Chapter 5 - Assets subject to the suggested new rules
5.1 This chapter evaluates a number of alternative approaches to legislatively prescribing the group of assets to which the proposed new rules should apply.
Typical mixed-use assets
5.2 The most common type of asset used for both income-earning and private purposes is the holiday home.
5.3 The expression “holiday home” is used here to mean residential property which is occupied on a short-term basis by people who are on holiday or on a weekend break or for any other reason. Holiday homes are also typically not occupied for a part of the year. The use of many holiday homes will be seasonal. Holiday homes that are near a beach or some other location where the focus is on warm-weather activity will typically be used much more in summer than in winter months, whereas other holiday homes may be located near a ski field and so predominantly used in winter months. Other properties may see year-round use, such as those located in city centres, or near places which provide activities that are less weather-dependent, such as vineyards. City-centre apartments may be rented by people travelling on business, as well as those on holiday.
5.4 The renting out of holiday homes when they are not being used by the owners has been facilitated in recent years by the advent of internet sites where people can list their holiday home. At present, there are around 15,000 privately held holiday homes advertised on the eight leading New Zealand websites. This development has been accompanied by an increase in the number of professional managers who deal with the “on-site” tasks required to facilitate renting holiday homes for absent owners.
5.5 Holiday homes will represent the majority of assets used both privately and for income-earning purposes. However, there are other assets that are also used in this way.
5.6 A number of businesses advertise management of yacht charters, providing a similar service to private yacht owners to that which property managers provide to owners of holiday homes. These yacht charter businesses advertise and organise charters of yachts which are privately owned, and pay a proportion of the charter fee to the owners of the yachts.
5.7 Some light aircraft will also be used privately and rented out, and there will inevitably be instances of other assets used in this way.
Defining what assets the rules will apply to
5.8 While holiday homes represent the majority of mixed-use assets (at least by value), the core provisions of the Income Tax Act deny deductions for private use for all kinds of assets, not just holiday homes.
5.9 Efficiency and fairness issues also arise. To avoid distortion of investment and spending decisions, the tax system should, where it is possible and pragmatic, provide the same treatment for all types of mixed-use assets, rather than different treatments for different kinds of mixed-se assets.
5.10 The question therefore arises as to which assets the proposals in this paper should apply. There are a number of different options, which are discussed below.
Option 1 – list of assets
5.11 One possible approach would be a schedule of assets, which would list assets by type, such as holiday homes, boats, aircraft and any other assets that it is appropriate for these rules to apply to. To ensure certainty was achieved, this list would probably need to be in a form with a clear legal status. This could be achieved by including the list in the legislation, a regulation, or perhaps a determination issued by Inland Revenue.
5.12 A list would reduce some compliance costs, as only taxpayers who owned an asset which appeared on the list would need to consider the new rules. It would also allow the new rules to be deployed on a targeted basis – they could readily be made to apply only to those kinds of assets where it is considered that their application was warranted. A targeted approach is appropriate where complex rules are created, because the compliance cost of complex rules should only be incurred when justified by the revenue collected or the need to create an efficient or equitable outcome.
5.13 However, such a list would give rise to several problems:
- Inequitable results. People who owned assets that were not on the list would receive a different treatment from assets that were on the list.
- Compliance costs and uncertainty arising from boundary issues. For example, if “holiday homes” were on the list, would the rules apply to a houseboat, an empty beachfront section or a caravan in a commercially run campground?
- The need to update the list when new assets to which the rules ought to apply are identified. Constantly updating a list adds complexity for Inland Revenue and asset owners, particularly for the latter as updates would inevitably result in different application dates for different assets.
- Applying the rules only to selected assets conflicts with the important “broad base, low rate” principle which guides policy decisions throughout the tax system. That principle discourages having different rules for different kinds of assets or activities when the underlying economic substance of the activity is the same.
- Owners of all kinds of assets need to apply some kind of apportionment rules to determine their entitlement to deductions under the Income Tax Act’s core provisions. This occurs regardless of whether the asset appears on a list. Consequently, it is not clear that a significant compliance cost saving is achieved by omitting some assets from these proposals.
