Craig Macalister, director of tax at the New Zealand Institute of Chartered Accounts, talks to Sybrand van Schalkwyk about the changes to the LAQC rules.
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A transcript of the podcast follows.
Sybrand: I am Sybrand van Schalkwyk and thank you for tuning into this podcast on the LAQC changes. Craig Macalister, tax director with the Institute of Chartered Accountants, who joins me today, is busy preparing for the nationwide road show on these changes. Hopefully you can all make it to one of these sessions, but if you can’t, this podcast should give you a broad understanding of the practical issues surrounding the changes.
Just one point to note, this discussion is not intended as legal or any other kind of advice but merely as a general guide.
Sybrand: Craig, perhaps to get us warmed up, can you give a brief history of the QC & LAQC regime and why we have it?
Craig: Interesting enough, Sybrand, QC rules go back to the changes that were made in our tax law in 1985, when changes were made to ensure that the dividends paid from capital reserves were actually paid as taxable amounts rather than flowing out as capital reserves, and following that change it then become awkward for people to find a suitable vehicle that they could continue to get limited liability, but still continue to allow them to get their capital gains out tax free.
Following the back of that a qualifying company regime was developed as a solution that gave limited liability for investors and continue to flow through the capital gains tax free to the shareholders, so that was a very flexible vehicle in that regard.
Loss attributing qualifying companies were essentially just a variant on the qualifying company which essentially allowed a limited liability treatment for a tax position that was treated analogous to a partnership, so again a very flexible vehicle.
And I suppose that all happened in around 1992-1993 and since that time, of course, we have seen the use of these vehicles very much for investment, particularly in housing, and they have also been common for people looking at investing in certain other schemes and arrangements, which the government I think was concerned would give rise to tax outcomes that they prefer not to see, so the decision has finally been taken to remove the ability to claim losses through these LAQC structures.
Of course, that was hinted when they did the reform of the partnership rules a couple of years ago now and it was hinted there that they were going to look at removing the ability to pass losses through LAQCs and of course now I see that it has come up in the 2010 Budget.
Sybrand: Okay. Yes, as you mentioned, so the 2010 Budget then announces that QC and LAQC regimes will be reviewed. So where exactly are we with this process?
Craig: Well, the government have announced, and of course we have now seen the legislation on the back of that announcement that – and it is relevant, of course – we have also seen the discussion document – the announcement was initially that both qualifying companies and loss attributing companies would go and be replaced with a vehicle known as a look through company – or that gets abbreviated to LTC – so that was the initial proposal.
And since that time, submissions were called and people have made their submissions. On the back of that the government have released legislation back to the people that made submissions on the discussion document. People have made their submissions back on that legislation, so the legislation is currently going through the process of being fine-tuned. It will be introduced by way of a Supplementary Order Paper to the August tax bill, which is the GST (Remedial Matters) Bill, and we understand that currently that has been reported back from the Finance and Expenditure Select Committee to the House, so we would anticipate that the Supplementary Order Paper containing the legislative changes, for qualifying and loss attributing companies and the like, probably won’t be too far away from being introduced in the House. And then, of course, as we understand it the Bill is likely to be passed in mid-December this year.
And of course, by introducing a Supplementary Order Paper there is no real public consultation on it so, in effect, the ability to make submissions on a discussion document and the input that we have been able to provide on the draft legislation is effectively a surrogate means of going through the public consultation process that would normally be undertaken at a finance and expenditure level.
Sybrand: Okay. So we obviously do not have final legislation but we have legislation that is probably, for all intents and purposes, just about final?
Craig: Yes. When you read it there are some technical issues that arise with it that do need fine tuning but the Government has been very clear to say that the key policy decisions are not going to change, so while there may be some technical changes in the legislation, the key framework of that legislation will pretty much stay much as it is at the moment. So I think it will be a reliable sort of guide for people looking at it to try and determine which way they move from here.
