R I P to LAQC's

Welcome to our world LTC's

Finally, the government has released the details of its reforms to the LAQC regime that were announced on budget night back in May.

The changes mean that every LAQC owner has important decisions to make in the lead up to the changes.

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» So what are the changes in a nutshell....
» So why the need for change?
» What’s the Institute of Chartered Accountants overall take on the changes?
» So what is the process going forward?
» So if I have an existing LAQC – what are my options?
» So what are the nuts and bolts of the new rules?
» So if I don’t want to become a LTC but prefer to transition to a sole trader, partnership, or limited
   partnership, what then..?
» So what if I just do nothing and remain a qualifying company?
» So, what is your advice to clients?

• New “flow-though” income tax rules are introduced for closely held companies (fewer than 5 shareholders)
• A new entity to be known as a “Look Through Company” will be created
• Allow existing QC’s and LAQC’s to transition into the new flow-through tax rules or change to another business vehicle such as a limited partnership, partnership, or sole trader, without a tax cost
• Existing Qualifying companies and Loss attributing qualifying companies will be allowed to continue but WITHOUT the ability to attribute losses
• Shareholders electing their companies to become LTC’s will have losses and profits flowed to shareholder’s personal tax returns
• The new rules will be introduced on 1 April 2011
• The government intends to review the dividend rules for closely held companies

In the budget, the government announced that the tax rate for companies will fall to 28%.

The trust and individual top tax rate though are aligned at 33%.

This means that losses attributing from LAQC’s will typically give shareholders a 33% tax saving.

But, if companies become profitable, these profits would only be taxed at 28%.

The government didn’t feel it could live with a situation where the losses saved 33% tax but allowed profits to be taxed at only 28%.

For property companies, it must be remembered that with the removal of depreciation on buildings, many companies will make the transition from loss to profit.

The budget night proposal was that the current QC rules would be replaced by a new set of rules to make both QCs and LAQCs flow-through entities for income tax purposes, similar to the treatment of limited partnerships. Under the proposal a company’s income and losses from both QCs and LAQCs would be passed through to shareholders: so income would be taxed and losses deducted at a shareholder’s own tax rate.

NZICA had some sympathy for the rationale for the proposals in relation to LAQCs, but opposed a full flow through model that sought to mimic the partnership rules. In NZICA’s view a more pragmatic and less compliance cost intensive solution would be to attribute the net income or loss of an LAQC to shareholders, as opposed to overlaying partnership tax rules on a company.

However, in the context of the Budget announcements, the more significant concern was the proposal to also move QCs into a partnership model. In NZICA’s submission on the proposals, the opening comment on this point was: “In terms of the QC rules, the Institute cannot think of a valid reason why the QC regime should be replaced in the way proposed. QCs were established for a very valid reason: to enable capital gains to flow to shareholders tax free without the need to liquidate the company. This overcame a law change in 1985 that taxed dividends sourced from capital reserves. Following this law change the company structure was not the vehicle of choice. QCs were a very good solution as dividends from capitals gains were tax exempt.

Shareholders in QCs receive no more tax advantages than the structural choices our tax system permit – that is, they have an interest in a limited liability company that allows tax free capital gains to be distributed to shareholders. This is the right policy choice for a tax system that does not have a general capital gains tax.

For this reason, NZICA says the Government has got the broad policy decisions right by allowing existing QC rules to remain pending a review of the dividend rules.

While LAQCs have the option to become look-through companies from 1 April 2011, the Government has announced that there will be an option to transfer at no tax cost to another entity type. Thus, for some people staying in the QC rules may still provide the right answer for them, whereas for others, they may prefer to avoid the technicalities associated with the new flow-through company model and transfer to a standard company, or some other entity type now at no tax cost.

Following limited consultation on the draft legislation, the legislation will be added as a Supplementary Order Paper to the Taxation (GST and Remedial Matters) Bill 2010 that is currently before the Finance and Expenditure Committee. This will ensure the legislation is enacted well before its application date of 1 April 2011.

It seems there is enough certainty now around the options to start planning for the new rules.

