Questions and Answers: Trust classification - what practitioners need to know

A trust can be resident in Australia for Australian tax purposes of a trustee is resident at any time during the tax year or the trust’s central control and management is in Australia. See section 95(2) of the Income Tax Assessment Act, which provides that:

(2) For the purposes of this Division, a trust estate shall be taken to be a resident trust estate in relation to a year of income if:

• (a) a trustee of the trust estate was a resident at any time during the year of income; or
• (b) the central management and control of the trust estate was in Australia at any time during the year of income.

Care will be required to consider the position from both a New Zealand and Australian tax perspective.

The payment of interest is a matter of contract between the trustee(s) and the beneficiary. However, where interest is not made, this can mean that a beneficiary who is owed money by trustees, and is not paid interest at an appropriate rate, the beneficiary can become a settlor for tax purposes. See question 6 below. This is not relevant here as the beneficiary is already a settlor.

You state that “The beneficiary’s current account builds up as the beneficiary is not taking the money because the tax rate is unsuitable.”

As a point of clarification, this question is answered on the basis that the income was taxed to the beneficiary and was not retained as trustee income (and taxed accordingly).

Interest paid to a beneficiary is interest income to the extent that the interest does not exceed the prescribed rate of interest. Amounts paid above that amount are treated as a distribution pursuant to section HC 14(2B) of the Income Tax Act 2007, which provides that:

“If a trustee pays to a beneficiary interest on an amount owed to the beneficiary, the payment is not a distribution by the trustee except to the extent to which the interest exceeds the amount given by the rate that is the greater of the market rate and the prescribed rate of interest.”

The “prescribed rate of interest” means the rate of interest declared by regulations made under section RA 21(3) (Regulations) to be the rate applying to employment-related loans.

As a general proposition New Zealand taxes trusts by reference to the residence of the settlor. As noted at 1.22 of Taxation of Trusts IS 24/01:

“… The trust rules interact with the core provisions to tax income derived by the trustees based on the residence of the settlors for foreign-sourced amounts. Foreign-sourced amounts are generally taxable in New Zealand only where the settlor is resident but exempt if the settlor is non-resident. However, all New Zealand-sourced amounts are taxed in New Zealand regardless of the residence of the settlor.”

This means that where a trust is administered offshore and does not have resident trustees, it is still necessary to consider how any distribution from such a trust would be classified for New Zealand tax purposes.

The trust rules contain specific provisions dealing with the tax treatment of foreign-sourced amounts derived by trustees. The general rule is that foreign sourced amounts are assessable as trustee income when the settlor is resident in New Zealand and exempt when the settlor is not resident. Section HC 25 of the Income Tax Act address situations where the trustee is not resident in New Zealand. The following commentary from Taxation of Trusts IS 24/01 at 7.8 to 7.18 is illustrative:

Foreign-sourced amounts - non-resident trustees

[7.8] A foreign-sourced amount derived by a non-resident is normally non-residents' foreign-sourced income (s BD 1(4)) and not assessable income (s BD 1(5)(c)). However, under s HC 25(2), when a non-resident trustee derives, as trustee income, a foreign-sourced amount that would be assessable income if derived by a New Zealand resident, it is assessable income of the trustee (subject to the exceptions discussed in this part). This applies if, at any time in the income year:

• a settlor of the trust is a New Zealand resident who is not a transitional resident; or
• the trust is a superannuation fund; or
• the trust is a testamentary trust or an inter vivos trust, of which:
  • a trustee is resident in New Zealand; and
  • a settlor died resident in New Zealand (whether or not they died in the income year) or, in the case of a corporate settlor, the last surviving settlor was resident in New Zealand when that settlor ceased to exist.

[7.9] Section HC 25(2) applies so foreign-sourced amounts are assessable if any one of the settlors of the trust (if there is more than one settlor) is resident in New Zealand at any time during an income year. An entire year of residency is not required. The amount must be one that would be assessable income if derived by a person resident in New Zealand, so it excludes, for example, some capital gains.

[7.10] Foreign-sourced amounts derived by a non-resident trustee are also assessable if a settlor died resident in New Zealand and a trustee is resident in New Zealand at any time in the year. It does not matter whether the settlor died in the income year. For example, if a New Zealand resident settlor of a trust that had non-resident trustees died in New Zealand in 2016, and any one of those trustees became resident in New Zealand for any part of the 2018 income year, any foreign-sourced amounts derived during the 2018 income year would be assessable income in New Zealand.

[7.11] The rule also applies if the last surviving settlor is a corporate settlor and that settlor ceases to exist. The residence of the settlor is determined by the residence of that corporate settlor.

[7.12] There are two exceptions to the general rule. If the exceptions apply, foreign-sourced amounts derived by a non-resident trustee are not income in New Zealand.

[7.13] Both exceptions require the trustee to be resident outside New Zealand at all times in the income year. This means if a trustee is resident in New Zealand for even a day, the exceptions do not apply.

[7.14] The first exception also requires that no settlement has been made on the trust since 17 December 1987 and, if an election has been made under s HZ 2 for the trust to pay tax on all its income, it was not made by the trustee (s HC 25(3)). The election in s HZ 2 relates to a choice on or before 31 May 1989 under s 228(7) of the Income Tax Act 1976 to pay income tax on trustee income derived from and including the 1989 tax year.

