Fair warning

Monday, 01 October 2012
Income distribution and loans from foreign foundations and trusts.

Many New Zealand-resident people who receive income by way of distributions or interest-free loans from foreign trusts and foundations do not realise that these are likely to be taxable in New Zealand and reported in their annual tax returns. Usually these distributions or interest-free loans are not returned in the respective tax returns, and go undetected until the Inland Revenue Department (IRD) comes knocking on the door.

If you, as a manager, administrator or trustee of a foreign trust or foundation established outside New Zealand, are contemplating a distribution or provision of an interest-free loan to a New Zealand-resident beneficiary, you should keep in mind the reporting obligations in New Zealand.

Usually foreign foundations are considered foreign companies for the purposes of New Zealand income tax legislation, as they often have a separate legal personality. While the foreign foundation operates like a discretionary trust where the beneficiaries benefit at the discretion of the foundation or management board, it does not change the fact that foreign foundations have separate legal personalities and thus are considered foreign companies for New Zealand income tax purposes.

The IRD has been suggesting that discretionary beneficiaries of foreign foundations are, in fact, shareholders, wanting to bring the foreign foundation within the ambit of the New Zealand-controlled foreign company regime. This argument, of course, is ludicrous, for the simple reason that the rights generally afforded to the discretionary beneficiaries of foreign foundations are limited and not automatic. More often than not, they arise at the time the foundation board decides that a distribution will be made and automatically subside once the distribution is made. Furthermore, the beneficiary rights do not include decision-making or voting rights.

While this may be true, this does not change the fact that a foreign foundation has a separate legal personality. Consequently it is treated as a foreign company for New Zealand income tax purposes, and thus any distributions or interest- free loans made by a foreign foundation to its discretionary beneficiaries are classified, under the New Zealand value-transfer provisions, as dividends. For interest-free loans, the portion of uncharged interest will be classified as dividend. For distribution, the whole of the distribution will be classified as dividend. Dividends received, other than intercompany dividends, form part of the taxable income of the recipient. These distributions will not have any imputation credits attached to them, and thus will incur a full income tax charge at the beneficiary’s marginal tax rate, which can be as high as 33 per cent. In essence, while the provisions are different, the same results occur for foundations as for foreign trusts, where low-interest loans can attract tax on the inadequacy of interest, beneficiary income distributions are taxed as dividends for a foundation or beneficiary income for a foreign trust, and capital distributions are taxed as dividends again for foreign foundations or as taxable distributions, subject to the application of the ordering rules, for foreign trusts.

There are ways to mitigate the exposure to tax. However, this can only be done before the beneficiary receives the distribution from the foreign foundation or a trust. Once the distribution is made there is not much one can do other than pay the full amount of tax. We suggest that as soon as you become aware of the possibility that a distribution will be made to a New Zealand resident beneficiary, or once you are already making distributions, you speak to an advisor to assess how the potential exposure to New Zealand income tax can be mitigated if not eliminated.

Author block
Martina Evans

Martina Evans TEP is an associate at Covisory Partners Ltd.

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