9 May, 2021 | The Week in Tax
The latest draft guidance for taxing crypto assets, and the latest tax audit claim stats from Accountancy Insurance
- Rethinking the taxation of property
- Inland Revenue releases latest crypto advice
- Inland Revenue audit activity
Transcript
In the wake of the government’s shock property tax announcements back in March, Inland Revenue has been preparing the relevant discussion documents and papers for consultation.
The range of matters to be addressed is formidable. What represents residential accommodation? What is the definition of a new build? How do we determine what proportion of a mixed-use loan can be deductible? What about the treatment of interest treated as non-deductible for a property, the sale of which is taxable under the Bright-line test or some other provision? Do we still need loss ring-fencing? The list goes on.
It’s a long and frankly daunting list, the inescapable conclusion of which is that no matter how hard Inland Revenue tries, and I know they are trying to make it as simple as possible, the tax treatment of residential property will ultimately be vastly more complex.
And that’s before you add matters such as preparing for climate change mitigation, earthquake strengthening costs, leaky building repairs and costs relating healthy home standards.
It’s no wonder some residential property investors are considering selling up completely or downsizing their investments.
And watching all this, I’ve been increasingly coming round to the view that maybe it is time to rethink completely how we tax residential rental investment property.
And maybe instead of trying to shoehorn the proposed changes into the existing tax framework we should go back to the basics and adopt the approach that was considered by the last Tax Working Group, but ultimately rejected in favour of a comprehensive capital gains tax. And that is taxing property on a deemed return basis.
Now, what the Tax Working Group looked at is replacing the existing taxation approach on rental income and instead determining taxable income based on the net equity at the beginning of the tax year, applying a rate of return, and taxing this amount at the investors relevant tax rate.
So, for example, Tina owns a residential rental investment property worth one million dollars at the beginning of the income year. That’s funded with 300,000 dollars of debt giving equity of $700,000. Tina’s marginal rate is 33%. The deemed rate of return is set at 3.5%.
Tina’s tax bill for the year would be $8,085 dollars, i.e. $700,000 – that’s the net equity – times the deemed rate of return of 3.5% times her marginal rate of 33% percent. She would not pay any tax on the actual rental income she derives from that property.
Now, this deemed rate of return is an idea has been around for some time. It was first suggested by the Mcleod Tax Review in 2001 when they referred to it as the Risk-Free Rate of Return. This was subsequently adopted for the Foreign Investment Fund (FIF) regime, which came into place with effect from 1st April 2007. The FIF regime has what they call the fair dividend rate, which was set back then at 5% and remains at that level today.
Although hugely controversial, and not terribly popular on its introduction, we’ve all learned to work with the FIF regime and the fair dividend rate. It has its merits in terms of conceptual simplicity. Also for investors, if your return exceeds 5%, your taxable income is capped at 5%. So that’s a win. It does away with the need for distinctions between what is capital and revenue.
And it would take into account some of those factors I mentioned earlier on. The devaluation of a property because it’s found to be a leaky home, or it has climate mitigation risks. Alternatively, the costs of earthquake strengthening would improve the value of the asset. The value of the building will rise therefore the Government benefits and it doesn’t need to worry about the questions we’re seeing right now that I mentioned right at the top of the podcast.
Now, it so happened that myself and Professor Susan St John talked about this particular proposal on a broader aspect at a Fabian Society presentation we made last week. And the more I think about the issue, we saw a change of approach as perhaps an answer to dealing with the housing crisis or a tax answer because ultimately the answers to the housing crisis are multiple and obviously include more supply. But tackling the demand side from the tax perspective was one area where we thought it was worth considering.
I deal with these issues as clients come to me with what are we going to do in this circumstance and that circumstance? And as I drill down into the detail of the impact of the reforms, I cannot help but wonder that it is time to have a really good look at what the Tax Working Group proposed and maybe think about adopting that, rather than trying to shoehorn existing concepts into an increasingly strained tax system.
The Tax Working Group also did some revenue impacts on their proposal. They were quite interesting, in that they figured that for the year ended 31st March 2022 – which is the first year this could have come into place – if they had applied a 3.5% rate of return, the Government would have raised close to one billion dollars.
Now that was ahead of the expected amount of revenue that could have been raised under the capital gains tax proposal that the Tax Working Group actually finished up running with. Just for comparison, in the first year, the expected capital gains that would have come out under the Tax Working Groups proposal across all the asset classes was about $400 million and was roughly $50 million in respect of residential rental investment and second homes.
So the deemed return approach – which Susan and I decided to call “fair economic return”, would have been a better fundraiser for the Government initially. It’s something that we won’t see obviously in the coming budget. But I think it is something that policymakers should have a serious think about, because from what I’m seeing and hearing from discussions around how the new tax proposals are going to work, we’re heading for an incredible degree of complexity and we’re going to expect that complexity to be negotiated by people who are probably not, in all honesty, the most sophisticated of investors and do not have access to the best quality advice. It’s actually a recipe for tax pitfalls, not just for investors, but also for those who are advising them.
Taxing crypto gains
Moving on, the recent jump in house prices has had widespread ramifications, as we’ve been discussing, but in terms of rapid growth, it’s been far outstripped by the extraordinary rise in the market capitalisation of cryptoassets. The market capitalisation of virtual currencies has gone from US$354 billion in September 2020 to just under US $.8 trillion dollars at the start of April.
So it’s quite timely then that Inland Revenue has issued some guidance for consultation on a couple of matters which are in the cryptoassets world. These are draft questions we’ve been asked, and the first one is on the income tax treatment of cryptoassets received from an airdrop, and the second one is, I need to be careful how I pronounce this, the tax treatment of cryptoassets received from a hard fork.
Questions about the tax treatment of these two particular events have been raised for some time.
Now, as I’ve said previously, the pace of change in the cryptoassets world is quite extraordinary and that’s been enhanced by the volume of money that’s going into it, as evidenced by the dramatic increase in market capitalisations. So Inland Revenue’s original advice that they would consider most proceeds realised from the disposal of cryptoassets to be taxable, has been shifting.
But what happens in these peculiar events?
So an air drop is a distribution of tokens without compensation, i.e. for free, generally undertaken with a view to increasing awareness of a new token and to increase liquidity in the early stages of a new token project. So, for example, they might use it to increase the supply of a cryptoasset in the market, reward early investors or users, or just simply raise awareness of that cryptoasset by distributing it to holders of other cryptoassets.
Inland Revenue’s view of what happens here is that if someone receives an airdrop cryptoasset it’s taxable if they have a cryptoassets business or acquired the cryptoasset as part of a profit-making undertaking or scheme, provided services to receive the airdrop, and critically, the cryptoassets are clearly payment for those services, or receive air drops on a regular basis, and the receipt has hallmarks of income. In other cases, however, it’s not taxable.
Obviously, people who are mining for cryptoassets or running an exchange will be caught. If they receive airdrop cryptoassets, they’ll be taxable on that airdrop. But the argument now will arise for someone who’s what you may call “an investor”, who has been holding these assets for some time. They receive these airdrops randomly or they’ve been holding other assets. The argument might be that in those cases, the receipt of the airdropping cryptoassets, won’t be taxable.
What about if you sell an air dropped cryptoasset? Again, it’s taxable if the person has a cryptoassets business, they dispose of it as part of the profit-making undertaking or scheme or providing services to receive the airdrop or acquired cryptoassets for the purpose of disposing of them.
in relation to cryptoassets received from a hard fork, similar considerations apply. Now a hard fork is something that changes the protocol code to create a new version of the block chain along the old version. Then creating a new token which operates under the rules of the amended protocol, while the original token continues to operate under the existing protocol. I appreciate this is all very nerdy speak.
