Tax Talk | IRD Discussion document – seeing tax avoidance everywhere

The reintroduction of the 39% tax rate for individual income of more than $180,000 has resulted in the government proposing new measures to address matters that are perceived by Inland Revenue to essentially be tax avoidance. Those measures attack long-established principles and will have a wide application.

Time to read: 6 mins

The proposals are to tax some of the proceeds from the sale of shares held on capital account and greatly expand the attribution of income from personal services. The government also aims to look at the income retention rules for companies and trusts.

These measures are being proposed to prevent taxpayers from what Inland Revenue perceive as exploiting the lack of a general capital gains tax, and also from diverting personal income to companies and trusts with tax rates of 28% and 33% respectively. The biggest area of concern for the government is the use of closely held companies and trusts by taxpayers who fall into the 39% personal tax bracket.

The government is proposing the following:

  • The sale of shares in a company by a controlling shareholder would be treated as a dividend to the extent the company and its subsidiaries have retained earnings resulting in a tax liability for the shareholder
  • The removal of the “80% one buyer” test for the personal services attribution rule. Other proposed changes to this rule would see the “80% one natural person supplier” test lowered to 50% and the possibility of the substantial business asset threshold being amended as well
  • A requirement for companies to hold records of their Available Subscribed Capital and net capital gains to increase the accuracy in relation to the tax treatment of distributions made

Sale of shares

The government believes the difference between the top personal tax rate and the company tax rate that first occurred in 2000 has encouraged businesses to retain earnings instead of paying them out as a dividend.

The wealth could then potentially be realised from an eventual sale of the company. While there are anti-avoidance rules which prevent the conversion of taxable retained earnings into untaxed capital gains, these are largely limited to related party transactions and are not applicable on a third-party sale, and require Inland Revenue to obtain evidence and go through time-consuming procedures.

To expand Inland Revenue’s arsenal the government proposes a portion of the proceeds, for the sale of shares by a shareholder of a controlling company be taxed as a dividend. The deemed dividend would equal the higher of the retained earnings of the company (grossed up to a pre-tax amount) and the imputation credit balance being divided by 28%.

Sales proceeds exceeding this deemed dividend would be recognised as a tax-free capital gain. The treatment will apply to companies that are controlled more than 50% by an individual or an individual and their associates. It will apply to partial share sales as well as disposals of 100% of the shares.

The rule is intended to apply to New Zealand tax resident individuals and is not intended to apply to non-resident companies or shareholders.

The details of the regime and calculations will be complex and a minefield for taxpayers and their advisors.

Expanding personal services attribution

The personal services attribution rules are being considered for considerable expansion by the government. The personal services attribution rules ensure income earned by a closely held company or trust for work done by a person (personal services), will be recognised as income of the person responsible for doing that work. The rule prevents a person from having their income from individual effort taxed at 28% or 33%, especially if, the person falls into the 39% tax rate.

The current personal services attribution rules apply when the following thresholds are met:

  • 80% of the associated entity’s income from the personal services is derived from the supply of services to the buyer or an associate of the buyer (or combination of both),
  • At least 80% of the associated entity’s income is derived from personal services that are performed by a person or a relative of theirs (or a combination of both), and
  • Substantial business assets are not a necessary part of the business structure used to derive the associated entity’s income from personal services (substantial business asset rule).

There is a further rule that came out of the famous Penny & Hooper case, in which Christchurch orthopaedic surgeons Ian Penny and Gary Hooper used company structures and family trusts to avoid a higher personal income tax rate by artificially lowering their salaries. The rule states that if a trust or closely held company derives its income from the personal services provided by an owner, the person performing the work must receive a market value salary.

In Penny & Hooper the doctors carried out work for many patients and therefore the 80% buyer test was not met. The government is proposing to remove the 80% limit − the first threshold to capture an entity with a diverse customer base. The second threshold is proposed to be lowered to 50% of a working person’s services producing income for an entity, with the aim of capturing more taxpayers under the personal services attribution rule. This will significantly expand the attribution rules to smaller building companies, medical practices etc. Under the proposals, in a Penny & Hooper situation, all the income less expenses would be required to be attributed to the person providing the service, not just a market value salary.

The threshold for substantial business assets rule is also proposed to increase to $200,000.

These changes are a significant expansion of the attribution rules and are clearly intended to make life much easier for Inland Revenue while removing legitimate structuring options that have always been available. There are different risks for those performing services and for those owning companies that contract to provide those services, and being able to retain income in a company or trust as security or for working capital is common practice that Inland Revenue wants to ignore.;

Record keeping

An issue government has identified is the poor level of record keeping when it comes to Available Subscribed Capital (ASC) and tracking historic capital gains. These amounts are important as they dictate what can be distributed from companies tax-free (usually on liquidation) as a return of capital or distribution of capital gains. Often businesses are not aware of their level of available subscribed capital as the relevant transactions happened many years ago and the relevant records have been subsequently destroyed. The government is proposing to overcome this issue by one of these proposals:

  • Reporting the ASC and available capital gains and losses annually and reported to Inland Revenue, or
  • Require taxpayers to record information as evidence they have calculated the tax-free distribution amount correctly, with no annual reporting requirement

This would ensure accurate records of ASC are retained, but the up-front compliance costs to identify these figures will be significant.

Comment

It is concerning the government is looking at this degree of tinkering after their promise in 2019 that a capital gains tax would not be on the agenda. Indeed, in combination with the ten-year bright line test, the general land taxing provisions, the financial arrangements rules and the foreign investment fund rules, it is increasingly looking like New Zealand has a capital gains tax in all but name and it might be better to simply revisit a broad-based capital gains tax than have a complex series of regimes which add unnecessary compliance costs to businesses and run the risk of inadvertent non-compliance.

Negative comments in the discussion paper about smaller or fewer dividends being paid to shareholders since 2000 are also concerning. Commentators in the 1990s frequently despaired at businesses paying out dividends to shareholders instead of reinvesting those funds into their business and allowing it to grow. From a New Zealand Inc approach, we would rather see government encourage business owners to reinvest in their business than force the payment of dividends that will not serve New Zealand Inc well in the long run.

The closing date for submissions on these proposals is 29 April 2022.

If you have any queries or would like our assistance in relation to this matter, then please contact your Baker Tilly Staples Rodway advisor.

DISCLAIMER: No liability is assumed by Baker Tilly Staples Rodway for any losses suffered by any person relying directly or indirectly upon any article within this website. It is recommended that you consult your advisor before acting on this information.

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