- Similarly how the abatement of working for families makes it harder for low-income earners to break out of poverty.
About 10 years ago, myself and a group of other tax agents were on our way to a meeting with the then Minister of Revenue Peter Dunne. On the way someone mentioned whether we ought to raise the question of the law of unintended consequences in relation to a tax issue. Another replied that he’d never heard of such a thing law. So, we decided we shouldn’t say anything about that particular point.
We get into the meeting with Minister Dunne. And lo and behold in the course of our discussion, he brings up the law of unintended consequences, at which point we had to pause the meeting and explain to the Minister why we’d all cracked up.
(Incidentally, during that meeting, we raised a matter I discussed last week, the inequitable taxation of ACC lump sums. That was an issue which was supposed to be looked at by officials, and 10 years on, I guess they’re still looking).
The international impacts
I recalled this because last week I also talked about the Greensill decision in Australia, and the implications for trustees of New Zealand trusts. And on Monday, I got a new enquiry from a client where the impact of Greensill could come into play and it’s a classic example of the law of unintended consequences.
A mother had decided that she wanted all three of her children to be trustees of the family trust, and this change was made for good reasons in managing a family dynamic. Problem is, one of those children lives in Australia. As I mentioned last week under Australian tax law, if any trustee of a trust is tax resident in Australia, the trust is deemed resident in Australia. That means the Greensill decision may apply, which basically says capital gains even if realised offshore and even if distributed to a non-resident, are subject to Australian tax at the top rate of 47%.
The implications are therefore potentially quite serious for this trust. Looking into it in more detail, the trust is deemed resident from the first day a trustee is a tax resident of Australia. The trustees will have to prepare and file Australian tax returns reporting the trust’s income as calculated for Australian tax purposes.
Now, in many cases, the trusts will distribute income to beneficiaries and from an Australian perspective, if non-Australian sourced income is distributed to a non-resident, it’s not an issue. It’s just that in the law there is a technical inconsistency, which means that the Australian resident trustees are liable for Australian tax on non-Australian sourced capital gains distributed to non-residents.
This is the impact of the Greensill decision which to recap involved a capital gain of A$58 million and was held to be taxable at 47%. What’s more, with Australian trusts, the rate for retained income is 47%, and this is further complicated by rules about which beneficiaries have what is termed “present entitlement” as at the date of balance date. So overall, this is potentially quite a serious issue if substantial capital gains been raised.
Now the logical response, you’d think is, “Aha, let’s get the trustee to resign” and once the trustee resigns, that ends the connection with Australia. A logical move, except the Australian tax legislation has thought of that point. And what happens then is there’s a deemed disposal of the trust’s assets on the date of the resignation of the trustee (This is a feature of some jurisdictions with a capital gains tax). In other words the Australian Tax Office, believes in Blondie’s maxim, “One way or another we’re going to get you”.
We are currently working through all these issues. This is a textbook case of whenever there’s a family trust and there is family overseas if you want one of the family to become a trustee, you have to put a big pause on that and get tax advice, particularly in relation to Australian residents.
I’ve seen some trustees who are living in the UK pop up on trusts. This is not quite as potentially catastrophic but it’s still problematic. There’s this dichotomy between New Zealand’s tax treatment, which based around the settlor and many other jurisdictions, which is based around the residence of the trustee. So, to repeat the key point, if you have any trustees that are tax resident overseas, you need to get tax advice.
Helping your children
Moving on, the second instance of unintended consequences this week involves family members such as parents, grandparents or trusts trying to help children or beneficiaries purchase property, the bank of Mum and Dad as it’s sometimes called. This has become incredibly more relevant as a by-product of the horrendous escalation in housing prices.
The issue that has to be watched out for is when the parents or whichever other entity is involved, a trust, for example, actually takes a direct ownership interest in the property to be acquired. At that point, whoever it is, is probably setting themselves up for some issues further down the track in relation to the bright-line test.
And these of course have been magnified by the fact that the bright-line test as of 27th March this year now runs for 10 years. These issues were probably manageable when the two-year bright-line test was initially introduced back in October 2015 but have now been considerably magnified with the extension of the bright-line test period to 10 years.
What is emerging in some cases is that families might say, right, well, “We’ll take a 25% interest in the property. And then as the equity and your income rises you can pay us back and gradually take over our interest”. So ultimately, the children or beneficiaries will own 100% of the property. The problem is the reduction in those minority interests in the property represent a disposal for income tax purposes and for the purposes of the bright-line test.
For example, let’s say parents co-owned a house with a child and the ownership structure was initially 50:50 between them, but change it to 75:25. In that case, there’s been change in the title in the ownership interest, and therefore there’s been a disposal by the parents of a 25% interest to their child. Therefore, this disposal would be subject to bright-line test. There would be no exemptions here because they’re not living in it and it’s not their main residence. Just bear in mind that even if that property was the main residence of the child, the parents having the interest would still have made a disposal for bright-line purposes.
