26 Jul, 2021 | The Week in Tax
- Beware the great unknown of NZ tax – the financial arrangements regime
- Not many happy about the interest limitation proposals
- Time for a new approach – the fair economic return
Transcript
The former US Secretary of Defense Donald Rumsfeld died recently. In the run up to the Iraq war he mused that there were things that we didn’t know we didn’t know. I was reminded of Rumsfeld’s quote yesterday when a new client approached me in something of a panic.
Their accounting system was picking up on unrealised foreign exchange movements, but they weren’t aware of the relevant tax for treatment. It was something of a shock to them when I ran through the provisions of the financial arrangements rules probably the biggest ‘didn’t know that we didn’t know’ in the New Zealand tax system.
To recap, because there’s not much on the Inland Revenue website about these rules, a financial arrangement is broadly defined as an arrangement where a person receives money in consideration for money to be provided in the future. Bonds and mortgages are two of the main types of financial arrangements caught. But the regime also applies to term deposits because there is a promise to pay interest at a later date. The regime also covers foreign exchange accounts such as those held by my client
Unfortunately, the rules have proved particularly troublesome for holders of overseas mortgages. For example people who may have migrated here from overseas but rent out their previous property in Australia, the UK, or the US, over which they have a foreign mortgage. Although they are reporting the rental income as they should, they get caught by the foreign exchange movements on the mortgages
The most extreme example I ever encountered was for one client who had a $300,000 positive movement in one year resulting in income and tax payable which subsequently reversed entirely in the following year. They still had to pay the tax in the first place, a very frustrating result for all concerned.
So these financial arrangements rules are nightmare for the unwary as it’s an incredibly comprehensive part of the act but it is not at all well known.
Fortunately, by and large most people are not subject to the rules because they are within the exemption for what we call a ‘cash basis holder’. But that exemption itself has a couple of traps in it and this is what unfortunately has caught my client.
Generally speaking, you can be a cash basis holder and you don’t have to calculate income on an unrealised basis if either the absolute value of all your income and expenditure in a foreign arrangement for an income year is $100,000 or less.
Remember that’s adding income and expenditure together; the rules do not operate on a net basis. When calculating these limits that still needs to be kept in mind as it’s one of the other traps that people fall into. For example, if you had $500,000 on term deposit and you had a $500,000 mortgage overseas so although your net financial position is nil, for the purposes of the financial arrangement you have $1,000,000 of financial arrangements so you’re outside the cash basis holder exemption.
By the way, the $1,000,000 limit applies if on every day in a particular income year the absolute value of each of each of the persons financial arrangements added together has a total value of $1,000,000 or less.
Now as I said most people should be able to be within those limits. The problem is there’s another clause which trips people up which they need to be aware of. This is where if the difference between the income which would be calculated on an unrealised basis (what we call accrual income) and income calculated on the cash basis, that is what you’ve actually received or realised, exceeds $40,000 at any time then you cannot be a cash basis person. What this means is that sudden movements in exchange rates can pull people into the financial arrangements regime, the classic example here being what happened following the Brexit referendum vote.
The financial arrangements rules are very much a trap for the unwary. How well it’s enforced of course is another matter because these are fairly arcane provisions and I’m not entirely sure Inland Revenue has all the resources to keep on top of what’s happening in this space.
Of course, it might help if Inland Revenue and the Government reviewed these thresholds and adjusted them more frequently. The $1,000,000 exemption threshold has not been adjusted since 1999. Quite frankly the financial arrangements regime should not really be pulling in small businesses into its net simply because of an out-of-date threshold.
This is one of the practical matters around the operation of the Income Tax Act which seems to be get left lying around until someone somewhere in Inland Revenue realises, we haven’t actually done anything in this space for 22 years. Anyway, the lesson is to be wary of financial arrangements regime as it applies much more widely than people realise and can trigger unexpected tax consequences.
Bypassing the proper review process
Speaking of unexpected and unintended tax consequences, submissions closed on 12th July for the Government’s discussion document on its interest limitation proposals. It’s fair to say that the proposals have generated a fair bit of controversy. I understand Inland Revenue’s received several hundred submissions so far and very unsurprisingly the majority are opposed to the proposals.
Some of these submissions are now available to the public and so it’s interesting to look at what other submitters have said. Chartered Accountants Australia and NZ have produced a massive and extremely comprehensive submission which runs to 108 pages. Now remember the discussion document itself was 143 pages so when the commentary on a document that size itself runs to 108 pages we’re talking about a great deal of complexity. We’re almost certainly heading into a lot of unintended consequences as CAANZ’s submission points out.
This is echoed by its fellow accounting body CPA Australia.
It points out that the measures were a surprise and did not go through the normal Generic Tax Policy Process and it foresees considerable confusion and remediation for the rules as a consequence.
CAANZ was also unhappy about the fact that the proposals did not go through the Generic Tax Policy Process (GTPP). This is meant to work out in advance of an implementation date what the issues are and get the legislation to a point where everyone is mostly satisfied with what’s being introduced. That didn’t happen here and is one of the reasons a lot of tax consultants, larger accounting firms and accounting bodies are unhappy about the proposals.
It’s interesting looking back that where there’s been departures from the GTPP these have commonly happened around taxation of property.
There were several unheralded moves by the previous National led Government outside the GTPP. In the 2010 Budget for example, depreciation on residential and commercial buildings was withdrawn without any forward consultation. Likewise, the same budget put an end to the loss attributing qualifying company regime partly in response to what was perceived to be issues around tax avoidance. But the depreciation changes and withdrawal of the LA QC regimes were also responses to the tax treatment of residential investment property being perceived to be too generous. Then in 2015 the first iteration of the bright-line test was introduced again outside without prior consultation through the GTPP.
