Chapter 2 - Flow-through of income and losses
Flow-through treatment
2.1 The Government has decided to replace the existing qualifying company rules with new rules making qualifying companies and LAQCs flow-through entities for income tax purposes. Qualifying companies are currently subject to company tax treatment, whereby income is taxable and losses deductible by the company at the company tax rate. In addition, LAQCs are partially transparent entities in which income is retained at the company level but losses can flow through to individual shareholders. Attributed losses are treated as if they were incurred by a shareholder in deriving their income, and so can be offset against the shareholder’s other income or be carried forward to future years.
2.2 With flow-through treatment for income tax purposes, a qualifying company’s income and losses will both be passed on to shareholders. That is, they will not be retained at the company level. Instead, income will be taxed and losses deducted at a shareholder’s marginal tax rate. The company’s tax treatment will be integrated with the tax treatment of the owners, on the basis that entities are agents for their owners.
2.3 Flow-through will be based on the rules currently applying to partnerships and will be primarily achieved by the rules in section HG 2 of the Income Tax Act 2007. In general, the ordinary partnership tax rules will apply to shareholders of qualifying companies under the new rules. For example, instead of fringe benefit tax (FBT) applying to the provision of a motor vehicle to a shareholder-employee, an apportionment of costs based on private and business use would have to be made, in accordance with existing partnership treatment. Similarly, section DC 4, which allows a deduction for working partner salaries, would be applicable.
2.4 This change will erase the distinction between qualifying companies and LAQCs, as both entities will be transparent. There will be only one classification under the new qualifying company rules.
2.5 Approximating partnership tax treatment will necessitate amending the definition of “company” in section YA 1 of the Income Tax Act to exclude qualifying companies. Without this change, a qualifying company would still be characterised as a company for income tax purposes, so the company’s income and expenses would not flow through to the shareholders but would instead be taxed and deducted at the company level. The definition of “partnership” will be amended to include a qualifying company. Similarly, the definition of “partner” will be amended to include a member of a qualifying company. These will be the primary amendments through which flow-through will be achieved, as qualifying companies will be brought within the scope of subpart HG and, in particular, section HG 2.
2.6 As a result of this change, the limited partnership and qualifying company tax rules will be largely aligned, with limited partners and qualifying company shareholders being treated the same for income tax purposes. Both entities will be transparent for income tax purposes while remaining separate legal entities at general law. However, some differences between the regimes, relating to the underlying structure of the entity, will remain. In particular, qualifying company shareholders will be able to take an active role in the management of the company while retaining limited liability, unlike limited partners in a limited partnership who may not participate in the management of the partnership.
Tax treatment of closely held entities
2.7 The Tax Review 2001 considered that closely held entities (with five or fewer members) should be taxed on a partnership basis, and widely held entities be taxed on a company basis. [4] Partnership tax treatment recognises the close economic connection between an entity and its members, and ensures that the income of closely held entities are taxed at the marginal tax rate of the ultimate beneficial owner.
2.8 Flow-through treatment for qualifying companies is consistent with this approach. Qualifying companies and their shareholders will be treated as a single economic entity, which is the original rationale for the qualifying company and LAQC rules. Flow-through treatment will more closely integrate the taxation of the company and its shareholders. The role that taxation factors play in the choice of business entity will be reduced, as flow-through qualifying companies and partnerships (general and limited) will be more substitutable.
Addressing current concerns
2.9 Flow-through treatment will address concerns with the current rules, in particular, arbitrage opportunities and the risk to tax base integrity, and the use of LAQCs as vehicles for tax avoidance or structuring around the limited partnership loss limitation rules. It will also fix the remission income inconsistency.
2.10 With partnership tax treatment, both the company’s income and losses would be passed on to the shareholders, so income would be taxed and losses deducted at a shareholder’s marginal tax rate. As a result, there would be no arbitrage opportunities due to the difference between company tax and higher personal tax rates – the company tax rate will not apply for qualifying companies. This treatment will therefore improve the integrity and coherence of the tax system.
2.11 This change will address the potential for LAQCs to be used as partners in general partnerships to structure around the limited partnership loss limitation rules. The proposed loss limitation rules for qualifying companies will prevent excessive losses from flowing through to shareholders via a qualifying company general partner.
2.12 The inconsistency in the LAQC rules that allows shareholders to benefit from allocated losses but to avoid liability for the company’s income tax will be closed by moving to flow-through tax treatment. Shareholders of a qualifying company will not be able to eliminate their liability for the company’s income tax (by revoking LAQC status) as all the company’s income – including deemed remission income – will instead be automatically taxed at the shareholder level.
