Profit distribution plans
Issue: Policy considerations
Submissions
(Corporate Taxpayers Group, Contact Energy, KPMG, New Zealand Institute of Chartered Accountants)
The legislative reforms to profit distribution plans (PDPs) should not proceed for the following reasons:
- The underlying policy rationale behind the proposed reform is based on an incorrect view of the legal form and substance of PDPs vis-à-vis dividend reinvestment plans. (Corporate Taxpayers Group)
- Economically like investments should be treated the same to ensure the integrity of the tax system. However the proposed changes should not proceed as the key commercial driver for PDPs is to retain capital within the company, and this justifies a different tax treatment. (KPMG)
- We support aligning the tax treatment of economically equivalent things, however PDPs are sufficiently different from other (taxable) distribution policies and this warrants a different tax outcome. (New Zealand Institute of Chartered Accountants)
- Officials’ imputation credit streaming concerns should be addressed through targeted reform rather than a wholesale change to the tax treatment of PDPs (Corporate Taxpayers Group). A better option would have been to debit the company imputation credit account with an amount sufficient to capture the tax liability (New Zealand Institute of Chartered Accountants).
- The concern that shareholders may not be taxed at their correct personal tax rate is not sufficient to justify the wholesale tax reform as proposed. (Corporate Taxpayers Group)
- The changes are inconsistent with the notion of a dividend: a dividend is a distribution of profit, whereas shares issued under a PDP are a share split that does not alter each shareholder’s underlying interest in the company. (Contact Energy, New Zealand Institute of Chartered Accountants)
- The reforms will have the effect of disestablishing a highly effective mechanism for corporates to retain capital and an effective savings mechanism for shareholders. (Corporate Taxpayers Group, New Zealand Institute of Chartered Accountants)
- The changes are contrary to tax simplification and add additional compliance costs on taxpayers. (New Zealand Institute of Chartered Accountants)
- Eliminating the ability of companies to undertake PDPs is inconsistent with the Government’s focus on helping businesses through the current financial crisis. (New Zealand Institute of Chartered Accountants)
- The consultation process undertaken by officials was limited and the submission points were rejected for minor reasons. The only comments made to support officials’ position that PDPs should have the same tax treatment as “substitutes” came from the Capital Market Development Taskforce, which did not have the benefit of reviewing private sector submissions. (Corporate Taxpayers Group, New Zealand Institute of Chartered Accountants)
Comment
The proposed changes to the tax treatment of PDPs are consistent with, and an extension of, existing policy around imputation credit streaming and the taxation of bonus issues.
Imputation credit streaming
New Zealand-resident companies earn tax credits from the payment of their company tax and from the imputation credits attached to dividends they receive from other New Zealand-resident companies. These credits can be attached by the company to dividends paid to its shareholders. This prevents double taxation so that income earned by the company is not taxed in the hands of both the company and its shareholders. It also means that company income is eventually taxed at the personal tax rates of its shareholders if that income has been distributed to the shareholders with full imputation credits attached.
The value of imputation credits is not the same for all shareholders. For some shareholders, imputation credits have little or no value. New Zealand-resident shareholders that pay tax can use the credits to reduce their New Zealand tax payable. However, tax-exempt New Zealand shareholders and foreign shareholders who have no New Zealand income tax against which to apply imputation credits do not benefit from imputation credits. This creates an incentive to direct the credits to those shareholders best able to use them – a practice commonly called imputation credit “streaming”. The current tax legislation contains rules that prevent streaming. One such rule requires that imputation credits must be paid out pro-rata to shareholders in relation to their shareholding proportion in the company.
Taxation of bonus issues
A bonus issue is an issue of shares by the company when nothing is provided in return. A bonus issue can either be taxable or non-taxable. The policy rationale behind treating some bonus issues as taxable and some as non-taxable is to maintain the integrity of the imputation system and ensure that taxpayers ultimately pay tax on company income at their marginal tax rate.
