Other policy issues raised in submissions

Issue: Relationship between the core provisions and mixed-use asset rules

Submission

(New Zealand Law Society, Chapman Tripp)

The relationship between the core provisions and subpart DG needs to be clarified. There is a concern that expenditure which is apportioned by the mixed-use asset rules will already have been apportioned by the core provisions. The motor vehicle logbook provisions provide a good model.

Comment

The policy intention of the mixed-use asset rules is that they provide an elaboration of the concept of apportionment which appears in the core provisions. There is certainly no intention that two “layers” of apportionment apply and officials are happy to recommend clarification of the legislation.

Recommendation

That the submission be accepted.

Issue: Treatment of capital expenditure

Submission

(New Zealand Institute of Chartered Accountants, Deloitte)

In some instances, a mixed-use asset may be used in a way which is neither private nor income-earning. An example would be when a helicopter was used to view a property which the owner was considering purchasing. This kind of capital use is already non-deductible and should be excluded from the apportionment formula.

Comment

There are two issues at stake here.

First, deductions for the actual use of the helicopter should be denied only once – having the capital component denied by the core provisions and then again by the mixed-use asset rules is not the correct outcome. This will be remedied by addressing the relationship between the core provisions and the mixed-use asset rules, as outlined above.

The second issue is the impact that this kind of non-deductible use has on the apportionment formula, which addresses expenditure which is not directly attributable to use. Much of this expenditure relates to periods when the asset is unused.

Officials consider it is reasonable for non-deductible capital use to be treated under the apportionment formula in the same way as non-deductible private use.

Recommendation

That the submission be accepted, subject to the comments above.

Issue: Application of rules to companies other than close companies

Submissions

(Ernst & Young, New Zealand Law Society)

Section DG 2(4) provides that the proposals only apply to companies which are close companies, but it is unclear whether this restriction is intended to apply just to the company which owns the asset or to all companies to which the rules might apply (such as companies which are shareholders of companies which own the asset). The application of this rule should be clarified. (Ernst & Young)

The current drafting of the rules would include within them a company which is a wholly owned subsidiary of a widely held company. This was presumably not intended. (New Zealand Law Society)

Comment

The mixed-use asset rules should only apply to a subsidiary company when any parent companies are also close companies. However, they should also apply to appropriate companies held by trusts and trustees. The rules should be redrafted to clearly achieve these objectives.

Recommendation

That the submissions be accepted.

Issue: Application of rules to look-through companies

Submission

(Ernst & Young)

The general definition of “company” excludes look-through companies (LTCs) so it is assumed that the proposed interest expenditure rules do not apply to them or where LTCs are shareholders in other companies which own mixed-use assets. The position of LTCs should be clarified expressly.

Comment

The policy intention of the rules is to capture assets which are held by individuals or in structures which are under the control of a small number of individuals. LTCs ought to be subject to these rules and an amendment is required. Limited partnerships and qualifying companies should also be explicitly dealt with.

Recommendation

That the submission be accepted.

Issue: Definition of “close company”

Submission

(BDO)

This bill would be an ideal opportunity to clarify paragraph (a) in the definition of “close company” to make it clear whether or not a “natural person” can include a natural person trustee.

Comment

This matter is being considered by officials as part of a separate project, but is not part of this bill.

Recommendation

That the submission be declined.

Issue: Guidance on what is expected to support positions taken on private use

Submission

(KPMG)

Inland Revenue should give some guidance on what is expected to support positions taken on private use.

Comment

Inland Revenue will publish information on the new rules once enacted. That information will include guidance on the records required to be kept of private use.

Recommendation

That the submission be noted.

Issue: Assets rented to associates, or for less than market value

Submission

(KPMG, Ernst & Young)

When an asset is used purely by associates, even when they pay market value, all of the use of the asset will be private use, so the mixed-use asset rules will not apply.

Ernst & Young note that this will also arise if the asset is always rented for less than market value.

Comment

Recommendations made elsewhere in this report propose to treat use by associates and use for which less than 80 percent of market value is paid as private use and as giving rise to exempt income. Officials agree that the application of the rules could be made clearer if the reference to earning “income” was changed to refer to “income (including exempt income)”.

Recommendation

That the submission be accepted.

Issue: Range of assets subject to rules

Submissions

(WHK, New Zealand Law Society)

Assets used predominantly for business purposes or acquired predominantly for business purposes should be excluded from the rules. (WHK)

The provisions include within their ambit assets which are not made available for rental use, but which are used within a business. It is unclear whether they are intended to be subject to the rules, and how the apportionment rules should apply to them. (New Zealand Law Society)

Comment

Officials propose to refine the scope of the rules to more precisely capture the key assets where the policy concern arises. This could be done by an additional provision that the rules will only apply to:

land (including buildings on land);
boats; and
aircraft.

This will mean that the rules will not apply to assets like bulldozers which are unlikely to deliver significant private benefit in their use.

While assets used in a business for non-rental use are not the predominant focus of these proposals, there will be some assets held in a business when private use is material, such as a helicopter which is used by a farmer and also to take the farmer and his friends heli-skiing. It is appropriate that the mixed-use asset rules apply to this kind of asset in the same way that they would apply if the helicopter was rented out and used by the owner for heli-skiing. However, an asset which is used inside a business is more likely to be acquired for the purposes of that business, rather than for private purposes. We recommend a new exemption from the rules for assets where:

the principal use in the income year has been as part of a business, which is not a rental business; and
the private or non-business use is minor; and
when the asset is owned by a trust or company, the FBT or deemed dividend rules apply.

Officials prefer a test based on use in the income year, rather than “purpose of acquisition”. A “purpose of acquisition” test is highly subjective and does not reflect that the use of an asset might change over time.

Recommendation

That the submissions be accepted, subject to officials’ comments.