But for example, in July 2017 there was a hard fork of Bitcoin that saw the creation of the Bitcoin cash token alongside Bitcoin itself.
If you receive cryptoassets as part of a hard fork, again, Inland Revenue’s arguments are it will be taxable if someone holds the cryptoassets as part of a cryptoassets business or acquired the cryptoassets as part of a profit-making undertaking or scheme. And similarly, if they dispose of cryptoassets received after a hard fork, they will be taxable if the person has a cryptoassets business, disposed of them as part of a profit-making undertaking or scheme, acquired those cryptoassets for the purpose of disposing them, or acquire the original cryptoassets for the purpose of disposing of them. For example, the person received new cryptoassets through an exchange.
There are quite detailed rules on this so it’s going to pay to work through these issues carefully. But Inland Revenue is steadily expanding on the advice it’s giving on cryptoassets, which is good to see.
Consultation on these two items run through till 25th of May. The principles as applied here seem reasonable at first sight, but obviously when you drill down into them you might think maybe we want to tweak what Inland Revenue is saying.
But as I said earlier, if you’re a cryptoassets investor and you’re holding a lot of cryptoassets as an investment, as part of a general portfolio, you’re probably now in a stronger position to argue that air drops and hard forks are not necessarily taxable.
Inland Revenue audit claims rise +30%
And finally, you may recall that last year I spoke with the accountancy insurance provider Accountancy Insurance. They’ve just released some information about the latest tax audit claims for the year ended 31st March 2021. What they said is they saw policy claims increase 31% in the 2020-2021 financial year compared with the previous 2019-2021 financial year.
So what happened here is that Inland Revenue is clearly still active in reviewing taxpayers despite Covid-19 and the various disruptions that caused. Accountancy Insurance noted that GST verification claim activity increased by 48% year on year and income tax related claim activity increased by 67% percent over the 12 months to March 2021.
Now, apparently, what drove those income tax claims were two specific projects, which we’ve discussed beforehand here, that Inland Revenue started in late 2020; a Bright-line test property initiative and another initiative on the automatic exchange of financial account information under the common reporting standards.
Interestingly only about 5% of claims related to rental property, employer obligations and other matters. Only just over 1.3% of claims related to full scale audits with just under 10% were what we call client risk reviews. But 55% of all claims made related to GST verification and just under 28% relates to income tax returns.
So, this comes out just as interesting news has just started to break that apparently Inland Revenue is going through another round of restructuring and reducing its audits investigation staff. I find it strange that they’re doing that at the time when they clearly can ramp up their activity. But this Accountancy Insurance report shows is that Inland Revenue is not dead or resting, but is still very active in this space. And you should expect that if you file a GST return with a significant GST refund claim, it will be subject to some scrutiny.
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.
2 May, 2021 | The Week in Tax
Terry Baucher and John Cantin explore that and other thorny tax issues, and the side-lining of our internationally respected tax consultation process
Transcript
Kia ora koutou katoa, it’s Friday, 30th of April 2021 and welcome to The Week In Tax. I’m Terry Baucher Taxpert and director of Baucher Consulting Ltd., a tax consultancy helping individuals, small businesses and professionals navigate the tax minefield.
My guest this week is John Cantin, a vastly experienced tax partner with KPMG, who probably is one of New Zealand’s leading tax gurus. John has written one of the most astute analysis of the Government’s recent proposal to limit interest deductions that I’ve seen. I recommend you read it because it cuts right through the emotion and gets to the heart of the issue.
Here’s the opening to his post.
“The Government’s decision to deny interest deductions to residential landlords has generated much heat. A particular focus has been its labelling as “closing a loophole”.
Quite clearly current law says interest is deductible for property investors who derive taxable income. (One Twitter commentator quotes the relevant section of the Act). At a technical level, interest deductions are not a loophole.
However, the outrage misses the point.
Simply, (most) voters see a residential landlord deducting interest and making non-taxable gains. In the language of politics, that is a loophole.
“Loophole” is shorthand to describe the policy problem. Voters understand it at this level. (Equally, in the same property context, “Mum and Dad investors” and “speculators” is the language of politics and not tax policy).”
Morena John, thank you for joining us.
John Cantin
Thank you for those kind words of introduction, I appreciate it very much.
Terry Baucher
Not a problem, John, really appreciate you joining us. So what is the policy problem?
John Cantin
The policy problem in a nutshell is how do you deal with dual purpose expenditure. Money that you send out the door that has two purposes. That’s very much the issue with interest on money borrowed to acquire a residential property.
TB
Now, that’s perfectly encapsulated and this is a long-standing problem, as you mentioned in your post, isn’t it?
John Cantin
It has been around for a long time period. And at a technical level, it’s the difference between use and purpose. So the interest deduction rules ask how have you used the money? Whereas when you’re looking at what’s driving the purpose of the interest, that’s a different question.
TB
Indeed, that’s actually a very nice distinction and a proper one to bring in. And so how much of a surprise to you was the Government’s move on this?
John Cantin
Completely out of the blue in the sense that nothing leaked or anything of that nature ahead of time. No indications, to that extent it’s a surprise. But as you say, this issue has been around for a long time. It goes back to some cases that are referred to in my article called Pacific Rendezvous and others.
If you go back to the late 90s, it was also a policy problem of what to do with interest deductibility because of moves by Inland Revenue to state what they thought the law was at the time, which were going to cause practical compliance problems for companies and others. So it does keep raising its head. And you think back to the Muldoon era interest limitation rules and the recovery rules back in the day and in the 80s, it has been around for a long time.
TB
You mentioned the Pacific Rendezvous case, the Court of Appeal decision from 1986. What actually happened in that case?
John Cantin
Relatively simply, it was, if I remember correctly, a motel Terry, and the owners had decided that they wanted to sell the property, but needed to do some, let’s call it refurbishment, redevelopment. They borrowed money, which was helping to let them do that. And they claimed all of the interest because it was used in operating the motel.
Inland Revenue said, well, actually, some of that interest relates to the sale, and you shouldn’t get a deduction for the whole lot. Court of Appeals said it’s all used in running the business, so it’s 100% deductible. So that’s where our use versus purpose question comes in. 100% use means 100% deductible, even if it will have a slightly different outcome as well or serve a different outcome.
TB
That decision in 1986 was right in the middle of the major tax reforms being led by Roger Douglas and Trevor de Cleene. Looking back it seems to me that with all the work going on around that time, it was a very, very clear expectation that the reforms would lead to some form of comprehensive capital taxation, capital gains tax. Call it what you want. Against that background, the Pacific Rendezvouss decision seemed quite logical because it might have been playing in the background of the Court.
But after March 1990, when David Caygill, then Finance Minister, pulled the pin on capital gains tax proposal, that decision reinforced and put in place an anomalous treatment, or loophole which sooner or later would need to be addressed. Would that be a fair assumption of how we’ve got to this position?
John Cantin
I think that the technical response is that the Court made a decision based on use rather than purpose. The Commissioner’s argument wasn’t entirely surprising because the interest deduction is to the extent it’s used, so that that suggests some sort of apportionment.
