Election Outcome and Tax Policies

After Labour’s victory in the 2020 General Election, their proposed tax policy changes are now likely to be implemented.

Labour has ruled out a capital gains tax and an increase in fuel taxes but is prepared to introduce a Digital Services Tax to target multinational digital businesses who have taken advantage of tax structuring options. Labour’s historical coalition partner, the Green Party, have notably been campaigning for a wealth tax, which Labour has repeatedly ruled out. Given that Labour has won enough seats to govern alone, the possibility of a wealth tax seems unlikely.

Labour’s election campaign promised no income tax changes for 98% of New Zealanders, however a new top marginal income tax rate of 39% for individuals earning over $180,000 will be implemented – expecting to raise $550 million of revenue a year.

For some of us this provides a sense of déjà vu, as we remember when we previously had a 39% tax rate from the 2001 to 2009 financial years. We saw disputes in the courts regarding the requirement to pay fair market salaries, legislation requiring income to be attributed to individuals and various policy statements from Inland Revenue.

As differences in tax rates widen, it impacts behaviour by incentivising tax planning to minimise application of top tax rates. Currently, there is little difference between the top income tax rates, 33% for trusts and individuals and 28% for companies.

It also leads to further inequity within the tax system because it is typically employees who are unable to alter how they are taxed, whilst business owners have greater flexibility to alter how their income is taxed.

For example, a distribution of accumulated income from a trust that has already been taxed at 33% may be distributed tax-free to a beneficiary who has a marginal tax rate of 39%. Individuals with investment income may also be further incentivised to invest in Portfolio Investment Entities instead of shares, where the top tax rate is capped at 28%. Conversations are likely occurring right now regarding whether shares in companies should be moved from personal ownership into trusts – and whether this is tax avoidance?

Companies will also face further costs with a 39% tax rate. Companies that currently pay fully imputed dividends at 28% are also required to withhold tax at 5% in order to reach the 33% marginal income tax rate. This withholding tax liability is likely to increase to 11%, which may place constraints on company cash flow or prevent dividends from being paid altogether. This will place further pressure on tax administration to keep accurate, up-to-date records as individuals on lower marginal tax rates may be entitled to tax refunds comprising the additional tax withheld.

Ultimately, this policy provides an opportunity for individuals to explore their different options to ensure efficient tax planning. However, utmost care should be taken when restructuring one’s affairs, in order to avoid undesirable consequences such as the breach of shareholder continuity resulting in the loss of imputation credits or tax losses, or potentially undertaking a tax avoidance arrangement.

Categories Tax

What is revenue?

“Revenue means the total amount of money a business has earned from its normal business activities, before expenses are deducted” (Work & Income, July 2020).

This core definition has been applied by thousands of businesses to apply for the Government’s wage subsidy scheme that was implemented due to the COVID-19 pandemic. Whether a 30 percent or more reduction in revenue for the original wage subsidy, or a 40 percent or more reduction for the wage subsidy extension, quantifying the reduction in ‘revenue’ was a key hurdle to be eligible.

With the potential for wage subsidy applicants to be audited, documenting the basis for an application and how the eligibility criteria have been met is
critical. In some cases, confirming eligibility should be straightforward. Retail stores, restaurants, cafes and bars that had to shut their doors overnight should be able to demonstrate a clear drop in ‘revenue’.

However, for other industries it may not be as straightforward. In some cases, the time at which an invoice is issued for GST purposes is different to the point in time at which income is recognised for tax and / or accounting purposes.

Take for example the construction industry where jobs are invoiced based on specific milestones. If invoices were raised during the lockdown, for work completed prior to the lockdown, then measuring the
change in revenue based on ‘invoicing’ would not provide a fair reflection of the effect of Covid-19 at that point in time.

It goes both ways – if a professional services firm was able to keep working during the lockdown but stopped issuing invoices for a particular period. The firm’s invoicing in that period would not provide an accurate reflection of the change in ‘revenue’.

The Work & Income definition also refers to “money”. Was this intended to have the same meaning as ‘income’ or is it intended to imply a cashflow test?

The different ways the revenue test is able to be interpreted, and not knowing what the audit process will comprise gives rise to uncertainty. A suggestion is to ensure that the method used to calculate the revenue reduction should be logical within the context of a particular business. If a standard measure, such as sales booked in the period does not align with what has occurred in practice, consider whether that is an accurate method.

Consideration should also be given to sensor checking eligibility using different approaches to ensure the outcome feels right. For example, a service-oriented business could look at hours worked by the team and cross check that against movement in WIP and sales.

If multiple measures have been used, and each supports the reduction in ‘revenue’ required to receive the wage subsidy then this suggests a reasonable approach has been taken.

Other tax changes in response to Covid-19

In addition to the tax loss carry-back scheme, the New Zealand Government has introduced a number of other tax changes to assist businesses and individuals to get through COVID-19.

Currently, if an asset is purchased for less than $500 it does not need to be depreciated. The cost is immediately deductible in the year of purchase. This ‘low-value asset’ threshold has been temporarily increased from $500 to $5,000 for assets purchased in the 12 months from 17 March 2020. The threshold will reduce to $1,000 for assets purchased from 17 March 2021.

