Happy new tax year and welcome to the 2023-24 tax year and as is often the case the start of a new tax year it means newly enacted legislation is now in place.
However, some of the same old issues are still with us.
The Taxation (Annual Rates for 2022-23, Platform Economy and Remedial Matters) Bill (Number 2) finally received the Royal Assent on 31st March. Apparently this bill had nearly 200 new clauses, which between them had some 42 different application dates. So, it was a surprisingly complex bill. But remember, its most controversial proposal to standardise the treatment of GST on fund management firms was removed.
As noted, the bill has got quite a considerable amount of new provisions in it, and we’ll pick up several over the next few weeks. But I want to start by looking at the new fringe benefit tax (FBT) exemptions for bikes and public transport. As you may recall, the bill originally had an exemption for public transport, but at the last minute an FBT exemption for bikes was introduced. That actually covers bikes and “low powered vehicles”, so obviously covers scooters, e-scooters, e-bikes. The exemption from FBT applies where you are travelling between home and work. There’s going to be a maximum cost for the low-powered vehicles, which is yet to be confirmed by regulation shortly.
Watch out for the hook in the FBT exemption for bikes and public transport
But the key point to keep in mind is that the bike or scooter must be used mainly for travelling between home and work. Therefore, where that isn’t the case, FBT would still apply. This together with the maximum price cap on the exemption should rule out people buying high end bikes, e-bikes or e-scooters and then using them mainly for private use hoping that it’s exempt from FBT.
Now the exemption is from FBT, there is no equivalent exemption for PAYE. What that means is, it is very important for employers to consider how they provide that benefit and don’t make the mistake of assuming “Well, the FBT exemption applies so nothing to worry about.” The issue that arises is where the employer purchases the bike or scooter directly, then the FBT exemption should apply. However, if the employee chooses and purchases a bike personally and is then reimbursed, then PAYE will apply and there’s no exemption.
This principle also applies to the exemption around the use of public transport or vehicle shares, such as Uber and similar apps. Again, the employer must incur the cost for the exemption to apply. As some have noted that’s actually administratively quite awkward. It seems likely quite a few employers will accidentally trip up on this by reimbursing the employee rather than incurring the costs directly. The hope is that this particular anomaly can be quickly resolved and therefore ease the compliance involved.
Now, the new act also contained a permanent exemption from the interest limitation rules for build to rent dwellings. This exemption will apply where there are at least 20 connected dwellings, and the landlord must offer a fixed term tenancies of at least ten years. By the way, for the purposes of the interest limitation rules, as of 1st April, only 50% of the interest is now deductible unless one of the exemptions, such as a new build or build to rent, applies.
Interest limitation rules and short-stay accommodation – don’t get mucking fuddled
Coincidentally, last week, Inland Revenue released a draft interpretation statement for consultation on the interest limitation rules and short-stay accommodation. The interpretation statement considers how the interest limitations will apply and then also explains what other income tax rules may be relevant depending on the circumstances. The draft interpretation statement runs to 79 pages and is now common practice, it’s accompanied by a fact sheet.
It says much about the complexity of the rules in this area that the fact sheet runs to 13 pages. That’s because not only are the interest limitation rules applicable owners of short-stay accommodation must also take into consideration the potential application of the mixed use asset rules which have been around for over ten years now, as well as the ring fencing rules.
For the purposes of the draft interpretation statement, short-stay accommodation is defined as accommodation provided to paying guests for up to four consecutive weeks. The interpretation statement covers five scenarios where such accommodation is provided:
either in a holiday home; in a person’s main home; in a separate dwelling on the same land as the main home; in a separate property used only for short-stay accommodation; and on a farm or lifestyle block.
Within each of those five scenarios, the interpretation statement will explain if and how the interest limitation rules will apply, what apportionment rules apply, and whether ring fencing rules apply. There are also variations within these scenarios. If there’s a new build involved, for example, a person’s holiday home is on new build land, then the interest limitation rules will not apply. However, the deductibility of interest is still subject to the other apportionment rules, such as those contained in the mixed-use asset provisions and the ring-fencing rules will still apply.
As can be seen, there’s a great deal of complexity now involved, and this is partly the result of the somewhat ad hoc approach adopted by the Government in tackling what it sees as the preferential treatment of residential property investment. It also reflects generally incoherent policy resulting from the lack of a comprehensive capital gains tax. Whatever, the key lesson to watch out for is that the short-stay accommodation rules are now incredibly involved, so proceed with great care.
