Capital Hill

Accounting and Bookkeeping Services

Tax Planning before 1 April 2017

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For most taxpayers, 31 March represents the end of the financial year. In the lead up to ‘year-end’ there are a number of actions that business owners may want to take to avoid missing the boat on simple tax planning opportunities.

Trading stock: stock can be valued at the lower of cost and market selling value (“MSV”), and generally it will be beneficial to use a lower MSV where possible. But to use MSV you must have evidence that this represents the market value of the specific stock items at or about balance date. The IRD have indicated that suitable evidence includes independent or internal valuations by suitably qualified persons of the price of goods and actual sales for a reasonable period before and/or after balance date.

Accruals and provisions: a tax deduction should be available if you are definitively committed to an expense at year end and can reliably estimate the amount. Ensure all expenditure is captured and accrued to minimise the amount of taxable income. One exception is employee related accruals that are tax deductible if they are incurred and are paid within 63 days after balance date (so by 6 June); consider paying any staff bonuses by then to gain a current year tax deduction.

Bad debts: to be tax deductible bad debts must be actually written off before year end – it’s no good booking the journals after balance date as part of your year-end accounts preparation. There also needs to be evidence that the debt was considered “bad” (e.g. review of accounts receivable, debt-enforcement notices and other actions taken).

Assets: if you are planning on buying any depreciable assets (e.g. plant and equipment), a full month’s depreciation can be claimed in the month of purchase, so it may be worth buying replacement assets just before 31 March.

Relevant to companies only:

Charitable donations: in order to claim a donation deduction, it needs to be paid in cash before 31 March. The amount of the donation is limited to the amount of a company’s net income in the absence of the donation. Hence, if a company has made a loss it might be beneficial to push the payment into the next year.

Shareholder current accounts: if a company is owed money by shareholders, consider paying commercially justifiable shareholder-employee salaries or paying a dividend to settle the debts.  If not done, there may be fringe benefit tax or deemed dividend issues.

Imputation Credit Account (ICA) balance: ensure the imputation credit account does not have a debit balance at 31 March, otherwise penalties will be incurred. If the ICA may be in debit, consider a making a voluntary provisional tax payment before 31 March.

When is Income from Professional Services Derived?

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The Inland Revenue Department (IRD) recently released a new interpretation statement discussing when income from professional services is considered to be derived, and hence becomes taxable. The statement replaces several older IRD Information Bulletin’s and consolidates their view, giving greater detail and more examples.

There are two main methods of recognising income, the accruals basis, which taxes income when earned and the cash basis, which taxes income when physically received.

Most businesses use the accruals basis, however professional services providers may be able to apply the cash basis. Historically, both doctors and barristers could use the cash basis because doctors could not create a lien over patients’ property, whilst barristers were unable to sue their clients for unpaid fees.

The IRD’s interpretation statement provides that the cash basis is not exclusively for these professions and can be applied in other circumstances. Similarly, there may be occasions where the accruals basis may be more appropriate for doctors and barristers. The statement draws on a vast body of case law and lists the following factors to help determine the most appropriate method:

The type of activity: the cash basis might be appropriate where the level of expenditure does not have a material effect on the income derived or there is a high risk of non-collectable income.

The characteristics of the type of income: the cash basis might be appropriate where there is a low expectation of payment inherent in the type of income, or where the timing of receipts are governed by legislation.

Legal and regulatory environment: standard contractual obligations may require payment at specific times, and hence it might be more appropriate to return the income on a cash basis.

Scale of the business or income earning activity: the larger the number of employees, the turnover and general size of a business will indicate the accruals basis should be adopted.

The level of sophistication or complexity of an activity: if a professional services activity requires fixed or circulating capital and accounts for trade receivables on a balance sheet, the accruals basis may be more appropriate.

The IRD provide the example of where the Court held that a pathology practice with five partners, 66 nursing staff across 21 collection centres, approximately 92,000 patients annually and gross fees of $2m per annum should apply the accruals basis. The Court held that the scale of the operation and the fact that a substantial amount of the work to derive the income was performed by nurses and not solely the taxpayer made the accruals basis more appropriate.

Conversely, the Courts determined that a solicitor who worked alone with only the assistance of a secretary should account for income on a cash basis. The size of the practice and the majority of the work being undertaken solely by the taxpayer influenced the outcome.

Use of the cash basis is relatively rare in today’s modern environment, it dates back to paper based accounting records, before modern software simplified the accounting process. However, the IRD’s statement does acknowledge that there are still situations where it is appropriate to recognise income on a cash basis.

Importance of Good Record Keeping

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A recent case Taxation Review Authority (TRA) decision has highlighted the importance of good record keeping.

