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Dividend Integrity proposals - another wolf in sheep’s clothing?

Tax Alert - April 2022

The Government has proposed a new “dividend integrity” rule that appears to resemble a capital gains tax wolf in dividend integrity clothing. Last year’s extension of the bright line test targeted the sale of Mum and Dads’ rental properties, the latest proposal is after the capital gain (or in some cases the full sale proceeds) on the sale of their business.

A discussion document just released, Dividend integrity and personal services income attribution, proposes to tax majority (more than 50%) shareholders on the sale of shares in a company to the extent that there are historical profits retained and/or reinvested in the company. A more detailed summary of the proposed rule is in the table below.

The Government’s concern is that shareholders are avoiding tax by retaining profits in a company rather than paying dividends, and then selling the shares in the company for an increased price that reflects the value of the undistributed profits. The increased sale proceeds are not subject to tax for the shareholder, whereas a dividend paid prior to sale would have been taxable at their marginal tax rate.

To put some numbers against this scenario, the company’s profits will have been subject to tax at 28% but as they are not paid up as a dividend there is no further tax at the shareholder level (potentially up to 11% additional tax for a taxpayer at the 39% top tax rate). The increase to the top personal tax rate and the greater differential between this and the corporate tax rate means that, in the Government’s opinion, the risk of tax avoidance is greater than in the past.

We sympathise with the concern in the context of transactions between associates. It can be possible to restructure companies between associates to achieve this result (known as “dividend stripping”). However, there is already a targeted anti-avoidance rule which prohibits this. The Government’s view is this rule is “complex to administer and costly to litigate” so instead they have proposed a law change that will capture a broad, but arbitrary, range of commercial transactions rather than target the fraction of a percent that are the issue.

In the context of third-party transactions, we don’t believe a problem exists. Sales of companies to third-parties are almost always priced on a ‘debt-free, cash-free’ basis, with typically minimal cash transferring as part of working capital; in the real world, no one pays cash for cash. What the rule will tax then in third party transactions, is not profits retained in cash, but profits reinvested in the assets of a business. The same reinvestment that is required for growth and a productive New Zealand economy. In 2011 the corporate income tax rate was reduced from 30% to 28%. The reasons cited by the Government at the time were to “encourage productive investment in New Zealand, thereby increasing productivity, raising wages and creating jobs”.

In effect, what the rule would achieve is a “catch up” tax on sale, to tax historical corporate profits at the shareholder’s marginal tax rate. The problem is that it all happens in one fell swoop, in the year of sale. This doesn’t reflect the economic reality that the profits were earned over time, nor that the 39% tax rate has only recently been introduced. For some family businesses this could be profits accumulated and reinvested in the business for multiple generations.

We believe that Government resources would be better applied to codifying a more targeted dividend stripping rule to deal with the perceived abuse in the context of associated party transactions. Instead, a blunt instrument has been proposed that creates many arbitrary outcomes and will materially distort ordinary commercial transactions that are not being structured to avoid the new 39% top marginal tax rate.

There are likely to be unintended consequences and distortions for Merger and Acquisition (M&A) activity if the proposed rule is implemented, and we can see the rule influencing and distorting behaviours.

  • The rule will be problematic for ‘locked box’ deals. Profits earned between the locked box date and the completion date economically belong to the purchaser, but will be taxable for the seller, not reflecting the economics on a locked box deal. This may need to be reflected in price depending on the negotiating positions of the seller and purchaser.
  • Privately owned businesses with a majority seller will be at a competitive disadvantage to a business with marginally more diverse ownership. This may disincentivise majority ownership and we might see more effective joint ventures with a third minority interest, e.g., two 49% shareholders with a third 2% investor (or employee shareholder).
  • The rule may add an interesting dynamic between majority and minority shareholders due to the inconsistency of the rule’s application. In the case of a business owned 51:49 by two shareholders, only the 51% shareholder would be subject to tax under this rule. It could be possible for the minority shareholder to receive greater after-tax proceeds than the majority shareholder.
  • The ‘look back’ rule could have a lock in effect. If a founder of a business raises capital and has a partial exit (say a private equity fund acquires 60% of the company), they will be incentivised to defer an exit event for 2 years, so the remaining 40% of the shares are not subject to the rule.