The taxation of capital is a longstanding issue and one which in my opinion, will need to be addressed sooner rather than later. Not only because of the tensions it creates within the tax system, but also because of the need to find additional revenue to meet the demands of an ageing population and the impact of climate change, which we’ve spoken about previously.
We like New Zealand Superannuation – but how are we going to pay for it?
And three reports this week highlighted this ongoing tension around meeting future liabilities. Firstly interest.co.nz covered a study coming out the University of Otago regarding New Zealand Superannuation. The study surveyed almost 1300 people in 2022 asking them what they felt about the age of eligibility, means testing and the willingness to increase both current and future taxes to pay for New Zealand Superannuation.
The study found there was widespread opposition to financial barriers for receiving superannuation. Means testing was not popular, but the support for keeping the retirement age at 65 has increased, with almost a quarter ranking the age of 65 as most important aspect of New Zealand super compared with a fifth back in the 2014 survey. 61% of those surveyed ranked raising the retirement age to 67 as the worst policy. The general response was they would prefer universal superannuation.
The New Zealand Super Fund, which has been established to help spread the cost of superannuation was popular. Although there was opposition to increases in current taxes to pay for New Zealand Superannuation, a majority of respondents still support higher current taxes to reduce the size of future increased tax increases given plausible investment returns.
A day earlier independent economist Cameron Bagrie told Newshub he had concluded New Zealand might need to introduce tax increases to have to deal with the impact of climate change and what he called an “infrastructure mess.” In his view, taking into consideration climate change, infrastructure and superannuation “If I step back, though, and think about tax rates in general over the next ten years, where do I think they’re going to be headed? I think they’re going to be biased up as opposed to down.”
Climate change will cost “multiple billions” under ALL scenarios
It is clear that the size and breadth of the economic and fiscal costs of climate change to New Zealand will be large. The physical impact of climate change and the choices the country makes to transition to a low emissions future will affect every aspect of the economy and society for generations. These impacts will have flow on implications for the Crown’s fiscal position.
What particularly seems to be concerning the Treasury and the Ministry for the Environment is that at present in the planning to help meet our climate targets there is an assumption that we will be purchasing offsets from offshore. As the report notes,
The cost of purchasing offshore mitigation to achieve New Zealand’s [commitments] presents a significant fiscal risk. For all scenarios considered, our analysis estimates this cost to be multiple billions over the period 2024 to 2030.
Multiple billions in this case could range from a low-end estimate of around $7.7 billion to perhaps as high as $23.7 billion. Apparently, the costs involved represent between 3.9% to 28% of the new operating expenditure that will be made available in each budget. Therefore, if climate change is swallowing up to 28% of the new operating expenditure that puts pressure on other areas such as education and health.
The report also discusses the potential tax implications. As noted at the start of section 6 on Fiscal Impacts, “Climate change will create multiple cost pressures for the Crown and is likely to negatively affect its tax base through changes to economic activity.” This presents a big question for policymakers and politicians – how do we have enough revenue to square the circle between meeting the demands for health and superannuation, and our climate change commitments? So that is why, like Cameron Bagrie, I think there is an inevitable pointer towards tax changes.
And on that bombshell, that’s all for this week. I’m Terry Baucher and you can find this podcast on my website www.baucher.tax or wherever you get your podcasts. Thank you for listening and please send me your feedback and tell your friends and clients. Until next time, kia pai to rā. Have a great day.
The draft legislation for the interest limitation rules was finally released on Tuesday through a Supplementary Order Paper to the Taxation (Annual Rates for 2021-22, GST and Remedial Matters) Bill. This Supplementary Order Paper (SOP) introduces amended sections CB 6A and CB 16A, which cover the changes to the bright-line test rules, and also to cover the interest limitation rules is a new subpart DH with sections DH 1 to DH 12. There are also new sections FC 9B to FC 9E which relate to the ability to roll over for the bright-line test purposes. In addition, there was a release of the regulatory impact statement and some very useful information sheets, six in all covering the basics of the changes.
There has been no change to the basic position, which was outlined in March, that interest limit deductibility would be limited for residential investment properties. As of today, between now and 31st March 2023, 25% of interest relating to residential property investment is non-deductible. And then that proportion of non-deductible interest will rise steadily over the next following years until it’s fully non-deductible with effect from 1 April 2025.
