“LAQCs” out, “Look Through Companies” in!
The New Zealand income tax system will soon allow for a new type of tax entity called a “look through company” as a replacement for the qualifying company (including the loss attributing qualifying company or LAQC). Deloitte middle market tax specialist Darren Johnson suggests that, while the Government and officials should be commended on the broad content of the proposals, the changes fall short in that they should apply to all companies by election.
In the May 2010 Budget, the Government signalled significant changes in relation to the qualifying company (Q Co) regime. At the same time a discussion document was issued and submissions were called for. We discussed the background to the proposed changes and discussion document in the June/July 2010 Tax Alert. From a policy perspective, the proposed changes largely result from the perceived abuse of the existing LAQC rules.
Draft legislation in relation to the proposed changes has now been issued. Government and officials should be commended in relation to the broad content of the draft changes as they relate to closely held companies and the changes that have been made to the original proposals. However, there are still a number of matters that should be addressed.
Overview of Changes
- Existing Q Cos and LAQCs will be allowed to use the current Q Co rules but without the ability to attribute losses (until a review of the dividend rules for closely-held companies has been completed).
This is in recognition that Q Cos are not just about LAQCs and loss flow through (the target of the proposed changes). Q Cos were originally introduced to deal with capital profits in close companies. It was a late concession (as a result of submissions) that allowed for the introduction of LAQCs.
- A new “look through company” regime will be introduced to replace the Q Co regime. A look through company (LTC) will be a transparent company for tax purposes, i.e. it is the shareholders that are taxed.
- Existing Q Cos and LAQCs may transition into a partnership, limited partnership, sole trader or LTC at no cost during their first income year starting on or after 1 April 2011.
A look through company
In simple terms, an LTC is essentially ignored for tax purposes, and taxable income, deductions, and tax credits pass up to shareholders in proportion to each shareholder’s interest in the company. The shareholder (not the company) is then responsible for paying tax on their share of the LTC’s taxable income or can utilise LTC losses (subject to loss limitation).
For other purposes, such as GST, the company continues to be recognised.
The key differences in the eligibility requirements of LTCs and Q Cos are as follows:
- While LTCs are also limited to five shareholders, with certain shareholders treated as one (the ‘count test’), the count test for a LTC treats relatives (rather than persons within one degree of relationship) as one person (i.e. the test is wider).
- LTCs cannot have corporate shareholders, whereas Q Cos are permitted to have corporate shareholders (so long as the corporate shareholders are also Q Cos).
- LTCs can earn unlimited foreign income, whereas Q Cos are limited to a concession of $10,000 of non-dividend foreign income.
- LTCs do not require trustee shareholders to distribute income as beneficiary income, but in not distributing this income, the trust may be counted as a shareholder in addition to the beneficiaries. Trustee shareholders of Q Cos must distribute taxable income as beneficiary income.
- LTCs can have only one class of shareholder. Q Cos that are not LAQCs can have multiple classes of shares.
- The deemed revocation of Q Co status upon a change in shareholding does not apply to a LTC. Instead, all shareholders need to elect to be an LTC, and revocation only happens due to a breach of eligibility requirements or actual revocation by a shareholder.
The shareholders of LTCs will be subject to loss limitation rules. The rules are similar to (but not the same as) those for limited partnerships.
The losses a shareholder can utilise in a particular year will be limited to what is effectively the maximum economic loss the shareholder can suffer from their investment in the LTC. This maximum economic loss is referred to as the shareholder “membership interest”.
The following are to be included in a shareholder’s “membership interest” (subject to certain adjustments):
- Equity, goods, or assets introduced or services provided to the LTC, or any amounts paid by the shareholder on behalf of the company.
- Loans made by the owner to the LTC.
- Share of the LTC debt guaranteed (or indemnities provided) by the owner or their associate.
- Share of the net LTC income previously recognised, and capital gains previously realised.
Deemed disposal rules
There will be deemed disposal rules that will apply when a company ceases to be an LTC or where a shareholder sells an interest in the LTC. Broadly speaking, these rules are similar to the rules that currently apply to partnerships, meaning that a deemed sale and reacquisition of assets will occur.
LAQCs are no longer effective
LAQCs will no longer be able pass losses up to their shareholders for income years starting on or after 1 April 2011. For existing LAQCs to continue to pass losses to their shareholder, they will need to transition into the new LTC rules.
However, for the vast majority of taxpayers with simple rental properties (or similar) that currently have LAQC structures generating losses, a carefully managed transition into the new LTC rules should result in relatively similar tax outcomes to those currently achieved.
Careful structuring should also mean that the loss deduction limitation should not apply. The key difference will be that depreciation recoveries or other similar disposal events will be triggered at the shareholder’s marginal tax rate rather than the company tax rate.
Concessionary Transition rules
Existing Q Cos (including LAQCs) as at 1 April 2011 should be able to transition into the new LTC rules, or other structures such as a general partnership, a limited partnership or a sole trader (but not currently a trading trust) from the income year beginning on or after 1 April 2011 at no tax cost. That is, the restructure transactions will effectively be ignored for tax purposes.
However, under the current proposal, there is only a limited period of six months from 1 April 2011 for existing Q Cos to elect to make this transition under the concessionary rules.
Some concerns with the current proposals
Three major concerns with the current proposals are as follows:
- Concessionary transition required before the close company dividend review
Transition into the LTC regime under concessionary rules will be required before a review of the close company dividend rules is complete. The existing Q Co regime was designed to address close company dividend issues (before a late decision, as a result of submissions, to allow LAQCs). It is therefore disappointing that taxpayers will need to make a decision on using the concessionary transition provisions before the outcome of the close company dividend review is complete.
- One shareholder can elect out
As currently drafted the proposals allow a single shareholder to revoke LTC status. The Inland Revenue’s view appears to be that as these are close companies, all shareholders should be aware when one person revokes LTC status. However this view appears to ignore the practical consequences when close relationships breakdown. The proposals should be amended to require a majority of shareholders to elect before a revocation from the LTC rules is effective.
- Shareholders liable for PAYE
Under the proposed LTC rules, shareholders will be liable for their shareholding of an LTC’s unpaid PAYE obligations. This is a concern as there does not appear to be any obvious reason to break a company’s limited liability status for a tax other than income tax.
Why limit LTCs to close companies?
The LTC rules have been drafted as applying to close companies only, as is the case with the Q Co rules they are intended to replace. However, unlike the Q Co rules (which were originally intended to deal with close company capital profit issues) there does not appear to be any obvious rationale for limiting the LTC rules to close companies.
Perhaps the LTC rules should be available to all taxpayers that want to use them, as they would be a simpler legal alternative to the limited partnership regime. Further, the removal of the close company restriction removes the ongoing risk of an LTC inadvertently falling out the regime through breach of the eligibility requirements.
If you have a qualifying company structure, important decisions will soon need to be made. The draft legislation is expected to be enacted before Christmas which does not leave a lot of time to sort through what action should be taken. If you require assistance or advice on what to do, please contact your usual Deloitte tax advisor or one of our mid market tax specialists.