Newsletter July 2010
Inside this edition
• Removal of Depreciation Claims
• Proposed Changes to LAQCs and QCs
• Trust Changes
• Advances to Beneficiaries – Deemed Income
• Penny and Hooper
Removal of Depreciation
Claims
One of the widely expected changes in the Budget was the removal of depreciation on buildings. From 1 April 2011, buildings must be depreciated at 0% unless a special ruling is applied for and received from the IRD. The IRD state that they will consider issuing a special ruling to allow a taxpayer to depreciate a building where that building has a useful life of less than 50 years.
The IRD have published two interpretation statements which provide guidance as to which assets are part of the building, and which are separate and can be depreciated in their own right. IS 10/01 issued on 31 March 2010 entitled “Residential Rental Properties – Depreciation of Items of Depreciable Property and IS1002 – Meaning of Building” sets out the meaning of the term “building” in the context of the depreciation provisions.
There is some confusion around which assets form part of the building and therefore will not be able to be depreciated, and which assets are separate from the building and can still be depreciated. Several years ago some practitioners were suggesting that their clients split out non-load bearing walls and plumbing from the cost of the building and depreciate them separately. Subsequent to this the IRD has disallowed such depreciation and has issued guidance as to what they consider is appropriate.
Although the depreciation provisions require consideration as to whether an item of depreciable property is a building, there is no definition of the term “building” in the Income Tax Act 2007.
Therefore we are left to read the ordinary meaning of building into the legislation.
The interpretation statement offers the following method to determine if the asset is part of the building or a separate asset:
Step 1: Determine whether the item is in some way attached or connected to the building. If the item is completely unattached then it will not form a part of the building. An item will not be considered attached, for these purposes, if its only means of attachment is being plugged or wired into an electrical outlet (such as a freestanding oven) or attached to a water or gas outlet. If the item is attached to the building, go to step 2.
Step 2: Determine whether the item is an integral part of the building such that a building would be considered incomplete or unable to function without the item. Also, is the asset able to function in its own right? If the item is not an integral part of the building, go to step 3.
Step 3: Determine whether the item is built-in or attached or connected to the building in such a way that it is part of the “fabric” of the building. Consider factors such as the nature and degree
of attachment, the difficulty involved in the item’s removal, and whether there would be any significant damage to the item or the building if the item were removed. If the item is part of the fabric of the building then it is part of the building for depreciation purposes. Obviously there will be issues with large items of plant fixed to the floor or building where, at the end of the plant’s economic life, removal will require all or part of the building’s demolition unless the building is treated as a temporary building.
Below is a summary of assets and how they should be treated in the IRD’s view. The same principles apply whether the building is a residential or commercial building.
Some items such as air conditioning can either be part of the building or a separate asset depending on how the air conditioning functions. If it is free-standing and can be removed from the building then it is a separate asset, but if it is built into the building (with ducting, etc.) then it is part of the building.
| Item | Part of Building | Separate Asset |
| · Plumbing and piping | x | |
| · Electrical wiring | x | |
| · Internal walls | x | |
| · Doors (internal & external) | x | |
| · Garage doors (where garage is part of building) | x | |
| · Fitted furniture (i.e. built-in wardrobes & cupboards) | x | |
| · Kitchen cupboards | x | |
| · Bathroom fittings & furniture | x | |
| · Wardrobes & cupboards not built-in (i.e. freestanding) | x | |
| · Carpet | x | |
| · Linoleum | x | |
| · Tiles (wall & floor) | x | |
| · Curtains | x | |
| · Blinds | x | |
| · Water heaters & hot-water cylinders | x | |
| · Heating / air conditioning systems(depending on whether built-in or not) | x | x |
Temporary buildings, buildings affected by acid, portable huts, cool stores and freezing chambers, certain farm and agricultural buildings such as barns, plastic hothouses, PVC tunnel houses, milk sheds and any other building which has an economic life of less than 50 years per the depreciation schedules issued by IRD are still able to be depreciated.
Proposed Changes to LAQCs and QCs
The IRD has recently released an issues paper proposing that for income years starting on or after 1 April 2011, Qualifying Companies (QCs) and Loss Attributing Qualifying Companies (LAQCs) will become flow-through entities for tax purposes – similar to limited partnerships. One objective is to preclude taxpayers relieving income tax at the top marginal rate when there is a loss and paying tax at the corporate rate when the QC has a profit and avoiding tax on debt remission income.
