Chapter 7 – Transitional Provisions

7.1 BE Regime
7.2 Resident Trusts
7.3 Non-Resident Trusts
7.4 Foreign Investment Funds
7.5 Recommendations


7.1 Branch Equivalent Regime

7.1.1 The CD proposes no transitional arrangements apart from the deferral of the implementation date of the BE and CV regimes until 1 April 1988. A number of submissions argue for complete exemption of investments entered into before the announcement of the regime and you will be aware of the general arguments made against retrospective tax changes. The Committee considers that complete "grandfathering" can seldom be justified since commercial decisions do not assume that the tax system applying when they are made will continue indefinitely. Nevertheless, we consider that a reasonable period of adjustment is necessary in order to give taxpayers time to restructure their affairs and gear up to comply with the regime. There has, however, been fair warning of the Government's intention to address tax haven avoidance.

7.1.2 To this end, we recommend that residents be exempt from the BE regime until 1 April 1990 in respect of interests acquired on or before 17 December 1987 in companies that are not resident in low tax jurisdictions specified in a transitional list. An illustrative transitional list is shown in Annex 5. Shareholders with controlling interests in tax haven companies will generally have known since at least the date of the 1987 Budget that they were to be subject to a CFC regime. We therefore consider that a 1 April 1988 implementation date is appropriate in these cases.

7.1.3 We also recommend that residents be exempt from the BE regime until 1 April 1989 in respect of interests acquired after 17 December 1987 in companies which are resident in the listed countries (though the exemption of any underlying controlled companies would depend on whether they also were resident in a listed country). After that date, a continued exemption would apply only if the company met the grey list test outlined in section 2.3. Taxpayers in this position would therefore not have to adjust the taxable income of the controlled company for significant preferences in the first year. It would in any case be difficult to compile lists of significant preferences in time for a 1 April 1988 start date.

7.1.4 For the purposes of determining whether a non-resident company is controlled, a resident's total interest in the company, whether acquired before or after 17 December 1987, would be considered. Similarly, a resident's total shareholding would be considered for the purposes of determining whether the 10 percent interest threshold for attribution of income was triggered. Attribution of income during the transitional period would, however, be based on that part of a resident's total interest that was acquired after 17 December 1987. An example illustrating these transitional provisions is shown in Annex 2.

7.2 Resident Trusts

7.2.1 As mentioned above, we consider that a more generous transition is justified for existing resident trusts (as defined in chapter 5) with non-resident trustees. In some cases, settlors will be able to wind up a trust and remove themselves from the new regime but this will often not be possible. Thus, some settlors of such resident trusts would be unable to alter their settlor status and could suffer a considerable additional tax liability that could not have been anticipated. The regime should not, however, protect existing settlors forever where they are able, through their influence over the trustee, to effect a wind up of a trust since a decision not to do so represents in effect a new settlement. Where a wind up is not feasible, the settlor should not be subject to the new regime. Since the trustee is offshore, the only other party, if any, with a connection with New Zealand will be resident beneficiaries. We do not consider that it is feasible to tax beneficiaries on undistributed trust income each year, but the benefit of deferral of tax that they enjoy can to some extent be addressed once a distribution (or vesting) is made.

7.2.2 The Committee therefore favours a trust transition which encourages settlors and trustees to wind up existing resident trusts with non-resident trustees if they can. If they are not able to, an interest element should be incorporated into the determination of the assessable income of a beneficiary resulting from a trust distribution. The latter approach is adopted in the United States in respect of distributions to United States beneficiaries from trusts settled by non-residents.

7.2.3 In order to encourage dissolution of a trust where it is feasible, we propose that distributions of income made on or before 31 March 1989 from existing trusts with non-resident trustees be subject to a final tax levied at a rate of 10 percent, provided that either the trust is wound up before 1 April 1989 or the settlor elects to be subject to the new settlor regime from that date. Distributions of capital profits and the corpus of such a trust made on or before 31 March 1989 should be exempt from tax in beneficiaries' hands. Our proposed rate of 10 percent reflects a compromise between the rate of tax which would have been payable had the distribution been unambiguously taxable under current law and the rate needed to encourage dissolution.

7.2.4 Where these alternatives are not availed of, we recommend that the non-resident trustee and the resident settlor not be subject to the settlor regime, but that all distributions, whether of income or capital (other than of the corpus of the trust), should be assessable in the hands of a resident beneficiary with an interest charge to reduce the advantage of deferral. The interest should be calculated from 1 April 1988, the implementation date of the settlor regime. A credit should be given for any foreign tax paid by the trustee. In addition, where a settlor has a loan, guarantee or other form of financial assistance outstanding to the trustee, he or she should be assessed on imputed interest at a prescribed rate (less any interest actually received by the settlor or paid by the trustee, as the case may be) computed on the amount of the loan, guarantee or other assistance.

