Chapter 8 – Transition
8.1 Introduction
8.2 BE Regime Transition
8.3 Trust Transition
8.1 Introduction
8.1.1 The transitional provisions applying to the international reforms were largely decided in response to Part 1 of our report. We propose one additional provision with respect to the BE regime and comment further on the trust transition where you reserved your decision. These issues are dealt with in this chapter.
8.1.2 No transitional provisions are to apply to the FIF regime which came into effect on 1 April 1988. This means that residents with interests in a FIF on 1 April 1988 will need to establish the market value of their interests on that date.
8.2 BE Regime Transition
8.2.1 The transitional arrangements approved for the BE regime provide that:
a taxpayers will be exempt from the regime for a two year period (i.e. until 1 April 1990) in respect of income interests acquired on or before 17 December 1987 in CFCs which are not resident in a transitional list of specified low tax jurisdictions; and
b taxpayers will be exempt from the regime for a one year period (i.e. until 1 April 1989) with respect to income interests which were acquired after 17 December 1987 in CFCs which are resident in a grey list country.
It is possible for a company to have no fiscal residence. Consequently, in order to establish that a CFC is not resident in a country on the transitional list, it is necessary to require taxpayers to establish that the CFC is resident in a country not on the list.
8.2.2 One of the consequences of the BE regime is that, where any provision of the tax law of the country of residence of a CFC has the effect of reducing the income tax it pays in that country, the tax credit allowed to New Zealand residents will also be reduced, thereby increasing the amount of New Zealand tax payable. This is the intended result since a central objective of the regime is to levy New Zealand tax on income which has borne less tax than would be levied under New Zealand law. Tax losses of a CFC, incurred in a past income year or by another company in the same group, which are available under the tax law of its country of residence for offset against its current year income, are an example of such a provision.
8.2.3 Many submissions argued that the benefit of past tax losses in particular (i.e. those incurred by a foreign company before it becomes a CFC or before the BE regime applies to it) should not be "clawed back" under the BE regime. In the Committee's view, it is difficult to distinguish the effect of a CFC's past tax losses from the effect of other provisions of the tax law of its country of residence. If the BE regime were never to offset the effect of a tax benefit available to a CFC, it would be necessary to define BE income as the taxable income of the CFC measured according to the law of its country of residence. The BE regime would then have an impact only where another country had a company tax rate lower than New Zealand's. Thus, we consider that no special provision should be included to preserve the effect of past tax losses of a CFC. Once the BE regime applies in respect of a CFC, attributed losses will be able to be carried forward by resident taxpayers so that it is not necessary to adjust the BE income for tax losses carried forward by a CFC. The attribution of BE losses to New Zealand resident taxpayers is explained in chapter 4.
8.2.4 While residents can take these considerations into account in making future investment decisions, they cannot do so in respect of existing investments except by disposing of them. We therefore propose an additional transitional measure to the ones proposed in Part 1 of our report. We propose that taxpayers with income interests held on 17 December 1987 in CFCs resident in a country other than those on the transitional list should be able to elect to bring those interests within the BE regime for the accounting years of such CFCs falling (in whole or in part) during the period commencing on 1 April 1988 and ending on 31 March 1990. Taxpayers should not, however, be able to bring in only losses and not profits. The election should therefore be available only if a taxpayer chooses to bring in all of his or her interests held on 17 December 1987 that would give rise to attributed income or losses under the BE regime from 1 April 1990.
8.2.5 The election should be made by taxpayers in their 1991 income year return. The aggregate attributed loss of the taxpayer for the period from 1 April 1988 to 1 April 1990 would be brought to account in the 1991 income year. The measure should not, however, enable taxpayers to increase an attributed loss over what it would have been in the absence of this transitional provision. For the purposes of calculating the attributed loss of a taxpayer in each of the transitional years, the taxpayer's income interest on any measurement day should be taken as the lesser of his or her income interest on that day and the income interest held at 17 December 1987. Any attributed income in one of those years should, however, be calculated according to the rules set out in chapters 3 and 4.
