At the end of last week, the Government announced a surprise tax measure for North Island businesses hit by recent flood damage. The measure means that they will not have to pay tax on insurance or compensation they might receive for any damaged buildings or plant or equipment.
As the Revenue Minister David Parker pointed out, generally speaking such payments are treated as taxable income. Recognising another tax bill is the last thing any businesses affected by the floods needs, the Government has decided to adopt a measure which was used previously following the Canterbury earthquakes and the Hurunui-Kaikoura earthquakes. It essentially allows a deferral of the tax on the compensation payments received to replace damaged or lost buildings and plants and equipment.
What happens is instead of a depreciation recovery (income) happening because you’ve received a payout, there’s a rollover relief which will defer the recognition of that income on the basis that there is a commitment to rebuild or replace the destroyed buildings or plant. There is a key difference here as to the measures used previously for the earthquakes, and that is there is no requirement for any replacement buildings to be located in the same region. This is because in some cases managed retreat is now being considered. For example, where a building which is in the Hawkes Bay has been destroyed or severely damaged by Cyclone Gabrielle, the business owner may decide to relocate to a different region. In this case the rollover relief would apply an exemption.
This is a good measure to see. The formal legislation will be introduced shortly probably around the time of the Budget, I might imagine, along with the other budget measures.
What happens if you rent a room to a flatmate?
Moving on, Inland Revenue has released an interesting draft Questions We’ve Been Asked consultation on how the bright-line test might apply to where a person rents out a room in their home to a flatmate. Alongside that there’s another Draft Questions We’ve Been Asked relating to the extent to which a person can claim deductions for expenditure incurred in deriving the rental income, when they’ve rented a room to in their home to a flatmate.
As always, there’s a bit of detail in these, but in summary, in relation to claiming deductions or costs incurred in renting a room out to a flatmate, the draft consultation concludes that deductions can be claimed to the extent that they’re incurred in deriving gross income. The rental income will be assessable and the amount of expenditure needs to be apportioned between private use living in the house and income earning use, rental income from a flatmate.
The draft consultation suggests that apportionment, based on the use of physical space, is a reasonable basis on which to determine what represents an income earning component of expenditure and therefore calculating the deduction available.
Interestingly, the interest limitation rule will not apply, if the land is used predominantly for the person’s main home. Similarly the residential ring fencing rule won’t apply if more than 50% of the land is used for most of the income made by the person as their main home.
The general rule here is that it’s a matter of fact, whether the dwelling is the person’s main home. You must consider all the circumstances. But the fact that you are renting out a room in, in your home to a flatmate while you are living there will not preclude the home being the person’s main home. And on that basis, the interest limitation and residential ring-fencing rules should not apply.
Which leads on to the second question as to whether then the bright-line test might apply. If so, would a person who is living in a home and rents out a room to a flatmate, qualify for the main home exclusion.
This draft consultation concludes that, yes, that person should qualify for the main home exclusion. Again, whether it’s a home is a matter of fact, and you consider where the person resides and has a fixed presence. Just a reminder, though, that there is a slight twist in for land acquired between 29th March 2018 and 26th March 2021. The main home exclusion applies where for most of the days in that bright-line period, the land is mainly used as a residence by the person.
But there may be situations where that in fact is actually incidental to the main purpose of carrying on rental activity. I think one of the questions there would be if you are starting to rent out more than one room if say there are four bedrooms and you’re renting three out. The question might then start to arise as to whether the main home exemption would be available. Anyway, it’s good to see some guidance on this as this question no doubt is going to pop up from time to time.
It’s provisional tax payment time
Monday is the due date for payment of the final instalment of Provisional tax for the March 2023 income year. The key thing to keep in mind here is if you think your residual income tax for the year to 31st March 2023 is going to exceed $60,000, then you need to make the full payment on Monday. Otherwise, use of money interest will apply on the unpaid provisional tax.
Incidentally, the interest rate on tax paid late rises to 10.39% with effect from Tuesday. Also, bear in mind, in some cases, you may also face late payment penalties, an initial 1% on the tax paid late. And then if it’s not paid in full within seven days, a further 4% is levied. Use of money interest continues to apply on top of these penalties. So, paying your tax late is an expensive proposition.
I’ve been dealing with Provisional tax for almost 30 years now, and it’s still something that confuses me from time to time. But the key point to always keep in mind about the latest iterations of these rules is that if your residual income tax is going to exceed $60,000 for a tax year then you need to pay the liability in full on the third provisional instalment date.
Not self-employed? You might still have to pay provisional tax
Usefully, Inland Revenue have released a Question We’ve Been Asked QB 23/05 on the impact of provisional tax for salary and wage earners who receive a one-off amount of income without tax deducted.
For example, this sort of income could be the gain from the exercise of shares granted under an employee share scheme, or from the transfer of a pension from overseas or a gain from a sale subject to tax under the bright-line test.
The general provisional tax rules are if your prior year residual income tax was less than $5,000, then this question you’ve been asked doesn’t apply. However, if it it’s more than $5,000, then you will be liable to pay terminal tax. No interest will run on that tax if it’s paid by the terminal tax due date, which is typically the 7th February following the end of the tax year for those without a tax agent, or the following 7th April for those with a tax agent.
As always in tax there’s a but, and the big but is what I mentioned a few minutes ago. What happens if your residual income tax exceeds more than $60,000? Then use of money interest at 10.39% will apply to any underpayment from the date of the third instalment, typically 7th May.
This is a really critical point if you have an untaxed gain such as those I mentioned, a gain under the bright-line test, transfer of a foreign superannuation scheme or as a result of exercising shares under an employee share scheme, and your tax liability exceeds $60,000, then you’re into the provisional tax payment regime straightaway and you have pay the tax in full on the third instalment date, typically 7th May, or this year, Monday 8th May.
Provisional tax does trip up a lot of people and but generally speaking, unless you’ve made a big gain, in which case you probably should have the funds available (or at least I’d hope so), you’ve got until the terminal tax date to meet those requirements.
One thing you need to do, by the way, if you are a salary earner and you have realised one of these untaxed gains, you should notify Inland Revenue as soon as possible before it starts its auto calculation assessment process. Otherwise, what might happen then is that they calculate you may be due a refund. They will make that refund and then you will have to repay the refund and the correct amount of provisional tax.
More feedback on taxing wealth
And finally, the controversy continues to around the Inland Revenue High Wealth Individual Research Project and the various related reports such as the Sapere report. There’s some fairly interesting commentary flying around on the topic. I thought Damien Venuto in the New Zealand Herald was on point when he said whether we like it or not, there is a reckoning coming around how we deal with tax.
The DomPost has an article by Susan Edmunds, which wasn’t online at the time of the podcast, talking about what was happening here and getting the views of Robyn Walker of Deloitte. Previous podcast guest John Cantin, as always, has some very insightful commentary. I think John makes an interesting comment about how the Sapere report and some other commentary brings in the question of benefits paid to taxpayers to provide an overall economic view. And he thinks that rather confuses the matter.
We don’t tax unrealised gains? Think again.
