Annex 4 – Trust Regime
1 Introduction
2 Residence and Taxpayer
3 Future Settlements
4 Existing Settlements
5 Distributions
6 Extinguishment of a Settlor
7 Relationship Between Proposed Regime and Existing Law
1 Introduction
1.1 A trust is created whenever a settlor transfers property to trustees to be held for the benefit of beneficiaries. Strictly speaking, a further settlement on the same trustees for the same beneficiaries upon the same trust provisions creates a new trust. For the sake of clarity, however, the individual transfers will be referred to in this annex as "settlements" and the collection of settlements made on the same terms as a "trust".
1.2 Trust income which vests in or is distributed to beneficiaries is termed "beneficiaries' income". By "trust income" we mean income which is not vested or distributed and therefore belongs to beneficiaries, defined or undefined, whose interests will crystallise only in the future.
1.3 Though there is no present beneficiary in whose hands trust income can feasibly be taxed, the objective of the international tax reforms require that the income be taxed on an annual basis. The issues are therefore:
a when should trust income be subject to New Zealand tax; and
b who should bear the liability for the tax?
2 Residence and Taxpayer
2.1 For individuals and companies, the first question is answered in terms of residence and source. The international regime extends this basic structure by attributing to New Zealand resident shareholders a share of the taxable income (including non-New Zealand source income) derived by non-resident companies.
2.2 In the Committee's view, the taxation of trusts should follow that of individuals and companies by developing rules for the residence of trusts.
2.3 Determination of residence defines the income to be taxed (worldwide income or source income). A closely related but separate issue is the identification of the taxpayer. It is desirable for practical and philosophical reasons that, wherever possible, the recipient of the income should be the taxpayer. If this is not possible, the residence of the taxpayer and the income recipient should be the same, since residence is a key criterion for determining the amount of income which is taxable. Failing that, for enforcement reasons, the taxpayer must be a person who is resident.
2.4 The only candidates for payers of tax on trust income are the trustees and the settlor. There is a good case for levying tax on the trustees: they are the legal owners of the income, they have the power of disposition over it and therefore the ability to pay tax from trust funds. The settlor has none of these and ordinarily could not oblige the trustees to meet what would be his or her own tax liability. In fact, the trustees would be in breach of trust if they did so. The best source of tax on trust income is therefore the trustees.
2.5 There are obvious difficulties in determining the residence of trusts by reference to the residence of the trustees. Individual trustees may be resident in a number of countries and it is easy to change the trustees of a trust. This would make residence ephemeral.
2.6 It would be possible, by analogy with companies, to determine residence by a concept such as "centre of administration and control". Where more than one such centre existed, a tie-breaker test or dual/multiple residence rules would be required. Such provisions would, however, be difficult for New Zealand to implement unilaterally in respect of trusts with centres of administration and control outside New Zealand. In addition, this approach would not satisfy the requirement of the international regime to tax foreign-source trust income where the origin of the trust and/or its corpus goes back to New Zealand.
2.7 An alternative approach would be to look for an ownership analogy with companies. Corporate structures provide a nexus of ownership between the offshore corporate income and New Zealand resident shareholders sufficient to justify taxing those shareholders on such income, provided that they have a power of disposition over the income or over systematic gains which are a reasonable surrogate for it.
2.8 The point of trusts, however, is that the ownership nexus is severed, except to the extent that the settlor retains a claim over the settled property in the form of outstanding debt. A nexus does, however, exist in the form of the influence or control which the settlor exercises through the establishment of the trust terms and, in some cases, through the power of the settlor to appoint or replace trustees. In the context of anti-avoidance legislation, this more tenuous nexus could be regarded as sufficient to justify determining the residence of a trust by the residence of the settlor.
2.9 Since no other definition of residence is feasible as a basis for taxing trust income, including foreign-source income, we propose that trustees should be liable for tax on trust income on the basis of residence as determined by the residence of the settlor.
3 Future Settlements
3.1 There are considerable legal difficulties in applying new rules to existing settlements. These are dealt with in section 4 below. New rules can, however, be applied immediately to settlements made on or after 17 December 1987, the date of release of the CD.
3.2 Trustees in a foreign jurisdiction may or may not accept that their trust is a New Zealand resident. It is expected that the majority will do so, and will therefore pay tax on trust income at the greater of the foreign or the New Zealand rate. Should any default occur, it is necessary to provide that any New Zealand settlor will be deemed to be the agent of the trustees and be assessable and liable for tax accordingly. This is not unduly harsh given the fact that the settlor will know the rules at the time of making the settlement and could require an indemnity from the trustees for tax liabilities.