To quickly recap, the main home is not affected by these proposals. It’s been confirmed that the limitation would not apply to interest related to any income earning use of the owner occupier’s main home, such as flatting. Commercial property which is not related to the provision of accommodation isn’t affected either. Farmland, certain Māori land, emergency, transitional, social and council housing are all exempt. So too is commercial accommodation but not short-stay accommodation which could provide a residential dwelling (Airbnb would be the target here). Care facilities, retirement villages and rest homes are exempt, as are employee accommodation, student accommodation and land outside New Zealand.
Now, the big exception to this is an exemption for a “new build.” This is going to last for 20 years from the date on which a Code of Compliance Certificate is issued. These provisions are in the proposed section DH 4. An interesting thing about this new build exemption is that it applies for the 20-year period, regardless of the number of owners. So, it’s not just the first owner, the builder perhaps, who has the exemption, but all subsequent owners up to a 20-year period. So that’s probably as simple as they could make it which is generous.
It’s interesting when you look at the accompanying regulatory impact statement to see that the Ministry of Housing and Urban Development was opposed to limiting interest deductions for residential property because it thought it was concerned about the negative impact this could have on new housing supply. The Ministry of Housing and Urban Development said it preferred a long new build exemption, at least 20 years, which it saw as crucial to ensure that the new supply of houses was not reduced.
I would actually recommend a good read of the regulatory impact statement, it’s got a lot of fascinating insights. So, the Ministry of Housing and Urban Development got its wishes, but I do know from consultation that there was a general hope that there will be a longer period granted for this new build exemption.
A new build doesn’t actually have to be a completely new material. It can include modular or relocated homes, which is excellent. And it also covers converting an existing dwelling into multiple new dwellings. And critically, because this was a sticking point when the announcements were first made, it also covers converting commercial building into residential dwellings.
When does the new build exemption apply? Well, it applies either from when you acquire your new build, if it already has a Code of Compliance Certificate or you acquired off the plans or when your new build receives a Code of Compliance Certificate. I imagine there will be submissions wanting to extend that period on that, but at least it’s a line in the sand. I do think it’s probably on balance, allowing it to cover run for 20 years, regardless of the number of owners it might run through is also sensible.
The rules clarify that there’s a land business exemption if you hold the land as part of a developing, subdividing or land dealing business or if you’re in the business of erecting buildings. Also, interest relating to remediation work and other expenses relating to the ownership and development of land also qualifies for the land business exemption.
There’s a development exemption which will apply for interest on land you develop, sub-divide or build on to create a new build. And again, that exemption will apply from when you start developing the land and it ends when you sell the land or receive a Code of Compliance Certificate for your new build, at which point it flips over to the new build exemption.
Now, what happens if you sell the property and you’ve had interest deductions denied, but the gain is taxable for whatever reason, either under the bight-line test or another reason? In most cases, you’ll be allowed to treat the non-deductible interest as a cost for the purposes of calculating the gain. However, the deduction will be limited to the gain on sale. In other words, if the total interest costs not previously deducted, exceed a taxable gain that may that arises on the sale, only the interest to the point of the total amount of the gain will be allowed.
The new subpart DH deals with the issue of existing loans and rules around borrowing. If you borrowed funds on or after 27th March 2021, the interest is no longer allowed from 1st October 2021. Except if you used the funds to purchase a property acquired before 27 March or for a new build. In relation to refinancing, amounts up to the level of the original loan will not affect the deductibility of interest. And if that original loan was subject to being phased out over time, then the same treatment applies.
There are also provisions covering the question of deductions for interest on variable loans, such as a revolving credit or overdraft facility. If the amount outstanding is higher than the amount outstanding on 27 March, only the interest on the amount outstanding at 27th March will be deductible under the phased approach. The interest on the rest will be deemed to be non-deductible. There’s going to be a special transition rule to help work out what happens if you took out a loan prior to 27, the March 2021.
What if you can’t work out exactly how much the loan was used for residential property and how much was used for other business purposes? The example they give here is buying a truck for a transport business. What will happen is that loan will be treated as being used to acquire other business property first, based on the market value of that business property, and then the balance will be applied to residential property. That’s actually quite a generous treatment.
So, as I said, the regulatory impact statement makes for some interesting reading, you can see the arguments between Treasury, which supported this initiative, don’t allow deductions and don’t think there should be a newbuild exemption. On the other hand the Ministry of Housing and Urban Development and Inland Revenue took the completely opposite approach to Treasury arguing we really we don’t think these rules should be adopted.
According to Inland Revenue, the option which has been adopted, Option Three, is expected to raise $1.12 billion over the forecast period from 1st October 2021 through to 31 March 2025. It will be interesting to see how those extra funds are deployed. You’d hope that they would be used to build more social housing and help ease the crisis, but we shall see.