I want to repeat a point I made last week in the podcast and on RNZ’s The Panel. We currently do tax unrealised gains. The Foreign Investment Fund regime is the very best example of that. The taxation of pension transfers is another. When someone transfers an overseas pension to New Zealand, they’re not always realising it. In some cases, people are taxed on the value of the pension transfer but they can’t access it until they reach age 55. So that’s not really a realised gain. There are the financial arrangements rules which tax unrealised foreign exchange gains and losses. Overseas, estate taxes in essence tax unrealised gains. So, the concept is not unusual.
I remember looking at the various commentary reports from the 1980s and early 1990s when New Zealand was overhauling its tax system. There was a real debate going on around whether it was practical to have an accrual-based capital gains system. Wisely, the reports concluded that much as that might be economically accurate, it simply was practically impossible. Wealth taxes, quasi do that in a way, but a capital gains tax on an unrealised basis is, to all intents and purposes, a non-starter.
So, the debate will continue, and we’ll see a lot of politicking around that. Like Damien Venuto I’d like to see some hard answers on this from politicians about how they are going to address the issues of demography, demographic change and climate change.
And on that bombshell, that’s all 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 time, kia pai to rā. Have a great day.
This week I’m joined by Shamubeel Eaqub, a partner at the boutique economic consultancy Sense Partners.
Shamubeel is a regular commentator on economics and is the author of several books including Generation Rent.
Terry Baucher (TB): Kia ora Shamubeel, welcome to the podcast. It’s been an interesting week, we’ve had three major reports on the true tax rate paid by the wealthy on their economic income. What have you made of all this? Are we any the wiser after these three reports?
Shamubeel Eaqub(SE): I think we are much wiser. I think we’ve all always suspected that the rich were not required to pay tax on a lot of their incomes. But we didn’t know how much income or how much wealth there was. So, the report by IRD in particular, I think was really useful to get a much better understanding of the survey of high wealth individuals and families. Just how rich they were and just how much income they were earning from wealth alone. The report that came out the previous week from Sapere and OliverShaw Consulting I think was really poor.
I think the official report laid bare those conjectures and I think fairly largely lobbying efforts that was done in the Sapere report.
(TB): Yes, the Sapere report was something, I’ve described it elsewhere as fairly indigestible. You had the complete difference in the conclusions the Sapere report reached that broadly speaking the wealthy were paying a fair amount of tax in line with middle income New Zealand. By contrast the reports from Treasury and Inland Revenue which show a completely different picture, with Inland Revenue concluding the median income tax rate on economic income was 8.9%, I think that raised a lot of eyebrows.
SE: It did. I mean the reports from Inland Revenue and Treasury didn’t show that the rich are not paying tax on the income that is taxable. What it showed was our tax system simply does not ask rich people to pay tax on the income that they earn. Most of the income earned, of course, is from capital. Wealth begets wealth and that huge amount of income, almost all of the income comes from that. You know, the wealthy becoming wealthier and they’re not paying tax on it because we don’t ask them to.
I think there was a sort of misconception that somehow the wealthy are sneaking around and not paying tax on what’s required of them. Although we suspect that they might do that as well. This report wasn’t really about that. But, you know, tax minimisation is a thing. There’s a whole profession that’s out there to help rich people do it very well, people like you, Terry. And then there was the other bit, which is, I think, a bigger and more pertinent question, which is “What counts as taxable income, and should that be taxed?”
TB: Yes, and that’s at the heart of this whole thing. It’s not controversial to be looking at the question of the distinction between economic income and taxable income, because I’ve seen other jurisdictions consider the same issues. On Wednesday, I was on Radio New Zealand’s The Panel. A panelist argued bringing in economic income into the equation isn’t right, because it’s not taxed and we’re also talking about gains not realised. But as you know, we do tax certain instruments on an unrealised basis. But broadly speaking, there is no controversy about looking at the economic value to determine what is a fair or what is a true rate of tax.
SE: There isn’t. And I think the norms will change over time as well. And at a particular point in time, income taxes were thought to be ridiculous, but they’re now the norm. There is nothing to say that there is no one form of income or wealth or a taxable base that we can’t tax. To me, it feels a little bit strange to think that just because we’ve got a system now, which defines taxable income as a particular way, that’s the only thing that we can possibly tax. That’s not true, as you know, when it comes to, for example, things like foreign shares, we have a foreign shares deemed rate of return regime, and that actually works pretty well because it takes a lot of the complexity away and you pay tax on the return that you’re likely to make on the asset that you have invested overseas.
We do tax [unrealised gains] already, it’s not like we don’t. We also do it on things like rates, which is calculated by reference to the value of our houses. So, it’s not like there is any reason why we should think that there can be no connection between wealth or the income earned and wealth. This whole thing that somehow it’s terrible we’re taxing unrealised wealth. As if these are poor people and they can’t afford to pay a tiny amount of that wealth by selling some of those assets or borrowing money or deferring it to a future point. There are so many ways we could design a system that would work quite well.
But to me, these [arguments] are just distractions. But these distractions are going to be really coordinated and very powerful because you know what? There’s a lot of money on the line.
TB: Were there any surprises for you in the numbers that came out?
SE: No, it wasn’t surprising. I think for most New Zealanders, the surprise would be just how rich the rich are.
TB: Yes. I figured that we might see something around the 10% mark because we knew other overseas jurisdictions had seen that. There’s that White House report from America where they actually have a capital gains tax and an estate tax and a gift tax. And they still think that the true tax rate on the economic income of the top 400 families in America is 8.2%, which is quite astonishing, really. Again, it illustrates the effect of what we tax and what we don’t tax although, the American system is riddled with particular exemptions. I do think you’re right, the scale of the wealth at the top end of these 300 odd families being collectively worth about $85 billion, I think that did take a few by surprise.
SE: Yes. I mean, it’s an extraordinary sum of money. And, you know, that is well beyond the conception of what any normal New Zealander could hope to have. And I think quite often when you think about the proposition to people when it comes to tax policy, particularly any taxes on wealth, they think that one, their wealth is going to be targeted or two, they might one day become wealthy.
But we’re not talking about that. We’re talking about, you know, a scale of wealth that there is very little chance that any normal New Zealander will ever achieve that kind of wealth.
TB: Yes, you’d have to have bought thousands of Bitcoin back in 2010 to match some of the numbers we’ve seen here. What do you think about the fact the median age of the respondents was 67? I think that was a little older than I was expecting to see. What can we read into that?
SE: I think it shows people who have made it, who worked hard, got lucky because luck and hard work are the two things that are the key ingredients for becoming quite wealthy. And sometimes intergenerational as well. I think it shows there was a bunch of people who came through that period of the economic reforms which made some big winners and losers, and some of them did spectacularly well.
And we see that, right. We know we know some of these individuals who are out there in that kind of age group. They’re quite visible and well known. It doesn’t detract from all the work they might have done. It’s more that I think they lived through a period of time which created opportunities that were quite unusual.
TB: Is that a moral, do you think, then, going forward for all of us, just come back to your point a few minutes ago, that people say “Well, so-and-so has made X and we can as well.” Or are we different economy, different times?