7.2.5 A less stringent transition is justified for resident testamentary trusts with non-resident trustees since these are not used for avoidance purposes. Where such trusts are wound up on or before 31 March 1989, the provisions outlined in paragraph 7.2.3 should apply. We propose that distributions of capital profits from this category of testamentary trusts made after 31 March 1989 be exempt in the hands of beneficiaries. Distributions of income should, however, be assessable with the interest charge since the beneficiaries of testamentary trusts may enjoy the advantages of tax deferral to the same extent as beneficiaries of other trusts.

7.2.6 Where a settlement is made after 17 December 1987 to an existing resident trust, the whole of the trust income could be subject to the new regime or only that part attributable to post-17 December 1987 settlements. It would, however, be difficult to arrive at workable apportionment rules because of the need to trace and compare settlements made at different times in the past and in various forms. We therefore favour the approach of bringing all trust income within the regime where a new settlement is made to an existing trust. This would have little practical impact, since future settlements could be made to a new trust on the same terms as an existing trust, but would avoid the need for apportionment rules.

7.2.7 In order to implement this transition, resident settlors should be required to disclose all settlements, as widely defined, on non-resident trustees existing on 1 April 1988. Settlors should also notify the Inland Revenue Department of the transition they have elected.

7.2.8 Settlements of trusts made by residents after 17 December 1987 and distributions of income or capital from such trusts would be subject to the new regime proposed in chapter 5.

7.3 Non-Resident Trusts

7.3.1 Non-resident trusts (i.e those which are not settled by a New Zealand resident) are not affected by the settlor regime, irrespective of when they were settled. The treatment of distributions from such trusts to resident beneficiaries is, however, to be clarified as part of the present reforms. The Committee's recommended treatment was outlined in chapter 5. The Government's intention to clarify the law in this area was included in the CD. We therefore propose that our recommended regime apply to distributions from non-resident trusts made after 17 December 1987.

7.4 Foreign Investment Funds

7.4.1 The foreign investment fund regime is targeted at tax haven entities. The Government signalled its concern about the use of tax havens in 1986 and again in the 1987 Budget. In addition, taxpayers will usually be readily able to dispose of the interests that would be affected by the regime. Thus, the Committee supports the implementation of the foreign investment fund regime from 1 April 1988.

7.5 Recommendations

7.5.1 The Committee recommends that:

a taxpayers be exempt from the BE regime for a two year period (i.e. until 1 April 1990) in respect of interests acquired on or before 17 December 1987 in companies which are not resident in a transitional list of specified tax havens;

b taxpayers be exempt from the BE regime for a one year period (i.e. until 1 April 1989) with respect to interests which were acquired after 17 December 1987 in companies which are resident in the list of countries specified in recommendation (a) of paragraph 7.17;

c distributions of income made on or before 31 March 1989 from existing trusts with non-resident trustees, be subject to a final tax levied at a rate of 10 percent, provided that either the trust is wound up by 1 April 1989 or the settlor elects to be subject to the new settlor regime from that date. Where either of these options applies, distributions of capital profits and the corpus of the trust made on or before 31 March 1989 should be exempt from tax in beneficiaries' hands;

d where neither option outlined in (c) applies in respect of existing trusts with non-resident trustees, other than testamentary settlements:

i all distributions, whether of income or capital (other than of the corpus of the trust), should be assessable in the hands of a resident beneficiary subject to an interest charge calculated from 1 April 1988, with the beneficiary receiving a credit for any foreign tax paid by the trustee; and

ii where a settlor has a loan, guarantee or other form of financial assistance outstanding to the trustee, he or she should be assessed on imputed interest at a prescribed rate (less any interest actually received by the settlor or paid by the trustee, as the case may be) computed on the amount of the loan, guarantee or other assistance outstanding;

e in the case of testamentary trusts in existence on 17 December 1987 where the deceased person was a resident and which do not wind up pursuant to recommendation (c):

i distributions of capital profits made after 31 March 1989 continue to be exempt in the hands of beneficiaries; and

ii distributions of income be assessable subject to an interest charge calculated from 1 April 1988;

f where a resident makes a settlement after 17 December 1987 to a trust in existence on that date, all of the trust settlements be deemed to have been made after 17 December 1987;

g taxpayers be required to make full disclosure of all settlements, as widely defined, to trusts with non-resident trustees existing on 1 April 1988;

h the implementation date for the proposed changes to the treatment of distributions from non-resident trusts be 17 December 1987; and

i the implementation date for the foreign investment fund regime be 1 April 1988.