It has been common practice in NZ for trustees distributing income to beneficiaries (typically those on a lower marginal tax rate) not to distribute the cash, but to leave the amount outstanding, thereby creating a beneficiary credit current account.
Two issues arise with that practice.
First, if the current account has been in place for many years, there can be an issue as to whether IRD will regard the transactions as a proper distribution of beneficiary income. It may be that the current account should be paid out in cash or a distribution of assets to ensure the efficacy of the earlier tax efficient distributions.
Second, the definition of settlor has recently been widened to include beneficiary’s with current accounts exhibiting certain features. Being a settlor of a trust in these circumstances may give rise to inadvertent tax implications, as explained below.
From 1 April 2020 a new definition of settlor in HC 27 of the Income Tax Act 2007 applies. Broadly, it provides that a beneficiary with a current account balance will not become a settlor of the trust if:
- the trustee pays interest to the beneficiary on the current account balance at a rate equal to or greater than the prescribed rate of interest, or
- the amount owing to the beneficiary at the end of the income year is not more than $25,000.
IRD have changed its published view on this issue in the past few years. Hence the amendment is not retrospective and IRD have issued an Operational statement to clarify their position where a taxpayer has relied on IR’s previous position i.e. for current accounts up to 31 March 2020.
If a beneficiary’s current account qualifies a beneficiary as a settlor of the trust, several potentially adverse tax implications could arise, such as:
- Where is the beneficiary currently resident? Could this affect the tax classification of the trust?
- If the beneficiary is planning to emigrate, could the beneficiary’s treatment as a settlor for NZ tax purposes be replicated in the new country and potentially drag the trust into that other country’s tax, capital gains tax or inheritance tax regime?
- Is the trust or the beneficiary in the business of dealing or developing land, or in the business of building ,as tainting issues could arise.
- Will the addition of another settlor affect the trust’s main home exclusion for the bright line test as it applies to residential land?
- Could the imposition of settlor status affect Working for Families Tax Credits, or other social security benefits received by the beneficiary.
- Will the new settlor be liable as agent for an income tax liability of the trustee?
Trustees may consider taking steps to reduce any current account below the threshold by making cash or asset distributions to the beneficiary before the end of the 2021 tax year. This coincides with the fact that adult beneficiaries will have a legislative right to receive copies of the trust’s financial statements by January 2021, thereby placing potential pressure on trustees to release the funds to the beneficiary. Reducing the current account balances below $25,000 would alleviate the need to pay interest on a beneficiary’s current account, which is generally not that desirable given the tax inefficiency.
Alternatively, given the new changes being introduced by the Trusts Act from January 2021, trustees may consider whether it’s worthwhile retaining the trust, and if they decide to wind up the Trust any potential tax implications will need to be addressed.
Winding up tax issues that arise can include triggering a new acquisition date for residential property under the 5 year bright line rules, depreciation recovery on accumulated depreciation, the potential forfeiture of tax losses in the trust itself, the impact a change of ownership will have on foreign investments, and for companies owned by the trust potential shareholder continuity breaches for maintaining imputation credits and tax losses. If the trust is GST registered there can be a cost if the recipient is not GST registered.
If retention of the trust is the preferred course, it would be appropriate to review the trust deed in light of the impact of provisions contained in the new Trusts Act, and from a trust tax perspective to ensure that the accumulation clause for beneficiary income has been amended to accommodate the extended period, and that the trust deed provides for an ability to distribute deemed tax law income as beneficiary income.