Sybrand: Great. Well, that leads straight on to our next question, and that is a question that I want to make a bit practical. What I want to talk about is what people should be thinking about doing – maybe if we use an example, and I am trying to use an example for the greatest number of people that would be affected by these changes. Say we had a mum and dad investor and they had their LAQC. They only had one rental property in that LAQC and they have lost the ability to depreciate that rental property, so it is likely that this company will be profit making. Say they bought it in 2006 for $300,000; it is now worth $350,000. They do not really want to sell the house; they want to carry on with this investment as sort of a nest egg for their retirement.
Now, they are going to be thinking, “Well, what shall we do? Shall we do anything? Shall we move to this new flow through company or shall we just sit still and stay with what we are?
Maybe if you can talk us through what their options are and maybe it will become clear what to do after that.
Craig: Sure. The default position really for people with qualifying companies, unless they are concerned about continuing to benefit personally from the losses, the default position really is no action required. In other words, do nothing. If they have an existing qualifying company, they can continue with that qualifying company. In other words, they will be grand parented into the old qualifying rules. The Government has signalled that they intend, within a two year period, to review the dividend rules for closely held companies with a view to devising a set of rules that will take over from the qualifying company rules.
But as we understand it, and as yet there is much work to be done in this area, but as we understand it the rules will continue to allow capital gains to come out tax free. However, of course, you cannot really predict the outcome of any review but that is the way we understand it.
So if they sit tight and do nothing, particularly if the property, given the removal of the ability to claim depreciation on the building, is likely to be making a profit, then the tax in the company is 28 cents in the dollar so they would probably be wise just to stick with the qualifying company rules in the interim.
Craig: However, if on the other hand the company – the properties that comprise the assets of a company have been making losses, then the issue really is the value of those losses to the owners. And in looking at that they will have to sit down and ensure that they remove the depreciation from the mix so that they are looking at the new environment going forward from the 2012 year, that is, post 1 April 2011 when the depreciation goes. So if they are still making losses in the absence of the ability to claim the depreciation, then those people have to sit down and decide whether or not a) whether to continue to have those losses available to them and b) do they still want to continue with a company type of structure.
So in making that decision, and looking at the value of those losses to the shareholders – and I suppose that the other point that people need to take into that mix when you are looking at that, is of course company tax is essentially at 28 cents in the dollar, so in deciding, well, do I really want to have my losses continuing to flow through to me or not, if you say you opt to do nothing, even though you have currently got an LAQC, then it will revert to QC rules, so essentially you still have the company as before; it just won’t have the ability to bring the losses home into your own name.
Bear in mind that once that starts making profits, it is taxed at 28 cents in the dollar. Now, if you decide that you do want to continue to have those losses flow through to you, then your option really is to switch to the new look through company rules, or you can opt to move to either a general partnership, or a limited partnership, or essentially take it back out into the shareholders’ own names or a sole trader status as they have referred to in the legislation.
But because there are up sides and down sides to doing that. So, as I say, the crossroads where people need to start making a decision is they need to start analysing what the value of those losses are to them in terms of the current here and now, in deciding whether or not they want to possibly just leave those losses sitting in the company to shelter future income arising in that company and then any future profits of course will then continue to be taxed at 28 cents in the dollar, or whether they want to take them out now.
Now, if they want to take them out now, as I said, they have got two options: 1) go with the look through company rules, or 2) go with either a general partnership, a limited partnership, or a sole trader. So let us look at the scenario if they want to go through a look through company, or an LTC, as the legislation called that. So if they want to go to an LTC, an LTC – essentially it will retain its company status, so for all intents and purposes, it will still be a company, but for tax purposes it will be taxed much like a general partnership.
So as I said earlier, there are up sides and down sides to that sort of tax type or entity type, and the big one really being if there is any movement of what would be shareholders, but essentially it taxes partners under the new rules because it is going to crystallise the sale or disposal of the underlying assets of that entity. So if you have got three shareholders currently in your loss attributing qualifying company and you move to a look through company, and one of those shareholders departs, then effectively you have got to dispose of one third of the assets of that company, and there are a number of rules that you have to go through to look at whether or not there is a tax situation arising out of that.
