trust holder in such circumstances, there is no provision for an ordinary beneficiary to be exempted.
A discretionary trust is one in which the trustees are given power to allocate income between members of a class of beneficiaries in varying proportions, or not at all. This requires a different method of calculating the beneficiary's share of income.
The starting point is the total income of the trust body for a year of assessment. This amount is compared with the total of all sums of an income nature received in Malaysia by the beneficiary from the trust in the basis year for that year of assessment.
The lower of the two sums becomes the beneficiary's ordinary source income from the trust. Where two or more beneficiaries have received income distributions during a basis year, the amounts are totalled in order to make the comparisons. The lower figure is then divided in proportion to the respective income distributions.
The following applies to the RST Trust for the years of assessment stated:
Where a trust is partly discretionary and partly for beneficiaries in fixed shares, the income is divided and the two parts are dealt with separately. The same thing can apply where there is an income accumulating part, so it is possible to have one trust segmented into three different parts.
Paragraph 28 of Schedule 6 exempts income derived from a source outside Malaysia, and received in Malaysia, and it appears that a discretionary beneficiary of a non-resident trust will not be taxed whether he himself is resident or not. As income received in Malaysia is exempt, the amount of it would be nil and, as that would be less than the total income, the ordinary source income would be nil.
The terms of a trust might provide that a person should be paid an annuity of a stipulated sum out of the trust income. This is dealt with by Section 63 of the Act in rather a different way from a share of the trust income.
For a trust body resident in Malaysia, or for a non-resident trust body with all of its income derived from Malaysia, the amount of any annuity payable for the basis year for a year of assessment can be deducted in full in arriving at total income for that year.
Any other non-resident trust body can only deduct the annuity payment up to the amount of its Malaysian source income.
For the recipient, the annuity represents a source of income. It is deemed to be derived from Malaysia when the trust body is resident in Malaysia, or when all of the income of the trust body is derived from Malaysia. This applies even if the trust body has no total income for the year. For non-resident trusts deriving part of their income from Malaysia, the annuity is also deemed to be derived from Malaysia but only to the extent that it is deductible in arriving at the total income of the trust.
A Malaysian-resident recipient of an annuity payable by a non-resident trust has a foreign source of income. Although such income would come within the scope of tax when it is received in Malaysia, it would be exempt from tax by paragraph 28 of Schedule 6, except to the extent that the annuity is deemed to be derived from Malaysia.
For a non-resident recipient, any annuity deemed to be derived from Malaysia would not be exempt from tax.
Madam L, who is resident in Malaysia, receives an annuity of RM24,000 per annum from a trust resident in Switzerland. The annuity income is remitted to her in Malaysia as it becomes due. For the year of assessment 2004, RM15,000 of the trust total income was derived from Malaysia and the rest from overseas.
Only RM15,000 of the annuity can be deducted by the trust body, leaving it with a total income and chargeable income of nil.
Out of Madam L's annuity income, RM15,000 is deemed to be derived from Malaysia. The balance of RM9,000 represents foreign source income which is exempt. Madam L will be chargeable to tax on her annuity income of RM15,000.
Anti-avoidance and settlements
The use of trusts for tax planning purposes has become widespread in some jurisdictions to counter the effect of high tax rates, inheritance taxes and capital gains tax. In Malaysia, however, little use has been made of trusts for tax planning, particularly since the repeal of estate duty in 1991 and the virtual halving of tax rates on income. Nevertheless, anti-avoidance provisions designed to combat aggressive tax planning still exist. Any attempt to use a trust for tax mitigation must do so with regard to the general anti-avoidance provisions contained in Section 140 of the Act. These empower the Director General to disregard certain transactions which have the effect of avoiding tax as well as to the specific provisions.
Section 65 contains specific anti-avoidance provisions dealing with trusts (or settlements as they are referred to in the section). It works by deeming the income of a settlement to be income of the settlor where certain conditions apply. The obvious intention is to prevent wealthy individuals from passing over their assets or income to family members who have nil or low tax rates. In Malaysia's benign tax climate few settlors will be tempted to use settlements to mitigate their taxes. Even so, students should not ignore the anti-avoidance provisions because they can easily affect a settlement made for non-tax reasons. The reason is that a beneficiary entitled to a share of income might not be a taxpayer in respect of that income, because it is taxed as the income of the settlor.
There are three circumstances in which the section comes into play and the income of a settlement is deemed to be the income of the settlor, instead of the income of the trustees or of the legal beneficiary.
The first situation is where, in consequence of the settlement, income will or may become payable or applicable in the basis period for a year of assessment for the benefit of a relative of the settlor who at the beginning of that year is under the age of 21 and is unmarried. Note that there are some absolute defences to this:
A 'relative' is one of the following:
The second situation is where the purported gift is incomplete so that, under the terms of the settlement, there is a possibility of the settled property (or the income from it) passing back to the settlor or to a husband or wife of the settlor. The following are good defences:
Adapted from Question 5 of Paper 3.2 (MYS) - June 2003. Mr C H Lee, who passed away on 31 May 2002, made a settlement on
1 January 1997, putting into the settlement part of his substantial holding of shares in his family company.
One of the named beneficiaries was his daughter Ruth who was born on 1 June 1982. She married on 31 December 2000. Under the terms of the settlement, the income share of any beneficiary who is a minor is to be accumulated until that person reaches the age of 18. After that, the person is to receive the income until age 30 and then the capital.
In making his settlement, C H Lee retained a power, exercisable during his lifetime, to appoint the whole or any part of the capital and accumulated income in favour of his wife or any child of his. The power of appointment was never exercised. C H Lee's wife passed away on 30 April 1998. The position with regard to Ruth is as follows:
A further, and rather rare, situation in which Section 65 may come into play is where the settlor, or any relative of his, or any company controlled by him or by them together, makes use of any income of the settlement by borrowing or otherwise. The consequence is that the income concerned is treated as that of the settlor.
Real property gains tax
For the purpose of this tax, the trustees, as a body of persons, are assessable and chargeable on a joint and several basis with the tax on any chargeable gains accruing to the trust. Otherwise the usual provisions apply in relation to chargeable gains.
Richard Thornton is examiner for Paper 3.2 (MYS)
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