I’m not sure that the courts actually had in mind that there might be a law change. With the greatest respect, I think, Terry, you might say that our courts are not great tax policy makers. You know, I’ve spent too much time on the Commissioner’s draft update on section BG 1 recently. And they’ve taken 100 odd pages to try and interpret what the Supreme Court said in the Ben Nevis decision. So I’m not sure that our courts are great at tax policy.
Occasionally they will point out errors in the legislation and things that might need to be fixed, but I don’t think they make decisions based on what the policy ought to be. But you’re absolutely right, that context of what was happening in the late 80s and The Consultative Document on the Taxation of Income from Capital, a comprehensive capital gains tax was the direction of travel amongst all of those reforms.
And that would certainly reduce the tension between use and purpose, because ultimately whether it was used in the business or used in the business and seeking a capital gain, well then it didn’t matter. You got a deduction for it – it would have made no difference.
But it hasn’t really been revisited as a particular issue specifically, except for the residential loss ring-fencing, that has the effect of limiting interest deductions, although not just interest, of course. So, some of those measures can be seen as responses to that.
TB
Yes, and that sort of use and purpose is coming back a little bit in these announced changes although we haven’t got much detail to work with at the moment. But there was a hint that if a property was sold, which was subject to tax under either the Bright-line test or some other measure then interest deductions previously denied would become deductible. That seemed to be hinted at in the initial papers released on 23rd March. But that’s also something that’s going to be under consultation, so we’ll see shortly.
I suppose that leads us into this move by the Government which doesn’t really sit well within the Generic Tax Policy Process in that normally there would be a process of consultation, saying we’re thinking about doing this, what are your thoughts and feedback? And then the legislation works through issues papers and then into legislation. But that’s all been shortcutted.
Is that a concern for the Generic Tax Policy Process (GTPP) in general, or is it now dead or merely resting, to borrow a phrase?
John Cantin
Really big questions, Terry. Look, I sort of go back to where the GTPP started in the mid-90s out of Sir Ivor Richardson’s review of Inland Revenue. And a significant driver for that was the reaction to the entertainment tax, amongst others, introduced in the early 90s. That was a National Government changing the business tax rules. And many of its supporters were particularly unhappy about that change even though I suspect something was in the ether.
Richardson recommended the GTPP and I think ministers since have seized on that as a way of depoliticising tax policy, they find it useful to test their thinking. And occasionally they walk back from some of the rules.
But I think we need to remember that the GTPP is essentially political, that relies on the goodwill of ministers, officials and people like you and I actually contributing. I’m reluctant to say it’s either dead or merely resting because the GTPP serves to answer two questions. One is, is this the right tax policy and the second is how best to do it. And that call as to what you consult on will be made by different Governments at different times, in different phases so far.
For example, if I remember correctly, when the GST rate was increased to 15%, there was no consultation on that increase – the first question wasn’t asked. The second question about how best to do it was, and that was what was consulted on. I suspect in this case, asking the first question, the call was made. We’re just going to get a whole lot of people saying, no, don’t do it.
And that’s not really going to advance the process at all. I would have liked to have seen some consultation, because I don’t think 100% denial of a deduction is the right answer either. But we’re in that process now where the detail will be consulted on.
So you have an ability to answer the second question, how best to do it, does it actually meet the policy objective and can it be done better? So I don’t think it’s dead or resting. I think different ministers, different Governments make calls on which of those two questions they want to ask the question of. I have said to others I haven’t stood for any election at all and I doubt I’d get a vote, but those are the people that we voted in to make those calls. So you do have to sort of step back and say, well, that’s their call. They live or die by that every three years. That’s the call they make. And we need to just carry on with it.
TB
That’s a great point you made there, John. About the GTPP you referenced the increase in the GST rate. I think at the same time they that they withdrew depreciation on buildings completely, and repealed the loss attributing qualifying regime. And we got no consultation on either of those points as well. And that was the National Government. So both sides will do it and as you say, politics, that their job depends on it. They will have to make political calls and we basically have to suck it up, putting it crudely, that’s just a fact of life.
John Cantin
It’s a fact of life. I do remember, though, that with those changes to GST and depreciation, LAQCs, there was the Tax Working Group led by Bob Buckle sitting in the background.
So, all of those things were not entirely unpredictable. And there was some measure of floating of those ideas through that tax working group’s report. So, some of that stuff was in the in the ether, as I call it. It wasn’t entirely unpredictable, but decisions are always made politically, often for budget measures where budget secrecy says we’re just going to make a call.
TB
Actually, I must admit, when I started my career in Britain where budget surprises were very frequent, I’ll be honest, sometimes it’s nice to have a wee surprise in the budget, even if you’re scrambling around trying to sort it out afterwards. “What does this mean? Well, we’ll have to tell you.”
There was one thing about the announcement that did surprise me. There was a lack of detail supporting the fiscal costs of the interest deduction measure. That surprised me because landlords are meant to file disclosure forms an IR3R return which has a specific interest disclosure item. What was your view on that?
John Cantin
I think initially surprising. I think part of it suggests that this was, I won’t say necessarily hurried, but a decision that the lead time on was not particularly long. So, not unsurprising in that sense.
But when you do think about it, one of the risks with any estimate here is the final design is unknown at the time of the announcement. There will be discussions on what is a new build, there will be consultation on how you apportion between business and residential property borrowings. There will be rules around interest stacking, as they call it, for companies and other entities or shareholders and other entities.
So, the whole picture potentially is a little muddied, and I think one of the risks is you come out and say, well, it’s worth $600 million, and then when you design it, it’s worth $200 million. That criticism always seems to be played that you got the numbers wrong. So, it might have been better to just say, well, until we’ve got the design sorted, we can’t really tell you how much, I think is probably the real answer here in terms of what’s happening.
TB
It’s as you’re saying, we don’t know how the final form will emerge and all those good questions about what a new bill, what’s the split between business and residential? I mean, what do you think would have been an appropriate policy response in this context?
John Cantin
I’m a Libra Terry, so I’d have gone straight down the middle 50/50.
TB
That’s a fair working hypothesis. When the announcement was made, I referenced what had happened in the U.K. But this goes further than the U.K. because the U.K. basically restricted the interest deduction to a basic rate of tax, 19%. But what’s proposed here is much more punitive.
John Cantin
I think that that speaks to the difference in the approaches to the tax system. The U.K. does what I call buckets, you know, separates business from other income. You have different tax rules for different streams of income. New Zealanders for a long time simply said it all goes into your taxable income, the expenses are deductible and it’s all one marginal rate. So, I think those are the differences.
The thinking here is quite different in the sense that it doesn’t look at it necessarily in isolation. It all feeds into the one taxable income number with one tax rate at the end, or marginal tax rate. So, I think that’s the driver.
But I think it’s important that you get the base right in the first place, making sure that you are taxing what ought to be taxed, and that’s a fair reflection of what the income is. So, if you go back to the repeal of building depreciation, I’m not sure that anyone was convinced there was no depreciation at all, apart from some officials in Treasury and Inland Revenue back in the day. They have now retreated from that. But again, we keep working on those base measures to make sure that people are paying tax on what really is income.
TB
That depreciation measure always struck me as a bit strange because the Bob Buckle group did say it was debatable whether it’s proper for residential property, but certainly for commercial property it should be in place.
In relation to the extended bright-line test period, this references a little bit to your point about how the UK approaches taxation, how appropriate is it that gains are taxed at a person’s marginal rate? Should it be a different rate maybe or maybe a person’s average rate over the period the property has been held?
