StreetSmart Group, Accounting, Chartered Accountants, Business Advisors, Auckland, New Zealand

The 2010 Budget?

The much anticipated 2010 budget was released on 20 May 2010 and, as expected, there were a number of tax reforms affecting us all. On the upside the reduction in personal tax rates from 1 October 2010 will benefit all of us and put more money in our pockets. The top personal tax rate will reduce from 38% to 33%, meaning the tax incentive to divest income from yourself personally to a trust has been removed. For property investors it will also mean that any rental losses offset against personal income will save a maximum 33% tax rather than 38% as currently. For the current tax year the top personal tax rate will drop from 38% to 35.5% as the change only takes effect mid year. A nice surprise was the company tax rate reduction from 30% to 28% effective 1 April 2011, which will benefit corporate businesses and property investors earning taxable profits. Once again companies will be given a transition period of two years to pay out dividends with 30% imputation credits attached before they revert to 28%. RWT to be paid on dividends with 28% imputation credits attached will increase to 5% so that dividends declared continue to have tax deducted at 33%. There has been no change to trust tax rates or rules and the trust tax rate remains at 33%, which will be the same as the top personal tax rate from 1 October 2010. The use of trusts to protect assets and for estate and family planning purposes is still as valid as it has always been. While the tax advantages of trusts have been largely removed trusts continue to be a very useful ownership structure for business owners, property investors, and high net worth individuals alike. The top tax rate applying to PIE’s (Portfolio Investment Entities) will reduce from 30% to 28% to align with the new corporate tax rate. This means that PIE’s and Kiwisaver investment vehicles will continue to offer tax advantages for individual tax payers in the top tax brackets as well as family trusts. The increase in GST from 12.5% to 15% from 1 October 2010 will affect us all, as we are all consumers. However, the effect on businesses who are registered for GST is mainly an administrative one – how to implement the GST change and how to account for the GST change during the transition period. Ironically this will be simpler for those businesses registered on GST invoice basis than those on GST payments basis. For businesses registered on a payments basis a one off adjustment will be required. The effect of the GST change for residential property investors will be increased real cost of rates, insurance, accounting and legal fees, property management services and so on. Residential property investors are not usually GST registered and so cannot claim back the GST content of business expenses incurred. Unless rents increase to compensate, the GST increase will reduce the cash generated by residential rental properties. Since businesses and commercial property investors are usually GST registered the increase in GST is effectively neutral for them, provided their customers are also GST registered. Care will need to be taken in relation to GST on long term contracts. More detailed information on the issues around the GST increase will be provided to clients in due course. The expected removal of deprecation on buildings has been confirmed with effect from 1 April 2011. This will affect both commercial and residential buildings with an expected useful life of 50 years or more. Further clarification on what is separate commercial fit out and what is building is expected from IRD, in addition to the information released by IRD in May. The 20% loading on new plant and equipment has also been removed effective immediately for all new plant and equipment purchased since 20 May 2010. This means that there is no longer any tax incentive to buy new instead of second hand. From a property investor viewpoint these changes mean that it may still be worth while obtaining a chattels valuation when you purchase investment property. Although the building structure itself is no longer depreciable the chattels and selected fit out may still be depreciable. The IRD have just published an Interpretation Statement (IS10/01) setting out their views on what items of depreciable property may be split out for residential rental properties. Repairs and maintenance is still tax deductible. However, in view of the change to depreciation on buildings it may be timely for government to review what is classed as repairs and maintenance and what is classed as improvements. Under existing tax rules improvements must be capitalised and, until the budget, could be depreciated. Now that improvements will no longer be depreciated from 1 April 2011, there may be scope to review the rules around what is R&M and what is an improvement. Under existing tax law any loss on disposal of business assets is generally tax deductible on the basis that they depreciated more than the claim made for tax purposes. However, buildings were an exception to this rule and a loss on sale of buildings is generally not deductible for tax purposes. However, it would seem logical that if a building was sold at a loss and no depreciation has been claimed then a real loss has