Chapter 6 – Trusts
6.1 Introduction
6.2 Existing Treatment of Trusts
6.3 Overview of Trust Regime
6.4 Definition of a Settlor
6.5 Trustee Income
6.6 Settlor Liability: Superannuation Funds
6.7 Settlor Liability: New Residents
6.8 Settlor Liability: Charitable Trusts
6.9 Beneficiary Income
6.10 Distributions From Qualifying Trusts
6.11 Distributions From Foreign Trusts
6.12 Distributions From Trusts Settled by New Residents
6.13 Non-Qualifying Distributions
6.14 Financial Assistance to Trusts
6.15 Residence of a Beneficiary
6.1 Introduction
6.1.1 In many circumstances, trusts can substitute for CFCs or FIFs. Hence, it is necessary to support the BE and FIF regimes with a regime applying to trusts. We referred to the trust regime in our first report as "the settlor regime" because it will bring within the tax net the foreign-source trustee income of trusts which have one or more New Zealand resident settlors. This trustee income is now not subject to tax in New Zealand where the trust has non-resident trustees.
6.1.2 A further deficiency with the current rules is the ambiguity about the tax treatment of distributions from non-resident trustees to New Zealand beneficiaries. This was discussed in the Consultative Document released in December and we have drafted legislation to deal explicitly with this type of income. The present rules also attempt to deal, though not very effectively, with the use of trusts for income splitting. With the recent considerable flattening of personal income tax rates, the need for such provisions has lessened. We have therefore taken the opportunity to recommend changes to the existing tax legislation applying to trusts. The result is a new regime for trusts which would apply to domestic trusts as well as to overseas trusts with New Zealand connections.
6.1.3 This chapter outlines the new regime. Transitional issues relating to the treatment of settlements in existence on or before 17 December 1987 are dealt with in chapter 8.
6.2 Existing Treatment of Trusts
6.2.1 The present tax treatment of trusts is dealt with primarily in sections 226 to 233 of the Income Tax Act 1976. Section 226 currently distinguishes between "specified" and "non-specified" trusts. Broadly speaking, non-specified trusts include trusts created by will or on an intestacy and inter-vivos trusts created before 19 July 1968. Specified trusts are inter-vivos trusts created on or after that date. The distinction was brought into existence by an amendment to the Land and Income Tax Act 1954 following the 1968 Budget. The difference between the two types of trust is purely a matter of tax treatment of the income derived by their trustees and beneficiaries. It is not founded in any jurisprudential distinction between trusts of different kinds.
6.2.2 The policy behind the distinction was an effort to frustrate income splitting by means of trusts which was thought to have become particularly prevalent in the 1960's. The benefits of income splitting achieved by taxpayers were enhanced by the steeply progressive income tax scales that prevailed at that time and that remained in force until relatively recently. The effect of this policy is that, broadly speaking, income of a specified trust is taxed at a higher rate than income of a non-specified trust.
6.2.3 The current law further distinguishes between trusts or, more precisely, between different streams of trust income, according to whether income is accumulated by trustees or distributed to beneficiaries and, if the latter, according to whether the distribution is pursuant to a discretion vested in the trustee or to a provision of the trust that fixes the rights of a beneficiary to income. Finally, a distinction is drawn in some circumstances according to whether the beneficiary is an infant or an adult.
6.2.4 Income accumulated by a trustee is taxed in the hands of the trustee at the rates that would apply if the trustee were an individual and had no other income. For specified trusts, there is a minimum rate of 35 percent, reflecting the 1968 policy of harsher treatment for these trusts.
6.2.5 When a trustee does not accumulate income but instead it is derived in trust for a beneficiary "entitled in possession" to the income, it is taxable to that beneficiary. This rule works well enough in the case of adults. If income vests in them by virtue of the provisions of a trust or by virtue of the exercise of a discretion by the trustee, they are entitled in possession to that income because they can call on the trustee to pay it over. This is not the case with infants (nor with persons who lack full legal capacity for other reasons, such as unsoundness of mind) since an infant is not entitled to the possession of income.
6.2.6 Thus, where, in the exercise of a discretion by a trustee, income is paid to or applied for the benefit of a beneficiary by a "bona fide transaction" which places the income beyond the possession and control of the trustee, the beneficiary is deemed to be entitled in possession to the income so long as the payment or application is made within six months of the end of the income year in which the income is derived. The six month rule enables a trustee to calculate the trust's income for the relevant year before applying the money for the benefit of a beneficiary.
6.2.7 An additional condition applies in the case of a specified trust or an infant beneficiary. In that case, where the income comes within the possession or under the control of the trustee or is used for the purposes of a business carried on by the trustee, it is reassessed to the trustee instead of the beneficiary. This rule is part of the harsher regime for specified trusts mentioned in paragraph 6.2.4.
6.2.8 The precise effect of the "bona fide transaction" requirement is not certain. In many cases this requirement poses few problems because income is employed to meet current needs of the beneficiary. In other cases, trustees go to some lengths to ensure that there has been something that qualifies as a payment or an application. A common technique is for the trustee to establish a sub-settlement for the benefit of the beneficiary and for income to be channelled to that sub-settlement. The second requirement outlined in paragraph 6.2.6 in many cases is also able to be avoided, albeit at some cost in the establishment of sub-settlements and other planning devices.
