Inside this edition
• The Future without Loss Attributing Qualifying Companies (LAQC’s)
• Gift Duty
• Use of Money Interest
The Future without Loss Attributing Qualifying Companies (LAQCs)
Many of the courses to-date on the topic of LAQCs and Look Through Companies (LTCs) have concentrated on the transitionary process from LAQCs through to LTCs and partnership / sole trader options.
For individuals buying rental properties where negative gearing is a feature, many have chosen in the past to purchase their rental properties in a LAQC. The main advantages of using a LAQC are that when the property commences to derive a profit from the rental activity, the shares in the LAQC can be transferred to a discretionary family trust without triggering depreciation recovered on the building (where applicable) and the ease of effectively transferring a property to the family trust by share transfer (meaning no conveyancing costs).
What should you do now when you wish to buy a rental property after 31 March 2011 as part of your retirement fund but initially a rental loss will be incurred through interest on bank financing for the properties?
The options available are:
- Buy the property in your own name, especially where your taxable income is over $70,000 per annum.
- If you are in business, trading through a company, where the attribution rules for personal services income do not apply, purchase the property in a company that is a tax group member with the trading company which can utilise the tax losses by way of subvention payment / offset.
- To the extent you are borrowing personally to fund the purchase of the property where the bank’s security is against your own assets (other than rental property), buy the property in a company and use your borrowed money to finance the acquisition of shares issued by the company. Ascertain whether the company will then derive a rental profit or loss.
- Provided there are five or fewer shareholders, and treating relatives as one shareholder, the property could be purchased by a LTC.
Reviewing the four options (using the above reference numbers) we comment as follows:
(1) The historical position of a person buying a rental property in his / her own name is likely to return as the favourite option for many. Not a good option for accountants as many clients will only require a rental statement in place of a full set of company Financial Statements and supporting Minutes! The principal benefits of the old LAQC regime, namely the ability to effectively transfer ownership of the property without giving rise to a depereciation recovery (by transferring shares) and the ability to debt restructure are, by and large, gone under the LTC regime.
With regards to the latter, this is a result of the look-through rules treating the shareholders as personally owning the property and personally entering into the loan agreements. Had the Government simply intended to flow through profits from a LTC and deem an underlying disposal of assets on a disposal of shares, there would have been no need to deem the debt arrangements to have been entered into by the shareholders. In our view, the effect of this will be to preclude certain debt restructurings into a LTC, e.g. sale of former family residence to release equity for the purchase of a new residence.
(2) One option that has not frequently been used is where the property investor is in business trading through a family company. In this situation a commonly owned company that meets the tax group member requirements with the trading company could be incorporated and used to buy the rental property. The rental losses incurred can be used against the taxable income of the trading company under the loss offset provisions. Many LAQCs in the past were insolvent companies where reinstating solvency was often achieved ultimately from the capital gain on the sale of the rental property and / or the company having a new issue of shares so that all creditors, including shareholder loan accounts, were repaid by the LAQC.
The tax grouping provisions for companies enable the shareholder’s salary for the year to be determined after taking into account the tax losses available from the group member rental investment company. The losses are usually utilised in the company group structure by way of subvention agreement and payment. The subvention payment restores the losses in the investment company for the year and enables the shareholder to be repaid the working capital funding provided to the company during the prior year to the extent of the subvention.
This tax grouping availability is particularly justifiable where the shareholder’s salary for the year equates to the trading company’s net profit. To be tax group members, the two companies must be commonly owned to the extent of 66% or more by the same shareholders based initially on each shareholder’s lowest voting interest in each company.
If the trading company is a QC, this option is not available as a profitable QC can only use tax losses incurred in another group company if that loss company is also a QC.
(3) This option effectively splits the borrowing between the debt borrowed by the company against the rental property and debt borrowed by the shareholder against other property (e.g. your home). This option would be adopted where rental profit was reasonably likely to arise in the company. We would recommend structuring the amount of company debt so that the company derives a rental profit. A prudent approach may be 40% interest- bearing bank debt in the company; your cash equity is lent interest-free to the company, and the company has share capital equal to the money borrowed by you in your own name to purchase the rental. Therefore, if 100% financed, 40% debt in the company and 60% capital, with you (the shareholder) borrowing the 60% to buy your shares in the company.