Issue: Application of rules to assets which change in use during the year

Submissions

(KPMG, New Zealand Institute of Chartered Accountants)

The rules will apply to assets which change in use during the year, such as a house which is occupied by the owner, empty for a period of time, and then rented to a long-term tenant. (KPMG, New Zealand Institute of Chartered Accountants)

A rental property which is rented and used privately for the entire year should not fall within the rules just because the tenant is away on holiday or working elsewhere for 62 or more days. (New Zealand Institute of Chartered Accountants)

Comment

Officials agree that these circumstances should not bring an asset within the rules. Two amendments are proposed to address these concerns:

a new exclusion for residential property which is rented on a long-term basis (existing concepts used for GST will be relied on); and
a rule that provides that when an asset changes use during the year, the mixed-use asset rules will only apply to the part of the year for which the asset is used on a short-term rental basis.

This second rule is necessary to deal with situations such as when an owner lives in a property for the first part of the year, and then uses it as a bach for their own use and for short-term rental for the second part of the year.

Recommendation

That the submissions be accepted.

Issue: Application of rules to leased assets

Submission

(New Zealand Institute of Chartered Accountants)

It is unclear whether the rules will apply to assets which are leased from an independent third party, or if they do, how the $50,000 threshold should apply. It is suggested that the threshold should apply to the lease payments made each year.

Comment

The proposals are intended to apply to leased assets. This is necessary both to reflect commercial reality and to ensure that mixed use asset owners are not able to structure around the application of the rules using lease arrangements.

The $50,000 threshold is part of the existing gateway test and provides that an asset which is not land is not subject to the rules unless it has a cost to the person of $50,000 or more. It would clearly not be sensible, and would provide a tax planning opportunity, if people were able to enter into long-term leases and not be subject to the rules because the $50,000 applied to the amount of the annual lease payments.

Officials recommend that when an asset is leased on a long-term basis, the $50,000 threshold apply to the market value of the asset when the person first leased it.

Recommendation

That the submission be accepted, subject to officials’ comments.

Issue: Application of $50,000 threshold to land

Submission

(New Zealand Institute of Chartered Accountants)

There is no need to refer separately to land in the gateway test – land will have a cost of more than $50,000 anyway so the $50,000 threshold on its own is sufficient.

Comment

The current gateway test provides that assets will be subject to the mixed-use asset rules if they (amongst other things) are either land or have a cost of more than $50,000.

Given land is an appreciating asset it seems possible that some taxpayers will own land which has been held for a long time and has a cost of less than $50,000.

Recommendation

That the submission be declined.

Issue: $50,000 threshold should be raised to $250,000

Submission

(PricewaterhouseCoopers)

Given the objective of the proposals is to target high-value assets, the threshold of $50,000 is too low, and should be increased to $250,000.

Comment

The objective of the proposals is not to target high-value assets; it is to increase fairness by ensuring that the owners of assets used privately and to earn income claim a fair proportion of their expenditure as deductible. The purpose of the $50,000 threshold is to exclude from the rules assets where the expenditure claimed is likely to be less significant, and the compliance costs are arguably not justified. This is inevitably arbitrary, but it is important to note that the boats and aircraft to which this rule applies can have significant maintenance costs.

Officials do not support increasing this threshold.

Recommendation

That this submission be declined.

Issue: Risk of an asset being subdivided into a number of assets to fall below the $50,000 threshold

Submission

(New Zealand Institute of Chartered Accountants)

There is a risk that people will seek to divide what is a single asset from a user perspective into a number of separate assets to fall below the $50,000 threshold. We recommend that the definition should be supplemented with a requirement that the item of property be a unit against which the extent of repairs and maintenance would be measured.

Comment

This seems a reasonable concern for assets such as power boats, where it might be argued that the motor and the hull could be treated as separate assets with one or both below the $50,000 threshold. This would defeat the policy objective of the rules. A definition which aggregates assets which are effectively used as a single asset would address this concern.

Recommendation

That the submission be accepted.

Issue: Concept of cost when a deduction is allowed elsewhere in the Act

Submission

(New Zealand Institute of Chartered Accountants)

When a deduction is allowed elsewhere under the Act in relation to the acquisition of an asset, its cost could be reduced or even zero, which may not be appropriate in some cases.

Comment

Officials agree that it would be undesirable for assets to fall below the $50,000 threshold test just because an argument could be made that their cost was reduced or even zero. This should be clarified.

Recommendation

That the submission be accepted.

Issue: Application of $50,000 threshold to partnerships and look-through companies

Submission

(Matter raised by officials)

Partners in a partnership and shareholders in look-through companies (LTCs) complete tax returns based on their share of the income and deductions. It would be unsatisfactory if applying the $50,000 threshold on an individual basis could see an asset with a total cost of more than $50,000 falling outside the rules.

Comment

It would defeat the fairness objectives of the rules if an asset which had a cost of $50,000 or more fell outside the rules just because it was owned in a partnership or LTC structure. This should be clarified.

Recommendation

That the submission be accepted.

Issue: The expression “motor vehicle” is not defined

Submission

(Ernst & Young)

Motor vehicles are excluded from the mixed-use asset rules, but the expression “motor vehicle” is not defined for these purposes.

Comment

The policy intention of the legislation is that “motor vehicle” should have its ordinary meaning in this context, so no definition is required.

Recommendation

That the submission be declined.

Issue: Single asset used for multiple purposes

Submission

(New Zealand Institute of Chartered Accountants)

The legislation does not provide for assets that can have multiple concurrent uses, and this should be amended. For example, a strata title of a building may be divided into a number of apartments used in different ways.

Comment

The intention of the legislation is that taxpayers take sensible rather than unduly technical approaches to the expression “item of property” when in instances like this the logical approach would be to apply the gateway tests to each apartment.

It is not clear how this approach could be detailed in legislation, but some examples of this approach could be provided by Inland Revenue.

Recommendation

That the submission be declined.

