Often we are asked to advise on distributions from Trusts. The taxation of distributions depends on the classification of a Trust and the residency of the beneficiary in receipt of a distribution. For tax purposes Trusts are classified into three categories:
- Complying Trusts – trusts where none of the income, derived by the trustee is non-resident passive income, non-resident’s foreign sourced income, or income that is exempt under CW54 and where the trustees have always satisfied their tax obligations. The requirements applies over the life of the Trust.;
- Foreign Trusts – trusts that have not had a NZ resident settlor anytime since 17 Dec 1987;
- Non-complying Trusts – trusts that are neither complying or foreign.
The distributions to beneficiaries of a Trust, other than beneficiary income distributions, will fall into one of the following categories:
- Exempt income – where the distribution is made by a complying trust
- Taxable Distribution – where the distribution consists of income or related party capital gains distributed by a foreign trust, or consist of income or capital gains distributed by a non-complying trust, or
- Non-Taxable Distribution – where the distribution consist of capital gains (other than related party gains) of a foreign trust, or corpus of a foreign or non-complying trust.
NZ has a settlor based regime for the taxation of Trusts. The term Settlor is broadly defined as “a person who transfers value to the trust”. It should be noted that a person who provides financial assistance to a Trust with an obligation to pay on demand and the right to demand is not exercised or is deferred (i.e. typical interest free loan repayable on demand), will be considered a settlor. Another example of a settlor would be a person (individual or a corporate) who guarantee’s a loan advanced by a bank to the Trust for no consideration. The concept of a Settlor is very important as it determines the taxation of Trusts. It should be noted that nominee settlors are disregarded for tax purposes. The change in the tax residency of the Settlor can have an impact on the taxation of trustee income & distributions.
The Trustee is liable for the tax obligations of the Trust in most situations, including as an agent for the Beneficiary’s tax obligations. In case of multiple Trustees, the legislation treats joint trustees as a single notional person with each being jointly and severally liable for the tax obligations. This liability ceases when the Trustee resigns and notifies the Commissioner. In the absence of such a notification the Commissioner will continue to hold the Trustee liable.
Whilst trusts are taxed in NZ by reference to the residence of the Settlor, the residence of Trustees becomes important in a number of situations for example when deciding whether a trustee derives resident or non-resident passive income. As Trustees are treated as a single notional person, it is enough to have only one NZ resident Trustee for the rest of the Trustees (even if resident offshore) to be treated as a single notional person resident in NZ.
A. BENEFICIARY INCOME
Income can be taxed either as Trustee Income at a 33% tax rate or as a Beneficiary Income at the marginal tax rate of a Beneficiary, unless a distribution is made to a NZ resident minor beneficiary in which case the applicable tax rate will be 33%. Whilst beneficiary income is taxed only once, a taxable distribution of an amount that is not Beneficiary income may be taxed twice, once to the Trustee and secondly to the Beneficiary. Generally the obligation to satisfy the income tax liability rests with the trustee as the agent for the Beneficiary. For income to be Beneficiary income it must be paid or absolutely vest in the Beneficiary within a prescribed period.
Distributions to Minor Beneficiaries
Minor Beneficiary income is excluded income for the Minor Beneficiary and the Trustee is liable to pay tax for the minor beneficiary (natural person resident in NZ under the age of 16) at the end of the income year of derivation. If all of these three criteria are not met then the minor beneficiary rule will not apply. There are some exemptions from the minor beneficiary rule, the most common being the de-minimis threshold of $ 1,000.
B. TRUSTEE INCOME
NZ sourced income derived by the Trustee of a Trust is generally assessable income. Trust rules however contain specific provisions that deal with foreign sourced amounts derived by the Trustee. The general proposition is that foreign sourced amounts will be assessable as Trustee income if the settlor is a NZ resident.
Foreign sourced amounts – non-resident trustees
Where a Trust has non-resident trustees, foreign sourced amounts will not be assessable as Trustee Income unless the Settlor is a NZ resident (other a transitional resident). In case where there is more than one Settlor the foreign sourced amount will be assessable if one of the Settlors is a NZ resident during the income year. It is enough for the settlor to be resident in NZ at any time in the year.
Foreign sourced amounts – resident trustees
Resident Trustee will not be taxable in NZ on foreign sourced amounts if no Settlor is NZ resident at any time in the year (other than a transitional resident), and the Trust is a registered Foreign Trust that has complied with its registration & disclosure obligations under s 59B of TAA.
C. DISTRIBUTIONS FROM COMPLYING, FOREIGN & NON-COMPLYING TRUSTS
A distribution from a complying trust that is not beneficiary income is an exempt income for the beneficiary.
