Tax News

How do you solve a problem like dual purpose expenditure?

2 May, 2021 | The Week in Tax

Terry Baucher and John Cantin explore that and other thorny tax issues, and the side-lining of our internationally respected tax consultation process

Transcript

Kia ora koutou katoa, it’s Friday, 30th of April 2021 and welcome to The Week In Tax. I’m Terry Baucher Taxpert and director of Baucher Consulting Ltd., a tax consultancy helping individuals, small businesses and professionals navigate the tax minefield.

My guest this week is John Cantin, a vastly experienced tax partner with KPMG, who probably is one of New Zealand’s leading tax gurus. John has written one of the most astute analysis of the Government’s recent proposal to limit interest deductions that I’ve seen. I recommend you read it because it cuts right through the emotion and gets to the heart of the issue.

Here’s the opening to his post.

“The Government’s decision to deny interest deductions to residential landlords has generated much heat. A particular focus has been its labelling as “closing a loophole”.

Quite clearly current law says interest is deductible for property investors who derive taxable income. (One Twitter commentator quotes the relevant section of the Act). At a technical level, interest deductions are not a loophole.

However, the outrage misses the point.

Simply, (most) voters see a residential landlord deducting interest and making non-taxable gains. In the language of politics, that is a loophole.

“Loophole” is shorthand to describe the policy problem. Voters understand it at this level. (Equally, in the same property context, “Mum and Dad investors” and “speculators” is the language of politics and not tax policy).”

Morena John, thank you for joining us.

John Cantin
Thank you for those kind words of introduction, I appreciate it very much.

Terry Baucher
Not a problem, John, really appreciate you joining us. So what is the policy problem?

John Cantin
The policy problem in a nutshell is how do you deal with dual purpose expenditure. Money that you send out the door that has two purposes. That’s very much the issue with interest on money borrowed to acquire a residential property.

TB
Now, that’s perfectly encapsulated and this is a long-standing problem, as you mentioned in your post, isn’t it?

John Cantin
It has been around for a long time period. And at a technical level, it’s the difference between use and purpose. So the interest deduction rules ask how have you used the money? Whereas when you’re looking at what’s driving the purpose of the interest, that’s a different question.

TB
Indeed, that’s actually a very nice distinction and a proper one to bring in. And so how much of a surprise to you was the Government’s move on this?

John Cantin
Completely out of the blue in the sense that nothing leaked or anything of that nature ahead of time. No indications, to that extent it’s a surprise. But as you say, this issue has been around for a long time. It goes back to some cases that are referred to in my article called Pacific Rendezvous and others.

If you go back to the late 90s, it was also a policy problem of what to do with interest deductibility because of moves by Inland Revenue to state what they thought the law was at the time, which were going to cause practical compliance problems for companies and others. So it does keep raising its head. And you think back to the Muldoon era interest limitation rules and the recovery rules back in the day and in the 80s, it has been around for a long time.

TB
You mentioned the Pacific Rendezvous case, the Court of Appeal decision from 1986. What actually happened in that case?

John Cantin
Relatively simply, it was, if I remember correctly, a motel Terry, and the owners had decided that they wanted to sell the property, but needed to do some, let’s call it refurbishment, redevelopment. They borrowed money, which was helping to let them do that. And they claimed all of the interest because it was used in operating the motel.

Inland Revenue said, well, actually, some of that interest relates to the sale, and you shouldn’t get a deduction for the whole lot. Court of Appeals said it’s all used in running the business, so it’s 100% deductible. So that’s where our use versus purpose question comes in. 100% use means 100% deductible, even if it will have a slightly different outcome as well or serve a different outcome.

TB
That decision in 1986 was right in the middle of the major tax reforms being led by Roger Douglas and Trevor de Cleene. Looking back it seems to me that with all the work going on around that time, it was a very, very clear expectation that the reforms would lead to some form of comprehensive capital taxation, capital gains tax. Call it what you want. Against that background, the Pacific Rendezvouss decision seemed quite logical because it might have been playing in the background of the Court.

But after March 1990, when David Caygill, then Finance Minister, pulled the pin on capital gains tax proposal, that decision reinforced and put in place an anomalous treatment, or loophole which sooner or later would need to be addressed. Would that be a fair assumption of how we’ve got to this position?

John Cantin
I think that the technical response is that the Court made a decision based on use rather than purpose. The Commissioner’s argument wasn’t entirely surprising because the interest deduction is to the extent it’s used, so that that suggests some sort of apportionment.

I’m not sure that the courts actually had in mind that there might be a law change. With the greatest respect, I think, Terry, you might say that our courts are not great tax policy makers. You know, I’ve spent too much time on the Commissioner’s draft update on section BG 1 recently. And they’ve taken 100 odd pages to try and interpret what the Supreme Court said in the Ben Nevis decision. So I’m not sure that our courts are great at tax policy.