Non-taxable bonus issues
One example of a non-taxable bonus issue occurs when a company issues new shares to all shareholders on a pro-rata basis, so that all shareholders retain their proportionate shareholding in the company. This is analogous to a share split, where there has been no change in substance, only a proportionate change in the number of shares held by each shareholder.
Taxable bonus issues
A special provision allows a company to elect to treat a bonus issue that would otherwise be non-taxable as a taxable dividend. The policy rationale behind allowing companies to elect for a bonus issue to be taxable is to allow the company to pass out imputation credits to its shareholders without the need to pay a cash dividend. This policy is consistent with the principle of integration of the tax system and may be advantageous to the company, for example, just before a reorganisation or merger that would result in a breach of continuity and a loss of imputation credits.
Bonus issues in lieu
A bonus issue in lieu occurs when a company gives its shareholders a choice of whether to receive a bonus issue or money, or money’s worth, and the shareholder elects to receive the bonus issue. Even though a bonus issue in lieu can have the form of a non-taxable bonus issue, the current rules treat it as taxable. This is because it is part of an arrangement that could undermine the policy intention of the imputation system. The bonus issue in lieu arrangement which gives shareholders a choice, rather than making a pro-rata distribution of shares, undermines the policy intention of the imputation system in two ways. First, it can provide a tax rate advantage to shareholders with higher marginal tax rates; secondly, it can allow streaming of imputation credits.
If a bonus issue in lieu were not taxable, taxpayers on lower tax rates could opt for a cash payment, which would be treated as a taxable dividend. Since the personal tax on the dividend would be less than the imputation credits attached, the taxpayer could use the excess imputation credits to offset tax on other income, as intended under the imputation system. On the other hand, higher tax rate shareholders may choose to receive bonus shares, which could be sold on-market for cash with no tax payable (provided the shares are held on capital account). By treating a bonus issue in lieu as taxable, this ensures that shareholders must pay the difference between the tax payable at their personal tax rate and the underlying company tax. While there are other arrangements in the tax system when taxpayers are not necessarily taxed at their correct personal tax rates, these have resulted from specific policy decisions being made. No such decision has been made for PDPs.
Further, the potential for imputation credit streaming arises because, as noted earlier, for some shareholders, imputation credits have little or no value. In the absence of the rules that tax bonus issues in lieu, those shareholders that are unable to utilise imputation credits (such as foreign shareholders) could elect to receive the bonus shares rather than the monetary amount. If the bonus shares are non-taxable, imputation credits will not be attached, and this preserves the credits for shareholders who can best use them. This defeats the current policy settings that are in place for the imputation system.
The PDP arrangement is substantially similar to a bonus issue in lieu as it effectively provides shareholders with a choice of receiving a bonus issue of shares, or a cash amount. Accordingly, a PDP is not analogous to an ordinary (non-taxable) share split. Even though the legal form of a PDP means that all shareholders initially receive a bonus issue, the substance of the arrangement is that the shareholders are effectively given a choice of whether to receive bonus shares or a cash amount.
While PDPs have non-tax commercial purposes, such as the retention of cash in the company, officials consider that the proposed extension of the bonus issues in lieu treatment to PDPs does not frustrate these uses. It merely removes an unintended tax subsidy from the arrangement.
Alternatives considered by officials
Officials have considered alternative solutions to address the concerns with PDPs. In general, these alternative solutions lead to equity and fiscal concerns. One alternative considered was to require companies to reduce their imputation credit account balance by the maximum imputation ratio (ordinarily 28%) of the value of the bonus shares that are retained by recipient shareholders. This option sufficiently addresses the issue related to imputation credit streaming. However, officials have two main concerns with this option.
First, there are equity concerns. Under this option, shareholders who retained bonus shares under a PDP would effectively be taxed at a final tax rate of 28%. Individual shareholders on lower tax rates (those on 10.5% and 17.5%) would effectively be taxed at the higher rate of 28% and, unlike the proposed new tax treatment, these shareholders will be unable to use excess imputation credits under this alternative option. It also means that higher-rate individual shareholders (those on 30% and 33%) are effectively taxed at a lower rate of 28%.
