LAQC / LTC TAX CHANGES

As you will now be well aware the LAQC / LTC tax changes are fast approaching.  They take effect 1 April 2011.  If you have an LAQC and you have not yet discussed with us what course of action to take you need to contact us urgently and book an LAQC/LTC review meeting.  As a recap some of the key points to note in respect of the rule changes are as follows:

• If you do nothing your LAQC will remain an LAQC, but a rule change from 1 April 2011 means shareholders of LAQCs can no longer claim tax losses.  In other words the LAQC loses the ability to attribute its losses to shareholders.  In most cases doing nothing is not an option.

• In conjunction with the LAQC/LTC changes, depreciation can no longer be claimed on buildings.  In many cases this means that tax losses that are currently being experienced will turn to tax profits.  This means you need to ask the question as to whether your current structure is appropriate given this change in tax result?

Broadly speaking if you have an LAQC at present you have a number of options available to you including the following:

• Do nothing and remain in the LAQC regime - although as noted you will not be able to attribute losses to shareholders.

• Convert the LAQC to an LTC, but leave everything else the same.

• Convert the LAQC to an LTC, but at the same time examine whether the shareholding structure in relation to the company is appropriate.

• Convert the LAQC into an ordinary company and potentially restructure the shares as well.

In summary, the changes to the LAQC rules and the implementation of the LTC regime means that all existing LAQC clients need to have their affairs reviewed to determine what the best structure is for them from 1 April 2011 onwards.  We are offering LAQC/LTC review meetings at a discounted cost of $150 plus GST.  Do not delay in setting this meeting up as you need to have the advice in advance of 31 March 2011.

Matthew Gilligan
Director

Learn More about Matthew
Contact Matthew at mg@gra.co.nz
or call +64 9 522 7955

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Since announcing in May that the LAQC regime was going to be the subject of an overhaul the property investment community has been anxiously awaiting the Government’s follow-up to the Issues Paper released at the time.  On Friday 15 October 2010 draft legislation was released.  As at the time of writing all practitioners, including myself, were poring over the draft to get to grips with the new regime.  The objective of this article is to provide an overview of the proposed rules.  Contact Us At GRA

Recap

In May sweeping changes to tax rules were announced with the ones of most significance to property investors being the prohibition on claiming depreciation on buildings after the end of the 2011 financial year and drops in personal income tax rates.  At the same time the Government announced that they wished to review the current tax rules in relation to LAQCs.  In the Issues Paper it was proposed that LAQCs would be treated as limited partnerships for tax purposes with the three main consequences of this being:

• LAQC profits would be attributed to shareholders (as well as losses).  Perhaps unsurprisingly the IRD had expressed concern that the existing tax rules allow an arbitrage in that shareholders of a loss making LAQC can offset losses against their personal income where the tax rate has historically been as high as 39%, whereas they could hold shares in a profit making LAQC and have the profit taxed at the lower company tax rate (historically 33%, now 30% and moving to 28% from 1 April 2011).
• Losses able to be claimed by shareholders to be limited to the shareholder’s “investment“ in the LAQC.  Broadly speaking this was proposed to include capital of the company, together with retained profit and any company debt guaranteed by the shareholders.  Shareholder loans were not included and many submissions were subsequently fielded on this point.  The objective here was to limit the ability of the shareholders to claim losses that exceed their economic exposure to the activities of the LAQC.
• Shareholders to be regarded as owning the underlying assets of the company for tax purposes.  This meant that upon disposal of shares there would be a disposal of the underlying assets potentially triggering depreciation recovery or tax on any “tainted” gains through association to dealers, developers etc.

Draft Legislation

With draft legislation now available it is clear that the Government is committed to implementing these changes and the outcome is largely as set out in the original Issues Paper albeit that the route chosen is simultaneously more complicated, but more friendly for taxpayers.

The headline of the draft legislation could well be “LAQCs are gone”.  From the 2011/2012 income year existing LAQCs will no longer have the ability to attribute their losses to shareholders which effectively represents the end of the LAQC regime.  Before readers with LAQCs that are going to produce tax losses post 2011 throw their hands up in despair let me introduce you to the new LTC structure.   Contact Us At GRA

The new LTC rules (LTC stands for “look through company”) are essentially the same as the proposed rules in the Issues Paper released in May.  In other words an LTC is a company that will be taxed as a limited partnership.  All profits and losses of an LTC will be attributed to shareholders in accordance with their shareholding interests.  If losses are produced the shareholders ability to claim those losses and offset them against other forms of income will be restricted if the losses exceed what is known as their “membership basis”.  Broadly speaking the membership basis is as noted above with the confirmation that shareholder loans are included in the calculation.  The sale of shares in an LTC will be treated as the sale of the underlying assets so that potentially issues like depreciation recovery will arise.  In saying that it is noted that there are thresholds and exceptions as to when there will be a tax cost. Contact Us At GRA

Transition Options & Relief for LAQCs

On a positive note the new rules contain extensive transitional rules that allow existing LAQCs to seamlessly transfer into the LTC regime or into an alternative limited partnership, general partnership or sole trader structure if desired without a tax cost.  This is an excellent outcome for taxpayers utilising LAQCs at present.