Occasionally they will point out errors in the legislation and things that might need to be fixed, but I don’t think they make decisions based on what the policy ought to be. But you’re absolutely right, that context of what was happening in the late 80s and The Consultative Document on the Taxation of Income from Capital, a comprehensive capital gains tax was the direction of travel amongst all of those reforms.

And that would certainly reduce the tension between use and purpose, because ultimately whether it was used in the business or used in the business and seeking a capital gain, well then it didn’t matter. You got a deduction for it – it would have made no difference.

But it hasn’t really been revisited as a particular issue specifically, except for the residential loss ring-fencing, that has the effect of limiting interest deductions, although not just interest, of course. So, some of those measures can be seen as responses to that.

TB
Yes, and that sort of use and purpose is coming back a little bit in these announced changes although we haven’t got much detail to work with at the moment. But there was a hint that if a property was sold, which was subject to tax under either the Bright-line test or some other measure then interest deductions previously denied would become deductible. That seemed to be hinted at in the initial papers released on 23rd March. But that’s also something that’s going to be under consultation, so we’ll see shortly.

I suppose that leads us into this move by the Government which doesn’t really sit well within the Generic Tax Policy Process in that normally there would be a process of consultation, saying we’re thinking about doing this, what are your thoughts and feedback? And then the legislation works through issues papers and then into legislation. But that’s all been shortcutted.

Is that a concern for the Generic Tax Policy Process (GTPP) in general, or is it now dead or merely resting, to borrow a phrase?

John Cantin
Really big questions, Terry. Look, I sort of go back to where the GTPP started in the mid-90s out of Sir Ivor Richardson’s review of Inland Revenue. And a significant driver for that was the reaction to the entertainment tax, amongst others, introduced in the early 90s. That was a National Government changing the business tax rules. And many of its supporters were particularly unhappy about that change even though I suspect something was in the ether.

Richardson recommended the GTPP and I think ministers since have seized on that as a way of depoliticising tax policy, they find it useful to test their thinking. And occasionally they walk back from some of the rules.

But I think we need to remember that the GTPP is essentially political, that relies on the goodwill of ministers, officials and people like you and I actually contributing. I’m reluctant to say it’s either dead or merely resting because the GTPP serves to answer two questions. One is, is this the right tax policy and the second is how best to do it. And that call as to what you consult on will be made by different Governments at different times, in different phases so far.

For example, if I remember correctly, when the GST rate was increased to 15%, there was no consultation on that increase – the first question wasn’t asked. The second question about how best to do it was, and that was what was consulted on. I suspect in this case, asking the first question, the call was made. We’re just going to get a whole lot of people saying, no, don’t do it.

And that’s not really going to advance the process at all. I would have liked to have seen some consultation, because I don’t think 100% denial of a deduction is the right answer either. But we’re in that process now where the detail will be consulted on.

So you have an ability to answer the second question, how best to do it, does it actually meet the policy objective and can it be done better? So I don’t think it’s dead or resting. I think different ministers, different Governments make calls on which of those two questions they want to ask the question of. I have said to others I haven’t stood for any election at all and I doubt I’d get a vote, but those are the people that we voted in to make those calls. So you do have to sort of step back and say, well, that’s their call. They live or die by that every three years. That’s the call they make. And we need to just carry on with it.

TB
That’s a great point you made there, John. About the GTPP you referenced the increase in the GST rate. I think at the same time they that they withdrew depreciation on buildings completely, and repealed the loss attributing qualifying regime. And we got no consultation on either of those points as well. And that was the National Government. So both sides will do it and as you say, politics, that their job depends on it. They will have to make political calls and we basically have to suck it up, putting it crudely, that’s just a fact of life.

John Cantin
It’s a fact of life. I do remember, though, that with those changes to GST and depreciation, LAQCs, there was the Tax Working Group led by Bob Buckle sitting in the background.

So, all of those things were not entirely unpredictable. And there was some measure of floating of those ideas through that tax working group’s report. So, some of that stuff was in the in the ether, as I call it. It wasn’t entirely unpredictable, but decisions are always made politically, often for budget measures where budget secrecy says we’re just going to make a call.

TB
Actually, I must admit, when I started my career in Britain where budget surprises were very frequent, I’ll be honest, sometimes it’s nice to have a wee surprise in the budget, even if you’re scrambling around trying to sort it out afterwards. “What does this mean? Well, we’ll have to tell you.”

There was one thing about the announcement that did surprise me. There was a lack of detail supporting the fiscal costs of the interest deduction measure. That surprised me because landlords are meant to file disclosure forms an IR3R return which has a specific interest disclosure item. What was your view on that?

