Mixed-use asset remedials
Issue: Support for remedial amendments
Clauses 47 to 49
Submission
(New Zealand Institute of Chartered Accountants)
New Zealand Institute of Chartered Accountants supports the proposed remedial amendments contained in clauses 47 to 49 of the bill.
Comment
Officials note the support for the amendments which ensure the mixed-use asset rules operate in accordance with the policy intention and correct minor errors in legislative examples.
Recommendation
That the submission be noted.
Issue: Minor technical issues with remedial amendments
Submission
(New Zealand Institute of Chartered Accountants)
The drafting of the amendment to section DG 6 should be amended to make it clear that paragraph (b) is a continuation of the section.
Comment
The drafting convention is to leave the section as originally drafted – including paragraphs (a) and (b) – so the history of the provision is clear; accordingly the section in the principal Act will read:
“Despite section YB 3(1), for the purposes of this subpart, a company and a person other than a company are associated persons if—
(a) repealed; or
(b) the person’s share in the company gives them a right to use the asset.”
Recommendation
That the submission be declined.
Submission
(Ernst & Young)
Repealing and replacing section DZ 21(2) arguably repeals the example, it should be clarified that the example remains.
Comment
An example in the legislation is not part of the legislation, it is an interpretation aid. Therefore, replacing a subsection does not repeal the following example as it is a stand-alone item and not “attached” to the particular subsection.
Recommendation
That the submission be declined.
Issue: Further mixed-use asset amendments
Submission
(New Zealand Institute of Chartered Accountants)
The legislation was rushed and is in need of further remedial attention.
Comment
Officials note NZICA’s concern and will continue to work with NZICA (and other stakeholders) to address remedial issues with the rules.
Recommendation
That the submission be noted.
Issue: In certain circumstances, the asset value is too high for land
Submission
(New Zealand Institute of Chartered Accountants)
Leased assets
Where a mixed-use asset is leased, the valuation of that mixed-use asset should reflect the degree of ownership interest in the asset.
Where a close company seeks to claim interest deductions in respect of a mixed-use asset, the company must first determine the amount of its debt value and its asset value to determine the amount of interest it is allowed to claim.
The “asset value” for land, including an improvement to land, is the amount given by the later of either its most recent capital value or annual value (as set by the relevant local authority), or its cost on acquisition (or market value, if the transaction involves an associated person).
If a crib/batch is on leased land, the capital value greatly overstates the value to the lessee as the lessee does not own the land. Therefore, there is a greater likelihood that the asset value will result in either:
- a denial of an interest deduction to the company; and
- a denial of an interest deduction to a shareholder.
The quarantining provisions in section DG 16(1), which apply to all taxpayers, also require amendment for valuation purposes when an asset is a leased asset.
Two new rules are required for leased assets:
1. a rule that applies if there is a lease between associated persons and prevents “gaming” of the rules in such situations; and
2. a valuation rule for leased assets where the parties are not associated.
Two activities on a single title
The legislation also requires amendment to provide for apportionment when a single legal property title covers two separate activities and the mixed-use asset rules applies to only one of those activities.
The situation envisaged is when a taxpayer owns a beach house which is on a piece of land with two houses. The capital value on the legal title will give the value for both houses and the whole of the land area. Where the mixed-use activity is being carried on by only one of the owners, it would be very difficult for that owner to reach the quarantining threshold because of the presence of the two houses.
This is similar to a situation where a farmer sets up a house on the farm as a farmstay. The house is on the farm land, and is used to derive rental income, but is also used by the farmer’s children and their friends when they come home. If the land value cannot be apportioned, then the farmer would never be able to claim any expenditure associated with the farmstay, as the income would never reach 2 percent of the value of the total farm.
Comment
Officials agree, that in certain circumstances, using the capital value or annual value (as set by the relevant local authority) could overstate the assets’ value for the purposes of subpart DG. In the lease example raised by the submitter, it is arguable that a leasehold estate is an asset separate from the freehold estate and therefore does not have a capital/annual value itself – which means that the relevant “asset value” is the price paid for the leasehold estate or the market value (if acquired from an associate).
