SME Tax Regimes: What Must Change Prepared by: Michael Turner Polson Higgs October/November 2014
Polson Higgs Polson Higgs is a leading independent accounting and business advisory firm in the South Island. The firm employs over 60 staff and has 5 partners specialising in all aspects of accounting and business. Polson Higgs is recognised as one of the leading providers of tax expertise in the South Island. It prides itself on providing pro-active, practical and down to earth tax advice to its clients, which range from high profile corporates to family businesses. Recognising the important role of continuing education, Polson Higgs has been involved in writing and presenting a large number of highly successful national courses. Disclaimer Polson Higgs professional development provides training and materials. While every effort has been made to ensure the material provided is up to date and accurate at the time of publication, the material is general in nature and should not be used as a substitute for professional advice. Accordingly, specific professional advice should be sought on any matter before relying on the content of this course. No responsibility is taken for updating this material from the date of publication or in relation to sales after the event. Copyright Notice Polson Higgs 2014 Polson Higgs reserves the copyright in this work under the Copyright Act 1994 and accordingly the work may not be copied or reproduced without the specific written approval of Polson Higgs. Enquiries should be addressed to: The Training Manager PH: (03) 477 9923 Polson Higgs PO Box 5346 Dunedin 9058 Printed: October 2014 Disclaimer
Biographical Details Michael Turner Partner Polson Higgs Dunedin Michael started his career in Business Services, working for three years with small businesses before specialising in Tax in 1993. Michael is a partner at Polson Higgs, has been a lecturer and examiner in taxation at the University of Otago and has presented extensively on tax matters over the last 20 years. This includes presenting national courses on a wide range of topics. He is currently a member of the Institute s Tax Advisory Group and is involved in submissions to IRD and Government on tax changes. Biographical Details
SME Tax Regime What Must Change Contents Polson Higgs... 2 Disclaimer... 2 1 Introduction... 1 2 Company... 2 3 Look-Through Company... 9 4 Trusts... Error! Bookmark not defined. 5 The Case for a Qualifying Company Regime... 16 6 How do we achieve simplification for SMEs?... 19 Contents
1 Introduction In this paper I attempt to review SME tax regimes or parts thereof which require change both from a big picture point of view as well as some of the detail. The views expressed in this paper are my own. It should be acknowledged that IRD policy and strategy are currently working on a project which will consider a number of the areas I comment on. While we look forward to the project having a positive outcome, history will show that many of these issues have existed for years and in some cases decades. In this paper I focus on issues under the relevant entity headings, however the issues do tend to fall under the following broad headings. 1. Is the policy right? 2. Does the legislation satisfy the policy? 3. It might be right but it is just too hard 4. A solution looking for a problem 5. It works just as long as you do not look at the detail It has been suggested that 97% of enterprises in New Zealand are small businesses. There are 459,300 enterprises employing fewer than 20 people and a further 380,000 selfemployed people (The Small Business Sector report 2014 from the Ministry of Business Innovation and Employment), so in total there are over 800,000 people looking to prepare tax returns based on the SME tax regimes available. Often these SME businesses have limited resources (money and time) to spend on meeting tax compliance, they are relatively unsophisticated taxpayers and materiality means not all complex issues can be satisfactorily resolved. For these reasons, it is vitally important that the regimes available to these businesses are as simple as they can be and provide certainty in their application. Complexity and uncertainty places an unjustified burden on the SMEs and in extreme situations creates undesirable behaviour. A dividend review was promised by the Government as part of the grand-parenting of the QC regime and the removal of the LAQC regime (see above comment about work currently underway). The original proposed window for a QC/LAQC to transition to a LTC was 6 months from the start of the 2011/2012 year. Following the Institute s submissions that taxpayers should be entitled to digest the outcome of the review of the dividend rules before they make a final decision, a further window of 6 months was inserted from the start of the 2012/2013 year. Following enactment of what was effectively a two year transition rule, we received feedback from the IRD that this was in response to our submission that people wanted transitional rules at the end of the dividend review. Accordingly, this review should have been completed and changes legislated by 30 September 2012 at the latest to satisfy the objective of the two year transition window. It is disappointing that this timeframe was not met. Page 1