Tax depreciation on industrial and commercial buildings has been re-introduced for the 2021 tax year and onward. The diminishing value rate will be 2%, while the straight-line rate will be 1.5%. This is a permanent measure which will have a flow-on effect and improve the balance sheet of some large companies through the partial reversal of deferred tax liabilities.

The residual income tax threshold, which determines whether a taxpayer has a provisional tax obligation has been permanently lifted from $2,500 to $5,000 for the 2020-21 income year and onward. This is expected to remove 95,000 taxpayers from the provisional tax regime, assisting cash-flow and compliance related issues faced by individual taxpayers and small businesses.

Taxpayers affected by COVID-19 that are unable to physically or financially make tax payments will not be charged use of money interest (UOMI) on late payment of taxes from 14 February 2020. However, taxpayers will need to demonstrate to IRD that they have been “significantly adversely affected”. IRD is further offering taxpayers the opportunity to set up instalment arrangements to meet outstanding tax liabilities to those facing difficulty in paying outstanding amounts. Amendments to the Tax Administration Act 1994 have been made to give IRD greater discretion over its ability to allow extension of due dates and filing timeframes for taxpayers affected by COVID-19.

Changes to the tax loss continuity rules will be introduced. At present, an entity is only able to carry forward tax losses if shareholder continuity of 49% is maintained from the time a loss amount is incurred, until it is utilised. A ‘same or similar business’ test has been proposed, whereby a business can carry forward tax losses provided it continues to operate in the same or similar way, irrespective of a change in ownership. This test is being modelled on the current Australian loss carry forward rules. The change is targeted at taxpayers who are seeking new capital to stay afloat, without tax losses being forfeited due to a change in ownership. A ‘same or similar business’ test aims to instil confidence in prospective investors as to future cash-flow benefits from utilising the current period losses against future profits.

Finally, the extension of the new R&D tax credits rules to companies that incur tax losses, initially intended to be enacted effective from the 2020-21 tax year, has been brought forward to the 2020 tax year to allow timely access to the regime.

The package contains a number of measures designed to provide cashflow advantages. Hopefully there is something for everyone.

Carry back of tax losses

Ordinarily, if a taxpayer incurs a tax loss within a particular year, they are able to carry that loss forward and offset it against income derived in a future year, thereby reducing the taxpayer’s future tax payable. As part of the Government’s Covid-19 response, on 30 April 2020 legislation was passed under urgency which allows tax losses to be offset against income derived in a previous year, thereby enabling the taxpayer to obtain a refund comprising prior year income tax paid. This temporary tax loss carry-back scheme is available to most taxpayers, e.g. trusts, companies and individuals.

A permanent scheme to replace the temporary rules is under development and will apply from the 2022 income year, however, the current scheme applies for a two-year period as follows:

  • A tax loss incurred in the 2020 income year is able to be carried back and offset against taxable income derived in the 2019 income year.
  • A tax loss incurred in the 2021 year is able to be carried back and offset against taxable income derived in the 2020 year.

A tax loss cannot be carried back multiple years, instead it applies to the “net loss year” and the immediately preceding “taxable income year”.

Taking each year in succession, most taxpayers will have already filed their 2019 income tax return, but a request to amend that return can be made via MyIR or a letter can be sent to IRD requesting a reassessment (pursuant to section 113 of the Tax Administration Act 1994). The loss amount can be determined by either preparing a 2020 tax calculation based on ‘actual’ results or preparing an estimate. The ability to make an estimate allows taxpayers to access the refund faster. However, if an estimate of the 2020 tax loss is later found to exceed the actual loss amount, tax will need to be repaid to IRD, on which interest will apply.

With respect to utilising expected losses in the 2021 year against profits derived in the 2020 income year, in most cases the 2020 income tax return would not have been filed and may not be filed for some time, however 2020 provisional tax may have been paid to IRD. To enable provisional tax payments to be refunded, taxpayers will have the option of submitting an estimate of their 2020 provisional tax liability (that takes into account expected losses for 2021) – the time to do so has been extended to when the tax return is filed. Excess tax paid, based on the provisional tax estimate, will be refunded.

If a company incurs a loss and it is a member of a wholly owned group of companies, it can only carry back the amount that can’t first be offset against the income of other companies in the group.

If taxable income for the 2019 year was paid by way of shareholder salary, this cannot be reversed under the tax loss carry back initiative. However, provisional tax paid for the 2020 year in relation to an expected shareholder salary could be refunded under the initiative.

Under ordinary rules, 49% shareholder continuity must be maintained from the time a loss is incurred until it is utilised. A similar rule will apply to the loss carry back scheme, i.e. if there has been a change in ownership that breaches the threshold, a tax loss cannot be offset against income derived prior to the breach. However, part period calculations can be completed, as applicable.

The pragmatism underpinning this scheme will be appreciated as it allows sound businesses to secure a refund of tax paid in better times.

GST issues paper

On 24 February, Inland Revenue released an Officials’ Issues Paper seeking feedback on various GST issues.