[7.15] The second exception also requires that if a settlement were made on the trust after 17 December 1987, it was made only by a settlor who was not resident in New Zealand at the date of the settlement and at any time between 17 December 1987 and the date of the settlement (s HC 25(4)). This means non-residents who settled trusts before becoming resident do not automatically create a liability on foreign-sourced income derived by the non-resident trustee.

[7.16] Although subss (3) and (4) of s HC 25 mean certain non-resident trustees are not required to pay tax on foreign-sourced amounts, those provisions do not affect the settlor's income tax liability under the trust rules (s HC 25(5)(a)). A New Zealand resident settlor may still be liable as agent of the non-resident trustee for income tax payable by the trustee under s HC 29, subject to the exceptions discussed in Part 13 (Compliance). A settlor will also have an income tax liability if they have made an election under s HC 33.

[7.17] Subsections (3) and (4) of s HC 25 also have no effect when determining whether the tax obligations on the trustee's income tax liability are met for the purposes of s HC 10(1)(a)(ii) and meeting the requirements for a complying trust (s HC 25(5)). To achieve complying trust status, the trustee must pay tax on the trustee's worldwide income for the life of the trust (s HC 10(1)(a)(i)). This is not achieved if the exceptions apply. However, a trustee, settlor or beneficiary of a trust can elect, under s HC 33, to satisfy the income tax liability on the worldwide income of a trust to gain or maintain complying trust status (see Part 10 (Transitional issues on becoming resident)).

[7.18] Where the trustees are non-resident and foreign-sourced amounts are assessable as trustee income under s HC 25(2), the trustees are treated as resident in New Zealand under other provisions in calculating the taxable income of the trustees. These provisions are:

• ss EW 9 and EW 11 (which state the situations where the financial arrangements rules will or will not apply);
• s LJ 2 (which states when a person can claim a tax credit for foreign income tax paid);
• s OE 1 (which states when a person can choose to be a branch equivalent tax account person); and
• the international tax rules (which are defined in s YA 1 as including the rules relating to controlled foreign companies, foreign investment funds and foreign tax credits).

A distribution of a foreign- sourced amount derived by a non-resident beneficiary is not subject to tax in New Zealand. See Taxation of Trusts IS 24/01 at 102, which provides that:

[8.102] If the distribution is a foreign-sourced amount that is derived by a non-resident beneficiary, then no tax is payable. Section BD 1(3) in the core provisions removes non-residents' foreign-sourced income (as defined in s BD 1(4)) from having the status as excluded income. Section BD 1(5) then excludes non-residents' foreign- sourced income from a person's assessable income.

This question needs to be considered from an income tax perspective and from the perspective of the Ministry of Social Development.

From an income tax perspective, subject to the terms of the trust, the payment can be income or capital. Where the beneficiary has a current account with a positive balance, in the alternative it could be the repayment of a loan.

However, from an MSD perspective it is important to appreciate that the definition of income is defined more widely than for income tax purposes and payments from a trust can be counted as income for income assessment purposes regardless of how these payments are treated for trust purposes.

See Residential Care Subsidy - Work and Income

What’s included as income:

• Income or payments from a trust or estate.

Where a beneficiary has a current account with a credit balance of $25,000 or more, unless interest is paid at the market rate or a prescribed rate (that is the FBT rate), the beneficiary will become a settlor of the trust for tax purposes. See section HC 27(2)(bb) of the Income Tax Act 2007. Also see IS 24/01 at 2.41 to 2.43.

[2.41] Section HC 27(2) (bb) provides that a beneficiary is a settlor of the trust if they are owed money by the trustee, subject to the exceptions below. It should be noted that once a beneficiary becomes a settlor, they do not cease to be one because one of the exceptions applies at a later date.

[2.42] The amount owing to a beneficiary is determined at the end of an income year by s HC 27(7). It is the amount of debt at the time adjusted to include the effect of transactions made after the end of the income year and by the date given for allocating beneficiary income in s HC 6(1B). These adjustments need to be included in the financial statements of the trust for the income year. Adjustments could result in the threshold below being exceeded and the beneficiary becoming a settlor.

[2.43] The section does not apply if the amount owing is:

• not more than $25,000; or
• more than $25,000 and the trustee pays the beneficiary interest at either the market rate or a prescribed rate by the date given for the income year in s HC 6(1B).

The ordering rules apply to distributions from foreign and non-complying trusts to determine what has been distributed. To consider the ordering rules it is necessary to identify what comprises a taxable distribution. As set out at 8.62 to 8.63 of Taxation of Trusts IS 24/01 as follows:

[8.62] For a non-complying trust, a distribution is a taxable distribution under s HC 15(2) to the extent to which it is not a distribution of:

• beneficiary income;
• a part of the corpus of the trust; or
• a payment or transaction that represents a distribution of the corpus of the trust.

[8.63] For a foreign trust, a distribution is a taxable distribution under s HC 15(4) to the extent to which it is not a distribution of:

• beneficiary income;
• a part of the corpus of the trust;
• a profit from the realisation of a capital asset or another capital gain (other than certain capital gains made with an associated person);
• a foreign superannuation withdrawal;
• a pension; or
• a payment or transaction that represents a distribution of either the corpus of the trust or a capital gain.