As you can imagine, it wasn’t just the Ministry of Housing and Urban Development and Inland Revenue who were a bit sceptical of the proposals. A total of 484 submissions were received from various bodies. The majority came from private landlords, but also included tax advisors, property investors, representative groups, real estate agents, iwi groups, property developers and engineers. This has stirred up quite a significant amount of debate and will continue to do so. We’ve got a long way ahead of us as we work through all these provisions. And no doubt, as we drill down into the detail, more points of contention will emerge.
The process going forward is that the Finance and Expenditure Committee should call for submissions very shortly and it’s expected there will be about six weeks to respond. Now, according to the Parliamentary timetable, the actual report on the tax bill of which this legislation is now part is due to be released next March. So, as I said, there’s some way to go before we might see the final form of the legislation. But at the moment it’s applicable and these rules are in force. We’ll obviously keep you updated on developments along the way.
Well, in the meantime, 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 kia pai te wiki, have a great week!
Chapter 5 of the discussion document on the proposed interest limitation rules deals with the matter of great interest to a lot of people, and that is what happens with interest deductions which have been disallowed for a residential investment property which is subsequently sold, and the sale is taxable. Now, just to recap, the interest deductions for residential investment properties are to be restricted and eventually disallowed in full starting from 1st October this year. There is an exemption to this if the property qualifies for the development or new build exemption, which we discussed last week.
Now, amidst all the noise, it’s worth pointing out, the reason for this proposed treatment is to reduce the tax advantage for property investment and not full deductions for interest have been allowed. But the income from a capital gain has often not been taxed.
So the question that then arises is, should a deduction for interest be allowed for at the time of sale if the sale is taxable – or what we call on revenue account. As in that case, all the income from investing in the property is taxed.
Now, just as an aside on this, the terminology of revenue and capital account causes some confusion. It was interesting last week when I was presenting to the Employers Manufacturers Association and the New Zealand Chinese Building Industry Association that there was obvious confusion in the audience around the terminology of revenue and capital account.
The short answer is that land held on revenue account will be taxed on sale. So, for example, that would be properties purchased with the intention of disposal or acquired for the purposes of business relating to land such as development. It gets a little bit more confusing with the bright-line test because property is taxed under the bright-line test, become held on revenue account only once it is known that they will be sold within the bright-line period. Prior to that point they’re not held on revenue account.
Otherwise, the discussion document in Chapter 5 at paragraph 5.8 goes into some detail about what the types of properties which will be deemed to be held on revenue account and therefore taxable, but for the purpose of the interest limitation rules that the question the discussion document wants to address given that we are denying deductions from 1 October, what do we do when a property is sold, which is taxable, i.e. was held on revenue account?
Four Options are proposed. Option A deductions are denied in full. Option B interest deductions are allowed at the point of sale and under that option it would be possible for excess deductions to be offset against other income.
For example, Annette buys a house for $1 million, three years later, she sells it for $1.2 million. The house was used as a residential rental property for the whole period. Over the three years, she incurred $300,000 of accumulated interest deductions.
Under Option B she would be able to deduct $200,000 dollars against the taxable liability arising from the sale of property in the year of sale. The remaining $100,000 could be offset against other income for the year, resulting in net taxable reduction of $100,000 available to her.
Now, what the discussion document points out, and this is a problem Inland Revenue is going to have to think carefully about, is if Annette sold that property on capital account, say it wasn’t subject to bright-line test, she wouldn’t get a deduction for the interest. And that means that she has an incentive to say that she’s selling on revenue account. So, this deferred interest deduction Option sets up a tension within the new rules, which is inevitably going to lead to quite a lot of discussions between Inland Revenue and taxpayers about transactions. Anyway, that’s Option B; interest is deductible at the point of sale, and any excess can be offset against other income.
Option C allows a deduction for the accumulated interest at the point of sale, but only enough that it does not give rise to a gain or loss. So, in Annette’s case of $300,000 of accumulated interest and a taxable gain of $200,000, only $200,000 of the accumulated interest is allowed as a deduction in the year of sale. The excess $100,000 would be forfeited.
Option D is a variation on this. It says the $200,000 is allowed at the point of sale and the excess $100,000 would be ring fenced and carried forward under the ring-fencing rules for offset against property income.
Now, as mentioned above, there is this ongoing tension that this whole provision will create between sales on revenue account where interest becomes deductible and selling on capital account where interest is non-deductible. The discussion document then does consider whether some interest should be allowed for sales made on capital account.