6.2.9 In the case of fixed trusts other than specified trusts, income that vests in an infant beneficiary is also deemed to be income to which the beneficiary is entitled in possession.
6.2.10 In view of the ineffectiveness of the specified/non-specified trust distinction in countering income splitting and of the substantial flattening of the personal income tax scale, the Committee considers that the distinction should be removed. In addition, because the settlor regime supersedes the current trust provisions to some extent it is simpler to replace all of sections 226 to 233 by new provisions which cover both wholly domestic trusts and trusts with foreign elements.
Recommendation
6.2.11 Accordingly, the Committee recommends that the present distinction between specified and non-specified trusts in sections 226 to 233 of the Act be removed from 1 April 1988.
6.3 Overview of Trust Regime
6.3.1 The major difference between the existing tax treatment of trusts and the proposed new regime is that the latter brings within the New Zealand tax net the trustee income of trusts with non-resident trustees which have a New Zealand resident settlor. Such income has previously not been subject to tax in New Zealand except where it has a New Zealand source. As explained in Part 1 of our report, the new regime recognises that the economic substance of a trust may differ from its legal appearance. A settlor may have substantial influence over the trustee, usually on an informal basis though there may be specific provision in the trust deed so that, in practice if not in law, a settlor may be able to wind up a trust and influence or control the disposition of its property.
6.3.2 If this assumption does not accord with the circumstances of a particular trust, then in future New Zealand residents can settle trusts on resident trustees and divest themselves of any liability for tax on trustee income. If they wish to use non-resident trustees, they must be prepared to have the trustee's liability for New Zealand tax on trustee income fall back on them should the trustee default. We recognise that this choice may not be available in respect of trusts that were settled before 17 December 1987 and so have recommended that the settlor in these circumstances not be liable for tax on trustee income. A number of transitional provisions relating to these trust are outlined in chapter 8.
6.3.3 Thus, under the new regime, the foreign-source trustee income of any trust will be taxable in New Zealand where, at any time in an income year, a settlor of the trust is resident in New Zealand. Trustee income is income derived by a trustee of a trust in any year that is not beneficiary income of any beneficiary of the trust. The tax treatment of trustee income is discussed in section 6.5. We refer to a trust in respect of which trustee income has been taxable in New Zealand in every income year since its settlement as a "qualifying trust". The liability for the tax on trustee income will fall on the trustee. Where there is no resident trustee, the New Zealand resident settlor will be liable as agent of the trustee. In effect, the settlor is treated as the "taxpayer of last resort" in respect of trustee income.
6.3.4 We propose that settlors of trusts that are charitable trusts or superannuation funds not be liable for tax on trustee income as agents of the trustees. In addition, we propose that, where a trust is settled by a new resident before he or she becomes resident in New Zealand, the settlor should not be liable for tax on trustee income provided that the settlor has not been resident in New Zealand at any time after 17 December 1987. These provisions are outlined in sections 6.6 to 6.8. We propose, however, that a new resident in the above circumstances should be able to elect to become liable for tax on trustee income. Similarly, a trustee of a trust which has a settlor who is no longer resident or who has died should be able to elect to continue to pay tax on foreign-source trustee income so that the trust retains it status as a qualifying trust.
6.3.5 The income derived by a trustee of a trust in any income year is either "trustee income" or "beneficiary income". Beneficiary income is, broadly, that part of the income derived by the trustee in any income year which vests in or is distributed to a beneficiary in the same year. Section 6.9 sets out the proposed treatment of such income. A beneficiary may also receive distributions from a trust other than beneficiary income. Such distributions could consist of income received by a beneficiary after the income year in which it is derived by the trustee or distributions from current or prior year gains that are not taxable income. Any payment, benefit, property or other consideration derived by a beneficiary from a trust, including beneficiary income, will be referred to as a "distribution". The draft legislation refers to the taxable portion of such a distribution as a "taxable distribution". The taxation of distributions is discussed in sections 6.10 to 6.12.
6.3.6 As noted above, trusts in respect of which trustee income has been subject to tax in New Zealand in all income years since their establishment will be called "qualifying trusts". We use the term "qualifying" since we propose that distributions from such trusts, other than beneficiary income, should qualify as non-assessable income in the hands of beneficiaries.
6.3.7 A second category of trust will be called a "foreign trust". We define a foreign trust as a trust that has not had a settlor who is or was a resident of New Zealand at any time after 17 December 1987. We propose that distributions of the trustee income of these trusts derived by the trustee in accounting years commencing on or after 1 April 1988 and any beneficiary income derived by a beneficiary of such a trust be taxable in New Zealand but other distributions be non-assessable. These proposals are discussed in section 6.11.
6.3.8 Distributions, other than beneficiary income, which are made by the trustee of a trust that is neither a qualifying trust nor a foreign trust will be referred to as "non-qualifying distributions". This term is not used in the draft legislation but, for convenience of exposition, we have employed it in this report. For example, distributions from trusts in respect of which trustee income has not been subject to tax in New Zealand in all income years since their settlement, other than foreign trusts, will be non-qualifying distributions. Since non-qualifying distributions may consist of income which has never been taxed in New Zealand and may not have been taxed in any other jurisdiction, they should not be non-assessable in the hands of beneficiaries. Our proposals in relation to these distributions are outlined in section 6.13.
