Let’s talk about tax.
Or more particularly let’s talk about tax and companies.
Well dear readers what a week it has been in the Beltway. Secret recordings down south and secret payouts from Wellington. All the more bizarre as – Mike Williams confirmed – MPs staffers pretty much have sack at will contracts. If your MP doesn’t like you – that’s it you’re out. No lengthy performance management for them. Facepalm. So maybe this factoid could get added to new MPs induction?
But as always the key issue gets missed. Exactly who under 40 years old knows what a dictaphone is?
And into this maelstom Inland Revenue released a paper on taxation of individuals and some stuff on debt. Both worthy topics of discussion. But then Ryman released its results. And their CEO said like tax is paid – just not like income tax and just like not by them.
So after last week’s post I thought I’d have a look.
Oh yes the real tax is very easily found in the Income Tax Note. Tax losses of $28.9 million in the 2017 year. Up from last year when they were only $15 million of losses. They are a growth stock after all. Quite different from the tax expense which was $6m tax payable.
To your correspondent this looks awfully like her specialist subject of interest deductions for capital profits. All mixed up in a world where interest expense isn’t in the P&L but instead added to the asset value. Complying with both accounting and tax. And yeah totes a tax loophole but one from like whenever.
And again in Ryman’s accounts the rent equivalent from the time value of money of the occupancy advances is in neither the accounting nor the tax profit. Because reasons.
Now expecting controversy the CEO front footed the issue saying that the shareholders paid tax and that Ryman had actually paid GST. He then also referred to the PAYE deducted as they were employers. Kinda going to ignore that bit tho coz the whole claiming credit for other people’s tax really gets on my nerves.
And I’ll take his word on the GST angle coz I am cr@p at GST. But with his shareholders paid the tax comment – he is talking about imputation. And as I haven’t covered that before dear readers – today you get imputation. Oh and other random thoughts on tax and companies.
Now the official gig about imputation is how – notwithstanding that they are separate legal peeps – the company is merely a vehicle for their shareholders to do stuff. So for tax purposes the company structure should – sort of – get looked through to its shareholders. And this means dividends are in substance the same income as company profits and so should get a credit for tax paid by the company.
And as a tax person this stuff is considered to be in the stating the flaming obvious category.
But as I am no longer an insider – I am increasingly finding it interesting just how public policy on companies manages to talk out of both sides of its mouth. And how – much like the sack at will contracts or milliennials using dictaphones – no one has noticed.
On one hand we have the Companies Act which sets up companies with separate legal personalities from its shareholders. Meaning that if you transact with a company and it doesn’t pay you. Bad luck bucko. Nothing to do with the shareholders. Limited liability; corporate veil and all that.
But for tax if you only have a few shareholders those losses can flow through to the shareholders and be offset against against other income. The negative gearing thing but using a company. Coz in substance the company and shareholders are like the same.
And a similar thing happens with the Trust rules. Trust law says that it is trustees that own the assets. And once you have handed stuff over to them as settlor – that’s it – that stuff isn’t yours anymore. So if that settlor owes you money – also bad luck bucko. Don’t for a second think you can approach the trustees – coz whoa – settlor nothing to do with them.
But then tax says – for trusts – as settlors call the shots; it’s the residence of the settlor that is important. Mmmm. This means that a trust with a New Zealand resident trustee and a foreigner wot gave the stuff to the trustee – foreign trust – isn’t taxed on foreign income. Coz that would be like wrong. Even though the assets are owned by a New Zealand resident. And New Zealand residents normally pay tax on foreign income.
Right. Awesome. Thanks for playing.
Anyway back to imputation.
Now put any thoughts of separate legal personalities outside your pretty heads dear readers and think substance. Think companies are vehicles for shareholders. Don’t think about small shareholders having no say or liability if anything goes wrong. Just think one economic unit.
And then you will have no problem seeing potential double taxation if profit and dividends are both taxed. Coz #doubletaxationisgross.
So as part of the uber tax reforms in the late eighties imputation was brought in. Tax paid by the company can be magically turned into a tax credit called – imaginatively – an imputation credit which then travels with a dividend. Creating light and laughter in the capital markets. Or as I have put to me – increased inequality. As when imputation came in it gave dividend recipients – aka well off people – an income boost courtesy of the tax system. Probs also a tax free boost in the share price too.
