Inside This Edition
• Look Through Companies
• Use of Qualifying Company Transitional Process to Transition to Partnership
• Trusts and Abolition of Gift Duty
• Partnerships and Motor Vehicles
• Time Limit for passing out 30% Credits
Changes to LAQC Rules
Changes to the LAQC rules have meant that many taxpayers have made the decision to transition from an LAQC (or QC) to the new Look-Through Company (LTC) regime.
A major factor in deciding to move to this new entity would most likely be the ability for taxpayers to have continued access to losses, while maintaining limited liability through use of a corporate entity.
Each year there is a requirement to calculate the “owner’s basis” in the LTC. This is important, as the amount of deductions can be limited in some cases. A limitation is most likely to arise where the LTC is a trading entity and its losses are partially being funded by third-party creditors. For most LTCs, a loss limitation will not arise as the shareholders are funding the losses. However, a potential issue could arise where joint current accounts are recorded in the LTC’s financial statements.
Consider the example of an LTC with one natural person owner, and that person has advanced funds through a joint current account to cover LTC expenses.
When calculating the owner’s basis at year- end, only half of the balance in the joint current account counts towards the investment part of the calculation. Potentially, this could limit an owner’s entitlement to deductions that they have funded by way of cash injections.
In situations where this issue could arise, we suggest that current accounts are kept separate to avoid any loss of deductions. If advances from shareholders have previously been incorrectly credited to a joint current account, there is no reason why this cannot be amended by journal entry in the first year of the LTC.
Change in Owner
While a large number of taxpayers have decided to elect into the LTC regime, there are certain tax consequences which require clarification where there is a change in ownership.
Once an LTC election is made, any change in shareholding has no effect on that election. However, an LTC can fall out of the regime if the eligibility requirements are not met or if one of the shareholders revokes the election.
If an exiting owner revokes the LTC election, the new owner can advise the IRD to ignore and reverse the revocation before the start of the following income year.
Where part or all of an owner’s shares are sold, the exiting partner is deemed to sell their share of the underlying assets. The exiting owner is required to account for any income arising from this deemed disposal.
This disposal is ignored where the thresholds in Sections HB5 to HB10 are met. The first threshold states that where the disposal proceeds do not exceed the tax book value of the owner’s share of the LTC’s property by more than $50,000, the purchaser will step into the vendor’s tax base.
Other thresholds apply to:
- Ignore the deemed sale of the owner’s share of trading stock, where the annual turnover is $3 million or less;
- Ignore the deemed sale of depreciable tangible property, provided the historical cost of the asset is $200,000 or less;
- Ignore the requirement to undertake a base price adjustment for financial arrangements (provided the LTC is not in the business of deriving income from financial arrangements and they are incidental to the LTC’s business); and
- Ignore disposals of short-term sale and purchase agreements.
Paying an Owner Salary
One further issue worth noting is the deductibility requirements where an LTC decides to pay an owner a salary. For a deduction to be allowed the requirements of Section DC3B (ITA07) must be met, which states that there must be a written contract of employment between the owner and the LTC.
The owner must be a “working owner” as defined in section YA1 of the Income Tax Act 2007, i.e. an owner who:
- performs the duties that are required in carrying on the business of the LTC; and
- the LTC is not wholly or mainly engaged in:
– investing money;
– holding or dealing in shares, securities or investments; or
– holding or dealing in estates or interests in land.
Where these requirements are met, the payments are subject to the PAYE rules and treated as being salary and wages to the owner. However, if the requirements are not met, the payment is treated as a distribution to the owner and included in the calculation of the owner’s basis.
Use of Qualifying Company Transitional Process to
Transition to Partnership
Whilst advisors have mostly focused on what to do with existing Loss Attributing Qualifying Companies (LAQCs), consideration should also be given to whether to transition QCs to partnerships as a tax-free means of shifting QC assets directly to, for example, shareholder trusts.
Whilst the corporate structure, with shares held by trusts, will ordinarily prove more tax efficient due to the lower corporate tax rate, if earnings are constantly being passed out of the company to shareholders, consideration should be given to transitioning to a partnership so as to simplify taxpayers’ affairs, e.g. QCs with positive rental income where the net rents are passed out to shareholders in the form of dividends are a candidate for such restructuring.