SE: Well, I think we will mint new billionaires and multimillionaires over time. They will be the Rod Drurys, and the Peter Becks, as well as the Stephen Tindalls and other people.
So there are different ways and some people are at the right point at the right time with the right skills and all those bits that make that magic. But the reality is, in a country of five million people, not all five million of us will have that magic.
TB: Indeed.
SE: A vanishingly small number of us will ever have that. So, I don’t think it’s a model that’s replicable, per se. It’s, of course, nice to have that aspiration that we should try and improve ourselves. We should start businesses; we should try and do well. We should create jobs. But actually, for most of us, we’re not going to achieve and attain those kinds of numbers, that kind of wealth.
TB: Actually on wealth one of the things that I was intrigued to see Inland Revenue had looked at was the impact of inheritances. And this saw $411 million that had been transferred in what they call sizeable gifts, which is more than $25,000. But that was over a 50-year period, which isn’t terribly significant. I think that if memory serves right, half of that happened in the decade between 2010 and 2020.
What do you make of that? We’re not talking about old money being passed down from generation to generation, are we? Or maybe the money is still locked up in trusts. Did that surprise you? Because it was a surprise to me. I was expecting to see bigger numbers than actually popped up.
SE: Yes, I think there are now a lot of family offices for the truly wealthy families. It doesn’t make sense to give the money away. It’s much easier to keep it locked up because you get the economies of scale from running a family office, which gives you the ability to create even more wealth for future generations.
So, I wasn’t super surprised because there was no great incentive to dilute your wealth and to give that money away. I’m not really clear on what the definitions were in terms of those inheritances. Was it really money being gifted or was it the returns that are given to family members? There are lots of different ways that you could think about that. But my sense is that there is no great tax incentive for [the wealthy] to give the money away. There is no kind of reason for why you shouldn’t have the trusts and structures going on in perpetuity.
So was Thomas Piketty right?
TB: I see that Thomas Piketty has been quoted on Newshub about the report.
We know that Piketty is David Parker’s favourite economist or one of his favourites. Do you think this vindicates what Piketty has been saying?
SE: But I think it confirms what we know to be true, wealth begets wealth. To be very rich, it’s very helpful to begin by being very rich. And we also know that because of the way that our tax system is designed, it is designed for the many rather than for the few.
So, you know, inevitably you’re going to see the critique that this is the politics of envy and all that kind of stuff. But actually, when you jump back and ask the question ‘What is income and what should be taxed?’ it does take you away from that idea of envy. And actually, your income is very large and you’re not paying the same share as everybody else. Why is it that because you are wealthy, you are exempt from this income that you earning?
I think this was the core fundamental of the kinds of things that Piketty has been arguing for, why is this unearned income, this accident of birth? Why is it that you have some God given right to keep that protected from the rest of society? Why is it that that wealth, that income is not part of the wider taxation system in a society that you choose to participate in?
TB: I guess a response to that would be, well, we pay most of the tax anyway. It’s a small group, the numbers being pushed say the top 2% or 3% pay 26% of the tax. So the probable counter might be, ‘Well, we are paying enough anyway. We are paying our share.’ What would you say to that? Again, I guess it’s a question of how we define income, isn’t it?
SE: I think so. And I think, it’s also entirely possible to counter that with saying, ‘Well, if you also pay 20% like the rest of us, then, in fact, that future reality might be that all of us pay 15%.’
TB: The broad base, low-rate approach, broadening the base and lowering the rate. Yes.
SE Exactly. So, the alternative features are not just that they pay more. It might be that they pay more and the rest of us pay less. And again, this still goes back to the fundamental question of what is income and what we choose to define as taxable income.
And I think that’s really what came through that entire work. It wasn’t really about wealth. I mean, for me, it was really about asking the question of what do we actually consider to be income? And why is it that our tax system deliberately and specifically excludes some forms of income? Just because they happen to be the domain of the rich.
A ground-breaking report
TB: The report has been described as groundbreaking and not because of its methodologies, because those are fairly common. We were talking earlier that there seem to be three different methodologies and Treasury got down to nine different calculations of effective average tax rate, which I think was testing the patience of even the most dedicated of us.
What marks this report out as groundbreaking in my view, is we’ve actually got really good hard data, to work on for a change. And so it’ll be interesting to see how this plays out around the world.
SE: As you know, Terry, this is not new in the sense that there’s been other countries, particularly the US, where they’ve really kicked this off trying to find out what’s going on, because, you know, the domain of the very rich is quite opaque.
They can keep things opaque because they’re very rich and they have very good lawyers and very good accountants. And also, people are private because they don’t want people to know how much money they’ve got. But the groundbreaking nature of this study was very much that now we have real data based on an extraordinarily high rate of response.
TB: I think it was 93%. And, you know, fair’s fair, to be honest when the project was announced, there was a lot of immediate pushback on this. But 93% compliance, I think, is something I would expect that’s actually better than Inland Revenue were hoping for at the start of the project.
SE: I think it’s excellent. I mean, we know that there is a large enough population to give us a really good understanding of what this group of people look like. But I think it also speaks to something about it’s not like these people are necessarily trying to hide things, right?
When you see these kinds of numbers come out, there’s always a tension that all the rich are trying to hide things or they’re not trying to pay their fair share.
My sense is that that’s not really what the high rate of participation shows. I think what it shows is that people are relatively open. I mean, of course, there’s always a risk of not complying with Inland Revenue’s requests. But to me, it shows that even the very rich families, they do feel there’s a civic responsibility participating in society, that they want to be part of New Zealand and a tax system that is fair and transparent.
At least for me, the signals were very positive that these very high net worth individuals and families, they wanted to share that information so that we could have an open conversation about what is it that we want to do. Because the reality is that if we make changes on things like capital gains or wealth taxes, it’s not going to be just those families that will be affected, it will be a wider group of people. And having that transparency and openness does make it easier for us to have those conversations.
I think the study is really helpful because those studies give us real data and also just showed us the distribution of New Zealand. You know, the 99% of New Zealanders will live very different lives to that top 1%.
So how did the rich get rich?
TB: Yes, indeed. Just on the distribution in the report was there anything of interest to you about the range of the sources of that wealth? There’s some property, new technologies. Anything stood out for you in that data?
SE: Well, I mean, to me it was more that there was such a variety. I think that’s cool, right? It shows that to be filthy rich, there isn’t a common formula. There’s lots of different ways people have become filthy rich. Some of it because of, you know, like just being at the right time, at the right place in the right industry or having the right whatever. But it wasn’t all property. It wasn’t all one thing.
TB: Now the property thing is really interesting. I think on average each of the 311 families held 22 properties. But the analysis and modelling by Inland Revenue showed the capital gains weren’t all from property, they represented a range of things, portfolio investments, but mainly their own businesses that they had built up.
And that actually was something I thought was quite encouraging because you take that and the fact that we did not see a lot of inheritances being passed down and you got the impression that there were people who could come in and start at the bottom and have huge success. You mentioned Peter Beck earlier. Rod Drury of Xero would be another example of that. Stephen Tindall with The Warehouse, three different types of industries there. None of those are traditional industries, by the way. They’re not farming, or forestry related, but they’re all very wealthy people as a result of that. I guess people might say it shows a more diverse economy and the opportunity existing in that. So, I was encouraged by that.