2 Company Under the company heading, the following items are worthy of discussion. There will undoubtedly be further issues which others will also see as priorities. Substituting Debentures Historically, there have been issues in relation to debt and equity funding that have implications for deductibility purposes. Section FA 2 potentially comes into play where the company borrows funds and the borrowings are linked to shareholding (substituting debentures) or where interest payments are linked to the level of profits earned by the company (profit related debentures). Arguably, all single shareholding companies were potentially subject to the substituting debenture rules, with 100% of shareholder loans coming from the 100% shareholder. In addition, many family SMEs were also potentially subject to the rules. The Taxation (Annual Rates, Employee Allowances and Remedial Matters) Bill looks to address these historic sections and repeals the part of section FA 2 which relates to substituting debentures because these rules are out of date and no longer serve any purpose. These changes will apply from 2015/2016. These substituting debenture rules were introduced in 1940 and the policy rationale was made largely redundant by the imputation system (introduced in 1989). The IRD have noted the rule could be easily circumvented and there was likely to be non-compliance from a lack of awareness. The repeal of the substituting debenture rule will be welcome, however SMEs have had to live with the uncertainty and complexity created by the existence of section FA 2 perhaps for 24 years longer than was necessary. Dividends Where dividends are fully imputed, practically it is the difference between the company tax rate (28%) and the shareholder tax rate (33%) that will give rise to the need for RWT. While dividends will be able to be fully imputed, the maximum rate imputation credits may be attached at is currently 28/72. RWT on dividends has remained at 33%. Accordingly, even where dividends are fully imputed a 5% RWT cost will apply. For qualifying companies, any dividend is exempt from RWT. The reduction in the company tax rate while RWT on dividends remains at 33% imposes an arguably unnecessary compliance cost on SMEs. In many instances for SMEs, pre-tax income could be paid to the same group of people (or to people within a family) with no requirement to deduct tax (e.g. shareholder salary subject to section RD 3(2)), so the argument that RWT reduces the risk of non-payment must be questioned. Likewise the fact that QCs are not subject to RWT on dividends suggests the issue is not significant. The dividend RWT rules, while existing for many years, were in the main academic with a company tax rate at 33% and a maximum RWT rate on dividends at 33%, reduced by imputation credits. However, the reduction in the company tax rate from 33% to 30% in 2008/2009, and from 30% to 28% for the 2011/2012 and later years has resulted in this issue now being material. Page 2
Shareholder salaries When PAYE is required to be deducted from shareholder salaries is set out in section RD 3(2). While these rules are broadly understood, there is still a wide-spread practice by some of deducting PAYE from regular payments to shareholders and not deducting PAYE from year-end bonuses. This approach does not fit with the legislation as it currently exists, but one must ask, if it allows SMEs to manage their tax payments, and the Government ends up with the tax at roughly the same time, should this common practice be legislated for? Shareholder employee loans Calculating interest at the prescribed rate on employee loans is often important to avoid a FBT liability. To correctly calculate interest, it is necessary to establish the daily loan balance. Under section RD 36, an amount of income an employee applied to a loan is treated as being applied towards the repayment of the loan on the first day of the income year (or the day the loan was advanced if this is a later date). Accordingly shareholder employees who are crediting salary, interest and dividends against their overdrawn current accounts potentially get the benefit of those credits (for FBT purposes) from the first day in the income year. However, section RD 36(2) limits the application of salary, interest or dividends to those loans on the first day of the income year where PAYE, RWT or NRWT is required to be withheld. Previously, section RD 36(2) required that the income was not resident / non-resident passive income. The relaxing of this, effective from 1 April 2008, potentially meant that fully imputed dividends would be credited at the start of the year. However, as soon as the company tax rate dropped below 33%, this was no longer the case. This is surely worth revisiting. Inter-group transfers Where a transfer of value occurs between two companies (i.e. an interest free loan), this could be a dividend where the recipient company is associated with a shareholder in the company providing the value. Section CD 27 potentially provides relief. Where property (not a loan) is made available at less than market value, and the value of the benefit is less than $10,000 in the year, the transaction can be ignored (section CD 27(2)). Where the company providing the value is a shareholder in the recipient company (or is associated with another company that has a shareholding in the recipient and the associated company could have received the transfer without creating assessable income), section CD 27(3) potentially applies. This is targeted at subsidiary companies owned by the same parent company. In addition, for section CD 27(3) to apply, the associated company cannot have a shareholding in the company providing the benefit and no person (other than a parent company) has both an interest in the company providing the benefit and an interest of more than 10% in the associated company. Accordingly, section CD 27(3) is targeting: Page 3
Interest free loan Mr X 100% Company A Company B 75% Company X 100% 75% Company A Company B Interest free loan Inter-entity loans are common however the application of section CD 27(3) is far from straightforward. Should section CD 27(2) be extended to include loans where the interest benefit is less than $10,000 and provide a simple threshold in addition to section CD 27(3) that can be easily applied? Capital gains Capital gains made by the company will generally be tax free (given the absence of a capital gains tax in New Zealand), but these cannot be distributed tax free to the shareholder, other than on liquidation (section CD 44). In addition, capital gains made on a transaction with an associated person will be tainted and will be taxable on distribution (section CD 44(10B)). A transaction between a company and an associated person that results in a capital gain only remains available for the tax free distribution on liquidation where: The company is a close company (where there are 5 or fewer natural persons who own more than 50% of the company); and The associated person is not a company; and