If you already have an LAQC you have several options to choose from next year. You can, without a tax cost:

1. Continue as a qualifying company (QC), without the ability to attribute losses
   • This is the ‘default’ option for all existing QC’s and LAQC’s
   • You will no longer be able to attribute losses to your shareholders but can still access capital gains with tax exempt dividends
   • This applies until the government has completed it’s review of the dividend rules for closely-held companies
2. Be taxed as an ordinary company
   • You will need to revoke LAQC election
   • Any new losses will have to be used by the company, not the shareholders
   • All dividends will be taxable to shareholders, including those declared from capital gains
   • You will be able to take advantage of the 28% company tax rate
3. Be taxed as a look-through company (LTC)
   • You will need to elect to become a LTC before 30 September 2011
4. Become a limited partnership, an ordinary partnership, or sole trader
   • Special rules will enable you to transition into a limited partnership, partnership, or sole trader, with no tax cost, i.e. no depreciation recovery
   • You will need to restructure your business and either make the company non-active or wind it up within 12 months of 1 April 2011. This means changing all property titles and re-documenting mortgages.

Look-through companies: Overview
The proposed legislation creates a new tax entity, a look-through company (LTC).

A LTC’s profits and losses are passed on to its shareholders in accordance with their shareholding.

A LTC is taxed as a transparent entity. Income is taxed and losses are deducted in the shareholder’s personal tax return and at their own marginal tax rate.

The LTC rules include a loss limitation rule. This means owners can offset tax losses to the extent the losses reflect their economic loss. Following responses to submissions on the officials’ issues paper, the ‘basis calculation’ for the loss limitation rule includes loans made by the owner to the company. Withers Tsang made a submission on this point and we are pleased to see this has been adopted.

All owners must elect for an eligible company to become an LTC. A company will remain an LTC unless:

• the company breaches the eligibility criteria, or
• an owner chooses to revoke the LTC election.

Look-through applies for income tax purposes only. The registered company retains its limited liability benefits under general company law. And it may still be recognised separately from its shareholders for other tax purposes.

Transitional rules for existing qualifying companies (QCs) and LAQCs: Overview
The transitional rules enable existing QCs and LAQCs to leave the QC rules and use the LTC rules, or transition their business structure into a partnership, limited partnership or a sole trade, with no tax cost and no depreciation recovery.

These transitional rules apply only to companies that are QCs or LAQCs in the income year prior to the income year starting on or after 1 April 2011.

The transitional provisions apply only where the QC or LAQC is making the transition in their first income year starting on or after 1 April 2011.

Transition into LTC rules
Existing QCs and LAQCs may transition to become an LTC during their first income year starting on or after 1 April 2011.

To transition, all the shareholders of the QC or LAQC must make an LTC election within 6 months of the start of that income year. Making this LTC election revokes the previous QC and LAQC elections, with effect for, and from the beginning of, the first income year starting on or after 1 April 2011. For most companies this means they have until 30 September 2011 to elect to become an LTC.

When an existing company becomes an LTC its owners are usually deemed to have an amount of income equal to their proportion of the amount of the company’s reserves that would be taxable if the company was liquidated and assets distributed; the owners will pay tax on this income amount. However, under the transitional provision no income amount will arise, and so no tax will be paid by owners when an existing QC or LAQC transitions to become an LTC.

For the purposes of the LTC loss limitation rules, there are two options for determining an owner’s basis:

• The market value or the accounting book value of the amounts used to determine an owner’s basis for the loss limitation rules. The values are taken at the last day of the transitional year.
• The historic basis, as if the LTC rules had always applied and the LTC had always existed.

Full legislation is available on www.taxpolicy.govt.nz. There is also a detailed commentary on the new legislation.

The following key details have been drawn from that commentary.

Look Through Company Eligibility Criteria
An LTC is a company that is resident in New Zealand under domestic law and under any relevant double tax agreement. This means it’s management base will need to remain in New Zealand.

The shareholders of a company using the LTC rules are referred to as ‘owners’ and can be either individuals or trusts.
An LTC must have five or fewer ‘look-through counted owners’. For the purpose of this requirement:

• Individuals are regarded as one look-through counted owner if they are relatives, e.g. spouse, or connections to the second degree of blood relationship.
• The trustees of a trust are regarded as one look-through counted owner for an income year unless all the income the trust was allocated from the LTC in that income year, and in each of the preceding five income years, was paid out as beneficiary income in those years.
• An individual beneficiary of a trust is a look-through counted owner if the beneficiary is allocated, by the trust, income from the LTC as beneficiary income in that income year, or in any of the five preceding income years. This means that there will need to be careful management of the owner count test when the company is owned by a trust.
• If a company is the beneficiary of a trust and has received income from the LTC as beneficiary income in that income year, or in any of the five preceding income years then the company itself is not regarded as a look-through counted owner. Instead the test counts all natural persons who have a voting interest in relation to that company.

