Date posted: 22/11/2017 7 min read

Complying and foreign trusts - a risk factor for NZ accountants?

In the wake of the ‘Panama Papers’, rules on foreign trusts have been changed and there are new regulations to be followed. What do accountants need to know?

In Brief

  • A trust can be both a foreign trust and a complying domestic trust at the same time – with dual status.
  • Tax specialists take the view that a trust which has dual status should be treated as a complying trust.
  • Inland Revenue says a dual status trust should still register as a foreign trust.

By John Hart.

The New Zealand government has changed its rules on foreign trusts and accountants should be aware of possible risk factors in this area.

Foreign trusts now have to be registered with the Inland Revenue Department and file annual returns, following an inquiry and publication of the Shewan report, which recommended greater foreign trust disclosure in the wake of the ‘Panama Papers’ leaks. 

The new regime requires registration of trusts and provision of information on settlors, protectors and beneficiaries, as well as annual returns with a set of financial statements.  

The deadline for registering foreign trusts with the Inland Revenue Department was 30 June 2017, for trusts existing before 21 February 2017. Foreign trusts created on or after 21 February must be registered within 30 days of creation.

An important but little-known issue is that a trust can be both a foreign trust and a complying trust at the same time. Broadly speaking, a complying trust is a domestic trust normally settled by a New Zealand resident and is liable to tax in New Zealand on its worldwide income.

The scheme of the trust taxation legislation is to focus on the residency of the settlor, rather than the residency of the trustee, in determining a trust’s tax liabilities. However, while the foreign trust definition in the Income Tax Act refers to a trust which has exclusively non-New Zealand resident settlors, somewhat surprisingly, the complying trust definition contains no express reference to the residency of the settlor. 

Dual Status Trusts

A typical example of a ‘dual status’ trust would be a trust of the type shown in the diagram below. Such a trust has no offshore assets and files tax returns in New Zealand and pays tax on its worldwide income here. It will also comply with all other NZ tax reporting and filing obligations.

As a result, this trust falls within the complying trust definition, even though it also falls within the foreign trust definition.  

It was never intended that a trust should have dual status in this way, as the tax treatment of a trust is determined by its classification as foreign, complying or non-complying. For example, foreign trusts are subject to so-called ordering rules in relation to distributions. Complying trusts are not. If a dual status trust makes a distribution, does it have to comply with the ordering rules?

Double taxation?

Most specialist commentators take the view that a trust which has dual status should be treated as a complying trust, as this is a more favourable treatment, and such a trust if treated as a foreign trust might be subject to double taxation. This can occur if the trust pays tax on income and retains it and subsequently makes a ‘taxable distribution’ to a beneficiary. Taxable distributions from a foreign trust are taxable, whereas retained earning distributions from a complying trust are not.  

In the 1989 Tax Information Bulletin drafted by the Inland Revenue Department shortly after enactment of the current trust taxation regime, this dual status was referred to.  The bulletin says “if the trust also satisfies the definition of a [complying] trust, it will be treated as a [complying] trust rather than as a foreign trust”.

This is an eminently sensible interpretation, but for some reason is not addressed or repeated in the current draft interpretation statement issued by IRD, which is intended to replace the 1989 TIB.  

In discussions with Inland Revenue, it appears they accept it is appropriate from a general compliance perspective to treat a dual status trust as a complying trust (for example, no ordering rules would apply and the rent-free use of trust assets do not constitute a deemed taxable distribution). However, they say such a dual status trust should still register as a foreign trust under the foreign trust disclosure regime.

In the writer’s view, this does not make sense as the legislation does not ‘work’ with a dual status trust: It is a legislative anomaly that should have been fixed many years ago.  

The simple legislative amendment to fix this anomaly is to provide in section HC 33 of the Income Tax Act that a trust of this type can elect to be exclusively a complying trust, thereby overcoming dual status.  

Related: ATO powers up with data-matching tech

More powerful data-matching tools from the ATO are catching out more tax avoiders. What can accountants do to comply?

Inland Revenue’s justification for asserting that dual status trusts should register as foreign trusts under the new rules is that this will assist Inland Revenue in complying with its AEOI/CRS reporting obligations. That seems misconceived, given that the AEOI/CRS rules are something completely different from New Zealand’s domestic foreign trust disclosure regime.  

Inland Revenue has conceded that the “core provisions” of the Income Tax Act can be read to produce an outcome that means if it meets complying trust status as well as foreign trust status, it is taxed as a complying trust. If that is the case, it is hard to see the justification for taking a different approach in relation to registration under the foreign trust disclosure regime.  

What should you do if you have a dual status trust?

It really depends on your appetite for taking a contrary view to Inland Revenue. If a trust such as in the example below was registered as a complying trust, the position is unlikely to be tested. If you are seeking to change the status of such a trust from foreign to complying, you are likely to find that Inland Revenue will accept this for general tax treatment purposes, but may insist on registration under the new foreign trust registration regime.

My personal view is the Inland Revenue approach makes no sense and should be resisted, but it is reflective of the “mission from God” mentality we are presently seeing both locally and internationally in relation to collection and exchange of tax information.

John Hart is a specialist tax trust lawyer based in New Zealand.

Pictures by Fairfax New Zealand.