Under this scenario, the company will be liable to pay 28% income tax on the company’s net income after deducting the interest on the borrowings by the company to fund the purchase of the property. Provided the shares in the company that the shareholder acquires using bank finance carry entitlement to dividend distributions paid by the company, the interest on the share acquisition borrowing is tax deductible to you provided you are a New Zealand tax resident. We would recommend that a dividend be paid in Year 2 and annually thereafter to show that income is being earned from the shares. The dividend need only be a small percentage of tax- paid profit although, based on the Court of Appeal decision in the case of Commissioner of Inland Revenue v Brierley (1990) 12 NZTC 7,184, there is no need to pay a dividend to justify the interest deduction on borrowings to fund the acquisition of shares.
This option can result in additional tax savings given the company tax rate of 28% and the individual tax rate of 33% on taxable income over $70,000.
Only one property should be purchased by a company. The reason for this is that, should the property be sold to a non-associated person and a capital gain result, then the company can be liquidated and the capital gain distributed in the course of liquidating the company. The bank borrowings outstanding on the share funding debt when the company is liquidated / removed should either be repaid or, if not repaid, an audit trail maintained showing that all the paid-up share capital proceeds from distributing the paid-up share capital are invested in an income producing investment in order to continue the interest deduction on borrowings. Should a relative within two degrees of relationship wish to buy the rental property then, prior to selling the property, ensure a legal step is taken towards liquidating / removing the company and that the property is being purchased by an individual or discretionary family trust – not to a company. We can assist if you are uncertain.
(4) In many ways, the LTC option is the final choice but may need to be adopted for many salary and wage earners. The main disadvantages of the LTC are:
(i) the loss limitation rules limiting the loss offset for the year to your capital at risk; and
(ii) being taxed at your marginal tax rate when the LTC goes into profit (although an election could be filed to revoke the LTC status effective for a future year when the company goes into profit).
For most people with rental properties, the loss limitation rules are unlikely to be applicable given most people are likely to invest some equity into the property, and also the “loss” (basically represented by cash expenditure such as rates, insurance and interest) is likely funded by the shareholder from his / her earnings. We expect that most existing LAQCs with rental properties owned by the LAQC will need to elect to become a LTC (election required to be completed and filed with Inland Revenue by 30 September 2011).
The above covers the rental property scenario. The other area where LAQCs were often adopted was for start-up businesses where the profitability of the business was uncertain. The use of a LTC for the first years of a start-up business will likely be applicable so that if tax losses arise, the tax benefit of those losses will transfer to the shareholder(s) to the extent permitted by the formula in Section HB11 (the loss limitation rules).
Under the previous law, tax losses incurred by a LAQC transferred to shareholders according to each shareholder’s effective interest. The tax benefit included the tax loss represented by unpaid creditors. The LTC law transfers the tax loss according to each shareholder’s effective interest in the company but limits the extent of tax losses
available to shareholders, especially where there are unpaid trade creditors. In addition, the backdating of LTC revocations to the start of the year is not possible except where the LTC requirements are breached in the year, e.g. shares being sold to a company that is not a LTC or issuing a new class of share.
The Taxation (Tax Administration and Remedial Matters) Bill introduced to Parliament proposes two changes, effective
1 October 2011, being:
- In the definition of a gift, gift is intended to be a disposition of property before 1 October 2011.
- Section 61, which imposes gift duty, will apply to every gift made after the commencement of the Estate and Gift Duty Act 1968 and before 1 October 2011.
The effect of the above is:
(a) No gift duty will be assessed on gifts made on and after 1 October 2011; and
(b) Where a gift is made after 1 October 2010 and prior to 1 October 2011, the rate of gift duty will not be affected by the value of gifts made after 30 September
The rate of gift duty imposed on a gift takes into account the value of all gifts made within 12 months prior to the current gift and all gifts made within12 months after the current gift.
Therefore, if you gift $27,000 on 1 April 2011 to your family trust and then on 1 October 2011gift $1,500,000 to your family trust, no gift duty will be payable on the $27,000 provided there are no other dutiable gifts on and after 2 April 2010 and on and prior to 30 September 2011, and the proposed changes are passed into law.
Use of Money Interest (UOMI)
Another proposed law change is that all UOMI charged will become deductible effective for the tax year ending 31 March 2011.
For the year ended 31 March 2010 and prior, UOMI will be deductible as long as the return filed for the year has claimed a deduction for UOMI charged by the Commissioner in that year.