A LTC must have only one class of shares. All the shares must have the same rights to vote regarding distributions, the company constitution, capital variation and director appointments, and to receive distributions of profits and net assets.

An owner’s shareholding is known as their ‘look-through interest’.

To become a LTC a company must meet all the eligibility criteria. It must continue to meet it for the whole of the income year. If a LTC breaches the eligibility criteria its LTC status is lost from the first day of the income year in which the breach occurs. It cannot then use the LTC rules in the year in which the breach occurs or either of the following two income years.

This stand down period is harsher than the existing LAQC rules and compliance with the eligibility criteria will therefore be an important management issue on an ongoing basis.

Election rules
All owners must sign the LTC election in order for a company to use the LTC rules.

The LTC election must be received by the Commissioner before the start of the income year in which the company wishes to be an LTC. Newly incorporated or non-active companies must file the LTC election by the date for filing their first income tax return.

If an LTC election is received before the start of the year but is later discovered to be invalid due to a mistake the Commissioner may accept it as a valid election. The Commissioner’s discretion will be exercised only if the mistake is rectified in the relevant income year and if the Commissioner is satisfied that exceptional circumstances, such as a severe illness, caused the mistake. As with the LAQC rules, it is clear there will be little mercy shown to those making incorrect elections or missing deadlines.

A company will remain an LTC without any further LTC election. It will cease to be an LTC only if it breaches the eligibility criteria, or the LTC election is revoked. This is a positive thing. Change to shareholding in the current LAQC regime requires shareholders to re-elect to retain LAQC status.

Any owner may revoke the LTC election. The revocation letter must be received before the start of the income year to which it applies. Again, if a revocation letter is received after the start of the income year to which it relates, the Commissioner may still accept it, if it was late due to exceptional circumstances.

If an owner revokes the LTC election the company cannot use the LTC rules in the year for which the revocation is made, or in either of the following two income years.

If the owner who revoked the LTC election subsequently sells all of their shares to another person within 31 days of the start of the income year to which the revocation relates, the person acquiring the shares may write to the Commissioner to request that the LTC election continue to stand and the previous owner’s revocation be ignored.

Becoming a look-through company
Any loss balance of a company is extinguished before it becomes an LTC. This is similar to the existing LAQC rules.

If a company becomes an LTC after its first year of trading its reserves are regarded as held by the owners in proportion to their look-through interest.

When a company becomes an LTC, each owner will be deemed to have an amount of income arising on the first day of the income year the company becomes an LTC. This is similar to the existing qualifying company election tax rules.

LAQC’s or QC’s transitions to the new rules will not be effected by these elective taxes.

A look-through company is transparent
Owners are treated as holding property in proportion to their effective look-through interest.

Income, expenses, tax credits, rebates, gains and losses are all passed through to owners. These items are allocated in accordance with owners’ interest in the company, and will usually be allocated according to the average yearly interests, as if each item occurred uniformly throughout the year.

If the voting interest varies during the year owners have two options to determine their effective interest:

• a weighted average basis, or
• the actual look-through interest of each owner in each period during the income year. This is applied to the income, expenses and other flow-through items from each period, and then added together. Broadly this requires ‘in-year accounting’ for each period of ownership within the income year.

Income may be apportioned to owners who were not owners when the LTC derives the income. This income is taxable. Likewise, expenditures or losses may be apportioned to owners who were not owners when the LTC incurred the expenditure. This expenditure is deductible, subject to the other tests of deductibility in the Income Tax Act.

Loss limitation
Loss limitations are not currently a feature of the LAQC rules so this is a new compliance issue completely.

The deductions an owner may claim are restricted if the overall deductions exceed the adjusted tax book value of their investment in the LTC. This is referred to as the “membership basis”. It will be necessary for us to calculate a running balance of each owner’s membership basis.

Membership basis is calculated as the sum of the

• Equity, goods or assets introduced or services provided to the LTC, or any amounts paid by the shareholder on behalf of the company.
• Loans made by the owner to the LTC or the shareholders advance account.
• Share of the LTC debt guaranteed by the owner.
• Share of the net LTC income previously recognised, and capital gains previously realised.

• Distributions, including dividends, made by the LTC to the owner.
• Share of the LTC debt guarantees (or indemnities) extinguished by the owner.
• Share of the net LTC loss previously deducted.
• Share of the capital losses previously realised.
• Any previous distributions.
• The amount of investments made by an owner within 60 days of the last day of the LTC’s income year which are disallowed.