Recommendations
8.2.6 Accordingly, the Committee recommends that:
a taxpayers be entitled to elect, in respect of all of their income interests held on 17 December 1987 in all CFCs resident in countries other than those on the transitional list, to apply the BE regime for the accounting years of such CFCs falling in whole or in part during the period 1 April 1988 to 31 March 1990; and
b for the purposes of calculating the attributed loss of a taxpayer in respect of each such CFC in the transitional period, the taxpayer's income interest on any measurement day be taken as the lesser of the taxpayer's income interest on that day and the income interest he or she held at 17 December 1987.
8.3 Trust Transition
8.3.1 As outlined in chapter 6, residents who settle a trust on or before 17 December 1987 are not to be liable for tax on the trustee income of the trust as agent of the trustee. This does not affect the trustee's liability - the trustee, whether resident or not, will be liable for tax on trustee income in any income year in which there is a settlor resident in New Zealand. Where a settlement is made after 17 December 1987, the settlor will not be liable as agent of the trustee if the trustee is a resident natural person or trustee company.
8.3.2 While residents who settled trusts on or before 17 December 1987 are to be relieved of liability as a settlor, an alternative transitional arrangement is to apply to them. This was one of the areas in the Committee's first report where you reserved your decision. The Committee recommended that, in respect of settlements by residents on non-resident trustees in existence on 17 December 1987, distributions of income made on or before 31 March 1989 should be subject to a final tax at a rate of 10 percent and distributions of capital profits and corpus should be non-assessable provided that either the trust is wound up on or before that date or the settlor elects to be subject to the settlor regime from that date (i.e. the settlor elects to be liable for tax on the trustee income of the trust). In the terminology of this report and the draft legislation, the settlor regime means the qualifying trust regime.
8.3.3 We recommended that, if neither of these options were taken up and:
a the settlement was not a testamentary settlement:
i all distributions, whether of income or capital (other than the corpus of the trust) should be assessable, with an interest charge calculated from 1 April 1988, with the beneficiary receiving a credit for 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;
b the settlement was by will or as a result of intestacy;
i distributions of capital profits made after 31 March 1989 should continue to be non-assessable in the hands of beneficiaries; and
ii distributions of income be assessable subject to an interest charge calculated from 1 April 1988.
8.3.4 In response to these recommendations, you announced in your press statement with the Minister of Revenue that:
"At this stage, the Government considers that from 1 April 1989 resident trusts [i.e. those with resident settlors] should be taxed according to the settlor regime, except where the settlor can demonstrate that there is manifest good reason for such an exception and it can be shown that either the trust is subject to tax in a high tax jurisdiction or the imposition of the settlor regime would cause undue hardship to the settlor."
8.3.5 The main problem with this approach is the administrative burden such a discretion would place on the Inland Revenue Department. Most settlors would be expected to apply for the exemption and the Department would need to decide in each case whether there was "manifest good reason" and either undue hardship or that a trust was subject to tax in a high tax jurisdiction. It is difficult to decide what criteria could be used to establish "manifest good reason". A trustee of a trust would no doubt verify that a settlor who was not a beneficiary had no right to the income or assets of the trust, since this is the legal position. The undue hardship test does not add to the general discretion of the Commissioner to waive tax in the case of hardship. The substantive operative test would therefore be whether the trustee was subject to tax in a high tax jurisdiction.
8.3.6 Though this is a feasible test, it would bring within the regime settlors who have no way of altering their settlor status and who could therefore suffer a considerable additional tax liability which could not have been anticipated. Our proposed transition aimed to avoid this outcome.
8.3.7 To offset partially the deferral advantage of remaining outside the settlor regime, we proposed that distributions from a pre-17 December 1987 settlement should be subject to an interest charge in the hands of resident beneficiaries. Interest would be charged from the later of the 1988 income year or the year in which the income distributed was derived. The notional tax that would have been paid on the distributed income in the year that the income was derived would then be computed and carried forward at a prescribed interest rate to the year in which the distribution was made. An interest charge would therefore be complicated in practice, especially when the principal purpose of the provision is to encourage such trusts to either wind up or come within the qualifying trust regime. A simpler incentive should suffice.
