Terry Baucher assesses the IRD's proposal for a big stick to counter top tax rate avoidance, potential tax changes make a difference to the cost of living, and what you should do to get ready for tax year end

Last week I mentioned that Inland Revenue had released a discussion document, Dividend Integrity and Personal Services Income Attribution, which set out its proposals for measures to limit the ability of individuals to avoid the 39% or 33% personal income tax rate through use of a company structure. This is what we call integrity measures designed to support the integrity of the tax system. In this case, the proposals are to support the objective of the increase in the top tax rate to 39% and to counter attempts to avoid that rate by diverting income through to entities taxed at a lower rate.

Now this paper is pretty detailed and runs to 54 pages. There’s a lot in here which will get tax agents and consultants sitting upright and reading the fine print as in some cases they will be affected directly. It's actually the first of potentially three tranches in this area. Tranches two and three will consider the question of trust, integrity and company income retention issues, and finally integrity issues with the taxation of portfolio investment income. And the reason for the last one is that portfolio investment entity income is taxed at the maximum prescribed investor rate of 28%, which is undoubtedly attractive to taxpayers with income which is now taxed at the maximum tax rate of 39%.

The Inland Revenue discussion document has three proposals. Firstly, that any sale of shares in the company by the controlling shareholder be treated as giving rise to a dividend for that shareholder to the extent the company and its subsidiaries has retained earnings.

Secondly, companies should be required on a prospective basis, i.e. from a future date, to maintain a record of their available subscribed capital and net capital gains. These can then be more easily and accurately calculated at the time of any share cancellation or liquidation. That's a relatively uncontroversial proposal.

And thirdly, the so-called “80% one buyer test” for the personal services attribution rule be removed. This one will probably cause a bit of a stir.

The document begins by explaining these measures are required to support the 39% tax rate. There's a lot of very interesting detail in this discussion, for example it notes that with the top tax rate of 39%, the gap between this and the company tax rate of 28% at 11 percentage points is actually smaller than the gap in most OECD countries.

But then, as the document says, “However, New Zealand is particularly vulnerable to a gap between the company tax rate and the top personal tax rate because of the absence of a general tax on capital gains.”

And so to repeat a long running theme of these podcasts, this lack of coverage of the capital gains has unintended consequences throughout the tax system. And this question of dealing with this arbitrage opportunity between differing tax rates is, in essence, a by-product of that.

As Inland Revenue notes, one answer would be to align the company, personal and trust tax rates. This was the case until 1999, when the rate was 33% for companies, individuals and for trusts. But this ended on 1 April 2000 when the individual top rate went up to 39%. And since then, the company income tax rate has fallen to 28%.

So this is a matter which needs to be addressed. There’s a really interesting graph illustrating the distribution of taxable income and noting there’s a huge spike at around $70,000, where the tax rate rises to 33%.

Taxable income distribution: PAYE and non-PAYE income
(year ended 31 March 2020)

There's also some interesting data around what high wealth individuals pay in tax. For the 2018 income year, Inland Revenue calculated the 350 richest individuals in New Zealand paid $26 million in tax.  Meanwhile the 8,468 companies and 1,867 trusts they controlled, paid a further $639 million and $102 million in tax respectively, indicating a significant amount of income earned through lower rate entities.  

It appears to Inland Revenue that tax is being deferred through retention of dividends in companies.

The opportunity in New Zealand is that a sale of the shares under current legislation would bypass the potential liability on distribution. The shareholder is basically able to convert what would be income if it was distributed to him or her, to a capital gain. And clearly, the Government wants to put an end to that, but can't because it doesn't have a capital gains tax.  The discussion document therefore proposes that any sale of shares in the company will be deemed to give rise to a dividend.  This will trigger a tax liability for the shareholder.

The paper goes into detail around this particular issue, and I think this is going to be quite controversial. Because although I could see a measure where a controlling shareholder sells shares to a related party such as, for example, someone holding shares personally sells them to a trust or to a holding company, which they control. You could see straight away that Inland Revenue could counter this by arguing it's tax avoidance.

But the matter gets more complicated where third parties are involved. And this is where I think the rules are going to cause some consternation because it proposes transactions involving third parties would also be subject to this rule. That, I think is where most pushback will come in on this position.  Without getting into a lot of detail on this there could be genuine commercial transactions resulting in some might say is a de facto capital gains tax.

The proposal is not all bad. If a dividend is triggered, then the company will receive a credit to what is called its available subscribed capital, ie, its share capital, which can later be distributed essentially tax free.

In making its proposals, the paper looks at what happens in Australia, the Netherlands and Japan and draws on some ideas from there. It's interesting to see Inland Revenue looking at overseas examples.  All three of those jurisdictions, to my knowledge, have capital gains tax as well, but they still have these integrity measures.

But the key point is this question that any sale, will trigger a dividend. There’s no de-minimis proposed. This could disadvantage a company trying to expand by bringing in new shareholders. It might have to use cash reserves it wants to keep to pay the withholding tax on the deemed dividend.  The potentially adverse tax consequences for its shareholders might hinder that expansion. I expect there will be a fair degree of pushback as a lot of thought will go into responding to this proposal.  It will be interesting to see exactly what comes back.

Cleaning up tracking accounts

Less controversial and something probably overdue, is the proposal for what they call tracking accounts to cover the question of a company's available subscribed capital, and the available capital distribution amounts realised from capital gains. Both of these may be distributed tax free either on liquidation or in a share cancellation in the case of available subscribed capital. But the requirement for companies to track this is rather limited, and these are very complicated transactions.