Investments will be disallowed if they are distributed or reduced within 60 days after the last day of the income year. This does not apply if the ‘reduction’ of investments within 60 days of the balance sheet date is less than $10,000.

Any deductions that an owner does not claim due to the operation of the loss limitation rule are carried forward and may be claimed in future years, subject to the application of the loss limitation rule in those years. Owners may use these deductions only against income from the LTC, i.e. they will be ring fenced.

If the company exits the LTC rules but continues to be taxed as an ordinary company the owner may claim the deductions as a loss against any future dividends he receives from the company.

Whilst on the face of it the introduction of these loss limitation rules is a negative aspect of the new LTC, in practice it seems very unlikely that a shareholder in a property company will actually have losses restricted by these rules. This is because bank debts that are guaranteed by the owners and their current account balances will all be factored into their calculation of “money at risk” or “membership basis” as it is know. LTC owners can expect an impact at the compliance cost level though as it will be necessary to make this membership basis calculation each year for each owner.

Sale or Disposal of look-through interests
Owners of an LTC are treated as holding LTC property directly, in proportion to their interests. When owners sell their shares in the LTC they are treated as disposing of their share of the underlying LTC property. They will bear any tax consequences associated with the disposal. For property companies this will typically mean depreciation recoveries.

The requirement for the owner selling the shares to account for tax on this disposal of underlying property is removed when the tax adjustment that would otherwise be required is below certain thresholds. When these provisions apply, the new owner is treated as acquiring their interests in the LTC’s underlying property for the same cost that the exiting owner had acquired them.

The thresholds are:
$50,000 threshold

• Exiting owners are required to account for tax on sale of shares only if the amount of the disposal proceeds exceeds the total net tax book value of the owner’s share of the LTC property.

• Exiting owners do not have to perform a revenue account adjustment for trading stock if the LTC’s total annual turnover is $3 million or less.

• Exiting owners do not have to account for depreciation recovery or loss on their share of any depreciable tangible asset if the historical cost of the asset is $200,000 or less. This rules out most NZ property assets

The thresholds do not apply if the LTC exits the LTC rules, but the company otherwise continues. The owner is deemed to have disposed of and immediately reacquired their shares at market value at date of exit.

Important Point
This means that losing LTC status will become a taxing event that will trigger the like of depreciation recovery. Currently, the loss of LAQC status is not a taxing event, this further ratchets up the importance of monitoring and managing the eligibility criteria and the owner count tests, especially where there are trust shareholders and income is distributed to beneficiaries.

Ceasing to be a look-through company
If a company ceases to be an LTC but continues in existence, it will be taxed as an ordinary company at the 28% company tax rate. Any retained revenue profits held by the company would have been allocated to owners who would have been subject to tax on this income, in the year the income arose.

Any dividends paid by the company in the income years after it ceases as an LTC will therefore be regarded as paid firstly from this retained revenue profit, until an amount of dividends equal to the amount of retained profit has been paid.

Dividends regarded as paid from this retained revenue profit are exempt income in the hands of the shareholder recipients.

Working owners
A deduction is available to owners of an LTC for payments made to working owners. A working owner is an owner who is employed by the LTC under a written contract of service and who personally and actively performs the duties of their employment for the LTC under that contract.

An LTC’s payments to a working owner are included in that owner’s salary or wages, and the PAYE rules will apply.

This tightens up the current rules that allowed working shareholders to be allocated a shareholders salary without the need to deduct PAYE or have a formal contract.

Tax administration
An LTC must file a return of income. The return must specify the amount of income and deductions allocated to each owner, similar to a partnership tax return.

Existing QCs and LAQCs may transition to become a partnership, or a limited partnership, or sole trader, during their first income year starting on or after 1 April 2011. This year is referred to as the ‘transitional income year’, and effectively provides a QC or LAQC with up to twelve months to restructure their business.

During the transitional year the QC or LAQC must:

• Revoke, in writing, its QC/LAQC status, within 6 months of the start of that year
• Give written notice to the IRD that it intends to become a sole trader, partnership or limited partnership, on or before the date the revocation notice is received.
• Liquidate the company, or register the company as a non-active company, before the end of the transitional year
• Create, before the end of the transitional year, a partnership or limited partnership, consisting of partners who are the same as the shareholders in the QC/LAQC, holding the same partnership share as their effective interests in the QC/LAQC.

For a QC or LAQC transitioning into a limited partnership, it does not matter which of its shareholders become limited partners and which become general partners.