There’s also a potential kicker for such a transaction if the property is sold or gifted below its market value within the bright-line period, the transaction is treated as having happened at market value. So, for example, if the market value of the property had increased from $500,000 to $1 million, then the parents reducing their interest would be taxed on whatever their share of that $1 million was, rather than what actual cash they might have received. So potentially there could be some very sticky tax bills arising.
Arguably, one potential way round this might be that the parents lend the money to the child and not take a direct ownership interest, but you know, horses for courses, individual circumstances will come into play.
So, you just have to be very careful and proceed with great care if you are taking a financial interest in your child’s property to help them on the ladder. Otherwise, it could be another example of unintended tax consequences.
And the third unintended consequences that we might see in tax relates to the recent announcements from the government about changes to working for families.
What the Government has done has announced increases to the amount payable. The family tax credit is going to be increased by $5 per child. And on average, families will be $20 a week better off. But, and there’s always a ‘but’ in this, what the Government has given with one hand it has quietly decided to take on the other by raising the abatement rate to 27%.
Now abatement is what happens when a family’s annual income exceeds $42,700 then working for families credits start to be abated. And what this means is that people on average incomes actually have the highest effective marginal tax rates in the country.
For example, a family earning $48,000, the point at which the tax rate moves from 17.5% to 30%, their effective marginal tax rate, once you add in the impact of abatement is 57%. In other words, for every dollar of extra income they earn, they will lose 30% in tax and 27% of their working for families tax credits
For family’s with income just over $70,000, the marginal tax rate rise to 60%. And if you’ve got a student loan, that’s another 12% on top of that. A person earning just above $48,000 with a student loan could be facing an effective marginal tax rate of 69%. This is the unintended consequences of the abatement rates. The theory is conceptually sound, but the problem is it traps people on low income and makes it very hard for them to break out of the need to receive social assistance.
This is one of these things that is consistently glossed over by politicians and has been one of those sneaky little tax increases that that previous finance minister Bill English did. Grant Robertson is just the latest to increase the abatement rate and so quietly claw back some of the assistance. The unintended consequence is that the step up makes it harder to get out of poverty.
There is meant to be a review of working for families going on at the moment, but that’s been paused. As we know, the Welfare Expert Advisory Group recommended significant increases in benefits and that report is now nearly over two years old.
To summarise this week’s lesson, tax is full of unintended consequences. Therefore, always proceed with caution if you’re making significant changes, such as appointing a trustee or wanting to co-invest with your children on a property purchase.
Well, that’s it for this week. I’m Terry Baucher and you can find this podcast on my website, www.baucher.tax or wherever you get your podcasts. Thank you for listening, and please send me your feedback and tell your friends and clients. Until next week, party week, have a great week and go the Black Caps.
- A closer look at the new bright-line test rollover relief provisions
- Inland Revenue launches a new research project into high-wealth individuals
- Feedback from last week’s podcast
One of the positive matters coming out of the interest limitation rule changes is an extension of the rollover relief for bright-line test purposes. As is known, a change of ownership will often reset the timetable for the bright-line test purposes.
When the bright-line test was introduced in October 2015, the initial period was two years and so the resetting of the timetable wasn’t considered to be a great deal. But as of 27th of March this year, the bright-line period is 10 years, so it is now a very significant issue.
Accordingly, there has been pressure on Inland Revenue and the Government to include some rollover relief provisions, and the supplementary paper does include these. Now the proposals won’t go as far as people would like, but they’re a start. The key features are that certain transactions will now be eligible for rollover relief and that is mainly some transfers to family trusts and to/from look through companies and partnerships. There’s also going to be specific relief proposed for transfers to trusts constituted under Te Ture Whenua Māori Act 1993 and also transfers to land trusts as part of settling claims under Te Tiriti.
The key one for the family trusts is that rollover relief will apply. That is, the period of ownership will be combined, and not deemed to be a break for transfers of residential land to a family trust, provided that each transferor of the land is also a beneficiary of the trust. At least one of the transferors of the land must also be a “principal settlor” of the trust. That’s a loaded phrase in itself. And each beneficiary, except for those beneficiaries who are also principal settlors, has a family connection with a principal settlor, or is a company controlled by a family member beneficiary, or is a charity.
In relation to transfers to/from look through companies and partnerships, the rollover relief will also apply. The provisions are complicated but will apply where the persons transferring the residential land to or from a look through company or partnership, have ownership interests in the look through company or partnership in proportion to their individual interests in the land and their cost base relative to the total cost base of the land.
