Terry Baucher looks at the tax unexpected tax implications for New Zealand residents who own British property in the time of Brexit; and the new focus of the IRD and what to expect from them

This week, Brexit and the tax headaches from a falling pound, the Government's tax policy work program is announced, and 15 years ago.

Brexit has dominated British politics since the upset referendum result three years ago. It's personal for me because I was born in Northern Ireland. And my brother John, lives in Belfast. The Troubles began 50 years ago this month. I actually remember soldiers coming onto the street. I am therefore personally very disconcerted to see armed police wandering around with their Bushmasters. Not something I'd take as a normal view in society. And Brexit threatens the stability of the Good Friday Agreement. Talking with John, Northern Ireland is rather more unsettled than people might realise. To borrow a phrase that Gerry Adams used, "They haven't gone away you know."

Leaving aside the politics, Brexit has caused quite some consternation for two groups of investors. Those with investments in British sterling because they will be caught under the foreign investment fund rules, and the exchange rate fluctuations will reduce their returns.

The group though that probably has a bigger issue or headache with the Brexit and the implications, and it's a fairly substantial number, are those who are renting out property in the UK. And in particular if they have mortgages because the mortgages are subject to the financial arrangements rules.

Now the financial arrangements rules are one of the sets of rules within the tax act. They've been around for a long time. They were actually first introduced in 1986. But they're not at all well known. And they are so complicated that Inland Revenue doesn't actually have a specific pamphlet that you can go to and read all about them.

Now the financial arrangements rules are also referred to as the accrual rules. And that is because they calculate income on an accrual basis. They're actually a conceptually pure, tax regime. They tax the entire economic return over the life of the instrument. Now why they apply in relation to mortgages because mortgages are classified as financial arrangements. And Brexit has had the good effect for some people, for those mortgages, of reducing the amount of the value of, in New Zealand, dollars of the mortgage.

Now under the financial arrangements regime, and basic economics, you've made an economic gain there. If your liability at the start the year was in New Zealand dollars, say $250,000, and thanks to Sterling's fall, it is reduced to $230,000, you are $20,000 better off. Now for most people, the cash basis rules will mean that this doesn't normally become a problem until the mortgage is redeemed. At which point you get the unusual scenario, for many people, that the gain on the sale of the property is not taxed, but the gain in repaying the mortgage is. Welcome to my world.

That's something that has been well known for some time, or at least within the tax community. However, what people should be watchful of is that the financial arrangements rules have a trigger point that if the movement on an accruals basis is more $40,000 then you must calculate on an arising base, or an accrual basis. Hence the name accrual rules. And what that means is that, as we saw back in 2016-17 tax year, and we saw again this year, if Sterling falls, people's liabilities diminish rather rapidly. And they then get faced with an unrealized Forex gain on their mortgages.

So people should be watching this very carefully because they may inadvertently fall into the financial arrangements regime and be liable for tax. The unexpectedly high cut in the OCR, official cash rate, on Wednesday has eased pressure. Because I notice that Sterling has come back, or has gained against the dollar. One of the expected side effects of that cut. But people should be alert, particularly anyone running mortgages of into six figures. You could potentially be sitting on unrealized financial arrangement for Forex gains which are taxable, and you're into the provisional tax regime, or terminal tax.

People also, as an aside, should be aware that if they have a UK investment property, and they're paying interest in the UK, they are still liable for non-resident withholding tax on the interest payments on that. I had heard Inland Revenue realized that that was a rather unacceptable compliance burden. But to date, have seen nothing that makes a change to those rules. So be aware that that is happening. Inland Revenue has been running programmes to review people's compliance obligations in respect to non-resident withholding tax.

What the IRD is working on

Moving on. The Government released its updated 2019-20 tax policy work programme. Now this is a regular event that sets out what tax policy areas are going to be worked on which will lead to eventual legislation and changes. The last one was released in May 2018, but nothing had happened since then. And the delay being in fact because of the Tax Working Group’s report in February, and the Government's response in April. So, the tax policy work programme had to be updated. What was released yesterday will cover the next 18 months. And there's a lot to cover in here. Too much for one podcast. We'll just pick out the interesting ones over the next few weeks.

There are 11 areas marked out in the tax policy work programme, which ties into the Government's focus on productivity, growth, and wellbeing as outlined in the Budget. So, there's several work streams, and there are six that are given regarded as key areas.

Firstly land. Policy work will continue looking at the review of the current land rules, particularly in relation to investment property and speculation, land banking, and vacant land. Unsurprisingly, enforcement of the current tax rules will also be a priority, and we're seeing that. One of the measures you may recall is that now everyone has to provide an IRD number in respect of any sale of property. That's tied into making sure the bright line test is enforced.