SE: I think so. I think for most New Zealanders, the story of wealth creation kind of goes to a housing type story, right? Actually, there are a lot of people who’ve made a lot of money by starting businesses, selling businesses, or keeping businesses and growing them. And that to me is what creates economic vitality. That’s what creates a better New Zealand, right? That’s what creates more jobs.
I mean, of course we need homes. But you know what? It’s such a passive way to create wealth. Businesses are exciting because you’re creating jobs and changing lives through providing livelihoods. That, to me, is enormously more satisfying and exciting. Seeing a lot of that in the very high net worth individuals tax statistics, I think was very encouraging.
But it’s also true that not only do they make money by being in business, they continue to invest in businesses. So, it’s not like, there are these rich families that are sitting there with all this money sitting idle. We know they’re using that money all the time. They’re always looking for the next big opportunity. Of course, they don’t get it always right. But the reality is that, you know, I’ve been involved with businesses startups with these high net worth individuals, and they are the ones who back people. They’ll say ‘Here is a cheque for $1,000,000. I’m going to back you.’ And that is hugely powerful.
TB: That was something I came across when I was on the Small Business Council, the access to venture capital in New Zealand is surprisingly good. There is a fair amount available, and it is these wealthy people reinvesting in businesses. They go looking for the next Xero, the next Rocket Lab. And again, that’s encouraging.
What next?
So, what next? If you’re the Finance Minister or the Prime Minister, you’ve got this report and you say, ‘Right, here’s what we’re going to do.’ What would be the three things you would say to address the issues these reports have thrown up and improve our tax system?
SE: Well, if I were truly a politician in New Zealand, you know that I would have already sent out a poll asking a small group of people what they think about more taxes because we do politics by polling in New Zealand. And the polls will show that nobody, no New Zealander wants more taxes because they’re afraid that they might one day be rich, and they might be asked to pay tax on it.
So, you know that that the self-interest, that greed, that fear of missing out of a potential future, which is I think almost impossible, I think that would motivate most polls and they would show that people don’t want more taxes. And as Finance Minister, if I were truly in Cabinet today, I would see those polls and say ‘Bugger it, I’m not going to do anything. Bury this thing.’
That is the sad reality, it’s heartbreaking that we have seen very little action when it comes to tax policy in New Zealand for decades. Because you know what? We just don’t have the steel and the political consensus across the community to do anything different.
TB: Yes, I think that’s it in a nutshell. I mean, I think Jim Bolger’s ‘Bugger the pollsters’ is something that should be adopted when it comes to tax. Because the politicians, and it’s interesting, doesn’t matter which side, they run away from the issue.
I know I’m a broken record on this. I’m looking at what’s coming down the track, what the Tax Working Group saw was coming down the track. We’ve got demographics working against us with ageing, higher superannuation costs, greater health care demands and now climate change.
The Climate Change Commission in its report released yesterdaybasically said ‘We can’t buy our way out of reducing our emissions, we need to diversify.’ And that report, when it talked about tax, made repeated mentions of tax incentives for better investment to address these issues.
So, it seems to me that like it or not, politicians are going to have to address these facts or simply say, well, ‘You can’t have anything because we need to protect these unrealised gains.’
SE: You know, I was probably being overly pessimistic. But I think the thing is, in the current moment in time, the crisis still feels like it’s two or three or four or five political cycles away.
If you make changes on tax policy today, inevitably you will see whoever’s in power next undo them. So there will be no enduring tax policy because we don’t have consensus in New Zealand. Do we have a pressing need to shift our tax policy? Of course, we do because of demographics and because of climate change, because of large infrastructure deficits, we know that we need to change things. But we also know that New Zealand has an extraordinary reactionary political system. There is no leadership, it is reactionary. And so, unless there is a crisis, until something really breaks, we’re not going to change.
TB: So you don’t think Cyclone Gabrielle, or the Auckland floods are a breaking point?
SE: Not at all. I mean, they might cost the government, you know, a maximum of $15 billion in the scheme of things. That’s nothing spread over three or four years.
You know, the Government’s tax take per year is $100 billion. Those costs are at the margins. So that’s not enough. It’s when you’ve got Cyclone Gabrielle happening every year or every other year when people can’t get access to insurance, when we’ve got coastal properties that are being inundated, when we’ve got erosion that’s taking away what we’ve previously valued as multi-million-dollar bachs. That’s when you’re going to start to really strike those pressure points, because we haven’t actually planned for any of this stuff.
TB: Those are all happening right now, actually. I mean, Tairawhiti East Coast region, I think Cyclone Gabrielle was the fourth major event that warrants special tax treatment inside 12 months. But as just said, it’s now receding into the background. Maybe it’s not so much our politicians, it’s also our media cycle just isn’t adapted to that.
SE: I think it’s less about the media cycle, it’s also what we want to hear as citizens, as engaged people in politics, people who are engaged in the civics of the country. Are we actually engaged in grappling with these big structural issues? And the answer is no. And I think the conversations that we have on public policy in New Zealand are, by and large infantile.
You know, they are by and large led by people who are lobbyists and people who are actually biased with a huge amount of self-interest because it is a small group of people who do everything. There’ll be the tax experts who are providing expert advice to people to minimise their taxes and the same people who are going there to try and design a business tax system. Well, I don’t know, man can you really trust them?
TB: Well, reputational risk here, but yes, I think self-interest is a problem. But let’s just be bold, let’s say you’ve decided ‘Bugger the pollsters’ what would you do?
What tweaks would you do if you were looking at something that might take the population around along with you? What would be the first thing to do.
A tax switch?
SE: You know, I think one would be relatively easy in that you would do a tax switch. You would implement a land tax and you reduce something like GST. That switch would be quite immediate and it would create a much better balance in New Zealand. It wouldn’t capture the very high net worth because it’s not about that, but it would create the introduction of a wealth tax. We already have the mechanisms for that with things like the rating tools.
But, you remember with the Tax Working Group, the land tax was one of those things that was identified as a good tax to have, because we know that not only would it incentivise better use of our land that we have, but it’s also that one asset that can’t run away, like unlike many of the other types of assets that people hold. So that would be the big thing.
But fundamentally for me, it’s really around if you really want to change tax policy, you’re going to have to create consensus. And you know, we can’t do that until we have some kind of bipartisan agreement about, one, what the issues are, and two, that we fundamentally either need to have higher taxes or we simply cannot have all the services that we have promised ourselves.
Now, that’s a really hard conversation to have. You know, you look at the quality of our political leaders. They’re not engaged in any of that debate. You know, most of our political leadership is engaged in the politics of who’s going to do the least.
TB: It’s a very small target strategy.
SE: It’s sort of, if you ask me what needs to change, I think the change that needs to happen is not that you need to jump in and make lots of changes, because the reality is that the knee jerk reaction will be to reverse those through a change of government. I think the change that requires us to have is actually creating something like the Climate Change Commission that creates this conversation. Some of those public policy issues that take the politics out of it.