Distributions and dividends
2.13 Applying partnership tax treatment will mean that qualifying companies will no longer, for income tax purposes, pay dividends to shareholders, as no income will be retained by the company under the new rules. Instead, profits and losses will be allocated directly to shareholders without going through the imputation system. This is a natural consequence of flow-through tax treatment. This will allow the current qualifying company rules to be significantly simplified. A number of sections in the Income Tax Act will be able to be removed, including section CW 15 and sections HA 14 to HA 16.
2.14 Similar to the existing limited partnership rules, any amounts earned by a qualifying company will retain their character in the shareholder’s hands. For example, capital gains will retain their character because they will be treated as being earned directly by the shareholder and, therefore, will generally not be subject to tax.
2.15 Qualifying companies will not need or be able to operate an imputation credit account. This will reduce compliance costs for closely held companies. However, if the qualifying company election is revoked or the requirements cease to be met, the qualifying company will revert to being an ordinary company and normal company tax treatment, including the maintenance of an imputation credit account, will apply.
2.16 Distributions to non-residents are currently subject to non-resident withholding tax (NRWT). With flow-through treatment, however, non-resident shareholders of a qualifying company will be allocated their portion of the company’s income and expenditure, and any actual distributions from the qualifying company to non-resident shareholders will not be recognised for NRWT purposes. However, the underlying income may be subject to NRWT. For example, dividends paid by New Zealand-resident companies to a qualifying company will be allocated to the qualifying company’s non-resident shareholders according to their effective interest in the company and subject to NRWT.
Removal of current shareholder liability for company’s tax
2.17 The current liability of qualifying company shareholders for a company’s unpaid income tax will be removed. This is a natural consequence of flow-through treatment.
Treatment of foreign losses
2.18 Currently, LAQC losses are deductible against a shareholder’s other income, but foreign-sourced controlled foreign company (CFC) and some foreign investment fund (FIF) losses can only be offset against CFC and FIF income. That is, CFC and some FIF losses are ring-fenced. It is therefore possible for shareholders not to be able to receive the benefit of foreign losses if they have no available foreign income to offset the losses against.
2.19 Section HA 25 of the Income Tax Act provides that an LAQC may elect to retain attributed CFC and FIF net losses at the company level instead of passing such losses to shareholders, to facilitate later use of these losses. Any retained losses may be offset against the company’s foreign income in subsequent years. However, flow-through treatment means that losses will not be able to be retained at the company level to be carried forward for future years. Furthermore, there will be no income retained by the company against which the losses can be offset.
2.20 It is therefore proposed to remove section HA 25, which will prevent qualifying companies from electing to retain foreign losses at the company level. Instead, foreign losses will automatically flow-through to shareholders and will be subject to the normal rules for attributed CFC and FIF losses in subpart DN of the Income Tax Act.
Shareholder’s effective interest
2.21 The basis for the allocation of a qualifying company’s income tax liability and losses to a shareholder, as well as certain shareholder elections, is the shareholder’s “effective interest” in the company. The meaning of effective interest is set out in section HA 43 of the Income Tax Act. It generally means a shareholder’s voting interest in the company – for example, based on the number of shares held. However, if a market value circumstance exists, a shareholder’s effective interest is the average of their voting interest and market value interest. If a shareholder’s interest changes during an income year, a weighted average is used.
2.22 It is proposed to maintain the same definition of “effective interest”, in sections HA 43 and 44 of the Income Tax Act, under the new qualifying company rules.
Anti-streaming rule
2.23 Under the new qualifying company regime, it is proposed that assessable income, exempt income, excluded income, expenditure, capital gains and capital losses will be apportioned by the qualifying company to each shareholder in accordance with each shareholder’s effective interest in the company. Shareholders will derive income and expenses from each source and would then include these amounts in their tax return for the appropriate income year. This anti-streaming rule will be similar to that applying for partnerships in section HG 2(2) of the Income Tax Act, and follows the approach recommended by the Valabh Committee.
2.24 This rule will ensure income or losses from particular sources – for example, foreign-sourced income – cannot be streamed to the shareholder who would benefit the most. Without an anti-streaming rule, certain types of income that are exempt from tax (such as capital gains) could be disproportionately allocated to shareholders on higher marginal tax rates, and taxable income could be allocated to shareholders on lower marginal tax rates in order to reduce the amount of tax payable. Such a rule will help protect the integrity of the tax system, as well as provide certainty in the allocation of income and expenditure.