News

GST on loan repayments

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The recent High Court decision of Burke v Commissioner of Inland Revenue (2019) is a timely reminder that understanding the legal form of a transaction is important for applying the correct GST treatment.

Mr Burke was a GST registered, self-employed contractor, who renovated houses and buildings. In mid-2006, Mr Burke entered into a venture with Citywide Capital Limited (CCL). CCL gave Mr Burke a loan to fund the purchase and development of two properties.

The loan agreement had a number of terms. Mr Burke was responsible for paying any suppliers and sub-contractors directly. He was required to use CCL’s accountant to process his GST returns, with any GST refunds to be collected by CCL as partial repayment of any outstanding loan.

Cashflow constraints meant Mr Burke was required to drawdown additional loan capital from CCL throughout the project, in order to pay suppliers. Under the loan arrangement, CCL paid suppliers directly, however the legal form of the arrangement between Mr Burke and CCL was an increase to the existing loan. At the time, CCL’s accountant submitted Mr Burke’s GST returns claiming GST on the payments made to suppliers.

In August 2007, the first property sold, and Mr Burke made a loan repayment of approximately $500,000 to CCL. During an IRD review commenced in 2015, the Commissioner discovered that GST had not been returned on the sale of the property in 2007, however it had been in a later GST return, filed on 11 March 2016. Furthermore, in the same GST return Mr Burke claimed GST on part of the repayment to CCL, equivalent to the additional amount he borrowed to cover supplier costs.

Mr Burke asserted that he was entitled to claim input GST on this amount, given it was in respect of payments to suppliers.

The Taxation Review Authority (TRA) concluded that input GST could not be claimed, as the repayment of these costs to CCL was simply a loan repayment, and not in exchange for a supply of any good or service as defined in the Goods and Services Tax Act 1985. Mr Burke appealed to the High Court, but unfortunately for him, the High Court agreed with the TRA.

This decision emphasises the importance of understanding the true legal nature of payments. GST is deducted on goods and services that are acquired for use in making taxable supplies.

The inability to connect the loan repayment to CCL, to the acquisition of goods and services used in the development should have led him to the conclusion that GST could not be claimed.

Purchase price allocation

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Buying or selling a business is a significant decision, and commonly involves vendor and purchaser negotiations on many aspects of the transaction.

The price is often one of the first points to be negotiated. Irrespective of whether the transaction is for shares in a company or its underlying assets, a single amount is typically agreed. However, where the transaction is for assets it is important to remember that the tax implications of selling the assets (e.g. trading stock, depreciable plant, equipment, goodwill and liabilities) needs to be determined and the amount derived is fundamental to this process.

For tax purposes, the price is allocated between the various assets on the balance sheet by a ‘purchase price allocation’ (PPA). For example, if depreciable assets are sold as part of a transaction and values have not been agreed on an asset by asset basis, the purchaser and vendor could determine different ‘market values’ resulting in inconsistent treatment.

This issue is exacerbated by the fact that vendors are motivated to allocate high values to non-taxable capital assets such as land or goodwill, whilst minimising the value attributable to assets such as trading stock, or plant and machinery, which reduces the vendor’s tax bill on sale.

Conversely, purchasers can gain a tax advantage by allocating as much value as possible to revenue account assets and depreciable property, to provide larger future tax deductions.

Consequently, the Government is concerned that the tax base is eroded, if different pricing allocations are adopted by vendors and purchasers in a transaction.

To address this, Inland Revenue (IRD) issued an official consultation paper in December 2019, with an aim to implement legislation in 2020, which seeks to ensure consistency in application of the PPA by both the vendor and purchaser.

In theory the IRD’s proposal is simple. The vendor and purchaser must use the same PPA across the various assets included in the transaction, through mutual agreement. If they cannot agree, IRD proposes that the purchaser must use the vendor’s allocation when filing their tax return. If the vendor does not prepare the allocation for any reason, then the purchaser can make it instead.

It is proposed that details of the PPA are provided to IRD within three months of the transaction. This additional disclosure is expected to encourage all parties to apply ‘market value’ fairly due to the risk of subsequent review by IRD.

Property sales – business premises exclusion

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The land taxing provisions deem certain sales of land to be subject to income tax, subject to a limited number of exceptions. One such is exception is for ‘business premises’. However, the circumstances in which it applies can be a grey area. Hence, two recent ‘Questions We’ve Been Asked’ (QWBA) issued by Inland Revenue (IRD) are welcome.

