If you conduct business or invest through a qualifying company (QC) or loss-attributing qualifying company (LAQC), there are significant law changes coming into force on 1 April 2011 that will impact on your structure.
The Government has introduced a new type of tax entity called a look-through company (LTC). LAQCs are abolished from 1 April 2011. Plain QCs remain for the time being, but are intended ultimately to be replaced by LTCs.
This FYI compares the tax treatment of the new LTC with that of QCs and LAQCs. We then discuss the options available to shareholders in existing QCs and LAQCs once the LTC regime comes into force.
Why are the changes being made?
The introduction of LTCs and abolition of LAQCs reflects a number of policy concerns about the current QC/LAQC regime. The most significant of these are as follows:
An LAQC's losses and income are treated differently for tax purposes. People whose marginal tax rates are higher than the company rate have been able to exploit this difference to save tax ("tax arbitrage"). To explain:
- LAQC losses are attributed to the shareholders in the income year the losses are incurred by the company. Shareholders can immediately use their share of the LAQC losses to reduce their personal taxable income and make tax savings at their marginal tax rates.
- By contrast, if and when the LAQC enters a profit position, the income is taxed at the company tax rate (currently 30% but reducing to 28% from 1 April 2011). Only if and when that tax paid income is distributed to the shareholders as imputed dividends will additional tax reflecting the difference between the company tax rate and the top personal tax rate (33%) be collected. This is now seen as an inappropriate deferral advantage relative to the treatment of losses.
LAQC losses that exceed shareholders' economic exposure
An LAQC attributes all its losses to its shareholders in proportion to their shareholdings. Significantly, LAQC losses that can be attributed include losses funded by (say) company borrowings to which shareholders have no legal or economic exposure, because of the company limited liability shield. This is also seen as inappropriate.
How will the new rules work?
The abolition of LAQCs from 1 April 2011 will remove the arbitrage opportunity described above.
Plain QCs will be able to continue as before (at least for the time being) without the benefits of loss attribution, but also without any requirement to recognise company income at shareholder level on a current-year basis.
The new LTC entity is to be fully tax transparent. This means that shareholders will have the benefit of tax loss attribution (as under the LAQC regime), but (in contrast to a QC) company income will similarly be attributed directly to shareholders and taxed at their personal marginal tax rate on a current-year basis. Company income will have to be returned by shareholders regardless of whether the company actually distributes the income to them.
As under the QC/LAQC rules, companies must meet strict ownership criteria to be able to enter the LTC regime. Generally, a company will be eligible if it has five or fewer natural person shareholders (counting shareholders who are closely related as one for this purpose). Trusts may also be shareholders provided certain requirements are met. If one LTC holds shares in another LTC, whether the "subsidiary" LTC meets the ownership criteria will be determined by "looking through" the "parent" LTC to its underlying shareholders. Furthermore, an LTC can have only one class of shares.
As companies, LTCs will provide shareholders with a liability shield for non-tax purposes. The combination of full tax transparency and limited liability means the characteristics of an LTC will be very similar to those of a limited partnership. However, LTCs are a necessary alternative to limited partnerships. This is because limited partners lose their limited liability if they participate in the management of the partnership, meaning a limited partnership is not a suitable vehicle for a hands-on businessperson or active investor. A company is also a more familiar and more easily administered vehicle than a limited partnership.
Other important features of the LTC regime are as follows:
Loss Limitation Rule
LTC shareholders will be subject to a modified version of the loss limitation rule that currently applies to limited partners in limited partnerships. This addresses the second policy concern associated with LAQCs noted above.
The LTC loss limitation rule will cap the total amount of company tax losses (aggregated for all income years) that a shareholder can claim at the shareholder's "owner's basis" in the LTC. Under this approach, a shareholder will effectively be prevented from deducting losses in excess of his or her equity in the LTC. However, for this purpose equity includes (in addition to contributed share capital):
- a proportionate share of the LTC's undistributed income and capital gains from the current and preceding tax years (in which the company was an LTC); and
- loans made by the shareholder to the LTC (including shareholder current account credit balances), assets introduced or services provided to the LTC by the shareholder, and the shareholder's exposure under any personal guarantee or indemnity for company debt.
Tax consequences on sale of shares
Because the LTC is tax-transparent, for tax purposes, a shareholder who sells LTC shares will be deemed to dispose of a proportionate interest in all the LTC's assets. A disposal of shares in an LTC may therefore trigger tax consequences for the shareholder. For example, it may trigger realisation of income from assets the LTC holds on revenue account, and depreciation recovery income from disposal of depreciable assets of the LTC.
The regime does incorporate de minimis rules (similar to rules for partnerships), allowing these tax consequences to be ignored in certain circumstances. However, beyond these thresholds the tax results will have to be recognised by shareholders.
What options are available to an existing QC or LAQC from 1 April 2011? From 1 April 2011, existing QCs and LAQCs may continue to operate as plain QCs. This will be the default position. Existing LAQCs that continue as QCs will not be able to attribute losses to shareholders from 1 April 2011; but similarly (and in contrast to LTCs) their income will not be attributed to shareholders.
Alternatively, existing QCs and LAQCs may, without incurring tax costs:
- transition into the new LTC regime;
- change to another business structure (such as an ordinary partnership, a limited partnership, or a sole trader); or
- become an ordinary company for tax purposes.
An election to transition into the new LTC regime or to change to a new business structure can be made in either of the first two income years beginning on or after 1 April 2011. Existing QCs and LAQCs have six months from the start of the income year they choose to make the transition to notify the IRD of their transition to the LTC regime or change of business structure from that year.
If the choice is made to change to a new business structure, the ownership of that new business structure must consist of and be proportionate with the interests of the shareholder(s) of the existing QC or LAQC, and the transition (ie. all necessary transfers and documentation) must be completed by the end of the transitional year.
The QC's or LAQC's assets and liabilities (including tax balances) will automatically transfer to the new LTC, partnership, or sole trader, with no immediate tax implications. The new tax treatment for the LTC or new business structure will apply from the start of the transitional year.
We expect that most existing LAQCs will transition into the LTC regime to preserve the ability to attribute losses. However, this will come at the cost of future income being taxed directly at shareholder level at the shareholder's marginal tax rate.
We expect most existing profit-making QCs (or LAQCs approaching a profit position) will choose to remain QCs so that tax on income is only taxed at the company tax rate until distributed.
What will happen to losses accumulated by an existing QC?
The carried forward loss balance (if any) of a plain QC will be able to be used by the shareholders post-transition into the LTC regime. Likewise, if the plain QC transitions to a new business structure, the losses will be available to the partners of a new partnership or the new sole trader (ie. the former QC shareholders) for future use.