Trusts update July 2023
Over the last few years there have been several changes that alter the landscape for family trusts. These changes include a new Trusts Act 2019, new and comprehensive disclosure requirements that began for the year ended 31 March 2021 and a high profile tax avoidance case (Frucor) which did not involve trusts but which did involve the use of associated entities where all rules were followed by the taxpayer but overall the structure was deemed by the Supreme Court to be a tax avoidance arrangement. At the time of writing in July 2023 the Government has introduced a change to the trustee tax rate which will further impact trustees and beneficiaries of family trusts beginning from 1 April 2024.
While reading some of the commentary in the media as well as reading IRD and ATO documents (often in NZ we end up taking similar positions to the positions taken by the ATO and the government in Australia), it occurred to us that some trustees of family trusts may need to update their understanding in order to obtain the asset protection and family benefits that they had in mind when setting up their trust, as well as to manage the IRD audit risk that exists when using a trust that stems from the differential tax rates that are available when using a trust (i.e. the trustee rate which is still 33% for the current financial year which is less than the top personal marginal tax rate of 39% as well as lower tax rates that may be available when allocating income to beneficiaries).
The environment is constantly changing and now is a good time to review the administration of your trust to ensure that your procedures are fit for purpose.
Below are some principles to keep in mind when operating your trust:
The trust is a relationship and set of responsibilities
The concept of a trust is very old, dating back to the 13th century, initially created to allow for continuous ownership of property after the death of the original owner.
The trust deed sets out the roles of the various people involved in any trust. A trust will always have:
- A settlor, which is a person who puts money into the trust. Note that for tax purposes “settlor” is defined very widely, and can include non cash benefits provided to the trust.
- Trustees, who are charged with managing the assets and income of the trust for the benefit of the beneficiaries. Trustees must act in the best interests of the beneficiaries and the trust and must avoid conflicts of interest. Trustees must act in accordance with the trust deed as well as the trust legislation, which includes the Trusts Act 2019 and the Income Tax Act 2007. Other sources of law include previous decisions of the courts (common law).
- Beneficiaries – the people who the assets are held in trust for. These will often be listed in the trust deed by name. Sometimes they are not listed by name but by relationship status for example “children and grandchildren of Mr and Mrs Smith”.
The trustees can make distributions of trustee income or trust capital. They can also elect for the trust to retain the income and pay tax at the trust level.
Note though that the Income Tax Act 2007 contains a “General Anti Avoidance Provision” which can be used by the IRD to set aside any tax benefits obtained from the use of trusts (or in fact any arrangement which has been set up which has the purpose or effect of altering the incidence of tax).
For most small business owners and professional people, the most relevant example of this was the case “Penny and Hooper” where the taxpayers (who were orthopedic surgeons) used a combination of a company and a family trust to limit their exposure to the personal top marginal income tax rate. The IRD took issue with this and ultimately the arrangement was determined by the Supreme Court, the highest court in New Zealand, to be a tax avoidance arrangement.
What does all of this mean for you?
As noted above, trusts have been in existence for hundreds of years and hence are an established part of the legal landscape. Trusts are very popular in New Zealand with some estimates putting the number of trusts in New Zealand as being between 300,000 and 500,000.
Just because there are a lot of trusts out there and they have been there for a long time does not mean that you can take your obligations as a trustee lightly.
Principles to keep in mind when operating your trust
Treat the role of trustee seriously
If you have put assets into a trust and are now a trustee of a family trust, these assets are no longer yours. You need to manage the assets for the beneficiaries in accordance with the trust deed, the Trusts Act 2019 and other sources of law. Documentation of trust investment and income allocation decisions is important. You cannot treat the trust bank account as an extension of your personal bank account. Having an independent trustee like a lawyer will help you to comply with these requirements.
Do not view the trust as a tax saving vehicle
If you are making allocations of trustee income to beneficiaries, then the beneficiaries must be entitled to the money i.e. the allocation must be real. In legal terms any allocated income must “vest” in the beneficiary. If you as the trustee retain control of income that has been allocated for tax purposes to beneficiaries then it is likely that the IRD would view the arrangement as a tax avoidance arrangement. The IRD penalties for a tax avoidance arrangement range up to 100% of the tax shortfall (i.e. the difference in tax paid as a result of the arrangement).
Note that it is the trustees role to make any allocations of trust profit. As the accountants for the trust, we can record the transactions and prepare minutes and tax returns but we cannot allocate income to beneficiaries. Our role is limited to recording the decisions of the trustees and advising the relevant tax payments.
While it is possible that tax savings can result from either retaining income as trustee income or allocating income to beneficiaries, these savings cannot be the main driver for the decisions that you make.
Operate your business like a professional manager
If your family trust owns all or most of the shares in your business and there is business profit left over after paying you, the IRD will want to take a close look at this, in particular if your business income exceeds $180,000.
If you are working in the business, then in an audit situation the IRD will be interested in the amount that you are paid for your work. It will not be acceptable to them to say that you earn the same amount that people in similar jobs get paid, you will need to show that you are being paid a premium for the business management and entrepreneurship skills that you have that have led to your high income. Documentation will limit your risk and if your situation and level of salary paid to working owners of the business results in significant tax savings vs paying tax on the income directly in your names then it would be worth incurring cost to get an external independent party to value the role that the working owners perform.
While a trust is an established and valid asset ownership structure, many trusts in New Zealand are likely not managed properly. We recommend discussing with your lawyer to ensure that you have proper trust administration in place . This will likely include having an independent trustee. Failing to do this may mean that your trust is not effective for the asset protection and family reasons that the trust was put in place.
Similarly, while it may seem to you that tax mitigation is a key reason to use a trust structure, it is likely in an audit situation that the IRD would not agree. Large penalties can apply. The most common areas that the IRD are likely to take issue with are the diversion of company profits that would have been taxed in the hands of the working owner to a trust and then the diversion of trust income to beneficiaries. In order to manage these risks, documentation of the level of the shareholder income that working owners receive in their business is important, this must be updated regularly and must take into account additional responsibilities that come from owning and managing the business.
To ensure that allocation of trust income to beneficiaries is acceptable to the IRD, the same principle applies. It should be documented by the trustees what allocations are made to which beneficiary and why. The beneficiary must actually receive the entitlement to the money that is being allocated.
If you are reading this and concerned about tax positions that you have taken in the past, please get in touch to arrange a time to discuss. It is possible to make a “voluntary disclosure” to correct prior tax positions and if a voluntary disclosure is made prior to an audit then there will generally be no penalties that apply or at least a discount to the level of the penalties (depending how the IRD view the transactions that have led to the voluntary disclosure).
One final point – the changes to the disclosure rules for trusts and the trust income tax return form require more information than ever before as to who the beneficiaries of the trust are and what is happening to trust income and assets. Part of the explanation for the change was that the government wanted to collect more data to inform policy changes (and we are already seeing the results of this with the change in the trustee tax rate). It’s safe to assume that the IRD will also be using this data in selecting who to audit.