The treatment of business premises is different depending on the situation.

The first situation is the bright-line provision that taxes the sale of residential property sold within five years of acquisition. For the bright-line test to apply, the land must not have been used ‘predominantly as business premises’; irrespective of whether there is a dwelling on the premises. ‘Predominantly’ has both a time and space element to it. Hence, the land must have been used as a business premises for more than 50% of the ownership period, and more than 50% of the land area must have been used as business premises. The test does not require the landowner to occupy the land for the purpose of their own business – the test can be met where the land is let and used as the business premises of a tenant. Bare land (zoned residential) can also be classified as business premises where it is used for business activity. The exclusion operates on an all or nothing basis. Providing the land is used ‘predominantly’ for business premises, the sale of land will not be taxable pursuant to the bright-line test. However, if the land was only used, say 40% of the time as business premises, the test will fail and 100% of the profit on disposal will be subject to tax.

The second situation is the use of the business premises exclusion contained in section CB 19, which overrides the application of the broader land taxing provisions (e.g. the dealer, developer or builder provisions). When using this provision, the business exclusion can be claimed if the land is the premises of a business and the person acquired or erected, and occupied the premises to carry on a substantial business from them. This requires the land to have been used in the business of the owner; if however, the land was let and used as business premises of the tenant, the exclusion cannot be used. It also requires the business activity to be “substantial”, which comes down to the application of case law. Although this is more stringent than in the first situation above, this exclusion can apply to part of a sale. For example, the sale of 100% of a mixed use commercial and residential property could be taxed under the brightline if the residential use area is larger than the commercial area, i.e. it is not predominantly business premises. However, in the second situation, the CB 19 exclusion can shelter the profit on the commercial portion of the building.

Overall, these recent QWBA publications provide clarity on the application of the business premises exclusion to different scenarios, and contain some good examples, so they are worth a read if you think they may apply.

Generation Z – our future workforce

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The rise of Generation Z (‘Gen Z’) is imminent in today’s workforce. Comprised of those born between mid-1990s and early-2000s, Gen Z has grown up in a world with technology at their fingertips. Common traits include: confidence, desire to succeed, thriving on recognition, being adaptable and tech-savvy. However, their most valuable aspect is they represent an organisation’s future.

Fast forward 10 years from now – baby boomers will be retired and employers will have no choice but to recruit an increasing number of Gen Z employees. As Gen Z members are currently young, they are perhaps not a priority when it comes to recruitment planning. However, it is crucial employers learn to understand this generation and how to attract, recruit and retain them.

If Gen Z members are not being challenged, recognised or rewarded for their efforts, they will have no hesitation to search for opportunity elsewhere. Today, it is increasingly common for employees to change jobs after spending only months with their employer. It is clear that the fierce, unparalleled loyalty that was once displayed by previous generations will not be as prevalent in the future. Being adaptable and tech savvy also means Gen Z will demand remote working and flexible working – such “perks” will become expected, rather than incentives.

To attract Gen Z into their organisations, employers should be aware that the approach to job searching is significantly different to the traditional methods. Often, Gen Z begin their job search on the organisation’s website – looking for the organisation’s culture to impress them. They then head to social media to learn more. Hence, organisations need to get creative with different social platforms and use them to reach out to potential candidates.

Organisations should also assess whether existing recruitment processes remain appropriate. For example, it is currently commonplace for psychometric testing, essay writing, and even written case studies to be requested before interview stage. An absence of face-to-face communication can make Gen Z candidates feel like just a number. Understandably, this lack of human interaction does not initiate feelings of loyalty. Extensive recruitment processes can also dissuade Gen Z workers from applying at all, meaning employers are missing out on potential candidates. To combat this, organisations should prioritise the key aspects of the recruitment process, and eliminate any unnecessary stages.

Ultimately, whether an organisation can tailor their recruitment plan for Gen Z will depend on its individual circumstances. Nonetheless, it is important for employers to understand this generation and how to best attract, recruit and retain them.

Court case – tax avoidance arrangement

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Two recent (connected) cases at the Taxation Review Authority (TRA) demonstrate that unnecessarily complex transactions can raise a red flag for IRD.