been incurred, and should be allowed as a tax deduction. We hope that this apparent anomaly will be remedied. While depreciation on buildings is to be removed from 1 April 2011, depreciation recovered on sale of property remains. This means that if a building is sold at a profit and depreciation had been claimed prior to 1 April 2011, then a portion of the capital profit equivalent to the depreciation claimed will continue to be taxable. While the budget has not implemented ring fencing of property losses which was a possibility, nor a capital gains tax, the tax rules around Loss Attributing Qualifying Companies (LAQC’s) are to be changed. The budget announced that LAQC’s will be taxed in a similar manner to limited partnerships. That effectively means that tax losses would continue to be attributed to the shareholders, but taxable profits would also be attributed to those same shareholders and not retained in the company for tax purposes. Therefore profits may be taxed at the top personal tax rate of 33% rather than retained in the company and taxed at 28%. It also means that there may be some limitation of losses attributed for tax purposes as under the limited partnership rules losses offset against other income are restricted to the amount invested or “at risk”. Any disallowed losses will be carried forward by the individual shareholder until their investment in the company increases. The change in the way LAQC’s are taxed will have far reaching implications, just some of which include: LAQC's will no longer exist after 1 April 2011 A new corporate tax structure called LTC (Look Through Company) will be introduced from 1 April 2011 Tax implications on disposal of shares in a LTC by a shareholder LTC’s will not be subject to Fringe Benefit Tax (FBT) LTC’s will not be able to declare dividends and will not need to maintain an imputation credit account LAQC’s can revoke their LAQC status from the beginning of the income tax year in which the revocation is made. Therefore, those LAQC’s earning taxable profits could opt out of the LAQC regime and revert to a normal company for tax purposes. This would enable them to retain profits in the company for tax purposes and pay tax at 28% instead of the shareholders nominal tax rate of up to 33%. However, one of the very valid reasons for setting up a QC to own investment property is the ability to pass realised capital gains on disposal of the property to the shareholders tax free, without the need to wind up the company. Opting out of the QC regime would mean that realised capital gains on disposal of property would not be able to be passed out to shareholders tax free without winding up the company. If the company only owns one property then this is not so problematic. But it becomes an issue if the company owns more than one property as the capital gain will be trapped in the company unless it is wound up. If the company is wound up it is likely to trigger depreciation recovered on the other properties owned assuming that depreciation has been claimed up to 31 March 2011. It would also incur additional accounting and legal expenses. The changes to the LAQC rules are major. Now the rules are clear each LAQC needs to review its position and make some tax planning and business decisions prior to 31 March 2011 as to the best course of action. We are proactively contacting our LAQC clients about this. Other changes in the budget include: Compulsory Zero-Rating of Land for GST purposes from 1 April 2011 Changes to the way Working for Families is calculated by disallowing inclusion of investment and rental property losses and possible inclusion of trust distributions and income from PIE’s Reducing the thin capitalization “safe harbour” funding threshold from 75% to 60% for international businesses generating income from NZ Allocation of more funding to IRD to increase its audit and compliance activity In summary, the budget was probably one of the most interesting for many years and has been well received by most commentators and the general public. The aim of the government was to make the system fairer, reduce reliance on direct taxation, and use the increase in GST and the reduction in personal and company tax rates to encourage productive investment while reducing debt fuelled consumption and tax driven property investment. The changes to the LAQC regime were a clever move as the government did not specifically target property investors, which would have been unfair, but all businesses operating under the LAQC rules. In many ways the proposed changes are logical as the losses able to be claimed for tax purposes will now be related to the amount of money actually invested in the company and at risk. The removal of depreciation claims on buildings for property investors was well signaled and, although costly for many investors, we hope will be followed by changes to related matters such as R&M and allowing tax losses on sale of buildings. We don’t believe that the budget has simplified the tax regime at all, and in fact it is starting to look like another very busy tax planning year for StreetSMART. Ann Loudon Bernard Mazur Director Director StreetSMART Accountants Limited

The much anticipated 2010 budget was released on 20 May 2010 and, as expected, there were a number of tax reforms affecting us all.

