Chapter 8 - Transition
8.1 Existing qualifying companies which continue to meet the eligibility requirements will automatically transition into the new rules, and may not remain under the current rules.
8.2 If an existing qualifying company revokes its election into the qualifying company rules, ordinary company tax treatment will apply from the start of the income year in which the revocation notice is received by Inland Revenue, unless a later income year is nominated.
8.3 The flow-through tax treatment will apply for income years beginning on or after 1 April 2011. Qualifying companies with early balance dates will continue operating under the current rules until the start of their next income year after 1 April 2011.
Tax consequences of transition
8.4 There will be no deemed disposal and reacquisition of an existing qualifying company’s assets when it transitions into the new qualifying company rules, in order to reduce the tax compliance costs of transition.
8.5 It is proposed that shareholders of qualifying companies that transition into the new treatment will need to determine their initial membership basis. The limited partnership rules have two methods for determining this, a market value method and an historical method. Similar methods may be appropriate for determining the initial membership basis for a transitioning qualifying company.
Existing carried-forward losses
8.6 When a company elects into the qualifying company rules, any loss balances which arose in the income years during which the company was not a qualifying company are forfeited. This includes attributed CFC losses and FIF losses. It is proposed to maintain this treatment under the new qualifying company rules.
8.7 Officials propose that any loss balances accumulated by an existing qualifying company (not also being an LAQC) will be allocated, under the new rules, to shareholders in the qualifying company based on their effective interest. These losses will only be allowed to be offset against the shareholder’s income from that qualifying company.
Imputation credit account
8.8 A qualifying company under the new rules will not be able to maintain an imputation credit account (ICA) or other memorandum account. Any existing credits in an ICA or other memorandum account would be extinguished on the qualifying company’s transition into the new rules. This is appropriate because, under the partnership model, there will be no separate taxable distribution from a qualifying company to its shareholders.
Qualifying company election tax
8.9 Under the current qualifying company rules, dividends paid by a qualifying company to its shareholders either have imputation credits and/or dividend withholding payment credits attached or are exempt from tax to the extent that the dividends are unimputed. Thus, it is necessary to tax the company’s reserves at the time of entry into the qualifying company rules, as once the company is a qualifying company those reserves will subsequently be able to be distributed tax-free to the extent that dividends are unimputed.
8.10 The tax on these reserves is referred to as the qualifying company election tax (QCET), and is payable at the company tax rate. It is levied on an amount that is broadly equivalent to the amount which would be taxable if the company were to wind up. QCET prevents taxable reserves within a company being rendered exempt simply by electing into the qualifying company rules.
8.11 Under the new qualifying company rules, a company’s reserves would be treated as being held by a shareholder in proportion to each shareholder’s effective interest. The qualifying company would be treated as not holding the reserves. This will be achieved through the flow-through mechanisms in section HG 2 of the Income Tax Act.
8.12 A company’s retained earnings that have not been subject to tax (that is, which are unimputed) will be attributable directly to shareholders when the company becomes a qualifying company. Therefore, there would be no taxable distribution when the company makes an actual distribution to its shareholders. Such amounts could still be distributed tax-free to shareholders. It is necessary, therefore, to retain a form of QCET to cater for situations when an ordinary company enters the qualifying company rules, to ensure unimputed retained earnings are taxed.
8.13 Owing to flow-through treatment, the qualifying company itself will not retain any reserves or be able to pay QCET on those reserves. It is proposed to amend the QCET rules in sections HA 40 to 42 of the Income Tax Act to make shareholders separately liable for QCET based on their share of the company’s reserves when the company enters the qualifying company rules. A shareholder’s portion of the company’s reserves will be determined by their effective interest in the qualifying company. The values on which QCET is calculated will be reflected in the tax cost of revenue account property under the new qualifying company rules.
8.14 To determine a shareholder’s personal liability for QCET, the current formula in section HA 41 will be adapted. QCET will be calculated on the company’s reserves (which are allocated to shareholders) but will be paid by each shareholder at their tax rate in proportion to their effective interest in the company. This could be achieved by including the amount calculated before tax in each shareholder’s return which, therefore, will be subject to ordinary income tax.