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Shining some light on the impenetrable maze of the financial arrangements regime

Shining some light on the impenetrable maze of the financial arrangements regime

28 Jun, 2022 | The Week in Tax

  •  Shining some light on the impenetrable maze of the financial arrangements regime
  • Inland Revenue brings estate agents into line
  • Google NZ’s latest results show the need for international tax reform

Transcript

The financial arrangements regime is one of the most complicated parts of the income tax. It has huge scope but is not particularly well known. And until very recently there has been little practical guidance on the regime from Inland Revenue. Fortunately, all that is changing now. In the past couple of years, Inland Revenue has issued a series of Interpretation Statements which have clarified how the regime operates.

This week it’s released a revised draft Interpretation Statement on the critical issue of cash basis persons and how the regime applies to these people. Now, this is particularly important guidance because a person who is a cash basis person accounts for income and expenditure from a financial arrangements regime on a cash or realised basis rather than the at accrual or unrealised basis. The draft statement also sets out the adjustment that must be made when a person ceases to be a cash basis person and then has to switch to accounting for their financial arrangements income and expenditure on the accrual or unrealised basis.

There’s an accompanying fact sheet, so you don’t have to go through the whole full 33 pages of the Interpretation Statement. Page four of this fact sheet has a very useful flowchart, setting out process for determining if a person is a cash basis person. In summary, a cash basis person is someone who does not hold financial arrangements which exceed either of the following thresholds $100,000 of income and expenditure in the income year or the total value of these financial arrangements is under $1 million.

In relation to the $1 million threshold, the taxpayer must be below that threshold throughout the entire income year. So, if you cross it for just one day, that’s it, and you may be in the regime. If both those thresholds are exceeded the person cannot be a cash basis person.

Then there’s the second test you apply, if neither, or only one of the thresholds is exceeded. In this case you still have to check whether the difference between income and expenditure calculated on the cash basis, realised basis and under the accrual or unrealised basis does not exceed $40,000. This is what they call the deferral threshold. If it does, then the cash basis cannot apply. Now this $40,000 deferral threshold is often overlooked when people are considering whether or not they’re within the cash basis person. The Interpretation Statement has some good, worked examples how this applies.

If someone falls into or out of the cash basis status, they have to carry out a cash basis adjustment. And again, the Interpretation Statement has a good, detailed example. One of the issues that many people encounter is exchange rate fluctuations, which can put people unexpectedly into the regime and therefore have unintended consequences.

The classic examples I’ve seen are with people holding overseas mortgages against an overseas investment property and the fluctuation of the thresholds. Brexit in particular was one of those events that caught quite a number of people. Incidentally, this is perhaps why one of the examples here refers to the 2016-17 tax income year when Brexit happened.

The Interpretation Statement has a useful tip about financial statements subject to exchange rate fluctuations. It suggests identifying when the New Zealand dollar was at its lowest point compared to the foreign currency in the year and calculate the value of the New Zealand financial arrangements at that time. That’s a quick way of determining the highest possible value of the arrangement during the income year, assuming the principal hasn’t changed materially.

Paragraph 69 of the Interpretation Statement also includes some nice examples of why people might adopt the accrual basis from the outset. Doing so might resolve the problems around cash basis adjustments or they might want to actually bring the income or expenditure such as an unrealised exchange loss into account immediately.

The financial arrangements regime is actually another example where thresholds have not been frequently adjusted. These particular thresholds were last set at the start of the 1997-98 income year. They now catch far more people than were probably ever intended. Using the Reserve Bank calculator based on CPI, those absolute thresholds now would be $170,000 instead of $100,000, $1.7 million instead of $1,000,000 and the deferral threshold would be $70,000. If you use the Reserve Bank’s housing inflation calculator, then the income expenditure threshold would be $560,000, the absolute threshold for all financial arrangements would be $5.6 million and the deferral threshold $225,000. So whichever inflation indicator you’re using an adjustment is therefore well overdue.