TB: So, are you saying there should be the equivalent of the Climate Change Commission, a Tax Policy Commission that alongside David Parker’s Tax Principles Act, but sits there and pushes out the reports and saying, ‘This is it, guys, this is what we can do.’ In other words, a semi-permanent tax working group.
SE: Except of course it must have powers and it must have the ability to hold the politicians to account. Quite often what we do with things like the Climate Change Commission is we give them the power to design, but we don’t give them the power to actually fund or hold the powerful to account.
It’s not going to be very hard, right, because no politicians want to give the power away to somebody else. There will be no independent body that they’re going to give the powers away. The only one that they’ve really done that with is the Reserve Bank, and I think they’ve been regretting it ever since.
TB: Yes, I was thinking of the Reserve Bank too. I think that’s probably as good a point as any to leave it there.
Shamubeel, thank you so much for being on the show. Really appreciate your insights on this. I hope I don’t feel so pessimistic, but to be frank, we probably have good reasons for people to be sceptical about what will change anyway.
That’s all for this week. I’m Terry Baucher and you can find this podcast on my website 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, kia pai to rā.
This report was commissioned by the tax advisory firm OliverShaw and has been released ahead of two reports coming out next week, one from Inland Revenue on the tax and effective economic income of high wealth individuals in New Zealand and the other from Treasury on the effective tax rate of New Zealanders across the income and wealth distributions.
As you may recall, the Inland Revenue project reviewing the net wealth of the 400 richest families in New Zealand has been highly controversial and generated quite a bit of pushback from the outset. There were mutterings about court actions to prevent the proposal going ahead, although as far as I’m aware, none of those have ever eventuated.
Nevertheless, the controversy prompted OliverShaw to commission a report because, as they say in the Foreword of the report:
“From what has been said about the methodology of the Inland Revenue study, it seems that the Inland Revenue and Treasury studies may use different methodologies. A comparison of two different studies using different methodologies could easily produce a misleading and confusing picture of our tax system.
Moreover, the Inland Revenue methodology seems inconsistent with OECD and academic effective tax rate studies….We therefore considered it important to have a study that uses a more consistent approach to estimate the effective tax rates that are imposed on the incomes of low, medium and high wealth households rather than just high wealth individuals.”
That’s the rationale that OliverShaw gave for the project. Incidentally the Oliver in OliverShaw, is Robin Oliver, a former Deputy Commissioner of Inland Revenue and a member of the last Tax Working Group. So, he speaks with a lot of authority. You will also recall Oliver was one of three members of the Tax Working Group who produced a dissenting opinion on the proposal for a comprehensive capital gains tax.
Worth keeping in mind, however, that Oliver and the other two dissenters, Kirk Hope and Joanne Hodge did agree with the rest of the group in extending the taxation of residential investment properties. This probably should be kept in mind amongst all controversy the Sapere Research Group report has produced.
The report, to put it mildly, is massive, it runs to a total of 267 pages, in three parts. There’s a foreword from OliverShaw, followed by a detailed outline of the report. And finally, the report itself, which breaks down into five sections, an introduction, an overview of New Zealand’s tax and benefit systems, the effective tax rates estimates, section four then interprets and applies these effective tax rate estimates. And finally, there is the conclusion in section five.
So it is colossal and to be honest, I haven’t yet got my head around all that’s in here. It’s certainly, as I’ve heard one or two other experts say, a report that merits rereading as often is the case when you’re processing this much data. As far as I can recall nothing like this was prepared for the Tax Working Group. (No doubt some will correct me if I’m wrong on that).
It’s an extensive piece of research and its conclusions are a little controversial, because in essence, they appear to be saying that the average effective tax rate paid by the wealthy is not far off that paid by other middle-income earners.
By the way, the classification of what is middle-income is something that perhaps might provoke some pushback. Low income is seen as under $48,000, which is the threshold at which the income tax rate increases from 17.5% to 30%. Medium-wealth households are described as those that derive annual net real economic incomes between $48,000 and $500,000. High wealth, high income households are those deriving net real economic incomes in excess of $500,000.
That medium-income upper threshold of $500,000 seems pretty high to me. But no doubt the statisticians and others have got a reasonable background on it.
As I said, there’s so much in this report to digest that it’s possibly the reason why there’s a fair bit of confusion about what it is really driving at. In summarising the report’s conclusions Robin Oliver commented;
“One of the questions asked is whether the very wealthy pay taxes at the same or higher rate than middle income earners…This research shows clearly that, whether you consider taxable income or other measures, such as economic income, the answer is: ‘Yes, they do.’ “
That certainly raised a few eyebrows around the place, including that of Craig Elliffe, another member of the last tax working group. And if you want a good critique of the report and where some of the issues are going to be explored further, The Spinoff has a very good article in which they spoke to Craig Elliffe at length on the matter.
For myself I’m still digesting the report. As I said, it’s massive and a significant amount of data to absorb. So, I’m not so keen to rush to judgement. Certainly, that conclusion that Robin Oliver cited surprised me. On the other hand, when he was interviewed for Newstalk ZB, he did point out that there’s a real problem with the tax rate jumping from 17.5% to 30%, around the $48,000 threshold.
Indeed, one of the conclusions of the report is arguably the highest effective tax rates are paid by those on the lowest incomes once you take into consideration the impact of abatement of benefits.
Getting your retaliation in first?
The report has generated a lot of controversy, which appears to be the deliberate intention of OliverShaw. It certainly follows the motto adopted by the 1974 Lions captain Willie John McBride when they were about to play the Springboks “Let’s get our retaliation in first”.
I’m therefore going to withhold further comment on the report until I’ve seen the reports from Inland Revenue and Treasury. We’ll then be looking at three very comprehensive reports and I’m sure a clearer picture will emerge as from these reports once they’re considered as a whole.
Still, it’s good to see tax in the news. I think generally we don’t talk seriously enough about tax. Politicians will fence around the topic talking in slogans, but the nature of what we tax, and how we tax is incredibly important. As I’ve said repeatedly in the past, I am concerned that we’re facing significant fiscal challenges from climate change and changing demographics. Our tax system has to be seen to be robust enough to meet those demands.
Does that mean, as the economist Cameron Bagrie suggested recently, we may need to be raising taxes? All of that is up for consideration. So, a debate around what’s taxed and who pays what is very good to see. And I look forward to engaging more in that debate.
Lessons from FATCA?
Moving on, as noted above, one of the controversies about the Separe report and in general, is over the question of the true economic income of the highest net worth New Zealanders. And the controversy really arises because we don’t know very much. Data is scarce on this topic and that generally bedevils tax policy and tax revenue authorities around the world and has done for a long period of time.
A report from the United States this week looks at the data obtained as a result of the highly controversial Foreign Account Tax Compliance Act, or FATCA.
If you recall, this was introduced in the wake of the Global Financial Crisis, and it required banks and financial institutions in overseas jurisdictions to provide data to the United States Internal Revenue Service (“the IRS”), regarding foreign wealth held by United States citizens in those foreign jurisdictions.
To recap, the United States requires all its citizens, whether or not they are living in the United States, to file tax returns. As part of those filings, they are required to provide details of all overseas financial bank accounts. FATCA is an incredibly important piece of legislation, probably one of the most important pieces of tax legislation in the last decade, because it became the genesis of the OECD’s Common Reporting Standards on the Automatic Exchange of Information.