Certain distributions from foreign and non-complying trusts may be classified as “Taxable Distributions” and taxed to the beneficiary. Income derived by a trustee of a foreign or a non-complying trust may not have been liable to NZ income tax at the level of Trustee and consequently accumulated income will be taxable when distributed to NZ resident beneficiaries.
A Trustee makes a distribution to a beneficiary when the trustee transfers value to a person because the person is a beneficiary. An example of a distribution is when the trustee permits beneficiaries to reside in a property owned by a trust without paying market rental. For a complying trust such distribution will be exempt income for the beneficiary. However such a distribution by foreign or non-complying trust may be treated as a “taxable distribution” and taxed accordingly. What constitutes a “taxable distribution” varies between Foreign and Non-Complying Trusts.
Foreign Trusts – Taxable Distribution
A distribution made by a Trustee of a Foreign Trust to a NZ resident Beneficiary is a Taxable Distribution if it is a distribution of:
- Accumulated Trustee Income;
- Related party capital gains.
A taxable distribution received by a NZ resident beneficiary is subject to NZ income tax at the marginal tax rate of a Beneficiary. Distributions of a Third Party Capital gain and Corpus do not form part of Taxable Distributions and therefore will not be subject to tax in NZ if distributed to a NZ resident Beneficiary.
Taxable Distribution from Foreign Trust to a non-resident beneficiary is taxable to the extent that income has a NZ source with consequential double taxation. Accordingly NZ Foreign Trusts should avoid accumulating NZ sourced income and keep in mind that a foreign currency bank account with a NZ bank will give rise to NZ sourced income/ loss. There are ordering rules to determine the character of the distribution with the first slice of any distribution being seen to be sourced from income followed by accumulated income, related party capital gain, capital gain and corpus.
A distribution made by a Trustee of a Non-Complying Trust to a NZ resident beneficiary is a Taxable Distribution if it is a distribution of the following:
- Accumulated Trustee Income;
- Any Capital gains
A taxable distribution received by a NZ resident Beneficiary is subject to NZ income tax at 45%. Distributions of Corpus do not form part of Taxable Distribution and therefore will not be subject to tax in NZ if distributed to a NZ resident Beneficiary.
When it comes to distributions from foreign or non-complying trusts one must be mindful of the ordering rules. The purpose of the ordering rules is to prevent manipulation of distributions so as to achieve either non-taxation of a distribution, streaming of distributions or a deferral of taxation that could arise as a result of distributing non-taxable amounts before taxable amounts. Ordering rules prescribe the order and classification of distributions.
D. MIGRANTS MOVING TO NEW ZEALAND
Migrants moving to NZ or NZ citizens returning to live in NZ may need to consider their NZ income tax implications if they are a settlor, trustee or a beneficiary of a foreign or a non-complying trust.
When a non-resident settles a Trust before assuming residence in NZ, such trust will be a Foreign Trust regardless of the residence of the trustees or the beneficiaries. The Trust can retain its foreign Trust status for up to one year after the settlor, who is not a transitional resident, becomes resident in NZ. To prevent the Trust from becoming a non-complying Trust at the end of this period, the Settlor (who is a natural person) may elect for the Trust to become a complying Trust. If the election is not made within the time frame specified, the Trust will become a non-complying trust in relation to distribution of amounts derived by the Trustee after the expiry of the election period, even if the Trustee has paid tax on trustee income.
Distributions to Transitional Residents
Where a transitional resident receives beneficiary income from a foreign or non-complying trust, the income retains its underlying character. If income has a foreign source, then it will be exempt for the transitional resident beneficiary.
Where a trustee of a Foreign Trust derives NZ sourced income or capital gain, such distributions to a transitional resident will be subject to ordering rules and will be taxable where the distribution comprises accumulated trustee income and related party capital gain amounts that have a NZ source.
If a person ceases to be a NZ tax resident and resumes his NZ tax residency within 5 years, such person will be taxable in NZ on all distributions received from a foreign or non-complying trust during the period of absence.
E. NZ RESIDENTS LEAVING NEW ZEALAND
Where New Zealanders who are either Trustees, Settlors or Beneficiaries of NZ Trusts leave New Zealand, they can create a whole host of issues for themselves in their new country of residence and for the remaining NZ trustees.
Most foreign countries tax trusts by reference to the residence of trustee (e.g. Australia). More often than not it is enough for one Trustee to be resident in Australia, which will bring the NZ Trust into the Australian tax net. Whilst income from NZ trust could be distributed to a Beneficiary, this may not be so with capital gains, which could give rise to an unintended exposure to capital gains tax (CGT) in Australia.
Furthermore migration of Settlors, Trustees, Beneficiaries needs to be considered for the purposes of Residential Land Withholding Tax and Offshore Persons.
Taxation of trusts and distributions can be complex and is largely dependent on the facts of each case. If you are in doubt please speak to us.