I too agree with CAANZ and CPA Australia that there will be unintended consequences as a result of these changes but it’s also interesting to note that the taxation of property has been a headache for governments for some time to the extent they felt compelled to take action outside the normal policy process.
Patching another unreviewed policy
One of the things that hasn’t been done and probably should be is a comprehensive look at property taxation legislation. We haven’t had a review of the original bright-line test legislation and its consequences. These reviews are quite normal under the GTPP. But now we’re putting patches on that legislation and extending its period to 10 years. Meanwhile it’s clear there’s confusion about whether a property sale is subject to bright-line test or other taxing provisions within the Income Tax Act.
It’s against that backdrop Professor Susan St. John and I decided to move forward the idea of what we called a Fair Economic Return. This is building on an idea that was first mooted by the McLeod Tax review in 2001. It suggested applying a deemed rate of return to property as an alternative taxation basis. No-one is particularly sold on a capital gains tax but there was a recognition even 20 years ago that the tax treatment of property was favourable and causing distortions in the tax system. Those distortions have become magnified over the past 20 years resulting in measures such as we’ve just described attempting to address these issues.
With that in mind Professor St. John and I have produced a working paper suggesting a Fair Economic Return. We haven’t formalised a rate that should apply but the working paper has examples of how it would operate whether rate was 1, 2, or 3%.
This rate would be applied to the net equity of all property held by a person.
To get around the definitional issues of what is the main home, we have suggested there should be an exemption available to each person. In our initial working paper, we’ve suggested that exemption could be $1,000,000.
Here’s an example of how it would work for a couple living in Auckland whose only property asset is their house worth $3 million with a $500,000 mortgage. The net equity in the property is therefore $2.5 million. Applying each person’s exemption $1,000,000, this leaves $500,000 subject to the Fair Economic Return at a rate of let’s say 1%. This results in income of $2,500 for each person.
This is the idea Susan and I have put out there and we’ve been talking this week on radio about it. It’s obviously going to generate a fair bit of feedback, not all of it favourable, but that’s not surprising.
The view we’ve reached is it’s time to try a different approach because patches to the existing tax system such as interest limitation rules, extension of bright-line tests but incorporating exemptions for new builds etc, do not work, these are just patches, it’s time for a comprehensive and different approach to the whole issue of property taxation.
We’re updating the paper to absorb commentary and we’re always happy to take comments on that.
In the meantime, that’s it for me for this week. I’m Terry Baucher and you can find this podcast on my website www.baucher.tax or wherever you get your podcasts. Thank you for listening and please send me your feedback and tell your friends and clients. Until next week ka kite āno!
21 Jul, 2021 | The Week in Tax
- Parliament’s Finance and Expenditure Committee launches enquiry into cryptoassets, tax treatment of forks and hard drops
- Deductibility of meal expenses of self-employed
- Inland Revenue office closed for earthquake risk
Transcript
Earlier this week, Parliament’s Finance and Expenditure Select Committee announced it was launching an enquiry into “the current and future nature impact and risks of cryptocurrencies.”
This is a very broad ranging enquiry, the terms of reference include enquiring into and establishing the nature and benefits of cryptocurrency, how they are created and traded, understanding the environmental impact of mining cryptocurrency (which is something increasingly in the news). Identify risks to users and traders of cryptocurrency, what risks cryptocurrencies pose to the monetary system and financial stability. The tax implications in New Zealand and how cryptocurrencies are used by criminal organisations. And to establish whether the means exist to regulate cryptocurrency either by sovereign states, central banks or multilateral cooperation.
Now this is part of a worldwide trend. Cryptoassets are now worth over a trillion dollars following a huge surge in value. Increasingly, governments around the world are looking at what’s going on in this space, particularly as cryptocurrencies are also linked to the ransomware attacks that we’ve been seeing, the most notable example in New Zealand being the Waikato DHB.
Over in Australia, the Australian Tax Office (the ATO) is concerned that many taxpayers are not meeting their obligations, thinking cryptocurrency gains are tax free or only taxable when the holdings are cashed back into Australian dollars. ATO data shows a dramatic increase in trading since the beginning of 2020. It now estimates there are over 600,000 taxpayers in Australia that have invested in cryptoassets.
The ATO has said that it is going to write to around 100,000 taxpayers with cryptoassets, explain their tax obligations and urge them to review their previously lodged returns. That’s quite a big project. It also expects to “prompt” almost 300,000 taxpayers as they lodge their June 2021 tax returns to report their cryptocurrency capital gains or losses. So the ATO has come out swinging.
Over here Inland Revenue has been consistently expanding the release of information on how it considers cryptoassets should be treated. And a couple of weeks back, it released its final versions of a couple of “Questions we’ve been asked” about the consequences of receiving cryptoassets from either a hard fork or an airdrop. These are QB 21/06 and QB 21/07.
QB 21/06 deals with the tax treatment of cryptoassets received from an airdrop. Briefly, it’s saying that receipt of such airdropped cryptoassets are taxable where the person has a cryptoassets business, acquired the cryptoassets as part of a profit-making undertaking or scheme, provided services to receive that airdrop and the cryptoassets are a payment for those services or receives air drops on a regular basis. But beyond these circumstances the airdrop is probably not taxable.