6.3.9 The distinction between qualifying, foreign and other trusts is therefore an important determinant of the way in which we propose that distributions from trusts should be taxed.
6.4 Definition of a Settlor
6.4.1 A cornerstone of the regime is the definition of a settlor. This is dealt with in section 226 of the draft legislation. There are several legs to the definition:
a a settlor is defined, broadly, as any person who, directly or indirectly (e.g. via nominees, solicitors, accountants, financial institutions, etc) and whether by one transaction or a series of transactions, makes or has made any disposition of property on a trust. A disposition of property is in turn defined widely;
b where a trust is settled by a resident company and the company is wound up, any person who at the time of the settlement had a direct control interest, as that term is defined for the purposes of the BE regime, in the company would be deemed to be a settlor if the person's direct control interest together with that held by associated persons is 10 percent or more. A parallel rule applies where such a person is a company and is itself wound up, and so on;
c where a trust is settled by a CFC, any resident who at the time of the settlement, or at the time a CFC becomes a settlor by virtue of rule b above, has a control interest in the CFC is deemed to be a settlor of the trust if the resident's control interest and that of associated persons is 10 percent or more;
d where a trust is settled by a trustee of another trust, any person who is a settlor of the first trust is deemed to be a settlor of the second;
e where the trustee of a trust is a company and a resident acquires an interest in that company with the effect or purpose of requiring the trustee to treat the resident, or any person he or she nominates, as a beneficiary, the resident is deemed to be a settlor;
f a general anti-avoidance rule is included to define as settlors any persons who make an arrangement in relation to a trust which has the effect of defeating the intent and application of this definition.
6.4.2 The above definition of a settlor elaborates for the purposes of the draft legislation the very wide definition of a settlor and a settlement recommended in our previous report.
6.5 Trustee Income
6.5.1 As mentioned above, "trustee income" means income derived by a trustee of a trust in any income year that is not beneficiary income of any beneficiary of the trust. Where trustee income is derived in New Zealand, the trustee, whether resident or not, will be liable for tax in New Zealand on the income.
6.5.2 The settlor regime brings into the New Zealand tax net trustee income which is derived outside New Zealand in any income year if the trust has a settlor who is resident in New Zealand at any time during the year. Thus, where there is a resident settlor, both New Zealand- and foreign-source trustee income will be assessable in New Zealand.
6.5.3 As the Committee recognised in Part 1 of its report, where trustee income is to be subject to New Zealand taxation, the best course is to tax it in the hands of the trustee as if he or she were a resident. It is the trustee who derives the income and it is to the trustee that one should look in the first instance for the resultant tax. Consequently, in the case of a trust where there is a New Zealand resident settlor at any time during the income year, the primary liability for income tax should fall on the trustee.
6.5.4 As discussed in our previous report, where there may be difficulties in enforcing the trustee's liability for tax on non-New Zealand source income, it is necessary to make the resident settlor liable for tax on trustee income as agent for the trustee. Such difficulties may obviously arise where a trust has no resident trustees. If a trustee is resident, the Department can pursue the trustee through the legal process and has recourse to the trustee's assets. Where, however, the trustee is a shell company with no tangible assets in New Zealand, problems of enforcement may still occur. We therefore propose that the settlor of a trust not be liable for tax on trustee income if the trustee is resident in New Zealand and is a natural person, a trustee company within the meaning of the Trustee Act 1956.
6.5.5 In other cases, the settlor of a trust will be liable as agent of the trustee for tax on the trustee income of the trust. This liability will not, however, arise if the trust was settled on or before 17 December 1987 unless the settlor elects to be so liable. We propose a number of other exemptions in respect of superannuation funds, new residents and charitable trusts which are discussed in sections 6.6, 6.7 and 6.8.
6.5.6 In summary, foreign-source trustee income will be liable for tax in New Zealand in any income year in which the trust has a settlor who is resident in New Zealand. The primary liability for the tax will fall on the trustee. Where the trust was settled after 17 December 1987, a liability for tax on trustee income, in the event of the default of the trustee, will also fall on a resident settlor except in certain circumstances. We propose that these circumstances be that:
a the trust has a resident trustee who is a natural person or a trustee company; or
b the trust is a superannuation fund. (This exemption is referred to in section 6.6); or
c the trust was settled by a person before becoming resident in New Zealand who had not been resident in New Zealand at any time after 17 December 1987. (This is the new resident exemption which is discussed in section 6.7); or
d the trust is a charitable trust. (This is discussed in section 6.8).
6.5.7 Where there is more than one resident settlor, the simplest treatment is to make them jointly and severally liable for the tax as agents of the trustee. The use of the term "agent" brings into play all the provisions of the Income Tax Act in respect of agency liability. One of these is that an agent has a right of indemnity from his principal, in this case the trustee. Thus, for mechanical collection purposes, and to fit in with the existing pattern of the Act, it is appropriate to give the settlor the status of agent. This approach should not, however, obscure the policy considerations that make it appropriate for a New Zealand resident settlor to be treated, in effect, as a "taxpayer of last resort" in respect of the trustee income of a trust.
