LEGAL UPDATE APRIL 2011
LAQC CHANGES
During 2010 the Government introduced four major reforms to property taxation. These were:
(a) The changes to the depreciation rules;
(b) Abolition of gift duty;
(c) Major changes to the Loss Attributing Qualifying Companies rules; and
(d) Reduction in nominal income tax rates.
In this article I will briefly summarise the changes to the LAQC rules. I shall start with a brief background to LAQC’s, and their essential features. Then I shall summarise the legislative changes which took effect from 1 April 2011. Finally, a few words about the advantages and disadvantages of the various alternatives to LAQC’s.
Background
For many years, probably the majority of residential property investors held their portfolio through LAQC companies. It is important to reflect why this was so, and what it meant in practise.
An LAQC was an ordinary limited liability company, with special tax status. Simply put, the advantages of a company-owning property is that the beneficial owner had the protection (such as it was, given ubiquitous personal guarantees to banks) of a limited liability company, the control (shareholding) was easily transferred, and company profits were taxed at the company tax rate, which was generally lower than the investors personal income tax rate.
A tax benefit not available to an ordinary company, which was available to an LAQC, was the ability to offset any company tax losses against the owners personal income. The entire tax losses of the company could be assigned to shareholders to offset their personal tax liability. When building depreciation was available these tax losses could exceed the capital introduced by the shareholder to the company. Shares could generally be transferred to another party (such as a family trust), without any tax liability arising from depreciation recovered. Furthermore, capital profits from the business could be distributed tax free, without the necessity for liquidating the company.
Accordingly an LAQC had a number of tax advantages over ordinary companies. It was generally preferable to property being held personally, particularly for shareholders on a high nominal tax rate. A property owner on an income tax rate above 33% would probably have benefited from an LAQC rather than personal ownership of residential investment property.
The earner of the larger personal income could own all or the majority of the company shares, and utilise all or the majority of tax losses to offset their higher personal tax rate. If shareholders incomes subsequently varied, for instance if the majority shareholder with the greater income lost their job and was then on the lowest income, the tax benefits could be retained by transferring a majority of shares to the new highest earner.
There were some disadvantages with LAQC’s. The shareholder was personally responsible for the income tax liabilities of the company. Tax losses had to be applied to shareholders in proportion to their shareholding. Tax losses could be lost if share transfers were not carefully managed. Tax losses could remain unusable if they exceeded the tax liabilities of the shareholder, for instance if the shares were held by a trust which had no other income. Generally an LAQC was unsuitable where ultimate ownership was vested in a family trust.
The abolition of LAQC’s was announced in the May 2010 budget. Enabling legislation was passed in December 2010. Since 1 April 2011 existing LAQC’s have reverted to QC status, and will no longer be able to attribute tax losses to shareholders. These Qualifying Companies (QC) may continue to use the current QC rules for an interim period of two years. During this period the Government will be reviewing the dividend rules for closely-held companies. It is likely that QC status will then be abolished. QC’s were originally intended to address close company dividend rules. Unfortunately elections are required prior to the completion of the review of close company dividend rules.
This is the default position for all LAQC’s. In theory no action need by taken by the shareholders. However there may well be adverse implications from inaction.
What has occurred?
In summary, from 1 April this year the company tax rate has been lowered to 28%. Personal tax rates have also been lowered, and the ability to transfer losses from LAQC’s has ended. LAQC’s have become QC’s.
Elections required by 30 September 2011 (or 30 September 2012)
Property investors operating an LAQC may elect one of five alternative scenarios. These are to:-
(a) Do nothing. The LAQC has already defaulted to a QC; or
(b) Convert the LAQC (now QC) to a new type of entity known as a Look Through Company (LTC); or
(c) Convert the LAQC (now QC) to a limited partnership, ordinary partnership or sole trader;
(d) Convert the LAQC to an ordinary company by revoking LAQC status. This option had to be elected before 1 April 2011; or
(e) Transfer the property from the LAQC (now QC) to a family trust.
An election to LTC, limited partnership, ordinary partnership or sole trader must be made in one of the first two income tax years after 1 April 2011. QC’s and LAQC’s have six months from the start of each transitional tax year to advise the Inland Revenue Department of the election. The tax treatment for the entity they transition to will then apply from the start of that transitional year.
