Take Care with Beneficiary Loan Accounts in Credit

It is common for family trusts to resolve that a distribution be made to beneficiaries but the actual amount paid to the beneficiaries is less than the authorised “distribution”.  In the financial accounts the difference between the authorised distribution and the actual amount paid is treated as a loan or liability of the trust owed to the beneficiaries.  This liability is often recorded in the “beneficiary current accounts” for the trust.

What is the change? 
 
From 1 April 2020, a new legislative amendment to the Income Tax Act 2007 (“Act”) will come into effect which changes the current position on charging interest on beneficiary current accounts.  The change is likely to be relevant to many trusts. 
 
Under the new position, Inland Revenue will deem trust beneficiaries who have beneficiary current accounts to be settlors of the trust for tax purposes unless:  

• the prescribed (or higher) rate of interest is charged on beneficiary current account balances; or 
• the balance of the beneficiary’s current account in the relevant tax year is less than $25,000.   

The prescribed rate of interest is the rate which applies to certain employment-related loans and varies according to the regulations applying under the Act.

Inland Revenue’s current operational position is that a failure to charge a market rate of interest on a beneficiary current account balance will not result in the beneficiary being deemed a settlor of the trust for tax purposes.  Therefore, it has been common for beneficiary current accounts to charge no interest or low rates of interest.  Inland Revenue has confirmed that its existing position will continue to apply until 31 March 2020. 

Under Inland Revenue’s existing position, a beneficiary who receives a payment of funds from a trust (as a distribution) and later loans those funds back to the trust can already be deemed to be a settlor if the beneficiary:   

• contracts to be paid nil or a less than market rate of interest;   
• contracts to receive interest but does not demand such interest or defers demanding the interest; or 
• does not demand repayment of the capital of the loan.  

 Why does it matter? 
 
The question of whether a person is a settlor of a trust can be important for a number of reasons in the taxation of trusts.  For example:

•  An increase in the number of settlors for any particular trust increases the ambit of the associated persons rules for that trust, which may have unintended tax consequences in some cases. 
•  Inland Revenue’s new position also creates tax risks for overseas trusts (with non-resident trustees) who have beneficiaries living in New Zealand, as follows: 
  • The tax residence of the settlors of a trust determines whether the trust is classified as a complying trust, a foreign trust or a non-complying trust.  Broadly, a greater variety of distributions from foreign and non-complying trusts are taxable, and at a higher rate, than distributions from a complying trust.    If a New Zealand resident beneficiary of an overseas trust is deemed to be a settlor, then the trust may in some cases become a non-complying trust.
  • A settlor can be liable as agent for all tax payable by the trustees on trustee income if there is no trustee resident in New Zealand (although in some cases this liability can be limited according to the proportion of settlements made by the settlor).  This may apply to New Zealand resident beneficiaries of overseas trusts who are deemed to be settlors.  That beneficiary may (as settlor) be jointly and severally liable for the tax payable by the trustees.   
• We have also had clients who have been subject to tax in overseas jurisdictions because they were beneficiaries of the New Zealand trusts and also deemed to be settlors of those trusts.  While, the rules for determining whether a person is a settlor of a trust may be different in these overseas jurisdictions than in New Zealand, caution should be exercised. 

To prepare for the change in Inland Revenue’s policy, we recommend you discuss the implications of any beneficiary current accounts you may have with your accountant or seek specialist advice.