With another quiet week on the taxation front (new Government settling in, US election, Guy Fawkes??), post some feedback I received from some of you with respect to last week’s management fee discussion and record keeping, this week I thought I would cover off another area of taxation law sometimes overlooked, application of the ordering rules in relation to distributions New Zealand tax residents receive from a foreign trust.
When it comes to considering the New Zealand income tax implications for your client in relation to a distribution they have received from a foreign trust, I trust that everyone will be on the same page, that a distribution by the foreign trustees referenced as having the character as a distribution of beneficiary income is without a doubt assessable income for your client – no different to a distribution of beneficiary income by a New Zealand complying trust to a New Zealand resident beneficiary.
Unlike non-beneficiary income distributions from the New Zealand complying trust which are usually non-assessable in your client’s hands, such distributions from a foreign trust may still be assessable income for your client, if the amount received is deemed to be a taxable distribution.
In this regard, I suspect most of you will be across the definition of a taxable distribution as defined in section HC 15 of the ITA07, essentially being any distribution which is not beneficiary income, trust corpus or realised non-related party capital gains.
Well nothing in that definition to really test our investigative skills you might say, we can simply reach out to the foreign trustees and just have them confirm to us, how they may have characterised the distribution that has been made to our client. Provided the response fits into either the corpus or capital gains categories, then our job is done – correct?
Unfortunately not, due to the existence of section HC 16, introduced to catch all the crooked foreign trustees out there, who simply can’t wait to take advantage of the New Zealand tax system, by simply narrating the distribution as something that it isn’t.
Section HC 16 basically operates to say, “It doesn’t matter what you call it, we are going to treat it this way”.
Arguably draconian in its nature therefore (because it simply ignores the reality of the situation no matter how good the foreign trusts records are), any distribution is considered to be made up of the following elements, in the following order, until each respective element is exhausted (i.e. the total distributions received by your client are in excess of the particular element):
- income derived by the trustee in the current income year;
- income derived by the trustee in an earlier income year;
- a capital gain derived by the trustee in the current income year;
- a capital gain derived by the trustee in an earlier income year; and
- the corpus of the trust.
As a consequence of section HC 16, sections HC 15 and HC 16 must therefore be interpreted together.
With respect to this interpretation of the ordering rules, some guidance (although not comprehensive in my view), can be located in IR’s interpretation statements – IS 18/01, ‘Taxation of trusts — income tax’ and IS 19/04, ‘Distributions from foreign trusts’.
As a final note, which comes back to the record keeping aspect, if the records you manage to obtain (if the foreign trustees are helpful which I have found is not always the case) are insufficient to determine the above elements, then all distributions received by your client will simply be treated as taxable distributions.
So good luck and if you get stuck, don’t hesitate to reach out for some assistance.