The point here that frustrates me is that there’s a persistent theme across the tax system, where thresholds are not adjusted for inflation frequently enough. It’s a sneaky way for governments of both hues to collect additional revenue without too much notice. Quite apart from these financial arrangements regime thresholds, the income tax thresholds were last adjusted in 2010 as is well known.

The abatement threshold for working for families, that is the threshold above which abatement clawback applies hasn’t kept up inflation. By my calculation, I believe it’s now lower than what someone on minimum wage would earn. And the threshold for student loan repayments above which 12% is deducted from your income, that hasn’t been adjusted for some period. Governments really ought to be much more proactive about changing these thresholds. There’s actually a good political point here, in that doing so would de-politicize the issue.  However, as I said, governments appear to quite like this sneaky increase in revenue.

Rant aside, it’s good to see guidance like this from Inland Revenue, the fact sheet is particularly useful. No doubt we’ll see more guidance on this area, but in the meantime, you should definitely have read this because this is a complicated regime and it catches far more people than you would expect.

Targeting real estate agents

Moving on, there was an interesting little piece in Stuff this week regarding the success of Inland Revenue’s campaign about real estate agents claiming personal expenditure when they shouldn’t as an attempt to reduce their tax bills. Inland Revenue advertised it was looking at estate agents’ expenditure which it thought was excessive.

We haven’t heard too many stories about who has been caught by this, but Inland Revenue took the view that focussing some attention on the issue would encourage others to behave. Basically, what was happening that some agents were understating income and overstating expenses. And it appears now over 90% of the tax returns for the March 2021 income year have been filed, Inland Revenue compared the results from that sector relative to earlier tax years and it has seen these trends reverse, particularly in relation to what it called private expenditure.

One of the one of the issues is claims for gifts, personal clothing and grooming and entertainment expenditure. And there was also under-reporting for GST purposes. Some people apparently used a net amount in their bank account for GST purposes. This is actually a really good example of Inland Revenue applying the blowtorch by saying “We have got the data we can match this and don’t think we’re not noticing what’s going on here”. So good to see on that.

There’s an interesting point here which I think Inland Revenue should issue some guidance on. And that is where someone who is working with clients and has to look professional, and therefore purchases smarter clothes for that role, what proportion may be claimable?

I remember a very famous case on this issue from my time in the UK: Mallalieu versus Drummond. A female barrister claimed a deduction for some very sombre, dark clothing that she wore only in court. She didn’t win her case, but the point still stands if you are purchasing clothes which are only use work to what extend is that deductible. And I think Inland Revenue should come out and clarify what it thinks about that.

Incidentally, Mallalieu didn’t involve the astonishing Section 189 of the Income and Corporations Taxes Act 1970.  This allowed an individual to claim an expense for “keeping and maintaining a horse to enable him to perform the same or otherwise expend money wholly, exclusively unnecessarily the performance of said duties”. Yes, the UK tax legislation in 1970 (and actually again in the 1988 consolidation), had a reference for a specific deduction for a horse. That provision actually wasn’t updated until 2003. So, if you think our tax legislation is a bit arcane to spare a thought for the UK.

How much of Google’s NZ revenue escapes the NZ tax net

International tax has been in the news lately because concerns are starting to grow as to whether the tax deal signed last year by 130 countries, including New Zealand, is actually going to be implemented. Inland Revenue currently has a major issues paper out on the topic, submissions on which close next week.

The Revenue Minister David Parker was speaking to the Finance and Expenditure Committee this week. From his reported comments he expressed some concern about whether the so-called Pillar One and Pillar Two proposals would come into effect.

But the need for those rules to come into place was underlined, in my view, by Google New Zealand’s December 2021 results, which were published on the Companies Office website yesterday.