In addition, the bonus issue income is not counted for social assistance purposes (such as Working for Families entitlements) which may mean that taxpayers receive benefits that they would not receive if the payment was taxable.
The second concern is that this option is fiscally negative, with an estimated fiscal cost of $7 million per annum, should there be a tenfold increase in the use of PDPs. This predicted revenue loss is largely due to the expected increased take-up of PDPs if they are given what is effectively a concessionary tax treatment. This is a cost that would be borne by the Government.
Officials note that the change to the tax treatment of PDPs is not an ad hoc change to the tax treatment of capital. It is consistent with the policy behind the tax treatment of bonus issues in lieu, and as such, is simply an extension of the current policy on imputation credit streaming.
Compliance costs for taxpayers
Officials do not consider the changes to PDPs to be contrary to tax simplification. In general, the changes around tax simplification amend the way in which taxpayers file tax returns rather than the income that is included in tax returns.
The proposed change to treat bonus shares issued under PDPs as taxable dividends increases compliance costs for taxpayers, however these costs are no higher than if a cash dividend was paid. This is because publicly listed companies generally already have mechanisms in place for withholding resident withholding tax (RWT) or non-resident withholding tax (NRWT) on dividends. If RWT is correctly deducted, a resident shareholder will typically not be required to file a tax return, simply because they receive a dividend under a PDP (assuming their total dividend income for the year is $200 or less or they are on the top marginal tax rate of 33%). A resident shareholder will only have to put the dividend in their tax return if they are already filing a tax return for another reason. For these shareholders, due to the rate of RWT on dividends, it is unlikely that the shareholders would face a tax liability as a result of the dividend.
Consultation process
Consultation was undertaken by officials throughout the policy development process. An officials’ issues paper was released for public consultation in 2009. After the first round of consultation, the Capital Market Development Taskforce reported. The Taskforce was industry-led and comprised a number of individuals from both the public and private sectors. Following the Taskforce’s report, officials consulted on a solution that provided for a more consistent tax treatment across similar transactions. In addition to these two formal consultation rounds, the Minister of Revenue has on a number of occasions announced the progression of work on PDPs, and officials have been involved in a number of discussions with interested parties.
Recommendation
That the submissions be declined.
Issue: Support for proposed profit distribution plan changes
Submission
(New Zealand Law Society)
The Law Society generally accepts the Government’s rationale for making the tax treatment of PDPs the same as the tax treatment of bonus issues.
Recommendation
That the submission be noted.
Issue: Rules for non-cash dividends
Submission
(New Zealand Institute of Chartered Accountants)
The rules for non-cash dividends should be reviewed. The existing and proposed laws relating to RWT on non-cash dividends is confusing. There needs to be a review of the application of RWT to non-cash dividends to ensure the rules operate in a clear and user-friendly manner.
Comment
The clarity of the rules for non-cash dividends has been raised with officials in the past. While officials accept that there is benefit in reviewing the rules, the timing of any such review will depend on the Government’s priorities for the Tax Policy Work Programme.
Recommendation
That the submission be noted.
Issue: Definition of “profit distribution plan”
Submission
(New Zealand Law Society)
The definition of a “profit distribution plan” in clause 88(14) requires all shareholders to be notified of the issue of shares. This is an unnecessary requirement. It is not clear that notification of shareholders other than those receiving the shares should be required, nor why failure to notify one or more of those shareholders who are receiving the shares should take the transaction outside the PDP definition. The key element is that the company makes a bonus issue of shares and gives the shareholders an option to have some or all of the shares repurchased or redeemed.
Comment
As far as officials are aware, in practice PDPs have been offered to all shareholders and all shareholders are notified of the offer. However, officials agree that from a policy perspective, the new rules should apply regardless of whether all shareholders are notified or not. If all shareholders were required to be notified, this would mean companies could easily get around the new rules by simply notifying some, but not all, shareholders.
