International Trust Regime
Geoffrey Clews, Barrister
1. The Settlor Regime
1.1 The key element of New Zealand’s tax laws relating to international trusts is the so-called settlor regime. This imposes a tax liability in this country on any New Zealand resident who has settled property on a trust outside the jurisdiction when there is no trustee of that trust resident in this country and prepared to accept a liability in this country for the income of the trust. Just as the Controlled Foreign Company regime attributes an overseas company’s income to controlling New Zealand shareholders, the international trust regime attributes an offshore trust’s worldwide income to any New Zealand resident settlor of that trust unless another party has elected for the trust to pay tax in New Zealand.
1.2 These rules are buttressed by a wide concept of “settlement” and “settlor”. Essentially any provision of goods, services or money to a trust for less than market consideration will amount to a settlement sufficient to attract a liability for tax on the trust’s income. Moreover, nominee settlements are sufficient to ensure that the principal in the arrangement is treated as the settlor rather than the nominee. A control interest of 10% or more in a CFC that settles a trust is sufficient also to make the person holding that control interest a settlor of that trust.
1.3 There are broad anti-avoidance provisions designed to ensure that settlement is attributed in a number of instances where contrived arrangements are entered into to establish an offshore trust. Equally, there are provisions designed to relieve a New Zealand resident settlor from liability for all of the income of the trust where it is possible to establish that others have also settled property upon the trust so that attribution of income to the New Zealand resident would be excessive.
1.4 In addition to the settlor regime, the New Zealand tax system subjects distributions from some overseas trusts to a special rate of tax, 45%. This often means that trusts established offshore are set up in anticipation that distributions will not be made to beneficiaries while they are tax resident in New Zealand.
2. Categories of Trusts
2.1 Under New Zealand Income tax law trusts can fall into one of three categories. The classification of trusts occurs at the time a distribution is made. The classification is necessary to determine the tax treatment of the distribution. The concept of distribution is widely defined to include any disposal by a trustee to a beneficiary of trust property for less than market value.
2.2 The three categories are Qualifying Trusts, Foreign Trust and Non Qualifying Trusts. Qualifying Trusts (“QT’s”) are trusts that have met all of their obligations for the Trustees’ income tax liability from the time of any settlement to the tax year in which a distribution is being made. It is unusual for trusts established outside New Zealand to be QT’s.
2.3 Foreign Trusts (“FT’s”) are those that have never had a New Zealand resident settlor. Because of the wide definition of “settlor” there is a risk that a person who becomes a New Zealand tax resident, having first settled a trust outside this country, may unwittingly settle further value on the trust after becoming resident. This can attract the settlor regime described above and great care is required to avoid this.
2.4 Non Qualifying Trusts (NQT’s) are those that are neither QT’s nor FT’s. The significance of the classification lies in the tax treatment of distributions.
2.5 It is possible for a trust to have a hybrid character. It may be partly an FT and partly a QT. An election process allows a trust to be brought within the New Zealand tax net within one year of a settlor becoming resident here, while at the same time retaining FT status for settlement made before residence was assumed. This can greatly affect the distributions that may be made to New Zealand resident beneficiaries.
3. Tax Treatment of Distributions
3.1 QT’s may distribute to their beneficiaries tax free, except for beneficiary income. Such income is that which vests in interest in the beneficiary or is paid or applied as income to the beneficiary within the income year or 6 months thereafter. It is taxed to the beneficiary at his or her marginal tax rate. The trustee can be liable as agent for the beneficiary’s tax.
3.2 By contrast, where income of a QT is dealt with as trustee income and is subsequently distributed, it is free of tax. No distinction is then made between capital and revenue, and all distributions of accumulated income, corpus or capital gains are tax free.
3.3 FT’s may distribute some assets tax free and some are taxed at the recipient beneficiary’s marginal tax rate. Taxable distributions are all those that are not beneficiary income, corpus of the trust and certain capital gains.
3.4 NQT’s make taxable distributions if they distribute anything that is not beneficiary income or trust corpus. Capital gains of an NQT are therefore caught. The tax rate that applies is also higher than for other trusts. A flat rate of 45% applies to taxable distributions from NQT’s, 6% higher than the present top personal marginal rate of tax of 39%.
4. Ordering rules
4.1 Because the distinction between income, capital gains and corpus affects the tax treatment of a distribution, strict ordering rules apply.
4.2 Broadly speaking these are designed to require a trust to treat a distribution as one of current or retained revenue, while any of that remains to be dealt with. Only then will distributions be treated as coming from capital gains, first current and then retained. Only after they have been exhausted will a distribution from corpus be deemed to occur. Corpus is also narrowly defined. It means the market value of property settled on the trust at the date of settlement. It has a fixed value and any growth in the value of settled property is not corpus but must be treated as a capital gain. Importantly certain transactions are excluded from corpus. One example is where property is settled on trust which would, but for the settlement, have been income of the settlor.
This abstract should not be relied upon as legal advice. It is intended as a commentary in summary form only and to be generally descriptive of the law it covers. No responsibility or liability is accepted for the content of this abstract or for loss or damage that may be occasioned by applying it, or otherwise relying upon it, contrary to this warning.
© G D Clews 2005