Google’s revenue, as reported for income tax purposes, rose from $43.8 million in 2020 to $57.8 million in 2021. Its pre-tax profit went from $10.2 million to just under $18 million, and Google ended up with $3 million corporate income tax for the year ended 31st December 2021 once you take into account timing adjustments.

But what’s really interesting when you drill into the financial statements is what’s going on with related parties. The notes to the financial statements disclose the transactions with the related parties. We can see that the service fees Google New Zealand paid to other overseas companies in the Alphabet Group (the owner of Google) in the year amounted to $697.8 million. Now that’s up from $517.1 million in 2020.

This gives you an indication of the level of advertising revenue activity actually going through Google New Zealand. These service fees are perfectly valid although Inland Revenue will no doubt have its transfer pricing specialists run their eye over these fees. There may be some queries going on, we don’t know as the accounts are silent on that.  But the level of activity here indicates how much advertising revenue is going through Google New Zealand and how much is being paid offshore as a legitimate deduction for income tax purposes.

But it shows the arrangements that are in place that enable substantial amounts of advertising revenue pass through Google New Zealand, but it finishes up paying only $3 million in income tax. It does pay a substantial amount of GST, according to the financial statements the GST payable has on 31st of December 2021 was just over $21 million. This would indicate a very significant level of taxable supplies deemed to be made in New Zealand. But it’s likely that the GST Google New Zealand is charging is probably also being claimed by New Zealand businesses. In other words, it’s largely a net zero-sum game.

Anyway, my hope is that the international tax deal will go through. There is politics being played in America, no surprises there, but also in Europe where the EU is trying to get unanimity amongst its 27 member states. It’s a question of “Watch this space” for developments. But Google gives you an example of why we would want to know more about what’s going on here and hope the deal goes through.

International Tax was a topic at the International Fiscal Association Conference held last week. As this was held under Chatham House rules, I can’t really say too much about it, but there were a lot of interesting topics from excellent presenters and a fairly lively debate on a number of topics including international tax.

Another featured topic was the controversial dividend integrity and personal services attribution rules, and that had probably the liveliest debate. The key takeaway for me from that particular session was a comment that these proposals show the limits of what can be done in the current tax system without a capital gains tax system. Because when you sit back, the cause of controversy there was that there were potentially capital transactions happening, which would be tax free under our present regime. However, Inland Revenue was looking at this and saying, “These transactions mean tax is not being paid”.

Now, the other take away I had, is that this tension is just getting worse and isn’t going to be resolved until the matter of taxing capital gains is resolved as well. I’m on record as supporting a capital gains tax. It probably is needed not so much as a revenue raiser but to preserve the integrity of the tax system. Because when you have such a hole in your base, it will be exploited. Incidentally, this means you can’t really argue, you’ve got your tax system is broad based. There are measures in place to deal with this, but we are talking about patches upon patches.

And so, this debate, which is going on for all the time I’ve been here in New Zealand but has intensified in recent years, is going to continue. At some point the issue will have to be grasped and resolved. No, it won’t be terribly popular. But if you want to maintain the integrity of the tax system, it seems to me that some form of capital gains tax is pretty near inevitable.

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 time Mānawatia a Matariki, enjoy Matariki!

Beware the great unknown of NZ tax – the financial arrangements regime

26 Jul, 2021 | The Week in Tax

  • Beware the great unknown of NZ tax – the financial arrangements regime
  • Not many happy about the interest limitation proposals
  • Time for a new approach – the fair economic return

Transcript

The former US Secretary of Defense Donald Rumsfeld died recently.  In the run up to the Iraq war he mused that there were things that we didn’t know we didn’t know.  I was reminded of Rumsfeld’s quote yesterday when a new client approached me in something of a panic.

Their accounting system was picking up on unrealised foreign exchange movements, but they weren’t aware of the relevant tax for treatment.  It was something of a shock to them when I ran through the provisions of the financial arrangements rules probably the biggest ‘didn’t know that we didn’t know’ in the New Zealand tax system.