As the paper points out, the definition of ‘available subscribed capital’ runs to 40 subsections and 2820 words. So, there's a lot of detail to work through, and if companies haven't kept up their records on this, then confusion may arise if, say, 10 years down the track they're looking to either liquidate or make a share cancellation.

I don't see this proposal causing much controversy. I think Inland Revenue's proposals here are fair and probably something that should have been done a long time ago. They will apply on a prospective basis, as I mentioned earlier on.

Personal services income attribution - a 50% rule?

And then finally, the third part deals with personal services income attribution.  And what this part does is picking up the principles from the Penny and Hooper decision.  This was the tax case involving two orthopaedic surgeons, which ruled on the tax avoidance issues arising from the last time the tax rate was increased to 39%.

The discussion document is basically trying to codify that decision.  The intention is to put an end to people attempting to use what you might call interposed entities, lower rate entities, to avoid paying tax personally. The particular issue it's driving at is when an individual, referred to as a working person, performs personal services and is associated with an entity, a company usually, that provides those personal services to a third person, the buyer.

Inland Revenue is now looking at a fundamental redesign of this personal service attribution rule, which was designed to capture employment like situations. It was really designed where contractors might be providing services to basically one customer (the ‘80% one buyer rule’) and in effect, they were employees.  However, they could potentially avoid tax obligations by making use of an interposed entity with a lower tax rate.

Inland Revenue thinks that 80% rule is too narrow. The proposal is to broaden its application and by doing so it can at the same time deal with the issue that arose with the Penny and Hooper case.

Under current legislation, Bill is an accountant who is the sole employee and shareholder of his company A-plus Accounting Limited. The company pays tax at 28% on income from accounting services provided to clients and pays Bill a salary of $70,000, just below the 33% threshold. Any residual profits are either retained in the company or made available to Bill as loans.

The proposal is to remove that 80% one buyer rule and so that now Bill's net income for the year, if it exceeds $70,000 will all be attributed to him where 80% of the services sold by that company are provided by Bill.  Sole practitioners and smaller accounting firms and tax agents will find themselves in the gun. In fact, the discussion document suggests maybe this threshold of 80% should be lowered to 50%.

Now, you might think that the bigger issue is not the 33% threshold at $70,000, but the $180,000 threshold, so why do we want such a low threshold for this rule to apply? The discussion document points to the evidence that shows that there is income deferral going on. It appears to be at the $70,000 threshold (see the graph above) and wants to put an end to that.

So that's a more detailed look at what is a very important paper. It's likely to generate quite a lot of controversy and feedback from accountants and other tax specialists. It's also another part in the long running tale of the implications of not having a capital gains tax. But certainly, this one will run and run. Submissions are now open and will run through until 29th April. I expect all the major accounting bodies and firms will be responding.

Using tax to mitigate cost of living impacts

Moving on briefly, there's been a lot to talk about what tax changes could be done to help the increased cost of living. And Daniel Dunkley ran through some of the proposals.

One idea that pops up regularly is the question of removing GST from food. My view, which I expressed to Daniel and is also probably that of most tax specialists, is that this would undermine the integrity of GST, because we don't have any exemptions on that. 

I also don't think it would achieve the objective that is hoped for. There is, regardless of what people might say, an administrative cost to splitting out tax rates, having zero rate for food and standard rate for other household goods in your shopping trolley. And that differential, that cost involved, will be passed on to customers.

So the full effect of the GST decrease will never flow through to customers. To be perfectly frank; supermarkets and operators will play the margins around this. I suggest you have a look at what's happened with the fuel excise cut. It was 25 cents, but in every case did the pump price fall by 25 cents? And how could you tell because prices move around so much?

As I said to Daniel, and has been a longstanding view of mine, if the issue is getting money to people who have not enough money, give them more money. The Welfare Expert Advisory Group was staunch when it said that there was a desperate need to raise benefits. We also saw how the temporary JobSeeker rate was increased when COVID first hit. So, this issue of increasing benefits hasn't gone away.

The best position would not be to tinker with the tax system. You could perhaps look at tax thresholds, definitely, but they still would not be as effective as giving people an extra $30-40 or more cash in hand.

End of year preparations

And finally, the end of the tax year is fast approaching, so there's plenty of tax issues that you might want to get done before 31st March. A key one to think about is if you're going to enter the look through company regime, you need to get the election in before the start of the tax year. In some situations you might have more of a bit of a grace period for dropping out of the regime, as part of the Government’s response to the Omicron variant. But it you are electing to join the regime, I suggest you file the election on or before 31st March.

Coming back to companies and shareholders another important issue is the current accounts of the shareholders. You should check to see if any shareholder has an overdrawn current account (that is more drawings than earnings). If so, then either see about paying a dividend or a salary to clear that negative balance, although of course, you're up against the issue of the higher tax rate I discussed earlier. If that's not possible, charge interest at the prescribed fringe benefit tax rate of 4.5%.

Companies may have made loan advances to other companies, look at those carefully because you may need to charge interest there to avoid what we call a deemed dividend.

Another very important matter is if there are any bad debts. If so, then consider writing them off before 31st March in order to claim a deduction. And then if you're thinking about bringing forward expenditure to claim deductions such on depreciation, then do so.

Companies should check their imputation credit accounts balances and make sure these are positive. There are mechanisms through tax pooling to manage this problem if you miss a negative balance.

Well, that's it for this week. I’m Terry Baucher and you can find this podcast on my website www.baucher.tax 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, ka pai te wiki, have a great week.

Terry Baucher is an Auckland-based tax specialist with 25 years experience. He works with individuals and entities who have complex tax issues. Prior to starting his own business, he spent six years with one of the "Big Four' accountancy firms including a period advising Australian businesses how to do business in New Zealand. You can contact him here.