Taxation of capital

In March 2022 Inland Revenue released a government discussion document that contains a proposal that represents a further erosion of the principle that New Zealand does not tax capital gains.

Currently, if a person sells shares in a company and the shares were not purchased with the intention of resale (such as by a share trader), the amount derived should comprise a non-taxable capital gain. However, Inland Revenue is proposing a change in which a sale of shares could trigger a taxable dividend.

The background to the change is publicised as an ‘integrity measure’ to support application of the 39% tax rate, but it would apply irrespective of the applicable tax rate.

The logic is that companies and trusts can earn income on behalf of high-income individuals. In the case of a company, it can derive income which is taxed at 28% and this income could accumulate to the company over time and not be paid out as a dividend to be taxed at the shareholder’s marginal tax rate. If the shares in the company are then sold to a third party, the vendor derives a non-taxable capital gain. The concern is that the value of the shares is partly tied to the amount of the retained earnings of the company, so the individual should be treated as deriving those retained earnings, i.e. a deemed taxable dividend should be triggered.

As evidence that such a change is necessary, Inland Revenue refers to the fact that since the top personal tax rate first increased to 39% in 2000, NZ has seen “a notable increase in the imputation credit account balances of non-listed companies.” This would suggest that people are using companies to store value and avoid the higher personal tax rates.

The detailed proposal is that share sales by ‘controlling shareholders’, being someone who holds more than 50% of the voting interests in the company (including shares held by associated persons), will trigger taxable income based on the higher of:

  • the accounting retained earnings, less non-taxable capital gains, plus imputation credit account (ICA) balance, or
  • the ICA balance divided by the tax rate.

If a controlling shareholder only sells a portion of their shares, the taxable amount is pro-rated. To the extent the company’s imputation credits feature in the above calculation(s), the shareholder will claim the amount of the credit against their tax liability and the company’s ICA balance will be reduced.

Some exceptions are proposed, such as for the sale of shares in listed companies or shares held by Portfolio Investment Entities.

Finally, IRD is also proposing that companies are required to maintain a record of their ‘available subscribed capital’ (ASC) and capital gains. Currently, distributions by a company are not taxable to the extent they are a return of ASC or if on liquidation, a capital gain. Because companies do not have to keep a record of their ASC and capital gain amounts, it becomes difficult for the IRD to verify the non-taxable amount on a share repurchase or in a liquidation.

There is a lack of acknowledgement by the Government that profits are often retained by a company and reinvested for future growth or acquisitions. It is common for ‘value’ to be retained in a company for decades with no need or occasion for it to be distributed. The fact a share sale gives rise to a tax-free capital gain is a feature of our tax system.

The proposals appear to be driven by a philosophical drive to recharacterise a capital gain into a taxable gain.

Farewell to “tax invoices’’

Despite significant technological and operational business changes, the rules regarding GST tax invoices have remained largely unchanged since GST was first introduced in 1986. However, new legislation was passed on 29 March 2022 that is intended to improve and modernise GST invoicing and record-keeping requirements.

A long-standing requirement to be able to make a GST deduction on a standard taxable supply is that a “tax invoice” must be held at the time a GST return is filed. This requirement is being repealed. Instead, the concept of “taxable supply information” (‘’TSI’’) has been introduced and is required instead. For supplies that exceed $1,000, TSI comprises:

  • the name and registration number of the supplier,
  • recipient details,
  • address of the recipient,
  • date on which the taxable supply information is issued,
  • a description of the goods of services supplied, and
  • the consideration for the supply and details of the GST amount charged.

Meanwhile, the ‘form’ of credit and debit notes are being replaced by “supply correction information” (SCI), which is deemed to have a larger scope. The issue of a SCI is required within 28 days of the TSI being issued, or by a date agreed between the supplier and the recipient.

