Chapter 5 – Trusts

5.1 Introduction
5.2 Trust Income
5.3 Distributions From Resident Trusts
5.4 Distributions From Non-resident Trusts

5.1 Introduction

5.1.1 In this chapter we comment on the future regime for trusts (which also has implications for existing trusts). By existing trusts, we mean settlements made before 17 December 1987. The treatment of these trusts, and the transition to the proposed new regime, is dealt with in chapter 7.

5.2. Trust Income

5.2.1 The international tax reforms cannot be fully effective unless there is a regime to apply to trusts since, in many cases, a trust can substitute for a company. The CD treats "foreign trusts" (i.e. those with non-resident trustees) in a similar manner to foreign companies. Since there is no resident trustee and the beneficiaries may not be identified, the CD proposes that resident settlors be liable for tax on trustee's income. This approach ignores the legal relationships between a settlor and a trustee since the former has no right to the income of the trust. Indeed, the whole point of a trust is to ensure that property and the income it produces is legally divested by a settlor. In reality, however, a settlor often has substantial influence over the trustee, usually on an informal basis though there may be specific provision in the trust deed and, in practice if not in law, may be able to wind up the trust and take back the property. Thus, the economic substance of a trust may differ from its legal appearance.

5.2.2 In order to meet the objectives of the international reforms, trust income derived by non-resident trustees of trusts settled by New Zealand residents must be taxed each year as it is earned. Ignoring enforcement problems, the best course would be to tax the income in the hands of the trustee as if he or she were a resident. Where the trustee did not comply, there would be little alternative but to tax the resident settlor since there may be no identifiable resident beneficiaries. In the first instance, however, the legal liability for the tax should be placed on the trustee. This could be achieved by defining trusts with resident settlors to be New Zealand residents for tax purposes. The trust would then be liable for New Zealand tax on its foreign- and New Zealand- source income in the same way as other residents. Where a non-resident trustee defaulted on the liability, the resident settlor would be liable as the agent of the trustee. It would be necessary to define a trust settlement widely to include settlements made indirectly through nominees or associates and all dispositions of property to a trust made for less than full consideration.

5.2.3 The Committee therefore supports the basic approach of the CD. This closely follows the grantor trust provisions in the United States. This regime would, however, be unjustifiably severe if it applied to all existing trusts since settlors will usually be unable to alter their settlor status and, furthermore, distribution requirements and trustees' powers are comparatively inflexible. Hence, we recommend more generous transitional provisions for trusts than for companies.

5.2.4 The concept of the residence of a trust could also apply to existing trusts. As with future trusts, residence would be determined by the residence of the settlor. Where there was:

a a resident settlor and a resident trustee, the trustee would be liable for tax on trust income, whether sourced in New Zealand or elsewhere, as at present;

b a resident settlor and a non-resident trustee, the trustee would be liable for tax on trust income, as in (a), but in the event of default, the settlor would be liable;

c no resident settlor but a resident trustee, the trustee would be liable for tax on the trust's New Zealand-source income as would be the case with any other non-resident. If, however, the trust had no New Zealand-source income, the trustee would have no New Zealand tax liability.

5.2.5 One consequence of this approach would be that New Zealand would not tax the foreign-source trust income of a resident who was the trustee of a trust with a non-resident settlor. In our view, this is the appropriate treatment since such income has no definite connection with New Zealand apart from the existence here of the trust administrator (who will, however, have no beneficial interest in the income). Beneficiaries may be resident here, but their interests do not materialise until there is a distribution or vesting. This makes it infeasible to tax beneficiaries on trust income. Resident beneficiaries should, however, be taxed on any trust income which is distributed to or vested in them, as discussed in the next subsection. This leaves only the resident trustee to tax but, if that were done, he or she would of course resign in favour of a non-resident trustee. Thus, we believe there is little to be gained from attempting to tax foreign-source income derived by resident trustees of non-resident trusts.

5.2.6 The adoption of this trust residence rule would remove some ambiguities in the taxation of existing trusts. There may be other consequential changes to the current treatment of trusts that will need to be addressed when the Committee considers the draft legislation dealing with trusts.

5.3 Distributions From Resident Trusts

5.3.1 Distributions to beneficiaries from resident trusts (as defined in the previous section) made out of trust income (i.e. income which has been taxed as assessable income in the hands of the trustee or the resident settlor) should be exempt from tax since they will have already borne the appropriate amount of New Zealand tax.

5.3.2 Where a distribution from a resident trust is not made out of trust income, it should continue to be assessable or exempt to the beneficiary as under the present rules, except in the situation dealt with in paragraph 7.2.4.

5.4 Distributions From Non-Resident Trusts

5.4.1 There are deficiencies in the present tax treatment of trust distributions received by resident beneficiaries from non-resident trusts (i.e those with no resident settlor). Case law supports the view that if trust income has been taxed in the hands of the non-resident trustee, it is not assessable a second time in the hands of the beneficiary. If, however, the trustee has not paid tax on that income, the treatment of the distribution in the hands of the beneficiary is unclear.

5.4.2 This unsatisfactory ambiguity should be resolved by amending the law to make it clear that resident beneficiaries will be assessable on all income distributions received from non-resident trusts. A credit should be given for any foreign or New Zealand tax paid by the trustee on the income out of which the distribution is made. This would necessitate the trustee keeping records of the income of the trust and the tax paid, but the onus for establishing that a credit should be given can be placed on the beneficiary.

5.4.3 The trust regime should mirror the taxation of individuals since individuals are ultimately the beneficiaries of trust income. Since capital gains will normally be exempt in the hands of resident individuals, capital profits, as defined in New Zealand tax terms, distributed to beneficiaries should also be exempt in their hands. Similarly, a distribution of the corpus (i.e. the original capital settled plus all additional settlements) of the trust should not be assessable to a beneficiary.

5.4.4 Further elaboration of the Committee's views on trusts is contained in Annex 4. Our recommendations on transitional provisions relating to existing trusts are outlined in chapter 7.

Recommendation

5.4.5 The Committee recommends that, in respect of future trust settlements:

a a settlor be widely defined as any person who directly or indirectly provides money, goods, services or other benefits to a trust for inadequate consideration;

b a trust be treated as a resident of New Zealand for income tax purposes if the settlor of the trust is a New Zealand resident;

c the trustee of a resident trust be primarily liable for tax on trust income but, in the event of the trustee defaulting on such a liability, the settlor be liable as agent of the trustee;

d distributions of trust income (i.e. income which has been taxed in the hands of the trustee or the resident settlor) to a beneficiary from a resident trust be exempt from tax in the beneficiary's hands;

e all distributions of income to a beneficiary from a non-resident trust be taxable in the hands of the beneficiary, but the beneficiary be allowed a credit for any foreign or New Zealand tax paid by the trustee; and

f distributions of capital profits as defined in New Zealand tax terms or the corpus to a resident beneficiary from a non-resident trust be exempt from tax in the hands of the beneficiary.