Section HC 16(2) of the Income Tax Act 2007 sets out the ordering rules, which determine the sequence in which distributions are made. Subject to the exclusions in subsection HC 16(6)(exclusion: terms of trust) and 16(7)(exclusion: taxable distributions), the elements of a distribution are treated as consisting first of the following elements in the following order:

The distribution is treated as consisting of the following elements in the following order:

• (aa) first, an amount derived by the trustee that is beneficiary income of the beneficiary in the previous income year:
• (a) second, an amount of income that the trustee derives in the income year:
• (b) third, an amount of income, other than beneficiary income, that the trustee has derived in an earlier income year:
• (c) fourth, an amount that the trustee derives in the income year from the realisation of a capital asset of the trust or another capital gain and that is not income under section HC 15(5B) for the purposes of this section:
• (d) fifth, an amount that the trustee has derived in an earlier income year from the realisation of a capital asset of the trust or another capital gain:
• (e) last, the corpus of the trust.

Accordingly, the ordering rules prevent trustees selecting the most tax effective element to distribute.

Section HC 15 of the Income Tax Act 2007 sets out how taxable distributions are calculated, which are by reference to New Zealand principles. For example. the profit from the realisation of a capital asset or other capital gain is determined pursuant to section HC 15(5) as follows:

Determining amount of gain

(5) For the purposes of subsection (4)(c),—

• (a) the profit or other capital gain does not include a gain that must be taken into account for the purposes of determining an income tax liability:
• (ab) if the trustee is not a trustee of a trust referred to in paragraph (ac), the profit or other capital gain does not include an amount of capital gain (the gain amount) that is derived by the trustee through a transaction or a series of transactions if-
  • (i) the transaction or series of transactions is between the trustee and an associated person who is not a natural person or corporate trustee; and
  • (ii) the gain amount is greater than the capital gain that the trustee would derive from a transaction at market value:
• (ac) if the trustee is a trustee of a trust, for which a CFC is a settlor and no person is treated as a settlor under section HC 28(3) or (4), the profit or other capital gain does not include an amount of capital gain that is derived by the trustee through a transaction or a series of transactions between the trustee and an associated person:
• (b)the amount of the profit is determined after subtracting any capital loss that the trustee incurs in the income year in which the amount was derived.

Importantly, where a foreign or non-complying trust’s records do not allow an accurate determination of the elements of a distribution for the purposes of section JHC 16, the distribution is a taxable distribution. The ordering rules are explained further in Taxation of Trusts IS 24/01 at 8.113 to 8.119:

[8.113] Because some distributions are taxable and some are not, opportunities could arise for avoiding or deferring tax on income accumulated in trusts by distributing otherwise taxable amounts to non-resident beneficiaries or by distributing non- taxable amounts before taxable amounts. The ordering rules for distributions in s HC 16 limit opportunities for manipulating distributions from foreign and non- complying trusts in this manner. These rules determine the order in which amounts are treated as having been distributed from such trusts.

[8.114] The rules override the treatment of the distributions that would otherwise apply based on the terms of the trust or the exercise of the trustee's discretion. The rules can affect whether a distribution is treated as a distribution of income, a capital gain or corpus, so determine whether it is a taxable distribution or not. As noted earlier, it is necessary to interpret the definition of taxable distribution and the ordering rules together.

[8.115] The ordering rules in s HC 16 apply when a trustee of a foreign or non-complying trust makes a distribution to a beneficiary. The four exceptions to the rules are discussed from [8.143].

[8.116] The rules treat a distribution as being made up of the following elements in the following order (s HC 16(2)):

• income derived by the trustee that is beneficiary income of the beneficiary in the previous income year,
• income derived by the trustee in the current income year;
• income derived by the trustee in an earlier income year other than beneficiary income;
• a capital gain derived by the trustee in the current income year that is not income under s HC 15(5B);
• a capital gain derived by the trustee in an earlier income year; and
• the corpus of the trust.

[8.117] The ordering rules apply on an end-of-year basis. That is, a distribution is not characterised at the time at which it is made. Rather, distributions are characterised at the end of the income year in which they are made by reference to the total income and capital gains derived by the trustee in that income year (and previous income years). The ordering rules are applied individually to each distribution made by the trustee in the order in which the distributions are made (subject to potential reordering under s HC 16(5), as discussed from [8.133]).

[8.118] The amount of each element (eg current year income) is finite. Once an amount of an element has been treated under s HC 16 as included in a distribution, that amount is no longer available to be treated as included in another distribution (s HC 16(3)(a)). This means the order in which the distributions are made can be significant.

[8.119] For each distribution, the elements must be applied in the order in s HC 16(2). The next element is relevant only to the extent that the total of the available amounts in the elements so far considered is less than the amount of the distribution (s HC 16(3)(b)).

[8.120] Figure | Hoahoa 3 summarises the steps for classifying the distribution amount subject to deductions, capital losses and the reordering rule. Each of the elements is further explained following Figure | Hoahoa 3.

The correct determination is pursuant to New Zealand concepts. The following commentary from Taxation of Trusts IS 24/01 at 8.73 to 8.81 is illustrative:

[8.73] The definition of taxable distribution in s HC 15(4) excludes all distributions to the extent it is "a profit from the realisation of a capital asset or another capital gain" or "a payment or transaction that represents a distribution of a capital gain". These gains are not taxable distributions.

