Published November 2010
In May 2010 the Government announced the introduction of flow-through treatment of profits and losses for closely held companies. Government is keen to implement measures that prevent what is sometimes referred to as ‘Arbitrage’, i.e., the retaining of profits in a company and therefore the utilisation of a company tax rate (28% as of 1 April next year) that is lower than the top personal rate (33%).
Inland Revenue’s policy division has now prepared draft legislation to implement the far reaching changes to the Qualifying Company regime. Although the legislation is still in a draft form, it is likely to become final within weeks.
- As of 1 April 2011, LAQCs will not be allowed to attribute losses to shareholders.
- The legislation creates a new entity, called a ‘Look through Company’ (LTC).
- Companies will be allowed to transition across to become an LTC, or alternatively they can change to another business structure (for example a partnership), without any tax cost.
- An LTC’s profits and losses will be passed on to its owners, according to each shareholder’s effective interest in the company. This means that losses and profits will be deducted or taxed at the owner’s marginal tax rate.
- Losses in LTCs will only flow through to owners to the extent that those losses reflect their economic loss. (Getting complicated now)
- Owners who wish to convert their LAQC to an LTC must formally elect to become an LTC. In other words, we as your accountants will need to complete precise IRD forms to ensure an LTC election is valid.
- The shareholders of an LTC will be treated, for tax purposes, as holding the assets of that LTC directly. This raises complex issues where those assets are sold.
- Remember, this is all a tax fiction only – an LTC retains its identity as a registered company and therefore is still governed by The Companies Act.
We must at this point stress the very general nature of the above overview. The legislation is quite complicated and we know you don’t want wordy and complex updates on tax. It’s our job to cut through all of that for you.
- Stay as a Qualifying Company (QC). This means you will not be able to allocate any company losses to shareholders. Losses will need to be used by the company, against other company income. If your company makes regular losses, and you want to use those losses against personal income (such as profits from another business, or wages from employment), this option may not work best for you.
- Be taxed as an ordinary company. Once again, you will not be able to allocate company losses to shareholders. Also, you will miss out on certain other benefits that QCs enjoy, such as the ability to distribute capital gains without winding up the company.
- Be taxed as a Look Through Company (LTC), as summarised above.
- Restructure to another type of entity, such as a partnership, a limited partnership, a trust or a sole trader. As you can imagine, such a restructure is not necessarily a simple matter and will most likely involve solicitors' conveyance costs and possibly bank costs for transferring ownership of the property and the associated bank loan(s) to the new entity.
Another point to note is that depreciation on buildings can no longer be claimed from 1 April 2011. For lots of investors this can mean their rental property may produce a “profit” for tax purposes. Combined with the changes to the LAQC rules it means most investors are going to need to change their structures.
We have to stress at this very early point that the legislation for the changes to LAQC’s is still in draft form and is expected to be finalised in the near future..