While officials agree with the submission in principle, officials recommend that a different drafting solution to that put forward by the submitter be adopted.
Recommendation
That the submission be accepted, subject to officials’ comments.
Issue: Application date of proposed changes
Submissions
(Contact Energy, KPMG)
If the legislative changes do proceed, Contact Energy seeks a change in the timing of the effective date of the legislative changes from 1 July 2012 to 1 October 2012. This is to allow a reasonable transitional period as the current application date of 1 July 2012 has significant commercial ramifications for Contact Energy.
If the legislative changes do proceed, KPMG submits that the application date should be deferred to 1 April 2013. This allows time for replacement capital raising measures to be considered and employed by affected parties, and aligns with the imputation year.
Comment
There are arguments both for deferring and retaining the 1 July 2012 application date.
The application date of 1 July 2012 currently in the bill was originally chosen because it is expected to be soon after enactment of the bill. The change to the tax treatment of PDPs has been well signalled and is an issue that has been discussed with interested parties on a number of occasions since 2009.
In officials’ discussions with taxpayers during consultation there have been concerns raised around the need to provide certainty on the tax treatment of PDPs, particularly given the original product ruling issued by Inland Revenue (which provided tax certainty) has expired. Officials understand this uncertainty has led to a number of companies not offering PDPs.
The uncertain tax treatment is also a concern for shareholders in companies that offer PDPs. From a shareholder’s perspective, it is important to have certainty around the dividend-paying policies of the company and the resulting tax consequences for them in respect of the dividends they receive.
One argument against retaining the 1 July application date is that it may be complex from the shareholder’s perspective because it may mean that they receive two dividends from Contact Energy that have different tax treatments (interim in March and final in September). However, officials consider that from a tax perspective, the complexity is lessened for taxpayers because it means the two dividends that were received in the standard tax year (1April 2012 – 31 March 2013) will be subject to the same tax treatment.
Deferring the application date will have a fiscal cost. The PDP change is estimated to result in a fiscal gain for the 2012–13 year onwards of $0.76 million per year. This costing was based on an application date of 1 July 2012. If the application date was deferred, as suggested by the submitters, this would reduce the $0.76 million fiscal gain that was originally reported for the 2012–13 year. The amount of the reduction would depend on how long the application date is deferred. The deferral requested by Contact Energy to 1 October 2012, for example, would reduce the fiscal gain for the 2012–13 year by half. The fiscal gain that was reported for years from 2013–14 onwards would be unaffected.
On the other hand, the deferral sought by Contact Energy is relatively small. Officials have had further discussions with Contact Energy to clarify the implications it would face if the application date is not deferred as requested. Contact Energy generally carries out two dividend payments per year (March and September). A 1 July application date would affect Contact Energy’s September 2012 dividend payment given that the September dividend is not determined until the results from the financial year ending 30 June 2012 are available. Contact Energy has communicated that it needs approximately four months from enactment of the bill to carry out a number of steps, including confirming the implications of any decision for its non-resident shareholders with foreign jurisdictions, making decisions regarding the form that future dividend payments will take, and communicating the changes to shareholders. These steps cannot be carried out until the date of enactment because of the uncertainty around whether and when the bill will be enacted.
While Contact Energy would be able to pay its September 2012 dividend if the 1 July application date was retained, this would involve increased shareholder communications overall because interim decisions would potentially need to be taken rather than decisions about the appropriate distribution mechanism for the medium term.
On balance, officials consider that the arguments for a small deferral to the application date favour those over retaining the application date. Therefore, officials recommend that Contact Energy’s submission that the application date be deferred to 1 October 2012 be accepted.
Officials recommend that KPMG’s submission that the application date be deferred to 1 April 2013 be declined on the basis that Contact Energy is the only company officials are aware of that is currently using PDPs. This is the only affected party that has put forward a submission on the application date of the PDP changes.