The disposal is on the liquidation of the company (see Binding Ruling BR Pub 10/06 for an explanation of what this term means). The tainted capital gains provision dates back to section 4(5A) of the Income Tax Act 1976. This provision existed at a time that section 4(5) of the Income Tax Act 1976 provided that the distribution of capital gains to shareholders was not a dividend. Accordingly, one can understand the policy rationale of excluding related person capital gains from what could be distributed tax-free. However with the repeal of the ability to pass capital gains out in a tax efficient manner from 1 April 1988, section 4(5A) was continued in section 4A(9). The policy rationale for retaining the provision must have been relating to a concern that companies would restructure by selling assets to new companies as a way to increase the tax base, or to allow shareholders to access the unrealised capital gains. At best, the current rules result in significant overreach of this policy rationale, potentially impacting on many commercial intra-family transactions. This provision remained in place until the Taxation (International Taxation, Life Insurance and Remedial Matters) Act reformed the definition of associated person from 1 April 2010 by repealing what was contained in section CD 44(11), dealing with related person capital gains and replacing it with section CD 44(10B) dealing with associated person capital gains. The proposed change from a related person to an associated person rule was strongly opposed by the Institute. In its 2009 submission on this point, the Institute stated that: Page 4
The current proposal is to change the related person test to an associated person test, which will greatly reduce the scope for these dividends to be passed out in nontaxable form. As noted above, the proposed definitions of associated persons are broad and unwieldy, and it [is] unreasonable to expect taxpayers to agree to such proposals when there is no indication of where the limits of the associated persons boundaries lie ; and later The Institute considers that this is not a simplification rather a broadening of the distributions that are taxed as dividends upon the liquidation of a company. Accordingly the Institute submitted that the proposal should be withdrawn. However, rather than withdraw the proposal, the Government enacted them resulting in the broadening of the tax base identified by the Institute. The broader associated person test makes it very difficult to carry out cost effective legitimate succession planning for SMEs. Instead, SMEs are forced into complex processes often involving in specie distributions to get around this issue. Example Bob is an elderly farmer who has been farming in a company (not QC or LTC), owned by the family trust. He has two sons who are both working on the property. The company s land holding represents the family farm that Bob purchased from his parents plus a smaller standalone property and some grazing blocks that were acquired 10 years ago. Bob now believes it is time to pass ownership of the properties to his sons. His plan is to sell the smaller stand-alone property and grazing blocks to his youngest son s company, and transfer the shares in the family company to the other son. The proceeds from the share sale will be used, via the trust, to equalise the equity between the two sons. Under section YB 3, the existing company will be associated to the sons. Each son, as a beneficiary of the trust, will be deemed to own the shares in the family company. Likewise, a company owned by the youngest son will be associated under section YB 2. Accordingly if the transfer of land from the family company to the son or son s company results in a capital gain, it is tainted and will be taxable on liquidation. Note this would not give rise to an adverse tax issue if the company was a QC. Section CD 44(10C) will not provide relief as the transaction is not on liquidation. Accordingly Bob, if he wishes to carry out the transaction in a tax-effective manner, will need to commence liquidation and in specie distributions of the properties to the shareholder trust (note section CD 44(10C) cannot apply as the company is not a close company), and the trust will then need to sell the respective properties to the sons. The distribution of the property under an in specie distribution will be regarded as a market value transaction (section FC 1) and will require consideration of depreciation recovered, gains on trading stock and other tax issues. The transfer from the trust to the sons will be a further market value transfer. The liquidation and in specie distribution will come with a cost (legal fees, valuation and liquidation costs), as will the requirement to crystallise tax issues on both properties (depreciation recovered, transfer of consumables, and possible some livestock issues). These costs may in fact prevent the transaction from occurring or might force an alternative Page 5
transaction, such as the two sons owning 50% each of the company and carrying on the business together. Alternatively, the issue may not be considered and a tainted gain realised in error. As explained above, I do not believe there are sufficient policy grounds to justify such a major impediment to an ordinary family succession issue. Urgent legislative reform in this area is critical. In addition to the above, section CD 44(10C) provides the associated person capital gain issue in section CD 44(10B) does not exist if: The company is a close company; and The associated person is not a company; and The disposal is on the liquidation of the company. In this context, the definition of close company becomes particularly important. Close company is defined in section YA 1 as a company where 5 or fewer natural persons hold more than 50% of the voting interest or market value interest. Natural persons refers to individuals and excludes trusts. Accordingly, with modern company ownership often incorporating substantial trust ownership (commonly 98% in SMEs), these companies do not meet the definition of close company and therefore do not benefit from the concession set out in section