Issue: Exclusion for assets when “area apportionment” basis is too wide

Submission

(New Zealand Law Society)

An asset where all or part of the expenditure is apportioned on an area or other similar basis is excluded from the rules. This exclusion is too wide for an asset which has multiple uses, such as a bach which has a doctor’s surgery at the front of it, and the exclusion should be made on an expenditure basis.

Comment

The general policy intention is that the mixed-use asset rules do not apply when existing similar apportionment methods apply, such as the rules under which apportionment by area is carried out.

When an asset has multiple uses as described, the mixed-use asset rules should still apply to the expenditure which relates to mixed use.

Recommendation

That the submission be accepted.

Issue: Concept of “active use”

Submissions

(New Zealand Institute of Chartered Accountants, Ernst & Young)

The concept of “use” for income-earning purposes should include periods when an amount is paid for the use of the asset which prevents any other use, but the asset is not actually used – for example, a bach is booked and paid for but the person does not show up. (New Zealand Institute of Chartered Accountants)

The concept of “use” does not accord with the normal position under income tax law as use for income-earning purposes – the focus of the rules should be on periods for which no income is earned from any source. (Ernst & Young)

Comment

The primary purpose of the concept of “active use” is to distinguish from periods when the asset is “available for use”. Officials agree that the kind of time periods described above by NZICA should be treated as income-earning periods.

The issue with the approach suggested by Ernst & Young is that the issue that these proposals are seeking to address is the concept that time periods when a mixed-use asset is not being physically used to earn income, but is available and being marketed for income earning use, can be treated as use for income-earning purposes.

Recommendation

That the submissions be accepted in part, subject to officials’ comments.

Issue: The concept of “private use” is too wide

Submissions

(New Zealand Law Society, New Zealand Institute of Chartered Accountants)

The concept of “private use” captures all use by the person or any associate, whether income earning or not. This is much too wide. (New Zealand Law Society)

It should be made clear that when the person using the asset is not the owner and is not associated with the owner – such as an employee – the use is not private use. (New Zealand Institute of Chartered Accountants)

Comment

The intention of this provision is to capture all situations where the asset is used by the person who holds the asset, or an associate of that person, where that person is a natural person (individual). Officials agree that the rules should be clarified to make this intention clear. The example given by NZICA is not intended to be captured by the rules.

Recommendation

That the submissions be accepted.

Issue: Market value, discounts and compliance costs

Submission

(Bell Gully, KPMG, Ernst & Young)

The definition of “market value” should be amended to provide for customary use such as volume discounts. (Bell Gully)

Inland Revenue should provide some guidance on what is required to establish market value, especially in circumstances when a discount has been provided because, for example, the property has proved hard to let. (KPMG)

Because of the compliance costs and risks of dispute, it is unreasonable to require taxpayers to establish that all income derived, even from unrelated parties, is at market value. For example, a taxpayer starting out in business may rent an asset at a reduced price for marketing purposes. (Ernst & Young)

Comment

The concept of market value used in the legislation is defined in the legislation and follows the fringe benefit tax definition. It refers to transactions made in the open market, freely offered, on ordinary terms, and to a member of the public at arm’s length. Officials consider that the examples raised by submitters would all fall within this definition.

However, guidance material published when the legislation is enacted could confirm this point.

Recommendation

That the submissions about amending the definition of market value be declined, but the submission about Inland Revenue providing guidance be accepted.

Issue: Exclusion from private use

Submission

(New Zealand Institute of Chartered Accountants, Ernst & Young, New Zealand Law Society)

Where an asset is used as part of a business for deriving indirect income this use should not constitute private use. (New Zealand Institute of Chartered Accountants)

Where income is derived indirectly, it is too difficult to determine whether the income from the use of the asset is a market value amount. (New Zealand Institute of Chartered Accountants, Ernst & Young)

The requirement that the income derived directly or indirectly from the use of the asset is a market value amount should be removed as it is too difficult to apply. (New Zealand Institute of Chartered Accountants)

The only requirement for use to be excluded from private use is that a market value amount is derived from direct or indirect use, and all other provisions should be deleted. (New Zealand Law Society)

The requirement that the amount paid includes an amount for the services of the person should be removed, as it is too difficult to ascertain where the asset is used in the person’s own business. (Ernst & Young, New Zealand Institute of Chartered Accountants)

Comment

The submissions refer to an exception to the definition of “private use”. The purpose of the exception is to exclude ordinary business and commercial use by the owner from the definition of private use. However, officials understand that as presently drafted the exclusion may not cover all business and commercial use arrangements.

Two amendments are proposed in response to other submissions which ought to reduce the frequency with which this exemption needs to be relied upon. Use will not be treated as private use when either:

in the income year the asset has been principally used in a business which is not a business of renting out the asset, the private use is minor and (when owned by a company or trust) that private use has been subject to FBT or the deemed dividend rules; or
at least 80 percent of market value has been paid for the use of the asset.

However, submitters had a concern that when an asset was used in a business in a way which generated income indirectly, it was impossible to know whether the requirement that the “income derived indirectly from the use of the asset is a market value amount” was satisfied. The example was given of a farmer who used his helicopter to check on his stock. In a bad year – such as a year of drought – the farmer may make a loss. The connection between the income he derives from selling sheep and the use of the helicopter are too remote.

Officials agree that there may be a better way to address these kinds of situations, such as an exclusion from the concept of private use where the asset is used in a person’s own business as part of the ordinary income earning process of that business.

Recommendation

That the submissions be accepted in part, subject to officials’ comments above.

Issue: Associated persons test

Submission

(KPMG)

The associated persons test should not be varied from 25 percent to 5 percent. This creates additional complexity and compliance issues because people who are not normally treated as associated will be for the purpose of these rules.

Comment

The original intention of this amendment was to refine the targeting of the rules to companies controlled by 10 or fewer shareholders. However, the amendment is ineffective to do that, and officials recommend that it be removed.

Recommendation

That the submission be accepted.

Issue: Application of rules where reimbursement payments are received

Submission

(BDO)

It is unclear how the rules apply when a person uses an asset owned by another person and reimburses the owner for their expenditure.