[8.74] The amount of any capital gain is reduced under s HC 15(5)(b) by any capital loss that the trustee incurs in the income year in which the capital gain was derived. For example, if in an income year a trustee makes a $100 capital gain on one transaction and a $100 capital loss on another transaction, there is no capital gain to include for the year.

[8.75] The capital gains included are those that have been realised. A capital gain is realised when it has been converted into money or money's worth. A capital gain that has accrued, but has not been converted into money or money's worth, is not realised. In this context, a loss that has accrued, but has not been realised, is not incurred.

[8.76] Under s HC 15(5C) and (5D), the source of a capital gain or loss is determined under s YD 4 (classes of income treated as having a New Zealand source).

[8.77] Section HC 15(5) excludes certain capital gains of a foreign trust from distributions that are not taxable distributions. This means they cannot be distributed by a foreign trust tax-free.

[8.78] A capital gain does not include a gain that is required to be included for the purpose of calculating a person's income. For example, s CB 6 provides that an amount that a person derives from disposing of land is income of the person if they acquired the land for the purpose of disposing of it. In the absence of s CB 6, such an amount might be regarded as a capital amount. As it is included in the person's income under s CB 6, it does not give rise to a capital gain for the purposes of the definition of taxable distribution.

[8.79] In addition, some gains a trustee derives from a transaction (or a series of transactions) with an associated person are not capital gains for the purposes of the definition of taxable distribution.

[8.80] A capital gain does not include an amount derived by a trustee with an associated person where a controlled foreign company is the settlor and no person is treated as a settlor under s HC 28(3) or (4) (s HC 15(5) (ac)). A person is treated as a settlor under these provisions if they have a control interest of 10% or more.

[8.81] A capital gain also does not include an amount resulting from a transaction between a trustee and an associated person who is not a natural person or corporate trustee. This applies only if the gain is greater than that the trustee would derive from a transaction at market value.

The amount that you are paying will be from net income that has been derived in the first instance by the trustees. The trustees will need to determine whether the payment is a distribution of income, capital, or if relevant, the repayment of a loan.

Amounts distributed to beneficiaries of foreign and non-complying trusts that are not income under ordinary concepts can be taxable. This is explained in Taxation of Trusts IS 24/01 at 8.99 to 8.101 and 8.106 as follows:

[8.99] Taxable distributions derived by a beneficiary from a non-complying trust have a special tax treatment.

[8.100] Section HC 19 provides that such a taxable distribution:

• is excluded income of the person under s CX 59;
• may be reduced by tax losses calculated under s HC 22; and
• is taxed at the non-complying trust rate set out in s HC 34(1) under s BF 1(b).

[8.101] Under s HC 34(2), the tax is payable at the due date for the beneficiary's terminal tax for a tax year under s RA 13. If the beneficiary has a 31 March balance date but does not have an agent, this will be 7 February in the following year.

[8.106] A different approach is adopted for taxable distributions from foreign trusts as these distributions are included in the assessable income of the beneficiary in the ordinary way. A taxable distribution to which s HC 18 applies is income of the beneficiary recipient under s CV 13(c). However, s BD 1(5)(c) operates to remove from assessable income any taxable distributions derived by non-resident beneficiaries that are foreign-sourced amounts under s BD 1(4).

See question 10.

A complying trust cannot become a foreign trust. The definition of foreign trust in section HC 11 of the Income Tax Act 2007 requires (subject to the comments below) that no settlor is resident in New Zealand at any time in the period that:

• starts on the later of 17 December 1987 and the date on which a settlement was first made on the trust, and
• ends whenever it is necessary to determine whether the trust is a foreign trust.

A trust settled by a New Zealand resident before 17 December 1987 may also be a foreign trust, but only if the settlor (and any other settlors) were not resident in New Zealand at any time on or after 17 December 1987.

However, a complying trust can become a non-complying trust. This could occur, for example, where the tax obligations relating to a trustee’s income tax liability have not been satisfied for every year.

An application is not required for a New Zealand settled trust to become a complying trust. The trust will be a complying trust if it has met the requirements of section HC 10 for the life of the Trust. As noted at Taxation of Trusts IS 24/01 at 8.19:

[8.19] Complying trusts are essentially trusts where tax has always been paid in New Zealand on the worldwide income derived by the trustee, whether by obligation or election, and the tax obligations relating to the trustee's income tax liabilities have been satisfied.

In the event that a trust has become non-complying trust, see question 15.

This depends on the context. The death of a settlor does not mean that a complying trust will become non-complying for that reason. However, whether a settlor is resident in New Zealand at the time of death can be relevant when determining assessable income. This is discussed in Taxation of Trusts IS 24/01 in the following terms at 7.8 to 7.13:

[7.8] A foreign-sourced amount derived by a non-resident is normally non-residents' foreign-sourced income (s BD 1(4)) and not assessable income (s BD 1(5)(c)). However, under s HC 25(2), when a non-resident trustee derives, as trustee income, a foreign-sourced amount that would be assessable income if derived by a New Zealand resident, it is assessable income of the trustee (subject to the exceptions discussed in this part). This applies if, at any time in the income year:

• a settlor of the trust is a New Zealand resident who is not a transitional resident; or
• the trust is a superannuation fund; or
• the trust is a testamentary trust or an inter vivos trust, of which:
  • a trustee is resident in New Zealand; and
  • a settlor died resident in New Zealand (whether or not they died in the income year) or, in the case of a corporate settlor, the last surviving settlor was resident in New Zealand when that settlor ceased to exist.