CD 44(10C). Depending on what progress (if any) can be made in relation to associated person capital gains, refinement of section CD 44(10C) may also be desirable. If one was starting with a blank piece of paper, the question should be asked, should shareholders in all SME companies be able to access capital gains without the need to liquidate or join a special regime. Under the heading The Case for a Qualifying Company Regime, I strongly suggest at least an elective corporate regime allowing access to capital gains is required. The Government s proposed dividend review should go further and consider the policy reasons for not allowing all SME companies tax free access to capital gains without liquidation. Unimputed reserves Care needs to be taken in any instance where reserves can arise in the company but no imputation credits exist. This can arise for instance where a transaction occurs for tax purposes at a different value to market value (the value the transaction should be reflected for commercial purposes and for accounting purposes). The new section EC 4B and section EC 4C dealing with the transfer of livestock potentially give rise to such a situation. Section EC 4B (effective from 28 March 2012) requires the transferee on a transfer of livestock from an associated person to elect to use the herd scheme. Where section EC 4B applies, section EC 4C will then deem the transfer of livestock to occur at herd values at the end of the income year. Accordingly commercial values may differ from tax values potentially giving rise to unimputed reserves. Page 6
A similar result occurs under the mixed use asset rules under section CW 8B where some income from the mixed use asset is treated as exempt. The IRD believe this to be a wider policy issue where income with tax preferences is clawed back when profits are distributed from companies. In my view it is the Government that has set the legislation giving rise to the exempt income and it is inappropriate to now tax that, especially for example when the Government have specifically denied the deductions relating to that income (e.g. mixed use assets). Example Crow s Nest Limited own a holiday home on the Coromandel. Over the year, the following occurs: Days $ Third party rental 30 7,500 Shareholder rental 30 7,500 15,000 Less expenses 15,000 Profit Nil Assume the quarantining rules do not apply. Under section CW 8B, the shareholder rental is exempt from tax. Under section DG 9, only $7,500 of expenditure will be tax deductible (15,000 x (30 60)), with a deduction denied for the other $7,500 of the costs. However, on distribution of the exempt income from the company (with no imputation credits), a $2,475 tax liability results. This result is completely inappropriate when in reality the property has broken even. If the section CW 8B income is to be eventually taxed, equity would say the $7,500 of disallowed deductions should be reinstated. I believe further legislative reform is justified in this area. Debt remission / capitalisation One issue which has exercised practitioners minds for some time is how to deal with insolvent companies for tax purposes. Clearly there are also commercial implications (i.e. the Companies Act 1993) where a company trades while insolvent. With debt remission producing an asymmetrical tax result under the accrual rules, practitioners were forced to consider capitalising debt into shares to avoid remission income (i.e. taxable income, with no corresponding deduction). This issue has been with us for quite some time, dating back probably to the introduction of the accrual rules, although the debt parking rules applying from 20 May 1999 further limited options available. In May 2014 the IRD released a draft QWBA covering the application of section BG 1 to four scenarios. Scenario 4 dealt with debt capitalisation. It should be noted that the final QWBA QB14/11, issued in October 2014, omits Scenario 4 as a result of wider issues requiring clarification. Scenario 4 involved an insolvent company agreeing to repay to a shareholder a portion of their loan and the shareholder subscribing for more shares with the two amounts offset so that no cash changes hands. The IRD originally suggested that section BG 1 would potentially apply, as Parliament intended that remission income be taxed and the overall effect of the transaction from an economic and commercial viewpoint is that this loan has been remitted. Page 7
I hope the wider issues requiring clarification means that this scenario is being considered from a policy perspective, as this tax outcome is unacceptable where net shareholder s ownership interests are not changed by the debt capitalisation. The hope is that this will be a feature of the Government s next tax policy work programme. Note also the comments below under the heading How transparent is a LTC which discusses the implications of liquidating a LTC which owes money to shareholders. Page 8
3 Look-Through Company Introduction The LTC regime was introduced with some haste and was effective from 1 April 2011. It is fair to say that the regime has a number of technical deficiencies and at this stage it falls into the category of it works just as long as you do not look at the detail. Given this is a key SME tax regime, this is not acceptable. IRD policy and strategy are currently working on a project to review SME tax regimes, which is starting with the LTC regime. It is critical that this regime works in a clear and easily understood way, which does not place an undue compliance cost on SMEs. Tax on entry On joining the LTC regime (with the exception of QCs transiting to LTCs) the untaxed reserves of the company are effectively attributed to the shareholders with tax paid at their marginal tax rates. This recognises that under the LTC regime, those reserves, effectively for tax purposes, become the owners at the time the company becomes an LTC. Under section CB 32C, a shareholder is deemed to have income based on the untaxed reserves on the first day of the first income year the company becomes an LTC (where in the immediate prior year it was not an LTC). The amount of income is calculated by way