Comment

Under the recommendations in this report, a payment which is less than 80 percent of the market value of the use of the asset would be treated as private use, and the income would be exempt. An amount which is 80 percent or more of market value would be an income-earning day and the income would be taxable.

Recommendation

That the submission be noted.

Issue: Treatment of time spent maintaining the asset

Submissions

(PricewaterhouseCoopers, KPMG, Bachcare, TradeMe)

Time spent by the owner preparing or maintaining the asset for income-earning purposes should not be private use. KPMG suggests an integrity measure could be to limit this to days when the property is not suitable for ordinary use. (PricewaterhouseCoopers, KPMG)

Owners should be allowed to stay in the property to carry out maintenance at the beginning and end of each holiday season – two days for every six-month period when the bach is rented out for 30 days in each six-month period is suggested. (Bachcare)

Owners should be able to stay in the property to carry out maintenance. This should not be treated as private use – staying in the property will be a practical necessity if they live some distance away. (TradeMe)

Comment

Careful consideration when developing these proposals was given to the concept of excluding “maintenance days” when the owner works on the asset. The following factors count against allowing maintenance days to be excluded from the private use calculation:

The inherent difficulties with defining a “maintenance day”. For example, would the person be required to spend some, all, or a substantial part of the day working on the asset? How would this be enforced?
Allowing maintenance days to be excluded from private use would provide an opportunity for some asset owners to combine their private use with maintenance to achieve greater levels of deduction. For example, there would be a risk that bach owners could claim what is essentially a private day as a maintenance day because they mowed the lawns every two weeks or so.
The likelihood that many owners do combine private use and maintenance.

The submissions about people needing to travel some distance to carry out maintenance are useful. Different people will value their time in different ways, but it seems likely that if people really did need to travel a considerable distance to reach their bach, and received no private benefit from being there, then they would pay for someone else to carry out the maintenance rather than incur the travel time and costs.

For these reasons, officials do not consider that a blanket exemption for “maintenance days” should be allowed.

However, there may be circumstances when the owner of an asset – typically a bach – needs to repair damage caused by a renter. Officials recommend elsewhere in this report that a deduction is allowed for these costs without apportionment. When the owner of the bach needs to stay in the bach to carry out this kind of repair, it would be reasonable not to treat that as private use.

Recommendation

That the submissions be accepted in part, subject to officials’ comments above.

Issue: Treatment of periods when the owner is relocating the asset to enable income-earning use

Submission

(KPMG)

When the owner spends time moving the asset (such as a boat or a helicopter) to enable income-earning use, this should not count as private use.

Comment

This raises many of the same questions as the owner staying at a bach for maintenance purposes. The private benefit derived from an asset like a boat or an aircraft is typically the enjoyment of using – sailing or flying – it. It is not clear to officials that this enjoyment is eliminated simply because that use is to be followed or preceded by a rental use.

However, there may be instances when the costs of the relocation of the asset are explicitly or implicitly incorporated in the amount charged for the asset. Where additional income is derived in this way, it is reasonable that the period the owner spends relocating the asset not be treated as private use.

Recommendation

That the submission be accepted subject to officials’ comments.

Issue: Treatment of periods when the property is unavailable due to external contractors’ work

Submission

(Bachcare)

Periods when the property is unavailable due to it being repaired by external contractors should not be included in any private use.

Comment

Periods when the property is unavailable due to it being repaired by external contractors is not included in any private use under either the proposals as introduced or as recommended to be amended in this report. Officials have discussed this with the submitter, and the submitter has accepted this point.

Recommendation

That the submission be noted.

Issue: Treatment of periods when the asset is unavailable due to income-earning process

Submission

(New Zealand Institute of Chartered Accountants)

Income earning days should include days when the asset is unavailable for private use, even if it is not actively used to earn income on those days. An example would be a plane which is rented to fly to Sydney, and then rented to fly back one week later. It is not economic to return the plane to New Zealand between rentals, so it remains in Sydney where it is unavailable for private use.

Comment

The situation described above seems reasonable, although the plane being in Sydney does not render it unavailable for private use if the owners or associates happened to be in Sydney at that time.

However, introducing such an exemption into the proposals would risk the policy intention of ensuring that a fair proportion of expenditure is deductible. An exemption would give the wrong result in the following example:

A boat owner lives in Wellington.
He places his boat with a Marlborough Sounds yacht charter business.
A number of bookings are made throughout the summer.
The yacht is moored in the Marlborough Sounds for the entire summer because that is where each charter begins and ends.

An exemption would allow the owner to claim that the entire summer was an income-earning period. It is not clear how a fair distinction could be drawn between this kind of situation and the charter plane described above, and in either case the asset is available for private use in the “between hire” periods anyway.

Recommendation

That the submission be declined.

Issue: Definition of “interest expenditure” is too broad

Submission

(KPMG, Ernst & Young)

The proposals include in the definition of “interest” amounts paid on fixed-rate foreign equity or fixed-rate shares, and stapled debt securities. These are currently not deductible for companies, but the effect of this proposal is to allow a deduction for a proportion of them. This component should be removed from the proposals.

Comment

There are two implications in the submission:

amounts paid on fixed-rate foreign equity or fixed-rate shares and stapled debt securities do not need to be brought into the apportionment rules, because they are not deductible;
a further consequence of the rules is that a part of these amounts are made deductible.

Neither of these outcomes are sensible and officials agree with the submissions that these provisions ought to be removed.

Recommendation

That the submission be accepted.

Issue: Financial arrangement deductions are not matched by financial arrangement income

Submission

(New Zealand Law Society, Bell Gully)

Expenditure under a financial arrangement is subject to apportionment under the rules, but income amounts will be taxable in full. The rules should be clarified and where expenditure is apportioned, income should also be apportioned. (New Zealand Law Society, Bell Gully)

It is not clear that a loss in respect of a foreign currency arrangement would satisfy the requirement for being deductible in full. This creates a mismatch, as the income will be taxable in full. (Bell Gully)

Comment

Financial arrangement income is taxable even if the financial arrangement is held entirely for private purposes. There is no inconsistency with allowing a deduction for only a part of the expenditure but taxing all income amounts.