[7.9] Section HC 25(2) applies so foreign-sourced amounts are assessable if any one of the settlors of the trust (if there is more than one settlor) is resident in New Zealand at any time during an income year. An entire year of residency is not required. The amount must be one that would be assessable income if derived by a person resident in New Zealand, so it excludes, for example, some capital gains.

[7.10] Foreign-sourced amounts derived by a non-resident trustee are also assessable if a settlor died resident in New Zealand and a trustee is resident in New Zealand at any time in the year. It does not matter whether the settlor died in the income year. For example, if a New Zealand resident settlor of a trust that had non-resident trustees died in New Zealand in 2016, and any one of those trustees became resident in New Zealand for any part of the 2018 income year, any foreign-sourced amounts derived during the 2018 income year would be assessable income in New Zealand.

[7.11] The rule also applies if the last surviving settlor is a corporate settlor and that settlor ceases to exist. The residence of the settlor is determined by the residence of that corporate settlor.

[7.12] There are two exceptions to the general rule. If the exceptions apply, foreign-sourced amounts derived by a non-resident trustee are not income in New Zealand.

[7.13] Both exceptions require the trustee to be resident outside New Zealand at all times in the income year. This means if a trustee is resident in New Zealand for even a day, the exceptions do not apply.

Section 33(5) of the Income Tax Act 2007, which determines the taxation consequences before and after the election to satisfy the trustee’s tax liability provides that a distribution made before the electing, year has the taxation consequences that it have in the absence of the election. Essentially, this means the correction is prospective, not retrospective. This is explained in Taxation of Trusts IS 24/01 in the following terms:

[11.4] Under s HC 10(1)(ab)(ii), a trust that would otherwise become a non-complying trust can continue to be a complying trust. A person must:

• make an election under s HC 33(1); and
• for all income years beginning on or after the date on which the election applies to the trust and before the time of distribution, satisfy the trustee's tax obligations relating to the trustee's income tax liability for the trustee income.

[11.5] The election works in the same way as a late election described in Part 10 (Transitional issues on becoming resident). The person who makes the election can be a settlor, trustee or beneficiary. The person making the election can choose for it to apply from the:

• date of the election (the electing date);
• beginning of the income year that includes the electing date (the electing year); or
• beginning of the income year that is four years or less before the beginning of the electing year.

[11.6] If a trustee is required to file a return of income for an income year, the person must notify the Commissioner of the election within the time allowed for filing a return of income for the year. The election is made on form IR463.

[11.7] The election may require the Commissioner to make an assessment or reassessment in a year or years before the year in which the election is made. If this is the case, the person making the election must provide the Commissioner with the information required to determine the correct assessment under s 113F of the TAA.

[11.8] Where the election results in an increase in the assessed income tax liability of the trustee for an income year before the electing year, the person and trustee are not liable for a penalty under part 9 of the TAA if the Commissioner accepts that the trustee's tax position for each income year beginning on or after the effective date and before the electing year is not any of:

• an unacceptable tax position under s 141B of the TAA;
• an abusive tax position under s 141D of the TAA; and
• a tax position that causes the trustee to be liable to pay a shortfall penalty for evasion of a similar act under s 141E of the TAA.

[11.9] The effect of an election on distributions is determined by s HC 33(5).

[11.10] Firstly, a distribution made before the beginning of the electing year has the tax consequences that it would have in the absence of an election.

[11.11] Secondly, a distribution made after the beginning of the electing year for an amount derived by a trustee before the effective date is treated as being a distribution by a trust having the same status that the trust had when the amount was derived. The status could be that of a foreign trust, non-complying trust or complying trust.

[11.12] Thirdly, a distribution made after the beginning of the electing year from an amount derived on or after the effective date is treated as being made by the trustee as trustee of a complying trust if the requirements of s HC 10(1)(ab) are met for trustee income derived on or after the effective date. These requirements are essentially that the obligations to pay tax on the worldwide income of the trustee from the date the election applies have been met. A distribution is otherwise treated as coming from a non-complying trust.

Where a complying trust becomes non-complying care is required to consider what this means for beneficiaries occupying trust property in their capacity as a beneficiary where a market rent is not paid. This is discussed in Taxation of Trusts IS 24/01 at 8.5 as follows:

[8.5] An example of different tax treatment arising from the classification of a trust is where a trustee permits beneficiaries to reside in a property owned by the trust without paying market value rent. For a beneficiary of a complying trust, the distribution is exempt income under s HC 20. However, for a beneficiary of a foreign or a non- complying trust, the distribution may be treated as a taxable distribution with the tax status determined by ss HC 18 and HC 19 respectively.

A trust is classified for tax purposes by reference to the residence of the settlor. See HC 10 and HC 11 of the Income Tax Act 2007. However, note that many jurisdictions tax on the basis of the residence of the trustee, meaning that a trust can be resident in more than one jurisdiction for tax purposes.