Existing QCs and LAQCs may continue to use the qualifying company rules WITHOUT THE ABILITY TO ATTRIBUTE LOSSES. This will be the default option for all existing QCs and LAQCs for income years starting on or after 1 April 2011.

The existing rules which allow a LAQC to attribute losses to its shareholders, have been removed.

Distribution from capital gains will remain tax exempt and it seems these remaining QC’s may be able to take advantage of the new 28% company tax rate if they are profitable.

Differences between look-through company rules and qualifying company rules
Many clients are familiar with the qualifying company (QC) rules; these are some of the key differences in eligibility criteria and election rules between LTCs and QCs.

LTC eligibility criteria:

• No restrictions on the amount of foreign-sourced non-dividend income that an LTC may receive. This means an LTC will be able to own an offshore property asset.
• Trustees of a trust are regarded as one look-through counted owner, unless all the income the trust was allocated from the LTC in that income year and in all of the preceding five income years was paid as beneficiary income.
• No obligation on the trustees to allocate the LTC income as beneficiary income, unlike QC rules which require a trust to pay QC dividends as beneficiary income. This was the reason previously that we often advised against trusts owning LAQC’s.
• An ordinary company may be the beneficiary of a trust. But if it receives income from an LTC as beneficiary income its natural person shareholders will be regarded as look-through counted owners under the count test.

• No directors’ elections are required.
• All shareholders must sign LTC election; no majority elections.
• Once the shareholders have elected for the company to be an LTC, there are no revocations by event, so no further elections are required. Previously changes in shareholding required LAQC’s to re-elect within 60 days of the change.
• A trustee signs the LTC election for a trust shareholder; no accompanying beneficiary signatory is necessary.
• Any shareholder can revoke the LTC election.
• A revocation is effective prospectively, so a revocation for an income year must be made before the start of that income year.
• There is no election for shareholders to take personal liability for the company’s tax liability, as shareholders are allocated an LTC’s income and losses, directly anyway.

This stand down period is a completely new concept.

The new rules create a variety of options for current LAQC clients.

The variety of these options means there isn’t a one size fits all solution that will work for everyone.

Each company will need to make a decision on which way it chooses to go.

We will be offering all LAQC clients a discounted consultation ($210 plus GST) to review their affairs one on one with us.

We recommend you take us up on the offer. The timelines are short:

• The new rules come into effect 1 April 2011
• Election to become a LTC must be filed by 30 September 2011
• Election to become a partnership or sole trader must be filed by 30 September 2011
• Companies opting to become sole traders or partnerships have one year to transfer ownership of properties, re-document mortgages, and either liquidate or become non-active.
• Doing nothing will result in the loss of the ability to attribute losses

Many property owners chose to use LAQC’s because their properties produced losses and many shareholding splits are structured to direct these losses to the high income earners.

If losses have become profits, these shareholding splits may no longer be appropriate.

Changing shareholdings under the new LTC rules will trigger depreciation recoveries so it you are not happy that your shareholding split is appropriate, you will need to take steps to change it urgently before the 1 April 2011 introduction date.

It may also be appropriate to consider selling LAQC shares to trusts prior to the new rules taking effect, especially if companies are profitable.

Remember that if you do want to transfer your shares, the process includes valuing them. This usually means all the properties will need to be valued to achieve this. There may well be matrimonial property issues and gifting issues to consider if you want to change your shareholdings.

Don’t leave this to the last moment, the process is surprisingly involved and you will need to consult your lawyers now to ensure it can be completed before 1 April.

It seems to us unlikely that companies will choose to revoke their LAQC status and return to being standard companies. Despite this option, allowing the use of the 28% corporate tax rate, the only way to extract capital gains tax free is to liquidate the companies. This is at best a giant hassle and at worst, practically impossible if the company owns multiple property assets.

Whilst transitioning to a sole trader or partnership has a certain appeal, especially the overall simplicity it allows, the reality is that the transition is still likely to be costly, given all properties will need to be sold out and mortgages re-documented. Some banks apply fixed rate break penalties when loans are re-documented.

Partners in partnerships are also jointly and severally liable for debts of the partnership and the LTC will still allow the benefits of limited liability and separate entity status.

It is our hunch that most LAQC owners will choose to elect to become LTC’s rather than transition to a sole trader or partnership model.

Remember that the opt in election deadline for this is 30 September 2011. So put this in your diary today.

This is definitely not one to miss.

The team at Withers Tsang stands ready and willing to review your options with you directly and will look forward to doing so in the months to come.

R I P to LAQC’s

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