This rule will likely apply to all sales of profitable companies by private shareholders and will add complexity and compliance costs every time. This is a continued trajectory of compliance heavy policies (like the purchase price allocation rules which took effect from 1 July last year) which are making it harder and more expensive to do M&A.

Given the wide variety of structures used to transfer economic ownership to employees, we are concerned that the proposed rule could have unintended consequences for employee share schemes and the (non-tax) benefits they provide. Consideration should be given to excluding transfers of shares to employees from the rule to avoid creating a barrier to their introduction (through tax cost or complexity).

On the other hand, the rule may make traditional employee share schemes preferable to phantom share schemes if issuing shares to employees can dilute ownership below 50%. There has been a trend in recent years towards phantom share schemes in smaller businesses to avoid the company law complications of having minority shareholders. The proposals could unwind this shift, another example of tax influencing and distorting business decisions.

The rule will apply to internal restructures / sales of shares but with added complexity. A confusing example in the Discussion Document suggests the purchasing company will be the entity deemed to pay the dividend, rather than the acquired entity with a second potential dividend being deemed paid by the acquired company. There will be a host of compliance issues to work through, even for the most basic restructures and, this again will mean additional compliance costs.

The Discussion Document unhelpfully doesn’t include any guidance on how the rule should apply to the transfer of shares on death, when gifted or on the settlement of a trust and it’s not yet clear whether these would trigger a tax cost. There is a comment that the shareholder’s income should be limited to the sale proceeds (which should be nil in these situations) but this doesn’t necessarily sit well with other tax rules that generally treat these sorts of transaction as occurring for market value.

Available Subscribed Capital / capital gains reporting proposal

The Discussion Document is seeking feedback on two options regarding the documentation and/or reporting of ASC and capital gain amounts. These amounts are necessary to calculate on the liquidation of a company or the cancellation of shares (as certain amounts can be paid to shareholders tax free). Inland Revenue considers they can be difficult to determine and has suggested:

  • Option One: Require the amount of ASC and the capital gain amount to be determined annually and reported to Inland Revenue.
  • Option Two: Require taxpayers to record the information to evidence that they have calculated the tax-free amounts correctly (with Inland Revenue determining the amounts in the absence of reliable evidence), with no annual reporting requirement.

We recognise that these amounts can be difficult to determine, particularly for companies that have existed for a long time, but in our view an annual reporting requirement (Option One) is too far when there is no requirement for Inland Revenue to accept the disclosed amounts if any and when they are utilised in the future. This would be another example of a measure that would increase the compliance burden and costs on all companies for limited fiscal benefit or certainty.

Personal services attribution proposal

The scope of the personal services attribution rule is proposed to be materially widened. This rule can apply to attribute income to an individual where personal services are provided through a contracting vehicle (commonly a company owned by a trust), effectively capping the tax at the company or trust tax rates. We have provided detail on this proposal in a separate article.

What’s next?

The Government has signalled this Discussion Document is just the first of three tranches of integrity proposals. The second tranche will consider trust integrity and company income retention issues and the third will cover integrity issues with the taxation of portfolio investment income. In addition, they’ve mentioned that the use of shareholder loans is on the list for review, but this has been deferred due to limited resources.

We’d like to see the Government and Inland Revenue go back to the drawing board on this one. Further definition of the problem is required and a more targeted approach needed to resolve it.

Given the wide-reaching nature of the proposals and the potential commercial issues and distortions we would have expected a more comprehensive consultation process to fully evaluate the problem and the solution. The proposed timing of legislation being introduced later this year once again means we are likely to have rushed tax policy with significant overreach and unintended consequences.

Is it a wolf in sheep’s clothing? It is certainly another example of untargeted tax policy that will penalise the majority for a problem that doesn’t exist and it seems to fly directly in the face of the Government’s undertaking not to introduce new taxes or to tax capital gains.

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