Tax Planning for the 39% Trust tax rate increase.

Despite the government promising no new taxes in the budget the increase of the trust tax rate to 39% did not come as a huge surprise.

With the release of the IRD report into high net wealth people's effective tax rates and talk of wealth taxes it was inevitable we would see some change.

If you asked me to be philosophical, I would say this, the fact that the top marginal rate for individuals was 39% and the trust rate was 33% 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% less.

This of course they were perfectly entitled to do to minimize 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 nobody 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 1 April 2024 which means there is a window of opportunity to plan now to minimize 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%.

If a company declares $1000 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 that 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% 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% this top-up was typically 5% but with the trust rate moving to 39% the top-up will become 11% from 1 April 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% on 1 April 2024.

Those wishing to do this will need to find the extra 5% withholding tax required and be able to cashflow its payment to IRD at the point the dividend is declared.

Directors will need to balance the desire of shareholders to minimize the tax by distributing the retained earnings now with the companies own requirements for this capital.

There are further considerations.

2023 terminal tax is payable 7 April 2024 and the 3rd installment of 2024 Provisional tax is payable 7 May 2024.

This means the tax payment dates for these earnings up to 31 March 2024 are after the 1 April date when the trust tax rate rises.

This means there is unlikely to be sufficient imputation credits available to distribute all profits generated to 31 March 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 1 April 2024.

Those with properties held directly by trusts will need to plan for higher provisional taxes from 1 April 2024, this coming on top of the already heavy impact of the removal of interest deductibility from residential rental property.

Both these issues now 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.

By Mark Withers of PKF Withers Tsang