To recap, because there’s not much on the Inland Revenue website about these rules, a financial arrangement is broadly defined as an arrangement where a person receives money in consideration for money to be provided in the future.  Bonds and mortgages are two of the main types of financial arrangements caught. But the regime also applies to term deposits because there is a promise to pay interest at a later date. The regime also covers foreign exchange accounts such as those held by my client

Unfortunately, the rules have proved particularly troublesome for holders of overseas mortgages. For example people who may have migrated here from overseas but rent out their previous property in Australia, the UK, or the US, over which they have a foreign mortgage. Although they are reporting the rental income as they should, they get caught by the foreign exchange movements on the mortgages

The most extreme example I ever encountered was for one client who had a $300,000 positive movement in one year resulting in income and tax payable which subsequently reversed entirely in the following year. They still had to pay the tax in the first place, a very frustrating result for all concerned.

So these financial arrangements rules are nightmare for the unwary as it’s an incredibly comprehensive part of the act but it is not at all well known.

Fortunately, by and large most people are not subject to the rules because they are within the exemption for what we call a ‘cash basis holder’. But that exemption itself has a couple of traps in it and this is what unfortunately has caught my client.

Generally speaking, you can be a cash basis holder and you don’t have to calculate income on an unrealised basis if either the absolute value of all your income and expenditure in a foreign arrangement for an income year is $100,000 or less.

Remember that’s adding income and expenditure together; the rules do not operate on a net basis. When calculating these limits that still needs to be kept in mind as it’s one of the other traps that people fall into. For example, if you had $500,000 on term deposit and you had a $500,000 mortgage overseas so although your net financial position is nil, for the purposes of the financial arrangement you have $1,000,000 of financial arrangements so you’re outside the cash basis holder exemption.

By the way, the $1,000,000 limit applies if on every day in a particular income year the absolute value of each of each of the persons financial arrangements added together has a total value of $1,000,000 or less.

Now as I said most people should be able to be within those limits.  The problem is there’s another clause which trips people up which they need to be aware of.  This is where if the difference between the income which would be calculated on an unrealised basis (what we call accrual income) and income calculated on the cash basis, that is what you’ve actually received or realised, exceeds $40,000 at any time then you cannot be a cash basis person.  What this means is that sudden movements in exchange rates can pull people into the financial arrangements regime, the classic example here being what happened following the Brexit referendum vote.

The financial arrangements rules are very much a trap for the unwary. How well it’s enforced of course is another matter because these are fairly arcane provisions and I’m not entirely sure Inland Revenue has all the resources to keep on top of what’s happening in this space.

Of course, it might help if Inland Revenue and the Government reviewed these thresholds and adjusted them more frequently. The $1,000,000 exemption threshold has not been adjusted since 1999. Quite frankly the financial arrangements regime should not really be pulling in small businesses into its net simply because of an out-of-date threshold.

This is one of the practical matters around the operation of the Income Tax Act which seems to be get left lying around until someone somewhere in Inland Revenue realises, we haven’t actually done anything in this space for 22 years.  Anyway, the lesson is to be wary of financial arrangements regime as it applies much more widely than people realise and can trigger unexpected tax consequences.

Bypassing the proper review process

Speaking of unexpected and unintended tax consequences, submissions closed on 12th July for the Government’s discussion document on its interest limitation proposals. It’s fair to say that the proposals have generated a fair bit of controversy. I understand Inland Revenue’s received several hundred submissions so far and very unsurprisingly the majority are opposed to the proposals.

Some of these submissions are now available to the public and so it’s interesting to look at what other submitters have said.  Chartered Accountants Australia and NZ have produced a massive and extremely comprehensive submission which runs to 108 pages. Now remember the discussion document itself was 143 pages so when the commentary on a document that size itself runs to 108 pages we’re talking about a great deal of complexity.  We’re almost certainly heading into a lot of unintended consequences as CAANZ’s submission points out.