Record-keeping requirements have been simplified as businesses are only required to keep a record of the TSI and SCI for all taxable supplies made and received. Supplies valued less than $200, will not require TSI to be issued, but in order to claim GST a TSI must be requested from the supplier. For supplies under $200, TSI must include, name, GST registration number of the supplier, date of supply, description and amount of consideration for the supply.

The changes bring in an element of confusion because other than the reference to ‘taxable supply information’ it is difficult to determine the practical effect of the changes. But because the process of ‘invoicing’ is so fundamental, additional time has been given to allow businesses to work through implementation of the changes, hence they apply to
taxable periods beginning on or after 1 April 2023.

One change that was introduced with immediate effect is that Inland Revenue approval will no longer be required to issue buyer created tax invoices. Instead, the parties simply need to agree that the recipient will issue the invoices (or TSI from 1 April 2023) and record their reasons for doing so if it is not part of their normal terms of business. This is a positive change that is welcomed, but whether the broader changes above are also positive remains to be seen.

Tax due diligence when buying or selling

The summer break is a time for reflection on the year that has been. For business owners, this break is an opportunity to evaluate their future strategy and consider whether it is time to exit, or conversely, grow by purchasing someone else’s business. Whether buying or selling, it is a demanding exercise.

A business sale can either be in the form of a share sale, where the shares in the company that owns the business are transferred, or an asset sale, where the underlying assets of the business are transferred. If the transaction is by share sale, the purchaser takes on the past risks and obligations of the target company. It is therefore important to understand if there are any ‘skeletons in the closet’. This risk is mitigated by undertaking ‘due diligence’. This same risk does not arise in an asset sale, because the vendor’s ‘history’ is not transferred to the purchaser.

For the vendor, due diligence might subject the business to a level of scrutiny not experienced before. For the purchaser, a large volume of information may be presented and it will be important to remain focused on information that is material and relevant.

From a tax perspective, due diligence is aimed at confirming whether the target company has satisfied its historic tax obligations and therefore no risks exist that a tax liability might arise in relation to a period prior to the change of ownership. There is both a qualitative and quantitative element to this process.

The tax return filing history will be reviewed to confirm that there are no outstanding returns and to what extent past returns have been filed on time. Not just income tax returns, but also GST, FBT, PAYE, etc. Past tax advice will be requested and reviewed to determine whether the positions taken are correct and reasonable. The general business profile will be reviewed to identify what tax adjustments need to be made and this will be cross-checked against the tax position taken to ensure there is alignment.

Common risk areas will be reviewed, for example, a business that engages contractors may be scrutinised to ensure these individuals are not actually employees. The treatment of Covid subsidies could also be reviewed. Has non-deductible capital expenditure been identified and adjusted. Does the target have a large number of vehicles on its fixed asset register, if yes, how have they been treated for FBT purposes… the list goes on.

Generally, Inland Revenue is able to reassess a tax return if it was filed in the past four to five years (the time bar period). Hence, due diligence is typically undertaken on the four most recently filed tax return periods.

Finally, the qualitative element comes into play. The team performing the due diligence will form a view of the target company’s approach to tax compliance based on what they have seen. For example, if a company files its income tax returns late, does not use an external accountant, and does not seek advice on material transactions, a negative view will form.

This, along with other issues identified, may ultimately lead to more comprehensive warranties and indemnities, a portion of the sales price being placed in escrow or, at the extreme, a reduced price for the business.

Where is this going?

On 2nd December 2020, legislation was introduced by the Government that increased the top personal marginal tax rate to 39% on income over $180,000 from the start of the 2021/22 income year.

Three other changes were included in that legislation. It introduced:

  • new information-gathering powers for the purpose of tax policy development,
  • a new requirement for most trusts that derive assessable income to prepare financial statements, and
  • increases the information that trusts must disclose as part of the income tax return filing process.

This legislation was enacted under urgency and did not go through the usual consultation process. At the time, David Parker signaled that if trusts are being used for the sole purpose of paying a lower tax rate “we will move on it”.

Fast forward one year and three things have happened.