3.3 For these purposes, "settlor" will need to be widely defined as any person who has, directly or indirectly, caused an increment in wealth of the trust by the transfer to it of money, goods, services of other benefits at less than arms-length prices. Where there is more than one resident settlor, the settlors should be jointly and severally liable. Where residents and non-residents make settlements on the same trust, residents will be treated as having made all settlements on the trust. This rule is necessary to avoid the need for complicated apportionment rules. It is not disadvantageous because residents and non-residents can make settlements on separate trusts.
3.4 In summary, we propose that the rules for future settlements be as follows:
a "settlor" be defined as any person who provides money, goods, services or other benefit to a trust for inadequate consideration, and "settlement" be defined accordingly;
b a trust, being all settlements made on or after 17 December 1987 by a resident settlor subject to the same trust provisions, be resident in New Zealand if and as long as any settlor of the trust is resident in New Zealand;
c settlors be required to make disclosure, within a set period, of any settlements as defined;
d New Zealand resident trusts be taxable in New Zealand on worldwide trust income;
e the trustees of a resident trust be liable for tax at the domestic trustee rate as if the trustees were one individual beneficially entitled to the income and be entitled to a credit for any foreign tax paid, but not entitled to tax rebates or income support measures;
f to the extent that any resident trust fails to meet its tax liabilities, the New Zealand settlor be liable for the tax as agent of the trustee or, where there is more than one resident settlor, they be jointly and severally liable.
4 Existing Settlements
4.1 If the above rules were applied to existing settlements, they could be unduly harsh because in many jurisdictions a settlor has no way of changing his or her status as a settlor and has no legal access to trust funds from which to pay the tax. Resident shareholders disadvantaged by the new international regime for companies at least have the option of selling their shares. The only way out for a disadvantaged settlor would be to emigrate from New Zealand. The Committee has therefore proposed a transition for trusts which recognises these legal constraints.
5 Distributions
5.1 Under the proposed rules for future settlements, trustees and settlors will taxed on income which will eventually accrue to beneficiaries. At present, individuals who derive foreign income are entitled to credits for foreign tax paid on the income and, in the absence of the general taxation of capital gains in New Zealand, they are not taxed on capital gains. It is proposed to carry these principles through to the tax treatment of distributions from trusts settled after 17 December 1987.
5.2 Distributions to New Zealand resident beneficiaries, excluding capital, capital gains, and distributions from assessable income which has already borne New Zealand income tax would be taxed in the hands of those beneficiaries, with a credit for foreign tax paid on the income. For tax purposes, such distributions should be deemed to be made pro-rata from all sources within each income year, and on a last in first out ("LIFO") basis from year to year.
6 Extinguishment of a Settlor
6.1 As the trust regime proposed by the Committee has as its basis the residence of the settlor, it is necessary to have rules to determine the residence of the trust on the extinguishment of the settlor. The Committee proposes that, on the death of an individual settlor of a trust, whether inter vivos or testamentary, the future residence of the trust should be determined by the residence of the settlor at death.
6.2 Where a trust is a sub-trust that has itself been settled by a trust, or where a trust has been settled by a company, the settlor of the trust which settled the sub-trust, or the shareholders of the company, as the case may be, will be deemed to be settlors of the first-mentioned trust. Thus, in the Committee's view: :
a on the winding up or extinguishment of a trust which has settled a sub-trust, the residence of the settlor of the trust should determine the future residence of the sub-trust;
b on the winding up, liquidation, or extinguishment of a company settlor, the residence of the shareholders of the company at the date of settlement should determine the future residence of the trust.
6.3 These rules follow the principle that the residence of a trust should be traced back to the residence of the original settlor. With respect to rules (a) and (b) above, the settling of a trust through another trust or through a company should be treated as being equivalent to an indirect settlement by the settlor of the first trust or by the shareholders of the company.
6.4 The Committee are considering whether, for these purposes, the best test of the residence of a trust is the domicile rather than the residence of the extinguished settlor.
7. Relationship Between Proposed Regime and Existing Law
7.1 The Committee intends to review the relationship between this proposed trust regime and the present law governing existing trusts and will comment further in its next report.