On the upside the reduction in personal tax rates from 1 October 2010 will benefit all of us and put more money in our pockets. The top personal tax rate will reduce from 38% to 33%, meaning the tax incentive to divest income from yourself personally to a trust has been removed. For property investors it will also mean that any rental losses offset against personal income will save a maximum 33% tax rather than 38% as currently. For the current tax year the top personal tax rate will drop from 38% to 35.5% as the change only takes effect mid year.

A nice surprise was the company tax rate reduction from 30% to 28% effective 1 April 2011, which will benefit corporate businesses and property investors earning taxable profits.   Once again companies will be given a transition period of two years to pay out dividends with 30% imputation credits attached before they revert to 28%. RWT to be paid on dividends with 28% imputation credits attached will increase to 5% so that dividends declared continue to have tax deducted at 33%.

There has been no change to trust tax rates or rules and the trust tax rate remains at 33%, which will be the same as the top personal tax rate from 1 October 2010. The use of trusts to protect assets and for estate and family planning purposes is still as valid as it has always been. While the tax advantages of trusts have been largely removed trusts continue to be a very useful ownership structure for business owners, property investors, and high net worth individuals alike.

The top tax rate applying to PIE’s (Portfolio Investment Entities) will reduce from 30% to 28% to align with the new corporate tax rate. This means that PIE’s and Kiwisaver investment vehicles will continue to offer tax advantages for individual tax payers in the top tax brackets as well as family trusts.

The increase in GST from 12.5% to 15% from 1 October 2010 will affect us all, as we are all consumers. However, the effect on businesses who are registered for GST is mainly an administrative one – how to implement the GST change and how to account for the GST change during the transition period. Ironically this will be simpler for those businesses registered on GST invoice basis than those on GST payments basis. For businesses registered on a payments basis a one off adjustment will be required.

The effect of the GST change for residential property investors will be increased real cost of rates, insurance, accounting and legal fees, property management services and so on. Residential property investors are not usually GST registered and so cannot claim back the GST content of business expenses incurred. Unless rents increase to compensate, the GST increase will reduce the cash generated by residential rental properties. Since businesses and commercial property investors are usually GST registered the increase in GST is effectively neutral for them, provided their customers are also GST registered.

Care will need to be taken in relation to GST on long term contracts. More detailed information on the issues around the GST increase will be provided to clients in due course.

The expected removal of deprecation on buildings has been confirmed with effect from 1 April 2011. This will affect both commercial and residential buildings with an expected useful life of 50 years or more. Further clarification on what is separate commercial fit out and what is building is expected from IRD, in addition to the information released by IRD in May.

The 20% loading on new plant and equipment has also been removed effective immediately for all new plant and equipment purchased since 20 May 2010. This means that there is no longer any tax incentive to buy new instead of second hand.

From a property investor viewpoint these changes mean that it may still be worth while obtaining a chattels valuation when you purchase investment property. Although the building structure itself is no longer depreciable the chattels and selected fit out may still be depreciable. The IRD have just published an Interpretation Statement (IS10/01) setting out their views on what items of depreciable property may be split out for residential rental properties.

Repairs and maintenance is still tax deductible. However, in view of the change to depreciation on buildings it may be timely for government to review what is classed as repairs and maintenance and what is classed as improvements. Under existing tax rules improvements must be capitalised and, until the budget, could be depreciated. Now that improvements will no longer be depreciated from 1 April 2011, there may be scope to review the rules around what is R&M and what is an improvement.

Under existing tax law any loss on disposal of business assets is generally tax deductible on the basis that they depreciated more than the claim made for tax purposes. However, buildings were an exception to this rule and a loss on sale of buildings is generally not deductible for tax purposes. However, it would seem logical that if a building was sold at a loss and no depreciation has been claimed then a real loss has been incurred, and should be allowed as a tax deduction. We hope that this apparent anomaly will be remedied.

