Let’s talk about tax (and interest deductions for capital gains).

While your correspondent is a confirmed Anglican – Episcopalian actually – I don’t consider myself a Christian anymore and haven’t taken communion for over twenty years. The same cannot be said for the rest of my extended family which is pretty hard core christian and includes three ordained priests. It used to be overrun with lawyers so priests is definitely pareto improvement.

From time to time at family gatherings when my darling christian family is discussing something theological – yes it is fun but I love them a lot – one of them will say ‘but of course it all went wrong at the Council of Nicaea’. That I think was when the Christian Church became a proper institution and started telling its followers what to do. And having seen public institutions operate at times for themselves rather than the people they are serving I am sympathetic to that view.

But for tax – in New Zealand – its Council of Nicaea was the 1986 Pacific Rendezvous case.
 

Pacific Rendezvous was – and is – a motel. They wanted to sell the business but to get a better price they decided they needed to do some capital works. They borrowed money to do that and claimed most of the interest as a tax deduction. 

They were pretty open that the building works were because they wanted to get a better price for the sale of their business. And of course we all know dear readers that the proceeds from a sale of a business that was not started with the intention of sale is tax free.

Unsurprisingly the Commissioner – who was a he at the time – was not best pleased. Deductions to earn untaxed income you cannot be serious. And so he took Pacific Rendezvous to court to overturn the deductions associated with the tax free capital bit.

But the Courts were like ‘nah totes fine’. Coz – get this – the interest was also connected with earning taxable income. You know the like really small motel fees even tho the whole gig was an ‘enhancing the business ahead of sale’ thing.

Impressive. 

And that dear readers is why I am so not a lawyer. Having to hold such stuff in my head as legit would totally make it explode.

But I digress.

Now of course Parliament or the government at the time still had the chance to overturn that case coz of course Parliament, not the courts, has the final say. Or it could have simply taxed the capital returns  – sorry now I am just being silly. 

What actually happened was some 13 years later after a fruitless interpretative tour of the provisions Bill English – when he was just a little baby MoF and long before his two stints at the leader thing – proposed and Michael Cullen enacted – that companies could have as many interest deductions as they wanted because compliance costs. You know coz otherwise ‘they’ll just use trusts’.

It was subject to the thin capitalisation rules and as the banks were to discover to their chagrin – the anti avoidance rules – but deductions to earn capital profits game on.

Now the capital profits thing was considered at the time – chapter 4 – and quite a compelling economic case was made for some form of interest restriction. But by Chapter 6 there became insurrountable practical issues that made this not possible. Those issues included:

• The need for rules to ensure that the deduction was not separated from the capital income;

• Difficulties with bringing in unrealised gains;

• If done on realisation  – potential issues with retropective adjustments along period capital gain was earned;

• Need to factor in capital losses.

And it was true that in the past Muldoon – well then must be wrong – had attempted to do something by clawing back interest deductions to the extent a capital gain was made. Imaginatively it was called ‘clawback’ and everyone hated it. And yes people did use trusts and holding companies to avoid it. Oh and soz can’t find a decent link to reference this so you will just have to trust me on this.

But you know what?  Tax policy is so much cleverer now and we group companies and treat them as one entity for losses and lots of other stuff all which could get around these issues. In fact the recent National governments in a bipartisan and a thinking only of the tax system way have enacted rules that mean interest restrictions for capital gains are no longer the insurrountable issue they apparently were in 1999. Who says John Key doesn’t have a legacy?

So working up the list. 

• Can’t see the issue with capital losses as if that capital was lost in a closely held setting on deductible expenses it is already fully deductible. Outside that any interest limitation for capital gains would only apply to the extent there was untaxed capital income. And as we are talking about losses – not income – no interest restrictions. Simple.

• Would only do it on realisation. Taxing unrealised stuff while technically correct is a compliance nightmare. But the new R&D rules which claw back cashed out losses when a capital gain is made – from page 24 – could totes be made to work here. Interest deductions could be allowed on a current year basis but if a capital profit is made – they are clawed back in the year of sale. If deferral was still a big deal – a use of money charge could be added in too. Personally I would give up the interest charge. Simpler and an acknowledgement of the earning of taxed income.

• And the whole deduction being separated from income was fixed with the debt stacking rules for mixed use assets. So let’s use that. 

Coz the thing is while no one seems to be bringing in a capital gains tax anymore it is still massively anomalous that deductions are allowed for earning untaxed income just coz some incidental income was earned as well. 

Now Labour is planning to have a bit of a go in this area by going after negative gearing through ringfencing losses. Better than nothing I guess. But still kinda partial as only touches people with not enough rental income to offset the deductions. And Grant, Phil and the new Michael – even for this – you totes will need the debt stacking rules or else ‘they’ll just use trusts’ or holding companies. 

And yeah extending the brightline test to 5 years. Again better than nothing but there is still lots of scope to play the whole deductions for untaxed gains for property holdings over 5 years or – as with Pacific Rendezvous themselves – businesses.

But for any other political party with an allergy to a capital gains tax but big on the whole tax fairness thing perhaps you might want to look again at interest clawback on sale? This time thanks to the foresight and the public spirited nature of the John Key led governments – it would actually work.

Namaste