However, officials agree it is appropriate to clarify/amend the “asset value” concept for land (or an interest in land) where the mixed-use asset itself is only a part of the underlying freehold estate valued by the capital/annual value, and this results in an inappropriately high “asset value” for the purposes of the close company interest apportionment rule in section DG 11, and the loss quarantining rule in section DG 16.
The capital/annual value may give too high an asset value because:
- the mixed-use asset is a leasehold (rather than freehold) estate; or
- a property has a single legal title but different activities are carried on within that single title, only one of which involves mixed use – for example, a farmstay on a large commercial farm or two baches on a single title, only one of which meets the mixed-use asset criteria.
When these situations arise, the legislation should provide an option to use as the “asset value” a reasonable apportionment of the capital/annual value of the freehold property to the mixed-use asset based on:
- in the case of a leased asset, the market value of the leasehold estate (a valuation that is less than three years old, and has been completed by a registered valuer, will be accepted as the market value); and/or
- in the case of two activities/assets on a single title:
– the percentage of the land area used for the mixed-use activity (for example, the proportionate area the dwelling and curtilage bear to the total land area); or
– some other reasonable apportionment determined under a valuation by a registered valuer (such valuation must be less than three years old).
Recommendation
That the submission be accepted, subject to officials’ comments.
Issue: Quarantined losses and depreciation recovery income
Submission
(New Zealand Institute of Chartered Accountants)
When a mixed-use asset has quarantined expenditure, the taxpayer should be able to offset any depreciation recovery income against the quarantined losses if the asset is sold.
There seems to be no policy reason why a taxpayer should not be able to offset any depreciation recovery income against quarantined losses but officials seem to consider that depreciation recovery income cannot be offset against quarantined losses.
This gives rise to various issues. The first is that section DG 17(1)(b) states that section DG 17 applies when (inter alia) the person’s income for the current year from the use of the asset is more than the amount of their deductions under sections DG 7, DG8 and DG 11.
We understand that some officials considered that depreciation recovery income would not arise “from the use of the asset” (that is, it results from the disposal of the asset rather than the “use” of the asset) which is defined in section DG 3(7) as “use of the asset for its intended purpose”.
The second issue is that section EE 49(3) (which provides the calculation when there is depreciation recovery income and there has been mixed-use of an asset) has a numerator based on the “deductions” which are deductions for which the person is allowed a deduction under Part D (see section BD 2). In the case of quarantined deductions, a person is not allowed a deduction; therefore the numerator would be zero. Accordingly the amount of the depreciation recovery income would be nil or a low amount. This is the correct outcome in our view as it would seem egregious that taxpayers are expected to pay depreciation recovery income when they have not been able to claim depreciation deductions.
The third issue is that, in some instances, there will be situations when a mixed-use asset was used before the advent of the mixed-use asset rules. Accordingly, the formula in section EE 49(3) will have an amount in the numerator as there were deductions permitted in the years before the mixed-use asset rules. We consider that the taxpayer should be able to use the quarantined losses as they have been paying tax on income derived over the period when the mixed-use asset rules were in place, but were denied any deductions under subpart DG. The very least those taxpayers should expect is to be able to use the quarantined losses against depreciation recovery income when they have been denied a depreciation deduction while the mixed-use asset rules have been in place.
Comment
A number of points are covered in this submission:
(a) Taxpayers should be able to access quarantined losses to reduce depreciation recovery income derived from the sale of a mixed-use asset and, under one interpretation of the current rules, they are unable to do so. It is not the role of policy officials to give the Commissioner’s interpretation of current law. However, from a policy perspective, depreciation recovery income is a mechanism to reverse depreciation deductions claimed over the life of an asset, where that asset has not depreciated to the extent anticipated by the depreciation rate (in some cases, it will have actually appreciated in value). If the depreciation deductions in respect of the mixed-use asset have been quarantined (thus not been accessible to the taxpayer) and then depreciation recovery income arises upon the sale of the asset, officials agree taxpayers should be able to access those quarantined deductions to offset against the depreciation recovery income. The depreciation recovery income otherwise imposes an additional tax liability on the taxpayer who has not had the benefit of the deductions the recovery income intends to reverse. In summary, officials agree in principle with the submission.