John Cantin
I’ll probably come at that with having listened to officials for too long Terry, is from a framework of this is all income, what you’re really saying is that gain has been accruing over the number of years that you’ve held the property. An economist will say, well, it’s income and should be taxed on an unrealised basis. So, by waiting until you sell it, the Government misses out on the tax it should have collected through all of the years that you held it.
If you sold it year nine, that’s eight years’ worth of gain tax hasn’t been paid on. So if you were to average the rates, then you should probably add an interest factor to that as well to compensate the Government for not having been paid earlier. I know that’s an odd concept because, you know, I haven’t got the income, so why should I pay the tax. But that’s the economist’s view of how income accrues.
Then you start getting into the complications of saying what should the interest rate be and what should the average rate be over those years? From a simplistic perspective, you simply go with the rate that applies in the year the gain is realised.
And of course, the Bright-line test is not the only time we do that. You know, if you happen to get a big bonus in a year that’s out of the ordinary, you still get taxed on that at your marginal rate in that year that you get the bonus. So, it is just one of those features of our system.
TB
It was actually reading about an ACC claim that had been denied and then she got a lump sum payment, which was then taxed at rates well above what would have been her normal rate, that prompted me to ask that question. That’s always struck me as an anomalous treatment in that context. But as you say, it’s built it into the system and that’s the way it stands.
John Cantin
Sometimes we should ask the questions of whether that should be the answer. And it sort of comes back to the article Terry. I think the loophole language is unfortunate and the defence of it in the sense that you can claim the interest deduction I don’t think answers the question because the question is, should you have that interest deduction even though the current law says you can?
And I think you should always be asking the question, albeit you can’t ask it every time of all the thousand odd sections that we have. Is it still the right answer? And as the world changes our answer might change as well.
TB
Well, that seems a very good place to leave it John. I really appreciate you coming on and talking with me. Thank you for being our guest and have a great day.
John Cantin
Thanks very much, Terry. Appreciate it.
TB
That’s it for today. I’m Terry Baucher. And you can find this podcast on my website, 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.
24 Apr, 2021 | The Week in Tax
- Inland Revenue targets the construction industry
- The unfair tax treatment of ACC lump sum payments
- The latest OECD data on carbon pricing
Transcript
This week, Inland Revenue launches a construction industry education campaign, an odd case highlights the continuing unfair tax treatment of lump sum payments, the OECD data around the use of taxes on carbon.
On Tuesday, Inland Revenue launched an education campaign for the construction industry. As its press release to tax agents indicated, “The purpose of the campaign is to engage with those in the construction industry, to ensure they’re getting it right from the start and support them in understanding their tax obligations if they undertake cash transactions.”
The release goes on “Our customer research indicates that people are more likely to engage in hidden economy activity e.g., cash jobs, in an environment of economic uncertainty such as the current Covid-19 environment. We want to reduce the risk of this through awareness, education and compliance.”
And what it proposes to do is place Inland Revenue ads around building sites and hardware stores, together with online ads. Now, as part of this, Inland Revenue has put together a website called Rebuild NZ, and it’s to highlight to those in the construction industry how they can ensure they meet their tax obligations as well as doing their bit to help rebuild New Zealand.
Now, this is a useful initiative from Inland Revenue. They do these campaigns regularly. This one actually is quite interesting in that it is tackling the question of cash, jobs and cashies, but it’s not too heavy handed in its approach. Its website’s heading is “Cashies won’t rebuild our country”. So it’s playing on emotional strings. And this is actually quite standard practice now. You notice a play on what’s the consequences of not contributing to the tax take. The website declares every “undeclared cash job hurts our economy and the greater New Zealand.” So it’s really pulling the emotional triggers.
A couple of things of note on that. The website wisely, in my view, points out it’s OK to do cashies. You just need to declare them on your annual tax return. What Inland Revenue is saying is that per se, these aren’t illegal, but they become problematic if you don’t declare the revenue from them.
There will be some persons who, for whatever reason, want to be paid cash. And you can draw your own conclusions as to why they might want that. But if they are following the rules, make the necessary declarations then Inland Revenue is unconcerned, relatively speaking.
The other thing the website highlights here is, and I quote, “Can cash jobs really be tracked”? And it underlines this absolutely, giving the following example.
If two tradies work together, one declares a job, the other doesn’t. They can be dobbed in without realising it. If we audit one person, it might indicate another business or contractor that needs to be audited. Also, there’s always a chance of a random audit. We can see when tradies buy supplies such as paint, carpet or timber without a corresponding declared job. We can also access information held by other government departments, banks, loyalty cards, casinos and many other organisations to make sure all income is being declared.
Interesting reference to casinos in there, because clearly casinos are a place where cash is handy for gambling. And if you’ve read many tax cases down the years you’ll know an excuse for unexplained income is often, “Oh, I got lucky on the horses or down at a casino.”
So what they’re saying is it’s never too late to do the right thing, come forward, make voluntary disclosures, or if you wish, report tax or tax evasion or tax fraud anonymously.
As I said, we’ve seen a number of these campaigns before. As Inland Revenue works through the final part of its Business Transformation programme and gets fully back up to speed we’ll see more and more resources deployed into taxing the hidden economy. The estimate is that it could be worth a billion dollars a year in undeclared GST and income tax.
ACC lump sum tax unfairness
Moving on. A case before the Taxation Review Authority, the tax equivalent of the District Court, caught my eye the other day. A taxpayer had commenced challenge proceedings against the Commissioner of Inland Revenue contesting the tax treatment of a lump sum paid to her by ACC on 9th November 2017. The payment was for weekly compensation due to her for the period from the date of her injury on 22nd April 2014 to 17th September 2017.
The taxpayer contended that the payment should have been treated for tax purposes as having been derived on an accruals basis and spread over the income years to which the payment related, rather than on a cash basis as assessed by the Commissioner.
As you can see, although she received over three years compensation in one sum, Inland Revenue treated it as income for the one year, even though it actually related to nearly three years, and taxed it at the relevant rate. And because of the way the tax system applied, a large chunk of that lump sum would have been taxed at 33%, when in fact probably it would have been taxed at lower rates had it been received when it should have been.
It’s not the first time I’ve seen this. It’s actually something I have raised directly with then Minister of Revenue Peter Dunne almost 10 years ago. It’s a well-known problem of the tax system, that whenever ACC denies a claim or is slow paying out, often the recipients lose out on the tax side of it, because when they finally get the correct amount of compensation, it’s paid as a lump sum and taxed accordingly.
The taxpayer in this case understandably outraged, then tried to take a case through the Taxation Review Authority. And in response, Inland Revenue – the Commissioner – applied for an order striking it out as there was no cause of action as it was clearly untenable and could not succeed. And the TRA agreed there was no tenable prospect of success.
But that doesn’t get past the issue that the taxpayer had a very fair point, and it’s something, as I said, I’ve seen before. And it is frustrating that this continues to happen, and Inland Revenue and successive Ministers of Revenue are inclined to do nothing about it.
In the interests of equity and fairness, this is an issue that should be addressed. By the way, the lump sum taxation of redundancy payments should also be addressed for the same reasons: a taxpayer may normally have their earnings taxed at 17.5%, but instead, when a lump sum, the tax system will tax it at 33%. And now with an increase in the tax rate to 39%, there is a likelihood that an even higher rate of tax – more than double in fact – could apply to a lump sum payment.
So addressing this is well overdue in my mind. But it’s funny, there’s a lot of stuff goes on in the tax world. But basic stuff like this which affects ordinary people, seems to just get left on the “Can’t be bothered” or “Too hard” piles.