of formula but simply this is equal to the company s untaxed reserves multiplied by the shareholders effective interest in the company. The calculation of the untaxed reserves effectively means calculating the amount that would be a dividend on a notional liquidation (i.e. all property was disposed of, all liabilities repaid, and the company was liquidated), less assessable income derived from the notional liquidation. Imputation credits (and other balances) are added to the amount of untaxed reserves to gross them up and then the gross value of the imputation credits is deducted to arrive at the untaxed income. The formula to calculate income on joining the regime can be summarised as follows: Dividends + ICs notional income IC coy tax rate Dividends is the sum of amounts that would be dividends if the company disposed of all its property at market value, repaid all its liabilities, and was liquidated. Accordingly, we are looking for the taxable amount on a notional liquidation. IC is the balance of the imputation credit account and the FDP account balance taking into account tax due for early years but not paid less refunds due for early years but not yet received. Notional income is the assessable income derived by undertaking the notional liquidation, i.e. the unrealised amounts. Page 9
Example: Tax cost of entry to the regime Minaret Limited, a standard balance date company, has unimputed reserves of $20,000 at 31 March 2014. The company has two shareholders, brothers George and Harold Osbourne. The company meets all requirements and elects into the LTC regime from 1 April 2014. This means that in the 2014/2015 income year, if Minaret becomes an LTC, George and Harold are each allocated $10,000 in income (representing the untaxed reserves). This is additional to any net income or loss that is allocated from the company s trading for that year. The actual tax cost on this allocation will depend on George and Harold s personal marginal tax rates. If alternatively the company had $7,778 of imputation credits (i.e. tax paid at 28% on the $20,000 of reserves), the formula in section HB 32C will result in no entry tax to pay. This will mean that, after joining the LTC regime, the shareholders can access the reserves without the need to top up to the 33% rate. In October 2014 the IRD published QB 14/11 where Scenario 2, Questions 1 and 2 consider the IRD s view if electing to enter the LTC regime could be considered tax avoidance. In Question 1, the Commissioner considers for an operating company electing into the LTC regime, thereby allowing shareholders to access reserves at no extra tax cost, would not be subject to the general anti-avoidance provision in section BG 1. However in Question 2, where the company electing into the LTC regime is selling its assets and to be liquidated (so not operating ), the Commissioner suggests that the anti-avoidance rules would potentially apply. The Commissioner suggests that Parliament s purpose for the LTC rules can only be given effect where the company is operating and the decision to join the LTC regime makes no other use of the LTC regime other than the initial election and treatment afforded a LTC on wind-up. The Commissioner goes on to state in terms of the liquidation the step to obtain LTC status is an unnecessary step in achieving that objective. In the author s view, the IRD s analysis on this issue is weak and appears to be written from a revenue protection point of view. As I have already discussed under company capital gains, there are a number of ways liquidation can be achieved, some involving a number of purely tax driven steps such as in specie distributions which are simply carried out to avoid the negative impact of tainted capital gains legislation. If Parliament s purpose was that the LTC regime is only available to operating companies, I respectfully suggest the law is changed to simply state this. How transparent is a LTC? Section HB 1 sets out the treatment of the LTC for the purposes of this Act for a person in their capacity of owner of an effective look-through interest for a look-through company. Section CB 32B provides that a person who has an effective look-through interest for a lookthrough company has an amount of income, to the extent to which an amount of income results from the application of subpart HB Likewise, section DV 22 provides that a person who has an effective look-through interest for a look-through company has a deduction to the extent to which a deduction results from the application of subpart HB. (See below comments on loss limitation). Page 10
Under section HB 1(4), a person (shareholder) is treated as (and the company is treated as not): carrying on an activity carried on by the company and having the status, intention and purpose of the company; holding property that the company holds in proportion to the person s effective lookthrough interest; being a party to an arrangement the company is a party to in proportion to the person s effective look-through interest; doing a thing and entitled to a thing that the company does or is entitled to in proportion to the person s effective look-through interest. It is these provisions which in effect create the transparent nature of the LTC. These provisions are very similar to the words in section HG 2(1) which create the transparent nature of a partnership. It is the holding of property, being party to an arrangement and doing a thing and being entitled to a thing that the company does in proportion to the person s effective lookthrough interest which creates the apportionment in accordance with the shareholding. However there has been a great deal of uncertainty created by the IRD as to how transparent the LTC should be considered. The IRD have suggested the wording in section HB 1 in their capacity somehow means we are viewing the shareholder in a different capacity from the individual (who owns the shares). This was suggested in TIB Vol. 23 No. 10 December 2011, when the IRD commented on interest deductibility where an LTC had borrowed funds to buy a house from a shareholder, and the shareholder had used the funds privately (i.e. to buy a new