(b) If taxpayers have not had the benefit of depreciation deductions because the mixed-use asset rules quarantine the deductions, when applying the depreciation recovery formula in section EE 49, the numerator should be 0 and therefore no depreciation recovery income arises. Again, policy officials do not give the Commissioner’s interpretation of the legislation. However, for the same reason identified above, from a policy perspective, officials accept that the outcome identified by the submitter is the correct policy outcome.
(c) If a taxpayer holds a mixed-use asset and they held the asset before the introduction of the mixed-use asset rules, they should be able to use losses quarantined under the mixed-use asset rules to offset depreciation recovery income arising from the sale of the asset after the rules were introduced. Officials consider that, when the benefit of depreciation deductions have previously been obtained by a taxpayer (because the deductions were claimed before the enactment of the mixed-use asset rules), it is appropriate that depreciation recovery income gives rise to a tax liability (in the absence of other deductions/losses available to the taxpayer). This is because the depreciation recovery income reverses a previous tax benefit obtained by the taxpayer. Therefore, officials disagree with this submission, to the extent the taxpayer has had the benefit of depreciation deductions before the mixed-use asset rules were enacted.
In summary, officials accept in principle the submitter’s points in (a) and (b) above, but disagree with the submission in (c). Given the rules in this area are complex and affect a number of taxpayers, officials believe it is appropriate to decline the submission in the context of this bill, but to consider the submissions further, engage with the submitter and design a robust solution that can be included in a future tax bill that will be subject to full consultation.
Recommendation
That the submission be declined.
Issue: Taxation of exempt income when distributed to shareholders
Submission
(New Zealand Institute of Chartered Accountants)
When a company distributes retained earnings that have arisen from exempt income under the mixed-use asset rules, these should retain their character as exempt income rather than being taxed as unimputed dividends.
Comment
Officials appreciate the concern raised by the submitter; however this is a policy issue that requires significant consideration. Some tax preferences (such as other tax exemptions) are clawed back when profits are distributed to shareholders. On the other hand, officials can see an argument that the tax exemption should flow through to the shareholder, otherwise the intended symmetry between denial of deductions and exemption of income is arguably not achieved.
Officials therefore note the submission, but recommend that it be declined for inclusion in this bill on the basis that the rules in this area are complex and affect a number of taxpayers, so it is appropriate to engage with the submitter and design a robust solution that can be included in a future tax bill that will be subject to full consultation.
Recommendation
That the submission be declined.
Issue: Clarification of application to shareholders who lease assets to subsidiaries
Submission
(New Zealand Institute of Chartered Accountants)
Clarification is needed as to how the mixed-use asset rules apply when a parent company has, say, leased an asset on a full-time basis to a subsidiary that uses the asset in a way that qualifies it for the application of the mixed-use asset rules.
Comment
Officials note the submission and will engage with the submitter to clarify the issue identified. This may involve including a measure in a future tax bill that will be subject to full consultation.
Recommendation
That the submission be declined.
Issue: Amendment to deal with capital use of a mixed-use asset
Submission
(Deloitte, New Zealand Institute of Chartered Accountants)
An amendment to the apportionment formula is needed when there is capital use of an asset, as well as income-earning use and private use.
The issue is explained by the following example:
A privately owned corporate group owns a plane that has the following use (per year):
- private use (for example, the owner of the group flying overseas on holiday) – 20 days;
- income-earning use (for example, the owner/management flying overseas for business purposes where there is a direct nexus with income) – 20 days; and
- capital use (for example, the owner/management flying overseas to analyse potential capital acquisitions) – 20 days.
The plane is therefore used 1/3 for private use, 1/3 for income-earning use and 1/3 for capital use. The plane is unused for the remainder of the year.
The following expenditure is incurred in relation to the plane:
- $100 solely relating to private use (for example, fuel and pilot costs directly attributable to private use);
- $100 solely relating to income-earning use (for example, fuel and pilot costs directly attributable to income-earning use);
- $100 solely relating to capital use (for example, fuel and pilot costs directly attributable to capital use); and
- $100 “mixed use” expenditure that does not solely relate to any specific use (for example, annual insurance premium for the plane).