Following the introduction of FATCA. Other jurisdictions thought, “Well, if our financial institutions have to supply this information to the United States, it would be handy if we also knew exactly which of our citizens and tax residents had wealth overseas.” So that was the genesis of the Common Reporting Standards (“the CRS”).
The IRS, together with the United States National Bureau of Economic Research, have just released a report which pulls together all the data so far provided to the IRS since 2015, when FATCA took full effect.
This has enabled the IRS and therefore the United States government to get a clearer handle on what wealth is held offshore and by whom.
According to the report, around 1.5 million US taxpayers hold foreign financial accounts. The total value of those is around US$4 trillion as of the year ended 31st December 2018.
Just for comparison, the total financial assets of the US households amounted to roughly US$80 trillion in 2022. What is of particular interest to the IRS is about one in seven of these overseas accounts are held in jurisdictions usually considered tax havens such as Switzerland, Luxembourg and the Cayman Islands, but those accounts total nearly US$2 trillion. The report’s authors conclude that this indicates accounts in tax havens are, on average, larger.
Another point of interest is the ratio of tax haven assets to GDP is estimated to be about 10%. That was higher than previously estimated. The implication is that financial assets in tax havens may have grown significantly faster than the overall U.S. economy since 2007, which is that baseline for that previous estimated ratio of tax havens wealth to GDP.
The FATCA data is enabling the IRS to get a better idea of who holds overseas assets. It appears that more than 60% of the individuals in the top 0.01% of the income distribution in the United States own foreign accounts, either directly or indirectly. What also happens is that the proportion owning offshore accounts rises as the incomes deciles rises. This apparently ties in with literature, which says that there's a strong correlation between the wealthier a person is, the more wealth is held offshore.
Now this data is prepared for the United States and comes out of FATCA, but I expect Inland Revenue would be mining the data it’s receiving through the Common Reporting Standards.
And it might be that we might see some of those findings reflected in next week’s reports. It doesn’t surprise me, by the way, that the wealthier a person is, the more wealth is likely to be held offshore because wealthier persons will seek to diversify their asset holdings.
That’s a natural response and shouldn’t necessarily be seen as being sinister. But whatever the reason, it’s interesting to see what the IRS has gathered so far from its data.
And of course, it will be interesting to see how they respond to that data. Of course, they’ll certainly get pushback from the Republican Congress on that. But that’s politics and taxes, they go hand in hand. I’m curious to see what, if any, reference to CRS data comes out of next week’s Treasury and Inland Revenue reports.
New Inland Revenue guidance on the bright-line test and family transactions
And finally, this week, and also connected to our main story, Inland Revenue has released some guidance in relation to the bright-line test and family transactions. Now this particular Interpretation Statement IS 23/02 is very specific.
It applies to the application of the five year bright-line test, that is where the land was purchased between 29th March 2018 when the bright-line test period increased from 2 to 5 years and, 27th March 2021 when the bright-line period was further extended to ten years. As is now usual, the interpretation statement is accompanied by a useful six-page fact sheet.
The Interpretation Statement covers scenarios where parents are assisting children or other close relatives with buying first homes, a partner is added to the title of residential land and where land is inherited under a will which is then on-sold to other beneficiaries.
Generally speaking, if you sell residential land to a family member or partner within the bright-line period, that potentially will trigger a taxable charge. That may also be the case if the land is gifted or sold below market value. On the other hand, if residential land inherited under a will is sold to other beneficiaries under that will, that sale would be exempt from the bright-line test. However, any subsequent sale by those recipients to a third party within the relevant bright-line period would be taxable.
Inland Revenue have promised to release separate guidance on this issue of transactions between family members in relation to the ten-year bright-line period, and that will be considerably more involved.
Something which comes up repeatedly and lies at the heart of the controversy surrounding the Sapere report are the implications of the lack of a comprehensive capital gains tax. At the moment, it results in distortions where someone’s economic wealth rises without being subject to tax, whereas in other cases an equivalent rise in value may be taxed because of a different set of circumstances. The various iterations of the bright line test are a good example of this frankly, incoherent approach.
That’s all for this week. Next week we’ll be looking in detail at the Treasury and Inland Revenue reports on tax and economic incomes of New Zealanders and how their conclusions and methodologies compare with those in the Sapere report.
Until then, I’m Terry Baucher and you can find this podcast on my website or wherever you get your podcasts. Thank you for listening and please send me your feedback and tell your friends and clients. Until next time, kia pai to rā. Have a great day.
Happy new tax year and welcome to the 2023-24 tax year and as is often the case the start of a new tax year it means newly enacted legislation is now in place.
However, some of the same old issues are still with us.
The Taxation (Annual Rates for 2022-23, Platform Economy and Remedial Matters) Bill (Number 2) finally received the Royal Assent on 31st March. Apparently this bill had nearly 200 new clauses, which between them had some 42 different application dates. So, it was a surprisingly complex bill. But remember, its most controversial proposal to standardise the treatment of GST on fund management firms was removed.
As noted, the bill has got quite a considerable amount of new provisions in it, and we’ll pick up several over the next few weeks. But I want to start by looking at the new fringe benefit tax (FBT) exemptions for bikes and public transport. As you may recall, the bill originally had an exemption for public transport, but at the last minute an FBT exemption for bikes was introduced. That actually covers bikes and “low powered vehicles”, so obviously covers scooters, e-scooters, e-bikes. The exemption from FBT applies where you are travelling between home and work. There’s going to be a maximum cost for the low-powered vehicles, which is yet to be confirmed by regulation shortly.
Watch out for the hook in the FBT exemption for bikes and public transport
But the key point to keep in mind is that the bike or scooter must be used mainly for travelling between home and work. Therefore, where that isn’t the case, FBT would still apply. This together with the maximum price cap on the exemption should rule out people buying high end bikes, e-bikes or e-scooters and then using them mainly for private use hoping that it’s exempt from FBT.
Now the exemption is from FBT, there is no equivalent exemption for PAYE. What that means is, it is very important for employers to consider how they provide that benefit and don’t make the mistake of assuming “Well, the FBT exemption applies so nothing to worry about.” The issue that arises is where the employer purchases the bike or scooter directly, then the FBT exemption should apply. However, if the employee chooses and purchases a bike personally and is then reimbursed, then PAYE will apply and there’s no exemption.
This principle also applies to the exemption around the use of public transport or vehicle shares, such as Uber and similar apps. Again, the employer must incur the cost for the exemption to apply. As some have noted that’s actually administratively quite awkward. It seems likely quite a few employers will accidentally trip up on this by reimbursing the employee rather than incurring the costs directly. The hope is that this particular anomaly can be quickly resolved and therefore ease the compliance involved.
Now, the new act also contained a permanent exemption from the interest limitation rules for build to rent dwellings. This exemption will apply where there are at least 20 connected dwellings, and the landlord must offer a fixed term tenancies of at least ten years. By the way, for the purposes of the interest limitation rules, as of 1st April, only 50% of the interest is now deductible unless one of the exemptions, such as a new build or build to rent, applies.
