Business interruption due to Covid-19

The onset of the Covid-19 pandemic had an immediate impact on businesses nationwide. Lockdowns and the border closure have caused massive disruption. For many this was temporary, for some, permanent.

Inland Revenue has released a draft Interpretation Statement “Income tax and GST – deductions for businesses disrupted by Covid-19 pandemic”. The statement sets out Inland Revenue’s ‘draft’ view on to what extent businesses can claim tax deductions for expenditure incurred whilst impacted by Covid-19. The deadline for comment is 28 May 2021.

Within the draft document, Inland Revenue first covers the technical principles governing whether an expense is deductible or not and then covers a number of examples to demonstrate how the principles apply in practice. It appears Inland Revenue is taking a hard line.

Broadly, an expense is deductible if it is incurred to derive assessable income or in the course of carrying on a business. The leading case on whether a business exists was decided by the Court of Appeal in Grieve v CIR (1984). Inland Revenue revisits the principles of that case and outlines: whether a business exists or not is based on a two-fold assessment as to the nature of the activities carried on and the intention of the taxpayer in engaging in those activities. The end result being that if a business does not exist, then expenditure that is incurred post-cessation is non-deductible.

Whether a business has ceased is determined by the facts in each scenario and the nature of activities that continue to be carried on. The example is provided of a small international tourism business that has had to stop making sales while the borders are closed. To minimise costs it holds $100,000 of stock at its warehouse, which the owner visits weekly to maintain, he checks emails daily for new orders and continues to pay a security guard service to monitor and patrol the building. Inland Revenue take the view that “it is no longer possible to make a profit in the current climate” and that the pattern of activity, commitment of time and effort etc. do not suggest an existence of a business. A different interpretation could suggest that a business continues to operate as resources, time, money and effort, remain committed with the view to profit in the future.

There appears to be a lack of acknowledgement by Inland Revenue that the current global situation created by Covid-19 is more likely to be temporary than permanent and therefore if a business has not literally closed its doors, the owners will be doing everything possible to reopen once life returns to normal. As stated in Grieve:

The legislation sensibly allows for deductions and allowances to be claimed even where the overall result is a trading loss. It is not for the Courts or the Commissioner to confine the recognition of businesses to those that are always profitable or to do so only so long as they operate at a profit.

Inland Revenue also makes no allowance for whether the expense has been incurred to derive income in the future, nor how the need for the expense arose. For example, Australian case law supports the view that if the obligation to incur an expense arose as part of operating a business, it continues to be deductible after the business has ceased, e.g. interest on debt.

In the past Inland Revenue has cast doubt on whether the New Zealand courts would take a similar view. However, that uncertainty appears to have now been squashed.

Penalising R&M

Classifying expenditure as either deductible repairs and maintenance (R&M) or non-deductible capital expenditure is not clear cut. It is a question of fact and no two situations are the same. But it is advantageous from a tax perspective to classify as much expenditure as possible as R&M, which gives rise to the risk of pushing ‘the line’ too far. There isn’t a rigid test to be applied, but the courts have identified a two-stage approach for determining the nature of the expenditure and whether it comprises R&M:

  1. Identify the relevant asset being repaired or worked on.
  2. Consider the nature and extent of the work done to that asset.

Repair and maintenance of assets can be achieved in several ways. For example, the asset may simply be patched up or it could be restored to “as new” condition or substantial parts of the asset may be replaced. If the expenditure results in the reconstruction, replacement or renewal of the asset it is likely to be capital expenditure. Whereas, expenditure incurred to repair or maintain the asset to its original condition is generally deductible in the year it is incurred. If the expenditure creates a substantially new or improved asset, then it is likely to be capital.

A recent Taxation Review Authority case (TRA 015/19 [2020]) is one such example and serves to highlight the risk of getting it wrong.

The taxpayer in the TRA case incurred $680k carrying out works at two adjacent properties. Of this, R&M deductions of over $408k were claimed. The expenditure related to alterations to a building used as a bar and restaurant. Two building consent applications reflected the floor area of the relevant building would increase from 250m2 to 592m2 and described the work as the addition of a covered veranda and extra toilets. A fire consultant’s report described the work as internal refurbishment and the creation of an external dining and recreation area that included the construction of trellis and PVC roofing. The taxpayer tried to argue the work comprised two separate projects that could be apportioned between R&M versus capital expenditure.

The TRA disagreed with the taxpayer and took the view it was one capital project to extend and modernise the building and could not be apportioned. The TRA also considered the question of whether the taxpayer was liable for a shortfall penalty, which are charged based on the circumstances and the severity of the actions by the taxpayer. The TRA commented: “…the position taken by the disputant lacked any particular merit.”

Accordingly, a shortfall penalty for ‘unacceptable interpretation’ was imposed, subject to a 50% reduction for good behaviour.