5.14 Officials do not consider that the proposed rules are so complex that it would be necessary to limit their application to only a restricted group of asset owners. It is acknowledged however, that there is a difference in complexity between the two-outcome and three-outcome model.
Option 2 – a minimum-value threshold
5.15 Under a minimum-value threshold approach, all assets would be included in the rules if their value (or perhaps their cost) exceeded the specified amount.
5.16 The advantage of a threshold is that it allows a trade-off to be made between the compliance cost of applying the rules and the correct tax outcome. A threshold would also enable “high value” assets to be targeted without the range of potential inequities and complexity that specifying individual asset types would result in. Low-value assets such as computers, where the deduction at issue might be a few hundred dollars of depreciation, could easily be excluded.
5.17 However, a threshold rule can be complex in application and can give rise to problems. These might include:
- The decision to use cost or market value as the base. Market value is the most equitable, but has a compliance cost implication for assets other than real property for which the local authority rating value could be used. Cost is simple, but can lead to inequitable results between two owners of similar assets where one acquired the asset recently and the other has held it for a very long time.
- Whether tax depreciation, or some other progressive fall in value over time, should be recognised.
- If cost is used, how improvements to the asset should be factored in.
Option 3 – no limit to application
5.18 There are strong arguments, around equity and the obligation on all taxpayers to calculate deductions using robust methodology, for applying the new rules to all types of assets regardless of their value.
5.19 However, some compliance cost concerns remain. If the new rules were to apply to assets regardless of value, a person who owned a computer could end up being required to record their days of income-earning and private use for the purposes of apportioning a depreciation deduction of a few hundred dollars.
5.20 One way of managing compliance costs in this instance might be to apply the following rules:
- allowing expenditure which relates solely to income-earning (such as the installation of software below the value required to be capitalised and used solely for income-earning purposes) to be deductible in full;
- continuing to deny a deduction for expenditure which relates solely to private purposes (such as game software); and
- allowing the taxpayer to claim the appropriate proportion of mixed-use expenditure (such as annual depreciation) only if he or she applied the new apportionment rules. If the taxpayer chose not to apply the apportionment rules, no deduction for mixed use expenditure could be claimed.
5.21 While this approach forces people to make the trade-off between incurring compliance costs and losing their tax deduction, it is relatively harsh.
Option 4 – conceptual definition of assets
5.22 This approach would provide a conceptual definition of the assets to which the new rules would apply. Assets would be identified that are the most likely to give rise to outcomes under current law which are arguably unfair. The following criteria could be used:
- The asset is rented on a short-term basis only. This would target the key assets which give rise to concerns, such as holiday homes, yachts and aircraft. This would leave out assets where the current law in this area is working reasonably well, such as long-term residential rentals. In the case of residential property, the Residential Tenancies Act 1986 does not apply to temporary or transient accommodation such as hotels and motels ordinarily provided for periods of less than 28 days at a time. This concept may be a useful way of excluding some assets from the suggested new rules.
- The asset is unused for a specified minimum proportion of the year. As noted in earlier chapters, difficult deduction questions only arise for expenditure which is not readily attributable to (or able to be apportioned between) income earning use and actual private use. If a person owns an asset which is actually used for all (or almost all) of the time, no difficult questions of allocation of expenditure arise, so there is no need for the new rules to apply.
- The asset is actually used privately.
Analysis and suggested approach
5.23 While a list of assets has some attraction, it may be considered too arbitrary. A threshold has some merits, but if used on its own would invariably be complex. Applying the proposed new rules to all assets is conceptually attractive. However, we think the required record-keeping obligations may not be justifiable for low-value assets.
5.24 Officials’ recommendation is that the conceptual definition of assets be used. It enables the assets where significant deductions are at issue, primarily holiday homes, to be targeted. It will also encompass other mixed-use assets without the need to maintain a list, and so avoid the inequities and compliance costs that would result from not all assets being on the list.