Interest limitation rules and short-stay accommodation – don’t get mucking fuddled
Coincidentally, last week, Inland Revenue released a draft interpretation statement for consultation on the interest limitation rules and short-stay accommodation. The interpretation statement considers how the interest limitations will apply and then also explains what other income tax rules may be relevant depending on the circumstances. The draft interpretation statement runs to 79 pages and is now common practice, it’s accompanied by a fact sheet.
It says much about the complexity of the rules in this area that the fact sheet runs to 13 pages. That’s because not only are the interest limitation rules applicable owners of short-stay accommodation must also take into consideration the potential application of the mixed use asset rules which have been around for over ten years now, as well as the ring fencing rules.
For the purposes of the draft interpretation statement, short-stay accommodation is defined as accommodation provided to paying guests for up to four consecutive weeks. The interpretation statement covers five scenarios where such accommodation is provided:
either in a holiday home; in a person’s main home; in a separate dwelling on the same land as the main home; in a separate property used only for short-stay accommodation; and on a farm or lifestyle block.
Within each of those five scenarios, the interpretation statement will explain if and how the interest limitation rules will apply, what apportionment rules apply, and whether ring fencing rules apply. There are also variations within these scenarios. If there’s a new build involved, for example, a person’s holiday home is on new build land, then the interest limitation rules will not apply. However, the deductibility of interest is still subject to the other apportionment rules, such as those contained in the mixed-use asset provisions and the ring-fencing rules will still apply.
As can be seen, there’s a great deal of complexity now involved, and this is partly the result of the somewhat ad hoc approach adopted by the Government in tackling what it sees as the preferential treatment of residential property investment. It also reflects generally incoherent policy resulting from the lack of a comprehensive capital gains tax. Whatever, the key lesson to watch out for is that the short-stay accommodation rules are now incredibly involved, so proceed with great care.
The taxation of capital is a longstanding issue and one which in my opinion, will need to be addressed sooner rather than later. Not only because of the tensions it creates within the tax system, but also because of the need to find additional revenue to meet the demands of an ageing population and the impact of climate change, which we’ve spoken about previously.
We like New Zealand Superannuation – but how are we going to pay for it?
And three reports this week highlighted this ongoing tension around meeting future liabilities. Firstly interest.co.nz covered a study coming out the University of Otago regarding New Zealand Superannuation. The study surveyed almost 1300 people in 2022 asking them what they felt about the age of eligibility, means testing and the willingness to increase both current and future taxes to pay for New Zealand Superannuation.
The study found there was widespread opposition to financial barriers for receiving superannuation. Means testing was not popular, but the support for keeping the retirement age at 65 has increased, with almost a quarter ranking the age of 65 as most important aspect of New Zealand super compared with a fifth back in the 2014 survey. 61% of those surveyed ranked raising the retirement age to 67 as the worst policy. The general response was they would prefer universal superannuation.
The New Zealand Super Fund, which has been established to help spread the cost of superannuation was popular. Although there was opposition to increases in current taxes to pay for New Zealand Superannuation, a majority of respondents still support higher current taxes to reduce the size of future increased tax increases given plausible investment returns.
A day earlier independent economist Cameron Bagrie told Newshub he had concluded New Zealand might need to introduce tax increases to have to deal with the impact of climate change and what he called an “infrastructure mess.” In his view, taking into consideration climate change, infrastructure and superannuation “If I step back, though, and think about tax rates in general over the next ten years, where do I think they’re going to be headed? I think they’re going to be biased up as opposed to down.”
Climate change will cost “multiple billions” under ALL scenarios
Bagrie will probably be reinforced in his view by the Climate, Economic and Fiscal Assessment for 2023 released last week by the Treasury and Ministry for the Environment. This report concluded,
It is clear that the size and breadth of the economic and fiscal costs of climate change to New Zealand will be large. The physical impact of climate change and the choices the country makes to transition to a low emissions future will affect every aspect of the economy and society for generations. These impacts will have flow on implications for the Crown’s fiscal position.
What particularly seems to be concerning the Treasury and the Ministry for the Environment is that at present in the planning to help meet our climate targets there is an assumption that we will be purchasing offsets from offshore. As the report notes,
The cost of purchasing offshore mitigation to achieve New Zealand’s [commitments] presents a significant fiscal risk. For all scenarios considered, our analysis estimates this cost to be multiple billions over the period 2024 to 2030.
Multiple billions in this case could range from a low-end estimate of around $7.7 billion to perhaps as high as $23.7 billion. Apparently, the costs involved represent between 3.9% to 28% of the new operating expenditure that will be made available in each budget. Therefore, if climate change is swallowing up to 28% of the new operating expenditure that puts pressure on other areas such as education and health.
The report also discusses the potential tax implications. As noted at the start of section 6 on Fiscal Impacts, “Climate change will create multiple cost pressures for the Crown and is likely to negatively affect its tax base through changes to economic activity.” This presents a big question for policymakers and politicians – how do we have enough revenue to square the circle between meeting the demands for health and superannuation, and our climate change commitments? So that is why, like Cameron Bagrie, I think there is an inevitable pointer towards tax changes.
And on that bombshell, that’s all 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 time, kia pai to rā. Have a great day.
Friday was the final day of the 2022-23 tax year for most taxpayers. One of the more important tasks to achieve that day was filing any outstanding tax returns for the 2021-22 tax year. March 31st is the latest due date for taxpayers with a tax agent and most tax agents, including myself, were busy filing tax returns to meet this deadline.
A key reason the deadline is important is because under the Tax Administration Act, Inland Revenue have four years after the end of the tax year in which a tax return is filed to open any investigation into that return. This is what we call the time bar period. For example, Friday was the last day for Inland Revenue to open a review of a tax return for the year ended 31st March 2018, which was filed during the year ended 31st March 2019. The four-year time bar period expired on 31st March 2023. If the deadline isn’t met and you’re late, even by a day, then effectively you give Inland Revenue an extra year in which to review a return.
But there are circumstances in which Inland Revenue can reach back beyond this four year period. And a Technical Decision Summary released this week is a good illustration of when that might happen. Technical Decision Summaries come out of disputes which have gone before the Adjudication Unit of Inland Revenue. They’re not formal decisions, but they’re very good indicators of the type of cases Inland Revenue has been reviewing and how it would approach a case.
The background is that an individual taxpayer had a business and got into a dispute regarding the treatment of deposits made to bank accounts owned by the taxpayer and associates during the 2010, 2011, 2012, and 2016 tax years. Did these deposits represent assessable income. If they were, was the taxpayer liable for a tax evasion shortfall penalty Inland Revenue was also looking for an increase in that shortfall penalty for obstruction. And that last point is not something we’ve seen very much of before.
But before Inland Revenue get to that, the question that had to be decided was whether they were entitled to amend the assessments to increase the amounts, because the years in question were outside the four-year time bar period I just mentioned. Now, this is the most interesting part of this whole case because it is a good background of when Inland Revenue can amend to increase income in a tax return. It’s also worth remembering they may also go past the time-bar to decrease an amount of a net loss.