Now putting aside such inconvenient facts – your correspondent has always defended imputation. Because in order to get the light and laughter or increased inequality – companies actually have to pay tax. And of that – big fan.
But all of this is only useful if shareholders are resident. Coz the credits only have value to New Zealand residents. And this is kind of why foreign companies may not care about paying tax here. And did I mention tax has to actually be paid?
And this last point that brings me back to Ryman’s chairman. He is right. If the company doesn’t pay tax – then the shareholders do when a dividend is paid. So honestly what are we all getting excited about?
Well – profits have to be like actually distributed before that happens and shareholders have to be taxpayers. And Ryman distributes less than 25% of their accounting profit.
And the residence of shareholders? Who knows. Lots of nominee companies listed which could mean KiwiSavers or non-residents. Oh and Ngai Tahu. Who seems to be a charity.
So yeah maybe. Some tax will be paid by some shareholders. That is true. Let’s hope it exceeds the tax losses Ryman is producing.
PS. This will be the last post – except if it isn’t – for the next couple of weeks. Your correspondent is getting all her chickens back for a while. And much as I love you all dear readers – I love them more. Until Mid July. Xx
Let’s talk about tax.
Or more particularly let’s talk about how retirement villages don’t pay much tax.
Your correspondent has just returned from Auckland having: topped up her CPD hours; seen old friends and talked with tax peeps. And in that short period while I was away another industry was outed as being non-taxpaying. Now it is retirement villages and they aren’t even foreign.
But don’t panic. Steven Joyce says Inland Revenue is reviewing sectors of the economy which has low tax to accounting profits. And if there is a policy problem it can be put on the policy work programme. Phew.
Now as I have 5 days to complete 3 major pieces of assessment from my yoga course I have had two months to do – the sensible thing would be to put this issue down and pick it up after I have done my assessment. Coz it is not like they about to start taxpaying anytime soon.
But the issue is really interesting.
I am sure 4 days is enough to do all that other work. And I do need breaks from all that right brained stuff. I mean isn’t yoga all about balance?
So let’s have a look at the public stuff dear readers and see if we can’t unpick why these lovely people – much like our multinational friends – aren’t major contributors to the fisc. Now I know there are a few different operators but I thought I’d have a look at Ryman. Who may or may not be representative of the rest of them.
Tax actually paid
Now their tax stuff is interesting. Accounting tax expense of $3.9 million on an accounting profit of $305 million. But accounting tax expense is a total distraction if you want to know how much tax is actually paid. Why? Different rules. Future post I think.
Next place to look – imputation account which increased by $37,000. That can be real tax but can also include imputation credits from dividends received. So close but no cigar.
And then there is the oblique reference in note 4 to their tax losses in New Zealand having increased from $2.5 million in 2015 to $17.9 million in 2016. Bingo! That looks like they made a tax loss of $15 million in 2016 when they made an accounting profit of $305 million. Nice work if you can get it.
Ok now before we get into some exciting detail let’s have a think about what these retirement villages actually do. They can provide hospital services; some provide cafeterias; and they generally keep the place maintained. But mostly they ‘sell’ lifetime rights to apartments and flats on their premises.
And it is this lifetime rights/apartment thing that is – in your correspondents view – the most interesting.
Looking at Ryman’s accounts and marketing material the deal seems to be residents provide an occupancy advance and get to have undisturbed use of an apartment until they ‘leave’. On ‘departure’ the right will be ‘resold’ and the former resident gets back wot they paid less some fees.
So the retirement village gets the benefit of any capital gain on the apartment as well as the benefit of forgone interest payable on the advance. All comparable to a ‘normal’ landlord who would receive the benefit of rent and capital gain on their property.
And like a ‘normal’ landlord they don’t really know how long the resident or tenant will want to stay. It could be one day or 30 years. But economically this doesn’t matter as the longer the resident stays the less in NPV terms the retirement village has to pay back. So whether landlord gets rent or repayable occupancy advance they both give the same outcome pretax and pre accounting rules. That is with rent over a long period you get lots of rent; with interest free occupancy advances over a long period you get lots of not having to pay interest.
However this isn’t how it pans out for accounting or tax.
For accounting the advances are carried at full value because they could be called immediately – occupancy advances in section j of Significant Accounting Policies. And because of this there is no time value of money benefit ever turning up in the Profit and Loss account – or what ever it is called now. Unlike rent which would get booked to the P&L when it was earned.
