Understanding the Tax Treatment of Trust Distributions

When it comes to the tax treatment of trust distributions, it's important to consider the classification of the trust for tax purposes. There are three main classifications to be aware of:

Complying Trusts

Complying trusts are the most common type of trusts in New Zealand. These trusts are settled by New Zealand residents who have fulfilled all the trust's tax obligations. Additionally, all income generated by the trust has been fully taxed in New Zealand. In the case of complying trusts, income can be taxed either as trustee income or beneficiary income. However, any distributions of accumulated income, capital gains, or the trust's property (known as corpus) are tax-free.

Real-life example: Let's say John, a New Zealand resident, establishes a trust and ensures all tax requirements are met. The trust generates income from investments, rental properties, and business profits, all of which are taxed appropriately. John can choose to distribute some of the income to beneficiaries, and these distributions won't attract any additional tax.

Foreign Trusts

Foreign trusts are trusts that do not have a New Zealand resident settlor from December 17, 1987 (when the current trust rules were introduced) until the distribution is made. It's important to note that even if a foreign trust has a New Zealand resident trustee, its classification is determined by the residence of the settlor, not the trustee.

Real-life example: Sarah, a non-resident of New Zealand, establishes a trust in New Zealand through a local trustee. The trust generates income from overseas investments. If Sarah later decides to distribute some of the trust's income to beneficiaries, the distribution may be subject to tax in New Zealand, depending on the nature of the income and the specific circumstances.

Non-complying Trusts

Non-complying trusts refer to trusts that do not fall into either the complying or foreign trust categories. When distributions of income and capital gains (excluding corpus) are made from a non-complying trust, they are treated as beneficiary income or taxable distributions. Taxable distributions from non-complying trusts are subject to a higher tax rate of 45%.

Real-life example: Michael establishes a trust but fails to fulfill all the necessary tax obligations or meet the criteria for a complying or foreign trust. When he distributes income or capital gains to beneficiaries, those distributions will be subject to a higher tax rate of 45%.

It's important to note that trustee income derived from a non-complying trust is taxed at the trustee rate of 33% (which may increase to 39% from April 1, 2023, if Labour is in government).

Understanding the tax treatment of trust distributions can be complex, but knowing the classification of the trust can help navigate the tax obligations and implications for both trustees and beneficiaries.