Firstly, Inland Revenue has initiated a research project in which it is examining the lives of 400 New Zealand taxpayers worth in excess of $20m to estimate their effective tax rate on economic income (which is broader than taxable income).

A range of information will be demanded for the 2016-2021 income years including details of partners and dependants, significant personal assets (how much they cost and the date acquired), real estate interests, details of companies and trusts, and other financial flows.

This information is being demanded under the new legislation referred to above, with requests separated into three tranches due in November 2021, January 2022 and May 2022, each delving further into the lives of these taxpayers to enable Inland Revenue to measure the ‘households’ total income. The results of Inland Revenue’s research project will be released in an anonymised form in mid 2023.

Secondly, on 15th October 2021 Inland Revenue released an Officials Issues Paper seeking feedback on what level of detail should be required within a trust’s financial statements pursuant to a future Order in Council. A draft operational statement was also released by Inland Revenue on the same day which proposes how the new information gathering
powers will apply to trusts. Based on the draft statement the following types of information will need to be submitted each year:

  • a statement of profit or loss and a statement of financial position,
  • details of taxable and non-taxable distributions and who they have been paid to, and
  • the nature and value of any settlements onto a trust, and who a settlement has been made by.

The third element to factor into this picture is that the increase in information to be provided is occurring at a time when Inland Revenue has
implemented a new IT system that provides them with an unprecedented ability to analyse and manipulate data.

During the build up to the general election in 2020 Jacinda Ardern ruled out Labour bringing in a capital gains tax under her leadership. However, as the new information that is being gathered is analysed, it might reveal a segment of income being used for the necessities and luxuries of life that have not been taxed; which could open the door for a generational change to the basis on which income tax is levied.

New Tax Legislation

On 9 September 2021, the Government introduced the Taxation (Annual Rates for 2021-22, GST and Remedial Matters) Bill (“the Bill”) into Parliament, containing over 100 tax amendments. Changes of note are summarised as follows.

One significant amendment is in relation to purchases from associated persons. Under current law, if a GST registered person (‘the purchaser’) acquires second-hand goods from an associated person who has not used them to make
taxable supplies, and that associate originally purchased the goods from a non-GST registered person, the purchaser’s second-hand goods deduction is zero. This has been a frustrating and illogical rule that has caught out numerous taxpayers over the years – they will know who they are. In what is an arguably overdue amendment, it is proposed that the purchaser (in the above situation) will be allowed to claim an input tax deduction equal to the tax fraction of the original purchase price of the associated person.

When the top marginal tax rate increased to 39%, there was a flow on increase to the default FBT rate from 49.25% to 63.93%, which has meant employers applying one of the default or short form options are arguably overpaying FBT in the first three quarters. Under the proposed new pooled alternate option, employers would only pay FBT at the increased rate for employees with all-inclusive pay of $129,681 or more, which generally equates to employees that are subject to the top marginal income tax rate (i.e. for employees that earn over $180,000). On the other hand, FBT would be payable at the 49.25% rate in relation to employees with all-inclusive pay of under $129,681 (i.e. employees that earn less than $180,000). Consequently, this should prevent employers from overpaying FBT during the year.

Reflecting how complex the residential bright-line provisions are becoming, the Bill also contains further refinements to these rules. For example, one amendment proposes that where a main home takes longer than 12 months to construct, the construction period will continue to be treated as “main home days” for bright-line purposes.

The average person may not realise that sales suppression software exists. However, this is a key point of contention for Inland Revenue, as this software alters point-of-sale data to manipulate revenue – facilitating tax evasion. While not necessarily commonly used, Inland Revenue considers the spread of such software to be a major risk to the integrity of the tax system. Thus, criminal and civil penalties of up to $250,000 are being introduced for the supply or possession of such software.

Finally, in what seems to be the end of an era for ‘baby boomers’ and late adopters of technology, fax as an approved method of communication with Inland Revenue is being removed.

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.