Closely-held companies – Officials’ issues paper released
Tax Alert Special
On 8 September 2015, Minister of Revenue Todd McClay released an Officials’ issues paper, Closely held company taxation issues (“the Paper”).
Closely held companies, being companies which typically have only a few shareholders, make up a significant proportion of New Zealand’s 400,000 incorporated companies. Given the nature of these businesses, there are specific tax rules available to ensure that the decision as to whether to convert a small business to a company is not driven by tax considerations. One such example is the look-through company (“LTC”) regime. The LTC rules introduced a regime which created a transparent outcome for companies which elected into the regime. The rules were introduced in 2010 to replace the loss-attributing qualifying company rules and allow income and expenditure of a company to be allocated to the shareholders in proportion to their interest in the company. When the LTC rules were introduced, the qualifying company (“QC”) regime was grandparented meaning that companies that were already QCs could continue to be so.
At the end of the 2014 income year, there were approximately 50,000 LTCs and 70,000 QCs. While there are many reasons why a company may want to continue operating under the grandparented QC regime as opposed to transitioning to the LTC regime, concerns have emerged about the workability of the LTC rules. The numbers of LTCs versus QCs supports the general view that the LTC rules can be difficult to apply and that in some instances eligibility criteria are a barrier to entry for some closely held companies. On this basis, the Paper reviews the LTC rules and suggests a range of changes to make the LTC rules more workable. The Paper also considers and suggests changes with respect to the application of the general dividend rules to closely held companies that are not LTCs or QCs.
While it is good to see some progress in this area, it is unfortunate that the Paper only focusses on fixing legislative design issues which arose as a result of a rushed in LTC regime back in 2010. There has been no real consideration of the fundamental issues, particularly around what the treatment of capital gains should be for closely held companies. It is our understanding that the paper was to have addressed the issues that were first raised in the Valabh Reports that initially led to the introduction of the QC regime.
Review of LTCs
By way of background, the desired policy framework for entity taxation is that businesses can operate through a variety of structures/entities and that tax distortions between structures/entities should be eliminated (or kept to a minimum). With regard to LTCs, it is acknowledged that this regime allows the owners of closely held businesses to be taxed as if they owned the underlying investment individually while still being afforded the protection of limited liability. This helps to prevent tax being a distorting factor in what would otherwise be a commercial decision to incorporate a company.
The key proposals in the Paper are outlined below.
LTC entry criteria
Currently an LTC can only have one class of share, the rationale for this being that it makes it easier to determine relative shareholding for the purposes of allocating an LTCs income and deductions. However, Officials now acknowledge that there can be legitimate commercial or generational planning reasons for shares to carry different voting rights and that the current restriction prevents some companies from becoming LTCs. It is therefore proposed that different classes of shares carrying different voting rights be allowed, provided all the other rights are the same (i.e. rights to income and deductions).
LTCs must have five or fewer shareholders (“look-through counted owners”) and special rules currently exist to count the number of shareholders so that (broadly) owners which are relatives are counted together. With regard to trustees who are shareholders, currently the rules look at whether LTC income has been distributed to beneficiaries or not, and if so beneficiaries that have received distributions within the past three years can become look-through counted owners. Officials’ state that this approach provides scope for beneficiaries to be rotated so that the profits of the LTC are able to be distributed to a larger beneficiary class while still meeting the required counted owners test. Further, because the test currently focusses on beneficiary income only, it is suggested that there is scope to make other types of distributions which do not affect the numbers of beneficiaries that are counted for the purposes of the entry criteria. As a result of these concerns, it is proposed that the way trustees and/or beneficiaries are counted will be tightened to include all distributions made (whether beneficiary or trustee income, corpus or capital) to a beneficiary within the last six years. If there are no distributions during this period, the trustee should continue to be counted as a separate counted owner.
Further, it is also proposed that a company will not be eligible for LTC status if a trustee shareholder makes a distribution from LTC interests to a corporate beneficiary. Currently, an LTC shareholder cannot be a corporate entity (unless that corporate entity is also itself an LTC). Officials therefore suggest that allowing a trustee shareholder of an LTC to make a distribution from that LTC interest to a corporate beneficiary is not consistent with the intended exclusion of corporate ownership of LTCs. In order to address this issue, it is proposed that the LTC status of an entity would cease from the beginning of the income year in which a distribution from LTC interests is made to a corporate beneficiary.
Officials acknowledge that these last two changes may cause some companies to lose their current LTC status, but consider this is the right policy approach.
Lastly, it also proposed that both charities and Maori authorities be excluded from being either shareholders in an LTC or beneficiaries of a shareholding trust on the basis that both of these entities likely have a wide set of beneficiaries and so are contrary to the policy that LTCs are a vehicle for closely controlled companies.
Removal of the deduction limitation rule in most cases
The deduction limitation rule is intended to ensure each shareholder is prevented from deducting tax expenses in excess of the amount they have invested in the business. Since its introduction, this rule has long been a source of irritation because it requires a complex calculation for each owner every year which only results in limiting deductions in 1% of all cases. This rule gives rise to unnecessary compliance costs and can be difficult to accurately apply for small to medium taxpayers. It is therefore very pleasing news that it is proposed that the deduction limitation rule be removed in most cases.
The rule will however be retained to apply in situations where there are partnerships of LTCs. This is on the basis that a similar deduction limitation rule applies to alternative structures which provide the flow-through treatment for widely held investments (i.e. limited partnerships).