Now, just quickly, an airdrop is basically a distribution of tokens without compensation. What I understand, is that these are undertaken with the view of increasing awareness of a new token. It might also be done to increase the supply of cryptoassets in the market. The income tax treatment will very much depend on the nature and purpose and intent of the investor who receives them.
What happens when a person who received airdropped cryptoassets disposes of them? Well, it’s taxable if it’s part of a business or they provided services to receive them, or they acquired them with the purpose of disposing of them. But in some cases, the cryptoassets were possibly acquired by the investor who was just sitting on a particular cryptoasset and received an airdrop without providing any services for it. So that may not be taxable because can you say that the airdropped cryptoassets were acquired with a purpose of disposal?
QB 21/07 deals with the consequences of receiving cryptoassets from a hard fork. A hard fork, by the way, is generally defined as where the protocol code of the block chain has been changed to create a new version of the block chain outside the old version. You have a new token which operates under the rules of an amended protocol, whereas the original token continues to operate under the existing protocol. An example would be the July 2017 hard fork of Bitcoin which saw the creation of Bitcoin cash alongside Bitcoin.
In the wonderful terminology of the crypto world there’s also a software which updates the protocol but is intended to be adopted by all users on the network. And so no new coin is expected to be created. The example given here is the August 2017 SegWit fork to the Bitcoin protocol.
2017 is probably a century ago in the cryptoassets world as this is a space that’s moving very, very quickly. Hence why the Finance and Expenditure Committee wants to have a look at enquiry into what’s going on.
Now, generally speaking the principles are similar to that of QB 21/06. So, if someone’s received cryptoassets following a hard fork, it’s taxable if they’re in a cryptoassets business or acquired the cryptoassets as part of a profit-making scheme or undertaking. In most other circumstances, the receipt is not taxable.
However, when cryptoassets received from a hard fork are disposed of, those will be taxable again, where the person has a cryptoassets business or acquired the cryptoassets as part of a profit-making undertaking a scheme or for the purpose of disposing of them.
As ever, there’s a lot going on in the cryptoassets space. Inland Revenue is, like most other tax authorities, and the ATO is a good example, trying to keep up with the play here. It will be interesting just to see how matters develop. Australia has a capital gains tax, so to borrow a line from Blondie “One way or another, they’re going to get you”. But here the rules are a little less clear. It’s actually good Inland Revenue is setting out rules, but the pace of change means that it’s probably sometime behind the eight ball.
GST on meal expenses for the self employed
Moving on, Inland Revenue released an Interpretation Statement IS 21/06 last week. This deals with the income tax and GST treatment of meal expenses incurred by self-employed persons.
Now, this is quite a substantial document, it actually runs to 37 pages, because what it also does is discuss the treatment of meal allowances paid to employees. It does so to illustrate the differences with the treatment of self-employed persons and also the treatment of entertainment expenditure.
The basic principle it is setting out is that in general, self-employed taxpayers cannot deduct meal expenses for income tax purposes. That is because they are treated as expenditure which is of a private nature. This is what they call the “private limitation” rule. Now, there are some certain limited circumstances where amounts expended on food could be deductible, such as where the requirements of the taxpayer’s business imposed extra meal costs such as a remote working location or unusual working hours.
The Interpretation Statement then goes on to explain there is a clear distinction between the treatment of self-employed taxpayers’ meal expenses compared with employees receiving meal allowances reimbursements while performing their duties. The latter is deductible expenditure to the employer and exempt income for the employee, not subject to FBT. The Interpretation Statement suggests self-employed persons may decide to operate through a closely held company and they become an employee of the company. In which case the same treatment applies. The reason given for this distinction is the different legal arrangements existing around these situations.
There’s also a difference in the treatment of entertainment expenditure. Entertainment expenditure generally for businesses is only 50% deductible. However, for the self-employed the Interpretation Statement considers the entertainment rules are overridden by the private limitation, so no deduction is available.
In relation to GST, where meal expenses are either private or domestic in nature for income tax purposes and non-deductible, then no GST input tax can be claimed. This is because they are being used for private and domestic purposes and not for making taxable supplies.
This Interpretation Statement is not going to be terribly welcome for self-employed taxpayers. It’s interesting to see this come out, but I wonder whether Inland Revenue will actually be devoting considerable energy into its implementation. But the rules are there and there’s a very clear if harsh distinction drawn between the self-employed and employees receiving meals allowances from their employer.
IRD Wellington is working from home
And finally, Inland Revenue, or at least its central Wellington office is homeless. The head office of Inland Revenue is in the Asteron building in Featherston Street, Wellington. About a thousand IR staff work there, mostly senior management, the policy and technical people and maybe some investigation staff. It’s not one of the big call centres dealing with the general public.
Anyway IR has closed the office and sent staff home after a new seismic assessment put the Asteron building at a lower level of earthquake compliance than previously thought. This is quite a major disruption, but thanks to Covid-19, we’ve got used to working from home. Inland Revenue certainly, yesterday ran a meeting that was scheduled without any particular interruptions.
Tongue in cheek now, I wonder if Inland Revenue might now be prepared to consider the treatment of remediation expenses a little bit more generously. This is an unclear area.
Fortunately, the reintroduction of depreciation does address a problem which had emerged where remediation expenses were considered non-deductible and were also non-depreciable, hence putting building owners under the pump. That’s been somewhat resolved by the reintroduction of building depreciation from 1st April 2020.
The Asteron building was apparently the largest office building in in Wellington. So that’s a significant loss. Seven floors are closed and one thousand staff, which is 20 per cent of Inland Revenue are now working from home. That’s going to be very disruptive. I hope it’s resolved very quickly because although we’ve got used to working from home there are benefits from working together and people will miss their colleagues. So anyway, good luck to the Inland Revenue staff affected. I hope this is sorted out pretty quickly.
