The Week In Tax · Interest limitation rules enacted, defining cash basis persons, the Australian Budget

The Taxation Annual Rates for 2021-22, GST, and Remedial Matters Bill was passed into law earlier this week. This is the bill that contained the controversial interest limitation rules. With the enactment, Inland Revenue have released two special reports, one covering a new option for employers to calculate fringe benefit tax following the rise in the top tax rate to 39%.

The second is on the interest and limitation and additional bright-line test changes and clocks in at 216 pages which gives you a good idea of the complexity of the changes

To recap, although the relevant legislation has only just been enacted, the interest limitation rules have actually been in force since 1st of October last year. Since that date the interest deductions for residential investment property is limited to 75% of the interest paid.

Now, the 75% limitation will apply until 31st March next year, at which point it will reduce to 50% and gradually the amount deductible will decrease until no interest will be deductible from 1st April 2025, unless the property in question qualifies as a new build.  The special report goes into these changes in detail and helpfully contains almost 100 examples.

The special report also covers changes to the bright-line test, which was extended with effect from 27th March last year to 10 years. Now the act codifies that change and also includes some rollover relief provisions in new sections CB 6AC and CB 6AF. These enable transactions involving look through companies, transfers to and from look through companies or partnerships, that the bright-line test doesn’t reset the timeline for ownership. There’s also a limited exemption for where a trust transfers property back to a settlor.

Other submitters and I wanted to see expansion of the rollover relief provisions for trusts, but they were not pushed through in this bill. But we should see more in the next tax bill, which will be released around the time of the budget, which by the way will be on Thursday, 19th May.  The special report does note that although trust resettlement transactions are not currently covered by the legislation it is intended that rollover relief for some resettlement transactions should be introduced in the next available tax bill.

As I’ve said previously, given the complexity of these rules, I think we can expect to see amendments of a technical nature, and in some cases perhaps quite substantial, coming through in subsequent tax bills. But it’s good that Inland Revenue have made this guidance available with plenty of examples to work through.

Even more complexity

Moving on, the interest limitation rules apply to residential investment property in New Zealand, rental property overseas is excluded from the rules, which means deductions are still available. However, they are subject to the loss ring fencing rules. The whole treatment of residential property has been radically altered in the last three or four years, firstly with the introduction of the loss ring fencing rules and now the interest limitation rules.

With overseas properties, one of the issues that arises is the application of the financial arrangements regime to interest deductions that we claim for overseas mortgages relating to investment property. This is an area which I’ve discussed in the past and in particular, the problem that arises where exchange rate fluctuations on an unrealised basis may trigger income for a taxpayer.  This is because the value of the mortgage in New Zealand dollar diminishes and economically, the taxpayer has made a gain at least on paper.

The financial arrangements regime is probably one of the most complex parts of the Income Tax Act. And previously, there hasn’t been a lot of official Inland Revenue guidance that is in a digestible form for your average taxpayer. But fortunately, in recent years, that’s started to change. For example, we had interpretation statement 20/07, which explained the application of financial arrangements rules to foreign currency loans used to finance foreign residential investment property.

We’ve now got a draft interpretation statement out for consultation which explains when people can account for income and expenditure under the financial arrangements rules on a cash basis rather than an accrual basis. This is the exemption available for what are termed “cash basis persons”.

Now this is very handy guidance to see because it walks through the meanings of when a person can be a cash basis person for financial arrangements regime and then the implications if they fall out of it. And it gives examples of that. It also covers the adjustment that’s required when a person ceases to be a cash basis person and must return financial arrangements income on the accrual basis. That is, unrealised gains and losses must be picked up and included in income.

The interpretation statement sets out four steps for determining cash basis person status. Firstly, determine all the financial arrangements held by that person. Secondly, exclude what are termed “excepted financial arrangements”.  Thirdly check whether the absolute value of income and expenditure for the income year in question is less than $100,000 AND whether in every day in the income year, the total absolute value of all financial arrangements is $1million or less.