Receipt of foreign income and non-resident ownership
For now at least, Officials consider that the status quo should be retained for LTCs that are used either for onshore investment into New Zealand or offshore investment out of New Zealand. Importantly, with regard to situations where a non-resident has invested in New Zealand assets through an LTC, it is noted that it is possible that any issues that arise as a result of hybrid mis-matching will be addressed by the wider OECD base erosion and profit shifting project when the recommendations are finalised later this year.
However, it is proposed that an LTCs foreign income will be restricted to the greater of $10,000 or 20% of its gross income when more than 50% of the LTC’s shares are held by non-residents. The policy rationale for this proposed change is that LTCs were designed as a domestically focussed vehicle and not as a vehicle for conduit investment.
Tax paid on entry to the regime
It is proposed to amend the income adjustment rule performed at the time of entering into the LTC regime. Currently, for compliance cost reasons, this formula uses the company tax rate (currently 28%) meaning that no further income tax is paid by the LTC’s shareholders on election into the LTC regime where income is fully imputed. As such, there can be a tax rate advantage for shareholders on a 30% or 33% marginal tax rate by virtue of the fact tax is paid at 28% with no further tax arising when those amounts are passed through to the owners once the company is an LTC. Conversely for shareholders that are on a lower than 28% marginal rate, it can be a disadvantage. In order to achieve a more equitable outcome the formula will be adjusted so that tax is paid at the marginal rates of shareholders on election into the LTC regime.
Debt remission and LTCs
Concerns have arisen in relation to the interaction of the LTC rules and the financial arrangements rules in situations where a debt is advanced by a shareholder to the LTC and later subsequently remitted. While it seems appropriate that the other shareholders of the LTC derive debt remission income, the creditor shareholder can be left deriving a proportional share of debt remission income with no tax deduction arising for the their overall economic loss. In order to resolve this situation it is proposed that in these situations, the creditor shareholder’s share of the debt remission income will be turned off.
Retention of QCs
Many entities have continued on as QCs since the introduction of the LTC rules. At this stage it is proposed that QCs will retain their status. However the Paper does include a proposal that QC’s will lose their status when a greater than 50% change in control occurs.
The proposals contained in the Paper are a step in the right direction. In particular, the retention of the QC regime is important given that number of closely held companies that continue to operate under this regime. Also, the proposed removal of the deduction limitation rule (in most cases) will ease the compliance burden on taxpayers and the proposed change to the application of the financial arrangement rules with respect to debt remission provides a more equitable outcome for LTC owners.
With regard to becoming an LTC, it’s clear that Officials have focused on addressing concerns surrounding the entry criteria to ensure that the regime is only available to closely controlled companies where the business owners could have otherwise owned the underlying investment individually (i.e. the intended policy outcome). In particular this focus has led to tightening of the entry criteria with respect to distributions from LTC interests by trustee shareholders. We suggest that further consideration may be required in relation to the practicalities of these proposals. For example a trustee shareholder may have other sources of income which it would like to distribute to a beneficiary as a capital distribution, meaning the trustee shareholder could be required to track the sources of its trust capital. Further, the prohibition on a trustee shareholder making a distribution from an LTC interest to a corporate beneficiary who is part of the same wholly owned group of companies would not appear to defeat the policy rationale for the LTC regime.
The proposal to change the formula determining tax paid on entry into the regime should also be given further thought as the current proposal may require shareholders to effectively prepay tax on distributions which they may not receive for some time, or possibly at all. One possible solution may be to track any taxable reserves of an LTC on entry into the regime and then tax them only when they are distributed to shareholders. Currently the regime has a similar solution for LTCs on exit of the regime where excluded amounts are tracked post exiting the regime.
Overall, the proposals regarding LTCs strike a reasonable balance between making the regime more workable and ensuring that base maintenance issues are addressed.
That said, some changes will mean that come current LTCs will be forced out of the rules which will entail some planning over the next few months. Those affected should consider making a submission.
Review of general dividend rules
In addition to the above proposals in relation to the LTC regime, the Paper goes on to review the rules around distributions/dividends made by closely held companies that are not LTCs or QCs. The Paper has the following proposals in relation to this.
- Currently, capital gains can become “tainted” gains when a company sells a capital asset to a related party. Upon liquidation, these gains are currently taxable in the hands of shareholders; however, if the company elected into the LTC regime, capital gains would have flowed through to the shareholder and would not have been taxable. The Paper recognises this arbitrage and proposes relaxing the restrictions around tainted capital gains to ensure capital gains derived by closely held companies are not taxable on liquidation merely because they were derived through a transaction with another related company.
- When a fully imputed dividend is paid to another company, withholding resident withholding tax (“RWT”) should be optional. The Paper includes comments that the optional removal of RWT obligations for closely held companies with respect of dividends and interest paid to shareholders could also be a possible solution to current concerns raised in relation to the RWT regime but that this would be considered as part of the wider work on streamlining business taxation processes.
- The current RWT rules provide for different withholding obligations with respect to cash and non-cash dividends (i.e. a single dividend which includes cash and non-cash dividends would be treated as two separate dividends). It is proposed that RWT obligations should be streamlined when cash and non-cash dividends are paid concurrently.
- Shareholder salaries should be able to be subject to a combination of PAYE and provisional tax provided the company maintains the approach consistently from year to year.
These changes are sensible and will certainly help with reducing compliance costs for closely held companies in many instances. However, with regard to the potential removal of the requirement to withhold RWT from dividends or interest paid to shareholders, businesses will need to consider whether the compliance costs are simply being switched from the payer to the recipient.
Submissions on the Paper can be made until 16 October 2015. Once the submissions are considered, resulting legislative changes will make their way into a taxation bill with changes intended to apply from the 2017-18 income year.
If you would like to explore these proposals further, please contact your usual Deloitte Advisor.