Planning for the 39% Trust Tax Rate

You may be aware that the Labour Party recently announced that the Trust tax rate will move from 33% to 39% from 1st April 2024. Assuming the proposal survives the election, in our view closely held companies with Trust shareholders should give some consideration to whether there are reasons to declare dividends before 31st March 2024 and going forward more regularly.

By way of background:
  • When a company retains profits it pays tax on these profits at 28% tax. The accumulated after tax earnings are recorded as retained earnings in the Financial Statements of the company.
  • The tax paid by the company is available to attach to retained earnings when they are ultimately distributed to shareholders.
  • The record of the tax paid by the company, available to be attached to the retained earnings is kept in what is referred to as an Imputation Credit Account (ICA).
  • Further to the standard 28% company tax rate, when a company wishes to distribute the retained earnings to shareholders, there is a requirement to attach 33% tax credits. With 28% having already been paid previously, at the time of the dividend the company pays an extra 5% tax referred to as Dividend Withholding Tax (DWT).
  • From a shareholder perspective when dividends are received there is 33% of tax already paid on the shareholders behalf. As such when the Trust tax rate is 33%, there was no additional income tax to pay. Once the Trust tax rate becomes 39% the Trust will have a further 6% to pay.
Factors to bear in mind when considering clearing out retained earnings:
  • Impact on cash flow – this is perhaps appropriately the number one consideration. By declaring dividends earlier than might otherwise be the case the DWT cost is brought forward. As such there are time value of money considerations. Any cash paid to IRD ahead of when that might usually occur, is cash that is not available for other things. Each company will need to consider whether the cash flow can sustain the DWT cost now and/or what the opportunity cost of the funds is. If companies are not able to pay the dividends in cash there will need to be agreement between shareholders and the company as to what happens with the net dividend.
  • Company windup – if a company has Trust shareholders and retained earnings and it has plans to wind up. Subject to cash flow considerations it will be appropriate to clear retained earnings before the new rate applies.
  • Cash being paid to shareholders – if a company is planning to pay cash to its shareholders by way of a dividend. Subject to cash flow consideration it may make sense to declare a larger dividend now to allow the cash to be drawn over time.
  • Continuity – the tax that companies pay on their retained profits (the record of which is kept in the company ICA) is effectively owned by the shareholders in place at the time the tax was paid. As such, there are shareholder continuity rules that force the forfeiture of ICs if the shareholding changes by more than 34% on a cumulative basis. If ICs are forfeited, the tax previously paid is no longer available to attach to the retained earnings when distributed. This is a problem because a company must attach 33% tax credits to all dividends. The result is that the company instead of paying 5% must pay 33% tax to distribute the retained earnings. The way to avoid losing tax credits when significant shareholding changes happen is to pass dividends prior to the shareholder change.

With the above in mind if there are shareholding changes on the radar subject to cash flow considerations it may make sense to clear the tax credits before that occurs.

Will the proposal survive the election?

If not and companies have paid dividends earlier than might have otherwise been the case they have also paid tax (5% DWT) earlier than might have otherwise been the case.

Is this tax avoidance?

We are aware that IRD are making some noise about the process of declaring dividends ahead of the 39% tax rate increase being some form of tax avoidance. The common view of tax specialists is that companies that declare dividends are not avoiding any tax rather they are incurring tax earlier than might otherwise be the case. That being said the long held adage is that anything done solely for tax purposes is frowned upon by IRD. As such if shareholders permanently waiver their entitlement to drawing the dividend in cash that could be a problem. It is important to have the correct paperwork in place to support any dividends done, and that there is no backdating of dividends.

I just have a Trust – how am I affected?

As noted above, this proposed rate change means that Trusts will have an additional 6% tax to pay beyond 1st April 2024 on any retained income if this is not distributed at lower rates to beneficiaries. Where there are usually distributions, there may be little impact as the tax is actually being paid on the residual rate of the beneficiary, not the Trust (note individual circumstances apply here).

However, the devil will be in the detail of the final legislation.

We will be reviewing Trusts and these structures on an individual basis, as we do the annual reviews with you our clients, over the coming months.

In the meantime should you want to discuss any of the above, please do not hesitate to give us a call.