In this FYI we explain the significant changes to the tax treatment of "mixed-use assets" proposed in a Bill recently introduced into Parliament. We also provide an update on our recent FYI ("One Man’s Leakage Is Another Man’s Moat" 8 August) concerning proposed changes to the tax treatment of lease inducement payments.
The centerpiece of the Taxation (Livestock Valuation, Assets Expenditure, and Remedial Matters) Bill (Bill) is the introduction of a new set of apportionment rules. These are aimed at restricting income tax deductions relating to assets used partly for income-earning purposes and partly for private purposes (mixed-use assets). The primary target are expenses such as rates, insurance, interest and maintenance associated with ownership of holiday homes that are used both privately and for rental purposes, but expenses associated with other assets such as boats and aircraft are also targeted.
The focus is on the treatment of expenses to the extent they relate to time when the asset is unused. Under current rules, a deduction is generally allowed to the extent that the asset is "available" for income-earning use, eg advertised for rental, even if it is largely unused in these periods. This leads to outcomes in which deductions are claimed in respect of all periods other than when the asset is being actually used for private purposes. The proposed new approach will allow deductions by reference only to periods when the asset is actually in income-earning use, with periods of non-use being disregarded.
How will the new rules work?
The proposed rules will apply to all taxpayers, other than companies that are not "close companies" (discussed below), with application from the beginning of the 2013/2014 income year (normally 1 April 2013). For an asset to come within the rules it must:
- be used to earn income and be used privately;
- have a value of at least NZ$50,000 (or land of any value); and
- be actually unused for (either private or income-earning purposes) at least 62 days (or 62 working days if the asset is typically only used on working days) in an income year.
Motor vehicles and assets in relation to which expenses are apportioned on the basis of floor-area or space (such as the home office) will not be subject to the rules.
A broad definition of "private use" is proposed, namely:
- any use of an asset by the owner, or an associated person of the owner, even if the use of the asset is non-exclusive, and even if a market value amount is received by the owner in consideration for the use; or
- where the amount received by the owner for the use of the asset is less than an arm's length amount.
One will be able to opt out of the new rules if income from the mixed-use asset is less than NZ$1,000 for an income year. The taxpayer will be able to elect that the income be treated as exempt income, with all associated expenses consequently being non-deductible.
Where the rules apply to an asset, deductions for relevant expenses in the income year will be, broadly, categorised as follows:
- Fully deductible: Expenses that relate to use of the asset solely for income-earning purposes (eg advertising), or that must be reasonably incurred to meet a regulatory requirement for non-private use, will be fully deductible.
- Not deductible: Expenses that relate to use of the asset solely for private purposes will not be deductible.
- Apportioned: Expenses that relate to use of the asset for both income-earning and private purposes will be apportioned the following formula:
Click here to view picture .
If a unit of measurement other than a day (eg nights or hours) would produce a more appropriate apportionment, the rules allow it to be used.
Ring-fencing of losses
Rules are also proposed to ring-fence "excess expenditure" (ie losses incurred in relation to the mixed-use asset) where the annual gross income from a mixed-use asset is less than 2% of its cost, or a more recent rateable value in the case of land. Annual gross income for this purpose will exclude any income derived from associated persons for the use of the asset. Such losses will not be able to be used to shelter other current year income, but will be able to be carried forward to future income years to shelter future taxable profit (if any) from the mixed-use asset.
This aspect of the proposed rules could have a significant impact, especially for taxpayers with high value mixed-use assets. For example, suppose:
- Mrs Y owns a bach with a cost of $800,000, but now has a rateable value of $1,000,000;
- Mrs Y uses the bach 50% for private purposes and 50% for income-earning purposes; and
- total rental income for the year is $15,000 and "apportionable" expenses (interest, repairs and maintenance, rates, insurance etc) $40,000.
Mrs Y has incurred a $5,000 loss in relation to the rental activity (gross income ($15,000) less 50% of apportionable expenses ($20,000)). However, as the gross income derived ($15,000) is less than 2% of the rateable value of the bach ($20,000), the loss will not be available to shelter other current year income of Mrs Y. Rather, the loss will need to be carried forward to shelter any future taxable profit from the rental activity.
Special ring-fencing rules apply to group companies, apportioned interest (discussed below) and assets where income is not separately identifiable.
Special interest deduction rules for close companies
The new apportionment rules will not apply to all companies, but will apply to close companies, being companies with five or fewer natural person shareholders (counting associated persons as a single shareholder). As well as having to apply the new apportionment rules generally to any mixed-use assets held, close companies, other companies in the same group, and their shareholders, will also be subject to special allocation rules concerning interest deductions.
The allocation rules seek to address the concern that an interest deduction for debt that has indirectly funded the acquisition of a mixed-use asset by a close company, may be currently fully available to a shareholder or related group company. For example, suppose:
- Mr X borrows $100 to subscribe for all the shares in Company A;
- Company A then borrows $100 and subscribes for all the shares in Company B for $200; and
- Company B then itself borrows $100 and acquires a mixed-use asset for $300, used in part for the private enjoyment of Mr X, and in part for income-earning purposes.
Without the proposed allocation rule, while interest deductions on Company B's $100 borrowings would be apportioned, both Mr X and Company A would probably be entitled to a full interest deduction on their respective $100 borrowings. It is thought that this is inappropriate because the total $200 borrowed by Mr X and Company A has been introduced as equity to Company B to meet two-thirds of the cost of the mixed-use asset.