As noted in Taxation of Trusts IS 24/01 at 11.20 to 1121:

[11.20] Many countries base the tax residence of trusts on the residence of the trustee. Consequently, even if one trustee of a complying trust becomes resident in another country it may result in the new country of residence seeking to tax the trustee income of that trust.

[11.21] In New Zealand, the residence of the trustee and the settlor need to be considered in determining the liability of the trustee to pay tax on trustee income. Where a trustee ceases to be New Zealand resident, they remain liable for tax on worldwide trustee income of a trust settled by a person who is resident in New Zealand. Tax liability on foreign-sourced amounts is imposed under s HC 25 on foreign trustees where the settlor is resident and not a transitional resident subject to two exceptions discussed in Part 7 (Trustee income). New Zealand-sourced income derived by a non-resident trustee does not depend on the residence of the settlor and is taxable based on the source rules in s YD 4.

The starting point is to establish whether the income meets the requirements of section HC 10(1)(a) of the Income Tax Act 2007. However, where this requirement is not met, there remains the option to make an election to remain a complying Trust. See 8.22 and 8.23 of Taxation of Trusts IS 24/01:

[8.22] A trust is treated as a complying trust for a distribution if the following requirements are met for the life of the trust up to the time of the distribution (s HC 10(1)(a)):

• no trustee income derived includes an amount of:
  • non-resident passive income (defined in s RF 2);
  • non-residents' foreign-sourced income (defined in s BD 1(4)); or
  • exempt income under s CW 54 (foreign-sourced income of a resident trustee under s HC 26); and
• the tax obligations relating to the trustee's income tax liability have been satisfied for every tax year.

[8.23] If the requirements of s HC 10(1)(a) are not met, a trust can still be a complying trust if one of the following three requirements are met (s HC 10(1)(ab) and (ac)):

• a person makes an election meeting the requirements of s HC 30(2) and s HC 10(2) (applies to foreign trusts that make an election in time);
• a person makes an election meeting the requirements of s HC 33(1), and for all income years beginning on the date from which the election applies until before the time of distribution, the tax obligations relating to the trustee's income tax liability for the trustee income determined consistently with s HC 33(1C) are satisfied (applies to all trusts that are not complying trusts); or
• the distribution meets the requirements of s HC 30(4)(ab) (applies to foreign trusts that make voluntary disclosures of a tax shortfall or elections after the election expiry date).

If a trustee pays to a beneficiary interest on an amount owed to the beneficiary, the payment is not a distribution by the trustee except to the extent to which the interest exceeds the amount given by the rate that is the greater of the market rate and the prescribed rate of interest.

Just checking, no tax paid by the trustees?

If the trust is not a complying trust, and the rate of interest exceeds the rate that is the greater of the market rate and the prescribed rate of interest, the trustee will need to consider whether the distribution is a taxable distribution.

Trusts are classified for New Zealand tax purposes in accordance with the Income Tax Act 2007. Where there has been a breach of trust, there may be implications for trust law purposes. However, such breaches will not inform the trust’s classification for income tax purposes (unless the trustees fail to meet tax liabilities).

From 1 April 2022 a trust may be non-active for an income year if the trust has:

• reportable income of $1,000 or less
• not been involved in any transactions that give income to an associated person, business or other entity
• costs and payments that do not affect its non-active status
• reasonable fees for administering it
• bank charges or minimal administrative costs that are $1,500 or less for the year
• insurance, rates, interest, and other costs related to living in a house owned by the trust and incurred by the beneficiaries of the trust.

From 1 April 2022 a testamentary trust may be non-active for an income year if the testamentary trust has:

• reportable income of $5,000 or less
• non-reportable income of up to $1,000 with deductions that would reduce the net income to below $200.

As noted in Taxation of Trusts IS 24.01 at 13.59:

“This measure provides relief to trusts or estates with little or no income. For example, it may remove the filing obligations for some trustees that own houses occupied by beneficiaries who do not pay rent.

Trustee income is defined in section HC 7(1) as an amount of income derived by a trustee to the extent to which it is not beneficiary income.

Taxation of Trusts IS 24/01 expands on this at 7.2 to 7.4 as follows:

[7.2] Under s HC 7(2), it also includes an amount of minor's beneficiary income to which s HC 35 applies as if it were trustee income for the purposes of determining the tax rate, paying tax on the income, and providing returns of income. The minor beneficiary rule is discussed in Part 6 (Minor beneficiary rule).

[7.3] Section HC 7(3) extends trustee income to include the market value of any property settlement a trust receives that is excluded from corpus under s HC 4(3) to (5). The amount is reduced by the market value that the trustee treats as beneficiary income or as a taxable distribution in the income year. Section CV 13(b) includes such amounts in the income of the trustee.

[7.4] The purpose of ss HC 7(3) and CV 13(b) is to ensure certain settlements excluded from corpus are taxed in the year of the settlement to prevent a deferral of tax on undistributed income by resettling amounts on a sub-trust.

See questions 1 and 16.

As a general proposition New Zealand taxes trusts by reference to the residence of the settlor. However, the residence of the trustee can also be relevant.

See further at question 16.

Taxable distributions from non-complying trusts are treated as excluded income of the beneficiary (ss HC 19 and CX 59). Such distributions are taxed at the non-complying trust rate, which is currently 45% (ss HC 34 and BF 1(b)).