Tax threshholds
And interestingly, yesterday an article came out in Stuff, which ties into this. It pointed out how tax rates for those middle-income earners are too high relative to their income because the thresholds have not been adjusted since April 2008.
As Geof Nightingale of PWC and the Tax Working Group pointed out, most attention needs to be paid to the tax rate applicable to middle income earner:
“I think our harshest tax rate isn’t at 39% or 33%. It’s 30%, which cuts in at 48,000 dollars. That’s below the median wage. That jump from 17.5% to 30% in the dollar is a steep one. It seems tough to be hit with that tax rate when you’re earning below the median income”.
I agreed with that, as did Robyn Walker, a partner at Deloitte.
And we also gave examples that if thresholds had been raised in line with wage inflation, the threshold at which 33% kicks in, which is currently $70,000, would probably be nearer to $100,000. And the $48,000-dollar threshold, when it rises to 30%, would be about $67,000.
So the thresholds are now well out of whack. But again, governments of both hues seem inclined to not do much about it or, kick it down the road and pretend when they do something, it’s a tax cut. Something I think they’ve been allowed to get away with for too long.
And that’s why Simon Bridges has put in this private member’s bill to change that. It will be interesting to see what exactly happens to it. You can bet that politics will come into play and what is actually quite a sensible measure will probably be stifled.
Taxes on carbon
And finally, yesterday, 22nd April was Earth Day. And obviously there were a number of events in recognition of that event. As part of the run up to Earth Day, the OECD released a brochure talking about effective carbon tax rates and how the 44 OECD and G20 countries price carbon emissions from energy use.
The OECD points out that carbon pricing is an effective decarbonisation policy because it makes low and zero carbon energy more competitive compared to high carbon alternatives by pricing carbon emissions properly. And it highlights what’s happened in the UK’s electricity sector, which used to be primarily coal and gas fired. The UK has increased effective carbon rates in that sector from seven euros per tonne of CO2 to more than 36 euros per tonne between 2012 and 2018. As a result, emissions in the electricity sector fell by 73% over that time.
And so what the OECD is saying is we should be looking at emission permit prices, carbon tax, or as we do here, an emissions trading scheme and fuel excise taxes. Fuel excise taxes always come with a caveat in that they are very regressive for low-income earners. One of the biggest problems we have with our transport policy here is the fuel taxes will hit low-income earners quite hard, particularly when we haven’t yet developed sufficient alternatives in public transport to enable alternatives
The OECD report wasn’t particularly complimentary about how the top 44 countries have been doing. It notes that three countries, Switzerland, Luxembourg and Norway, have reached a carbon pricing score rated on 60 euros per ton, which is the price expected by 2030 to be needed for carbon decarbonisation. Those three countries are close to 70% on that. And that’s mainly because of fuel taxes on the road sector.
But elsewhere, progress is patchy. Brazil and India are right down at one end of the scale. The USA is at 22%. New Zealand sits roughly just below the average at 33%.
There’s a lot of work to do and as we know, we’re now starting to get into the debate led by the Climate Change Commission as to how we deal with this matter. Tax is going to play a part in that.
As I said, fuel taxes are a problem for until we develop adequate alternative transport policies, public transport. Building more roads doesn’t help because that actually increases emissions. But the infrastructure deficit New Zealand has needs to be addressed and, tax will play a part in this.
As I’ve mentioned before, I think fringe benefit tax on high emission vehicles, as they do in the UK and Ireland, is something that we should be looking at. But I also feel very strongly that any taxes raised by this should be recycled back into ameliorating the impact for those who cannot choose alternatives to using their car.
Well, that’s it for today. Next week, I’ll be joined by John Cantin, a tax partner at KPMG who made some very interesting observations about the tax policy process and implications of the recent property tax proposals. We’ll be discussing this and the implications for the Generic Tax Policy Process.
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!
17 Apr, 2021 | The Week in Tax
- Cryptoassets under the spotlight
- 10 years of compulsory zero rating for land transactions
- A warning for trustees moving to Australia.
Transcript
New Zealand houses aren’t the only asset class that has exploded in value over the past 12 months. A report by the Secretary General of the OECD to the G20 finance ministers and central bank governors in Italy earlier this month noted that since he last reported to them in February 2021, the overall market capitalisation of virtual currencies has gone from just over US$1 tln to US$1.8 tln.
Now, quite apart from that near 80% increase, the growth has been almost five-fold since September 2020, when the market capitalisation was US$354 billion.
There are two things to note about this fantastic growth in value. Firstly it is going to attract keen interest from the tax authorities who will want their cut of the gains that have arisen. And of course, the tax authorities are still struggling to keep up with the pace of change in this sector. And Inland Revenue is no different from the rest.
There are some rulings in preparation at Inland Revenue including an updated release on how it views the treatment of cryptoassets. But its general position remains that cryptoassets will be taxable, with rare exceptions on the basis that rather akin to gold bullion, the value can only ever be released by sale, so therefore they must have been acquired with a purpose or intent of sale.
The thing is though, the whole cryptoassets sector is rapidly becoming ever more complex and new instruments are being developed, which point to Inland Revenue’s argument as not necessarily being sustainable. So that’s one point that people must be noting when preparing their tax returns for the year ended 31 March 2021. Now I’m sure we will see people coming forward who have substantial cryptoassets gains and are wishing to make the right tax declaration.
But the other matter, which is of concern to tax authorities, is trying to keep track of all of this. As is well known, the OECD has developed in recent years the Common Reporting Standards on the Automatic Exchange of Information. And what the Secretary General for the OECD said in his tax report to the G20 finance ministers and Reserve Bank governors, is that the OECD is designing a “tax reporting and exchange framework that will address the tax compliance risks associated with the emergence of cryptoassets and reflecting the crucial role the crypto exchanges play as intermediaries in the cryptoassets market.”
Now, the proposal is that basically they want to bring cryptoassets into the common reporting standards and in exchange for information. So that’s going to be quite complicated. One of the attractions of cryptoassets is they are supposedly off the grid or under the radar of the tax authorities, and, how shall we describe it, that the reporting requirements are a little bit more relaxed.
Anyway, the OECD is preparing detailed technical proposals on this, on a new tax reporting framework. And it is intending to deliver a proposal to the G20 later this year. As usual, we’ll bring you news on that when they when it happens.
After ten years, there is still confusion
Moving on, it is 10 years since compulsory zero rating of land transactions was introduced. From 1st of April 2011 most sales of land and buildings between GST registered persons became zero rated for GST purposes under what we now call compulsory zero rating provisions. If these apply, then the land transaction must be zero rated.
Now the provisions were introduced to prevent what was seen as a trend towards “Phoenix fraud”, whereby a vendor did not pay output tax on the sale of property to Inland Revenue but the purchaser claimed a GST refund. The suggestions were that the annual loss in GST was in the tens of millions of dollars.
Now, it’s important to note that this is between GST registered persons and what it did was fundamentally shifted the GST risk on transactions involving land buildings from Inland Revenue to the parties involved. And as an excellent little report on the matter from PWC points out, that wasn’t always fully appreciated by parties to transactions, particularly those who were seeking to claim an import tax deduction on the purchase.
After 10 years these rules should be relatively well known now. However, there’s still quite a lot of issues emerging on that. And I regularly encounter the issue where a GST registered purchaser has bought land from what they understood to be an unregistered person, only to find out afterwards that the vendor either is or should have been GST registered. Now that often comes up when they file a GST return and claim the input tax credit. Now, the result is they don’t get any input tax credit and that purchaser is understandably very upset. The last such case I handled the vendor finished up paying almost $400,000 as a consequence of getting that GST status wrong.