Sybrand: And that will just be for tax purposes, so from a general law perspective – I suppose from a general law perspective all that will happen is you have got this company that used to have three shareholders and now has two so you won’t need to update titles or anything like that?
Craig: Absolutely right. It continues on much as it was – the same legal entity as it was before; it just has a different tax fiction overlaying the tax treatment of that. So in that way that’s a good thing. But the tax considerations and the tax configurations of this entity are changed completely and there are underlying compliance costs associated with that. Now there are of course some elections that need to be made within certain key times in order to do that and people need to be aware of those election timeframes.
So the other thing with the look through company rules as well is that there is a loss limitation rule that accompanies those rules and that loss limitation rule is, again, borrowed from the partnership rules, or more specifically the limited partnership rules. And essentially what that is looking at is it is trying to cap the amount of the loss that the individual shareholders can claim to the amount of capital or skin in the game effectively that they have in that investment.
So in other words if they capitalised a company with $10,000 per partner then what the law is trying to cap the amount of loss that that person can take out of that LTC to $10,000 and that is called the owner’s basis. That amount can fluctuate. The formula that calculates that looks at the amount of the investment in, it looks at any income derived by the company, and then subtracts any deductions that have been claimed that flow through from that company, and any money that’s been pulled out of that company.
So the owner’s basis will fluctuate from year to year, so for example if you put more capital in, then that would increase and allow you to claim a loss to that extent, or to the extent that any additional investment raises the owner’s basis. So for example, we were talking before about putting $10,000 in each, if each of the partners put in another $5,000 the owner’s basis would move from $10,000 to $15,000.
Sybrand: Craig, can I ask, if you have a shareholder that has guaranteed the liabilities of the company, does that count as skin in the game?
Criag: It does indeed. And in the context of the LTC rules, any loans that the shareholders have made to the company will count, as well as any current account balances in credit with the company will count also.
Sybrand: So seeing as most of these one owner LAQCs, the bank will mostly say the shareholders should guarantee the loan, we are always going to end up with a situation where you have got a personal guarantee by the shareholder over the assets of the company and so there is a huge amount of loss that essentially can flow through to the shareholders. So the loss limitation rule will not have such a big impact on the flow through of losses. Is that correct?
Craig: That is correct. It may well be that life pretty much carries on as before for many of these entities.
Sybrand: Okay. Well, I am sure that is good news for most people.
Craig: I suppose there are going to be extra compliance costs involved because people are actually going to have to undertake these calculations and just check that their guarantee meets the requirements of the formula that is set out for the calculation of the loss limitation rules. But providing that people can tick all of those boxes, then it may well be that life just carries on as per what we have currently. But there are little hidden anomalies with these rules and it does pay to check the detail because, for example, if you have two shareholders in one company and one of those shareholders sells their shares, then that is effectively treated as a revocation of the look through status of that company altogether, which then crystallises the deemed disposal of all the assets and so on.
And so some of the detail of these rules does need to be understood by practitioners and by taxpayers to make sure that they don’t unnecessarily trip themselves up in the way they go about their business. But assuming they have no issues there then they will pretty much be able to carry on and pass their losses out as before.
Sybrand: Is there going to be a grace period like, for example the elections for QC status you have got 62 days before you lose out?
Craig: There is a 31-day grace period with revocation if there is a new owner that comes in within that period and takes over that shareholder’s shares.
Sybrand: Yes, sorry, I know that that’s one issue that I know a few people have been tripped up by is electing in and out of the QC rules and from a practical perspective it is quite a difficult thing to keep track of, and it is easy to miss. And the consequence of missing it is just dire. So that means there will be a grace period.
