Government Capital Gains Tax Creep
Tax proposals from Inland Revenue minister David Parker on 16 March 2022 reveal again his felonious regard for all private sector business owners. This comes off the back of government’s increased 39% tax rate hike and also the property bright-line extension all less than 10 year residential property owners be categorised as property speculators.
In a government discussion document today, proposals are outlined to strike at “closely-held” private companies:
1. Taxing company share sales
- Treat any sale of shares in a company by controlling shareholders as a taxable dividend to the extent of the company’s undistributed retained earnings
- This would apply to piece-meal share sales / sell-downs as well as 100% company sales
- A portion of the sale proceeds would be re-characterised as a dividend derived by the shareholder(s)
- Applies to individuals, trusts, corporate shareholders & limited partnerships that are the controlling shareholders of the sale company (ie, 50% or more control)
- Would not apply to non-resident companies (only NZ resident companies in the main), or to listed companies
- The taxable “dividend amount” upon share sales would be the grossed-up undistributed earnings of the company, proposed to be the “higher” of (a) the retained earnings according to IFRS accounting principles, but less capital gains, and (b) grossing up the sale company’s imputation credit balance (ICA)
- This deemed dividend would be entitled to carry imputation credits if available within the company’s ICA
- Very simplistically, if on a $1,000 sale price of a company with retained earnings of $720 (and imputation credits from tax paid of $280), the deemed dividend would be $1,000 taxable to the vendor shareholder. Tax payable on this would likely be $390 – $280 (imputation credits allowed on pass-through) = $110
- To mitigate “double-taxation”, the company’s “available subscribed capital” (its tax recognised paid-up capital that is returnable tax-free in circumstances) post-sale would be increased by the amount of the deemed dividend, so the buyer is not disadvantaged
2. Greater taxation of corporate professionals and personal service businesses
- Broaden the application of rules attributing taxable company/trust income to the principal where that income is derived by companies or trusts from personal services provided by majority shareholders or by settlors/trustees/beneficiaries to tax the working individuals, (rather than allowing the income to be taxed in the company or trust likely at a lower rate of tax); known as the personal services attribution rule
- Remove the “80% one-buyer rule”; that is, where a company/trust derives income from multiple buyers, the personal services attribution rule does not currently apply. However, under these proposals, where a person supplies their personal services to a portfolio of customers using a trust or company, that person would still be treated as deriving the company’s income personally instead of the company/trust
- Remove the “80% one individual supplier rule”. That is, where a company/trust derives income through the 80% substantive efforts of a working person, the attribution of income applies. Where, however there are other (non-associated) working persons in the entity, the attribution rule does not currently apply. The proposal is to reduce this “one individual supplier” rule, likely to 50% so that where “most” of the work arises from one person, the company/trust’s income will be taxed individually on a pass-through basis
- A further exemption from these rules currently applies where the company/trust uses substantial assets as integral to the provision of services. Substantial assets means assets of $75,000. New proposals lift this threshold of assets to $150,000 or to $200,000 (thus requiring more connected assets in the business to qualify for the exemption from attribution)
But wait, there’s more! This is the 1st of 3 tranches of the government’s thinking. If you are worried about the above two measures, beware the next two tranches!!!
3. Tranche 2
- is designed to chase down private companies and trusts that accumulate rather than distributing their income to shareholders or beneficiaries – possibly like the “old” excess retention tax repealed back in 1993!
4. Tranche 3
- will look at PIE’s – portfolio investment entities – currently taxed at a maximum 28% (or individual investor rates for multi-rate PIE’s), albeit noted as a less urgent concern.
The discussion document adopts now commonly used “spin” with new tax proposals pitched as improving the integrity of the tax system (or remedial legislation). The essential need for some very complex tax proposals all stems from the government’s hike in the top personal tax rate to 39%; it is stated NZ’s tax settings now allow for tax arbitrage through structuring lower rate entities to derive income.
- Top personal income tax rate at 39%
- Corporate tax rate at 28%
- Trustee tax rate at 33%
- Top PIE tax rate at 28%
- No general capital gains tax
The document then draws on 2020 tax take data to show a spike in business and other non-PAYE income at the 33% tax threshold of $70,000. It then draws on data mining of 350 high wealth families and individuals (> $50 million in net assets) with concerns this group controlled lower tax rate entities – close to 8,470 companies and 1,870 trusts – earning significant amounts of income. IRD analysed these entities tax payments in 2018 as $639 million by companies, $102 million by trusts, with individuals paying $26 million, pointing to the apparent disparity as a tax avoidance measure. There is no analysis of business investment, reinvestment, or debt reduction (net equity improvement).
High-level analysis / commentary
- These proposals are highly complex and the wider economic and business effects need to be thought through comprehensively
- In the context of tax system “integrity”, it is noteworthy these share sale proposals are already subject to taxation under the “dividend-stripping avoidance rules”. That is, if you sell shares in situations where you might otherwise have taken a taxable dividend, the share sale proceeds will be treated as a taxable dividend
- IRD has a targeted programme in place to challenge and chase down tax avoidance dividend stripping arrangements
- The discussion document notes, unlike other jurisdictions where tax entity arbitrage can arise, NZ does not have a capital gains tax and so is vulnerable. This rationale, and the taxation of share sales, is a clear indication of capital gains tax creep
- The discussion document suggests proposals are focused on setting objective, easily understood tax principles for the benefit of the taxpayer; this commentator is of the view the current rules are already fit for purpose and if we want a capital gains tax regime we should be honest in identifying the proposals as such. Taxing capital gains as revenue is a creeping incursion of this government since Prime Minister Ardern ruled out a capital gains tax under her leadership in April 2019 under the then coalition government
- The irony here is that this perceived “dis-integrity” of taxpayers has been wrought by the governments move to raise taxes with the 39% tax hike!
- Much of these proposals is about accelerating the timing of the tax take; existing long-established tax rules will eventually tax this targeted income but the government proposals here invoke a pass-through or deeming dividends to arise on a current year earnings or event basis
- Expanding the situations where the pass-through or attribution of corporate income from service providers to tax at the individual supplier level is far reaching given significant NZ businesses comprise small one-person or couples / partners plying their individual abilities servicing NZ Inc using companies for legal protection
- These measures are far-reaching and unprecedented in recent NZ tax law history. What is more alarming is the spectre of even more punitive taxation proposals coming NZ’s way from the 2nd and 3rd tranche of minister David Parker’s proposals. This may well not be the end of tax reforms either given the minister’s sponsoring of the controversial IRD research project into the wider financial affairs of wealthy NZers.
As always, don’t hesitate to give members of the VCFO team a call to talk about your plans and situation.