Recommendation

That the submission be declined.

Issue: Interest expenditure incurred by individuals who are trustees

Submission

(Ernst & Young)

Interest deductions for individuals are only subject to apportionment when the interest is incurred in relation to the asset. It is unclear whether this rule also applies when the individual is acting as a trustee.

Comment

The policy intention is that interest expenditure incurred by individuals is only subject to apportionment when the underlying debt was incurred to acquire the mixed-use asset (or shares in a company or group of companies which holds a mixed-use asset). This is the “tracing rule”.

This approach is even more relevant when the individual is a trustee, as it would be inappropriate for that person to have apportionment apply to debts incurred in their personal capacity.

Officials consider that the legislation – which simply requires that “the person is not a company” – is sufficiently clear to ensure that the tracing rule applies to individuals who are trustees, as they are clearly not companies.

Recommendation

That the submission be declined.

Issue: Interest deductions incurred by partners in partnerships

Submission

(Matter raised by officials)

Additional rules are needed to ensure that the apportionment rules apply to partners in both ordinary partnerships and limited partnerships.

Comment

The proposals contain “look-through” rules to ensure that shareholders in companies will be subject to limitations on their deductions if the company which owns the asset does not have sufficient debt.

Similar rules are required for partners in ordinary and limited partnerships, to ensure that, when partners borrow to acquire their interest in an ordinary or limited partnership, interest deductions on those borrowings are potentially subject to apportionment.

Recommendation

That the submission be accepted.

Issue: Application of mixed-use asset rules to qualifying companies and look-through companies

Submissions

(Ernst & Young, Matter raised by officials)

The proposals need to be amended to deal with interest incurred by qualifying companies, look-through companies and their shareholders, which have different treatment under current law than ordinary companies. (Matter raised by officials)

Comment

The proposals deal with interest in companies in the following way:

Apportionment is first applied to interest incurred (on debt up to the value of the asset) by the company which owns the asset.
It is then applied to group companies and other corporate shareholders (if necessary), applying the stacking rule.
It is then applied to any non-corporate shareholders (if necessary) applying the tracing rule.

A number of problems arise applying this standard framework to qualifying companies:

Qualifying companies are not subject to the rule under which all interest they incur is deductible, which makes it unreasonable to apply the stacking rule to them. Interest apportionment inside qualifying companies should therefore be on a tracing basis.
For the rules to operate fairly, it still remains necessary to consider interest incurred by shareholders to acquire his or her shares in the qualifying company, and potentially apply apportionment to it.

In the case of LTCs, the stacking rules will not apply because they are excluded from the legislative definition of “companies”, and so the tracing rules will automatically apply. However, as with LTCs, it remains necessary for the rules to operate fairly, and to consider interest incurred by shareholders to acquire their interest in the company, and potentially apply apportionment to it.

Recommendation

That the submissions be accepted.

Issue: Expenditure which relates to both mixed-use assets and other assets

Submission

(Bell Gully)

The rules should provide guidance on how to deal with expenditure which relates to both mixed-use assets and assets which are not subject to the mixed-use asset rules.

Comment

The objective of the proposals is to ensure that an appropriate proportion of expenditure on mixed-use assets is subject to the rules. Expenditure which does not relate to mixed-use assets should be entirely outside the rules.

There will be some instances when a single item of expenditure relates to both mixed use and other assets – for example, rates on an aircraft hangar that is used to house two aircraft, one of which is a mixed-use asset and the other which is solely used privately.

Officials consider that the current form of the legislation is sufficient for taxpayers to be able to make the kind of sensible apportionment that this example would require. For example, the expenditure which is subject to the apportionment formula is “… the total expenditure or loss that is incurred by the person for an income year in relation to the asset”.

Recommendation

That the submission be declined.

Issue: Rule for expenditure related to income-earning use

Submission

(Ernst & Young)

It is unclear whether expenditure such as rates, insurance and utilities can satisfy the requirement for expenditure to be solely attributable to the income-earning process.

Comment

The proposals divide expenditure into three categories – expenditure which relates solely to income earning (full deductions can be claimed), solely to private use (no deductions can be claimed), and the remainder (deductions are apportioned).

The “solely incurred” test is necessary to ensure that taxpayers can only claim full deductions for expenditure which delivers no private benefit.

Periodic charges like rates and insurance are more likely to be suited to the third category (apportionment) as they relate to both income earning and private use, and it could be difficult to divide the expenditure into the three separate categories.

However, these kinds of periodic charges could be divided into the three categories described above and this would produce the same outcome.

Other expenditure such as for utilities, which may vary between periods of use and non-use, and between different users, may give a slightly different outcome if entirely apportioned or separated into the three categories. However, because of the compliance cost of splitting the expenditure between each category, apportioning the entire item of expenditure is an acceptable outcome.

Given this approach, officials are therefore unconcerned that some items of expenditure might not satisfy the “solely” test, which is otherwise necessary to ensure the rules are robust.

Recommendation

That the submission be declined.

Issue: Companies and the rule for expenditure on income-earning use

Submission

(New Zealand Institute of Chartered Accountants)

The requirement that “the person not reasonably expect to receive a personal benefit” makes no sense when the person who holds the asset is a company.

Comment

The submitter is correct and the legislation should be amended to include situations where no benefit is received by a natural person who is associated with the person who incurs the expenditure.

Recommendation

That the submission be accepted.

Issue: Requirement that all repair and maintenance expenditure be apportioned

Submission

(New Zealand Institute of Chartered Accountants, KPMG)

The requirement that all repairs and maintenance expenditure be apportioned is an unfair outcome when the expenditure was incurred to remedy damage caused by a renter. NZICA notes that it is also the wrong outcome when the expenditure is incurred to remedy damage caused during private use.