Trusts and Abolition of Gift Duty
Gift duty is expected to be abolished with effect from 1 October 2011, removing the $27,000 per person per year limit on the amount that can be gifted before duty is payable. This will serve to only increase the benefits of trusts, although some safeguards will be required to unwind such
gifts where, for example, spouses and creditors are affected in extreme situations.
Assuming gift duty is abolished, consideration needs to be given to:
- the level of assets you require to be able to directly access, e.g. if the trustees fell into disagreement the assets they control may end up out of your reach;
- whether you should forgive part or all of any existing debts from your trust;
- whether further assets should be gifted to your trust;
- whether there are other factors requiring consideration, e.g. if you expect to require Government assistance for rest home care in the future, be aware that gifts above $27,000 for applications made more than five years before entering care will be disregarded when calculating eligibility, as will gifts of more than $5,500 per year within the five year period.
Litigation involving trusts has increased markedly, particularly regarding:
- claims from spouses and de facto partners;
- claims from beneficiaries, particularly from knowledgeable adult children who are unhappy with investment decisions made by the trustees of their parents’ trusts;
- claims from the Official Assignee and creditors.
- Claims that proceed usually settle out of Court.
Unfortunately, the Courts have not provided clear directions and some decisions, e.g. the Bundle of Rights doctrine (which in a relationship property context has resulted in trust property being treated as an asset of a beneficiary who also held the rights to hire and fire the trustees), have been widely criticised by professionals.
Do Trusts remain relevant?
There has been criticism that New Zealanders over use trusts, e.g. employees with minimal investments owning their family home through one or two trusts.
Whilst such people could achieve adequate / better protection from potential future spousal claims through a Section 21 Agreement, personal ownership of the family home is taken into account in the determination of eligibility for rest-home subsidies for the surviving spouse.
Partnerships and Motor Vehicles
Prior to 1 April 2011, a Goods & Services Tax (GST) registered partnership using a vehicle purchased by a partner was able to claim input tax credits under the old GST adjustment rules. Provided the vehicle was used principally for the purposes of making taxable supplies, GST was claimed in full on purchase and period-by-period output tax adjustments made for private use. These rules no longer apply to assets purchased on or after 1 April 2011.
In fact, under the new rules there is no similar provision which allows input tax credits to be claimed by a partnership, where a partner purchases a motor vehicle for both private and business use.
One option available is for the partnership to purchase the vehicle and claim GST, being the holder of a valid tax invoice. However, we are aware that this option does not suit a lot of partnerships where the cost of a motor vehicle may vary significantly depending on the partners’ preference.
In the option above, a Fringe Benefit Tax (FBT) liability is triggered if a partner using the vehicle purchased by the partnership also receives a PAYE salary.
One solution, therefore, would be for the partner to buy the vehicle and lease the vehicle to the partnership under an ordinary operating lease, with the partner registering for the taxable activity of motor vehicle leasing. If, however, the partner is an employee of the partnership, FBT consequences will ensue and therefore a more complicated structuring would be required to avoid FBT whilst at the same time enabling GST to be recovered.
Time Limit for Passing Out 30% Credits
With the corporate tax rate reduced to 28%, corporates once again have been given a two-year period to pass out their 30% credits, i.e. to 31 March 2013. After this date, the maximum credit which will be able to be attached to a dividend is 28/72. During this two-year transitional period, corporates may attach 30% or 28% credits to a distribution, and may do so within the same year without breaking the benchmark dividend rules.
However, the rules will be breached if a dividend is paid with a 28% credit followed by a dividend with a 30% credit during the same income year. This, of course, may be necessary in 2011/12 due to paying 2011 terminal tax after passing out 28% credits. In order to do so without loss of credits, a ratio change declaration will need to be filed before the 30% credit dividend is paid. Again, there is nothing to preclude excess 30% credits being attached to a distribution of profits which have been taxed at 28%.
Clearly, it would ordinarily not be prudent to distribute retained earnings to avoid a loss of 2% credits if the shareholders are going to incur another 3%; especially when those retained earnings are not represented by surplus cash, i.e. they are tied up in fixed assets or working capital.
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