Chapter 1 - Introduction

1.1 As part of Budget 2010, the Government announced that it would replace the current qualifying company rules with a new set of rules to make qualifying companies and loss attributing qualifying companies (LAQCs) flow-through entities for income tax purposes, similar to the treatment of limited partnerships. As a result, a company’s income and losses would both be passed on to shareholders, so income would be taxed and losses deducted at a shareholder’s marginal tax rate. [1] The purpose of the change is to address a number of problems with the current qualifying company rules which undermine the integrity of the tax system.

1.2 This issues paper seeks comment on the implementation and transition details of moving qualifying companies to flow-through treatment for income tax purposes.

Background to the qualifying company rules

1.3 The qualifying company rules were introduced in 1992 after a review of the tax system by the Valabh Committee. [2] In its report on the taxation of distributions from companies, the Valabh Committee recommended the introduction of a new elective regime for closely held New Zealand-resident companies. The regime would treat a qualifying company and its shareholders as one entity for income tax purposes, similar to the tax treatment of partnerships.

1.4 The primary purpose of the qualifying company rules was to remove the tax disincentive faced by the owners of closely held businesses who wish to operate through a company. Attaining the benefits of limited liability afforded by a corporate form meant sole traders and partnerships lost the ability to be taxed at the level of the owner.

1.5 The qualifying company rules have applied from the 1992–93 income year.

Current qualifying company rules

1.6 The qualifying company rules provide shareholders of closely held companies a form of partnership treatment for income tax purposes, while maintaining the corporate protections afforded under general law (such as a separate legal entity status and limited liability). Income is initially assessed at the company level. On election to be a qualifying company, the shareholders agree to be personally liable for their share of the company’s income tax liability that is not met.

1.7 Dividends paid out by qualifying companies are taxable only to the extent that imputation credits are available. When a qualifying company has no imputation credits, any dividends paid out are tax-free. As a result, shareholders can have tax-free access to the company’s capital gains without having to wind up the company.

1.8 The LAQC rules are a subset of the qualifying company rules. A company must satisfy additional criteria to be an LAQC. Like qualifying companies, income is also initially taxable at the company level. Unlike qualifying companies, however, an LAQC’s net losses are allocated to shareholders in proportion to their effective interest (generally based on voting interest) in the company. A loss will either be allowed as a deduction from the shareholder’s annual gross income or it will be carried forward.

Problems with the current rules

1.9 There are significant problems with the current LAQC rules which result in risks to the tax base. These are discussed in more detail below.

Arbitrage opportunities

1.10 The qualifying company and LAQC rules were implemented when the company rate and top individual tax rate were aligned at 33 percent. Since their introduction, a gap has opened up between the top individual tax rate (currently at 38 percent, but at 33 percent from 1 October 2010) and the company rate (currently 30 percent, but reducing to 28 percent from the 2011/12 income year). Income is initially assessed at the entity level, so profits are taxed at the company rate. With LAQCs, any losses can be allowed as a deduction from a shareholder’s annual gross income, which may be taxed at a higher rate. This disparity creates arbitrage opportunities and tax base integrity pressures.

1.11 The amount of losses that can be deducted from an LAQC shareholder’s other income may not be commensurate with the level of financial risk that the shareholder faces. That is, there are no loss limitation rules equivalent to those for limited partnerships, despite the similarity in economic terms between an LAQC shareholder and a limited partner. LAQC shareholders can deduct losses in excess of their equity in the LAQC. This is subject to the rules limiting deductions for arrangements involving money not at risk (sections GB 45 to GB 48 of the Income Tax Act 2007). While these rules have restricted schemes promoted using LAQCs, they are narrower in scope than the limited partnership loss limitation rules. The absence of comprehensive loss limitation rules is likely to distort efficient decision-making and resource allocation as a result of allowing investors to claim larger tax losses than their true economic losses.

Remission income inconsistency

1.12 An inconsistency in the LAQC rules allows shareholders to benefit from allocated losses but to avoid liability for an LAQC’s income tax. Generally, a taxpayer can claim a deduction for an expenditure or loss for income tax purposes when it is incurred, even if payment has not taken place. The Income Tax Act 2007 claws back the unpaid portion of expenditure or losses through the remitted income rules. This does not occur in the case of LAQCs, as the benefit of the loss is enjoyed by the shareholders but the remitted income is derived by the LAQC.

1.13 Remission income arises in the year of remission, rather than in the year in which the deduction was originally claimed. If remission income arises in an income year after the company has revoked its LAQC status, the directors and shareholders are not personally liable for the tax liability of the company, as that only applies for an income year during which the company is an LAQC. As a result, shareholders can claim LAQC losses and then eliminate personal liability for the tax on the remitted income simply by revoking LAQC status before remission income is derived by the company, which may not be able to pay the tax on that income.

Structuring around partnership rules

1.14 The 2006 discussion document, General and limited partnerships – proposed tax changes, raised the possibility of LAQCs being used to structure around the limited partnership loss limitation rules. [3] Loss limitation rules restrict the amount of losses that can flow through to a limited partner to the amount of that partner’s investment in the partnership. The loss limitation rules apply only to limited partners (as they have limited liability).

1.15 Currently, LAQCs can be used as partners in a general partnership to allow net tax losses in excess of the equity invested in the partnership to flow through to the individual LAQC shareholders, even though the LAQC vehicle serves to provide limited liability to the shareholders. This structure circumvents the policy intent behind the limited partnership loss limitation rules.

1.16 LAQCs can also be used to circumvent the disposal provisions under the partnership rules while shareholders still receive the benefit of loss flow-through, similar to partners in a partnership. For example, an individual can invest in forestry through an LAQC, receive its losses, and sell the shares in the company for a non-taxable gain, instead of investing in a forestry partnership and being taxed on any gain on disposal of their partnership interest.

How to make a submission

1.17 Officials invite submissions on the matters raised in this issues paper concerning the implementation details of making qualifying companies flow-through entities for income tax purposes. Submissions should be made by
5 July 2010 and be addressed to:

Qualifying company reforms
C/- Deputy Commissioner, Policy
Policy Advice Division
Inland Revenue Department
PO Box 2198
Wellington 6140

Or email [email protected] with “Qualifying company reforms” in the subject line.

1.18 Submissions should include a brief summary of major points and recommendations. They should also indicate whether it would be acceptable for Inland Revenue and Treasury officials to contact those making the submission to discuss the points raised, if required.

1.19 Submissions may be the subject of a request under the Official Information Act 1982, which may result in their publication. The withholding of particular submissions on the grounds of privacy, or for any other reason, will be determined in accordance with that Act. Those making a submission who consider there is any part of it that should properly be withheld under the Act should clearly indicate this.

1 The term “shareholder” is used in this paper and refers to a person with an interest in a qualifying company, despite the company being treated as a partnership for income tax purposes in order to apply flow-through treatment.

2 Consultative Committee on the Taxation of Income from Capital, appointed in 1989 and chaired by Mr. Arthur Valabh.

3 General and limited partnerships – proposed tax changes, June 2006, p.42.