Property and LAQC Changes 1 April 2011
- No depreciation deduction will be allowed on commercial or residential buildings from 1 April 2011. However, a taxpayer is still able to apply to the Commissioner for a special depreciation rate as they can at present.
- The income tax treatment of fit-outs will be reviewed and the rules around the splitting of buildings from building components will be clarified.
- The current 20% loading on depreciation on new plant and equipment is now removed.
LAQC Proposed Changes
It is proposed that from 1 April 2011 a QC and LAQC will no longer be treated as a company, but instead be defined as a partnership. The consequences of the proposed changes are as follows:
QCs and LAQCs will be flow through entities (similar to limited partnerships). Losses are still able to be offset against a shareholder’s personal income tax (just like current practice), however, any taxable profits the company derives will also be taxed in the shareholders hands – i.e. at the shareholder’s personal income tax rate (rather than at the company tax rate).
Dividend and imputation credit account rules will no longer apply to QCs and LAQCs
A partnership income tax return will be filed rather that a company tax return.
- The LAQC regime is also to be modified to include a “loss limitation rule”, similar to that contained in the limited partnership regime. This rule will allow a shareholder of the LAQC to offset, for tax purposes, net losses only to the extent of the “shareholder’s basis” in the qualifying company. If the tax loss exceeds the shareholder basis in the company, the loss cannot be offset against other income and must be carried forward until the shareholder increases their investment in the company.
Reviewing your current situation
It is proposed that the new LAQC regime will apply for income years beginning on or after 1 April 2011, e.g. 1 April 2011 for a 31 March balance date, being the start of the 2012 income year. The company tax rate will also drop to 28% from the start of the 2012 income tax year. Accordingly, we recommend that taxpayers review the structures used to hold investments before this change takes effect. As an example, if you hold a rental property in a LAQC and the mortgage over the rental property has been paid off with the elimination of depreciation on rental properties from the start of the 2012 income tax year, the LAQC may derive a taxable profit rather than a loss as in previous years.
If a taxable profit is derived under the new regime it will be taxable in the shareholder’s hands at 33% (the new top personal tax rate) rather than 28% company tax rate. You may wish to consider electing out of the QC regime in this case. An election to exit the QC regime applies from the start of the income year in which the election is revoked unless the company chooses for it to apply from the start of a subsequent income year.
From 1 April 2011, if a QC revokes its election there would be a deemed disposal and reacquisition of the company’s assets at their market value on that date. This could give rise to adverse tax consequences for the shareholders. Under the current tax laws, there is no deemed disposal event for revoking QC status. Therefore if electing out of the QC regime is deemed the appropriate action, you may wish to exit the QC regime before 1 April 2011.
Changing your affairs to hold the loss generating assets in your own name
The problem of the loss limitation rule can be avoided where a loss generating asset (e.g. a rental property) is held personally by the investor. In that situation an unlimited amount of losses generated are able to be offset to the owner(s).
If you hold an asset in a LAQC and you are considering transferring it to be held in our own name or a partnership with your spouse, care needs to be taken with regard to the sale. The sale from a related LAQC to you personally will constitute a sale to an associated person and will for tax purposes be deemed to take place at market value. The sale may also result in depreciation recovery (income) in the LAQC. Depending on the level of depreciation recovery the company may need to consider paying provisional tax in the year of sale.
Inland Revenue could also argue that the reason for the sale was merely for tax purposes and could assert that the arrangement is a tax avoidance arrangement. You would therefore need other commercial reasons for changing the ownership rather than merely to save tax.
A further “fish hook” in the transfer of depreciable property between associated persons is that, notwithstanding that the present market value of the property may be higher than the original cost to the qualifying company; the purchaser will be restricted in its depreciation claim to the original cost price to the transferor. Whilst the general restriction on depreciation of buildings will essentially override this issue in most instances, this should be borne in mind in relation to any other assets presently held within LAQC structures.
The proposed rules for becoming a QC are similar to the current rules. However, limitations regarding income interests in CFCs and FIFs and the rule requiring less than $10,000 of foreign non-dividend income have been relaxed. Also, a QC will only be allowed to have one class of share (like a LAQC currently).
Where a shareholder disposes of his or her shares in a QC under the proposed rules, he or she would be treated as disposing of their share of the underlying company property and would bear any tax consequences associated with the disposal. This could result in significant compliance costs for QCs and their shareholders.
If a company ceases to be a QC, there would be a deemed disposition and reacquisition of the company’s assets at their market value on that date. This would give rise to tax consequences for the shareholders, who would be treated as disposing of their share of the QC’s property.
When a QC is liquidated a shareholder would be treated as disposing of and reacquiring all their interests in the company at market value as above, giving rise to tax consequences.
Existing QCs that continue to meet the eligibility requirement will automatically transition into the new rules. “Flow-through” tax treatment will apply from 1 April 2011.
There will be no deemed disposal and reacquisition of an existing QCs assets when it transitions into the new QC rules. This will avoid complicated compliance.
The Issues Paper does not specifically contemplate the situation where a LAQC has already distributed losses to a shareholder in excess of that “shareholder basis” (or funds “at risk”). Further details will be advised as they become available.
The change in the treatment of QCs and LAQCs has not yet been legislated – these are only proposed changes that could be amended based on feedback received.