Perhaps the best way to sum this up, if you have an LAQC at present going into the 2011/2012 income year you have four options as follows:

• Do nothing which will see your company remain an LAQC but lose the ability for the losses to be attributed to the shareholders. 
• Transition into the LTC regime.  Under the draft legislation you will have six months to file an election with the IRD to convert your LAQC into an LTC which will then see it taxed as noted above.
• Take advantage of the transition provisions to restructure your LAQC into a limited partnership, partnership or sole tradership.  Any such transition will not come at a tax cost but there are restrictions as to when this is available.
• Revoke LAQC status and have the company revert to being an ordinary company. 

Comment

In my view, the new rules contain no greater issues for investors that currently operate LAQCs than were raised in the original Issues Paper.  It is fair to say that the introduction of the new LTC regime complicates matters in that investors will now have grapple with a new regime but it seems likely to me that most will choose to transition their LAQCs into the LTC regime.  Whilst an LTC has potential disadvantages in terms of the potential limitation of losses and the disposal of shares potentially triggering tax consequences these potential disadvantages may not be an issue for many investors.  In most cases the shareholders of an LTC will be guaranteeing the debt and therefore the shareholder’s membership basis will likely always be large enough to allow full ability to claim any losses produced.  The treatment of a disposal of shares as being the disposal of underlying assets is definitely an issue for those of you whom have properties that have been heavily depreciated and you should seek advice as to your options prior to 31 March 2011 if you are in a situation.

In closing, I see the LTC as effectively replacing LAQCs and see them as being widely used by investors.  Having said that, the transition process presents both opportunities and risks for investors and I urge you to get advice in relation to your existing LAQCs and the transition options prior to 31 March 2011. Contact Us At GRA

Matthew Gilligan
Director

Learn More about Matthew
Contact Matthew at mg@gra.co.nz
or call +64 9 522 7955

P.S. Did you like this article? Go ahead and sign up to our free newsletter and receive tips, updates and useful information to help you protect your assets and grow your net worth.  GRA are accountants who provide expert accountant advice both in NZ and offshore.

BOOM OR DOOM  ?

No doubt you have been reading in the newspapers and listening to the media various reports reviewing what is going on in the property markets; highlights of the reports are both positive and negative, and you hear various opinions around the marketplace about what  2010 is going to hold for us.

Positives

On the positive side:-

We have low floating interest rates, the five year rates have firmed up and are now declining, signalling that the cost of funds for the long term rates will fall. ( Don’t fix for 5 years at present, just float your interest rates….your blended cost of capital will be lower if you float at present than fix for 5.); and  
 

2. We have positive net inflows from immigration annualising out at the time of writing at around +19,000 as a net inflow annually, indicating more housing demand in the wings, and  
3. Rents are rising with a shortfall in housing supply with a backdrop of historic lows in building consents versus positive net immigration. IE Pent up demand for housing is getting worse/better depending on your perspective. From a landlords perspective, this is great news.   
4. Business confidence has rebounded, in the face of general public confidence being very low.  However, there is a historic link between business confidence rebounding before the public’s confidence returns, generally linked to employment and the employers in the marketplace signalling a return to buoyancy eventually flowing through to the rest of the public once they see employment statistics improving.  
5. The exchange rate appears to be falling. Great news for exporters, - bring on the now well overdue export led recovery. Though it is up and down like a yo-yo and the flip side of a low exchange is imported inflation on cost of goods imported, - petrol, financing costs, etc.

Negatives

On the negative side:- 

We have a global backdrop of many nations signalling insolvency.

 

There is the prospect of sovereign default, not only in Greece currently restructuring its debt. The main areas of concern are the so labelled PIIGS. (Portugal, Ireland, Iceland Greece and Spain). With many nations indebted up to their eyeballs, even some of the traditionally stable nations in Europe have question marks hanging over their head. Obviously the USA is in dire straights, but so is the UK. You may have noticed the British pound weakening with the Kiwi now at 46 pence to the dollar at time of writing, a clear signal that the British economy’s budget deficits are a huge problem.  The signal from the market by that slide is that even the Kiwi is ranking better than the UK currency, in relative terms.  With concern over a domino effect in Europe, with the last domino leading perhaps to the USA, or mayby the whole thing in reverse starting with the USA.

 

Tax changes are a bucket of ice over property markets. The unanticipated effect ( but totally foreseeable) is that SMEs rely on their housing portfolio to gain access to capital. I can’t believe that the government does not realise that when you threaten house prices, you threaten SME lines of credit and businesses lose access to capital. Clearly there are no accountants in public practice dealing with SMEs advising government, or if there are they are simply out of touch, because they missed this link. My co-director John Rowe was talking about this on TV3 news 2 months ago. Why is it so obvious to everyone in business but not the government ?  