Comment

Officials agree that when the expenditure is incurred to remedy a specific instance of damage caused by a renter – such as a hole in a wall –the cost of the repair should be entirely deductible.

However, officials are not convinced that maintenance expenditure falls within the same category. Maintenance is the remedying of gradual deterioration or wear and tear, rather than something attributable to a specific instance. It will therefore result from either the passage of time or use over time – in which case apportionment seems to be the right approach.

Officials recommend that asset owners be allowed a deduction for repairs which are carried out solely to repair damage caused by a renter, and similarly, that repairs which are carried out solely to repair damage caused by a private user be non-deductible.

Officials recommend no change to the proposal that maintenance expenditure be required to be apportioned.

Recommendation

That the submission be accepted in part, subject to officials’ comments above.

Issue: Reference to “rating” in the interest and deduction quarantining provisions

Submission

(Ernst & Young)

The reference to the “amount given by rating” in the provision dealing with the asset value for interest deduction purposes should be amended to make it clear that it is the rateable value of the relevant land plus improvements. This same issue also arises in the deduction quarantining provisions.

Comments

The interest deduction provisions which apply to companies which hold a land-based mixed-use asset require companies to compare the value of that asset to the company’s debt. The rateable value of that asset is used as a proxy for market value.

Similar language is used in the deduction quarantining provisions – deduction quarantining only applies to land-based assets when the gross income derived from the asset is less than 2 percent of the amount given by its most recent rating.

The legislative references could usefully be clarified, perhaps by reference to the concepts of annual value, capital value and land value in section 13(3) of the Local Government (Rating) Act 2002.

Recommendation

That the submission be accepted.

Issue: Value of land in the interest provisions should be cost

Submission

(New Zealand Institute of Chartered Accountants, New Zealand Law Society)

The cost of land, rather than its rateable value, should be used as the value against which debt is assessed.

Comment

The interest provisions assess the current debt position of the company. It therefore makes sense that this is assessed against the current asset value of the company.

Officials therefore do not agree that the cost of land should be used in this provision.

However, it is inconsistent with this approach to use cost as the basis for assets which decline in value, as the legislation does now. Officials therefore recommend that the provision which deals with non-land assets be amended to use the tax book value for depreciation purposes as a reasonable proxy for the current value of these assets.

Recommendation

That the submission be declined.

Issue: Use of word “complex” in heading of interest provisions

Submission

(New Zealand Law Society)

The word “complex” should not be used in the heading of the interest provisions because it suggests something inappropriate about such matters. The word should be replaced with “corporate”.

Comment

The purpose of the heading was to distinguish between the provisions which come before it, which deal with the deductions for individual asset owners, and the provisions which come after it, which provide additional rules when assets are held in companies. The implication which the submitter draws was not intended, and officials do not think it is a necessary inference of the language used.

However, officials are indifferent between the words “complex” and “corporate” and are happy to recommend the submission be accepted.

Recommendation

That the submission be accepted.

Issue: Use of expression “voting interest” in relation to companies

Submission

(New Zealand Law Society, Ernst & Young)

The mixed-use asset proposals use the expression “voting interests” to refer to the shareholding a company has in another company. However, general legislation provides that the voting interest that a company would otherwise have in another company is to be attributed to its shareholders. This provision needs to be disabled, as it is elsewhere in the Act.

Comment

Officials agree with the submission.

Recommendation

That the submission be accepted.

Issue: Requirement for companies to provide statements to shareholders

Submission

(Chapman Tripp)

The requirement for companies to provide statements to their shareholders to enable shareholders to take interest apportionment calculations seems problematic given the possibility of different balance dates and return filing obligations. More work should be undertaken to identify a sensible and workable basis for interest apportionment, and in the meantime the proposals should not proceed.

Comment

While some entities and individuals may have different balance dates, those balance dates all relate to the same income year, and return filing dates do not differ for the income year regardless of when the balance date is in that income year.

Accordingly, officials do not agree that significant issues will arise where companies and shareholders have different balance dates.

Recommendation

That the submission be declined.

Issue: Need for information to be provided by group companies and shareholders

Submission

(Ernst & Young)

The Tax Administration Act provision which requires the person who holds the asset to provide information to shareholders needs to be amended to require other group companies and shareholders to provide information to the person who holds the asset. This will enable sequential application of the interest expenditure and deduction quarantining rules.

The provisions assume that the same person will be preparing returns for all parties and able to use all information. This may not accord with professional responsibilities.

Comment

The rules for both interest expenditure and deduction quarantining have been carefully designed to minimise the requirements for two-way information flows. In the case of interest expenditure, companies within the group will need to provide information to whoever is making the interest apportionment calculations. However, it does not seem necessary to legislate for that within a group of companies. This is especially the case given the recommendation elsewhere in this report to exclude certain group companies with minority shareholders from interest apportionment.

No two-way supply of information is necessary for the apportionment of interest by shareholders. The group of companies simply needs to advise the shareholders of their proportion of the net asset balance and the apportionment ratio.

Recommendation

That the submission be declined.

Issue: Taxpayer has more than one mixed-use asset

Submission

(New Zealand Institute of Chartered Accountants, KPMG, Ernst & Young)

The interest apportionment proposals do not work if a company has more than one mixed-use asset. They can result in the reversal of all interest expenditure, and even the creation of additional income.

Comment

Officials agree with the submission, and that an amendment is required.

Recommendation

That the submission be accepted.

Issue: Applying interest apportionment rules to group companies that are not wholly owned

Submission

(New Zealand Law Society, Chapman Tripp)

An ordering rule is required to determine which group company is the first to have its interest apportioned. Issues will arise when group companies are not wholly owned.

Comment

The proposals currently:

deem all group companies to be 100 percent commonly owned; and
allow the members of the group to determine amongst themselves in which order to apply the interest apportionment rule.