8.3.8 A trust that was settled by a resident on or before 17 December 1987 would be a qualifying trust only if the trustee had paid New Zealand income tax on the foreign- and New Zealand-source trustee income of the trust in every income year since its settlement. This would generally not be the case if the trust earned foreign-source income and had no resident trustees. If there is a resident trustee, then tax would generally have been paid on all of the trustee income of the trust.
8.3.9 As outlined in chapter 6, where a trust settled by a resident on or before 17 December 1987 is not a qualifying trust, we propose that all distributions from the trust, other than distributions of corpus, should be assessable at a rate of 45 percent and no credit should be given for any tax paid by the trustee other than withholding tax. We also proposed in chapter 6 that a resident settlor of such a trust should be assessed on income deemed to be derived in respect of any financial assistance outstanding to the trustee. We consider that the treatment of distributions from pre-17 December 1987 settlements by residents as non-qualifying distributions and the taxation of income deemed to be earned on any financial assistance given to the trustee adequately offsets the advantage that the persons connected with the trust derive by virtue of its trustee income not being subject to tax in New Zealand.
8.3.10 Nevertheless, the thrust of our previous recommendations was that the transitional measures should encourage the wind up of trusts settled on or before 17 December 1987. To this end, you agreed that distributions (other than distributions of capital profits or corpus) from trusts that were settled on or before 17 December 1987 are to be subject to a final tax at a rate of 10 percent provided that all of the property of the trust is distributed before 1 April 1989. Such distributions are therefore not to be included in the assessable income of the recipient. The definition of corpus for this purpose was discussed in section 6.11.
8.3.11 In addition, a beneficiary, settlor or trustee of a trust that was settled on or before 17 December 1987 is to have the option of converting the trust into a qualifying trust. In our previous report, we recommended that the conversion should be effected by the settlor electing to be liable for tax on the trustee income of the trust. We have, however, recommended in this report that all distributions from a qualifying trust should be non-assessable. A trust could therefore be converted to a qualifying trust and then wound up free of tax. This would not be consistent with the treatment outlined in the previous paragraph for trusts that wind up before 1 April 1989.
8.3.12 Accordingly, for greater consistency but also to encourage the wind up of trusts rather than their conversion to qualifying trusts, we propose that, in order for a trust to become a qualifying trust, a 10 percent tax should apply to the value of the net assets of the trust as at 31 March 1988. New Zealand income tax would then be deemed to have been paid on the trustee income of the trust in the income years ending before 31 March 1988. Where the value of the net assets of a trust exceed its corpus and any capital profits, this provision would result in a heavier tax impost than would be the case if the trust were wound up before 31 March 1989. We consider that this is appropriate so that there is a bias towards wind up. Since the relevant legislation will not be passed until later this year, we recommend that the last date for payment of the 10 percent tax be 7 February 1989.
8.3.13 Our proposals duplicate to some extent decisions that were made in response to our earlier report but, for the sake of completeness, we gather them together in the following recommendation.
Recommendation
8.3.14 Accordingly, the Committee recommends that:
a where a trust has been settled on or before 17 December 1987, distributions from the trust, other than distributions of capital profits or corpus, be subject to a final tax in the hands of the beneficiary at a rate of 10 percent and distributions of capital profits and corpus be non-assessable provided that all of the property of the trust is distributed before 1 April 1989; and
b where a trust settled on or before 17 December 1987 is not a qualifying trust or a foreign trust and a beneficiary, settlor or trustee of the trust pays to the Commissioner no later than 7 February 1989 an amount equal to 10 percent of the net assets of the trust as at 31 March 1988, New Zealand income tax be deemed to have been paid on the trustee income of the trust in prior income years.