A long-standing rule that has proved a source of frustration for those affected applies to transfers of goods between associated persons. The issue is highlighted in the following example. Joe buys a block of land on the edge of town from a third party. Neither the vendor, nor Joe, are GST registered, i.e. GST does not apply. Joe holds the land for a number of years and due to urban expansion, the opportunity arises to subdivide the block into 6 lots for sale. Joe incorporates a company to complete the subdivision and sells the land to the company.

Because of the work required to complete the subdivision, it comprises a ‘taxable activity’ and GST applies to the sale of the 6 sections. However, under current rules, the company is not entitled to a GST deduction on the purchase of the land, i.e. GST is paid on the sale, but can’t be claimed on the purchase. The problem arises because Joe’s GST deduction is limited to the amount of GST he originally incurred, which in this case was zero as GST did not apply to that transaction.

Officials now consider it appropriate for Joe to be entitled to a GST deduction. It is proposed that Joe should be entitled to a deduction based on 3/23rds of the price paid for the land. Arguably, the GST deduction should be based on the land’s market value. By restricting it to ‘cost’, GST is effectively being levied on the increase in the value of the land when it was held ‘privately’ by Joe. Changes are also proposed to the apportionment and adjustment rules that apply when goods and services are used for both taxable and non-taxable purposes. With the increased popularity of Airbnb, these rules have increasing application. Broadly, the current rules require a person to make periodic GST adjustments for any difference in the intended taxable use of an asset and the actual taxable use. One of the issues contained within the Issues Paper is what happens when the asset is sold or deemed to be sold.

For example, if a bach, sold by a GST registered vendor, has been used 30% for Airbnb, GST is paid on the full value of the sale, but an offsetting GST deduction is allowed based on the 70% proportion of private use, i.e. GST is paid on 30% of the sale proceeds. In isolation, this would arrive at a logical outcome. However, the offsetting deduction is limited to the amount of any unclaimed GST from the original purchase. This means that for an appreciating asset, GST becomes payable on the full capital gain since acquisition, with no offsetting GST claim.

Within the issues paper it is acknowledged that the cap on the ‘wash-up’ deduction gives rise to “over taxation”. The suggested solution is to remove the cap (for non-property developers). This would ensure GST is paid in-line with the extent the property has been used to make taxable supplies (30% in the above example). However, this would be calculated on the capital gain since acquisition, which could include when the property was not used to derive income.

Changes to make the rules fair are welcomed, the question becomes whether they will go far enough.

Categories Tax

Global tax

A series of legislative changes have been implemented over the past few years as part of the Government’s focus on ensuring multi-national corporations pay their fair share of tax.

International tax revenue represents approximately 10% of New Zealand’s tax revenue each year. Not only does it need to be preserved, but given international tax practices exhibited by some multi-national companies, it should be expected to grow. However, the changes do not just affect the likes of Google and Apple, but also smaller businesses that undertake cross border transactions.

One area of Inland Revenue’s (IRD) focus is the thin capitalisation (‘thin cap’) regime. Historically, if a NZ company had a loan from an overseas company in the same group, the NZ company could claim a full tax deduction for interest on the loan, providing the ‘debt to assets’ ratio (known as the thin cap ratio) was below 60%.

Although this test remains broadly the same, new legislation has changed the way the ratio is calculated, to reduce the asset value by liabilities that are not subject to interest. This is increasing the thin cap ratio.

Some businesses that have historically been below 60% are now above the threshold, and they are either restructuring their balance sheet to come back below 60% or accepting that their net interest deduction will be restricted.

A related measure is a new set of rules known as ‘Restricted Transfer Pricing’ (RTP). The RTP rule focuses on NZ companies with loans from overseas and seeks to ensure an appropriate rate of interest is charged. Previously a weak NZ balance sheet might have been used to justify a higher interest rate on an unsecured related party debt. However, the RTP rule requires the interest rate to be set with reference to the credit rating of the wider group’s parent company, ignoring non-commercial terms. This is generally giving rise to reductions in interest rates, thereby reducing interest deductions in NZ.

Further rules target ‘Hybrid Mismatch’ arrangements. These arise where a legal arrangement has different tax outcomes in different countries. For example, convertible loan notes are commonly treated as ‘loans’ in NZ, such that a deduction is available in NZ for interest payments. However, they are treated as ‘equity’ (i.e. shares) overseas, such that interest received overseas is not taxed.

A tax deduction in one country with no corresponding taxable income in another clearly erodes the global tax base. IRD’s new base erosion and profit shifting (BEPS) measures basically prohibit a NZ tax deduction if the amount received overseas is not subject to tax in that jurisdiction.

These rules are clearly complex and can be challenging for small and medium businesses to navigate. The IRD is attempting to ensure compliance with the new rules through the issue of a new BEPS disclosure form, which itself is complicated.

For affected entities, the new form applies for income years beginning on or after 1 July 2018. Encompassing these rules within the annual tax compliance requirements not only emphasises the importance of assessing the impact of the new BEPS measures, but also provides IRD with a platform to review and audit these disclosures.