This is echoed by its fellow accounting body CPA Australia. It points out that the measures were a surprise and did not go through the normal Generic Tax Policy Process and it foresees considerable confusion and remediation for the rules as a consequence.

CAANZ was also unhappy about the fact that the proposals did not go through the Generic Tax Policy Process (GTPP).  This is meant to work out in advance of an implementation date what the issues are and get the legislation to a point where everyone is mostly satisfied with what’s being introduced.  That didn’t happen here and is one of the reasons a lot of tax consultants, larger accounting firms and accounting bodies are unhappy about the proposals.

It’s interesting looking back that where there’s been departures from the GTPP these have commonly happened around taxation of property.

There were several unheralded moves by the previous National led Government outside the GTPP.  In the 2010 Budget for example, depreciation on residential and commercial buildings was withdrawn without any forward consultation.  Likewise, the same budget put an end to the loss attributing qualifying company regime partly in response to what was perceived to be issues around tax avoidance.   But the depreciation changes and withdrawal of the LA QC regimes were also responses to the tax treatment of residential investment property being perceived to be too generous.  Then in 2015 the first iteration of the bright-line test was introduced again outside without prior consultation through the GTPP.

I too agree with CAANZ and CPA Australia that there will be unintended consequences as a result of these changes but it’s also interesting to note that the taxation of property has been a headache for governments for some time to the extent they felt compelled to take action outside the normal policy process.

Patching another unreviewed policy

One of the things that hasn’t been done and probably should be is a comprehensive look at property taxation legislation.  We haven’t had a review of the original bright-line test legislation and its consequences. These reviews are quite normal under the GTPP.  But now we’re putting patches on that legislation and extending its period to 10 years. Meanwhile it’s clear there’s confusion about whether a property sale is subject to bright-line test or other taxing provisions within the Income Tax Act.

It’s against that backdrop Professor Susan St. John and I decided to move forward the idea of what we called a Fair Economic Return.  This is building on an idea that was first mooted by the McLeod Tax review in 2001. It suggested applying a deemed rate of return to property as an alternative taxation basis.  No-one is particularly sold on a capital gains tax but there was a recognition even 20 years ago that the tax treatment of property was favourable and causing distortions in the tax system. Those distortions have become magnified over the past 20 years resulting in measures such as we’ve just described attempting to address these issues.

With that in mind Professor St. John and I have produced a working paper suggesting a Fair Economic Return. We haven’t formalised a rate that should apply but the working paper has examples of how it would operate whether rate was 1, 2, or 3%.

This rate would be applied to the net equity of all property held by a person.

To get around the definitional issues of what is the main home, we have suggested there should be an exemption available to each person. In our initial working paper, we’ve suggested that exemption could be $1,000,000.

Here’s an example of how it would work for a couple living in Auckland whose only property asset is their house worth $3 million with a $500,000 mortgage.  The net equity in the property is therefore $2.5 million. Applying each person’s exemption $1,000,000, this leaves $500,000 subject to the Fair Economic Return at a rate of let’s say 1%.  This results in income of $2,500 for each person.

This is the idea Susan and I have put out there and we’ve been talking this week on radio about it. It’s obviously going to generate a fair bit of feedback, not all of it favourable, but that’s not surprising.

The view we’ve reached is it’s time to try a different approach because patches to the existing tax system such as interest limitation rules, extension of bright-line tests but incorporating exemptions for new builds etc, do not work, these are just patches, it’s time for a comprehensive and different approach to the whole issue of property taxation.

We’re updating the paper to absorb commentary and we’re always happy to take comments on that.

In the meantime, that’s it for me for this week. I’m Terry Baucher and you can find this podcast on my website www.baucher.tax or wherever you get your podcasts.  Thank you for listening and please send me your feedback and tell your friends and clients. Until next week ka kite āno!