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

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First of all with the OCR announcement this week, what about interest rates ? What will the banks do and what should be thinking about at present? You will remember in my last blog post I sent to you on interest rates just over a month ago, I suggested that you consider the cost benefit of breaking your fixed interest contracts and locking up on the 5 year rates, which at the time were a tad inside 6.5% for 5 years ( on average).

I suggested to you that the money market for long term borrowing was showing a steep rise in cost for the banks, indicating the 5 year rates would rise, while the short term rates were staying low.

And they have. The long term rates went up 1% on average the week after I emailed you. Thankfully a heap of you fixed long at 6.5% and some have emailed me telling me some of their savings they get from doing it.  I was thrilled to hear one person saved $86,000 over 5 years.

1. This was clearly ahead of expectation, because the the exchange rate fell 1.5c on the Aussie Kiwi cross rate, to around A$.7750 from early $A.792
2. He has very clearly indicated the rate will stay down, until late 2010 ( to encourage recovery) and suggested the immediate need to fix long and pay a premium over floating rates is unnecessary.
3. He has indicated may drop the rate further.

The Money Markets

Two things are happening to the cost of funds for the banks. Firstly the local cost of money, reflected in the OCR is falling.
Secondly (and less focused on by the media), the offshore LIBOR rates measuring interbank lending costs are falling, indicating banks are trusting each other more and placing less of a risk premium on the rates they charge to lend to each other.

This means NZ banks are paying less for the money they borrow offshore and less for the money they borrow locally, - all good news for borrowers as rates must drop in this environment.

So great news for property investors, businesses and households who are borrowers, terrible news for deposit holders whom rely on their fixed interest  savings for their income.


Rates – Short v Long Term

As you will be aware, the money borrowed from the overnight and short term money markets is cheaper than the long term bonds being issued by the banks, whom are all chasing the 5 year investors for their cash deposits.

The deposit holders know that rates are likely to rise over the medium to long term (the 10 year average interest rate in NZ is closer to 8%) and investors are reluctant to lend to banks at the current ‘super’ low rates, when they can lend to corporates like Fonterra at closer to 8%, and wait for the banks to pay more.

So one trend that is emerging is the corporates are cutting out the banks and going direct to the public (raising capital), competing for the long term investors money.

Another trend is the avalanche of investors locking up long over the last month,  causing pressure on the cost of these funds over 5 years, and rates are popping up as a result.

So where are rates going in at present ?

Short Term Rates ( Floating, 1-2 year rates)

The sort term money supply is forecast to remain cheap for 2009 and into 2010, all things being equal. We should see much of the above mentioned drop in the OCR passed through by the banks, and I would expect the floating and 1-2 year rates to fall over the next 90 days in line with OCR and LIBOR dropping.

Long Term Rates

The long term rates are still showing a premium supporting a rate in the early 7% range, with a recent easing in long term swap rates (falling nearly 15 basis points in the last 10 days). This indicates 5 year rates could fall off the 7.5% high at present, and in my view we could see a quarter to a half of a percent fall in 5 year rates in the next 2 months or so to the early 7’s. Thus there is no hurry to fix long term this month, as the 5 year rates are not likely to rise, and more likely to fall slightly.

So this months advice from me is WAIT and do not lock up long, because we are in a different place to where we were a month ago where the five year rates were obviously cheap and likely to rise.

Breaking Fixed Interest Contract

Many investors are still asking should they break their fixed interest contracts and re-fix or float. This is a tricky question, look at the cost benefit between the cost of breaking and the benefit derived from the cheaper rate over the period you re-fix or float for.

To help our clients, I have created a Fixed Interest Break Cost Analysis tool, a ‘rough and ready’ spreadsheet that helps you make a decision and estimate cost benefit.

Go ahead and visit our free resources section to download some useful tools from our wonderful new website, designed for business owners and investors.

And if you would like a hand working out what to do, we have a debt consultant that you can get to for free by Requesting an interview. Just explain that you wish to talk to one of our debt consultants.

Have a good month!