In addition to the above criteria, rollover relief is only going to be available if the transfer is made for an amount or consideration that is less than or equal to the total cost of the residential land to the transferor at the date of transfer.
All this is good, if complicated, but with care can be managed. But one issue that does stand out straight away is that the rollover relief does not cover transfers from trustees to beneficiaries. Therefore, the bright-line timetable will reset on such a transfer unless it is possible that another exemption relating to matrimonial relationship property agreements can be used. That also requires a great deal of care.
This is a little disappointing, and I would recommend people making submissions requesting that distributions or transfers of land to beneficiaries can also be included for bright-line test purposes. Or at least flush out from Inland Revenue the reason why it thinks this shouldn’t be the case.
If conditions are met for rollover relief, then under the new provisions, the trustees or the look through the companies would be deemed to have the acquisition cost and date mirrors the total cost of the land to the transferor and obviously at the same acquisition date as for the transferor. And similarly for transfers involving partnerships and look through companies.
Now this provision will come into force when the bill is passed, so that means the likely commencement date is going to be late March 2022. As I said, encouraging. But it would be useful at least, if the transfers from trusts could be covered by rollover relief as well.
A tax focus on HNW individuals
Moving on, Inland Revenue is in the early stages of starting a research project for high wealth individuals relating to their effective tax rates. And what they plan to do is to collect information to help Inland Revenue assess the fairness of the tax system.
This is something that the Government specifically allowed for in this year’s budget. Inland Revenue got five million this year to June 2022 as part of this project. Inland Revenue apparently selected some 400 individuals who are regarded as high wealth, and households in this particular group are expected to have or thought to have a net worth exceeding $20 million.
The project is based on household income, so the first stage is to confirm with the individuals selected who’s in the household. Then in stage two, which will be early next year, individuals will be sent a list of entities and business undertakings, such as trust in companies, Inland Revenue believes they have an interest in. They’ll be asked to confirm that interest and provide further details of any other entities Inland Revenue may not have identified That will similarly apply to partners and dependent children. And then finally, financial information relating to these entities must be provided.
The plan is to analyse this information and then provide a report in June 2023. And it’s all part of gathering data for better public policy in this area. The information provided will cover the 2016-2021 income tax years, and there will be an estimate of the effective tax rate based to relative economic gain over that period.
This is quite a big project for Inland Revenue, as I told others earlier. One of the unintended consequences of having abolished estate duty in 1992, is that we don’t actually have a lot of good data around wealth because grants of probate and wills are no longer made public.
But generally, around the world there’s growing concern around inequality, but also to the question around the brutal fact that most governments have been hit very, very hard by COVID-19 and are looking in the long term at the question of raising revenue. But that’s a long way off. In this particular case it’s more about “let’s find out what what’s out there.”
The revenue is using a specific provision, section 17 GB of the Tax Administration Act. And all this information is not to be shared with any operational part of Inland Revenue. According to an information sheet published, it will be held in a database separate from Inland Revenue’s main START system and will not form part of any of the individual’s tax records.
Inland Revenue must be absolutely secure in doing this. Otherwise, it will be buried in lawsuits over a breach of privacy. The Privacy Commissioner no doubt will be watching this one very carefully. Inland Revenue have had to get some sign off from the Privacy Commissioner on this so far.
It’ll be interesting to see what comes out of this. It is early stages, but I think you can expect to see and hear about some pushback. But for the moment, Inland Revenue believes it has the statutory tools to do this. So, it will be interesting to see how this exercise plays out.
Last week, Professor Lisa Marriott and I talked about Inland Revenue’s debt management, and in our discussions Lisa raised the question of maybe a tool to be considered would be publicising the names of debtors.
And one of our listeners, James (thank you, James) followed up with an email pointing out that in fact, Inland Revenue does already have some powers to communicate information to an approved credit reporting agency regarding a taxpayer’s reportable unpaid tax. This is under section 18H and Clause 33 of Schedule Seven of the Tax Administration Act.
Under this clause, if the reportable unpaid tax is in excess of $150,000 and the Commissioner of Inland Revenue has notified the taxpayer of this amount, then the Commissioner may give an approved credit reporting agency information in relation to the taxpayer and any amount of reportable unpaid tax. But they must have made reasonable attempts to recover this unpaid tax from the taxpayer before formally notifying the taxpayer that this is going to happen.
So, this is a first step, and the threshold is reasonably high, which gives me some comfort. It’s actually quite interesting to look back on this clause and see not much was said about it at the time. And certainly, the commentary issued in the bill doesn’t really refer to this in great detail. So this clause went through without too much comment. I’m not aware of it having been used, but we’ll put in an Official Information Act request and find out more on that and update you at a later time. So, thank you James, for letting us know on that. As always, we welcome feedback, good and bad from listeners and readers.