And it seems surprising this should be happening because the standard sale and purchase agreement does have specific provisions on the whole schedule declaring the GST status of the parties involved. I mean, one of the risks is that the GST position of one party depends on the GST profile or information of the other party. So it’s not often that that level of tax detail is required in tax transactions, but they are for compulsory zero rated land transactions.
The report from PWC has useful little tips for vendors and purchases. But the key point it makes is parties have got to take extra care with this. They’ve got to make sure that the GST status of both parties is absolutely clear and understood at the time the agreement was entered into. Otherwise subsequently, it gets very messy and expensive and the only people who win are lawyers and accountants with fees, trying to sort out the mess. Inland Revenue is quite happy about all of this because, as I said earlier, it has shifted the risk.
So generally speaking, if something goes wrong, it gets its cut and leaves it to the other parties in the transaction to sort themselves out. So again, pay attention if you’re involved in the purchase of land and buildings. It’s a compulsory zero rated transaction for GST purposes. Pay attention and make sure all the Is are dotted and the Ts are crossed.
A warning for trustees
And finally, just another reminder popped up with a new client coming to me this week, with a common issue, and that is the status of trustees who move to Australia.
Now as the Australian tax legislation for income tax purposes, deems a trust to be resident in Australia, if any trustee is a tax resident of Australia. So you could have a trust with seven, nine, 11, whatever number of trustees. But if one of those trustees is resident in Australia, then the trust is deemed to be resident in Australia and the consequences, particularly around capital gains tax, become potentially very severe.
There’s a slight anomaly in this position because often individuals that move from New Zealand to Australia qualify as what the Australian tax legislation calls a temporary resident.
And what that means is rather like our own transitional residence exemption. Non-Australian sourced income and gains are not taxable in Australia, but trusts are not covered, or companies are not covered by that exemption. So there is the situation where an individual who receives a distribution from a New Zealand trust is not going to be taxable on that in Australia, but if he is a trustee of that trust, making the distribution to him or her, then the trust is now within the Australian tax net.
So this new client is a reminder for anyone moving to Australia and they are either a trustee or have a power of appointment over trustees, then they need to resign as the trustee and revoke/transfer that power to another person who is not an Australian tax resident.
Given the sheer number of trusts we have in New Zealand, approximately half a million at last estimate, this is going to be a quite common scenario. So even if it is just a family trust holding a former residential family home in New Zealand, they could well be landed with a whole heap of Australian tax issues.
So anyone moving to Australia should take advice on the tax implications of you doing so and make full disclosures to your advisors. It is like the mess ups we see with the compulsory GST rating and land transactions. It’s astonishing how people are rather casual when explaining their circumstances to their advisers and often with very expensive consequences.
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 Apr, 2021 | The Week in Tax
- Small Businesses and tax compliance, PAYE for employees of overseas companies
- Managing fringe benefit tax
- A global minimum corporate tax rate?
Transcript
Friday was Small Business Day. If you spent money with a participating small business and posted your interchange on social media, you and the business could have won a share of $200,000 dollars. Now, this is part of an initiative underlining the importance of small businesses in the New Zealand economy.
MBIE defines a small business as one with fewer than 20 employees. And according to Stats New Zealand, there are approximately 530,000 small businesses in New Zealand meeting that definition. They represent 97% of all firms, account for 28% of employment and just over a quarter of New Zealand’s GDP.
So they’re very important to the economy, but most importantly, also for the community. When small businesses move out, the community suffers. So this sort of initiative and the work we were doing during my time with the Small Business Council is important for the economy.
However, when it comes to the tax system there’s actually very few concessions for small businesses. That is part of a deliberate policy, which generally I and most tax experts support, of minimising special exemptions and in doing so, focusing on the basics. And by minimising removing special exemptions, you eliminate the opportunities for people to try and rort the system.
But that comes at a cost for small businesses of greater compliance costs. Compliance costs will always fall heavily on small businesses because they are generally quite under-resourced to deal with this matter.
Now as I said currently our tax system generally makes no concessions for small businesses. However, there is one such example which does apply, and that is the shareholder-employee regime. Under this regime a shareholder who is also an employee of a company can instead of having their salary taxed through pay as you earn, opt to pay provisional tax. Their taxable income can then be determined after the end of the tax year.
It’s a very flexible regime, but it doesn’t always fit well with the general scheme of the Income Tax Act. And I think Inland Revenue may be thinking in terms of such businesses should actually be in the look through company regime. The problem is these special regimes add complexity.
The tax loss carryback regime, which is temporarily in place for the 2020 and 2021 income years, proved unworkable for shareholder employees. They’d already taken profits out of the business by way of a salary. So if the company had a loss in either of those later years and tried carrying it back, it had no income to offset against the loss. So, it was of no use to shareholders employees.
When other tax practitioners and I were discussing a permanent iteration of the current loss carryback regime with Inland Revenue policy a huge stumbling block was the question of the treatment of shareholder employees. In fact, it proved unworkable in the end. And last month the Minister of Revenue revealed a permanent iteration of the scheme is not going to be implemented.
In my view one of the side effects of not having specific small business regimes, is that Inland Revenue policymakers don’t pay enough attention to what’s going on in the small business sector, and that means compliance costs creep up for the sector as issues are not addressed. And in the last week, we’ve had a couple of good examples of how this has played out.
Covid-19 has revealed, a number of things that should have been addressed in relation to employer employee relationships, but for whatever reason had been parked as there was always something more interesting to work on. These strains have started to come through recently.
There was a story in the Herald (paywalled) about a very common thing, Kiwis coming back to New Zealand, but continuing to work for overseas based employers. And what’s happening is that a number of these are potentially facing double taxation, hopefully temporarily, and they understandably are confused about how much they own to which government.
One key concern is if an employee of an overseas employer is in New Zealand for more than 183 days, then technically the employer will need to start accounting for pay as you earn. However, in the meantime, that overseas jurisdiction may still be applying its equivalent of pay as you earn to the employee’s earnings. So there’s a risk of double taxation risk.
And one of the other problems is with foreign tax credits. Technically, under double tax agreements employment is taxable only in the jurisdiction in which it’s being exercised. So as the Herald article pointed out, in a worst case scenario, what can happen is that someone working in New Zealand for an overseas employer may have earned $100,000 dollars and paid UK pay as you earn, but won’t get any credit for it in New Zealand. Inland Revenue’s view is “Well, you’ve earned $100,000. This is the tax bill, pay it.” Meantime, the problem that particular employee faces is that he or she have to then go and get the overpaid UK tax refunded. And of course, that can take some time.
And it may also involve getting assistance through what we call the mutual agreement procedures between Inland Revenue here and the UK’s HM Revenue & Customs. All this takes a lot of time and a lot of stress. It’s a very good example of how the system is evolved, where it really isn’t terribly flexible, and issues arise. One answer is to put people into the Provisional tax regime. Another one is for such employees of overseas companies to register themselves for pay as you earn or what they call an IR56 taxpayer.
Now just to clarify, we’re assuming that the employees of the overseas company, is just an employee, and we’re not dealing with the issues of that employee having sufficient authority to create what we call a permanent establishment, which is a whole other raft of issues, but are not relevant to this particular discussion.