The ability for losses to flow through to shareholders is unaffected except that losses will be limited to the value of the ‘shareholder’s investment’ in the QC. A ‘shareholder’s investment’ includes any debt guaranteed by the shareholder. If losses exceed the ‘shareholder’s investment’ they are able to be carried forward to be offset against future profits sourced from the QC.
Capital gains would flow through to the partners automatically and would not need to be passed out as a dividend as they currently are.
The biggest effect of the proposed change is the effect on shareholders who sell their interest in the company where the company holds tax base property, such as real estate or forestry assets. In this case, the property would need to be valued at the date of disposal of the shares and the shareholder vendor would account for their share of the profits / deemed depreciation recovered as a consequence of the deemed sale.
If a QC’s status is revoked then it is deemed to dispose of any property held at that date. Accordingly consideration should be given to revoking QC status prior to 1 April 2011 for QCs which are not in loss.
A QC would not be required to maintain an Imputation Credit Account (ICA) as it is deemed to be a partnership.
MRA recently made a submission on the proposed changes to the effect that ‘shareholder advances’ to QCs be excluded from the accrual rules so as to avoid the clawback of losses suffered by shareholders in the event that these losses are not recouped before liquidation, and to make it clear that a transfer of shares to a spouse in a QC pursuant to a relationship property agreement does not give rise to an underlying disposal of QC property.
Once the IRD releases draft legislation we will update you further
Trust Changes
The definition of beneficiary income in the Income Tax Act 2007 has changed to allow trustees 12 months to allocate income to beneficiaries.
However, most trusts include a ‘capitalisation clause’ which deems income not paid out within six (6) months of the end of the income year to be capitalised. This means that the trustees, and beneficiaries, may not be able to take advantage of the extended definition where the Trust Deed requires the income to be distributed within six (6) months of balance date.
We advise that you should review any Trust Deed that you are a trustee of to establish whether there is an income capitalisation clause. Where this is the case, the deed of trust should be varied to take advantage of the amendment to the definition of beneficiary income. Such a variation would have immediate effect.
Advances to Beneficiaries – Deemed Income
In Case Z23, a property developer funded his living expenses through current account loans from several trusts of which he was a beneficiary.
The taxpayer made large gains on his property ventures and borrowed from the trusts against those gains. The loan account drawings totalled $5 million over 12 years. In that period the taxpayer received little or no salary from entities carrying out his development projects. Loan repayments were made on the taxpayer’s behalf when a trust received income from a development project.
The Taxation Review Authority held that the character of the taxpayer’s drawings was revenue as remuneration to the taxpayer for his personal exertions as the group entrepreneur and manager, and that the IRD was entitled to reconstruct the ‘arrangement’ as it constituted tax avoidance.
The taxpayer is appealing the decision and we will advise you when that judgement is released.
It is, however, our view that an advance to a beneficiary by trustees cannot ordinarily constitute income and that only in exceptional circumstances like the case in question, or where a taxpayer has taken advantage of family tax credits while using trustee income for consumption, that the IRD are likely to seek to apply the anti-avoidance provisions.
Penny and Hooper
Penny and Hooper is a landmark tax case which deals with personal services income derived through a company.
Messrs Penny and Hooper were orthopedic surgeons operating private practices in Christchurch. Prior to the increase in the top marginal tax rate to 39% both proceeded to incorporate companies and sell their medical practices into those companies.
From 2000 to 2003 they paid themselves salaries of $140,000 whilst their companies earned over $500,000, which was similar to what they were earning whilst operating as sole traders.
On 4 June 2010, the majority of the Court of Appeal ruled in favour of the IRD to the effect that the salaries paid to Penny and Hooper by their companies were ‘artificially low’.
The Court said that the use of a company did not constitute tax avoidance on its own. However, because the arrangement had the effect of reducing the taxpayer’s income to below-market levels by using the company structure to allow them the benefit of the company tax rate on income from personal exertion, the structure had the purpose and effect of avoiding tax.
The Court acknowledged the practical difficulties that the judgment could cause by stating that a market salary was not required in all cases. Such instances where a market salary could not be required are where the company is in a development stage, the company does not earn sufficient profits to pay a market salary, or where the company requires substantial assets as part of the income earning process.
We note that the case is being appealed to the Supreme Court.
If there is a lesson to be learned from this, it is that professionals seeking to incorporate should be able to demonstrate that profits retained in a company can be shown to be attributable to the efforts of staff or attributable to capital employed rather than the principals’ exertion.