Well, that’s it for today. Next week, I’ll be reviewing Inland Revenue’s just published 2021 annual report together with the latest developments, as always.
Until then, I’m Terry Baucher and you can find this podcast on my website www.baucher.tax cor 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 te wiki, have a great week!
- An overview of the Government’s discussion document on the design of the interest limitation
- Additional bright-line rules
It has been a massive week in tax beginning with the G7’s announcement that it had agreed a minimum corporate tax rate of 15% (more here), we had the Climate Change Commission’s release of its final advice to the Government, Propublica releasing Internal Revenue Service data about the tax affairs of the 25 richest Americans, the same day as Revenue Minister David Parker raised the same topic in his appearance before Parliament’s Finance and Expenditure Committee.
But the biggest news, and our topic today, is the release of the Government’s long-awaited discussion document on the design of the interest limitation rule and additional bright-line rules.
You will recall that on March 23rd the Government dropped a huge bombshell by announcing that it was proposing to limit interest deductions for residential rental investment properties starting October 1st.
Now, there’s been a flurry of activity since then with Inland Revenue consulting with an External Reference Group discussing the issues that came out of the Government’s announcements as part of preparing the discussion document which was released yesterday.
At 143 pages it’s a big document and it’s one of the largest such discussion documents issued in recent years. Just for comparison, the issues paper on loss ring-fencing released in 2018 was a mere 20 pages, and that for the introduction of the bright-line test back in 2015 just 36.
I was part of the External Reference Group, and it became very apparent very quickly that we were dealing with considerably complex issues, and we would be looking at quite a lot of very detailed legislation. So, there’s a massive amount of detail to consider here.
I don’t propose to go through everything in detail today because we’re still working our way through the document and considering the implications. Instead, what I’m going to do today is give an overview of the key points in the discussion document points, and then in the coming weeks, focus on specific issues of interest.
Now, the discussion document starts with an overview of the proposals and then works its way through another 13 chapters so there are 14 chapters, including the introductory chapter, in all. And one of the things that I think we might well appreciate is the document has been drafted so that it is not necessary for everyone to read the entire document unless you’re a tax adviser like me. But if you have a particular interest, you can go to the chapter that is relevant to you. And each chapter also contains specific questions that Inland Revenue and the Government are looking for responses about.
To summarise, the restriction will happen from 1st October 2021. The amount of the restriction will depend on whether the interest is “grandparented”, and that’s going to be one of the first points of interest. This is interest on debt drawn down before 27th March 2021 relating to residential investment property acquired before that. The deductions will be gradually phased ou between 1st of October 2021 and 31 March 2025. For grandparented interest, deductions will be gradually phased out between 1 October 2021 and 31 March 2025 as follows:
|Date interest incurred
||Percent of interest you can claim
|1 April 2020–31 March 2021
|1 April 2021–31 March 2022
|1 April 2021 to 30 September 2021 – 100%
1 October 2021 to 31 March 2022 – 75%
|1 April 2022–31 March 2023
|1 April 2023–31 March 2024
|1 April 2024–31 March 2025
|From 1 April 2025 onwards
Chapter 2 looks at what residential property is subject to the interest limitation. Now, there’s a good part here is that there are some exclusions.
- Land outside New Zealand
- Employee accommodation
- Care facilities such as hospitals, convalescent homes, nursing homes, and hospices
- Commercial accommodation such as hotels, motels, and boarding houses
- Retirement villages and rest homes; and
- Main home – the interest limitation proposal would not apply to interest related to any income-earning use of an owner-occupier’s main home such as a flatting situation.
Chapter 3 then looks at the entities affected by interest limitation, such as companies, Kāinga Ora and other organisations,
What interest expense is going to be non-deductible?
Then Chapter 4 – one of the ones going to get into quite a bit of detail – involved interest in allocation, which is how do you identify which interest expenses are going to be subject to the limitation?
And the proposal here is to follow the long-established practice that where a loan has been used for a mixture of taxable and non-taxable purposes, we trace the funding through to each purpose to determine the deductibility. The Government’s proposal is to use this existing approach for loans used to fund residential investment property. Now, the discussion document also covers refinancing, existing loans and some transitional issues around debt which existed prior to 27th March.
One of the issues considered in the paper is the question of what to do about loans that can’t actually be traced. In other words, because previously this wasn’t a requirement for many investors, and they don’t have the records to be able to trace. What do you do where you want to show that a loan that was taken out prior to 27th March was applied to, say, business use rather than residential property investment? A mixed-use loan, if you like.
There are two proposals to deal with this issue. One is to take an apportionment based on the value of the loans across the assets, based on the original acquisition costs and the cost of any improvements. The other option is what they call ‘debt stacking’, which is where taxpayers would allocate their pre-27th March loans firstly to assets that are not residential investment properties but qualify for interest deductions.