Well, that’s it for today. I’m Terry Baucher and you can find this podcast on my website www.baucher.tax or wherever you get your podcasts. Thank you for listening and please send me your feedback and tell your friends and clients. Until next week ka kite āno!
12 Jul, 2021 | The Week in Tax
- The unintended consequences of the interest limitation proposals
- A coming clampdown on the fringe benefit tax rules around twin cab utes
- Inland Revenue updates its advice on non-cash dividends
Transcript
Having pored over the 143-page discussion document on the interest limitation proposals for the last few weeks and discussed them with colleagues, the summary position I’ve reached is that the Government should be very mindful that there will be some unintended consequences, and it should therefore be prepared to fine tune its proposals.
In particular, two issues seem to be emerging. One is that the interest limitation rules and the proposals to allow an interest incurred in relation to new bills, may mean that the trend which was causing concern of first home buyers being squeezed out in favour of developers and investors with access to plenty of assets and therefore leverage, is probably going to accelerate.
Developers and investors are able to outbid first home buyers for vacant plots of land or buildings where a single home might exist now but has potential for it to be converted into two, three or more dwellings. Given that under the new build proposals, interest deductions will continue to be allowed for building additional dwellings the likelihood of first home buyers being able to buy vacant land, put a building on it and move in is likely to be diminished. They’re simply going to be outbid by those who have access to greater access to finance. And I think that trend will be accentuated by these proposals.
That probably is not an intended consequence, but as in taxes everywhere, unintended consequences are often in play and the housing market is probably one where the unintended consequences of decisions taken 30 or more years ago have now come home to roost with a vengeance.
And the other unintended consequence I believe is going to come about, is that the burden of these proposed changes will fall on a group that aren’t really its target. And they also happened to be the least equipped to manage the level of detail and compliance that will be expected. And this group here are the is the so-called mum and dad investors, people who have one, maybe two investment properties which represents their retirement fund.
This is a group of people who are not really in the Government’s target, they’re not the larger investors who are able to have been able to leverage up significantly and outbid first home buyers. These are people that have decided to purchase investment property for their retirement. Or it may be that a couple have formed a relationship and they’ve moved into one property and rented out the other property,
Whatever their circumstances, this is a group that’s going to face a significant amount of compliance going forward, and for very little reward for the Government I would add, either politically or in terms of actually improving the housing market.
It seems to me the Government ought to think seriously about an exemption for such a group. Maybe to say that holders of one investment property are exempt or the rules only apply above a threshold.
Currently, the average rental income in the country is about $25,500 dollars a year. Maybe if the gross rental income is, say, $30,000 dollars or less the rules won’t apply.
Alternatively, if the Government still wants to remove this tax anomaly of a full interest deduction for a partly untaxed return in the form of capital gains, it could then say only 50% per cent of the interest is deductible. By the way that was something a previous guest John Cantin suggested could be an option. It would be a more straightforward option.
The thing that has been interesting when dealing with the discussion document proposals is that although the concept of denying interest deductions seems straightforward in itself, what has been really revealing is the level of detail we’ve had to work through, particularly in relation to the new build exemption.
The complexity means tax agents like me, other advisers and individuals are now at a greater risk of getting their tax returns wrong – for example incorrectly calculating the proportion of interest that’s deductible. Greater complexity means a greater likelihood of something happening and a client suing for negligence. It could be that professional indemnity insurance premium premiums rise as a consequence.
But anyway, both advisers and those affected by this would want to see the Government think hard about making the proposals less onerous from a compliance perspective.
Submissions close on Monday the 12th. As I have said previously, be constructive with your submissions. The Government isn’t going to listen to people moaning that these are terribly unfair. That’s a fact of life. These submissions will be considered by Inland Revenue, and we’ll know more in about four to six weeks when the final form of the proposals is released together with the draft legislation. It’s a tight timeline because all of this is meant to be in place by 1st October.
Fringe benefit tax
Moving on, the issue of twin-cab utes and FBT is back in the press with Minister of Revenue, David Parker, saying he was considering a clampdown on the fringe benefit tax rules. He has apparently received advice on how twin-cab utes were being taxed and he has confirmed that he was considering acting on it.
Inland Revenue advice was that there is no exemption to twin cabs, which I’ve previously discussed. And that’s correct, even though there’s a popular belief there was one. What Inland Revenue believes is that the existing rules aren’t being properly enforced, which is also my conclusion.
The astonishing thing, though, is that Inland Revenue went on to say it wasn’t so keen on chasing down this matter because it wouldn’t bring in much money. David Parker said, quote, “Inland Revenue advised me that it’s not as big an issue relative to other enforcement priorities. But we’re having a look at the issue because they are proliferating.”
There are two points to be made about this. Firstly, Inland Revenue has a duty under section 6 of the Tax Administration Act 1994 “to protect the integrity of the tax system.” including people’s perception of the integrity of the tax system.
So a public statement making it known that it really didn’t feel that this was a big issue sends completely the wrong message about enforcement for myself and other tax advisors and those conscientious taxpayers, the vast majority of which want to follow the rules. Inland Revenue basically saying,” Well, we’re not really bothered about this”. In the context of an $85-billion annual tax take saying an extra $100 million a year isn’t that significant may be true, but it does nothing for the integrity of the tax system to say so.
