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Inland Revenue

Tax Policy

Chapter 7 - Transitioning into the LTC regime


7.1 There are several issues in relation to the rules that apply on becoming a LTC.

Entry formula

7.2 We are proposing to amend the adjustment done at the time of entering into the LTC regime. The adjustment is intended to reflect the fact that retained earnings earned before becoming a LTC would have been taxable in the hands of shareholders if distributed before the company became a LTC. This in effect provides a square-up or clean slate on entry given that any distribution by the LTC will be tax-free. The adjustment amount becomes income for the LTC owners.

7.3 The income adjustment is based on the income that would arise if the company had been liquidated immediately before becoming a LTC, except that unrealised gains are not realised. The formula is:

dividends + balances – assessable income – balances – exit exemption
                                                                    tax rate


dividends is the sum of the amounts that would be dividends if immediately before becoming a LTC the property of the company, other than cash, were disposed of at market value and the company met all its liabilities at market value and it was liquidated and the net cash amount was distributed to shareholders without imputation credits or foreign dividend payment credits attached. In other words a liquidation took place;

balances is the sum of the balances in the imputation credit account and foreign dividend payment credit account immediately before becoming a LTC, plus amounts of income tax payable for an earlier income year but not paid before the relevant date, less refunds due for the earlier income year but paid after the relevant date;

assessable income is the amount of income that would arise as a result of liquidation less any deductions that the company would have as a result of liquidating. This includes depreciation gains or losses, bad debts and disposals of revenue account property;

tax rate is the company tax rate in the income year before the income year in which the company becomes a LTC;

exit exemption is the exit dividends that, if the company had previously been a LTC and is now re-entering the LTC rules, would be attributed to any retained reserves from the previous LTC period that have not since been distributed;

7.4 For compliance cost reasons, the adjustment formula uses the company tax rate, currently 28%, but this means that no further tax is paid by LTC shareholders on fully imputed income, which is contrary to the liquidation concept.


If on liquidation there would be a $72 dividend with $28 imputations credits attached, the formula produces an answer of $0 additional income. In contrast, upon a real liquidation and for a shareholder on a tax rate of 33%, $5 more tax would be payable.

7.5 The question of whether utilising the LTC rules to take advantage of any under-taxation and subsequently liquidating would be considered tax avoidance by Inland Revenue has been raised in a number of fora in recent years. As a result Inland Revenue issued a Question We Have Been Asked (QWBA) on the issue as part of a wider QWBA (No. 14/11) on tax avoidance scenarios. That QWBA indicated that avoidance will be considered to arise if there is an arrangement that involves an election to become a LTC and to subsequently liquidate.

7.6 However, irrespective of whether avoidance is an issue, there is still a tax rate advantage for shareholders on 30% and 33% marginal tax rates. Conversely, if the company has a predominance of shareholders who are on marginal tax rates less than 28%, then overall there is an over-taxation on becoming a LTC.

7.7 To achieve a more equitable outcome, we are proposing that the adjustment formula in section CB 32C(5) should be replaced with a formula that ensures the income that arises is taxed at shareholders’ marginal tax rates, rather than the company rate of 28%.[32] The new formula would treat the retained income and imputation credits that would arise on liquidation of the company as being distributed to the individual LTC shareholders who would include the income and imputation credits in their return of income. This approach would leave it to each individual shareholder to determine what tax rate applies to their share of the income. Allocating out the income and imputation credits would produce a fairer tax outcome but would result in additional compliance costs.


Taking the earlier example, this would mean the shareholder on a tax rate of 33% would receive a dividend of $72 with $28 imputation credits attached, and a further $5 would be payable.

QCs transitioning to LTCs

7.8 An associated issue is how to treat transitioning QCs under the adjustment formula. Conceptually, the outcome should be, as above, as if the QC had been liquidated. Under this approach the revised formula would make it clear that consistent with the QC liquidation rules, unimputed amounts would not be taxed.

7.9 Previously, QCs had a two year exemption window, to encourage conversion, which included exemption from the entry formula. This is in fact not a “free” conversion as effectively imputation credits are lost, which is akin to taxing all shareholders at 28% with no subsequent square-up on taxed income. Although this benefits shareholders on 30% and 33% marginal tax rates, it disadvantages those on lesser marginal rates. Whether it results in a more tax advantageous outcome than under allocating out the income and imputation credits to all shareholders, therefore, depends on the composition of shareholders and their marginal tax rates. A QC with a preponderance of low tax-rate shareholders would always have the choice of making a distribution before electing to become a LTC, to avoid any tax disadvantage.

7.10 On balance, we are proposing that the standard liquidation approach should be applied. This means that not only would an entry adjustment be required, modified as suggested above, but also losses that had accumulated in the QC could not be carried over to the LTC. Allowing QC accumulated losses to be carried over would have a significant fiscal cost which would be hard to justify.

7.11 This would not, however, affect entitlements to losses transferred on conversion during the two year exemption window (under section DV 23). Those transferred losses have been able to be used to the extent that there has been LTC income post-conversion and this will continue to be the case.

Values at time of entry

7.12 A retrospective technical change should be made to clarify the values at which a LTC’s assets and liabilities are deemed to be held by the LTC owners and in the LTC accounts when an ordinary company or QC converts to a LTC. They should be based on the tax book values of the ordinary company or QC immediately before conversion.


[32] A similar gap on entry into the qualifying company rules was rectified several years ago.