When applying these rules, the first step will be to consider the extent to which interest incurred by the asset-holding company can be deducted:
- interest on total debt that is equal to or less than the cost (or rateable value for land) of the asset must be apportioned (using the formula above);
- to the extent total debt exceeds the cost (or rateable value for land) of the asset, interest will be subject to normal interest deductibility rules (ie likely to be fully deductible); or
- to the extent total debt is less than the cost of the asset, there will be an allocation to shareholders or related companies and apportionment of their interest deductions (if any).
Applying the allocation approach to our example, Company B will have to allocate its "net asset balance" (NAB), being the cost of the mixed-use asset (or rateable value for land) less its total interest-bearing debt (ie $200), to Company A. Because the NAB ($200) attributed to Company A exceeds its $100 borrowings, Company A's interest deductions will also be apportioned on the same basis as Company B's. The NAB would then be reduced by the amount of Company B's borrowings ($100) to $100, with this net NAB then attributed to Mr X, resulting in apportionment of his interest deductions on the $100 he borrowed to subscribe for the shares in Company A.Other more specific and nuanced rules are included to cater for particular fact situations, eg how to apportion NAB where there are multiple shareholders or in group company structures where mixed-use assets are equity funded and fully income-earning assets debt funded.
The inclusion of these allocation rules is understandable given the relative ease with which, in group structures, interest deductions could be "quarantined off" from the ownership of mixed-use assets. However, the rules are complex and there will undoubtedly be implementation issues.
In addition, as proposed, the rules rather arbitrarily operate by attributing all of a company's debt to its mixed-use assets, even where it has other fully income-producing assets. For example, suppose:
- Mr X funded Company A using $150 savings (ie without borrowing funds);
- Company A borrowed $50 and subscribed for $200 shares in Company B; and
- Company B borrowed $100 and acquired a mixed-use asset for $150 and a fully income-producing asset for $150.
Here the allocation/NAB rules will, as proposed, result in apportionment of interest deductions both on Company B's $50 borrowings and Company A's $100 borrowings. The fully income-producing asset effectively will be regarded as 100% equity funded. There will, apparently, be no ability to view each of the assets as partly debt funded and partly equity funded. This seems an unfairly punitive outcome which will hopefully be reviewed at the Select Committee stage.
Following changes made to the GST Act from 1 April 2011, input tax on goods and services acquired by registered persons may be deducted to the extent to which the goods or services are used for, or available for use in, making taxable supplies. At acquisition, a registered person can only claim input tax in proportion to the percentage of intended taxable use of the goods or services. The registered person is then required to perform adjustments, on a yearly basis, to reflect any increase or decrease in the amount of taxable use, relative to the percentage of intended taxable use at acquisition.
These existing GST apportionment rules would apply, without modification, to mixed-use assets and related expenses. However, officials have taken the view that there should be consistency, in relation to mixed-use assets, between the method for apportioning income tax deductions and GST input tax. Accordingly, the Bill contains amendments to the GST Act to align the approach for apportioning input tax on mixed-use assets and related expenses, with the new income tax approach. As such, GST input tax in relation to mixed-use assets will be deductible only on an actual taxable use basis, rather than an availability for taxable use basis.
The existing GST input tax apportionment rules will continue to apply outside the mixed-use asset context – for example, in relation to input tax on goods and services acquired for the purpose of making partly taxable and partly GST exempt supplies.
Lease Inducement Payments – An Update
In our FYI of 8 August ("One Man's Leakage Is Another Man's Moat") we commented on the proposal to tax lease inducement payments (LIPs). The proposal was controversial for a number of reasons. Not only was the long-standing capital status of LIPs to be overthrown, it was said that the proposal would apply to arrangements entered into from the date of the announcement. This was constitutionally improper, as the proposal had not been announced by the Government, let alone considered by Parliament, was reversing a long settled legal position and would result in uncertainty about the law in the meantime. As well, the likelihood that not all LIPs are deductible was not addressed. This was unprecedented, given that the purported reason for the proposal was to remove an alleged tax asymmetry of LIPs being deductible but not assessable.On 27 September, the Minister of Revenue issued a press release, which affirms the proposal to tax LIPs but addresses the other concerns as follows:
- The law change will apply to LPs on commercial leases entered into on or after 1 April 2013.
- All LIPs will be tax deductible for landlords by over-riding the capital limitation on deductions.
In addition, the Minister announced that, for both income and expense purposes, LIPs will be spread evenly over the term of the lease.
Lease Surrender Payments
Going beyond the initial proposal, the Minister has also announced a change to the tax treatment of lease surrender payments made by tenants to exit commercial leases.
At present, lease surrender payments are taxable to any landlord that is in the business of leasing property unless the surrender of the lease is of such significance to the landlord's business that it constitutes the loss of a structural asset. This has been acknowledged by Inland Revenue in public binding rulings. By contrast, lease surrender payments are generally not deductible to the tenant, since leases are usually part of the profit-making structure of a business, as held by the Court of Appeal in CIR v McKenzies New Zealand Ltd in 1988.From 1 April 2013, all commercial lease surrender payments will be deductible to the payer and assessable to the recipient. This is being sold as part of the Government's efforts to reduce non-deductible business (aka "black hole") expenses. Removing this tax asymmetry will dampen down criticism of the LIP changes and the shortcomings of the original proposal.