5.25 The first element of the conceptual definition is that the asset is rented on a short-term basis. The Residential Tenancies Act concepts are referred to above in the context of holiday homes. For boats, rental on a daily basis may be the appropriate measure, and for aircraft, perhaps hourly.
5.26 The second element of the conceptual definition is that the asset is unused for a reasonable proportion of the year. Officials suggest that a total of two months non-use in any 12-month period ending in the tax year is a reasonable threshold (although submissions are invited on this point). Where assets’ non-use periods fall below two months, owners could have the option of applying the new rules.
5.27 It is suggested that the conceptual test be bolstered with a minimum-value threshold test for assets other than land, notwithstanding officials’ concerns about such a test. While compliance costs of the new rules are not expected to be significant, a simple threshold test would ensure that the rules were not applied at a level if the revenue at stake or the distortionary effect is insignificant.
5.28 To ensure that the threshold test did not become unduly complex, the rules could be based on the cost of the asset used for tax depreciation. This would provide a mechanism for recognising improvements to the asset because they are required to be added to the cost price for tax depreciation purposes. However, a taxpayer whose asset fell below the threshold would be free to apply the rules. A taxpayer whose asset fell below the threshold and who chose not to apply the rules would not be denied a deduction, but would need to make a case under general law.
5.29 Excluding land from the threshold test would mean that it would not need to be considered by the owners of holiday homes. Excluding land also avoids some of the difficulties which arise mostly with land, such as low acquisition costs being significantly different from market value due to the asset having been acquired some time ago and then appreciating in value.
5.30 Officials propose a threshold of $50,000, comprising the cost of the asset plus any improvements required to be added for tax depreciation purposes. The $50,000 threshold should not be reduced by tax depreciation. Asset owners who fell below the threshold could apply the rules on a “safe harbour” basis. Submissions are invited on these proposals.
Exclusions from the proposed rules
5.31 Consistency across the tax system is important, but should not be pursued at all costs. Accordingly, when there are existing rules in place which deal adequately with assets used for both private and income-earning purposes, we propose that these rules should remain in place and the new rules should not apply. The following areas are already dealt with by their own set of rules:
- Motor vehicle logbook rules. These apply to the motor-vehicle expenses of a sole trader, the partners of a partnership and the shareholders of a look-through company when a motor vehicle is used both privately and to earn income.
- The established practice around the use of part of a home for earning income.
Both of these sets of rules and practices set out very similar concepts for apportionment of expenditure.
5.32 The motor-vehicle logbook rules allow a deduction for motor vehicle expenses which is the proportion calculated by dividing business mileage by total mileage. Most motor vehicles will not meet the test set out above of not being used for an aggregate of two months in any year. However, to ensure compliance, it would be necessary to monitor use. Officials do not think such monitoring is warranted, so would suggest that motor vehicles be expressly excluded from the proposed mixed-use asset rules.
5.33 The home-use expenses rule is an Inland Revenue-accepted practice derived from CIR v Banks (1978) 3 NZTC 61,236. Accepted forms of calculation include both a calculation which divides the total area of the home by the area of the space used for income-earning purposes, and a calculation apportioning expenditure by the number of days the home is used for income-earning purposes in a year.
5.34 Both the motor-vehicle logbook rules and the home-use expenses rules apply the same methodology proposed for the genuine mixed-use asset outcome discussed in Chapter 4.
5.35 Comparable assets used by shareholders or shareholder/employees that are subject to fringe benefit tax, or treated as giving rise to a taxable distribution, or income, are dealt with in Chapter 6.
- Is the conceptual method the best way to define the assets to which the new rules should apply?
- Do you agree with the proposal to have a non-use threshold as part of the conceptual method? Is two months of non-use in the income year right level?
- Do you agree with the proposal to have a threshold as a supplement to the conceptual method? Is $50,000 the right level? Do you agree with the proposal to calculate it using cost plus any improvements required to be capitalised?
- Do you agree with the proposal to leave existing rules in place for assets such as motor vehicles and use of part of the home for earning income? Are there any other areas where existing rules deal with private use that the proposals should not apply to?