John Hart of John W Hart Limited explores New Zealand's foreign trust regime and its use in international wealth planning.
The New Zealand “foreign trust” regime came into being over 25 years ago. It arose from a domestic initiative to make the use of offshore trusts for tax minimisation more difficult for New Zealand residents, by imposing a tax liability on the New Zealand-resident settlor as agent for the offshore trustee. Thus the emphasis for tax purposes shifted from the concept of trust tax residency to one of taxing a trust based exclusively on the residency of the settlor.
The settlor-based taxation approach worked in the converse scenario too, allowing non-residents to settle New Zealand trusts (ie, with a New Zealand trustee and usually New Zealand governing law) without incurring New Zealand tax. Such trusts are not liable for tax in New Zealand except in respect of New Zealand-sourced income, as long as the trusts continue to have no New Zealand-resident settlors.
The “settlor” and “settlement” definitions are cast very broadly so care has to be taken to ensure no inadvertent settlements occur. Broadly speaking, the settlement concept will take into account any conferring of value upon a trust on other than arm’s-length terms. For example, an interest-free loan advance to a trust will trigger a deemed settlement.
The foreign trust regime was initially used for international wealth planning by a small number of trustees, advisers and institutions who saw the advantage in using an onshore jurisdiction with a good reputation, international standing, good laws, good infrastructure and high-quality professional services. However, the real impetus for the development of the foreign trust regime was the introduction of offshore centre blacklisting by the Mexican government in the late 1990s as a result of pressure from the OECD. This then led to advisers for wealthy Mexican clients looking to onshore, non-blacklisted alternatives – and New Zealand was one of the few available.
A number of other Latin American countries followed the blacklist approach after Mexico, and New Zealand trusts appealed to advisers representing clients from these jurisdictions as well. Eventually Mexico moved away from a simple blacklist approach, but New Zealand trusts continued to attract Mexican clients and their advisers owing to their familiarity with, and the quality of, the jurisdiction.
The saying that “onshore is the new offshore” has substance, and it received a further impetus as a result of the post-9/11 initiatives undertaken by OECD and FATF, which made life more difficult for the “traditional” offshore financial centres. Onshore jurisdictions were generally left alone, including jurisdictions such as Delaware in the United States, New Zealand and the Netherlands.
New Zealand permits the use of private trust companies, as well as managed trust companies. Trustees are not presently regulated.
In terms of practical examples of the use of New Zealand structures, the most common structure is typical of what may be found in a multitude of jurisdictions around the world: in other words, a trust settled by an individual for the benefit of the settlor and his/her spouse, children and other issue, and/or remoter relatives. Assets would typically be held via an underlying wholly owned company. Management of investments in the underlying company may be delegated to professional investment managers or associated parties of the trustee (if it is an institutional trust company), or in some cases to the clients themselves.
We see trusts structured in many other ways as well. For example, a commercial escrow trust or an employee benefits trust. In other words, any typical trust vehicle that one might see in another jurisdiction can generally be replicated in New Zealand, with one possible exception under current rules being a fully “unitised” trust. Unit trusts in New Zealand are treated as companies for tax purposes and therefore they may not get the benefit of the New Zealand foreign trust tax treatment. There are some mechanisms for planning around this difficulty by structuring such a trust as a master trust with a number of sub-trusts beneath it. It may also be feasible to achieve a tax exemption by bringing the trusts within the New Zealand Portfolio Investment Entity regime (the PIE regime). The bottom line is that care needs to be taken in respect of trusts that involve pooling of investments and unitisation.
New Zealand provides a high degree of confidentiality from a client perspective. While we have a foreign trust disclosure regime, all this involves is the furnishing to the Inland Revenue Department of a form confirming the identity and address of the trustee; the name or another identifying feature of the trust (eg, the date of the trust instrument); and confirmation that none of the settlors of the trust are Australia-resident. A New Zealand foreign trust earning offshore-sourced income does not have to file a tax return in New Zealand or obtain a tax file number.
New Zealand does have an extensive range of double tax agreements and tax information exchange agreements, and the government has signed up to the OECD Common Reporting Standard, so the present “opacity” of New Zealand trusts will inevitably change.
There is a very substantial use of discretionary trusts in New Zealand for domestic estate planning and asset protection. These tend to be fully discretionary trusts with limited powers reserved for the settlor other than perhaps a power to appoint and remove the trustee and/or to appoint and remove beneficiaries. This lack of control at settlor level is, however, watered down by the fact that most domestic New Zealand trusts involve the settlors acting as trustees, or as directors of a private trust company.
What we have seen in recent years, particularly with the growth of the use of trusts by Latin American clients, is a demand for revocable trusts and trusts with substantial powers reserved to the settlor or other parties. While revocable trusts are unusual by New Zealand domestic standards they are permitted at law in New Zealand.
Reserved powers trusts are somewhat more of a novelty and have yet to be examined by our courts. However, if properly crafted there is no reason a reserved powers trust will not be considered valid and effective according to its terms, as long as clients and their advisers do not go overboard in reserving so many powers that the trustee is simply functioning as a nominee or custodian, in which case the efficacy of the trust for the client’s domestic tax planning or other purposes is likely to be compromised.