This is actually quite generous, by the way. The rationale for this is that well advised taxpayers would be able to restructure to achieve the same tax outcome under the tracing approach anyway. This is actually an acknowledgement of the disparity of investors we’re dealing with here. Some are quite sophisticated and would be across all the detail. Others, less so, perhaps because they may not have many properties and have not really been as diligent as perhaps they should have been in keeping records. So that’s a little bit of a generous exemption there. But the point is you’re still dealing with a great deal of complexity in approaches and the Government is asking us to say, well, which one would you prefer to use?
A particular point here to note is that with pre-27th March loans, while interest on those loans will be deductible, subject to phasing out, and any borrowing subsequent to that date will be completely limited. What’s proposed to help calculate this proportion is determining a “high watermark”, which is the amount of funding allocated to residential rental property as of 26th March 2021. And then from that point, variations above that are the ones that are going to be most closely subject to interest limitation. As you can see, we’re already into quite a lot of detail and we are just getting started.
Non-deductible interest and bright-line test sales
Chapter 5 looks at the proposals for the disposal of property subject to the interest limitation rule. This was the subject of a lot of discussion during the External Reference Group consultation. Because the issue here is if interest has been limited, but the property has been sold and the gain on the disposal is treated as taxable, what are we going to do with the interest that was treated as non-deductible? Can this now be allowed as a deduction on sale? This is targeting people caught under the bright-line test, and remember we are also talking about an extended 10-year period for the bright-line test.
There are several options under consideration. One is that deductions are denied in full stop. Secondly, the deductions are allowed at the point of sale. Thirdly, deductions are allowed at the point of sale to the extent they do not create a loss. And finally, there’s an anti-arbitrage rule to counter attempts to arbitrage the interest deductions available because some people might know they’ve got a taxable transaction coming up.
The Government’s looking for feedback on people’s preferred approach. My impression is that they will be allowing a deferred deduction of previously denied interest at the point of sale. But exactly how those rules will operate is what the Government wants to hear more about.
Chapter 6 considers the treatment of property development and related activities. The Government has determined that property developers should be exempt from the proposed rules. So that chapter looks at what is the definition of development and how far should this development exemption go. It also looks at what do we do in applying that exemption to one-off developments as well as professional developers?
A particular point of interest, because we’ve got ongoing issues around leaky homes and earthquakes strengthening, is remediation work. Will that qualify for the development exemption? So there’s a lot to consider in this chapter.
What is a new build?
Chapter 7 is one which also generate a lot of discussion – what is the definition of a “new build”? Under the proposals, new build residential properties are exempted from the proposed interest limitation rules, and they’re subject to a five year bright-line test rather than the 10-year test.
The chapter suggests the following could be considered a new build:
- a dwelling is added to vacant land,
- an additional dwelling is added to a property, whether stand-alone or attached,
- a dwelling (or multiple dwellings) replaces an existing dwelling,
- renovating an existing dwelling to create two or more dwellings,
- a dwelling converted from commercial premises such as an office block converted into apartments. This is one which I think is of particular interest. Following the announcement in March we heard one or two of these developments were put on hold so clarity around this is needed.
Chapter 8 then deals with the new build exemption from interest limitation and how long that exemption should apply to new owners? It’s also proposing that early owners, those who acquire a new build no later than 12 months after its Code Compliance Certificate is issued or add a new build to the land, would be eligible for the new build exemption. It then looks at what about subsequent purchases? Maybe the exemption is available for those who acquire a new build more than 12 months after the new build’s Code Compliance Certificate is issued and within a fixed period such as, say, 10 or 20 years. There’s a lot to consider in this issue.
Chapter 9 then discussed how the five-year bright-line test will apply for new builds.
A pleasant surprise
Chapter 10 is where we have a pleasant surprise. It deals with what we call rollover relief when the application of the bright-line test and interest limitation is “rolled over”. This is where the property is transferred between two parties and that transfer, which is a disposal for tax purposes, does not trigger an immediate tax charge under the bright-line test provisions.
The lack of a comprehensive rollover test was something that has been an issue before this interest and limitation issue arose. What’s proposed in here is some limited relief from the interest limitation and bright-line test in relation to transfers to trusts and transfers where there is, quote, “no significant change of ownership.”
What this means is in those circumstances, the taxing point will be deferred until there is a future disposal of the property that does not qualify for rollover relief. So, if the transfer qualifies for rollover relief, then the disposal of the residential land would be at cost to the transferral or original owner rather than market value, which is the current rules. The recipient would then be deemed to have the same acquisition date and cost base as the transferor.