6.5.8 Circumstances will arise where, though there is no New Zealand tax liability in respect of foreign-source trustee income because there is no resident settlor, a settlor or trustee would prefer that a trust be a qualifying trust so that distributions of the trust (apart from beneficiary income) are non-assessable. For example, a settlor who is emigrating may wish to continue to have all of the trustee income of a trust taxed in New Zealand. For similar reasons, the trustee of a testamentary trust or an inter-vivos trust following the death of a resident settlor may wish to retain a qualifying trust status. Accordingly, we propose that a settlor or trustee of a trust be permitted to elect to make foreign-source trustee income of the trust liable for tax in New Zealand in any income year, even though there may be no settlor of the trust resident in New Zealand in that year, by submitting a return of such income by the due date.
6.5.9 At present the trustee income of specified trusts is taxed at a rate of 35 percent and the trustee income of non-specified trusts at the ordinary marginal tax rates applying to individuals. Since we have recommended in paragraph 6.2.11 that the distinction between specified and non-specified trusts should be abandoned, we consider that there should be a uniform rate of tax in respect of trustee income with effect from 1 April 1988.
Recommendations
6.5.10 Accordingly, the Committee recommends that:
a a trustee be liable for tax on trustee income derived outside New Zealand in any income year in which the trust has a settlor who is resident in New Zealand at any time during the year;
b subject to the recommendations in sections 6.6 6.7 and 6.8, where a trust was settled after 17 December 1987, any resident settlor of the trust be liable for tax on trustee income as agent of the trustee except where the trust has a resident trustee who is a natural person or a trustee company within the meaning of the Trustee Act 1956;
c a settlor or trustee of a trust be permitted to elect to make foreign-source trustee income subject to tax in any income year by making a return of such income by the due date; and
d a trust in respect of which trustee income has been subject to tax in New Zealand, in the hands of either the trustee or the settlor, in every income year since the settlement of the trust be defined as a "qualifying trust".
6.6 Settlor liability: Superannuation Funds
6.6.1 A contributor to a superannuation fund falls within the definition of a settlor where the fund is constituted as a trust. Where, however, the superannuation fund is resident in New Zealand, a separate tax regime is to apply to the taxation of the trustee income of the fund. This regime is the subject of a separate consultative process and supersedes entirely the trust regime which falls within our ambit. Consequently, our proposals for the taxation of trusts do not apply where the trust is a resident superannuation fund.
6.6.2 Where a superannuation fund is a non-resident, our understanding is that the regime under consideration in the separate consultative process would not apply. We would not, however, propose to tax a resident contributor to a non-resident superannuation fund on the worldwide trustee income of a non-resident superannuation fund. Thus, a contributor who is technically a settlor of a superannuation fund should never be liable for tax on the trustee income of the fund.
6.6.3 The only liability that would fall on a contributor would arise if the superannuation fund were a non-resident fund that fell within the definition of a foreign investment fund. As outlined in chapter 5, residents with interests in superannuation funds that are FIFs should be taxed on the income derived from such interests under the FIF regime.
6.6.4 We therefore propose that a person who makes a settlement on a trust that is a superannuation fund, as the term is to be defined for the purposes of the new tax regime for superannuation funds, should not be liable for tax on the trustee income of the trust irrespective of the residence of the trustee. This exemption would apply, for example, to contributions made to a superannuation fund by an employee or an employer, including those made by a CFC.
Recommendation
6.6.5 The Committee therefore recommends that a person who makes a settlement on a trust that is a superannuation fund, as that term is to be defined for the purposes of the new tax regime for superannuation, not be liable for tax on the trustee income of the trust.
6.7 Settlor Liability: New Residents
6.7.1 An immigrant who settles a trust before becoming resident in New Zealand is in a position similar to a settlor of a trust in existence on 17 December 1987, provided that the immigrant has not previously been resident in New Zealand since 17 December 1987. Thus, we consider that a similar relief from liability for tax on trustee income is warranted in such cases. In particular, we consider that, where a person who has never previously been resident in New Zealand after 17 December 1987 becomes resident in New Zealand after that date and has settled a trust before becoming resident, that person should not be liable as agent of the trustee for tax on the trustee income of the trust.
Recommendation
6.7.2 The Committee therefore recommends that persons who become resident in New Zealand after 17 December 1987 who have settled a trust before becoming resident not be liable for tax on trustee income in respect of that trust, provided that they have not previously been resident in New Zealand since 17 December 1987.
6.8 Settlor Liability: Charitable Trusts
6.8.1 Trustees of charitable trusts are currently exempt from tax in New Zealand by virtue of sections 61(26) and 61(27) of the Act. The Government has announced its intention to review the tax exempt status of charitable trusts, but this is outside the brief of the Committee. Given that the trustee income of resident trustees of charitable trusts is exempt from tax in New Zealand, a person making a donation to a charitable trust (who would be a settlor under our definition) should not be liable for tax on the trustee income of the trust. Even if the trustee income of charitable trusts were taxable in New Zealand, it would not be appropriate to make resident settlors liable for tax on the worldwide trustee income of non-resident charitable trusts. Thus, we propose that the new regime for the taxation of trustee income should not apply to a person who makes a settlement on a charitable trust. For this purpose, we propose that a charitable trust be defined taking into account the terms of section 61(27). If, however, the definition in this section is changed as a result of the current review, it may be necessary to amend our proposed definition.