The taxpayer, an accountant, was accused by Inland Revenue (IRD) of using a company as a vehicle to create a tax advantage. He claimed to have sold his sole trade accountancy practice to his own company for $2m in 2002. The company did not have the ‘cash’ to purchase the business, and hence a loan was recognised to the company. Later, in 2007, his family trust purchased a family beach house for $1.3m. To fund the purchase of the beach house, the company borrowed from the bank to repay the debt it owed to him and he lent the funds to the trust.

The IRD did not dispute that the 2002 sale took place, however they argued that the sale price was just $425,000, creating a much smaller loan. On this approach, recognition of the $2m loan to the accountant triggered a taxable dividend for the difference.

Given the facts of the case, it is not surprising IRD were suspicious of the transaction.

Originally, the accountant was unable to produce a sale and purchase agreement evidencing the transaction. When eventually he did, IRD referred the agreement to a document examiner who found a number of irregularities, based on which the IRD concluded the document was a fabrication. The accountant’s explanation for the irregularities were that he had used a client’s sale and purchase agreement, that he had ‘twinked’ out the details and hand written in his own changes.

At the time of the transaction, the company’s 2002 financial statements only recorded a goodwill value for the purchase of the business of $425k. According to the accountant, the original value of $425k was recorded in the financial statements so that his wife did not know the true value of the business (the marriage later broke down). Then In 2003 the goodwill was written off. Over the course of the 2006 and 2007 years, the goodwill and loans were recorded back up to $2m.

The accountant advised the reason for the increase was to improve the standing of the company before a review by the accountant’s professional body. The taxpayer prepared three different sets of financial statements for the 2007 year before arriving at the final version.

The accountant claimed a reversing journal in his accounting software showed an original figure of $2m. IRD contended that this entry had not been made until 2008, after the purchase of the beach house. However, an accounting software expert called by the IRD, confirmed journals cannot be entered into prior years because they are effectively “frozen”.

IRDs final argument was that $2m was a vast overstatement of the value of the accountancy practice in 2002, for which they had the support of an independent valuer. Again, the taxpayer was able to explain in detail how he arrived at his calculation. He accepted the valuation may have been ‘over-enthusiastic’.

Notwithstanding the poor record keeping, unhelpful facts and the arguments put forward by the IRD, the TRA found in favour of the accountant. Accepting the sale was genuine, the price was what was paid by the company and therefore the repayment of the debt was not a taxable dividend. If the accountant had clear and accurate documentation from the outset, the court case and associated costs might have been avoided.

Trust Reforms

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Trusts are a popular way of protecting property and managing assets in New Zealand. The number of trusts we have in New Zealand is unknown, but estimates put the figure between 300,000 and 500,000.

The legislation governing NZ trusts has remained unchanged for decades as it has been predominantly governed by the Trustee Act 1956. The Act has been criticised for allowing the mismanagement of trusts with no easy legal redress for beneficiaries, however this is set to change. The legal framework has been subject to an in-depth review by the Law Commission, with the Trusts Act 2017 released in draft late last year, followed by ongoing consultation.

The draft bill seeks to clarify core trust concepts, resulting in a more useful piece of legislation that can be applied to fix practical problems and reduce the costs associated with trust administration. This will effectively impose ‘minimum standards’ for the governance of trusts so that trustees and beneficiaries are clear on their precise obligations, duties and rights.

The draft Bill features seven key proposed reforms that vary in nature from clarifying the key features of a trust, to detailing the duties and powers of trustees.

Under the new Act, trustees will be required to know the terms of the trust and act in accordance with them, act honestly and in good faith, to act for the benefit of the beneficiaries and to exercise their powers for a proper purpose. There are a further eleven default duties that apply, unless they are modified or excluded by the terms of an individual trust deed. The default duties cover areas such as the requirement to invest prudently, avoid conflicts of interest and to act for no reward. The formalisation of Trustee duties will provide protection to beneficiaries that assets will be dealt with in their best interests, and provide legal remedies if trustees fail to meet these standards. The Act also requires trustees to disclose certain information to beneficiaries who are reasonably likely to receive property under a trust.

It will be important for all trustees to understand the new law and their individual trust deeds, to ensure they discharge their duties with the appropriate standard of skill and care.

No changes to the tax treatment of trusts are proposed. However, there is additional focus on trusts from a tax perspective following the recent “Panama Papers” scandal and the alleged misuse of NZ foreign trusts, which has resulted in a Government led investigation into whether existing disclosure rules are adequate. In response, the Government is beefing up the requirements for foreign trusts in three key areas; registration, disclosure, and annual filing. The proposed changes will require all foreign trusts to formally register with the IRD and be subject to an increased number of disclosure requirements, with sanctions for non-compliance with the new rules.

To some degree, the new Act serves to codify existing case law and current best practice, bringing a degree of consistency to New Zealand’s trust regime. Ideally, this will reduce the frequency with which disputes end up before the courts and benefit all beneficiaries, which is ultimately what a trust is designed for.