So for an election to take effect from 1 April 2011, the election must be made by 30 September 2011.
Accordingly, if directors do not elect an alternative status, and advise the IRD of the election by 30 September 2011, the LAQC will by default be treated as a Qualifying Company for the entire 2011/2012 tax year. The tax losses, if any, generated by the QC will be trapped within the company. The shareholders will be unable to rely on these tax losses to reduce their personal tax liability.
Although an election may be made between 1 April and 30 September 2012, this will only take effect from 1 April 2012, and one years tax losses will be lost, albeit perhaps only temporarily. An election on 1 October 2012 will not be effective until 1 April 2013.
Default position – No election required. The LAQC will default to a QC
The default position is that on 1 April 2011 all LAQC’s lost the ability to attribute losses to shareholders. They will continue to be treated as QC’s, and will be treated as such for the 2011/12 financial year, unless an election is made by 30 September 2011. An election may be made between 1 April and 30 September 2012 for the 2012/2013 year.
Conversion to Look Through Company (LTC)
A Look Through Company is a new class of company which may attribute losses to shareholders in accordance with the owner’s effective interest in the LTC.
At first glance it only differs from an LAQC in that profits must be attributed to shareholders as well as tax losses. In fact it goes considerably beyond that. It is not merely tax losses and taxable profits, but the actual net income and expenses which are attributed to the shareholders.
In effect, the Inland Revenue Department disregards the existence of the company, and treats its income and expenditure as personal to the shareholders. Its income, expenses, tax credits, rebates, gains and losses are all passed to its owners, in accordance with their effective interest in the company – hence the title Look Through. Or to use the jargon of the IRD, the company is “transparent” for tax purposes.
Essentially the IRD will regard the assets of the LTC, and the income and expenses associated with those assets, are treated for tax purposes as if they are the personal assets of the shareholders.
The shareholder, not the company, is responsible for paying tax on their share of the LTC’s taxable income, or can utilise LTC losses. Tax losses which an owner cannot use in one year may be carried over into subsequent tax years.
The shareholder’s liability for their share of the LTC’s tax liabilities extends beyond income tax, to liability for unpaid PAYE.
The LTC rules introduce a new “loss-limitation” rule. Shareholders can offset tax losses only to the extent that their losses reflect their maximum economic loss. Unlike LAQC’s, the losses which may be attributed to shareholders of a LTC is limited to what is described as “membership interest”, i.e. the value of assets actually introduced to the company by that shareholder. This does however include capital gains previously realised. However for such losses to be available to the shareholder, they must first be realised, and taxed on the capital gain.
Membership interest is the total of equity, goods, assets or services provided to the LTC, loans made by the owner to the LTC, share in net LTC income previously recognised and capital gains previously realised, and the share of the LTC debt guaranteed (or indemnity) by the owner or their associate.
With an LAQC, the earner of the larger personal income can own all or the majority of the shares, and utilise all or the majority of the losses to off set their personal tax liability. However with a LTC the interest is effectively fixed, and limited to the extent of the membership interest. An adjustment of shareholding to reflect varying incomes will not be readily achievable.
LTC’s are limited to five shareholders. However certain shareholders are treated as one (the “count test”), i.e. relatives may be treated as one person.
One possibly significant difference from LAQC’s is that depreciation recoveries or other similar disposal events will be triggered at the shareholder’s marginal tax rate, not the company tax rate.
Shareholders of an LTC will be taxed on any profits at their personal marginal tax rate. If an LTC is expected to make a profit (and many now will do so, after the abolition of most building depreciation), why use an LTC when the profits generated by an ordinary company will be taxed at only 28%?
Unlike LAQC’s, LTC’s cannot have corporate shareholders. QC’s (but not LAQC’s) could have multiple classes of shareholder. LTC’s can only have one class.
All shareholders must elect LTC status. Furthermore a LTC can lose LTC status at the election of a single shareholder.