family home). The IRD suggest the words in their capacity of owner of an effective look through interest implies that an owner can have more than one capacity and that it is the use of the borrowed funds by the LTC, attributable under section HB 1(4)(d) to the person (in their capacity as owner) that is relevant to the interest deductibility, not the use of the funds by the person in their personal capacity. While this analysis produced a good result for LTCs buying houses off shareholders and borrowing to provide shareholders with funds to buy new private assets (i.e. refinancing) and for LAQCs transitioning to LTCs who had done this previously, it does throw the transparent nature of the LTC into serious doubt. This issue has become particularly important where an LTC is liquidated and is left owing the shareholder money, something which will frequently happen if the LTC has been making losses. The IRD in following the same analysis have considered that on liquidation, a base price adjustment under the accrual rules occurs, as the borrower (company) and lender (shareholder) are regarded as being in different capacities, income results to the LTC which then flows through to the shareholder and no deduction is available for the bad debt. The result of this analysis would be that any tax benefit from an LTC which has made losses, funded by shareholder loans, will effectively reverse on liquidation. This effectively means for most LTCs making losses that, over time, there are few tax benefits of the regime. This has caused the IRD to refer this capacity issue back to IRD policy, who are considering it as part of the LTC review. Page 11
Example Karen runs a small gift shop. At the outset, she set up a LTC company with $100 of share capital. Over the first three years, the following occurs: Sales Expenses Shareholder loans 2012 20,000 40,000 20,000 2013 20,000 40,000 20,000 2014 20,000 40,000 20,000 Karen has benefitted from the $20,000 loss each year against her other wage income. At the end of the 2014, Karen decides to liquidate the company with the following balance sheet: Assets cash 100 Liabilities Karen 60,000 59,900 Equity share capital 100 Retained earnings (60,000) 59,900 Under the IRD analysis, there would be a debt remission of $59,900 being the loan to Karen on liquidation. The IRD suggest this would result in $59,900 of income being attributed to Karen. No deduction would be available to Karen under the accrual rules for the debt written off. Under this analysis, over the life of the company, Karen s net result is the benefit of $100 of tax losses (20,000 + 20,000 + 20,000 59,900) rather than a deduction for the $60,000 actually lost. This is clearly not how the regime was sold to taxpayers when introduced. This result is unacceptable and if the IRD s analysis is correct, is a fundamental flaw in the way the legislation has been drafted. Clearly Parliament s purpose cannot be fulfilled where a regime intending to pass losses through to shareholders will reverse the benefit of these losses where the shareholder has funded the company with shareholder debt (the vast majority of SMEs). Note the May 2010 officials issues paper titled Qualifying Companies: implementation of flow-through tax treatment commented qualifying companies and their shareholders will be treated as a single economic entity while the original proposals moved somewhat from the issues paper, clearly this single economic entity view was where officials started. In the author s view, the LTC regime was intended to be, and needs to be, fully transparent. How can SMEs be expected to work within a regime, where such fundamental issues are unresolved. Three years in, there should be greater clarity and transparency and remedial legislation is required. Loss Limitation Rule Perhaps since the regime s introduction, the most contentious feature has been what has commonly been referred to as the loss limitation rule. What this rule is attempting to achieve is to ensure owners do not benefit from deductions in excess of money at risk. As highlighted in my 2010 NZICA tax conference paper, LTC/QC/LAQC changes, because of the look-through nature of the LTC, the loss limitation rule is in fact a denial of a deduction rule as both income and deductions are allocated to shareholders rather than the company s Page 12
net profit or loss. A person is denied a deduction to the extent to which their LTC deduction is greater than their owner s basis. This can in some instances mean the shareholder has LTC income but is not allowed the LTC deduction. The concept of owner s basis is similar to that of partner s basis for limited partnerships and is calculated using the following formula. Note this section has been amended to try and achieve the policy outcome but continues to cause problems. investments distributions + income deductions disallowed amounts The items in this formula are defined as follows: Investments is the total of: the market value of the person s shares at the time they purchased or subscribed for them; and The amount owed by the company as loans or current account to the shareholder (note there is no aggregation of associated person loans or current accounts); and Secured amounts of the shareholder or associate. Secured amounts are defined as the lesser of the following applicable amounts: The amount of the company s debts that the person is a guarantor divided by the total number of guarantors. Dividing by the total number of guarantors will disadvantage some guarantors; or the market value of recourse property for the secured debt. IRD Policy have expressed the view that they do not believe there will be recourse property in many instances so the calculation for most will be based on the broader guarantee. This point still requires further clarification. Distributions represent the market value of distributions to the shareholder including loans made to the shareholder from the company but does not include payments to working owners (under a contract of service under section DC 3B). Income is the total of: Income attributed to the person under the LTC rules in the current and previous income years? FIF dividends FIF income. Realised capital gains. Note the IRD suggest this is only gains made while the company is an LTC. I have difficulty with this interpretation on both policy grounds and the words used in the legislation. Deductions is the total of deductions, expenditure or loss incurred under the LTC rules in previous years relating to the company and capital losses that the company had derived. There is some uncertainty if deductions includes only tax deductible items or if nondeductible items should also be included. My view is that they should although this will not benefit taxpayers, and the IRD have been asked to clarify. Page 13