And tax is equally interesting. The Ryman gig seems to be that for the occupancy advance the resident gets title under the Unit Titles Act and a first mortgage for the period they are in the property. Fabulous.
Unfortunately your correspondent is about as far away from a property lawyer as it comes. But according to my property law advisor Wikipedia; a leasehold estate is where a person holds a temporary right to occupy land. Kinda looks like what is happening here. So that would be taxable under the land provisons. And even if it isn’t taxable there – to your correspondent – it looks pretty taxable as business income.
But in either case that involves taxing the entire advance and not just the interest benefit. Seems a bit mean.
True. But let’s look at deductions before we call meanness.
Tax deductions are allowed when expenses are incurred or legally committed to. Not when actually paid. So if you are a yoga teacher and you commit to a Tiffany Cruikshank course in Cadiz in May 2017 – she is here in Wellington ATM so exciting – paying the USD 500 deposit in April 2016 you can take a deduction for the full amount of USD 2790 in the 2016/17 tax year. Even though you don’t pay it until closer to the actual course. Tax geeks yeah I am talking about Mitsubshi.
So for our retirement village friends as they are committed to repaying the occupancy advance in the future on the day they receive it. Immediate deductibility which cancels any taxable income. Mmm.
Tbf though the tax act isn’t big on the whole time value of money thing.
Financial arrangement rules
The exception is the financial arrangement rules where embedded interest can be spread over the term of the loan. And there is even a specific determination that deals with retirement villages. Now that seems to have more bells and whistles than is obvious from Ryman’s accounts so not entirely sure it relates to them. But there is one bit that could apply as the determination does say that the repayable occupancy advance is considered to be a loan.
Except even this gives no taxable income. This is because value coming in is compared to expected value going out. And of course THEY ARE THE SAME AMOUNT! So nowt to bring in as income.
Fixing this gap it would involve imputing some form of interest benefit that was in lieu of rent. But what interest rate to use? What is the term? And then there is the whole thing that no one actually sees it as a lease agreement. Everyone sees it as ‘ownership’ with a guaranteed sale price back.
Also entirely possible that what I consider to be blindingly obvious; cleverer people than me may consider to be – well – wrong.
Then we get to much more old school techniques interest deductions to earn capital gains. And here Ryman seems to capitalise interest into new builds – section e of Significant Accounting Policies – rather than expense it for accounting. So there will be whole bunch of interest expense that isn’t in the P&L that will be on the tax return.
Unrealised capital gains
And finally thanks to NZ IRFS 13 – really does roll off the tongue doesn’t it – their accounting profits note 7 include a bunch of revaluations on their investment properties which I am guessing is the apartments. Bugg€r with this is that even a realised capital gains tax wouldn’t touch this and doesn’t look like these guys sell. Gareth’s thing though would work a treat as all the unrealised gains are on the balance sheet.
So here we have a property business that gets interest deductions; doesn’t pay tax on its capital gains or its imputed rent. Gains go on the P&L but not the interest expense. All while being totally compliant with tax and accounting.
No wonder they are share market darlings.
Thinking about the occupancy advances some more – depending on the counterfactual – maybe the value is in the tax system already as a reduced interest deduction.
The properties need funding somehow. Usually the options are debt which generates a deductible interest payment; equity which is subject to imputation or a combination of both. Here the assets are partially funded by the interest free occupancy advance. If the residents just paid rent – the assets would then need more capital. This could be completely debt funded which would mostly offset the rental income. May even exceed it if there was an expectation of a large capital gain. So while the occupancy advance is not in the tax system; neither is the extra interest deduction.
So maybe it is all an old school interest deduction for untaxed capital gain thing. But one for which a realised CGT would be useless as they don’t sell.
May need to look at Gareth’s thing again.
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.
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.
Let’s talk about tax.
Or more particularly let’s talk about tax; interest deductions and private expenditure in companies.
Your correspondent has returned from her ‘retirement cruise’; is recovering from jetlag and has returned to what passes for work these days. That will dear readers include a return to twice weekly posting. As a change from some of the more political posts I thought I’d return to a technical issue for a bit of light relief.
Earlier this year while I was still inside I went to a dinner party in a provincial city. At the party was a delightful gentleman I had met previously and was more than pleased to see again. The feeling appeared to be mutual and our conversation broadly went like this:
DG – Now Andrea tell me – which is better? To pay my mortgage or to pay my tax?