The other thing in here which David Parker has picked up on – he is also the Minister for the Environment – is that the climate change policies are undermined by not enforcing rules around twin-cab utes. These are high emitting vehicles and the Productivity Commission noted we are importing higher emission vehicles relative to what’s available in the rest of the world. In other words, New Zealand has become a bit of a dumping ground.
And so if we’re tackling emissions, reducing emissions is an ongoing job and in that context, not enforcing the FBT rules makes that job harder. Transport emissions are one area where New Zealand can make progress in reducing its emissions. Leaving aside the issues around reducing methane emissions from our agricultural sector, we can certainly do more in improving emissions from the transport sector.
So it will be interesting to see how this plays out. Inland Revenue I think will be upping the ante on this. Get any group of tax advisors together and we’ll all have stories about some of the abuses we’ve seen. Like Inland Revenue previously photographing or sending someone to watch popular boat ramps and boats being launched at the weekend, just to see whether a purported company vehicle was being used in a private capacity. Apparently one such boat launching ramp in Gisborne was opposite the Inland Revenue office and one company after a few weeks got a call from Inland Revenue asking if they were, in fact, correctly reporting FBT.
Transfers as ‘dividends’
Moving on, Inland Revenue has this week released a number of Interpretation Statements which give its view of how the law operates. One that people should pay particular attention to is Interpretation Statement 21/05 on non-cash dividends. Now, what this does is consider when a transfer of value from a company to a shareholder is treated as a dividend for tax purposes. These are sometimes also referred to as the deemed dividend rules.
The Interpretation Statement wisely, in my view, focuses on the type of non-cash transactions that are often entered into between small and medium companies and their shareholders. Now, sometimes FBT picks up some of these issues, but other times they don’t. A common example of a non-cash dividend would be a loan from a company to a shareholder.
So what the interpretation statement does is set out a number of examples of how these rules might work. For example, there’s a banana company which provides one of its shareholders with a large number of fresh bananas. That is a dividend. Another example would be the shareholder owes the company money and the company forgives the debt. That’s another as a dividend or a telecommunications company provides one of its shareholders with telecommunication services for free.
The interpretation statement works through various scenarios like this and clarifies which are dividends together with the rules for calculating the dividend and when the dividend is deemed to have been paid.
It’s actually a very valuable document. It’s also quite astonishing to realise it is in fact an update of a previous item on deemed dividends which dates from March 1984. I know Inland Revenue has got a lot on its plate, but it is a bit of a surprise to see it taking 37 years to update this sort of matter.
Anyway, the interpretation statement is out there. So people should be more aware of this deemed dividend issue. It obviously indicates that this is one of the areas Inland Revenue is looking at. They have, in fact, been quite interested in the area of shareholder advances, that is loans from the company to shareholders for some time. So this Interpretation Statement should serve as a warning.
Well, that’s it for today. I’m Terry Baucher and you can find this podcast on my website www.baucher.tax or wherever you get your podcasts. Thank you for listening and please send me your feedback and tell your friends and clients. Until next week ka kite āno!
6 Jul, 2021 | The Week in Tax
- How the interest limitation rules will apply to taxable sales of property
- Interpretation statement on income tax and GST treatment of businesses disrupted by the COVID-19 pandemic
- Global minimum tax rate proposals
Transcript
Chapter 5 of the discussion document on the proposed interest limitation rules deals with the matter of great interest to a lot of people, and that is what happens with interest deductions which have been disallowed for a residential investment property which is subsequently sold, and the sale is taxable. Now, just to recap, the interest deductions for residential investment properties are to be restricted and eventually disallowed in full starting from 1st October this year. There is an exemption to this if the property qualifies for the development or new build exemption, which we discussed last week.
Now, amidst all the noise, it’s worth pointing out, the reason for this proposed treatment is to reduce the tax advantage for property investment and not full deductions for interest have been allowed. But the income from a capital gain has often not been taxed.
So the question that then arises is, should a deduction for interest be allowed for at the time of sale if the sale is taxable – or what we call on revenue account. As in that case, all the income from investing in the property is taxed.
Now, just as an aside on this, the terminology of revenue and capital account causes some confusion. It was interesting last week when I was presenting to the Employers Manufacturers Association and the New Zealand Chinese Building Industry Association that there was obvious confusion in the audience around the terminology of revenue and capital account.
The short answer is that land held on revenue account will be taxed on sale. So, for example, that would be properties purchased with the intention of disposal or acquired for the purposes of business relating to land such as development. It gets a little bit more confusing with the bright-line test because property is taxed under the bright-line test, become held on revenue account only once it is known that they will be sold within the bright-line period. Prior to that point they’re not held on revenue account.
Otherwise, the discussion document in Chapter 5 at paragraph 5.8 goes into some detail about what the types of properties which will be deemed to be held on revenue account and therefore taxable, but for the purpose of the interest limitation rules that the question the discussion document wants to address given that we are denying deductions from 1 October, what do we do when a property is sold, which is taxable, i.e. was held on revenue account?
Four Options are proposed. Option A deductions are denied in full. Option B interest deductions are allowed at the point of sale and under that option it would be possible for excess deductions to be offset against other income.
For example, Annette buys a house for $1 million, three years later, she sells it for $1.2 million. The house was used as a residential rental property for the whole period. Over the three years, she incurred $300,000 of accumulated interest deductions.
Under Option B she would be able to deduct $200,000 dollars against the taxable liability arising from the sale of property in the year of sale. The remaining $100,000 could be offset against other income for the year, resulting in net taxable reduction of $100,000 available to her.