Now, this particular issue is particularly problematic when it comes to New Zealand employees of United States employers. The United States tax system is, to put it mildly, probably the most complicated in the world especially in contrast to our regime. It is full of special exemptions and procedurally as well, the Internal Revenue Service (the IRS) is a slow-moving beast.
Issues are starting to emerge where the IRS is expecting the US employer to deduct the US equivalent of pay as you earn. Meanwhile Inland Revenue here wants its cut and although the double tax agreement will give most taxing rights to New Zealand the IRS is very cumbersome in moving to say to the US employer, “Oh, yes, that’s now foreign sourced income so you no longer need to deduct tax.”
And then there’s the other issue I mentioned that the overseas company, could be treated as an employer and required to deduct PAYE in New Zealand. Now, fortunately, in that respect, Inland Revenue has a draft operational statement, which was released for consultation last year which deals with this issue of non-resident employers’ obligations to deduct pay as you earn, pay FBT and deduct employer superannuation contribution tax. The deadline for comments closed on it on 1st September so we ought to be seeing it fairly soon in final form.
And basically, Inland Revenue is saying an overseas employer isn’t going to need to apply PAYE so long as the employee’s presence does not create a permanent establishment or as the operational statement has it, “a sufficient presence.” So that’s a good solution. But I think this illustrates the problems with small businesses overseas and here of dealing with issues around tax systems that weren’t designed with such matters and are slow to respond.
And that leads on to a second related point, the question of fringe benefit tax and the new 39% tax rate, which came into effect on 1st April. As a consequence of the change in the tax rate, a new flat rate of FBT of 63.93% applies to non-cash employee benefits such as discounted goods and services and private use of company cars. But that only applies in in reality to employees earning more than $180,000, which is only 2% of earners.
But the FBT system expects employers to pay using a single rate which prior to 1st April was 49.25%. And so the increase to 63.93% represents a substantial burden. Now, it’s possible to work around that and not use the flat FBT rate by filing quarterly FBT returns and calculating FBT on an attributed basis, i.e. for each employee.
So, yes, that’s a solution, but it leads back to my point at the start of this podcast, it adds to complexity of the tax system and also increases the burden of compliance with small businesses. So I think the point has been reached in our system that going forward, Inland Revenue really should have a hard think about the fringe benefit tax compliance costs for small businesses.
Leaving aside the separate issue of how well FBT is being complied with, particularly in relation to work related vehicle, it does involve a fair amount of compliance for small businesses. The FBT regime dates from the mid-80s and I think it’s time for a rethink. In the 1980s it was probably a sensible approach that the employer paid FBT. Maybe now with better procedures in place, what should happen is that the employer calculates the value of the fringe benefit and that amount is then included as part of an employee’s salary and taxed at the relevant rate. This would immediately deal with the issue of applying this new 63.93%rate.
But that’s something that needs to be considered, perhaps as part a whole package of looking at compliance for small businesses. And I understand there is something in the works on that which we will be watching with great interest and report back on when we hear something in due course.
And finally this week, we’ve talked in the past about the international tax regime striving to try with the digital economy and each tax jurisdiction trying to find an appropriate level of taxation relative to a company’s economic activity in a country. The focus is on the GAFA, as they call Google, Apple, Facebook and Amazon.
Here in New Zealand these companies pay very little tax. Facebook does not publish financial statements in New Zealand, and Google’s accounts to December 2019 show that its revenue in New Zealand was $36.2 million. And it finished up, paying $3.6 million in income tax. That was actually an increase in from the 2018 year, where it paid around $400,000. But Google’s revenue from New Zealand is considerably more than $36 million.
And what’s happening here is replicated all around the world. So the OECD has been looking at this in conjunction with the G20 group of nations. This is part of a shift to try and stop the aggressive use of tax havens to minimise multinationals’ corporate tax bills. And this past week after a meeting of G20 finance ministers there appears to have been a breakthrough in that they are now exploring the equivalent of a global minimum tax on corporate profits.
What’s encouraging about this is that the US Treasury Secretary Janet Yellen, initiated the proposal, and this is a rapid, significant change from the Trump administration. There will be pushback on this, obviously, because certain jurisdictions and Ireland has been mentioned as one who already have a fairly low tax rate, concerned that their current 12.5% corporate tax rate may rise.
And obviously, tax havens will be looking at this with some unease. But my personal view is that the days of the tax havens are numbered because of the double impact of the Global Financial Crisis and Covid-19 anyway. It remains to be seen how well this will develop, but it is an encouraging sign. It might not actually make a great deal of difference to the New Zealand Government’s books, but it will certainly be a step forward in the right direction. As always, we will bring you developments as they happen.
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 ano!
29 Mar, 2021 | The Week in Tax
- A closer look at the Government’s shock property tax announcements
- Four questions on the future of tax
Transcript
It would be fair to say that the shockwaves from Tuesday’s announcements are still reverberating around investors and analysts and tax professionals.
The increase in the bright-line test period to 10 years was widely anticipated. But the move to completely eliminate, over time, interest deductions for residential property investors was a complete shock and has caused quite a considerable amount of commentary.
I would say at this point, I think several people have been extremely ill guided in some of the comments they have made online. Inland Revenue monitors social media, and some of the comments I’ve seen by property investors, understandably, given the shock and the implications for them, upset about what has happened and probably reacting somewhat intemperately, may come back to haunt them.
For example, saying that rent doesn’t cover the cost of a mortgage and other costs, as one investor said in print, is an open invitation to Inland Revenue to raise questions as to why if that was the case, that person had purchased property. It opens the door for Inland Revenue to then go on and say, “Well, you must have acquired that with a purpose or intent of sale.” Which if that is argued bypasses the bright-line test. It doesn’t matter how long you’ve held it in those in those circumstances, any gain will be taxable.
Now, that’s an extreme response Inland Revenue could take. But as I said, I think some people might, to borrow a phrase, that my mother would use “Cool their heels a wee bit” and sit back and reflect on the implications of what’s going on, rather than rushing to social media and excitedly make a comment that they may regret at a later date.
But still, there are good reasons for people to respond passionately given its surprise. Under the Generic Tax Policy Process, changes like this are usually signaled in advance. The Government issues consultation papers, and there’s a back and forth between industry specialists and Inland Revenue and Treasury on the implications of these proposals. That isn’t going to happen here.
In the course of the group call made to tax agents and tax advisors before the announcement, Inland Revenue made it clear that there would be no consultation about the bright-line test period and on restricting interest deduction issue. Inland Revenue would, however, consult around a key point that is emerging. What is the definition of “new builds”?
So these proposals are all outside the normal process and have understandably drawn criticism along the lines of “Can the Government do that?” They can. And in many ways, it’s surprising this doesn’t happen more often in tax policy.
Governments around the world will move very quickly when it suits them or when they feel that they need to close off loopholes. Coming from Britain, Budgets were always full of surprises and policy announcements. Sometimes there might be some leaks ahead of the announcement, but generally speaking, every Budget always contained a few surprises.
Now, the other thing attracting criticism is how the Government has rather deliberately phrased the move against interest deductions as closing a loophole. As a few people have pointed out, this is not correct. The position is that interest borrowed to derive gross income, such as rental income is deductible.
But what has become apparent in the residential property investment market is that there’s two parts of the economic return. There is the rental and then there’s the capital gain.
And the issue was that many leveraged investors who are most affected was that they were getting a full interest deduction but would only be taxed on part of the economic return. That is the rental income. All things being equal the capital gain would not be taxed unless the bright-line test applied. Restricting interest deductions in that context is actually consistent with the general income tax rule that an expense is only deductible to the extent it’s incurred in deriving gross income.