This second rule in particular is designed to lower compliance costs. Rather than groups needing to apply the interest apportionment calculation in a prescribed order, they may be able to identify a single company which has sufficient debt and apply interest apportionment only to that company.

Officials accept that concerns may arise when non-wholly owned companies are included within the group. The minority shareholders of those companies may be reluctant to have the interest deductions of “their” company apportioned.

Accordingly, officials propose the following amendment.

When a company is not a wholly owned member of the same group as the mixed-use asset company, it can be excluded from the interest apportionment rules entirely if:

no minority shareholder of the company, or person associated with them, has had private use of the asset; and
there has been no loss offset with, or no loss subvention payments from, the company.

While these amendments do not create an ordering rule, officials consider that they deal with the bulk of the concerns around non-wholly owned group companies at source, while preserving the compliance cost benefits of groups to determine which companies should have interest allocated to them first.

Recommendation

That the submission be declined, but an amendment be made to clarify the legislation.

Issue: Technical application of interest apportionment formula to group companies

Submission

(Ernst & Young)

It is not clear that when a group company applies the interest apportionment formula, it should use the numbers generated by the mixed-use asset company’s application of the formula.

Comment

Officials consider that the drafting is reasonably clear here, but it would be straightforward to add further clarification to avoid any possible confusion.

Recommendation

That the submission be accepted.

Issue: Interaction with depreciation rules

Submission

(Ernst & Young)

The provision dealing with depreciation recovery on sale should be clarified to ensure that the reference to “deductions allowed” in the depreciation rules is to the net depreciation loss deductions actually allowed after taking account of any part-use or subpart DG apportionments.

Comment

The policy intention behind the relevant depreciation rule is that only a proportion of the depreciation recovered will be taxable, reflecting that only a proportion of the depreciation allowed was deductible. The relevant provision in the depreciation legislation refers to:

all amounts of depreciation loss for which the person has been allowed a deduction for the item in each of the income years in which the person has owned the item.

In officials’ view, this clearly means the amounts which are deductible after any apportionment – the amount prior to apportionment is not an amount “for which the person has been allowed a deduction”. Officials do not consider that any amendment is required.

Recommendation

That the submission be declined.

Issue: Cost should be used as the benchmark for the 2% deduction quarantining test

Submission

(New Zealand Institute of Chartered Accountants, New Zealand Law Society, KPMG, Ernst & Young)

Cost, rather than rateable value, should be the benchmark against which the 2% threshold for the application of deduction quarantining is assessed. It is unclear why the 2% threshold was selected, and it is too high.

Comment

The deduction quarantining rules prevent a person who owns a mixed-use asset from offsetting a loss from the mixed-use asset against other income. As set out earlier in this report, it is a “wait and see” rule designed to deal with the issue that the apportionment formula does not prevent an asset which has a low level of use and a high level of expenditure from producing perennial losses. Such losses cannot be genuine business losses, and arise because in these circumstances the apportionment formula essentially allows deductions for private expenditure.

To reduce the number of instances where the deduction quarantining applies to genuine losses, the rules will only apply where the gross income derived from the asset is 2% or less of its value. With the Official Cash Rate at 2.5% and bank deposits returning around 4%, 2% was seen as a fairly low level that someone with a reasonable focus on earning income ought to be able to achieve.

The ability of an asset to earn income is related to its current value, not its historic cost. To put it another way, two identical properties would have the same ability to earn income even if one was bought in 1960 and the other in 2007.

However, this logic also means that the value for non-land assets should be their current tax book value, as a reasonable approximation of their market value, and officials recommend an amendment be made.

This creates the same valuation rules as are used in the interest apportionment rules.

Recommendation

That the submissions of the external submitters be declined.

That the officials’ recommendation be accepted.

Issue: 2% threshold is not realistic for many properties

Submission

(Bachcare)

The 2% threshold is not realistic for many properties; those outside areas of key demand or basic baches on high-value land. A 1.75% would be a better level.

Comment

The 2% threshold has been set to reduce the likelihood of the deduction quarantining rules applying to asset owners who have a genuine short-term business loss, who under our tax system ought to be able to offset their loss in the year in which it arises, regardless of the level of income which generates it. Arguments can be made that the threshold should be set higher, or that quarantining should apply regardless of the income earned, because a loss on a mixed-use asset which is a perennial loss should always be denied, regardless of the level of income which generates it.

The 2% threshold seeks to balance these two competing objectives, and on balance officials’ preference is that it remains where it is.

Recommendation

That the submission be declined.

Issue: Potential disparity between rateable value and market value

Submission

(TradeMe)

Rateable value may not always be the same as market value, so owners should be able to get a valuation from a registered valuer to use as an alternative.

Comment

As noted above, the 2% threshold has been chosen to strike a balance between those who make genuine short-term business losses and those who the apportionment formula allows to make perennial losses, but arguments can be made for a higher or no threshold at all.

As the submitter implies, the rateable value of the property is used as a proxy for market value, and was chosen because it is already available to all property owners and can be obtained without incurring compliance costs.

Officials are reluctant to allow registered valuations to be used as an alternative to the valuation given for rating purposes because allowing these kinds of choices allows taxpayers to “game” the rules. Taxpayers will choose the rateable value if it is less than the market value, and have a registered valuer give a valuation if it is more. The only way this can be avoided (and even then only partially) is to require an asset which has been valued by a registered valuer to continue to be valued in this way each year. This would impose an undesirable level of compliance costs.

Officials consider that using the rateable value at all times provides the best balance of even-handedness and compliance costs.

Recommendation

That the submission be declined.

Issue: Deduction quarantining rules exclude income from associated persons

Submission

(Ernst & Young)

The exclusion of income from associated persons from the 2% gross income threshold below which deduction quarantining applies is confusing.

Comment

The proposals as introduced excluded income from associated persons from the test to determine whether the deduction quarantining rules should apply. This was to prevent asset owners from avoiding the application of the deduction quarantining rules by creating income from associated persons to exceed the 2% threshold.