Now, what the discussion document points out, and this is a problem Inland Revenue is going to have to think carefully about, is if Annette sold that property on capital account, say it wasn’t subject to bright-line test, she wouldn’t get a deduction for the interest. And that means that she has an incentive to say that she’s selling on revenue account. So, this deferred interest deduction Option sets up a tension within the new rules, which is inevitably going to lead to quite a lot of discussions between Inland Revenue and taxpayers about transactions. Anyway, that’s Option B; interest is deductible at the point of sale, and any excess can be offset against other income.
Option C allows a deduction for the accumulated interest at the point of sale, but only enough that it does not give rise to a gain or loss. So, in Annette’s case of $300,000 of accumulated interest and a taxable gain of $200,000, only $200,000 of the accumulated interest is allowed as a deduction in the year of sale. The excess $100,000 would be forfeited.
Option D is a variation on this. It says the $200,000 is allowed at the point of sale and the excess $100,000 would be ring fenced and carried forward under the ring-fencing rules for offset against property income.
Now, as mentioned above, there is this ongoing tension that this whole provision will create between sales on revenue account where interest becomes deductible and selling on capital account where interest is non-deductible. The discussion document then does consider whether some interest should be allowed for sales made on capital account.
Under Option E, no deductions would be allowed. And the paper describes this as not allowing any interest deductions as a rough offset for the benefit of the capital gains not being taxed. And it goes on to note “this would have the strongest impact on reducing investor demand for residential property”. So that’s bound to be attractive to the Government given its intentions behind the policy.
Alternatively, Option F is that no deductions are allowed up to the amount of the untaxed gain, but any excess becomes deductible. This is an economic return argument. For example, Ray sells a residential rental property for untaxed gain of $200,000, but had incurred $150,000 dollars of interest, which had been disallowed for the period the property was rented. In that case, no interest deduction would be allowed, and they’ve completely forfeited.
If, on the other hand, the untaxed gain was still $200,000, but $250,000 of interest had been disallowed, Option F would allow a deduction of $50,000 for the excess interest over the gain.
So there’s a bit of detail here. I’m pretty certain people will want to see an interest deduction at the time of sale come in. And obviously the most generous option would be Option B.
The discussion document is asking for feedback on which of these proposals should apply and they’re all set out in Chapter 5. It’s reasonably readable, there’s just a lot of it. But I’d still urge everyone to have a read and make submissions as appropriate. And remember, the deadline for submissions is 12th July.
Pandemic support
Now, moving on, we’re still dealing with a pandemic, and on that point, as of Thursday, 1st July, a Resurgence Support Payment became available for those in the Wellington and greater Wellington area affected by the move to level two. Inland Revenue has opened applications for this Resurgence Support Payment and applications are open for the rest of July.
Now, at the same time, Inland Revenue has released an Interpretation Statement IS 21/4 on the income tax and GST deductions for businesses disrupted by the Covid-19 pandemic.
What this interpretation statement does is consider whether a business can claim an income tax deduction for expenditure or loss incurred when the businesses downscaled or stopped operating because of the pandemic. It also looks at GST implications of those events.
Generally, an income tax deduction will usually be allowed where a business has downscaled or ceased operating temporarily, provided no capital expenditure restriction under the Income Tax Act would apply.
However, a deduction will usually be disallowed where the business has completely ceased, even if it is possible that the business may restart later. And it gives an example of an English language school where they terminate the lease. The view taken by the Interpretation Statement is in those circumstances the business had ceased and from that point onwards, deductions are going to be restricted.
Now in determining whether a business has ceased operating temporarily or permanently it’s a question of fact, and the Interpretation Statement looks to the nature of those activities carried on and the business’s intention in engaging in those activities.
Coming back to this English language school example when it’s operating all its enrolled students are from overseas. Then it must close because the country went to Alert Level 4 and it remained closed until Alert Level 2. What the example provides is that for the period during Level 4 lockdown, because there was an intention to operate once the lockdown was over, all deductions for expenditure incurred during this period would be allowed, such as rent rates, power, water, insurance, etc.
Likewise, GST input tax deductions would be allowable. Now, on GST, what the Interpretation Statement points out is if a GST registered person ceases to carry on a taxable activity they may be required to deregister for GST and then they’d be liable to pay output tax on the value of goods and services used in the business at the time of de-registration.
But generally speaking, if businesses have been affected by the pandemic, but had the intention to try and carry on trading, they should be okay on income tax deductions and GST input claims. But if they reached a point where they basically have stopped, issues around deductibility and availability of input, tax claims and GST registration will need to be addressed.
International tax reform – 15% or 21%?
And finally this week, 130 countries and jurisdictions have signed up for a new Two Pillar plan to reform international tax rules and ensure that multinational enterprises pay a fair share of tax wherever they operate. There’s been a statement signed establishing a new framework for international tax reform. There’s a small group of nine of nine jurisdictions that have not yet signed the statement.
And the remaining elements of this framework and how it’ll be implemented will be finalised in October. One of the key things that they’ve signed up to is Pillar Two, which seeks to put a floor on competition over corporate income tax through an introduction of a global minimum corporate tax rate.
And the proposal is that the minimum tax rate will be at least 15%. The estimate is that that’s going to generate about USD150 billion in additional global tax revenues annually.
And Pillar One, which deals with taxing rights, will mean about another USD100 billion of profit to be reallocated to market jurisdictions.