Disallowed amounts: where a shareholder has made investments into the company within 60 days of the end of the financial year and those investments will be reduced within 60 days of the start of the next financial year (unless the amount is $10,000 or less) the amount of that investment is a disallowed amount. This is to prevent people increasing their investment just prior to balance date and reducing it just subsequent to balance date to increase their owner s basis and allow access to losses. An exclusion exists to ensure that a person disposing of their interests in the company is allowed a deduction, (assuming a deduction exists), equal to or less than the income the person receives on exiting the investment (section HB 11(10)). Where a person is denied a deduction under section HB 11, then section HB 12 may allow that deduction in a future year. Assuming the company remains an LTC and the person continues to be a shareholder, the deduction denied by section HB 11 may be allowed in a subsequent year by section HB 12(2), provided the owner s basis requirements in section HB 11 are satisfied. Section HB 12 applies unless the company has ceased to be an LTC or the person has ceased to have an effective interest in the LTC. If either of these has occurred, no deduction (other than against dividends) is allowed. This reverses if a company resumes being an LTC or the person resumes being a shareholder. Where the person is denied a deduction because the company has ceased to be an LTC or because they have ceased to be a shareholder, a deduction is still allowed in a later year to the extent to which dividends are received by the person from the company. The allowing of a deduction to the extent of dividends ensures that the deduction is only available when income is derived from the company. However as the dividend will be fully imputed (as the company will no longer be an LTC), the benefit of the deduction may be limited or deferred. On reviewing the loss limitation issue with the IRD, it seems to be accepted there are fundamental problems with the current rule. Known problems with the current loss limitation rule include: For companies entering the regime other than on transition, no market value calculation is performed to establish the amount invested, simply the amount paid for shares is used. The market value of shares would reflect realised and unrealised gains as well as revenue reserves, all of which should correctly be taken into account in calculating the money at risk. Commonly, loans to LTCs are made from within a family group (e.g. a family trust), however it is only owner s loans which are counted in the owner s basis. This can mean that, if not correctly structured, a family have significantly more money at risk than is taken into the owner s basis calculation. Dividing the LTC s guaranteed debt by the number of guarantors will significantly disadvantage some guarantors who carry most of the risk but have their guaranteed amount diluted. Loans from LTCs to owners are regarded as distributions and reduce the owner s basis. However, as the LTC is a separate legal entity, the owner remains liable to pay these amounts back, and could be forced to do so on liquidation, so to say this reduces the amount the owner has at risk is incorrect. According to the IRD, the income item includes capital gains the company derived while a LTC. The suggested exclusion of pre-ltc capital gains does not recognise the true amount of the owner s investment. Page 14
There is uncertainty if deductions should include just tax deductible amounts or all deductions (including non-deductible items). Clarity on this issue is desirable. While conceptually I do not have difficulty with a loss limitation regime, if a workable rule cannot be legislated (as is currently the case), I favour repeal of the loss limitation rule. The loss limitation rule was modelled on the limited partnership rule, but the target market for the two regimes was very different. Limited partnerships were introduced to address issues for foreign investors while the LTC regime is targeted at closely held SMEs. In my view, significant and appropriate reform is required in this area. Page 15
4 The Case for a Qualifying Company Regime As part of Budget 2010, the Government announced that it would replace the qualifying company regime. The QC regime was introduced in 1992 and was aimed at reducing the tax disincentive faced by owners of closely held businesses who wished to operate through a company. The 2010 officials issues paper following the Budget 2010 announcement identified the following problems with the regime: LAQC losses were allowed against the shareholder s income, reducing tax at potentially 38%, while income was taxed at the company tax rate of 30%. There was no loss limitation rule to restrict losses to the amount of money the shareholder had at risk. Remission income could be avoided by revoking the QC / LAQC status. LAQCs could be used to structure around the limited partnership loss limitation rules Partnership disposal rules did not apply to LAQC which allowed changes of ownership once losses were no longer being generated. After submissions on 15 October 2010, explanatory notes and draft legislation were released which: Introduced the look-through company (LTC) regime; and Grand-parented the existing QC and LAQC regimes; and Removed loss attribution for LAQCs. The decision to grand-parent the QC regime together with the delay in the dividend review has left taxpayers in a somewhat uncertain position. Some of the problems identified with the LTC regime, together with the nature of the entity, meant many QCs did not transition to LTCs. The QC rules were introduced after a recommendation of the Valabh Committee. Interestingly the Valabh Committee considered three models before settling on the QC model: The dividend exemption model (simple but does not provide a mechanism to align with personal tax rates) The qualifying company model Full integration / attribution The two principal reservations with an integration / attribution model were suggest as being a narrowing of eligible candidates because of a single share requirement, and practical consequences of attributing profits without regard to cashflow. Page 16