There are five categories of penalty that can apply to a ‘tax shortfall’ on a graduated scale, specifically:

  • 20% for not taking a reasonable tax position,
  • 20% for taking an unacceptable tax position,
  • 40% for gross carelessness,
  • 100% for taking an abusive tax position, and
  • 150% in the case of tax evasion or similar.

In practice, some discretion is exercised by Inland Revenue when deciding whether a shortfall penalty is charged and what type. However, in cases like this where a taxpayer is pushing the line too far, a penalty is more likely than not.

Employment recovery

Over a year on from NZ’s level four lockdown, businesses and communities alike have experienced their fair share of highs and lows. Many have had to rapidly adapt to the Covid-19 induced restrictions. For some, they have benefited from unpredictable productivity gains, meanwhile others have struggled to regain pre-pandemic momentum. Employment levels slumped to an eight year low in September 2020, with over 150,000 unemployed people. So nearly six months on, how does the job market stack up now?

Statistics released by Seek NZ reveal that March 2021 saw the highest number of jobs ever advertised on the site. Listings for jobs were up 11% on the prior month and up 55% on March 2020. Every region in NZ saw listings increase, with Bay of Plenty, Otago and the West Coast experiencing the largest growth (22%).

Perhaps in response to the expectation of a NZ / AU travel bubble, hospitality and tourism showed one of the most significant increases, with listings up 32% compared with February. Retail and consumer products followed closely behind with a 29% increase.

Trade Me Jobs paints a similar picture with over 70k jobs listed for the quarter ending 31 March 2021, representing a 22% increase in Q1 compared to prior year. The sectors with the largest year-on-year increase were automotive (50%), construction and roading (43%), and manufacturing and operations (40%). Although prior year figures may show signs of the economic uncertainty first felt from Covid-19, the Q1 figures for 2021 still exceed those of Q1 of 2019 (up 15%) and Q4 of 2020 (29%).

Interestingly, despite the increase in job listings, Seek NZ data shows that applications per job are actually down.

With an abundance of listings, job hopefuls should feel optimistic that their career or job search is looking up. However, employers may be feeling the pressure to find the right fit. It is not uncommon for hiring managers to have post hire regrets when they find their new hire is not fit for the role, and this inevitably comes at a cost.

New Zealand employers have cited increased stress on colleagues, increased workload for existing team members and increased stress on managers as the three top consequences of a bad hire. However, the ripple effect doesn’t stop there with lost productivity, higher recruitment costs and low staff morale also arising as a result of recruiting the wrong person.

Despite the above, the current state of the job market shows positive signs for NZ’s ongoing recovery in response to Covid-19. A resurgence in listings for hospitality and tourism provides a spark of optimism for a sector which has been hit particularly hard.

Government addresses housing affordability

On the 23rd March 2021 the Government announced that it would make a number of changes to the taxation of residential property to address housing affordability. Legislation has been enacted implementing some of the announced changes, whilst the balance is to be consulted upon before further legislation is drafted.

Legislated changes – The bright-line test taxes the sale of residential property if it is sold within a prescribed period of time, subject to specific exclusions such as for the family home and farmland. The new legislation prescribes that a residential property acquired on or after 27 March 2021 will be subject to a 10 year bright-line test, i.e. if it is disposed within 10 years of acquisition (generally the date a binding sale and purchase agreement is entered into) any capital gain will be subject to income tax. For transactions part way through completion as at 27 March 2021, guidance has been released by Inland Revenue to assist in determining whether the new 10-year period applies or not.

The exclusion for the ‘main home’ has also been modified. Under the old rules, the bright-line test applied on an all or nothing basis, i.e. if the property was ‘predominantly’ a main home it was not taxable on sale. This exclusion has been amended. For property acquired from 27 March 2021, if the main home is not used as the owner’s main home for more than 12 months at a time during the bright-line period, the profit on sale will be partly taxable based on the period it was not a main home. If the property was purchased before 27 March 2021 the main home exclusion continues to apply on an all or nothing basis.

Changes to be implemented – Although legislation has been passed increasing the bright-line period to10 years, as outlined above, it has been proposed that the pre-existing period of five years will continue to apply to ‘new builds’. However, at this stage what comprises a new build has not been defined.

The Government also proposed to introduce new legislation to disallow interest deductions relating to income from residential investment properties. The Government referred to this as ‘closing a loophole, even though being able to deduct expenditure incurred to derive taxable income is a fundamental and basic feature of New Zealand’s tax system.

The Government intends to deny interest deductions for residential rental properties acquired on or after 27 March 2021. For properties acquired before 27 March 2021, the ability to claim interest will be progressively phased out over four income years starting from 1 October 2021 (i.e. by 25% each year until the 2025-26 income year). An exemption is to be introduced for new builds. However, the definition of what comprises a new build has not yet been defined for this purpose either.