The tax obligations relating to the trustee’s income tax liability must be satisfied every tax year for a trust to remain a complying trust. However, as noted at 8.32 of Taxation of Trusts IS 24/01 “This requires the satisfaction of the trustee’s obligations, but not necessarily the actual payment of all income tax for which the trustee is liable. This ensures a trust may still be a complying trust where the trustees have entered into deferred payment arrangements with the Commissioner.”

Taxation of Trusts IS 24/01 comments as follows regarding foreign exemption trusts at 13.7 to 13.22:

[13.7] A trustee of a foreign exemption trust must register it with Inland Revenue (s 59B(2) of the TAA). A "foreign exemption trust" is defined in s 3(1) of the TAA for an income year or part of an income year (the test period). It means a trust for which a trustee is a New Zealand resident in the test period, no election under s HC 33 is effective for the trust and the test period, and:

• no settlor is resident in New Zealand at any time in the period starting on the later of 17 December 1987 and the date on which a settlement was first made on the trust and ending at the end of the test period; and/or
• the trustee takes a tax position that an amount of income derived by the trustee in or before the test period is exempt income under s HC 26.

[13.8] A foreign exemption trust is therefore any trust that is a foreign trust with a resident trustee or a trust where the trustee makes use or has made use of the foreign- sourced income exemption under s HC 26. An exception applies if an election under s HC 33 is effective. If an election has been made, the trustee is taxed on their worldwide income and is subject to the domestic trust disclosure rules rather than the foreign trust disclosure rules.

[13.9] Note that the definition of foreign exemption trust applies for the purposes of the foreign trust disclosure rules. The definition of foreign trust applies for working out how distributions are taxed under the ITA 2007.

[13.10] The registration can be treated as in force at a date prior to the successful application if the Commissioner considers the trustee made reasonable efforts to obtain registration at the earlier date (s 59B(1B) of the TAA). This may allow the trustee to use the foreign-sourced income exemption even though there have been minor compliance issues.

[13.11] A trust that was registered as a foreign trust when the Taxation (Annual Rates for 2022-23, Platform Economy, and Remedial Matters) Act 2023 received the Royal assent on 31 March 2023 is treated as being registered as a foreign exemption trust from that day (s 59B(1C) of the TAA) and is not required to register again.

[13.12] A trustee that used the foreign-sourced income exemption before the Royal assent on 31 March 2023 of the Taxation (Annual Rates for 2022-23, Platform Economy, and Remedial Matters) Act 2023 and did not need to register previously had until 30 April 2023 to apply for registration of the trust. If the need to register arises after the assent date, the trustee must apply in the period of 30 days from the requirement commencing (s 59C(1)(b) of the TAA).

[13.13] Subsections (3) and (4) of s 59C of the TAA provide for a grace period for registration if all trustees of a trust are natural persons who are not professional trustees, and none has been a trustee before with obligations to register a foreign exemption trust. If applicable, the time limit to apply for registration extends to four years and 30 days from the first date on which the trust became a foreign exemption trust.

[13.14] This concession recognises that some people may become trustees due to changes of circumstances and allows them time to understand their obligations. However, a trustee must apply for registration by the end of this grace period to obtain the benefit of the tax exemption for foreign-sourced amounts under ss HC 26 and CW 54 for the income years during the grace period. This is the case even if the trust has ceased to be a foreign exemption trust by the time the grace period ends.

[13.15] Where more than one trustee of a foreign exemption trust exists, each is responsible for the performance of the trustees' obligations relating to registration, disclosure of information, annual returns, financial statements and payment of fees (s 59B(7) of the TAA). However, the trustee that applies for registration of the trust is the contact trustee and is responsible for all communication with Inland Revenue (s 59B(3) of the TAA).

[13.16] The contact trustee must provide the following information about a foreign exemption trust at the time of registration (s 59B(3) of the TAA):

• the name of the trust;
• information about settlements made on the trust that are not the provision to the trustee of minor services incidental to the activities of the trust at less than market value and cover the period:
  • from when the trust was formed if the trustee is a professional trustee or not a natural person; or
  • from the later of when the trust was formed or four years before the earliest date when the trust was required to be registered if the trustee is a natural person;
• the name, email address, physical residential or business address, jurisdiction of tax residence, taxpayer identification number, and connection with the trust of:
  • settlors who have made settlements requiring disclosure;
  • all trustees and persons with control over the trust (eg protectors and people with powers of appointment); and
  • beneficiaries (information required about beneficiaries varies depending on factors such as whether the trust is fixed or discretionary and the dates of birth of the beneficiaries); and
• a copy of the trust deed, will or other document that creates and governs the trust, including any documents that amend or supplement the former documents.

[13.17] The contact trustee must also provide a signed declaration under s 59B(4) of the TAA that each person referred to on the registration form:

• is deceased;
• cannot be located; or
• has been informed of and has agreed to provide the information necessary for compliance with the requirements relating to the provision of information about the trust imposed by the TAA and the Anti-Money Laundering and Countering Financing of Terrorism Act 2009 (including any regulations under that Act).