Craig: There is a grace period. Of course, the anomalous situation that arises is potentially one that an exiting shareholder could effectively hold the other shareholders to ransom because if they want to exit or sell their shares then you get this effective deemed revocation and deemed disposal situation going on. So, the other shareholders will of course then have to be prepared to step into the breach and acquire those shares to ensure that the election carries on as before, or at least if they are not prepared to do that then people need to understand the consequences of that.
Sybrand: This could be a situation in matrimonial disputes where you often have the husband and wife as the shareholders in the company and then things break down and if one wanted to they could just sell their shares and cause that election to be revoked all of a sudden. So it is something to watch out for.
Craig: That is probably the most likely scenario. There are, of course, rules for matrimonial property agreements and the like and the interaction between those rules and these rules is not that clear. But if you could bring the shares within the matrimonial property agreement rules and the Act, then it may well be that the remaining owners can continue to have held those shares from the time they are required by the exiting partner. But the relationship between these rules and those rules is not that clear yet.
Sybrand: Okay. Craig, we are running out of time. Were there a few points that you want to make in summary?
Craig: Well, the other flexibility that these rules give you is to transfer to being a general partnership, limited partnership or sole trader status. Now, that may be an option for somebody who simply decides, “Look, I want out of having a company; I don’t need a company; I’m familiar with the general partnership rules; or I am happy to own the property in my own name”, and there are some transitional rules that effectively allow them to transition out of the qualifying company rules during this transitional period. So that’s an option people may want to consider as well. That would give them the benefit of continuing to keep the losses in their own name and also disposing of or walking away from the company structure for tax purposes. So that’s potentially a very good option for some people. Again a lot of it might depend on people’s personal circumstances, however, unlike going to an LTC there is actually a change in the physical entity type that holds this investment. So if you move to a general partnership then you are no longer in a limited liability company. It may be necessary to do a proper sale and purchase agreement across, lenders may have to be notified, and all those commercial issues you would consider selling property from one entity to another. This may complicate things a little bit. There is a six month window that people can elect if they want to transfer from the QC regime into a partnership structure or sole trader structure. So they can make that election within six months post 1 April 2011, and they have the whole year effectively to make that transition across. But when they do so they are expected to either liquidate the company or have it registered as a non-active company under the Financial Reporting Act, and they then have to pick up the ownership structure in a partnership and continue on as before. So there is a little bit more involved in moving from a partnership or a limited partnership or a sole trader ship than there is in moving to a look through company. But I think the default is really, in my view, that people need to look at the value of the losses in their own name, and if they are not too concerned about that then I think that the easiest solution, or the default solution is to stick with the qualifying company rules which still provide a very good vehicle, still allow people to get their capital gains out tax free. There is the uncertainty of the review of the dividend rules for closely held companies and how that is going to impact on them. We don’t know that for certain, but it would be very unlikely that the Government would seek to change the law to start taxing those distributions of capital through a qualifying company.
Sybrand: Thanks Craig. I found the discussion very interesting and I look forward to 1 December, the date of the road show in Christchurch. Hope the road show goes well, and that you have a successful outcome for you and the other presenters.
Craig: Thanks Sybrand. We have already started on the road show, we are in Auckland today. I am not delivering the presentation, as I am talking to you. We are going around the rest of the North Island the rest of this week and the South Island the following week we finish of in New Plymouth, Wanganui and Palmerston North. For people who do not manage to attend one of the Institute’s training sessions there are other road shows available. There are some in February next year. From the Institute’s point of view we are very keen to get people up to speed with these changes now because there is an awful lot of stuff people need to be familiar with, there is an awful lot of change going through in the GST space which takes effect from 1 April next year as well, that’s the zero rating of land transactions, which needs to be understood, and it is probably pretty critically important as that comes in from 1 April. As well as that there is also the changes to the definition of family income in the working for families environment as well, and that is going to have to be understood. So there is an awful lot of thinking for practitioners to do between now and next year.
Craig Macalister is the Director of Tax at the New Zealand Institute of Chartered Accountants. Craig can be contacted on email@example.com.