The current treatment is therefore an anomaly. What the Government has done is closed off an anomalous position, but only in respect of a certain group of investors, which again leads to outrage about the treatment. But that group is probably losing that argument about it not being a loophole, because to borrow a political phrase, “Explaining is losing” particularly if as in this instance a very technical argument applies.
Always at risk
But the overall point should be kept in mind, and this has happened before with the removal of the loss attributing qualifying company regime, tax preferred investments or rules that give a tax advantage will always be scrutinised by government. They are always therefore at risk of being abruptly closed off.
So, if you built an economic business model around relying on that, you are actually making yourself very vulnerable to a move like this.
Work in progress?
Moving on, one other point has emerged, which is surprising, and in the context of the General Tax Policy Process, concerning, is that it appears no details of the advice that was given by Treasury and Inland Revenue on the interest deduction move has been made publicly available.
This is surprising because it implies that this policy is still being worked out. As a result of that the fiscal impact is not clear.
If the interest deductions are restricted completely, that means the Government’s tax take will increase. And me and my fellow tax advisors have been crunching the numbers for our clients who will be affected. And we are giving them projections as to the likely additional amount of tax that would be payable. And that potentially could be quite significant, although it could be that property investors deleverage as a result, which may have a wider economic impact.
This whole policy, in fact, is a good example of something that came up at a seminar last night, which I will talk about a little later, the law of unintended consequences. This is something that hasn’t been done before and the consequences are still being worked out. One or two things I think that come to mind is we might see investors make more use of company structures because the corporate income tax rate at 28% is less than the 33% for property held in trust or possible 39% if properties are held individually.
I also wonder whether the Government should be looking carefully at the question of is the loss ring-fencing rule required any longer? One of the reasons that rule was introduced was the ability of people to leverage and get deductions for interest. But then, since interest deductions often represented the biggest single cost at a time when interest rates were higher, if they ran into losses, investors were then able to offset those losses against their other income.
Now, that loophole was closed off with effect from 1st April 2019. But the question remains now, given that the ability to leverage, which was the main issue around the need for loss ring-fencing, has been restricted, do we need the loss ring-fencing rules?
The other thing is, and this is something I think the Government will need to address as it was a stumbling block for the introduction of a capital gains tax, is that any gains will be taxed at a person’s marginal rate. In a company the rate is 28%, but for an individual from 1st April, it could be 39%. So, there’s a lot of unintended consequences and it’s understandable to see why investors feel rather picked on at the moment.
There’s interesting commentary from the Bank of New Zealand which started
its newsletter on this issue by saying that “The New Zealand government is dead set on containing soaring house prices. It has been saying so for some time now and prices have just kept soaring. So it should come as no surprise that their patience has now been exhausted and a full attack on prices is now under way.”
BNZ’s view is “Watch this space.” There will be a lot of arguments around the fall-out of this proposal.
The interest rate restriction rules, as an article in the Herald points out, are actually more restrictive than a similar measure introduced in the UK. What the British did was restrict the rate of the tax relief to the basic rate of tax, roughly 20%. These measures go completely further.
I feel that using something completely unknown whilst a shock to the system, and in line with what BNZ is saying the Government is determined to try and do, is leading the Government into untested waters.
And the alternative might have been to use an existing set of rules, the thin capitalisation rules, which might have achieved much the same sort of objective. But there will be a lot of fallout on this, and it’ll be interesting to see whether there is some tinkering around the edges of these measures.
The bright-line test
On the bright-line test itself, it’s been extended from two to 10 years. And there’s going to be a lot of questions on this about the impact of that, but particularly for people who are in the middle of settling on properties.
Extending the bright-line test period to 10 years has now been passed into law as part of a tax bill. But it has also provided some commentary with useful examples of what happens with sale and purchases underway at the time the proposals were announced.
Basically, if an offer was made before the announcement on 23rd March and accepted before 27th March, then the five-year test would apply. But if, an offer was made on 21st March, but the seller accepted the offer and signed the sale and purchase agreement on 27th March, then the extended 10-year period would apply.
Another of the examples given was of a verbal acceptance before 27th March but the agreement is not actually signed until 27th March. Then the 10-year rule will apply.
So people will have been pressured to making quick adjustments right now to finalise their sale and purchase agreements. Not ideal, and there will be a few people who have been caught on the wrong side of the new 10-year period as a result.
In relation to conditional offers, for example, someone submitted an offer on 18th March, which is accepted, and the agreement was signed prior to 27th March, conditional on finance. If the offer goes unconditional after 27th March, in this case, the 5-year rule would apply. Alternatively, there’s a change in the agreed purchase price which happens after 27th March, the 5-year rule would be applicable.
There’ll be plenty more commentary on this going forward. And it will be interesting to see the commentary in relation to the question of what expenditure becomes deductible as a result of a sale becoming taxable. We don’t know yet if interest expenditure, which has been disallowed, will then become deductible if a property is sold and it’s taxable under the bright-line test or any other measure. The implication is it should be. But we are we’re going to have to wait till May when consultation on this will arrive.
The future of tax
Moving on to an interesting bit of fun I had last night with some colleagues. The New Zealand Centre for Law and Business ran an event where myself, Paul Dunne of EY and Geof Nightingale of PWC where part of a panel.
We were asked four questions around the future of tax. Do we need more tax? Can tax help the runaway residential property market? Will changing demographics result in a changing tax mix? And reducing taxes on the wealthy is this a discredited theory? And if so, what are the implications for that?
This whole thing would be a worthwhile podcast in itself, but it was interesting to see how Paul, who was a member of the 2010 Victoria University Tax Working Group, and Geof, who was a member of that same 2010 tax working group and the recent Sir Michael Cullen-chaired group were mostly in agreement with the need for a comprehensive capital gains tax or rather better designed set of rules around that.
I think the discussion is still there as to whether we need a comprehensive capital gains tax or should it be limited to a particularly troublesome asset class at the moment, property. All of the members of the 2018 Tax Working Group agreed with increasing capital taxes on property. And you’ll note, by the way, some of the discussions that come out about the Government’s bright-line test period, with Treasury suggesting a 20-year period with no exemption for “new builds”.
By the way, as I said we don’t yet know what the definition of “new builds” will be. We’re going to have to wait and see. And on that point, Paul and Geof both made very pertinent points that the law of unintended consequences is very applicable here. They have clients who are involved in property syndicates who were in the process of converting commercial property into residential property. The question now is, are these “new builds”? They don’t know. So, there may be a pause while everyone waits to find out. What does that mean? No-one is going to commit millions of dollars to a project with an unknown tax outcome. So that was one theme of our discussions.
Do we need more tax? The view was that at roughly 30% of GDP, we should be OK. All three of us were in agreement that the ratio of government debt to GDP was not an issue, but we were all not so enamoured of high private debt as we see that as more concerning. So we had an interesting discussion and hopefully I can make the video recording available in due course.
Error correction
And finally, last week, I talked about charging interest at the prescribed rate of interest on overdrawn current accounts. I mentioned that from 1st April 2021 that rate was going to increase from 4.5% to 5.77%.
Well, another of my listeners from Inland Revenue has been in touch and thanked me for drawing their attention to this. It turns out that was a transcription error in their website and that 5.77% rate is incorrect. It will in fact remain at 4.5% going forward. So, thank you Rowan, for getting in touch. And thank you again to all my listeners and readers at Inland Revenue.
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!