Officials recommend elsewhere in this report that income from associated persons be treated as excluded income and not subject to tax. An amendment will be required to make it clear that excluded income is not included in the 2% deduction quarantining threshold.

Recommendation

That the submission be accepted.

Issue: Application of quarantined deductions to profits in future years

Submission

(Matter raised by officials)

The proposals should be amended to make it clear that quarantined deductions from one asset can only be offset against future profits from that same asset.

Comment

As noted earlier in this report, the policy intention is that quarantined deductions which arise from an asset can only be offset against future profits from that same asset. There is a slight ambiguity in the current drafting which can be read as allowing quarantined deductions from one asset to be offset against future profits from another asset.

Recommendation

That the submission be accepted.

Issue: Clarity of, and inconsistencies within, deduction quarantining rules

Submission

(Ernst & Young)

There seems to be an inherent inconsistency between the company which owns the asset having excess expenditure subject to quarantining and having an outstanding profit balance.
It is not clear what amounts need to be taken into account by group companies, and whether they involve amounts based on the group company’s own income and expenditure or those of the company which owns the asset.
If it is intended that the group company’s calculations should be based on the asset-owning company’s income and expenditure, there may be information and compliance issues.

Comment

When a mixed-use asset is held in a group of companies, the deduction quarantining rules require a group-wide approach to expenditure. This is because, to determine whether a loss has actually arisen to be quarantined, it is necessary to look at expenditure incurred not only by the company which owns the asset but also relevant expenditure incurred by other group companies. The legislation makes it clear that relevant expenditure is only interest which has already been identified under the apportionment rules.

This means that while the company which owns the asset may appear to be in profit – thereby having an outstanding profit balance – the mixed-use asset activity overall is in loss, once interest expenditure incurred by other group companies has also been deducted.

An example of the operation of these provisions is included at the end of sections DG 18 and DG 19.

Recommendation

That the submission be declined.

Issue: Application of quarantining rules to group companies

Submission

(New Zealand Law Society)

The same issues arise with the application of the quarantining rules to group companies as apply in the interest rules, which is that the rules do not set out the order of companies that the rules should be applied to.

Comment

As with the interest rules, groups of companies may choose which companies, and in which order, to apply the deduction quarantining rules to. This choice has been deliberately left to taxpayers so they can organise this in a way which gives rise to the least compliance costs, or meets whatever other objectives they might have.

The main issue arises with group companies which are not wholly owned. The modification to the interest rules under which certain companies which are not wholly owned will be excluded from the rules and will flow through to the deduction quarantining rules. This will lessen, although not entirely eliminate, the concern the submitters have.

Officials consider it preferable to continue to allow groups of companies to make their own decisions about these matters.

Recommendation

That the submission be declined.

Issue: No quarantining where income cannot be separately attributed

Submission

(New Zealand Institute of Chartered Accountants)

The submitter supports the proposal that deduction quarantining should not apply where a person owns a mixed-use asset to which income cannot be separately attributed.

Comment

Most of the assets to which the mixed-use asset proposals apply will be assets which are rented out. It is then straightforward to apply the test of whether the gross income from the asset is 2% or more of its value.

However, the rules can also apply when the asset is used in the person’s own business. In these instances, it will be difficult to apply the gross income test, because no income will be directly attributable to the use of the asset. Assets of this type are excluded, unless there is also a substantial proportion of rental use so that the 2% gross income test could be meaningfully applied.

Recommendation

That the submission be noted.

Issue: Level at which opt-out threshold is set

Submissions

(New Zealand Institute of Chartered Accountants, KPMG, PricewaterhouseCoopers)

The threshold of $1,000 of gross income for opting out is too low and should be:

2% of the asset value. (KPMG)
The higher of $5,000 or 2% of the asset value. (PricewaterhouseCoopers)
$10,000. (New Zealand Institute of Chartered Accountants)
Net income without applying the mixed-use asset rules. (New Zealand Institute of Chartered Accountants)

Comment

The proposals include two options under which a person who has a mixed-use asset can “opt out” of the tax system. The consequence of opting out is that the income from the asset is not taxable, and no deductions can be claimed. There are two grounds on which a person can opt out:

when the gross income from the asset for the income year is less than $1,000; and
when the result of the application of the mixed-use asset rules is that quarantined deductions arise.

Elsewhere in this report are recommendations that income from associated persons, and income which is less than 80 percent of the market value of the use of the asset be treated as exempt income. These recommendations will exclude further mixed-use asset owners from the rules, and make it easier for others to qualify for the opt-out thresholds above (because only market value income from non-associates will be counted).

The submissions focus on the first exemption set out above. The policy objective of this exemption is to reduce taxpayer compliance costs. If only a small amount of revenue will be produced from taxing the income from the asset, it is not worth taxpayers incurring compliance costs or Inland Revenue incurring administrative costs.

The appropriate measure for this exemption is a dollar amount, because compliance costs do not vary directly in proportion with asset value. Other things being equal, the compliance costs of a $400,000 bach will be the same as those for an $800,000 bach. Officials therefore do not agree with submissions that a threshold based on asset value should be used.

Nor do officials agree with a substantial increase in the dollar amount of the threshold, because to do so would be a disproportionate response to the compliance costs involved.

NZICA suggests as an alternative a threshold based on the net income arising from an asset, without application of the mixed-use asset rules. Officials note that a similar provision does exist, which allows a taxpayer to opt out if a quarantined deduction arises – essentially if net income after applying the mixed-use asset rules is nil or less, and gross income is less than 2 percent of the asset’s value.

However, officials consider that the threshold could be increased to further reduce compliance costs without raising any material issues of unfairness. This is especially the case as asset owners with low levels of income would be likely to be in loss after the application of the apportionment rules.

Officials recommend that the gross income threshold be increased to $4,000.

Recommendation

That the submission be accepted in part, subject to officials’ comments above.