Settlors, trusts and tax – What you need to know

Lee Majors rose to fame in the 80s hit TV show ‘The Six Million Dollar man’. In current times, the $25,000 Settlor might not share the same stardom, but in the complicated world of trusts and tax, it is increasingly important to have a close understanding of settlors. So what do you need to know?

We are currently working with a lot of changes when it comes to dealing with Trusts:

  • Disclosure requirements;
  • Information which beneficiaries are entitled to;
  • The definition of a settlor.

It’s the definition of a settlor that we provide some clarity on in this Knowledge Bank update.

Defining a settlor-based regime

We operate in a settlor-based tax regime, so the definition of a settlor is really important. The definition was already wide, it’s now even wider.

A settlor will now include a beneficiary who is owed by the Trust more than $25,000 at the end of the income year. This is UNLESS interest is charged at the prescribed rate (i.e. if fair interest is charged, the beneficiary has not provided value to the Trust).

This has been Inland Revenue’s historical legal position, but they didn’t have legislation to support it; they do now.

Application date

This change has effect from 1 April 2020 (note it’s the position at the end of the income year that’s driving any tax consequence).

End of the income year…

When does the beneficiary have a loan to the Trust? 

For example, the Feef Trust operates under a standard balance date to 31 March 2021. 

There’s a complicated rule re: beneficiary income and timing thereof, let’s just say the Trustees agree to beneficiary income of $30,000 on 1 May 2021 (no income tax return filed). Your trusty BDO accountant prepares the financial statements for the Trust to 31 March 2021 and records an amount owed to the beneficiary of $30,000.

Does this mean the beneficiary is deemed a settlor at 31 March 2021 or is the beneficiary a settlor for 31 March 2022 (if the debt position doesn’t change)?

It’s not necessarily clear. However, if there is an amount owed at 31 March 2021, we’d argue it arises at 11:59pm. Perhaps this is where we charge interest for one minute and the quantum probably means it’s a non-issue. 

Effectively, we therefore see this as potentially of interest for rolling balances, not new ones arising only from beneficiary income allocations for that year.

Why should we be interested?

We might not be affected, so don’t just default to charging interest to mitigate a beneficiary becoming an accidental settlor.

We might be interested though because:

  • It widens association for the purposes of the land taxing provisions (note Bright-line has taken a lot of the teeth out of association for residential property anyway);
  • Trustee income can be included in the Family scheme income and Working for Families Tax Credits calculation if the claimant is a settlor;
  • Similarly, it is also considered income in determining Student Loan repayment amounts;
  • Settlors can be liable as agent for unpaid income tax of the trust, where there is no New Zealand tax resident trustee;
  • The tax status of the Trust could make it non-complying. For example, a foreign trust which previously did not have a New Zealand resident settlor may become a non-complying trust (can we make an election?). 
  • We lose the exemption from tax for foreign sourced amounts for certain Trusts. Foreign-sourced amounts a Trust receives are exempt from income tax, provided there is no New Zealand tax resident settlor of the trust at any time in the income year. Conversely, it may be of benefit if we wish the Trust to a complying trust and need to retain at least one NZ resident settlor to do so.  

Any decision made will therefore need to be on a case-by-case basis and prevent future surprises. 

What if we are affected and contemplate charging interest, is there a downside?

A couple of things to immediately consider here: 

  • The Trust may need to account for resident withholding tax on the interest charge.
  • We have taxable income for the recipient beneficiary and perhaps no deduction for the Trust if the Trust is not applying the amount owed to income earning activities (note various new limitations for residential rentals etc).

As always, we have a team at BDO that can help.  Please contact us for more information and see other tax insights in our BDO Eyes on Tax page