Avoiding 39% tax in family trusts

As you will probably know, trusts are to be taxed at 39% if their income exceeds $10,000.

It is reasonable to expect a large number of trusts will have exactly or almost exactly $10,000 of income because the tax rate will be 33%. Be aware if you go just one dollar over the $10,000 threshold, all of the trust income is taxable at 39%.

Inland Revenue has issued a statement explaining what it will accept as legitimate tax avoidance and therefore acceptable. It includes the following:

  • Where a company is owned by a trust, a change in dividend policy is acceptable. For example, you could reduce trust income by just not paying dividends. 

  • Distributions to beneficiaries who have a lower tax rate.

  • Trustees could create a company and transfer income earning assets to it, which would then be taxed at 28%. However, see the last bullet point below in the list of unacceptable ways of avoiding the high rate of tax.

  • Winding up the trust.

  • Using PIE investments, which are taxed at 28%. Comment: Is this going to take money out of the bond market and possibly have an impact on the intereTalk to us if you have a trust and would like to know what options are available to youst rates offered by issuers?

Inland Revenue will not accept artificial and contrived ways to dodge the high rate of tax. Examples include:

  • Allocating income to a beneficiary who has no knowledge they have received the money or expectation of being paid it.

  • Using loans from a company to get funds into a trust instead of paying dividends to it. The loans could then be on-lent to beneficiaries.

  • Artificially altering the timing of income or expenditure, particularly where it is linked to existing contractual terms or practice.

  • Creating artificial expenditure, such as the trust paying management fees to a company, which cannot be commercially justified.

  • Making distributions to a company beneficiary where that company shares are owned by the trustees. Where this happens, the distribution has to be taxed at 39%.

  • Allocating income from a trust to a beneficiary who later resettles this money (gives it back) to the trust.

Changes to the Bright line test on property held briefly

Residential rental property owners will know they could be subject to tax on any gain on sale if they’ve owned the property for only a short period of time.

The name for this short period is “the bright line test”.

There were three bright line tests – for two years, five years and 10 years. Effective from 1 July 2024 it is proposed to replace the three bright line tests with just one test.

It will be for a two-year period regardless of whether the property was bought before or after 1 July 2024.

Note the start of the bright line test is from the date of settlement on purchase. It is not from the date of signing the sale and purchase agreement, unless it is a purchase off the plan in which case it is the date the agreement is signed. This has always been the case. The bright line period ends at the time of signing a sale and purchase agreement for the sale of property.

Main home exclusion - Here are some points to remember:

  • Where the bright line end date is after 1 July 2024 the main home exclusion will be based on the predominant use of the land.

  • The land must be used most of the time as the main home.

  • The exception is for a new build. When determining the predominant use, you ignore the period under construction.

Interest deductions on residential rentals

There have been significant changes to the tax deductibility of interest paid to buy residential rental property.

Previously, subject to certain transitional rules, the interest on money borrowed to buy property where the sale and purchase agreement was dated after the 27 March 2021 was not tax deductible.

Limits were imposed on property bought before this date. 

The current situation is:

Year ended 31 March 2024 – 50% of interest is claimable on property where the sale and purchase agreement was dated on or before the 27 March 2021.

Year ending 31 March 2025 – the cut-off date is dropped and interest deduction is partially allowed for all borrowing. The claim is limited to 80% of the interest incurred.

Year ending 31 March 2026 onwards – full tax deductibility of interest is restored.

Tax rate for trusts to go to 39%

Tax distortions are increasing.

A short while ago the top tax rate for both an individual and a family trust was 33 percent. When this was increased to 39 percent for the individual, there was an obvious incentive to retain as much income in a trust as possible.

If you have a trust, click here to read the whole article …

This led to the former government proposing an increase to 39 percent tax on trusts, effective from 1 April 2024. At this stage the new government has made no comment regarding the previous government’s proposed 39% flat tax rate for trusts. The Bill covering this lapsed when Parliament recessed for the election. 

