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Inland Revenue

Tax Policy

Appendix 2 - Alternative deduction limitation rules

A number of different ways to structure and apply a deduction limitation rule were considered during the course of the review. These were:

“Money at risk” versus “good money”

An alternative to the current owner’s money at risk approach would be to focus on the “good” money in the business. Under the “good money” approach deductions could be higher as long as they are genuine. For example, the owners would be allowed more deductions to the extent that the LTC has loans from third parties that are not subject to any security or guarantee provided by its owners. A prime example of such third party financing would be negative pledge financing from a bank – this is genuine business financing but is not money that the owners have at risk. Deductions would be allowed for a standard company but could not be passed through to shareholders to offset against their other income. In most cases, however, lenders would require security on any lending in which case the “at risk” and “good money” approaches should be broadly comparable.

Per LTC or per owner

The current rule calculates each owner’s “money at risk” and limits their deductions to that amount. The rule could alternatively be calculated on a per LTC basis, which may be simpler. Under the per LTC approach any restrictions on deductions would automatically flow through to owners according to their shareholding, irrespective of the amount that each owner has at risk.

A possible drawback to this approach is that it could produce a different allocation than under the current rule when owners have provided differing levels of lending or guarantees. This might lead to negotiations among owners to maintain relativities. The rule would ignore this aspect.

A further issue is where there is a change of shareholding in the LTC – the new owner would have a different “owner’s basis” and reconciling this may not be easy.

Starting with shareholders’ funds

Using shareholders’ funds at year-end, as taken from the annual accounts, as the starting point rather than adding investments and other inflows, less outflows, since inception of the LTC could be simpler in the longer term. Net shareholders’ funds automatically takes realised capital gains into account but there would need to be adjustments to deduct:

  • any revaluations of assets other than real property;
  • overdrawn shareholders’ current accounts and any loans to associates of shareholders;
  • any unrecorded impairment where assets are significantly overvalued; and
  • intangible assets owned by the LTC.

To this would need to be added:

  • loans from shareholders or associated non-corporate persons; and
  • loans to the LTC that are not already counted that are unconditionally guaranteed by the shareholders or persons of substance associated with the shareholders.