While depreciation on buildings is to be removed from 1 April 2011, depreciation recovered on sale of property remains. This means that if a building is sold at a profit and depreciation had been claimed prior to 1 April 2011, then a portion of the capital profit equivalent to the depreciation claimed will continue to be taxable.

While the budget has not implemented ring fencing of property losses which was a possibility, nor a capital gains tax, the tax rules around Loss Attributing Qualifying Companies (LAQC’s) are to be changed. The budget announced that LAQC’s will be taxed in a similar manner to limited partnerships. That effectively means that tax losses would continue to be attributed to the shareholders, but taxable profits would also be attributed to those same shareholders and not retained in the company for tax purposes.   Therefore profits may be taxed at the top personal tax rate of 33% rather than retained in the company and taxed at 28%.

It also means that there may be some limitation of losses attributed for tax purposes as under the limited partnership rules losses offset against other income are restricted to the amount invested or “at risk”.   Any disallowed losses will be carried forward by the individual shareholder until their investment in the company increases.

The change in the way LAQC’s are taxed will have far reaching implications, just some of which include:

LAQC's will no longer exist after 1 April 2011
A new corporate tax structure called LTC (Look Through Company) will be introduced from 1 April 2011
Tax implications on disposal of shares in a LTC by a shareholder
LTC’s will not be subject to Fringe Benefit Tax (FBT)
LTC’s will not be able to declare dividends and will not need to maintain an imputation credit account

LAQC’s can revoke their LAQC status from the beginning of the income tax year in which the revocation is made. Therefore, those LAQC’s earning taxable profits could opt out of the LAQC regime and revert to a normal company for tax purposes. This would enable them to retain profits in the company for tax purposes and pay tax at 28% instead of the shareholders nominal tax rate of up to 33%.

However, one of the very valid reasons for setting up a QC to own investment property is the ability to pass realised capital gains on disposal of the property to the shareholders tax free, without the need to wind up the company. Opting out of the QC regime would mean that realised capital gains on disposal of property would not be able to be passed out to shareholders tax free without winding up the company.

If the company only owns one property then this is not so problematic. But it becomes an issue if the company owns more than one property as the capital gain will be trapped in the company unless it is wound up. If the company is wound up it is likely to trigger depreciation recovered on the other properties owned assuming that depreciation has been claimed up to 31 March 2011. It would also incur additional accounting and legal expenses.

The changes to the LAQC rules are major. Now the rules are clear each LAQC needs to review its position and make some tax planning and business decisions prior to 31 March 2011 as to the best course of action. We are proactively contacting our LAQC clients about this.

Other changes in the budget include:

Compulsory Zero-Rating of Land for GST purposes from 1 April 2011
Changes to the way Working for Families is calculated by disallowing inclusion of investment and rental property losses and possible inclusion of trust distributions and income from PIE’s
Reducing the thin capitalization “safe harbour” funding threshold from 75% to 60% for international businesses generating income from NZ
Allocation of more funding to IRD to increase its audit and compliance activity

In summary, the budget was probably one of the most interesting for many years and has been well received by most commentators and the general public. The aim of the government was to make the system fairer, reduce reliance on direct taxation, and use the increase in GST and the reduction in personal and company tax rates to encourage productive investment while reducing debt fuelled consumption and tax driven property investment.

The changes to the LAQC regime were a clever move as the government did not specifically target property investors, which would have been unfair, but all businesses operating under the LAQC rules. In many ways the proposed changes are logical as the losses able to be claimed for tax purposes will now be related to the amount of money actually invested in the company and at risk.

The removal of depreciation claims on buildings for property investors was well signaled and, although costly for many investors, we hope will be followed by changes to related matters such as R&M and allowing tax losses on sale of buildings.

We don’t believe that the budget has simplified the tax regime at all, and in fact it is starting to look like another very busy tax planning year for StreetSMART.

Ann Loudon Bernard Mazur

Director Director

StreetSMART Accountants Limited

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