Time To Plan For The Trust Tax Jump
Trust rate changes start in April next year, which means there is a window to minimise some of the impact, writes Mark Withers.
2 July 2023
Despite the government’s promise of no new taxes in the Budget, the increase of the trust tax rate to 39 per cent did not come as a huge surprise.
With the release of the IRD report into high net wealth effective tax rates and talk of wealth taxes it was inevitable we would see some change.
I would say the top marginal rate for individuals at 39 per cent and the trust rate at 33 per cent was a ridiculous anomaly. It served to incentivise those earning over $180,000 to channel their energies into sheltering income-earning assets in trusts where the tax rate was 6 per cent less.
This, of course, they were perfectly entitled to do to minimise their tax burden within the confines of what was legal. The flow-on effect of this though was increased political pressure and rhetoric on whether legitimate tax planning was somehow crossing the line and becoming “tax avoidance” and whether this might lead to tax positions being challenged and overturned.
This served no-one and cast suspicion over transactions where there was no mischief.
The leveling of the trust and high marginal rates removes suspicion from legitimate tax and estate planning decisions as reduced tax is no longer a motivator for a transaction where the rate of tax might otherwise have been altered.
The change of the trust rate is effective from April 1, 2024, which means there is a window of opportunity to plan now to minimise some of the impacts the rate change will have.
If you conduct your property investing through a standard company (not an LTC) owned by a trust and have been retaining rental income in the company, this is important for you. To understand the issue let’s go back over some fundamentals.
Companies enjoy an income tax rate of 28 per cent. If a company declares $1,000 of profit it pays $280 of tax. The remaining tax-paid profit it retains of $720 is referred to as its “retained earnings”.
For each dollar of tax paid it earns one imputation credit.
If the directors decide to declare some or all of the retained profits as dividends to shareholders the company then attaches its imputation credits to the dividend so the shareholders get credit for the tax the company has already paid.
Because the shareholders’ tax rate is higher than the company rate of 28 per cent the shareholder is required to top up the tax on the dividend. This top-up comes in the form of Dividend Withholding Tax, which is withheld by the company when it declares the dividend. While the trust tax rate was 33 per cent, this top-up was typically 5 per cent, but with the trust rate moving to 39 per cent the top-up will become 11 per cent from April 1, 2024.
Because of the differential between the company tax rate and the trust tax rate there is a tax incentive to retain profits in a company rather than distribute a dividend to shareholders. These retained earnings may have been used to repay debt or buy more property over time.
The call now is whether to distribute some or all of these retained earnings where companies are owned by trusts before the tax rate the trust must pay becomes 39 per cent on April 1, 2024.
Those wishing to do this will need to find the extra 5 per cent withholding tax required and be able to cash flow its payment to IRD at the point the dividend is declared.
Directors will need to balance the desire of shareholders to minimise the tax by distributing the retained earnings now with the company’s own requirements for this capital.
Details To Consider
There are further considerations. The 2023 terminal tax is payable April 7, 2024 and the third instalment of 2024 provisional tax is payable May 7, 2024.
This means the tax payment dates for these earnings up to March 31, 2024 are after the April 1 date when the trust tax rate rises.
There is unlikely to be sufficient imputation credits available to distribute all profits generated to March 31, 2024 unless these taxes are paid before balance date so that dividends can then be distributed fully imputed before the trust tax rate rises on April 1, 2024.
Those with properties held by trusts will need to plan for higher provisional taxes from April 1, 2024, this coming on top of the already heavy impact of the removal of interest deductibility from residential rental property.
Both issues require careful consideration and planning. Impacted taxpayers should now begin mapping out a tax strategy with their accountant to ensure they have considered the options prior to the trust rate change.
Mark and his team specialise in advising on property-related transactions, valuation and restructure services, and tax planning. Withers Tsang & Co Phone 09 376 8860, www.wt.co.nz