Furthermore, while a 1 April 2013 date would align with the imputation year, officials consider that a further six-month deferral may result in increased uncertainty and negative fiscal effects.
Recommendation
That the submissions be accepted in part, and that the application date of 1 October 2012 be accepted, and the application date of 1 April 2013 be declined.
Issue: Shares repurchased under a profit distribution plan
Submission
(New Zealand Institute of Chartered Accountants)
Proposed section CD 23B of the Income Tax Act 2007 stipulates that the amount paid by a company when a shareholder elects to have a share issued under a PDP repurchased by the company is not a dividend. If the changes do proceed, while NZICA supports the proposals in section CD 23B, it submits that the relationship between proposed section CD 23B and CD 22 should be clarified. It also seeks clarity on whether section CD 23B applies to on-market repurchases.
Comment
New section CD 23B is intended to prevent cash amounts under a PDP from being taxed twice. If a shareholder elects for their bonus shares to be repurchased under a PDP, section CD 23B ensures that the cash proceeds are not taxable under the ordinary dividend rules. That is, it is only the bonus issue that is the taxable event.
Section CD 22 generally applies when a company pays an amount to shareholders, other than on liquidation, because of the off-market cancellation of shares in the company. This section allows the available subscribed capital of the company (generally equal to the amount paid to the company to subscribe for its shares) to be returned to shareholders tax-free if certain criteria are met. Section CD 22 is not intended to apply to section CD 23B and officials consider that legislative clarification of this point is not necessary. Section CD 23B applies only to share repurchases under a PDP. Section CD 7B states that shares issued under PDPs are dividends. That section also clearly states that section CD 22 does not apply in relation to a share issued under a PDP and repurchased by the company under that plan.
Section CD 23B is not intended to apply to on-market repurchases. Officials consider that legislative clarification is not needed, because as noted in the section heading, section CD 23B is only intended to apply to shares that are repurchased under PDPs and not to share repurchases generally.
While officials do not consider that legislative clarification of these issues is required, an explanation of the provisions will be provided in a Tax Information Bulletin article following enactment of the bill.
Recommendation
That the submission be declined.
Issue: Definition of “bonus issue”
Submission
(New Zealand Institute of Chartered Accountants)
NZICA seeks clarification on why it is necessary to amend the definition of “bonus issue” given that necessary amendments are already being made to the relevant statutory provisions to ensure PDPs are taxed and RWT tax is deducted. It submits that amending the definition of “bonus issue” risks confusing matters.
Comment
The definition of “bonus issue” in section YA 1 of the Income Tax Act 2007 is being amended to clarify that a bonus issue includes the issue of shares under a PDP. Along with the amendment to section CD 8, this amendment is necessary as it clarifies that the issue of shares under a PDP constitutes a taxable bonus issue. This ensures the tax treatment fully aligns with bonus issues in lieu, as intended.
Recommendation
That the submission be declined.
Issue: Minor technical drafting issues
Submission
(New Zealand Law Society)
The Law Society has identified two technical issues. First, clause 10 proposes to amend the definition of “returns” in section CD 43(2)(c) of the Income Tax Act 2007 so that it includes a new subparagraph (ii) referring specifically to repurchases of shares pursuant to a PDP. This is appropriate in concept, but the drafting is not appropriate. Paragraph (c) already refers to a cancellation of a share. A cancellation of a share is defined to include its acquisition by the issuing company, i.e. a repurchase. Accordingly, all that is required by way of amendment to paragraph (c) is to include a reference to new section CD 23B. The Law Society recommends clause 10 be amended, so that it simply inserts the words “, section CD 23B” after the words “section CD 22”.
Secondly, there is a typographical error in the currently proposed subparagraph (i) – after “section CD 24”, “of” should be “or”.
Comment
As noted by the submitter, the current definition of “cancellation” of a share includes the acquisition by the company. As such, the current drafting is not necessary and officials recommend that the amendment put forward by the submitter be accepted.
Officials recommend that the second issue also be accepted.
Recommendation
That the submission be accepted.