The overall objectives of a closely-held company regime were suggested by the Valabh Committee as being: The alignment of tax rates The pass-through of tax losses The pass-through of untaxed capital gains The minimisation of complexity The first three objectives were suggested as achieved under either an attribution or a qualifying company approach, subject to the observation that an attribution model has a narrower range of candidates. On the basis that the QC model was no more complex and available to more companies than a full attribution model, the Valabh Committee favoured the QC model. Having worked with both a QC and an attribution regime, neither are simple, however conceptually a QC regime is easier to understand and does not raise as many difficult issues as an attribution model. Reflecting on the reasons officials raised in 2010 regarding the QC/LAQC regime, these were almost entirely addressed by the turning off of the loss attribution. This, together with the fact that the QC regime has continued, albeit in a grand-parented form, suggests the regime may in fact still have a role to play. In reflecting on a way forward, there are a number of questions which need to be answered before a view can be taken: Do SMEs justify their own tax regimes? How consistently should the regimes be taxed? Should SMEs be able to operate through a corporate structure without all of the corporate tax restrictions? How many regimes should be available to SMEs? The options available sit on a spectrum between sole trader and a stand-alone separate company, and this could be depicted as follows: Partnership LTC LAQC Company Sole trader Limited partnership QC The LTC regime which was thrust upon us in 2011 is a valid option, albeit discounted by the Valabh Committee. If the technical issues can be resolved quickly, and its true transparent nature clarified, it should remain. In the author s view, however there remains a place for a QC type model, taxed as a separate entity but with limited tax preferences. I reach this view based in part on the fact that a fully transparent entity is not appropriate for all SMEs (for some of the reasons noted by the Valabh Committee) which is evidenced by the number of QCs which did not transition to LTCs (IRD figures in 2013 suggest there remain some 68,844 QCs). Page 17
The inability for SMEs to join a QC type regime and the unattractiveness of a transparent LTC regime (IRD figures in 2013 suggest there were 46,182 LTCs) will impose cost (forcing some SMEs to utilise and liquidate ordinary companies to access capital gains or associated person capital gains). The justification for not having such a regime may be: A desire not to have a proliferation of regimes A purist view that it is full transparency or nothing A view that capital gains are being accessed earlier than is appropriate. Likely areas where a QC would be used where a LTC is regarded as inappropriate are: Businesses where shareholding changes are likely, particularly where the business is holding revenue account property or other property in the tax base Businesses with more complex ownership structures e.g. two classes of shares Businesses looking to reinvest where the 28% corporate tax rate provides timing advantages. In my view, the costs of not having a QC type regime are likely to be more significant than the policy reasons which may wish to limit the number of regimes available. I believe the desirability of a QC type model should be considered and debated by the tax profession. Page 18
5 How do we achieve simplification for SMEs? Tax simplification is a focus for many governments, but invariable it is easier to talk about than it is to achieve. If we accept the proposition that SMEs are relatively unsophisticated taxpayers and are resource constrained in terms of time and money, and then consider SME tax regimes against this background, regimes should not be unnecessarily complex or contain fundamental uncertainty. However, simplicity and certainty invariably come with a cost, which is accepting a degree of over or under taxation. If simplicity and certainty were regarded as the appropriate measuring stick, regimes such as the LTC regime, the mixed use asset regime, the FBT regime and working for families, to name but a few, would score very poorly. The Institute have often submitted on the complexity of the working for families regime which has again become more complex with recent amendments. This regime is supposed to be interpreted by people who may not be well placed to do so. In my view if simplicity and certainty were key considerations, we would end up with simpler regimes designed for 99% of SMEs. The complexity is often as a result of trying to design regimes which cater for 100% of situations. In February 2012, the Institute issued a somewhat controversial paper suggesting ways SME tax regimes could be simplified. For some this was too radical; others could not accept the crude approximation of the tax liability. If the Institute s 2012 proposals are considered too radical, maybe some middle ground in SME simplification can be taken in relation to common problem areas. For example, should a simple motor vehicle set of rules apply to all SMEs irrespective of sole trader or company ownership. If we cannot move away from the status quo, and accept some approximations, we will not be able to achieve any meaningful simplification. Page 19