Now, the critical thing is disposals where there is non-zero consideration, either at market value or not, will not be eligible for rollover relief. That means if you are transferring property into a trust you must gift it in. If there’s any consideration received for the transfer you won’t qualify for rollover relief. (That may also mean the bright-line test applies and a tax charge on transfer arises).
There’s also a clarification here that rollover relief will apply where property is transferred between company or partnership and its owners so long as the property continues to be owned in the same proportion.
Now, all this is, as I said, is actually a pleasant surprise. It may be limited, but it does deal with an issue that had been of some concern previously. So it’s welcome to see the matter being addressed.
Chapter 11 then looks at the question of what to do with interposed entities. This is a quite technical point as they’re proposing new rules to ensure that taxpayers can’t claim interest deductions for borrowings used to acquire residential property investment property indirectly through a company or other interposed entity.
As I said it’s quite technical and as part of it involves one of the new definitions we’re going to see appearing in the Income Tax Act, what’s called the “affected assets percentage” as part of defining the terminology of a residential interposed entity. Basically, the idea is to stop people claiming a deduction for borrowing to buy shares in a company which then buys residential investment property. This is unsurprising, but just adds more complexity to the matter.
How does this fit with loss ring-fencing rules?
Chapter 12 deals with a particularly interesting issue which has cropped up about the implications for the rental loss ring-fencing rules. The chapter looks at the overlap between the ring-fencing rules and the proposed interest limitation rules. What it’s saying is the interest limitation rules should apply first to determine whether interest is potentially deductible in income year and then the ring-fencing rules will apply on the balance.
Now, if you’ve been working in this space, you’ll be aware that the loss ring-fencing rules can be applied on either a portfolio basis, that is across the entire portfolio, or on a property-by-property basis. Now, that’s not such an easy fit when you consider that the rules about tracing the purpose of loans really work on a property-by-property basis. So that chapter confirms that is the intention, that the interest limitation rules must be applied on a property-by-property basis.
Chapter 13 looks at the question of property, subject to an existing set of interest and deduction restriction rules called the mixed asset rules. When we started talking about this in the External Reference Group, quite a few brains, including my own, went clunk because we really are into very great technical detail.
And then finally, Chapter 14 looks at compliance administration and how are we going to manage this? What information is going to be required by Inland Revenue in order to enforce these rules? Does Inland Revenue need more powers? The likelihood is that the amount of detail to be included in a tax return will increase. That seems inevitable.
So that’s a brief overview of a highly complex position. I’m particularly concerned about how this is going to impact small investors with one or two properties. Unless they happen to be debt free, they face significantly increased compliance costs relative to the size of their portfolio.
It’s not just taxpayers who face an increased risk. Tax agents and advisers face greater risks because there’s so much more detail to get across. If we get the deductibility issue wrong, we could be liable. So one of the things that the Government’s saying is we do want to try and minimise compliance as much as possible.
So, I would urge people to submit. In doing so I think you should focus on what making the proposals as workable as possible. So be constructive. I know a lot of people are very unhappy about these rules. The Government knows you’re unhappy, I’ve discussed it with the Parliamentary Under-Secretary to the Minister of Revenue, Deborah Russell. The Government knows that people are unhappy about it but telling them that and railing against the proposals is just not going to make any difference.
So be constructive in your approach. Submissions have now opened, and they close on 12th July, because the whole thing has to come into force by 1st October. Now, we’ll be tracking this and as I say, we’re going to come back and pick up particular points of interest. And I’m very, very interested in hearing your feedback on this.
Well that’s it for today. Next week, barring any more tax bombshells, we’ll take a closer look at the G7 tax announcements and what the Climate Change Commission had to say about tax.
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.
- A closer look at the Government’s shock property tax announcements
- Four questions on the future of tax
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.
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!
- This week Inland Revenue reminds tax agents about the bright-line test
- It responds to comments in a previous podcast about Business Transformation
- The wealth tax debate continues
About 11 o’clock on Tuesday morning, myself and what appears to be just about every other tax agent in the country received an email from Inland Revenue with the subject line “Clients meeting the bright-line test”.
The email began: “Our records show the following clients have sold or transferred residential properties that meet the bright-line rule. This means these clients will be required to pay income tax on any profit they have made on the sale of the property.”
The email then set out the clients it believed were caught by the bright-line test rules. That is, they either sold property within two years of it being bought between 1st October 2015, and 28th March 2018 inclusive or within five years of it being bought on or after 29th March 2018.
Now readers and listeners will know that I have previously stated that we are aware that Inland Revenue has been gathering data in relation to the bright-line test. But this is the first time it’s really flexed its muscles and its capability to show exactly what it knows about what’s going on. And an insight into why Inland Revenue did that came the following Wednesday morning, when Stuff published a story under the banner headline “One in four property speculators dodging housing tax”.
