Closely held companies – changes to LTC eligibility and tainted capital gains
Tax Alert - May 2017
By Bill Hale and Jamie Hall1
The enactment of the Taxation (Annual Rates for 2016-17, Closely Held Companies, and Remedial Matters) Act 2017 (“the Act”) has brought into effect a number of legislative changes to the tax rules applying specifically to closely held companies (“CHCs”), being companies which typically have only a few shareholders, for example, look-through companies.
In addition, the Act also includes changes to narrow the scope of the tainted capital gains rule, which applies to all companies but may be of particular interest to CHCs.
While some of the above changes apply from 30 March 2017, being the date of enactment of the Act, most others apply from the 2017/18 income year.
In September 2015 Inland Revenue released the officials issue paper, Closely held company taxation issues (“the Issues Paper”), which sought response to possible changes to deal with concerns about the workability of various tax rules which apply to CHCs. These proposals were covered in a Special Tax Alert publication.
After considering a number of submissions on the proposals, Officials have refined the changes to those included in the Act. We comment on some of the key changes in respect of Look Through Companies (“LTCs”) and tainted capital gains below.
The LTC regime allows companies meeting certain criteria to be treated as transparent entities for income tax purposes. In effect, the rules aim to allow owners of these companies to be taxed as if they owned the underlying investment while still being afforded the protection of limited liability.
As a result of these rules being perceived as difficult to apply, resulting in increased compliance costs and in some instances not working in a manner which was consistent with the policy intent, a number of changes to the regime are included in the Act. Broadly, Officials have sought to make the LTC regime simpler to apply but have tightened the rules regarding those who are eligible to enjoy the concessions provided by the regime.
LTC entry criteria
In order to ensure that the LTC regime concessions are only available to CHCs, the Act includes a number of changes to the eligibility criteria from the 2017-18 income year. Key changes include:
1. Counting beneficiaries of trusts
The Act has amended the definition of a “look-through counted owner” which provides the mechanism for counting owners when testing whether the entity has met the requirement of having five or fewer counted owners. In particular, where an LTC is owned by a trust, the Act broadens the way beneficiaries are counted to include not only those who receive distributions of LTC income but also any beneficiary who receives any distribution from any source from the trust (whether beneficiary or trustee income, corpus or capital) during the current or preceding three income years. While the regime provides for the aggregation of those holding LTC interests for the purposes of the counted owners test in some situations, this change could significantly expand the number of counted owners a LTC has. This of course will be particularly relevant where the LTC owning trust has other investments from which wealth is earnt and distributed to beneficiaries.
2. Corporate beneficiaries
The definition of an LTC has been amended to expressly prohibit trusts who own LTCs from making distributions to corporate beneficiaries either directly or indirectly. Importantly, current structures involving LTC-owning trusts with corporate beneficiaries are not expressly prohibited by the new rules, provided that the trust does not make further distributions to its corporate beneficiary from the 2017-18 income year.
3. Maori Authorities and Charities
Amendments have been made to effectively preclude direct ownership by charities and direct or indirect ownership by Maori authorities of LTCs subject to the certain exemptions, including:
- The amended definition of “look-through company” allows for LTCs to make charitable distributions to charities which have no influence over the LTC or shareholding trusts of the LTC. This recognises that LTCs may want to make genuine charitable gifts.
- Those Maori authorities and charities who held interests in LTCs as at 3 May 2016 (the date the Act was first introduced into Parliament) are provided with grand-parenting relief meaning they can change the level of shareholding they have in LTCs prior to this date but cannot acquire new interests in LTCs they did not have before that date.
4. Transitional rule for entities losing LTC status
A new transition rule will apply to those entities who are LTCs at the end of the 2016-17 income year but which lose LTC status as a result of the amendments to the eligibility criteria included in the Act. Broadly, these entities will be able to transition to ordinary company status without triggering any potential tax events which can otherwise arise when an entity ceases to be an LTC.
It is clear that Officials have sought to limit the scenarios in which a taxpayer will be eligible to access the concessionary treatment provided by the LTC regime. By extending the counting of beneficiaries and limiting the ability of Maori authorities and charities to hold LTC interests, Officials have tried to eliminate ownership structures which they consider provide LTC benefits to people outside of the CHC context for which the rules were designed.
Notwithstanding this, it is pleasing to see that Officials have responded positively to some of the concerns raised during the submission process regarding the eligibility changes. For example, the time period over which trust distributions are assessed for the purposes of the counted owners test was not extended to six years as proposed. In addition, a specific four year transition rule has been included, meaning that the more stringent test will only apply to income earned from the beginning of the 2017-18 income year. Likewise, the introduction of the transitional rule for LTCs that lose their eligibility as a result of the changes provides a far more practical outcome for these entities than the proposals included in the Issues Paper.
Going forward, trusts with LTC interests will need to carefully consider the impact of the new rules. In particular, where trusts either have made or intend to make distributions to beneficiaries, trustees will need to consider the impact the distribution(s) could have on the LTC’s eligibility. This will be particularly relevant where a trust intends to make a distribution to a beneficiary which is a corporate entity. It may well be that the changes will result in taxpayers considering whether it is appropriate to have LTC interests held in the same trust as other income earning assets given the reduction in flexibility trusts could have in relation to distributions. Further, those establishing trusts for the purpose of holding an LTC interest should consider whether the trust deed has appropriate safe-guards to ensure any distributions are consistent with LTC regime eligibility criteria.
