Taxation of Trusts

This entry try to offer a comprehensive overview of how the tax laws apply to settlors, trustees and beneficiaries.

In most countries, Trustees must comply with tax administrative obligations. The extent of these obligations will depend on the country and the nature of the trust’s assets.

Record keeping

In general, a trustee that carries on business must maintain business records. If a trustee has had any debt forgiven, the trustee must keep a record of the amount(s) forgiven and details of any amount(s) distributed to beneficiaries.

In some countries, in addition to business records a trustee should (or is desirable) also retain:
•a copy of the trust deed
•any deeds of variation
•contact details for all trustees and beneficiaries
•any trust accounts and tax returns
•a schedule of assets and liabilities

Trust Taxation in New Zealand

If a trustee earns any income in relation with the trust, the trust must be registered with the Inland Revenue. In some cases, like in New Zealand, and in most offshore jurisdictions, if a trust’s sole asset is a family home and the home is not used in the production of any trust income, the trust does not require an Inland Revenue number.

In the former case, the trustee must file an annual return (IR 6). The trust must also register or GST if the trust is making taxable supplies.

A trustee that recieves interest income must deduct RWT unless the trustee holds a RWT deduction certificate or the interest payer has deducted RWT.

There are recent charity and trust case law in New Zealand, including the landmark Penny and Hooper case, the impact of lower marginal tax rates and new legislation, including changes to the PIE regime, the look-through companies regime and the abolition of gift duty.

Resident trustees of foreign trusts

Resident trustees of foreign trusts must also maintain records even if no income is derived in New Zealand.

Tax Avoidance

See also the general anti-avoidance rule (“GAAR”)

On 31 August 2011, Inland Revenue issued Revenue Alert RA 11/02. This Revenue Alert sets out the Commissioner’s views in response to the decision in Penny and Hooper as to when diverting personal services income through an associated entity such as a trust will constitute tax avoidance.

Key provisions

The main points of the Revenue Alert can be summariseed as follows:
•a finding of avoidance will not arise soley through the use of companies, trusts and other business structures
•care is required where the use of such structures allows the ” controller” of the business to divert income to an associated entity
•particular care is required where the business relates to the provision of services
•whether any diversion of income is ligitmate or not, i.e. whether it could amount to tax avoidance requires consideration of whether the “controller” is appropriately compensated for his or her skill or exertion, and where this is not the case, whether there are valid commercial reasons for the individual receiving a reduced level of remuneration.

The Inland Revenue will be concerned with arrangements where the compensation received by the contoller is artificially low while related entities benefit (or the controller ultimately benefits), and any commercial reasons for that transaction do not justify the low level of remuneration.

80% test

In the Revenue Alert the Commissioner states that:

“Given our focus on the more artificial arrangements, and the resources available to us, we are more likely to examine arrangements where the total remuneration and profit distributions received by the individual service provider is less than 80% of the total distributions received by the controller, his/her family and associated entities.”

However, it is important to appreciate that this suggested 80% “safe harbour” is neither a target or necessarily a safe harbour. Each case that is investigated will turn on its own facts.

Commercial reality in light of the business involved should be the main focus and not some” 80%” marker, “market” salaries or comparable industry averages.

There can and often are valid non-tax reasons why a business may pay the controller less than an arm’s-length party would receive over the short-term. For example:

• where adverse business conditions mean that the business’ profits are down but most of those profits are still paid out to the individual service providers

•if it is financially prudent to retain some profits in the business because it is anticipated that the business may experience financial difficulties in the near future

• where the profits are set aside with a view to the acqusition of furhter business assets

• the business relates to a charity and the controller receives less to ensure the charity’s return is maximised.

There is nothing to prevent individual service providers or related entities from owning the business and receiving distributions of profit reflecting that ownership. It may also be appropriate in certain circumstances for family members or associated entities to receive funds from the business as an employee or service provider, and/or an owner of capital equipment used by the business.

However, care needs to be taken to demonstrate a commercial basis for transactions and structures. The totality of the arrangements must be considered.

Objectively this means if you are effectively the business controller, or an adviser, step back and assess whether the structure in place is supported by appropriate documentation and a sensible commercial rationale. Although 80% of market may appear a safe harbour it would not be wise to rely on that. This marker is really an indication as to a tolerance threshold.

A prudent approach would be to have a commercially sensible structure with an appropriate governance in place that is applied in practice rather than just on paper.

Further Reading

Vicki Ammundsen, Taxation of Trusts, CCH New Zealand Limited (2011)