Based on Inland Revenue data the story outlined that of 1701 property sales subject to bright-line test in the 2019 income year, 1285 have paid up and complied, but Inland Revenue is looking at the other 416 taxpayers who appear not to have complied with the law. It’s also looking at a further 3,758 sales for that year, where the bright-line test might apply.
This email initiative, as you might imagine, caused quite a bit of a stir amongst the tax agent community, and we know that all accountants from small companies like ourselves to major Big Four firms received these letters for their clients. Although the emails set out the client Inland Revenue believed was caught by the rules, they weren’t any more specific than that.
This upset a few accountants because it means digging around to find out what’s going on here. It also transpires that Inland Revenue may have been a little premature in its information release. Apparently, there is a follow up email coming next week, which will actually set out the address of the property in question so that we can then more accurately work out what’s going on.
But there was a fairly lively debate about the matter on the Facebook page of the Accountants and Tax Agents Institute of New Zealand of which I’m a member. And quite a few interesting snippets emerged about who had received emails and why.
Inland Revenue’s systems appear to have picked up any change in the registration of title. So that would include obviously sales where the title to the property passed to a new owner. But it also appears to have included changes in trustees because contrary to what a common misconception, trusts don’t actually exist in law although they have a separate existence for tax purposes. But in law, the property is held by the trustees. So if you have individual trustees holding property and one retires, there has to be a change of registration on the title. And Inland Revenue systems have picked up a few of these and issued a “Please explain.” Overall, though, the majority of tax agents were reasonably happy that this was the sort of initiative that Inland Revenue should be doing.
I’ve said before that Inland Revenue has access to a lot of data but doesn’t really make people aware of just what it knows. And these bright-line test emails are an example of it using the information it holds and making people aware of their obligations. One or two accountants noted it was interesting to see a sale by that client because they never mentioned it to us. There was one particular case, I recall, where the client went ahead and did something which they thought would be outside of the bright-line test, but in fact the transaction was caught. He was most crestfallen when he eventually spoke to me about the matter and I explained how the rules operated.
So this email initiative is the sort of thing that we can expect to see Inland Revenue doing more of and we can expect it to be fine tuning how it does these information releases. Yes, in some cases, such as those where there’s just merely been a change of trustee, Inland Revenue has jumped the gun. Perhaps a little bit more thought around whether that particular transaction was caught would have saved some headaches and frantic calls between clients and accountants on the matter.
But when you consider the heat in the housing market and concerns everywhere amongst those locked out of the housing market and the desire for the government to raise revenue to fill the hole blown in its balance sheet by the Covid-19, it’s not surprising Inland Revenue will be taking this initiative. It reminds people, “Hey, these are the rules. We think you’re caught. If not, please explain”. So, in summary, I think we’ll see more of these initiatives further down the track
By the way, as a PR exercise, it does no harm. Firstly, it tells the new minister that it’s on top of things and secondly, reminds those who think that Inland Revenue is big and dumb, that in fact, it has got access to a lot of information. And to borrow a line from Liam Neeson, it will find you and will, if not kill you, certainly tax you.
Communicating in public
Moving on, a couple of weeks back, myself and Andrea Black took a look at Inland Revenue Business Transformation programme, and we weren’t terribly happy about some of what we found.
Well, on Tuesday, Sharon Thompson, Deputy Commissioner for Community Compliance Services, published a piece responding to our podcast.
And in particular, she addressed our suggestion the transformation hasn’t been successful because cost savings haven’t been reinvested into audit and investigation work. This was, “a narrow view of how Inland Revenue ensures tax revenue in New Zealand is as close as possible to what is required under our laws”. And our view that Inland Revenue’s current approach was incorrect is not supported by international research.
I think the phrase is “Shots fired!”, but it’s certainly intriguing to hear the Deputy Commissioner’s response. One of the points she made in responding to the specific questions we raised about the level of spending on investigations and debt management, was “Our new system has dramatically increased and improved the data we have access to. And we can watch, often in real time, as taxpayers file returns. So, if they’re getting it wrong, accidentally or deliberately, we can see and intervene, reducing the need for post-return audit and investigation.”
That is something I’ve heard from other Inland Revenue staff. If you file a tax return through the Inland Revenue portal, the system tracks the keystrokes. And in one example given to me last year by an Inland Revenue officer, if there is a suspiciously large number of adjustments being made to get the just right amount, they will look into it.
Sharon goes on to comment that every return that can generate a refund is checked automatically and amended returns are checked and screened. For example, between 1st July 2019 and 30th June 2020, Inland Revenue identified approximately 23,000 returns across all tax types which had errors or it believed were fraudulent with a value of just under $200 million. Now, that’s a good initiative and Andrea and I would not dispute that was a good result and also a good use of Inland Revenue resources.