There are to be deemed disposal rules when a company cease to be an LTC, or where a shareholder sells an interest in an LTC. These rules will be broadly similar to the rules currently applying to partnerships. A deemed sale and reacquisition of assets will occur on any transfer. The transfer of shares in a LTC will be treated as a sale of the underlying property. Unless the company has a constitution, and the constitution includes a pre-emptive clause, or prohibits the transfer of shares, any one shareholder can, by transferring their shares, trigger a deemed sale of the property. This may trigger a tax liability due to depreciation recovery.
There are certain benefits available with LTC’s which were not available to QC’s.
LTC’s may earn unlimited foreign income – QC’s were limited to a concession of $10,000 of non-dividend foreign income per year.
Trustee shareholders of LTC’s are not required to distribute taxable income as beneficiary income, unlike QC’s. However a trustee shareholder of an LTC must be counted as a shareholder in addition to the beneficiaries. This is likely to cause some difficulty and confusion in implementation.
One area of difficulty with QC’s was the deemed revocation of LAQC status on change of shareholding. This rule does not apply to LTC’s.
Is there any benefit from using an LTC? In many cases, the answer will be yes. It retains limited liability, not available for property owned personally or in a trust. Where a tax loss is anticipated it will still be preferable to personal ownership of a partnership, unless the partners nominal tax rates are less than 28%.
Limited partnership, ordinary partnership or sole trader
Concessionary transitional rules provide for the transfer of assets from an LAQC to a limited partnership, ordinary partnership or sole trader.
Limited partnerships were only introduced in recent years, as separate registered legal entities.
Limited Partnerships have been in existence for some years in Australia, the United States and the United Kingdom. The central feature of a Limited Liability Partnership is its hybrid nature. A Limited Partnership benefits from being taxed as a Partnership, whilst still providing the protection of Limited Liability. In this respect, it is in many ways similar to a Loss Attributing Qualifying Company (LAQC).
A Limited Partnership is formed on registration under the Act. It must have at least two partners, one of which must be the General Partner, and details of all partners must be registered. However, only details of the General Partner are made public. Details of the Limited Partners remain confidential. A Limited Partnership must prepare Annual Financial Accounts. However, they do not have to be audited or registered. There are no limits on the term of the partnership, the number of partners or the amount of funds invested by the partners. In addition to being registered, a Limited Partnership must have a written Partnership Agreement. The agreement must conform to a minimum standard imposed under the Act. Unlike limited liability companies under the Companies Act 1993, there is no deemed constitution.
Accordingly property held by a Limited partnership will be taxed at its own tax rate, not that of the shareholders. As with LTC, the new rules introduce a “loss-limitation” rule, limiting tax losses to the extent of actual economic loss. Confusing the loss limitation rules for limited partnerships is not the same as the rules for LTC’s.
If a property business is transitioned to a partnership or sole trader, the company must file a non-active company declaration or be wound up.
Ordinary company
An LAQC company may be converted to an ordinary company at any time, by revoking LAQC status.
A potential benefit of company ownership would be that income is taxed at the company rate, which from 1 April 2011 is 28%. For shareholders on the top tax rate this may reduce tax liability. However tax losses cannot be accessed by shareholders. As depreciation will not be available for buildings after 1 April 2011 (though it will still be available for chattels), some investors whose LAQC’s were making a tax loss may not now do so. Accordingly the inability to access tax losses may be of less significance. A disadvantage of ordinary companies is that any capital gains are usually inaccessible until the company is liquidated.
Transfer to a family or trading trust
The concessionary tax rules permit a tax-free transition from LAQC to limited partnership, ordinary partnership or sole trader. It does not provide a concession to a trading trust or family trust.
Conclusion
The IRD has been writing to LAQC’s to advise them of the forthcoming changes. Election forms will be provided. It is important that investors obtain accurate advice, and make an election without delay.
For the majority of taxpayers who currently operate rental properties through LAQC’s, a transition to a LTC would be most appropriate, provided that the company will still be generating a tax loss.
Due to the time restrictions for the transition we recommend elections being made prior to 30 September 2011
The transition of an LAQC to LTC, partnership, limited partnership, sole trader or ordinary company may be carried out without tax cost being incurred. A sale to a family trust may incur tax liability.
Please feel free to discuss any of the above matters directly with John Cox.