 

Is your business cyber safe?

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Technology and change is prevalent across all areas, right through from the supply chain to the customer. Computers are no longer isolated assets; complex cloud based systems allow all areas of an organisation to be truly digital.

Although this can have many benefits, an increased digital presence, combined with the expansion of mobile technology, is exposing businesses to risks; particularly where there has been the rapid introduction of new technologies to keep pace with competitors. As a result, businesses can often lack awareness of the true extent of their digital footprint and cyber-crime is unfortunately on the increase.

Whilst organisations are often aware of the cyber security and privacy threat, a recent survey (Global State of Information Security 2016) found that NZ businesses’ investment in cyber security measures are lagging behind that of comparable economies. Only 17% of NZ digital businesses currently have an internet security policy in place compared to 39% of Australian businesses. Similarly, just 20.5% of NZ businesses surveyed have aligned cyber security spending with business revenue, compared to an overwhelming 63% of global businesses.

There is a further risk that NZ industries may be losing out to global competitors due to a lack of investment in digital security. The EU, South Korea, Hong Kong and Singapore have all introduced comprehensive new data protection regulations. By comparison, NZ has a lack of mandatory reporting obligations for data breaches, which means our businesses may be unprepared to operate in global markets. Although security measures and policies are not currently compulsory here, companies looking to expand cannot afford to neglect the issue.

As every organisation uses digital technology and the internet to different degrees, context is key and a personalised approach specific to the business needs to be taken.

However it is of paramount importance that thought is given to implementing IT security strategies; as a security failure could result in catastrophic damage to the business on a reputational level and severely damage customer relationships.

In the event of a data breach, the business is no longer seen as a victim, but as someone who has not taken sufficient care over data provided to them. It is therefore recommended that:

  • cyber security measures are built into new digital initiatives as they are being developed,
  • businesses increase their investment into more advanced tools for detection of potential cyber attacks, and
  • policies are put in place to respond swiftly to any security breach, as reassurance to all stakeholders and to avoid reputational damage.

In-house IT teams may no longer have the expertise to keep up with the ever changing cyber-threat – outsourced expertise may need to be sought to provide a more cost effective and efficient solution.

How do we now treat feasibility expenditure?

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A recent Supreme Court decision, Trustpower Limited v Commissioner of Inland Revenue (IRD), has drastically changed how New Zealand businesses should treat feasibility expenditure for tax purposes.

Feasibility expenditure is a term used to refer to expenses incurred in the course of determining whether to acquire an asset; to some degree, such expenditure is incurred by all businesses. Until now, feasibility expenditure has generally been treated as tax deductible up until the point that a decision is made to acquire a particular asset. This is known as the ‘commitment approach’.

In the Trustpower case, the company had incurred expenditure to acquire resource consents prior to deciding whether to commit to potential power generation projects. The expenditure was treated as deductible feasibility expenditure under the commitment approach, however this was disregarded by the Court.

Instead, the expenditure was held to be non-deductible on the basis that the underlying projects were capital in nature. The Court reasoned that the projects could not proceed without the resource consents and thus represented tangible progress toward their completion.

The Supreme Court conceded that a deduction for feasibility expenditure may still be allowed for early stage work, but only limited guidance was provided regarding when expenses should be deductible. It was acknowledged that a deduction would be allowed for:

  • “feasibility assessments which are so preliminary in nature that they cannot sensibly be seen as directed to the acquisition of an asset of an enduring character”;
  • “…early stage feasibility assessments may be deductible. Such assessments can be seen as a normal incident of business”;
  • “Expenditure which is not directed towards a specific project or which is so preliminary as not to be directed towards the advancement of such a project …”

The decision of the Supreme Court was contrary to IRD’s own Interpretation Statement on feasibility expenditure, hence IRD is now updating its statement. The draft statement has summarised the IRD’s interpretation of the case:

“… in the Commissioner’s view, expenditure is likely to be deductible in accordance with the Supreme Court decision if it is a normal incident of the taxpayer’s business and it satisfies one of the following:

  • the expenditure is not directed towards a specific capital project; or
  • the expenditure is so preliminary as not to be directed towards materially advancing a specific capital project – or, put another way, the expenditure is not directed towards making tangible progress on a specific capital project.”

Business expansion and growth is good for the economy, the country, employers and employees.

As a result of the Supreme Court decision, expenditure on feasibility expenditure is now more likely to be non-deductible in most cases. This creates an economic disincentive for businesses to consider the feasibility of new projects and will represent a significant increase to the cost of expansion and growth for New Zealand businesses.

From a broader policy perspective, it does beg the question as to whether Government should step in and legislate the treatment of feasibility expenditure to maintain the status quo.

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