Both cases related to a taxpayer referred to as Mr Brown, who acquired a 2/3 interest in a joint venture known as the NPN Partnership (NPN) back in 1981. NPN held several residential property investments, of which a 2/3 share was transferred into one of Mr Brown’s family trusts.

Over a period spanning 20 plus years, the income rights to the rental income derived by NPN were sold from one of Mr Brown’s family trusts to another on three separate occasions. Although each transaction was slightly different, broadly, on each occasion the trust acquiring the income rights funded the purchase by way of vendor loan, with the interest capitalised and not payable until the expiry of the loan.

Close to the end date of each loan, the trust would sell the income rights to a newly settled family trust for a price equivalent to the outstanding loan with accumulated interest. In effect, each of these sales from trust to trust created a new loan. On each occasion, the new loan gave rise to an interest expense which the trust claimed as tax deductible, offsetting the rental income derived from NPN such that no tax was paid.

The Commissioner contended that the arrangements constituted a tax avoidance arrangement pursuant to BG 1 of the Income Tax Act, and sought to deny the interest deductions whilst reconstructing the income derived by NPN onto Mr Brown. The Commissioner contended that during the time the income rights were held in trust, the rental income was used my Mr Brown for his personal and family expenses. The taxpayer contended that the transactions were all standard commercial transactions, and there was no artificiality in the trusts obtaining the interest deductions.

However, the TRA supported the Commissioner, ruling that the transactions were driven with a tax motive in mind, with no commercial reality, given that the loans resulted in no economic cost to the trusts. The structure was artificial and contrived.

In sentencing, the TRA allowed IRD to impose re-assessments dating back to 2001, as they considered Mr Brown’s tax returns to be wilfully misleading. As a further sting in the tail, it was deemed that the Trustees of the family trusts had failed to meet their tax obligations, hence the income was taxable at the ‘non-complying trust rate’ of 45%.

A good reminder that whilst all taxpayers are entitled to arrange their affairs in a tax efficient manner, tax should not be the main motive for a transaction with no commercial substance.

Corporate governance for small businesses

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Good corporate governance is often viewed as important for large companies with an established board of directors. However, the principles that underpin good corporate governance can benefit any organisation, irrespective of size.

Why is it then that the term governance often raises alarm bells with small business owners? Perhaps it’s the fear of losing control over their business, or the assumption that they must report to someone else. When in fact, good corporate governance should lead to business owners feeling more empowered, more supported and more equipped to make good quality decisions.

In a nutshell, governance is all about thinking strategically and taking a ‘big picture view’ as opposed to focusing on day-to-day operations. In the context of small businesses, owner-operators are often bogged down with the day-to-day running requirements of the business, leaving little time to devote to long-term strategy and sustainability. One of the key benefits of governance structures is the ability for small business owners to take time to work “on” the business as opposed to work “in” it. This subtle switching of ‘hats’ is one of the first steps toward building a governance structure.

However, there is no ‘one-size-fits-all’ approach to governance; it will look different for each and every business. The approach will depend on the size and stage of the business, the operating environment, the risk profile and the key stakeholders. It is therefore crucial that all businesses take time to think about their governance practises. Broadly, governance structures typically fall into one of three categories: no formalised governance structure; an advisory board; or a full board. The idea of a full board may be overwhelming for SMEs or not appropriate given the size and scale of the business, but they may still benefit hugely from establishing an advisory board.

At one point or another, SME owners will inevitably need expert advice, that’s where an advisory board comes in. An advisory board is an informal group of business professionals who help advise owners on a number of business issues. Generally, an advisory board should have a legal advisor, an accountant, a marketing expert, a human resources expert, and a financial advisor.

The ability to draw on these different areas of expertise offers SMEs the benefit of a variety of different perspectives, knowledge, experience and most importantly support. Opting for an advisory board also ensures overall decision making authority remains with the owner, removing any apprehension owners may have about loss of control.

As entities progress through the business life-cycle, they may eventually find that their advisory board grows into a full board. There is an abundance of resources available that outline the composition and responsibilities of boards, including guidance issued by the Financial Markets Authority (FMA) which includes eight key principles that underpin best practice. The topics include areas such as ethical standards, board composition and performance, risk management, and reporting and disclosure. Whilst it is unlikely that all of the principles will be relevant for small businesses, they provide sound guidance on the fundamental areas and help simplify the underlying objectives of governance.