Now, our government will be watching this with interest, but in the past, we’ve discussed whether in fact this may have a significant impact for the Government’s finances, but still it’s progress. We’re still waiting to see whether this global minimum tax rate will settle at 15%. The US, as I’ve described previously, wants 21%. But it’s a question of wait and see. And as always, we’ll bring you developments as they happen.
Well, that’s it for this week. I’m Terry Baucher and you can find this podcast on my website www.baucher.tax or wherever you get your podcasts. Thank you for listening and please send me your feedback and tell your friends and clients. Until next week ka kite āno!
28 Jun, 2021 | The Week in Tax
- A look at the interest limitation rules and the proposed “new build” exemption
- The OECD’s latest Fighting Tax Crime, how does Inland Revenue measure up
- The new purchase price allocation rules
Transcript
The Government’s discussion document on the design of the interest limitation rules on the additional bright-line test was released a little bit over two weeks ago. Since then it’s been a hive of frantic activity amongst tax agents, accountants and lawyers as we try and digest the implications of what’s proposed and work out how we manage those changes.
As part of that, Inland Revenue has been running an external reference group made up of accountants, tax advisors, tax lawyers and industry specialists such as Fletcher Building. We’ve been going through parts of the proposals and giving Inland Revenue feedback on what we think of the proposals.
Yesterday we discussed the question of new builds. Now the new build definition is going to be incredibly important because the Government is proposing that owners of new builds will have a five year bright-line test exemption instead of the 10-year test which applies from 27th March. Also, and this is the bit that’s getting most people particularly interested, will be exempt from the proposed interest limitation rules.
The proposal is that a property should only qualify as a new built where residential housing supply has clearly increased. This, according to the discussion document,
“will occur when a self-contained dwelling with its own kitchen and bathroom has been added to residential land and the dwelling has received a Code Compliance Certificate.”
The discussion document then talks about three new build categories, simple new builds, complex new builds, and commercial residential conversions.
We were discussing these definitions with Inland Revenue as well as the question of how long should the exemption last; indefinitely or for a prescribed period of time? And if it is for a prescribed period of time, could a subsequent purchaser be able to make use of the balance of that period? A lot of details to consider there.
It’s of great interest, clearly, because late this past week, I made a presentation on the new rules to the Employers & Manufacturers Association and the New Zealand Chinese Building Industry Association. Some very interesting discussions came out of that – it’s apparent a lot of people clearly are focussing on what is a “new build” with many of the questions around the definition and what’s going to happen? Clearly this is a very important part of the Government proposals.
Running through a little bit of the detail. Simple new builds involve adding one or more self-contained dwellings to bare residential land. So that would include adding a dwelling to buy land that is one of more dwellings is allotted to bare residential land. It doesn’t matter whether a new build is fully or partially constructed on site, so it will cover modular homes. It would include a dwelling that has been relocated onto the land.
It includes replacing an existing dwelling with one or more dwellings. This is where an existing dwelling is removed or demolished and then replaced with one or two or more dwellings. It’s proposed that even one for one replacement would qualify, even though strictly there’s been no increase in housing supply. But there’s been an improvement in the quality of the housing. And we’ll come back to that point in a minute.
Complex new builds involve adding one or more self-contained dwellings to residential land that already has a dwelling on it without a separate title being issued for the new build portion of the land. So that would include adding a standalone dwelling and that could be a sleep-out, for example.
Adding, or attaching a new dwelling to an existing dwelling, for example, where dwellings are added on top of or underneath or next to an existing dwelling on residential land. Splitting an existing dwelling into multiple dwellings. This is where residential land has an existing dwelling on it that is then converted into multiple self-contained dwellings, for example, where a six-bedroom house is converted into three two-bedroom units.
In our discussion with Inland Revenue, the question arose about what to do with renovations and remediation and that led into a very interesting discussion. The same point came up at the afternoon’s seminar. What do we do, for example, where you have a house that’s previously been left as uninhabitable? Maybe, for example, it’s not up to building code or the healthy homes standard, but money is being spent to remediate these matters.
So we debated whether we think the interest portion on such work should be deductible. And the general view was broadly yes. You’ve obviously got some definitional issues about what is uninhabitable. But clearly, if the Government wants to increase the housing supply and the availability of accommodation, taking a house which was, say, previously had been left to rack and ruin and then bringing it up to healthy home standard, the view was the interest in that deduction probably should be allowable.
Of course, as a separate matter which we didn’t discuss, what about the deductibility of the actual expenditure on making a dwelling meet the healthy home standards? That’s less clear and arguably is non-deductible and that’s all part of the problem with the current tax system and how complex the whole matter has become. It’s pretty harsh on the capital treatment of buildings. Since 2011 we don’t have depreciation on residential accommodation. And I’m beginning to form the view that maybe we should restore that, because as this discussion on the question of renovation points out, buildings do fall into disrepair. There’s also the matter of leaky buildings and earthquake strengthening.
Finally, there’s commercial to residential conversions. This new-build category covers the conversion of commercial buildings into self-contained dwellings. For example, an office converted into apartments or a large commercial heritage building, such as a harbour warehouse that’s converted into townhouses. Such conversions are seen as new builds.
And the proposal is that the exemption goes to “an early owner” of new builds. This is a person who:
- acquires a new build off the plans before Code of Compliance Certificate is issued,
- acquires an already constructed new build, no later than 12 months after the new build’s Code of Compliance Certificate is issued;
- adds a new build to bare land;
- adds a complex new built to land; or
- completes a commercial residential conversion.
The other matter for debate on which no decision has yet been made, is how long should that exemption last? Inland Revenue have suggested this could be 20 years.