[13.18] Trustees of foreign exemption trusts must also comply with ongoing disclosure requirements. These disclosure requirements include a requirement to:

• file annual returns, including the trust's financial statements and details of any settlements and distributions made over the year, with the due date for filing the return six months after the trust's balance date or by 30 September if the trust does not have a balance date (s 59D of the TAA);
• provide updates to the information provided at registration before or with the income tax return that is next due after the trustee becomes aware of the addition or alteration (ss 59B(5) and 59C(2) of the TAA); and
• provide a signed declaration for person who becomes a settlor after registration (s 59D(2B)(c) of the TAA).

[13.19] If the contact trustee expects to cease to be the contact trustee, they must inform Inland Revenue of the date this is expected to occur, their contact details after that date and the contact details of the replacement contact trustee within 30 days of becoming aware of the anticipated date of cessation (s 59B(6) of the TAA). They must also provide details of changes to a trustee's email address, physical residential address or other contact details within 30 days of the anticipated change (s 59B(6B) of the TAA).

[13.20] Trustees must also maintain records required by s 22 of the TAA (discussed from [13.30]).

[13.21] A trustee must pay a fee to register a foreign exemption trust and for each annual return. However, no fees are payable where all trustees are natural persons who are not professional trustees (s 59E of the TAA).

[13.22] A trust that has a dual status as both a complying trust and foreign trust must still meet the registration and ongoing disclosure requirements of a foreign exemption trust if it has a trustee resident in New Zealand.

The starting point here is to determine the nature of the distribution and the application of the ordering rules. The following example from Taxation of Trusts IS 24/01 is illustrative:

Figure | Hoahoa 1: Flowchart to determine whether a distribution from a non-complying or foreign trust is a taxable distribution

Distributions other than beneficiary income from a complying trust (excluding community trusts) are exempt income. This reflects the underlying principle of complying trusts, which is that all trustee income has been fully tax paid.

No. Complying trusts are essentially trusts where tax has always been paid in New Zealand on worldwide income, whether by obligation or election. The purpose of the ordering rules is to limit opportunities for manipulating distributions from foreign and non-complying trusts by determine the order in which amounts are treated as having been distributed. See further at 8.113 onwards in Taxation of Trusts IS 24/01.

Trusts are classified for income tax purposes. Whether trustees of a trust require OIO consent depends on who is controlling the trust. In this regarding Landonline New Zealand notes that:

You can apply for consent to buy a home to live in through a trust or a company.

The law about this is complex – you will need the help of a New Zealand property or trust lawyer.

You can only get consent if all of the people who own or control the trust or company are ‘qualifying] individuals’. This means they are:

• New Zealanders
• ordinarily resident here
• holders of residence class visas, or
• Australian and Singaporean citizens and permanent residents.

Everyone who we consider to own or control the trust or company must live in the house.

This was considered in Davis v White [2016] NZHC 1626 where a trust was found to have failed by reason of uncertainty where there was no record of the trust terms.

Importantly, in that case the trustees were not able to demonstrate the trust terms by reference to documentation of cogent and reliable evidence. Where there is clear evidence as to the terms of the trust, a suitably qualified person can record the terms of the trust this can comprise a suitable record of the trust terms. This was considered in Re Porlock Pty Ltd [2015] NSWSC 1243 where an application was made to the Supreme Court of New South Wales for directions regarding a lost trust deed. In that case the Court held that it had no power to recreate a trust deed, explaining at [2] that “We are not in the same situation as one is when there is a lost will. What the court is doing is advising the trustee as to whether it would be justified in dealing with the trust property in the way in which it proposes. It is clear that the trustee recognises that it does not hold the trust property beneficially.”

However, as noted in Davis v White at [77] to [80]:

[77] In that case, there was secondary evidence available from a retired accountant who had had direct involvement in the administration of the trust, in the course of which he had written a letter detailing the operative provision of the trust which specified how the income and capital was to be distributed. His letter contained the following paragraph:

The Trust Deed provides that the income derived by the trust is to be paid to James D B Carr during his life and further provides that after the death of James D B Carr the property is to be held as to both capital and income for all and/or any of his children living at his death or attaining the age of 21 and if more than one in equal shares as tenants in common.

[78] The accountant had sworn an affidavit in the proceeding confirming his belief that his letter accurately set out both a list of the assets and the terms of trust, and further having regard to the terms of his letter, his belief that he had referred to and quoted from the actual trust deed when writing his summary of the operative terms of the trust.

[79] The accountant also deposed to the trust deed having been stored at his office up until his retirement some years earlier, and to the steps taken to undertake a thorough search to locate the deed or a copy of the deed, without success.

[80] The Court concluded that the evidence of the accountant, particularly that contained in his letter, was the "best evidence" as to what the terms of the deed were, and found that the trustees would be justified in acting upon the letter with the observation that, if at some time in the future the deed did happen to turn up and was found to contain provisions inconsistent with the accountant's letter, the trustees would nevertheless have the protection that the management and disposition of the trust fund was in accordance with the Court's advice.

See question 1.

Where a trust is liable for tax in more than one jurisdiction the ultimate outcome regarding the incidence of tax will depend on a number of factors including whether there is a Double Tax Agreement (DAT) that has application. See further at Double tax agreements (DTAs).

Where there is no applicable DTA, or the DTA does not apply to the relevant tax, double taxation is a possibility. Accordingly, extreme care is required where a trust may be subject to taxation in more than one jurisdiction.