Me – cough, splutter, mumble – well the thing is it isn’t a choice as tax is a legal obligation.
DG- oh don’t be silly of course I know that. What I mean is it better to have a mortgage on my house get the tax deductions and then have money to invest in shares and things for capital gains or have no mortgage not get the tax deductions but have more disposable income?
Me – Ah what makes you think you get a tax deduction for the mortgage on your house?
DG- This is the country – we get tax deductions for all sorts of things and besides I’m the director of a land owning company!
Me – Is that wine over there?
Now dear readers I am sure after Zen and the art of tax compliance you all know that to get tax deductions the expenditure has to be:
- Connected to the earning of income or in the ordinary course of a business and
- not private or domestic expenditure.
So therefore if DG owns his house in his own name – or in a family trust – as neither 1) or 2) is met there is no deduction for interest expenditure.
There is the possibility that if the money were borrowed on his house and used to buy shares THAT WERE DIVIDEND PAYING then the interest would be deductible. But if the money is borrowed to construct the house for him to live in – nuh.
The complication though is the comment about being a director of a land owning company. The rules above do not apply to a company and interest deductions. From about 2000 or so the rule broadly became:
- Are you a company resident in New Zealand?
- Have you incurred an interest expense?
If yes to both, then ‘would you like interest deductions with that?’
The private and domestic test still applies to such expenditure but I have always struggled to align any concept of private and domestic to a company.
So at first pass – yep – if DG holds his house in a company – in your correspondent’s view – he will get an interest deduction.
And yeah the Mixed Use Asset rules won’t apply here because ironically it isn’t a mixed use asset – it is wholly private and domestic.
But – not so fast – the music hasn’t stopped.
While there are special rules for companies and interest deductions there are also special (dividend) rules for transactions involving companies and shareholders aka ‘are policy makers really that dumb?’
These dividend rules say where ever there has been a transfer of value from a company to a shareholder there is a taxable dividend to the shareholder to the extent of the value transfer.
Ok again in English.
If a company gives a shareholder stuff – goods or services – that is a taxable dividend for the shareholder. Here the company has given the shareholder use of a house – so the shareholder DG – gets a taxable dividend.
And by ‘taxable dividend’ yes this means you need to put that value on your tax return and pay tax on it. And yes I know you didn’t get any actual cash but that doesn’t matter. You know how when you tick the box for dividend reinvestment on your publicly listed shares – you know how the dividend is still taxable even though you didn’t get any actual cash. Consider this as the same.
So what is the value that DG has received from the ‘land owning’ company? He has received the benefit of living in that house. And what do people usually pay for the benefit of living in a house they don’t own? You’re onto it – rent.
DG is then up for tax on the value of the rent not paid to the company as a dividend. And once more with feeling – it doesn’t matter that no cash has been paid from the company to the shareholder.
So the benefit DG received – use of the house without paying rent – is taxable to DG.
Now if DG has a tax rate of 33% – as the company tax rate is 28% – there will be a net 5% tax paid on the ‘imputed’ or deemed rent. That is he pays tax at 33% on the deemed rent and the company gets a deduction at 28% on the interest expense. In other words a gift to the people of New Zealand and how tax planning can go wrong. And if he didn’t know this was the case until my former colleagues come along – it will be 33% tax plus interest at about 8% plus a penalty of between 10% and 100%.
Awesome. Can only hope he didn’t also pay an agent for this wizard advice.
If his tax rate though is lower than the company rate this is where it could get really interesting. Technically even with DG putting the value of rent on his tax return there will still be a net tax deduction that ostensibly can be offset against other income.
In this case though the structure – or ‘arrangement’ as my former colleagues may start to call it – is really putting pressure on the whole ‘companies can’t have private expenditure’ thing. And from here we move into a complete world of pain – or ‘good case’ depending on which side you are on this – known as tax avoidance. Now the entire interest deduction is at risk with tax avoidance penalties of between 50% and 100%. Fun huh.
And don’t even think of paying rent to your company and making it a look through company so you get the deductions directly against your other income. The department was very clear with look through companies – the prequel – that this was tax avoidance too.
So DG I am not sure there really is any ‘country immunity’ for interest on your personal mortgage. Pay it but step away from the tax system. There be dragons.