Migration out of New Zealand
It is worth addressing some of the quirky, and potentially hazardous, consequences that arise for a New Zealand “complying trust” (generally a domestic trust established by a New Zealand tax resident) which become tax-exempt in whole or in part at the time of a resident’s expatriation.
For a New Zealand-resident individual who has a New Zealand trust, it will in the ordinary course of things be a complying trust. The trust will not be categorised as a “foreign trust” once the individual ceases to be a New Zealand tax resident, as such a trust must have never had a New Zealand-resident settlor. However, the trust will be treated as if it was a foreign trust under section HC 26(1) of the Income Tax Act 2007 (the Income Tax Act).
That section provides that:
A foreign-sourced amount that a New Zealand resident trustee derives in an income year is exempt income under section CW 54 (foreign-sourced amounts derived by trustees) if no settlor of the trust is at any time in the income year a New Zealand resident who is not a transitional resident.
This appears to be a good outcome from a tax perspective, as it means that the trust will effectively be treated as a foreign trust. However, one very significant downside of retaining a New Zealand trust which was previously a complying trust, and treating it as a tax-free vehicle once the individual migrates offshore, is that the trust will then no longer satisfy the “complying trust” definition in the Income Tax Act. A requirement of that definition is that, for the life of the trust up to the time of the distribution:
no trustee income derived includes an amount of non-resident passive income, or non-residents’ foreign-sourced income, or exempt income under section CW 54 (foreign-sourced amounts derived by trustees).
Section CW 54 states:
To the extent to which section HC 26 (foreign-sourced amounts: resident trustees) applies to a foreign-sourced amount that a trustee who is resident in New Zealand derives in an income year, the amount is exempt income.
As mentioned earlier, a trust in this category does not become a foreign trust at the time of migration of the settlor. In light of this last extract, clearly the trust also loses its status as a complying trust. This leads to only one conclusion: the trust has become a non-complying trust. This conclusion arises because the definition of non-complying trust is relatively “short and sweet”, as it is defined as a trust that is neither a complying trust nor a foreign trust.
A non-complying trust is subject to a penal tax regime. Distributions from the trust (other than beneficiary income – ie, current year income – and corpus) may be categorised as taxable distributions, taxed at the rate of 45 per cent.
Applying the definitions in the Income Tax Act, arguably this penal treatment could apply to distributions of tax-paid income earned while the trust was previously a complying trust. This is nonsensical, as the income would have already been taxed once, but unfortunately the definition of “taxable distribution” does not appear to allow the reserves accumulated during the period that the trust was a complying trust to be exempted from the taxable distribution definition. The focus is on the status of the trust at the time of the distribution.
Can we overcome this problem by voluntarily paying tax in New Zealand upon the trust’s worldwide income, in the hope that this will mean it satisfies the complying trust definition? Technically I do not believe so as the income in question is exempt income under section CW 54.
The Inland Revenue officially advises taxpayers that they may elect to keep such a trust as a complying trust by filing an election under section HC 33 of the Income Tax Act, but there is serious doubt about the validity of such an election given the income in question is exempt income.
Thankfully, the Inland Revenue Department has finally dealt with this anomaly by introducing remedial legislation presently before Parliament. This will validate the election process. Even if no election is made, if a trust continues to pay tax on its worldwide income it will retain complying trusts status.
Migration into New Zealand
For a new migrant to New Zealand, or a returning expatriate who has been non-resident for a continuous period of 10 years or more, there is a very attractive “transitional resident” tax exemption. This exempts the new arrival from tax in New Zealand on foreign-source income for four years.
For a non-resident migrant who has a foreign trust (ie, one settled while non-resident), that trust will retain its foreign trust status for up to five years after the individual settlor acquires NZ tax residency. After that date the trust will be deemed to be a complying trust (if an election is made to be one); or a non-complying trust if no election is made. From that date the trust will be treated for tax purposes as if it were two trusts with the different tax treatments applicable to complying, foreign or non-complying trusts.
Surprisingly, a non-complying trust can provide a useful tax deferral vehicle for new migrants, in a limited number of circumstances.
The key downside of a non-complying trust is that capital gains when distributed will be taxed. By contrast capital gains distributed from a foreign trust to a New Zealand resident beneficiary are tax-free.
It is important to note in respect of distributions of capital gains, that the key test is realisation of those gains, rather than the accrual of the gains. For example, if an asset valued at $1 million was injected into the trust, and if at the time of commencement of tax residency that asset was worth $2.5 million, it would be rather nice if that accrued gain was forever outside the New Zealand tax net. However, if the asset is sold for $3 million after the trust’s status changes to non-complying, the realised capital gain of $2 million would be exposed to tax when distributed to a New Zealand resident beneficiary.
Therefore accrued capital gains should be crystallised by sale prior to losing foreign trust status so they can later be withdrawn tax-free.
The situation with income reserves can also be problematic, as past-year income that has actually been derived by the trustee prior to the commencement of the individual’s residency (even if many years before that date) would be taxable to the beneficiary as a taxable distribution if distributed to the beneficiary while resident in New Zealand. This is the case for both foreign trusts and non-complying trusts.
In light of this, it is clearly desirable to extract revenue reserves prior to ceasing to be a transitional resident – ie, four years after residency commences.