If we assume the new government follows through with this and your taxable income is less than $180,000 (the threshold for the increase to 39 percent tax) it would pay to distribute as much of the trust income to you or any other beneficiary whose income is below $180,000. You would be paying tax at 33 percent whereas the trust would be paying tax at 39 percent. Remember, if you allocate income to a beneficiary to save some tax, you must also pay that beneficiary the money, at some stage.

There is just one problem. One of the prime reasons for setting up a family trust is to protect family assets so they can’t be sold up by creditors, if you’re ever sued. So, if the trustees of your trust distribute income every year to you and you don’t spend it, those savings would not be protected from someone suing you. Whereas the assets remaining in your family trust do not belong to you and would not be available to pay your debts.

As you can imagine, the income distributed from your family trust to save tax could accumulate to quite a large sum. If you give it back to the trust, ie its gone in a circle, Inland Revenue could say you only distributed it to avoid tax. It’s very difficult to predict when IRD will use the avoidance provisions they have at their disposal– please take our word for it being a risk.

Companies pay tax at the rate of 28 percent. Therefore, if you accumulated your savings within a company, you would pay a lot less tax than you would by doing so through a trust. You wouldn’t have the protection a trust offers, but that that might not necessarily matter to you.

The only time you would pay more than 28 percent is when you wanted to use some of the money. You would need to declare a dividend, which would then become part of your income.

When you retire and your income falls, you might find the distributions from a company ultimately get taxed at a lower rate than 28 percent and you actually get some tax back, depending on your other income.

It’s unlikely the government would consider putting up the company tax rate because New Zealand companies would not be competitive with those overseas.

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So we are keen! We’ll be contacting you once we have it sorted our end for your ONLA regular payments; and once we do it we’ll be able to help or advise you if you think it’s right for your business too.

Interest and rentals

The Government has produced a 143-page discussion document to try and sort out the complications arising from disallowing an interest deduction on residential rental property.

A typical complication is where the residential property is owned by a company and only forms a small part of the company income. Funding for the company can be constantly changing, so how do you know how much to allocate to the residential rental property?

Another one is the person who takes in a boarder or lets out part of their main home as an Air B&B. In these cases, the proposal is to allow a proportionate interest deduction.

For those who owned property before the law change, the deduction is to be scaled down over four years. The first reduction occurs at October 1 this year. The claim for interest is calculated on the basis of it being incurred. This means if you paid interest to, we will say September 25, you would also be able to claim the interest through to the end of September, even though you will not be paying it until after October 1.

Inland Revenue makes a meal of expenses

Inland Revenue has produced their interpretation of the tax law IS 21/06 on the subject of meal expenses.

The interpretation is based on case law.

The general principle is the self-employed can’t claim meal expenses, but shareholder employees of companies can. Why?

A company is a separate legal entity. It’s allowed to reimburse its staff, including the owner of the business, when they are away from work, for refreshments they could have received at work.

If an employee has to have a meal, due to having to work at a long-distance from the company base, the cost can also be tax deductible to the company. For example, a company employee has to work so remotely from the company base that it’s not until 9pm that they get home. It would be reasonable for an employer to pay for dinner. This would be tax deductible and it would not be income for the staff member.

A private individual running a business is treated differently. The legal starting point is that any food or drink is a personal cost because it’s necessary to maintain life.

Taking the example of getting home at 9pm, if the self-employed person bought a meal before travelling home, this would still be considered a personal expense.

There can be extreme examples. For example, a self employed person has to go to the Chatham Islands and stay the night. The only accommodation he can get into is the Waitangi Hotel. Although there is a supermarket, there is no self-catering at the hotel so he has to buy his dinner.  The excess cost of the meal over what he would normally pay, is tax deductible.

Note: If this person was running a company they would be an employee and the entire cost of dinner would be tax deductible.

What if the self-employed person has a couple of employees? Because they are away from their business base, the employer buys coffee and doughnuts for all three for morning tea. The expenditure on the employees is a tax-deductible cost. The expenditure for the employer is a personal cost and not tax deductible.

Instead of reimbursing, can an employer just pay a fixed allowance for morning and afternoon teas when the employee is working in a place away from their work place?  Yes.

One of the illustrations has an employee living in Upper Hutt and working all day in Wellington, about 30km away. Inland Revenue has used a reimbursement figure of $15.