Recommendations
6.8.2 Accordingly, the Committee recommends that a person who makes a settlement on a charitable trust not be liable for tax on the trustee income of the trust.
6.9 Beneficiary Income
6.9.1 As outlined in section 6.3, the receipts of a beneficiary of a trust arise from two sources:
a income derived by the beneficiary in the same income year as it is derived by the trustee, or paid to or applied for the benefit of the beneficiary within six months of the end of the income year. This is referred to as "beneficiary income"; and
b distributions of trustee income received by the beneficiary in an income year after the year in which it is derived by the trustee, or distributions from current or prior year gains of the trust that do not represent taxable income.
6.9.2 Beneficiary income, as noted in section 6.2, is currently defined as income derived by a trustee in any income year to which a beneficiary of the trust is entitled in possession in that year. In the light of the Committee's conclusion in section 6.2 that the specified/non-specified trust distinction should be dropped, we propose that beneficiary income be defined more widely as income derived by a trustee in any income year which:
a vests absolutely in interest in a beneficiary during the income year; or
b is paid or applied by the trustee to or for the benefit of the beneficiary during or within 6 months of the end of the income year
whether or not the beneficiary is an infant or is subject to any other legal incapacity.
6.9.3 This definition would remove the conditions that must be satisfied under current law in respect of specified trusts and infant beneficiaries and those of unsound mind. The effect would be to tax in beneficiaries' hands income that the current law attempts to tax to the trustee. We recommend, however, that trustees should continue to be liable for tax on beneficiary income as agents for the beneficiaries, as is now the case.
6.9.4 Where beneficiary income has been subject to tax in another jurisdiction in the hands of the trustee, the beneficiary (and the trustee as agent for the beneficiary) should receive a credit against the New Zealand income tax liability on the income for any foreign income or withholding tax paid by the trustee. In order that a disproportionate amount of the foreign tax paid by the trustee is not credited to a beneficiary, the credit allowed to the beneficiary should be equal to the proportion of the total foreign tax paid by the trustee that the beneficiary income bears to the total income derived by the trustee in that income year.
6.9.5 Where a trustee fails to meet an obligation for tax on beneficiary income and the beneficiary is a New Zealand resident, the liability will fall on the beneficiary. Where a beneficiary is a non-resident, the trustee will be liable, as agent of the beneficiary, for tax in New Zealand on beneficiary income only if that income has a New Zealand source. The rate of tax will depend on whether the income is ordinary income or non-resident withholding income. In either case, the settlor should have no liability for tax on beneficiary income.
6.9.6 The definition of a distribution needs to be wide enough to encompass indirect distributions to a resident beneficiary. For example, a taxable distribution paid through a tax-exempt or non-taxable third party who received the distribution from a trustee on the understanding that it was to be paid to or enjoyed by a beneficiary in a tax-free or lightly-taxed form should retain its character as a trust distribution. Other types of indirect distributions from a trustee include gifts, a loan, a release or abandonment of a debt and a disposition of property that purports to be a settlement on a non-qualifying or foreign trust for the benefit of the New Zealand resident or an associated person.
6.9.7 The enforcement of tax on such an extended definition of a trust distribution must rely to a large extent on disclosure. Failure by a beneficiary to disclose an indirect distribution would, however, constitute a failure to disclose assessable income and would be subject to the penalties applicable to tax evasion.
Recommendations
6.9.8 Accordingly, the Committee recommends that:
a the beneficiary income of a beneficiary of a trust be defined as income derived by the trustee of the trust in any income year which:
i vests absolutely in interest in a beneficiary during the income year; or
ii is paid or applied by the trustee to or for the benefit of the beneficiary during the income year or within 6 months of the end of the income year whether or not the beneficiary is an infant or is subject to any other legal incapacity;
b the credit allowed to a beneficiary of a trust in respect of tax paid by the trustee of the trust in any income year be equal to the proportion of the total tax paid by the trustee in that income year that the beneficiary income of the beneficiary bears to the total income derived by the trustee in that income year;
c the trustee of a trust continue to be liable for tax on beneficiary income as agent of the beneficiary; and
d the definition of a distribution encompass indirect distributions received from a trustee.
6.10 Distributions From Qualifying Trusts
6.10.1 As explained previously, the expression "taxable distribution" in relation to a trust refers to a distribution received by a beneficiary, other than beneficiary income, that we propose should be taxable. The taxation of trusts has never involved double taxation such as occurred under the classical system of company taxation. Where income has been taxed to the trustee and then distributed to a beneficiary, it has not constituted assessable income in the hands of the beneficiary.
6.10.2 Accordingly, we propose that distributions, other than beneficiary income, from qualifying trusts, which are trusts in respect of which the trustee income has been subject to tax in New Zealand in all income years since settlement of the trust, be non-assessable in the hands of beneficiaries. Thus, there would be no taxable distributions from a qualifying trust, other than distributions which represent beneficiary income.