Business tax is another work stream. They're looking at a number of items in this area including the tax treatment of spending on innovation, inquiry, looking to reduce compliance costs for businesses, feasibility and blackhole expenditure. That is capital expenditure that is not otherwise deductible is on the agenda which is good to hear.

That was also a matter that we covered in the Small Business Council. I can't say more than that at this stage, but we delivered the report to the Minister of Small Business, Stuart Nash, also the Minister of Revenue last week. It was received quite well to be honest, which is good to hear.

So a number of items that could be in this business area that could be looked at, would be quite apart from reducing compliance costs, seismic strengthening, the treatment of seismic strengthening. This is a grey area at all. Is this expenditure deductible? Or if it's not, it's therefore no deduction available. So, should we be looking at reintroducing depreciation, which was something the Tax Working Group suggested. There's also, I note here that they are looking at the previously mentioned financial arrangement issues.

In International tax, there's already a lot going on in this space, including the question about possible digital services tax. And the note here is that Government's preference is a multilateral approach through the OECD. Infrastructure. This is an interesting area which is examining whether the tax system is actually hindering or could have a role in driving infrastructure investment.

Exemptions and charities. Now this is something that has generated a bit of commentary. Many of the submissions that the Tax Working Group received were on the question of what was going on around with charities. There's a project going underway at the moment, and it will include a report to Ministers before the end of this year to address recommendations of the Tax Working Group which was let's have a careful look at this just to see which charities are actually distributing, and what is being distributed.

So another report will also look at other matters that could affect policy change. For example, the imputation credit refundability rules for donating trading stock, removing out of date concessions. Sort of minor bits and pieces on this. And the interesting one here is perhaps the tax rules for mutuals, and the $1,000 not for profit deduction threshold.

There's an enormous amount to cover in this tax policy work programme. We'll pick up bits and pieces as we go through. There are 11 areas that were outlined, which were land, business, infrastructure, information collection and use, business transformation, remedial reforms. That's tidying up little loose ends here and there. Social policy including the Government response to the Welfare Expert Advisory Group.

Who misses out ...

I'm not seeing anything here that is working on the question of trying to manage the interaction of tax on social assistance policy, and the very high effective marginal tax rates.  These are the people, receiving social assistance, have the highest effective marginal tax rates in the country. In some cases, they can reach 100%.

The environment, the sustainable economy. That is something that I mentioned before. You may recall an excellent podcast I had with Marjan van den Belt on the matter.

There's a lot of work here which is what you'd expect.  I'd hope they've got enough resources in Tax Policy for all of this. And that, as part of the Business Transformation, they have been given the resources to work through what's a fairly crunchy amount of policy work.

And by the way, even if it was a change in Government, much of this would be happening anyway. There may be a different emphasis, but much of what's in these tax policy work programmes would be there in any case. They're almost apolitical issues.

Now that's probably because our tax policy settings, broadly politically speaking, have been mutually agreed. There are obviously things around tax rates and thresholds that you can see political differences. But broadly speaking part, the parties are relatively aligned on the shape of the tax system, and how it should be run.

An anniversary

And finally, 15 years ago this week, I opened the doors of Baucher Consulting Limited. So, it's been an interesting 15 years. Looking back on it, 15 years ago, the top individual tax rate was 39% on income over $60,000. The first $38,000 was taxed at 19.5%. Trusts and companies were taxed at 33%. There was no KiwiSaver. There was no such thing as the Portfolio Investment Entity Regime. There was a Foreign Investment Fund Regime, but actually, that was one of the big changes that happened beginning from 1st of April, 2007 when the new Foreign Investment Fund Regime was introduced.

Since then, the other big change I would say is around the international response to the Global Financial Crisis, and the Common Reporting Standards and the American FATCA, Foreign Account Tax Compliance Act. The amount of information now that's swapped internationally is extraordinary. And it shows no sign of changing, in fact, it's incredibly important. That's been a huge change. And you saw we can see perhaps the end of the tax havens, or their secrecy as certainly been undermined by the advent of the Common Reporting Standards.

So been a very interesting 15 years. I'd like to take this opportunity to thank the very many people who believed in me over that time and special shout outs to my first ever client who is still with me, Danny's Real Pita Bread. Still the best Pita Bread in Auckland. David Chaston and Gareth Vaughan of www.interest.co.nz  for giving me a voice. The rest of the team at Baucher Consulting, Eric, Judith and Darren, and my wife Tina. Thank you all.

This article is a transcript of the August 9 edition of The Week In Tax, a podcast by Terry Baucher. This transcript is here with permission. You can also listen below.