Under Option E, no deductions would be allowed. And the paper describes this as not allowing any interest deductions as a rough offset for the benefit of the capital gains not being taxed. And it goes on to note “this would have the strongest impact on reducing investor demand for residential property”. So that’s bound to be attractive to the Government given its intentions behind the policy.
Alternatively, Option F is that no deductions are allowed up to the amount of the untaxed gain, but any excess becomes deductible. This is an economic return argument. For example, Ray sells a residential rental property for untaxed gain of $200,000, but had incurred $150,000 dollars of interest, which had been disallowed for the period the property was rented. In that case, no interest deduction would be allowed, and they’ve completely forfeited.
If, on the other hand, the untaxed gain was still $200,000, but $250,000 of interest had been disallowed, Option F would allow a deduction of $50,000 for the excess interest over the gain.
So there’s a bit of detail here. I’m pretty certain people will want to see an interest deduction at the time of sale come in. And obviously the most generous option would be Option B.
The discussion document is asking for feedback on which of these proposals should apply and they’re all set out in Chapter 5. It’s reasonably readable, there’s just a lot of it. But I’d still urge everyone to have a read and make submissions as appropriate. And remember, the deadline for submissions is 12th July.
Now, moving on, we’re still dealing with a pandemic, and on that point, as of Thursday, 1st July, a Resurgence Support Payment became available for those in the Wellington and greater Wellington area affected by the move to level two. Inland Revenue has opened applications for this Resurgence Support Payment and applications are open for the rest of July.
Now, at the same time, Inland Revenue has released an Interpretation Statement IS 21/4 on the income tax and GST deductions for businesses disrupted by the Covid-19 pandemic.
What this interpretation statement does is consider whether a business can claim an income tax deduction for expenditure or loss incurred when the businesses downscaled or stopped operating because of the pandemic. It also looks at GST implications of those events.
Generally, an income tax deduction will usually be allowed where a business has downscaled or ceased operating temporarily, provided no capital expenditure restriction under the Income Tax Act would apply.
However, a deduction will usually be disallowed where the business has completely ceased, even if it is possible that the business may restart later. And it gives an example of an English language school where they terminate the lease. The view taken by the Interpretation Statement is in those circumstances the business had ceased and from that point onwards, deductions are going to be restricted.
Now in determining whether a business has ceased operating temporarily or permanently it’s a question of fact, and the Interpretation Statement looks to the nature of those activities carried on and the business’s intention in engaging in those activities.
Coming back to this English language school example when it’s operating all its enrolled students are from overseas. Then it must close because the country went to Alert Level 4 and it remained closed until Alert Level 2. What the example provides is that for the period during Level 4 lockdown, because there was an intention to operate once the lockdown was over, all deductions for expenditure incurred during this period would be allowed, such as rent rates, power, water, insurance, etc.
Likewise, GST input tax deductions would be allowable. Now, on GST, what the Interpretation Statement points out is if a GST registered person ceases to carry on a taxable activity they may be required to deregister for GST and then they’d be liable to pay output tax on the value of goods and services used in the business at the time of de-registration.
But generally speaking, if businesses have been affected by the pandemic, but had the intention to try and carry on trading, they should be okay on income tax deductions and GST input claims. But if they reached a point where they basically have stopped, issues around deductibility and availability of input, tax claims and GST registration will need to be addressed.
International tax reform – 15% or 21%?
And finally this week, 130 countries and jurisdictions have signed up for a new Two Pillar plan to reform international tax rules and ensure that multinational enterprises pay a fair share of tax wherever they operate. There’s been a statement signed establishing a new framework for international tax reform. There’s a small group of nine of nine jurisdictions that have not yet signed the statement.
And the remaining elements of this framework and how it’ll be implemented will be finalised in October. One of the key things that they’ve signed up to is Pillar Two, which seeks to put a floor on competition over corporate income tax through an introduction of a global minimum corporate tax rate.
And the proposal is that the minimum tax rate will be at least 15%. The estimate is that that’s going to generate about USD150 billion in additional global tax revenues annually.
And Pillar One, which deals with taxing rights, will mean about another USD100 billion of profit to be reallocated to market jurisdictions.
Now, our government will be watching this with interest, but in the past, we’ve discussed whether in fact this may have a significant impact for the Government’s finances, but still it’s progress. We’re still waiting to see whether this global minimum tax rate will settle at 15%. The US, as I’ve described previously, wants 21%. But it’s a question of wait and see. And as always, we’ll bring you developments as they happen.
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 ka kite āno!
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
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.