Recommendation
6.10.3 Accordingly, the Committee recommends that all distributions from the trustee of a qualifying trust (other than beneficiary income) be non-assessable in the hands of resident beneficiaries.
6.11 Distributions From Foreign Trusts
6.11.1 "Foreign trust" is the term we have employed in our draft legislation to describe trusts settled by persons who at no time after 17 December 1987 have been residents of New Zealand. These trusts came within the definition of a non-resident trust in Part 1 of our report but the latter term is now superseded. Foreign trusts have no connection with New Zealand apart from the residence here of a potential beneficiary. We therefore concluded in our previous report that distributions of accumulated income from such trusts should be taxable in New Zealand with a credit for any foreign taxes paid by trustees but that distributions of capital profits and corpus should be exempt in the hands of beneficiaries.
6.11.2 As noted in section 6.9, the income of a resident beneficiary from a trust arise from two sources - beneficiary income and distributions of trust accumulations received by a beneficiary in an income year after the year in which it is derived by the trustee, or distributions from current year gains of the trust that do not represent taxable income. Beneficiary income in respect of a foreign trust should be taxable according to the provisions outlined in section 6.9.
6.11.3 It is generally believed that the present law does not tax distributions (as distinct from beneficiary income) from foreign trusts. For this reason, we propose that distributions from foreign trusts of trustee income derived by a trustee in income years commencing on or before 1 April 1987 should remain exempt. Distributions of trustee income of a foreign trust derived in income years commencing after 1 April 1987 should, however, be taxable to resident beneficiaries.
6.11.4 As proposed in our previous report, we recommend that distributions from a foreign trust of capital profits, whenever derived, or corpus should remain exempt. As is the case in the domestic context with respect to companies, when capital distributions are subject to more favourable tax treatment than income distributions, there is pressure to convert the latter to the former. An anti-avoidance rule is therefore necessary to prevent trustees generating contrived capital profits that could be channelled to New Zealand resident beneficiaries. Hence, we propose that a provision similar to that in section 4 relating to distributions of capital profits by companies be included to the effect that capital gains realised in transactions directly or indirectly with associated persons would be treated as a taxable distribution.
6.11.5 As we have indicated previously but, for clarity, note again, the income derived by a trustee in any income year will consist of taxable income (referred to in the draft legislation as "income") and non-taxable income (which is referred to as "capital gain" or "capital profit"). The taxable income will be either trustee income or, where it vests in or is paid or applied for the benefit of a beneficiary, beneficiary income. Thus, a distribution made to a beneficiary in any income year of income derived by the trustee in that year will be either beneficiary income or a non-assessable profit or gain. Distributions to beneficiaries of income derived in an earlier year will consist of either trustee income or capital profit or gain derived by the trustee in that year. To distinguish among these various sources, an ordering rule is necessary.
6.11.6 We propose that a distribution made to a beneficiary in any income year be deemed to be made first from the taxable income derived by the trustee in that year. Thus, to the extent that the taxable income of the trustee absorbed the distribution it would constitute beneficiary income of the beneficiary. Where distributions made in any income year exceeded the taxable income derived by the trustee in that year, the excess distribution should be deemed to be made first from any capital gains or profits derived by the trustee in that year. To the extent that a distribution in any income year exceeded both the taxable income and capital gain or profit derived by the trustee in that year, the excess should be deemed to be made from the trustee income of the trust derived in the previous income year not previously deemed to have been distributed pursuant to these rules. Any balance of the distribution exceeding the trustee income of the trust should be deemed to be made from any capital gain or profit derived by the trustee in that previous year not previously deemed to have been allocated, and so on. The last amount deemed to be distributed would be the corpus of the trust.
6.11.7 The corpus of a trust should be defined as any property settled on the trust by natural persons valued at its market value at the time of settlement. Corpus should, however, exclude:
a property settled directly or indirectly, whether by one transaction or a series of transactions, by a trustee of another trust;
b property that would have constituted assessable income of the settlor but for the fact that it is diverted to the trust; and
c property in respect of which a deduction can be claimed by the settlor in calculating his or her assessable income.
6.11.8 Where the ordering rule deems a distribution to be beneficiary income, it would be taxed to a resident beneficiary in the same way as beneficiary income derived from other trusts. The beneficiary would receive a credit for any foreign income or withholding tax or New Zealand income tax paid by the trustee on the income.
6.11.9 Distributions other than beneficiary income are derived either from untaxed income of the trustee derived in the same year as the year of the distribution or of such income or trustee income derived in earlier years. Whenever a beneficiary receives a distribution from trustee income of an earlier year, some deferral benefit is obtained. Because of this, we propose that where a distribution received by beneficiary is deemed to be made from trustee income derived by the trustee, no credit be given to a beneficiary for any tax paid by a trustee on the income. We do, however, propose that withholding taxes should be creditable. The amount of the withholding credit should be the proportion of withholding tax paid in respect of the distribution that the taxable distribution bears to the total distribution received by the beneficiary.