John Cantin
I think initially surprising. I think part of it suggests that this was, I won’t say necessarily hurried, but a decision that the lead time on was not particularly long. So, not unsurprising in that sense.

But when you do think about it, one of the risks with any estimate here is the final design is unknown at the time of the announcement. There will be discussions on what is a new build, there will be consultation on how you apportion between business and residential property borrowings. There will be rules around interest stacking, as they call it, for companies and other entities or shareholders and other entities.

So, the whole picture potentially is a little muddied, and I think one of the risks is you come out and say, well, it’s worth $600 million, and then when you design it, it’s worth $200 million. That criticism always seems to be played that you got the numbers wrong. So, it might have been better to just say, well, until we’ve got the design sorted, we can’t really tell you how much, I think is probably the real answer here in terms of what’s happening.

TB
It’s as you’re saying, we don’t know how the final form will emerge and all those good questions about what a new bill, what’s the split between business and residential? I mean, what do you think would have been an appropriate policy response in this context?

John Cantin
I’m a Libra Terry, so I’d have gone straight down the middle 50/50.

TB
That’s a fair working hypothesis.  When the announcement was made, I referenced what had happened in the U.K. But this goes further than the U.K. because the U.K. basically restricted the interest deduction to a basic rate of tax, 19%. But what’s proposed here is much more punitive.

John Cantin
I think that that speaks to the difference in the approaches to the tax system. The U.K. does what I call buckets, you know, separates business from other income. You have different tax rules for different streams of income. New Zealanders for a long time simply said it all goes into your taxable income, the expenses are deductible and it’s all one marginal rate. So, I think those are the differences.

The thinking here is quite different in the sense that it doesn’t look at it necessarily in isolation. It all feeds into the one taxable income number with one tax rate at the end, or marginal tax rate. So, I think that’s the driver.

But I think it’s important that you get the base right in the first place, making sure that you are taxing what ought to be taxed, and that’s a fair reflection of what the income is. So, if you go back to the repeal of building depreciation, I’m not sure that anyone was convinced there was no depreciation at all, apart from some officials in Treasury and Inland Revenue back in the day.  They have now retreated from that. But again, we keep working on those base measures to make sure that people are paying tax on what really is income.

TB
That depreciation measure always struck me as a bit strange because the Bob Buckle group did say it was debatable whether it’s proper for residential property, but certainly for commercial property it should be in place.

In relation to the extended bright-line test period, this references a little bit to your point about how the UK approaches taxation, how appropriate is it that gains are taxed at a person’s marginal rate? Should it be a different rate maybe or maybe a person’s average rate over the period the property has been held?

John Cantin
I’ll probably come at that with having listened to officials for too long Terry, is from a framework of this is all income, what you’re really saying is that gain has been accruing over the number of years that you’ve held the property. An economist will say, well, it’s income and should be taxed on an unrealised basis. So, by waiting until you sell it, the Government misses out on the tax it should have collected through all of the years that you held it.

If you sold it year nine, that’s eight years’ worth of gain tax hasn’t been paid on. So if you were to average the rates, then you should probably add an interest factor to that as well to compensate the Government for not having been paid earlier. I know that’s an odd concept because, you know, I haven’t got the income, so why should I pay the tax. But that’s the economist’s view of how income accrues.

Then you start getting into the complications of saying what should the interest rate be and what should the average rate be over those years? From a simplistic perspective, you simply go with the rate that applies in the year the gain is realised.

And of course, the Bright-line test is not the only time we do that. You know, if you happen to get a big bonus in a year that’s out of the ordinary, you still get taxed on that at your marginal rate in that year that you get the bonus. So, it is just one of those features of our system.

TB
It was actually reading about an ACC claim that had been denied and then she got a lump sum payment, which was then taxed at rates well above what would have been her normal rate, that prompted me to ask that question. That’s always struck me as an anomalous treatment in that context. But as you say, it’s built it into the system and that’s the way it stands.

John Cantin
Sometimes we should ask the questions of whether that should be the answer. And it sort of comes back to the article Terry. I think the loophole language is unfortunate and the defence of it in the sense that you can claim the interest deduction I don’t think answers the question because the question is, should you have that interest deduction even though the current law says you can?

And I think you should always be asking the question, albeit you can’t ask it every time of all the thousand odd sections that we have. Is it still the right answer? And as the world changes our answer might change as well.

TB
Well, that seems a very good place to leave it John. I really appreciate you coming on and talking with me. Thank you for being our guest and have a great day.

John Cantin
Thanks very much, Terry. Appreciate it.

TB
That’s it for today. I’m Terry Baucher. And you can find this podcast on my website, website www.baucher.tax or wherever you get your podcasts. Thank you for listening. And please send me your feedback and tell your friends and clients until next week, ka kite āno.