Over recent years a number of changes to the taxation of residential property have been made that did not appear to slow house price inflation, such as rental losses being ring-fenced, depreciation deductions being denied, the bright-line test being first introduced and then being extended to five years. But this is the first time a distinction is being created within the residential market itself by treating new builds differently. This could prove to fuel the price of new houses even more, particularly if the underlying issue of low supply has not been addressed.

 

Director’s Duties

Company directors have a duty under the Companies Act 1993 to not trade recklessly or take on obligations that their business cannot perform. Balancing the continued survival of a company versus their obligation against reckless trading has been a key feature of the Covid-19 economic environment.

Recognising that the economic impact of Covid-19 placed some companies in temporary financial distress as they adjusted to their new trading environment, amendments were made to the Companies Act 1993 for the benefit of directors. The amendments provided safeguards for company directors enabling them to take a longer term view of a company’s ability to trade. However, those safeguards ceased from 30 September 2020, so directors need to revert to the more stringent approach required prior to the amendment.

In a timely reminder of directors’ duties, the recent Supreme Court decision Madsen-Ries v Cooper [2020] illustrates when the actions of directors will be in breach of their duties.

Mr Cooper was the sole director of Debut Homes Ltd (Debut) a residential property developer. In 2012 Debut owed Inland Revenue more than $300k of GST, amongst other creditors. Mr Cooper was advised by his accountant that these debts were insurmountable. However, with 6 properties under development, Mr Cooper persisted in expectation of the profit from their sale. Additional finance from third parties, guaranteed personally by Mr Cooper, and a loan from his family trust, were used to complete the properties and pay secured creditors. However, no GST was paid to Inland Revenue on the sale of the 6 properties, adding to the GST liability already outstanding.

Finally, in March 2014, Debut was placed in liquidation by Inland Revenue with a GST liability exceeding 500k (including interest and penalties). The High Court held that Mr Cooper breached his duties under the Act by continuing to trade in a manner that benefited some creditors but was detrimental to others.

In September 2020 the Supreme Court restored the High Court’s orders and allowed the appeal by the liquidators. The actions of Mr Cooper amounted to reckless trading and a breach of a director’s duty to not enter obligations on behalf of the company where there was no intention or ability for the company to meet those obligations. Mr Cooper will likely be personally liable for some or all debts of the company and potentially barred from being a director.

Perseverance has been key to survival for many businesses during COVID-19. However, continuing to trade with the belief that a business will be profitable, while ignoring the reality of the balance sheet risks directors breaching their professional duties.

The 39% Rate Change

The top personal marginal tax rate increases to 39% on income over $180,000, with effect from 1 April 2021. Businesses should consider what the flow-on effects are and forward plan to ensure they are not caught off guard. Two key areas are discussed in this article.

Simplistically put, a company pays income tax at 28%. Imputation credits arise from that tax paid and are used to reduce the tax payable by shareholders when dividends are paid. Further tax may be payable by the shareholder if the tax liability on the dividends is more than the imputation credits.

If shares in a company are ultimately held by an individual, consideration should be given to declaring a dividend prior to 1 April 2021, in which case it will be taxed to the individual at 33% (rather than 39% to the extent income would exceed $180,000 from 1 April 2021).This requires a comparison between the income tax liability that will be triggered upon declaring a dividend prior to 1 April 2021, versus the expected future income tax liability that will be triggered if a dividend is declared on or after 1 April 2021.

The FBT regime ensures tax is paid on non-cash benefits provided to employees, such as company vehicles and fuel cards. When calculating FBT, employers have the option of using one of the following methods:

  1. The single rate option, where a single rate of 49.25% is applied to all benefits provided to employees.
  2. The short-form alternate option, where rates of 49.25% and 42.86% are applied to attributed and non-attributed benefits, respectively. This appeals to employers who predominantly provide attributed benefits to employees who earn more than $70k.
  3. The full alternate rate option, where a separate calculation is undertaken for each employee who has received attributed benefits with reference to each employee’s salary. A rate of 42.86% is applied to non-attributed benefits. This appeals to employers who predominantly provide benefits to employees who earn less than $70k.

Typically, benefits that are subject to FBT are provided to higher-earners, and consequently, the 49.25% FBT rate under the default FBT method equates to the current top marginal personal tax rate of 33%, which keeps the FBT filing process simple.

The full alternate rate option takes considerably more time to calculate, and as a result, employers that value time and efficiency tend to use the single rate or short-form alternate rate option, irrespective of the cash savings that the full alternate rate can provide.

With the introduction of the 39% marginal tax rate, the 49.25% and 42.86% FBT rates will be increasing to 63.93% and 49.25% respectively from 1 April 2021. This effectively means employers that use the single-rate option will be paying FBT as if all employees earn more than $180,000, when in reality the 39% rate is expected to apply to only 2% of New Zealanders. As a result, employers may wish to consider undertaking the short-form or full alternate rate calculation from 1 April 2021, as the cash saving may exceed the additional time and effort.

In the lead up to the 2022 financial year, companies should be exploring different options to ensure tax efficiencies are achieved.