6.11.10 Whether a distribution is deemed to be beneficiary income or a taxable distribution, it should be taxed at the marginal tax rate of the beneficiary.
6.11.11 The ordering rule outlined above would require the trustee on behalf of the beneficiary to determine the deemed source of all of the distributions made to any beneficiaries, not just those resident in New Zealand. A beneficiary should be required to provide sufficient information with a return of income to establish that the appropriate portion of a distribution has been included as assessable income and to establish the basis upon which any credit for foreign tax has been allocated. Where this information cannot be provided or is insufficient, all of the distribution should be taxable in the hands of the beneficiary.
Recommendations
6.11.12 Accordingly, the Committee recommends that, with effect from 1 April 1988:
a distributions from a foreign trust be taxable to a resident beneficiary to the extent that they are made out of trustee income derived in any income year commencing after 1 April 1988 but all other distributions from a foreign trust, other than beneficiary income, be exempt;
b distributions from a foreign trust be deemed to be made first from the most recent income year of the trustee and, with respect to any income year, first, from taxable income derived by the trustee in that income year and, secondly, from non-taxable gains derived in that year;
c distributions of capital profits realised in transactions directly or indirectly with associated persons be treated as taxable distributions;
d corpus be defined as any property settled on a trust by natural persons valued at its market value at the time of settlement other than:
i property settled directly or indirectly, whether by one transaction or a series of transactions, by a trustee of another trust;
ii property that would have constituted assessable income of the settlor but for the fact that it is diverted to the trust; and
iii property in respect of which a deduction can be claimed by the settlor in calculating his or her assessable income;
e where a distribution is deemed to be a taxable distribution other than beneficiary income, a credit for any foreign withholding tax be permitted such that the withholding credit does not exceed the proportion of the total withholding tax paid that the taxable distribution makes up of the total distribution; and
f the rate of tax applying to distributions from foreign trusts be the marginal tax rate of the recipient.
6.12 Distribution From Trusts Settled by New Residents
6.12.1 In section 6.7, we referred to a person who becomes resident in New Zealand after 17 December 1987 who had not previously been resident here after that date as a "new resident". We recommended that such a person should not be liable for tax on the trustee income of any trust settled before he or she became resident. This does not affect the liability of the trustee - the trustee is liable for tax on all of the trustee income of the trust, wherever it is derived, from the time at which the settlor becomes resident.
6.12.2 A trust settled by a new resident before he or she becomes resident has the status of a foreign trust. We propose that distributions from such a trust which are attributable to income years prior to the person becoming resident should continue to be treated as distributions from a foreign trust. The provisions for attributing distributions to particular sources were outlined in the previous section.
6.12.3 Once the new resident settlor becomes resident, the trustee of the trust will be liable for tax in New Zealand on the foreign- and New Zealand-source trustee income of the trust derived in or after the income year in which the settlor becomes resident. The settlor could also elect to be liable for tax on such income, pursuant to recommendation c in paragraph 6.5.10. Provided that the liability for tax on trustee income is met by either the trustee or the settlor in every income year after the settlor becomes resident, distributions from the trust attributable to those income years should be treated as distributions from a qualifying trust.
Recommendation
6.12.4 Accordingly, the Committee recommends that where a trust is settled by a new resident before the person becomes resident in New Zealand and the trustee or the settlor of the trust meets the New Zealand tax liability for tax on the foreign- and New Zealand-source trustee income of the trust in every income year after the settlor becomes resident:
a distributions from the trust which are attributed to income years ending before the settlor becomes resident be treated as distributions from a foreign trust; and
b distributions from the trust attributed to income years ending after the settlor becomes resident be treated as distributions from a qualifying trust.
6.13 Non-Qualifying Distributions
6.13.1 By "non-qualifying distributions", we mean distributions, other than beneficiary income, that are not distributions from either qualifying trusts or foreign trusts. In general, these are distributions from trusts in respect of which trustee income has not been subject to New Zealand tax in all years subsequent to their establishment but that have had a settlor who is or was a New Zealand resident at any time subsequent to 17 December 1987. For example, the settlor of the trust may in some years be resident in New Zealand and in other years not. In addition, distributions from a trust settled by a resident on a non-resident trustee before 17 December 1987 would be non-qualifying distributions unless the trust is converted to a qualifying trust pursuant to the recommendations outlined in chapter 8. Similarly, those from a testamentary trust (or an inter-vivos trust following the death of a resident settlor) in relation to which the trustee does not elect to be subject to tax in New Zealand on the foreign-source trustee income of the trust would be non-qualifying distributions.
6.13.2 In your press statement with the Minister of Revenue that accompanied our first report, you indicated that all distributions after 1 April 1988, except distributions of corpus, from trusts that had been settled by New Zealand residents but that do not come within the settlor regime would be taxable. In the terminology we have now adopted, a trust which comes within the settlor regime would be a qualifying trust. Accordingly, we propose that all non-qualifying distributions (other than beneficiary income) received by New Zealand residents be taxable with the exception of distributions of the corpus of the trust.