If you get past those, you still may have a problem with the fourth step, the income deferral threshold. This is something that’s not well known and is a real trap for young players.  It compares the income and expenditure calculated on a cash basis with what would be the income calculation on accrual basis. If the income deferral between the two is less than $40,000, then you can be a cash basis holder. If not, then you fall into the accrual regime.

Now, as you can imagine, all this is pretty complicated. And although it’s good to see some guidance on this matter, I can’t help but think that we need to step back and wonder whether we are pulling people into the regime, who really shouldn’t be there.

The complexity of these calculations is at times mind numbing and we need to look carefully at the thresholds for cash basis persons which have not been increased in over 20 years. This is yet another example of how the tax system, deliberately or otherwise, ignores the impact of inflation and pulls people into the net, which perhaps they shouldn’t be.

This is particularly true with the volatility of exchange rates at the moment. I’ve frequently seen unrealised exchange gains arise one year only to reverse the following year. Yes, these fluctuations get resolved by the final wash-up calculation (the “base price adjustment”), but it still imposes a high compliance burden for perhaps marginal amounts of extra tax.

This is a real issue for people and one I think merits review. There hasn’t been a review of the financial arrangements rules since 1999 on the basis the rules mostly work pretty well. Notwithstanding that, these thresholds should be increased and how the regime applies to overseas mortgages should be reviewed to determine if they should be part of the regime and if so, can we do something to make the matters more compliance friendly?

The way the regime works, by the way, is you get the bizarre scenario where the sale of the underlying property without which the mortgage wouldn’t exist is often exempt for New Zealand tax purposes. But the foreign exchange gains on the mortgage will be taxable. So that’s conceptually a little bit of a mismatch. Often, by the way, it should be said that you also get the scenario where even if the capital gain is exempt in New Zealand, the gain is often taxed in the country in which the property is situated.

An eye on what the Aussies are doing

And finally, earlier this week, the Australian budget was released.  This is a couple of months ahead of the normal, and that’s because there’s a general election coming up, which must be held no later than the end of May. Now, that means that the election result may mean that what’s in this budget may be well reversed by a new government.

But there were a couple of things in here that caught my eye that may not change. The Australian Government, like ours, is grappling with the rapid rises in the cost of living, so it has it has introduced a fuel excise cut.  It has also increased the low- and middle-income tax offset for the current year ending on 30 June 2022.

It proposes to increase this tax offset by A$420 for the current year to a maximum of A$1,500 dollars for individuals and A$3,000 for couples. But it’s not going to be available for taxpayers’ incomes over A$126,000. This measure is going to cost the Australian government A$4.1 billion to enact. It’s an example of something we talked about last week, using tax to try and take the pressure off cost of living increases..

A more permanent measure though, and something which we may see here, at least expanded, is that the Australian Tax Office has had its funding for its tax avoidance task force on multinationals, large corporates and high wealth individuals, expanded for a further two years. And it’s been given a total of A$652.6 million to extend the operation out to 30th June 2025.

Now, this taskforce was established in 2016, and undertakes compliance activities targeting multinationals, large public and private groups, trusts and high wealth individuals. The additional funding is expected to increase tax take by A$2.1 billion dollars, pretty much a little bit over a return of three to one for the investment. And for that reason, I expect that funding will stay in place whatever government is in power after the general election.

I also think it’s something Inland Revenue might be looking to see here. We have the high wealth individual project going on at the moment, looking into what wealth there is in New Zealand and how the wealthy hold that wealth and how they structure their tax affairs.

Although it’s a research project I think you could see Inland Revenue getting more funding following that project to investigate the tax practices of the wealthy. So watch this space. And as always, we will bring you developments as they emerge.

Well, 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 find your podcasts. Thank you for listening and please send your feedback and tell your friends and clients. Until next time, ka pai te wiki. Have a great week.