Time to rethink how we tax residential property investment?
The latest draft guidance for taxing crypto assets, and the latest tax audit claim stats from Accountancy Insurance
- Rethinking the taxation of property
- Inland Revenue releases latest crypto advice
- Inland Revenue audit activity
In the wake of the government’s shock property tax announcements back in March, Inland Revenue has been preparing the relevant discussion documents and papers for consultation.
The range of matters to be addressed is formidable. What represents residential accommodation? What is the definition of a new build? How do we determine what proportion of a mixed-use loan can be deductible? What about the treatment of interest treated as non-deductible for a property, the sale of which is taxable under the Bright-line test or some other provision? Do we still need loss ring-fencing? The list goes on.
It’s a long and frankly daunting list, the inescapable conclusion of which is that no matter how hard Inland Revenue tries, and I know they are trying to make it as simple as possible, the tax treatment of residential property will ultimately be vastly more complex.
And that’s before you add matters such as preparing for climate change mitigation, earthquake strengthening costs, leaky building repairs and costs relating healthy home standards.
It’s no wonder some residential property investors are considering selling up completely or downsizing their investments.
And watching all this, I’ve been increasingly coming round to the view that maybe it is time to rethink completely how we tax residential rental investment property.
And maybe instead of trying to shoehorn the proposed changes into the existing tax framework we should go back to the basics and adopt the approach that was considered by the last Tax Working Group, but ultimately rejected in favour of a comprehensive capital gains tax. And that is taxing property on a deemed return basis.
Now, what the Tax Working Group looked at is replacing the existing taxation approach on rental income and instead determining taxable income based on the net equity at the beginning of the tax year, applying a rate of return, and taxing this amount at the investors relevant tax rate.
So, for example, Tina owns a residential rental investment property worth one million dollars at the beginning of the income year. That’s funded with 300,000 dollars of debt giving equity of $700,000. Tina’s marginal rate is 33%. The deemed rate of return is set at 3.5%.
Tina’s tax bill for the year would be $8,085 dollars, i.e. $700,000 – that’s the net equity – times the deemed rate of return of 3.5% times her marginal rate of 33% percent. She would not pay any tax on the actual rental income she derives from that property.
Now, this deemed rate of return is an idea has been around for some time. It was first suggested by the Mcleod Tax Review in 2001 when they referred to it as the Risk-Free Rate of Return. This was subsequently adopted for the Foreign Investment Fund (FIF) regime, which came into place with effect from 1st April 2007. The FIF regime has what they call the fair dividend rate, which was set back then at 5% and remains at that level today.
Although hugely controversial, and not terribly popular on its introduction, we’ve all learned to work with the FIF regime and the fair dividend rate. It has its merits in terms of conceptual simplicity. Also for investors, if your return exceeds 5%, your taxable income is capped at 5%. So that’s a win. It does away with the need for distinctions between what is capital and revenue.
And it would take into account some of those factors I mentioned earlier on. The devaluation of a property because it’s found to be a leaky home, or it has climate mitigation risks. Alternatively, the costs of earthquake strengthening would improve the value of the asset. The value of the building will rise therefore the Government benefits and it doesn’t need to worry about the questions we’re seeing right now that I mentioned right at the top of the podcast.
Now, it so happened that myself and Professor Susan St John talked about this particular proposal on a broader aspect at a Fabian Society presentation we made last week. And the more I think about the issue, we saw a change of approach as perhaps an answer to dealing with the housing crisis or a tax answer because ultimately the answers to the housing crisis are multiple and obviously include more supply. But tackling the demand side from the tax perspective was one area where we thought it was worth considering.
I deal with these issues as clients come to me with what are we going to do in this circumstance and that circumstance? And as I drill down into the detail of the impact of the reforms, I cannot help but wonder that it is time to have a really good look at what the Tax Working Group proposed and maybe think about adopting that, rather than trying to shoehorn existing concepts into an increasingly strained tax system.
The Tax Working Group also did some revenue impacts on their proposal. They were quite interesting, in that they figured that for the year ended 31st March 2022 – which is the first year this could have come into place – if they had applied a 3.5% rate of return, the Government would have raised close to one billion dollars.
Now that was ahead of the expected amount of revenue that could have been raised under the capital gains tax proposal that the Tax Working Group actually finished up running with. Just for comparison, in the first year, the expected capital gains that would have come out under the Tax Working Groups proposal across all the asset classes was about $400 million and was roughly $50 million in respect of residential rental investment and second homes.
So the deemed return approach – which Susan and I decided to call “fair economic return”, would have been a better fundraiser for the Government initially. It’s something that we won’t see obviously in the coming budget. But I think it is something that policymakers should have a serious think about, because from what I’m seeing and hearing from discussions around how the new tax proposals are going to work, we’re heading for an incredible degree of complexity and we’re going to expect that complexity to be negotiated by people who are probably not, in all honesty, the most sophisticated of investors and do not have access to the best quality advice. It’s actually a recipe for tax pitfalls, not just for investors, but also for those who are advising them.
Taxing crypto gains
Moving on, the recent jump in house prices has had widespread ramifications, as we’ve been discussing, but in terms of rapid growth, it’s been far outstripped by the extraordinary rise in the market capitalisation of cryptoassets. The market capitalisation of virtual currencies has gone from US$354 billion in September 2020 to just under US $.8 trillion dollars at the start of April.