6.13.3 You also proposed that such distributions should be taxable with an interest charge to offset the benefit to the recipient of the deferral of tax. As explained further in chapter 8, we consider that an interest charge would be unduly complex if it were to be other than arbitrary. As a simpler alternative, we propose that the deferral advantage enjoyed by a beneficiary in relation to a non-qualifying distribution be reduced by taxing such distributions at a higher rate. We recommend that the rate be 45 percent. For comparison with the effect of an interest charge, this rate would result in a tax impost on a distribution that would equate with the tax that would be payable if the distribution were assumed to be income derived by the trustee over a period of five years immediately preceding its receipt by the beneficiary and interest were charged on the outstanding tax at a compound rate of 16 percent.
6.13.4 In addition, we propose that a credit should be permitted for foreign withholding taxes paid on non-qualifying distributions but not for income taxes paid by the trustee. The amount of withholding tax allowed as a credit should be the proportion of the total withholding tax paid on the distribution that the taxable distribution (which would be the entire amount of the distribution other than that part deemed to be corpus according to the ordering rule outlined in section 6.11) bears to the total distribution received by the beneficiary.
6.13.5 In order that fictional distributions are not counted, such as settlements of sub-trusts, distributions of trust accumulations by a trustee to another trust or distributions over which the trustee retains control should be deemed not to have been made for the purposes of applying the ordering rule. Where a beneficiary cannot provide satisfactory records to support the allocation of a portion of a distribution to corpus in accordance with the procedures set out in the previous paragraph, all of the distribution should be treated as a taxable distribution.
6.13.6 Non-qualifying distributions would also arise where the trustee or a new resident settlor of a trust settled before the settlor became resident here does not meet the New Zealand tax liability on the trustee income of the trust in respect of income years after the settlor becomes resident. All of the distributions of the trust, other than beneficiary income, would be treated as non-qualifying distributions.
Recommendations
6.13.7 Accordingly, the Committee recommends that:
a distributions from a trust which are not distributions from a qualifying trust or a foreign trust ("non-qualifying distributions"), other than such distributions which are beneficiary income or distributions of corpus, be taxable at a rate of 45 percent;
b non-qualifying distributions be deemed to be made first from sources other than corpus; and
c a credit be permitted for foreign withholding tax paid on a non-qualifying distribution but not for any income tax paid by the trustee.
6.14 Financial Assistance to Trusts
6.14.1 In our previous report, we proposed that a resident settlor of a trust settled before 17 December 1987 who did not elect to be subject to tax on trustee income should be liable for tax on income that would be deemed to be derived in respect of any financial assistance the settlor had provided to the trustee of the trust. This was proposed as a quid pro quo for not being liable for tax on the trustee income. The same argument applies wherever a settlor of a trust is resident here but the trust is such that distributions from it would be non-qualifying distributions. This would be the case, for example, if a settlor or trustee of a trust settled after 17 December failed to meet the New Zealand tax liability on the trustee income of the trust. Similarly, it would be the case where a new resident settlor failed to meet the obligation to pay tax on the trustee income of a trust settled before the person became resident here.
6.14.2 Accordingly, we propose that, where a distribution from a trust would be a non-qualifying distribution and:
a a resident settlor of the trust has a loan outstanding to the trustee and the rate of interest is less than the prescribed interest rate applying for fringe benefit tax purposes, the settlor should be assessed on interest on the loan outstanding computed at that rate. To avoid double-counting, any interest actually assessed to the settlor in respect of the loan should be deducted from the amount of deemed interest; or
b a resident settlor has a form of financial assistance, other than a loan, outstanding to the trustee of the trust, such as a guarantee, the settlor should be assessed annually on an amount equal to the consideration that would have been payable in an arms length transaction, less any consideration returned as assessable income of the settlor.
Recommendation
6.14.3 Accordingly, the Committee recommends that, where a distribution from a trust would be a non-qualifying distribution and:
a a resident settlor of the trust has a loan outstanding to the trustee and the rate of interest is less than the prescribed interest rate applying for fringe benefit tax purposes, the settlor be assessed on interest on the loan outstanding computed at that rate, less any interest actually assessed to the settlor in respect of the loan; or
b a resident settlor has a form of financial assistance, other than a loan, outstanding to the trustee of the trust, such as a guarantee, the settlor be assessed annually on an amount equal to the consideration that would have been payable in an arms length transaction, less any consideration returned as assessable income of the settlor.
6.15 Residence of a Beneficiary
6.15.1 One of the consequences of a sharp distinction between taxable and exempt distributions is that, where an otherwise taxable distribution is large enough, there would be an incentive for the intended recipient beneficiary to become a non-resident in order to receive the distribution. The Committee's proposed changes to the definition of residence of a natural person would make it considerably more difficult for a resident to cease to be resident. Nevertheless, we consider that a further provision is needed to the effect that, where a resident ceases to be a resident and within 5 years again becomes a resident, any taxable distributions received by the person during the period in which he or she was a non-resident from a trust, other than a qualifying trust, should be assessable in the income year in which the person commences to be resident again.
Recommendation
6.15.2 The Committee therefore recommends that where a resident ceases to be a resident and within 5 years again becomes a resident, any taxable distributions received by the person during the period in which he or she was not a resident, other than distributions from a qualifying trust, be assessable in the income year in which the person commences to be resident.