As noted, all the disputed periods 2010, 2011, 2012 and 2016 would have been time barred unless one of these exceptions applied. And the relevant exceptions are where Inland Revenue or the Commissioner of Inland Revenue, to be exact, is of the opinion that a tax return provided by a taxpayer is “fraudulent or wilfully misleading,” or does not mention income of a particular nature or derived from a particular source.
A key point here is that it is sufficient for the Commissioner to honestly believe on the available evidence and on the correct application of the law that the tax return in question meets the requirements for these exceptions to apply. And if you’re going to challenge the Commissioner, that will only succeed if the Commissioner did not honestly hold that opinion or misdirected himself as to the legal basis on which the opinion was formed, or his opinion was not one that was reasonably open to the Commissioner on the available information.
A decision to re-open a time-barred tax return is what we call a disputable decision so it can go before the courts. But the burden of proof rests with the taxpayer to show on the balance of probabilities that a decision made by the Commissioner to reopen time-barred years is wrong.
The adjudicator at the Tax Counsel Office went back to basics in examining the case because it’s a fairly serious matter if you’re going to reopen tax years. The Tax Counsel Office concluded on the evidence that the taxpayer knew they were breaching their tax obligations by not returning rental and business income. This was also apparent from and could be inferred from the taxpayer’s business experience. Furthermore the taxpayer went so far as to proactively provide misleading information about the requirement to file during a phone call with Inland Revenue. The Tax Counsel Office therefore formed the view the taxpayer’s returns were fraudulent and wilfully misleading.
However, the Tax Counsel Office also considered there wasn’t enough proof to show evasion for the 2011 year. But they did say there should be a gross carelessness shortfall, penalty of 40%. The taxpayer was held to have evaded tax in the other years so Inland Revenue went for tax evasion penalties, which are 150% of the tax evaded (discounted by 50% for previous good behaviour). Bear in mind, use of money interest will also be running on the tax evaded.
What Inland Revenue also did, which I haven’t seen much of before, is the shortfall penalties were increased by 25% for obstruction. This was done because the taxpayers continued and undue delays, misleading statements, clear diversion of income into other relatives’ bank accounts and repeated failure to be forthcoming about with information about deposits and bank accounts delayed and made it more difficult for the Inland Revenue to carry out the audit. This obstruction affected the 2011, 2012 and 2016 years and for each of those years, the shortfall penalty was increased by 25%.
The case illustrates when Inland Revenue can bypass the four-year time bar. Although it felt it was dealing with a case of tax evasion, the Tax Counsel Office also concluded the four-year time bar didn’t apply because no return had been provided and no declaration had been included of income, then the second leg was also available. The 25% increased shortfall penalty for obstruction is one of the first cases where I’ve seen it applied. In summary, this is a classic example of where the taxpayer screwed around and got found out and would have paid quite a considerable penalty.
Interest deductibility and thin capitaisation
Moving on, earlier this week, an article popped up over whether or not landlords are in business, and on the face of it they are. But landlords have been complaining that they are not treated like other businesses and are subject to more rules and regulations. One of the sore points for residential property landlords is the question of the interest deductibility, which is restricted.
According to Property Investors Federation vice-president Peter Lewis, he made the case that it is a business and the interest deductibility compared with other businesses is an example where they’re treated differently, however. And Brad Olsen, the Infometrics chief executive and economist, agreed with him on that.
When I was asked this question, my response was it’s not technically correct to say no other business is denied interest deductibility. Landlords are not unique in that sense. That’s because of the thin capitalisation rules which apply to New Zealand companies with overseas parent companies. Under these rules, if the debt to asset ratio exceeds 60% then interest deductions above that threshold are restricted.[i] (As an aside, I thought that when it was clear the Government was considering changes to residential rental property, adopting the thin capitalisation regime, which has been in place since 1995, would have been one option. But as we know, they went a different route).
The other point I made is that residential property investors have the ability to leverage quite significantly, and they also seem to get away with expectations of a lower return. In my view that’s partly an expectation of the capital gain which drives this behaviour. Brad Olsen probably was coming from the same point where he said the gains should be taxable.
On the other hand, you get do have investors with maybe ten or more properties. Then you quite clearly are running a business. If you are trying to level the playing field, then the question is perhaps whether the restrictions around interest deductibility should apply or rather maybe these investors are a group that are probably more appropriate for the thin capitalisation regime.
You may recall when John Cantin was on the podcast and we talking about interest restrictions, he made the point perhaps there always should have been some form of interest apportionment would not be remiss because there is a clear expectation of some non-taxable capital gain. As we will find out in the next item, interest is generally deductible to the extent it’s incurred in deriving gross income. And if capital gains aren’t gross income, why should you get a full deduction?
In my view, when thinking about regulations, while you’re in business, you just have to accept they are a fact of life. Some businesses are regulated more than others. For example, food manufacturers and restaurants, have a fair number of regulations imposed on them for the better health of the public at large.
Anyway, the argument over the treatment of interest deductions isn’t going to go away. Landlords may feel aggrieved about their treatment at this point in relation to interest, but they’re not entirely unique in my view, because the thin capitalisation rules apply to other businesses. It’s always worth remembering that if a property does become taxable because of the bright line test or some other provision, generally speaking, interest deductions incurred in relation to that property will become deductible on the disposal.
Capital expenditure?
And finally, this week in a slightly related matter, an interesting story out of the U.K. from the BBC after it emerged an OnlyFans creator had claimed a tax deduction for breast enhancement surgery.
Titillation aside this caused a bit of a stir in the U.K. because the deduction rules in the U.K. around self-employed are actually much more restrictive than here. On the face of it, the deduction seems to be a bit generous. The lady in question incurred the expense because she wanted to boost her appearance and drive up her income from the OnlyFans subscription-based website.
Titillation (ahem) aside, the reason why UK advisers looked a little bit sideways at this case is because the general rule for self-employed deductibility is it must be “wholly and exclusively incurred”. In theory, if there’s a private element no deduction would arise, and there would appear to be at least some private element in any breast enhancement.
By comparison as I just mentioned a few minutes ago, the relevant provision in New Zealand allows a deduction to the extent to which the expenditure is incurred in deriving assessable income or in the course of carrying on a business of deriving assessable income. It’s quite clear that for New Zealand tax purposes, a deduction of some of that breast enhancement expenditure would be allowed.
So, if you’re thinking about the end of the tax year and maximising your deductions, remember expenditure is deductible to the extent it’s incurred in deriving gross income and therefore some form of apportionment is available. The question here in New Zealand comes down to determining what proportion is deductible. However, a fellow tax specialist did wonder whether in this case breast enhancement might be capital expenditure and therefore subject to depreciation.
Well, on that bombshell, we’ll leave it there. We’re going to take a short break for Easter next week, so we’ll be back in a fortnight. In the meantime, I’m Terry Baucher and you can find this podcast on my website www.baucher.taxor wherever you get your podcasts. Thank you for listening and please send me your feedback and tell your friends and clients. Until next time, kia pai to rā. Have a great day.
[i] In some circumstances the thin capitalisation rules also apply to New Zealand resident investors with offshore investments