LTC entry tax
As proposed in the Issues Paper, the Act includes an amendment to the LTC entry tax formula. The impact of this change is that where an existing company elects to become an LTC, the retained earnings of the company immediately before becoming a LTC (the amount that would be treated as a dividend should the company have been liquidated) will be taxable to the LTC owner(s) at their marginal tax rate. In calculating their tax liability as a result of this entry tax formula, the owner will be entitled to claim any available imputation credits.
Readers may recall that under the old entry tax formula the company tax rate of 28% was applied, meaning that no further tax was payable by the LTC owners on election into the regime where historic retained earnings were fully imputed. As a result of this creating a perceived tax advantage for shareholders on a 30% or 33% marginal tax rate (and a tax disadvantage for owners on a lower marginal rate), Officials have amended the formula such that each owner must now determine whether or not they have a tax liability on entry into the regime based on their own tax profile.
While this change may address a potential tax benefit received by a shareholder(s) of an LTC in situations where their marginal tax rate is higher than 28%, shareholders of companies considering electing into the LTC regime will need to weigh up whether the change will result in them prepaying tax on distributions which they may not receive for some time, or possibly at all. While under the LTC regime shareholders are treated as owning the underlying investment, it is likely that in many instances the LTC could not practically distribute all of the retained earnings which are taxed on entry into the regime to the shareholders (for example due to working capital requirements). As such, it may be that cash tax is required to be paid by LTC shareholders on wealth which they cannot immediately access and which may otherwise not have been payable until the company ceased trading and either a dividend was declared or the company was liquidated. While this change may not adversely impact those entities with negative retained earnings such as highly geared property investment companies, it will likely mean that it is impractical for companies with existing retained earnings balances to enter into the LTC regime.
Other LTC changes
In addition to the above, there are a number of other LTC related amendments included in the Act but not discussed in detail in this article. In particular, the removal of the deduction limitation rule except in limited circumstances is a welcome change due to the complexity and limited benefit that the rule provided. Consequently, it should become easier for loss making LTCs to allocate tax losses to shareholders, including in situations where the deduction limitation rule would have previously prohibited this. Further changes have been made to limit the amount of foreign income that a foreign-controlled LTC can derive, the application of the debt remission rules in the LTC regime as well as the requirement for an LTC to have only one class of share on issue.
Tainted capital gains
One of the more welcome changes included in the Act is the narrowing of the “tainted capital gains” rule. This rule has historically applied to limit the amount of capital gain that could be distributed tax free to shareholders on liquidation of a company, in particular where a capital gain had arisen as a result of a transaction with an associated party. The policy rationale behind this rule was to prevent companies from generating and then distributing capital profits in lieu of dividends, which would have been regarded as taxable income. While acknowledging this concern, the ambit of the rule was far reaching and often resulted in companies deriving tainted capital gains from transactions which were genuine in nature and which occurred at a market value (and were not tax driven).
The new tainted gains rule
Effective from 30 March 2017 (the date the Act was enacted), the tainted capital gains rule will only apply to asset sales between companies that have at least 85% common ownership, with the original owners still retaining at least 85% interest in the asset at the time of liquidation.
In particular, a tainted capital gain will arise if:
- Company A makes a gain on the sale of property to another company (Company B); and
- At the time of the sale there is 85% common shareholding between Company A and Company B; and
- At the time Company A is liquidated the property is still either owned by Company A, Company B or another company with 85% or more common shareholding with Company A.
Helpfully, the new rule applies to all distributions made after 30 March 2017, even if the gain was made before that date. Further, to the extent that the transferred asset ceases to exist on the liquidation of Company A, any gain arising from the earlier transaction will not be tainted.
Officials have suggested that the threshold of 85% was chosen on the basis that a change of ownership to an unrelated third party of more than 15% is sufficient evidence that the transaction is genuine and involves a real transfer of the underlying assets, rather than a transfer in lieu of a dividend.
The loosening of the tainted capital gain rule is a positive change. The scope of the legislation as it previously stood was difficult to justify in many circumstances, particularly as it often resulted in genuine commercial transactions either being subject to the rule or worse yet not proceeding because of the potential tax implications only. By limiting the ambit of the rule to transactions between companies (only) and in situations where there is at least 85% common ownership, the rule now strikes a better balance between protecting the policy intent and ensuring genuine commercial transactions are not caught. It is however unfortunate that the Act does not adopt submissions suggesting CHC be allowed to distribute non-tainted capital gains to shareholders prior to liquidation.
Practically, we suggest that companies may wish to re-calculate their available capital distribution amount if they have previously considered that a non-taxable capital gain was tainted and therefore not eligible to be included. As noted above, even where the transaction giving rise to the gain occurred prior to 30 March 2017, provided the company deriving the gain has not yet been liquidated the new rule will apply to determine whether or not the gain is “tainted”.
For more information on the above changes, please contact your usual Deloitte advisor.
 The authors would like to acknowledge the contribution of Ashley Barnett in assisting with this article.
May 2017 Tax Alert contents