Impact of changes to the look-through company rules
Tax Alert - December 2017
By Emma Faulknor and Susan Wynne
Eight months have passed since the Taxation (Annual Rates for 2016-17, Closely Held Companies, and Remedial Matters) Act 2017 was enacted at the end of March 2017. The effect of this legislation was to make a number of changes to the specific tax rules that apply to closely held companies, in particular the look-through company (LTC) rules.
Overview of the changes
The LTC regime recognises that companies are taxed differently to individuals and is intended to be concessionary by extending the tax treatment of an individual to a company that has elected to be a LTC. This is achieved through the look-through nature of a LTC for income tax purposes.
The intention behind the recent amendments to the LTC regime was to strengthen the rules so that they better aligned with the original policy intent – a regime targeted to entities with a small number of owners with direct ownership interests.
The main changes to the LTC regime were to limit who could own an interest in an LTC to only individuals or trusts where certain conditions are met. This was to match the policy intent that LTCs are not widely held entities. These changes included:
- The method for counting look-through counted owners where a trust is a shareholder was expanded to include all beneficiaries who have received a distribution from the trust, including amounts received from trust capital and corpus.
- The definition of ‘look-through company’ was amended to exclude Maori Authorities and Charities from being LTC owners. Fortunately, the restrictions do not apply to Maori Authorities or Charities with an existing interest in an LTC by grandparenting existing structures that were in place prior to 3 May 2016, when the Bill was introduced.
- Trusts that own LTCs have been prohibited from distributing to corporate beneficiaries to ensure that the restriction on corporate owners is not circumvented. Trust owners are also restricted from making distributions to Maori Authorities unless the LTC qualifies as grandparented.
- A company is unable to be an LTC if it has more than 50% foreign ownership and foreign sourced income of more than both $10,000 and 20% of the company’s gross income for the year.
- The loss limitation rule that restricted the amount of deductions an LTC owner could claim for a tax year no longer applies to LTC interests. The exception is where a LTC is in a partnership or joint venture. The calculation has not changed.
- The LTC entry tax that applies when an existing company elects to become an LTC is now payable at the shareholders’ marginal tax rates rather than a flat 28%.
- A ‘self-remission’ concept was introduced so that a debt written off in an LTC owed to an owner is not taxable to that owner.
Most of the changes came into effect on 1 April 2017. More detail on the changes is discussed in our previous Tax Alert article here.
Impact of the changes
The amendments have seen LTCs being used less where an LTC may have historically been used. The revised LTC eligibility tests are also being considered more carefully where an LTC is either already in place or being considered. In contrast, the use of limited partnerships has been increasing. A limited partnership provides a similar transparent or look-through tax effect to owners as an LTC.
Tax transparent entities such as LTCs and limited partnerships are useful from a tax perspective. With the amendments to the LTC rules we have seen an increase in limited partnerships being utilised in the following situations:
- Where a separate legal entity is required;
- Where entities are able to benefit from a lower tax rate, e.g. Maori Authorities;
- Where entities want to offset losses against a profit-making owner;
- To access tax credits.
While similar in some respects, there are differences between the LTC and limited partnership regimes:
- Ease of establishment: Setting up an LTC is easier and less costly than setting up a limited partnership. An LTC is a New Zealand incorporated company that has made a tax election into the LTC regime where it meets the eligibility criteria. A limited partnership requires a formal partnership agreement to be written up by lawyers as part of the establishment process.
- Limitation of tax deductions: As discussed above, the cumbersome loss limitation rule, which can restrict tax deductions to owners, will no longer apply for most LTCs. The loss limitation rule continues to apply to limited partnerships, which will require this annual calculation to still be performed and could limit tax deductions to limited partners.
- Structure: An LTC must have five or fewer look-through counted owners. A limited partnership is not restricted in the number of owners but has two types of partner, a general partner and a limited partner, and must have at least one of each. A limited partner is restricted in their involvement in the management of the limited partnership. The general partner must undertake day-to-day management and they do not have limited liability.
There are still practical issues that arise when using a tax transparent entity, for example when interests are sold and purchased in either LTCs or limited partnerships. Essentially, when a person disposes of their interest in either an LTC or limited partnership, the person is treated as disposing of their interest in the underlying property, with the associated tax consequences. A concession applies when the gain on sale of the owner’s share of property is less than $50,000 so that tax consequences are deferred and the new owner effectively steps into the exiting owner’s shoes. There are also other concessions subject to relatively low thresholds for depreciable property or trading stock owned by the LTC or limited partnership.
This can require complicated calculations for the exiting owner to determine what tax liability may arise. The difficulty for a new owner and the remaining owners can be how to manage underlying assets with different cost bases for different ownership portions following ownership changes. For example, where an LTC or limited partnership holds depreciable assets, the portion of the asset equivalent to the interest a new entering owner has in the LTC should be revalued to the amount the entering owner paid, or was deemed to pay for the asset. Maintaining a tax fixed asset register can become complex in these circumstances or the issue may simply be ignored. The Inland Revenue commentary QB 14/02: Income tax - Entry of a new partner into a partnership - effect on continuing partners considered the income tax effects of a new partner entering an existing partnership and highlights the complexities of accounting for such changes.
Overall, the changes to the LTC regime are positive and the tax regime remains useful for closely held businesses. However, there continues to be more Inland Revenue can do to address all practical issues associated with the LTC and limited partnership regimes to ensure these operate effectively. Issues continue to arise when owners enter and exit look-through entities or contribute additional capital. In addition, look-through entities are not consistently treated as transparent within the tax rules, resulting in issues such as the application of the associated persons rules. As a result, the application of these regimes will continue to have some practical difficulties.
Contact your Deloitte usual tax advisor if you would like to discuss any issues raise in this article.
December 2017 Tax Alert contents
- BEPS proposals now before New Zealand Parliament
- Terms of reference announced for Tax Working Group
- R&D Tax Credits: Reflections from New Zealand and Australia
- Is AIM the right provisional tax method for you?
- GST on online shopping – the holiday is coming to an end
- Proving arm’s length pricing is set to become a taxpayer’s burden
- Impact of changes to the look-through company rules
- Are your GST processes and controls up to scratch?
- Recent tax developments