So it’s quite timely then that Inland Revenue has issued some guidance for consultation on a couple of matters which are in the cryptoassets world. These are draft questions we’ve been asked, and the first one is on the income tax treatment of cryptoassets received from an airdrop, and the second one is, I need to be careful how I pronounce this, the tax treatment of cryptoassets received from a hard fork.
Questions about the tax treatment of these two particular events have been raised for some time.
Now, as I’ve said previously, the pace of change in the cryptoassets world is quite extraordinary and that’s been enhanced by the volume of money that’s going into it, as evidenced by the dramatic increase in market capitalisations. So Inland Revenue’s original advice that they would consider most proceeds realised from the disposal of cryptoassets to be taxable, has been shifting.
But what happens in these peculiar events?
So an air drop is a distribution of tokens without compensation, i.e. for free, generally undertaken with a view to increasing awareness of a new token and to increase liquidity in the early stages of a new token project. So, for example, they might use it to increase the supply of a cryptoasset in the market, reward early investors or users, or just simply raise awareness of that cryptoasset by distributing it to holders of other cryptoassets.
Inland Revenue’s view of what happens here is that if someone receives an airdrop cryptoasset it’s taxable if they have a cryptoassets business or acquired the cryptoasset as part of a profit-making undertaking or scheme, provided services to receive the airdrop, and critically, the cryptoassets are clearly payment for those services, or receive air drops on a regular basis, and the receipt has hallmarks of income. In other cases, however, it’s not taxable.
Obviously, people who are mining for cryptoassets or running an exchange will be caught. If they receive airdrop cryptoassets, they’ll be taxable on that airdrop. But the argument now will arise for someone who’s what you may call “an investor”, who has been holding these assets for some time. They receive these airdrops randomly or they’ve been holding other assets. The argument might be that in those cases, the receipt of the airdropping cryptoassets, won’t be taxable.
What about if you sell an air dropped cryptoasset? Again, it’s taxable if the person has a cryptoassets business, they dispose of it as part of the profit-making undertaking or scheme or providing services to receive the airdrop or acquired cryptoassets for the purpose of disposing of them.
in relation to cryptoassets received from a hard fork, similar considerations apply. Now a hard fork is something that changes the protocol code to create a new version of the block chain along the old version. Then creating a new token which operates under the rules of the amended protocol, while the original token continues to operate under the existing protocol. I appreciate this is all very nerdy speak.
But for example, in July 2017 there was a hard fork of Bitcoin that saw the creation of the Bitcoin cash token alongside Bitcoin itself.
If you receive cryptoassets as part of a hard fork, again, Inland Revenue’s arguments are it will be taxable if someone holds the cryptoassets as part of a cryptoassets business or acquired the cryptoassets as part of a profit-making undertaking or scheme. And similarly, if they dispose of cryptoassets received after a hard fork, they will be taxable if the person has a cryptoassets business, disposed of them as part of a profit-making undertaking or scheme, acquired those cryptoassets for the purpose of disposing them, or acquire the original cryptoassets for the purpose of disposing of them. For example, the person received new cryptoassets through an exchange.
There are quite detailed rules on this so it’s going to pay to work through these issues carefully. But Inland Revenue is steadily expanding on the advice it’s giving on cryptoassets, which is good to see.
Consultation on these two items run through till 25th of May. The principles as applied here seem reasonable at first sight, but obviously when you drill down into them you might think maybe we want to tweak what Inland Revenue is saying.
But as I said earlier, if you’re a cryptoassets investor and you’re holding a lot of cryptoassets as an investment, as part of a general portfolio, you’re probably now in a stronger position to argue that air drops and hard forks are not necessarily taxable.
Inland Revenue audit claims rise +30%
And finally, you may recall that last year I spoke with the accountancy insurance provider Accountancy Insurance. They’ve just released some information about the latest tax audit claims for the year ended 31st March 2021. What they said is they saw policy claims increase 31% in the 2020-2021 financial year compared with the previous 2019-2021 financial year.
So what happened here is that Inland Revenue is clearly still active in reviewing taxpayers despite Covid-19 and the various disruptions that caused. Accountancy Insurance noted that GST verification claim activity increased by 48% year on year and income tax related claim activity increased by 67% percent over the 12 months to March 2021.
Now, apparently, what drove those income tax claims were two specific projects, which we’ve discussed beforehand here, that Inland Revenue started in late 2020; a Bright-line test property initiative and another initiative on the automatic exchange of financial account information under the common reporting standards.
Interestingly only about 5% of claims related to rental property, employer obligations and other matters. Only just over 1.3% of claims related to full scale audits with just under 10% were what we call client risk reviews. But 55% of all claims made related to GST verification and just under 28% relates to income tax returns.
So, this comes out just as interesting news has just started to break that apparently Inland Revenue is going through another round of restructuring and reducing its audits investigation staff. I find it strange that they’re doing that at the time when they clearly can ramp up their activity. But this Accountancy Insurance report shows is that Inland Revenue is not dead or resting, but is still very active in this space. And you should expect that if you file a GST return with a significant GST refund claim, it will be subject to some scrutiny.
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.