On this, an interesting point came up in yesterday’s seminar. People got up and said, “Wait a minute, you said five years there. And then you talked about 10 years and now you’ve mentioned 20 years. What’s this 20-year thing?” But you can see that the overlapping five year bright-line test, 10 year bright-line test and possible 20-year new build exemption adds to confusion about the whole process.
And that’s something that when you’re making submissions on the matter, you should think carefully about the coherence of the tax system and how much complexity we are introducing. We’ve got another two weeks until submissions close on 12th July. And I’d urge people to do so.
Fighting tax crime
Earlier this week, the OECD released a report called Fighting Tax Crime – 10 Global Principles following a meeting of the heads of tax crime investigations from 44 countries. There are 10 principles which they describe as “essential legal, institutional, administrative and operational mechanisms necessary for putting in place an efficient system for fighting tax crimes and other crimes”.
There’s quite a lot of detail in this report to unpick. The report includes 33 country profiles detailing each country’s domestic tax crime enforcement frameworks and the progress each country has made in implementing the Ten Global Principles. Now, New Zealand is one of those countries, and its chapter makes for some very interesting reading.
The first principle is that there is a criminalisation of tax offences and that countries have to have a legal framework put in place to ensure violations of tax law are categorised as a crime and penalised accordingly. Now, tax evasion is money laundering, and it should be well known that it was tax evasion which led to the notorious gangster Al Capone’s downfall, as he was jailed for tax evasion, a.k.a. money laundering. There are some interesting stats here, but they’re not quite as comprehensive as you might expect to see: the numbers in the report only go back to 2016.
But throughout the report, there’s some very interesting snippets. For example, the report mentions the tax gap, that is the difference between what tax should be expected to be collected and what actually is collected. The report notes that New Zealand does not calculate an overall tax gap. That’s actually not out of line with other countries. Some countries can report on what they think the GST or VAT gap is, but generally not every country can say “We’ve got a reasonable idea of what the tax gap is”.
The report then goes on to say that New Zealand has estimated that on average, the self-employed population under-report approximately 20% of their income. That’s quite a statement. You’d then be thinking “Well, what is Inland Revenue going to do about that and how much might that be?” In Australia, for example, they estimate their tax gap is about AU$31 billion, or about 7% of the tax take. A similar number here in New Zealand would be over NZ$5 billion, however that’s thought to be unlikely because unlike Australia, we have a very comprehensive GST. But the Tax Working Group did take into consideration a number of around between $850 million and $1 billion dollars annually.
The country reports discuss various principles, like a strategy for addressing tax crimes, investigative powers, the ability to freeze and seize and confiscate assets, and it notes between 2015 and 2019 New Zealand authorities seized $90 million dollars of assets in connection with criminal tax matters. And in fact, one of the highlights for New Zealand in this report was we have a strong legal framework for recovery of assets related to tax crimes.
The questions in my mind start to arise, and I disagree with the report on this particular point, is around Principle Six – adequate resources. The report notes that Inland Revenue’s hidden economy work for the year to June 2019 raised $108.8 million of tax revenue. And it notes
“[Inland Revenue] has no staff dedicated entirely to tax crime investigations, but rather maintains an agile workforce of specialist accountants and lawyers who operate under broad rules, enabling them to investigate tax crime cases either referred to them a suspected tax offending or revealed a suspected tax offending in the course of standard audits.”
That is the process, but the statement is a little too pat for my liking. And the question that keeps coming up in my mind is, is Inland Revenue directing its resources appropriately? Because when it’s saying, “We think the self-employed are underreporting 20% of their income” my question is, “What are you going to do about that?” And if you follow the money in the budget appropriations and you see that the investigations budget has been cut by $10 million, a cynic might answer “Maybe not enough”.
One of the things that the report suggested New Zealand could do better would be using enhanced forms of cooperation such as secondments and colocation of staff and joint intelligence agencies and centres. That actually would be helpful in terms of also working with anti-money laundering. I have my reservations about that, but we shall see.
Valuing business assets
Finally this week, there’s a new set of tax rules coming into place on 1st July in relation to how business assets are valued when they’re sold. And these are what we call the purchase price allocation rules. These rules apply to the sale of assets such as commercial property, forestry, land or business.
What the new rules do is make it clear that both the buyer and seller have to make the same allocation, the rules set out a process that must be followed. And if they can’t balance an account, agree on an allocation, they will have to notify Inland Revenue who they then make the allocation for them.
The idea is to bring consistency to agreements for the disposal of acquisition of property in businesses. What was happening was buyers and sellers were adopting different allocations for assets that were sold. This process would mean then for a vendor, allocating as much to tax free capital gain, such as goodwill, was to be preferred. Whereas for the purchaser, they’d want to be allocating as much as possible to taxable and depreciable assets because then, for example, stock and fixed assets, they can then expense or depreciate.
There were various estimates about how much this might be costing the Government – up to $50 million dollars a year was one estimate. The result was these rules have been introduced and take effect from 1st of July. They’re not terribly popular because they add a lot of detail and complexity to a process which is already quite stressful.
But the key thing is if you’re selling or purchasing a business you will need to pay more attention to what’s happening and how you’re allocating the costs between the various asset classes. The rules also apply to sales of residential land for $7.5 million or more, but only if neither buyer nor seller is an owner-occupier in relation to the land. As I said these rules are effective as of 1st July.
Well, that’s it for this week. I’m Terry Baucher and you can find this podcast on my website www.baucher.tax or wherever you get your podcasts. Thank you for listening and please send me your feedback and tell your friends and clients. Until next week ka kite āno!