 

In my mind, a question mark hangs over the stock market. In my view in a W, not a V. Assets were over valued in 2007 when the stock markets were supported by thriving markets with huge consumption and activity levels. In 2010, we have nearly recovered all of the losses of the market crash, but the markets are no longer thriving. I think the asset bubble has returned and we may see a crash again. This comment also applies to property assets, though not to the same degree. I am advising clients to sell their equities and return to cash for this reason. With little upside prospect, and plenty of downside, the risk/return analysis must surely point to holding cash and not shares in this environment ? Once inflation rears its head, hold physical assets ( property, select shares) but until we see governments inflating their way out of their indebted position, - we have a hard road to travel and I think cash will be king again before we know it.  

Tax Changes

 In the writer’s view, the tax changes in New Zealand signalled by John Key, while intended to promote investment in business, and ultimately generate a recovery, in fact have the opposite effect.  A bucket of ice thrown over the property market will lead to reduced consumption, reduced public confidence, and ultimately an erosion of the ability of small business in New Zealand to function.  The sooner the government come out and clarify the tax position that they are taking with property, and the softer they make such position, the sooner the markets will recover from the current icicles hanging off most For Sale signs around the country. 

 You might have heard that there was an increase of over 50% in listings between January and February year on year, an additional 5,000 properties listed over a base of 10,000 on realestate.co.nz between January and February alone. This statistic holds nationwide with listings across the board up around 47%. It seems Kiwis are panicking that the tax changes signalled may devalue property, and are running to their local real estate agent to sell in advance of the upcoming budget announcements. 

As mentioned in previous articles, the government have been responsible and ruled out many of the tax working group’s recommendations to give some clarity as to what they intend.  In short they have ruled out most of the recommendations made, but left the prospect of depreciation being denied on property investments and raised the question of ring fencing of losses.  While building depreciation being denied will definitely have an impact on property values and increase the number of mortgagee sales around the country with the impaired cash flow that this will create, the ring fencing of losses will be catastrophic.
 

In Sweden when the government ring fenced tax losses from property investment, the market fell some 35%.  Other experiences around the globe where governments make drastic intervention into property markets with changes to tax rules have been the same, with drastic reductions of property values when the government makes such changes.  While the government ruled out the risk free rate of return method for taxing equity in property and denying tax losses, they have left the door open to ring fencing of losses as a stand-alone policy.  In the writer’s view, they will not do it (ring fence losses) because they will quickly find out that the Sweden experience will become a New Zealand experience with massive devaluation of property assets.  Westpac also predicted this in their analysis on the same.  Westpac talked of a reduction of house prices of up to 34% if the risk free rate of return method of taxing property was brought in.  For this reason I do not believe the government will bring in ring fencing, because they are fundamentally pro-business and while it might be observed they are anti-property based on their current tax tendencies, the government will know that devaluing house prices in any significant manner will have the opposite effect to that what they want.  Such a move would destabilise banking and kill consumption (with nobody consuming in an environment with massive asset devaluation) and generally small to medium sized businesses which rely on their houses for working capital and financing will become destabilised by such measures.

Doom & Gloom or Opportunity for The Shrewd ?

In my opinion, 2010 will not be a good year for property, and neither equities.  We will see devaluation of financial assets in New Zealand and tax changes signalled by this government will have a big part to play in that.  But the backdrop of the global environment will make this worse.

The counter point is that what comes down ultimately goes up again in financial markets, and astute buyers looking for bargains in such a down market may well be rewarded in the medium term if they swim against the tide and look for the bargains in mortgagee sales or in the stock market. 2009 was a dramatic recovery, demonstrating this point. 

While property assets may be devalued by the cashflow taken away with tax changes, the cycle ultimately restarts at the new values established no matter how low property values may go (depending on what the government does), and accordingly, even if assets are devalued, they will grow again from a new, lower base.  In this regard, it is the writer’s view that if we see devaluation of assets, look at it an opportunity and get out and see if you can pick up a bargain. 

One thing is for sure -  we must see more mortgagee sales from changes to the depreciation regime, and such disposal of assets always results in great buying opportunities.

Anybody wondering what the impact of the changes to depreciation might do to their investment portfolio are welcome to email the writer for help at mg@gra.co.nz. 

We further note that we will keep a close eye on the government’s changes and report to you as things unfold, and we will most certainly have our eye firmly on this budget and be quick to give you a report when we know what is happening.

Talk soon.

Matthew Gilligan
Director

Learn More about Matthew
Contact Matthew at mg@gra.co.nz
or call +64 9 522 7955

P.S. Did you like this article? Go ahead and sign up to our free newsletter and receive tips, updates and useful information to help you protect your assets and grow your net worth.  GRA are accountants who provide expert accountant advice both in NZ and offshore.