However, Sharon’s article did not address the concerns that I’ve expressed previously and alluded to in the podcast with Andrea about Inland Revenue’s relationship with tax agents. Tax agents are vital to the operation of the tax system. But many other tax agents and I have reservations about how the new Business Transformation programme has integrated tax agents into its system.
The initiative I talked about a few minutes ago is something we would welcome, and we should expect to see that. Tax agents are actually Inland Revenue eyes and ears and so we do a lot of the pre-screening that Inland Revenue would otherwise have to do without us.
But we don’t always get access to Inland Revenue as easily as we should. The phone line for tax agents was abruptly turned off and then reinstated, but with limited hours, for example. So although Inland Revenue may feel that Andrea and I were unfair in some of our criticism, but equally, some of the criticism we raised still needs to be addressed.
The role of tax agents is one where tax agents have a great deal of concerns about what Inland Revenue expects and whether, in fact, it wants to work with tax agents going forward. My belief is Inland Revenue does, but it’s not communicating that very clearly to us at the moment.
I still feel that the dramatic fall in investigation hours of almost two thirds over the last five years is a matter for concern. But we will be able to see how Inland Revenue has worked through the Business Transformation process and see more of the numbers when its annual report is published shortly. It’s been delayed, apparently in part down to the Covid-19 outbreak.
Tax on wealth vs tax on work
And finally, the debate around taxation and housing and wealth taxes continues to rage all week. On Tuesday, Westpac published its Economic Overview for November, in which it made the point that future governments will be forced to either reduce spending or increase taxes because of the fiscal pressures that are starting to build over superannuation and health care.
The Report goes on.
“The required adjustments to our fiscal position can’t be delayed forever. Sooner or later, some form of consolidation will be necessary, though the precise form this takes will depend on which party is leading the government at the time. Our pick is that a future government will introduce some form of tax on assets such as a land tax, capital gains tax or a wealth tax. Societal concern about increasing wealth and inequality is only going to intensify, eventually creating a large constituency for such a tax. And tax experts agree that broadening the tax base would enhance economic efficiency.”
Later that afternoon, I spoke to Wallace Chapman on Radio New Zealand’s The Panel about this report and the ins and outs of a wealth tax. And in addressing the housing crisis, I made the suggestion that maybe a 10% stamp duty might be imposed on all investors or some measure like that.
Now, last week, I mentioned a Deutsche Bank report which suggested a working from home tax which unsurprisingly got pooh poohed. But the full report is actually quite interesting and actually has one of the more dramatic report openings to any bank report I’ve seen in a long time:
“To save capitalism, we must help the young. Democratic capitalism is under threat as increasing numbers of young people view the system as rigged against them. The pandemic has only exacerbated their economic disadvantage.”
Now, that’s quite an opening for any report, let alone something from a bank, but the report goes on to talk further about some tax changes and these proposals mirror what was suggested by Westpac. Deutsche Bank suggests that, for example, there is a need to have a tax on a primary residence, which if you think about the hoo-ha we had with the idea of a proposed capital gains tax taxing everything except the primary residence last year, you can imagine just how big a fight would happen if we said actually, “We’re taxing the main home as well.”
The Report also suggested that there may need to be additional taxes on financial assets such as stocks, bonds, due to their gains from loose monetary policy. As maybe people are well aware, stock markets have actually boomed quite substantially this year. New Zealand’s stock market has been hitting record highs recently. The Deutsche Bank report, notes that in the 30 years to 2019, the S&P 500, that’s the main index in the United States, gained over 800%, two thirds more than the return seen in three decades previously. The report suggests taxing such income on a basis similar to our foreign investment fund regime, and or remove exemptions and discounts and capital gains. Picking up my Stamp Duty proposal, the report suggests such duties are paid by the vendor and not, as is common, the purchaser.
Now, the point that the Report makes is the reason why it wants to increase the tax on capital is so as to avoid much higher income taxes, which are often cited as an argument against hard work. This is one of the criticisms of Labour’s proposed tax rate increase to 39%. It is very narrow and hits income earners, whereas there’s a growing consensus that it’s the taxation of capital which needs to be broadened.
So this debate is going on all around the world. When banks like Westpac here and Deutsche Bank in Germany are making comments about broadening the scope of capital taxation you know a fundamental shift is happening in taxation thinking. How that will play out, we’ll have to wait and see, and I’ll bring you developments as we go.
Well, that’s it for this week. Thank you for listening. I’m Terry Baucher and you can find this podcast on my website www.baucher.tax or wherever you get your regular podcasts. Please continue to send me your feedback and tell your friends and clients. Until next week, ka kite āno.