Under the general rules (that is, before applying the mixed-use asset rules), the approach would be to apportion the expenditure based on actual use. A deduction would be taken for $100 for the expenditure solely relating to the income-earning use (as per section DA 1). No deduction would be taken for the $200 solely relating to private and capital use (as per the private and capital limitations in section DA 2), and a $33 deduction would be taken for the portion of the mixed-use expenditure that is deemed to relate to the income-earning use (that is, 1/3 x $100 = $33) (as per section DA 1).
In addition, the following tax treatment results from the application of the mixed-use asset rules. In relation to the non-mixed-use expenditure, the $100 solely relating to the income-earning use should be fully deductible (as per section DG 7) and the $200 that solely relates to private and capital use should be non-deductible (as per the private and capital limitations in section DA 2).
$33 of the mixed-use expenditure that is considered to relate to income-earning use should be deductible under the rules. For this to be the case under the mixed-use asset rules, the full $100 of mixed-use expenditure needs to be included in the item “expenditure” in the apportionment formula in section DG 9 as the capital-use days are not income-earning days. This would effectively require there to be no apportionment under the capital limitation and the private limitation before the application of the apportionment formula:
expenditure x income-earning days / (income-earning days + counted days)
i.e. $100 x 20/60 = $33.
However, the item “expenditure” in the apportionment formula only includes expenditure in relation to the asset that is “deductible in the absence of this subpart” and the capital limitation and the private limitation could therefore be considered to apply before the apportionment under section DG 9. Clearly, however, the mixed-use expenditure that relates to private use must be included in “expenditure” in the apportionment formula otherwise the apportionment formula would be redundant.
If section DG 9 is read as requiring expenditure that might otherwise be apportioned as capital expenditure to be excluded from “expenditure” in the apportionment formula, expenditure relating to the capital use of the asset would be subject to two levels of apportionment (that is, denied once by the capital limitation and then again by the mixed-use asset rules). As capital-use days are treated as “counted days” in the apportionment formula, excluding capital expenditure from “expenditure” would limit the deduction for the capital mixed-use expenditure twice:
expenditure x income-earning days / (income-earning days + counted days)
i.e. $67 x 20/60 = $22.
This problem could potentially be corrected by:
(1) extending the words “and that would be deductible in the absence of this subpart” in subsection DG 9(3)(a) and including the words “prior to any apportionment of expenditure due to capital or private use of the asset”; or
(2) excluding “capital use days” from “counted days” in the apportionment formula and addressing the private limitation with something similar to (1).
This would result in the following outcome:
expenditure x income-earning days / (income-earning days +
counted days – capital use days)
i.e. $67 x 20/(20+40-20) = $33.
“Capital-use days” could be defined as “the total number of days in the income year on which the asset is in use and the use is of a capital nature”. This outcome would then appropriately focus the formula on apportioning otherwise deductible expenditure between private and income-earning use.
The submitter suggests that option 1 would be simpler as it essentially just clarifies that the apportionment formula does all the apportionment for capital and private use. Option 2 would further complicate the apportionment formula.
Comment
Officials agree with the submission and agree in principle that option 1 is a sensible approach to address the issue. Officials recommend however that the appropriate solution is to delete the words: “… and that would be deductible in the absence of this subpart” from section DG 9(3)(a). This is because section DG 8(3)(a) states section DG 8 overrides the capital limitation and the private limitation, and section DG 9 is the formula that determines the amount deductible under section DG 8(1), so the capital and private limitation are already overridden. Accordingly, if the words: “… and that would be deductible in the absence of this subpart” are removed from the definition of expenditure in section DG 9(3)(a), the expenditure that is apportioned under that formula will be all expenditure (including capital and private expenditure).
Recommendation
That the submission be accepted.
Issue: Different definition of “asset income” for quarantining rules
Submission
(Matter raised by officials)
The definition of “asset income” in section DG 17 should be aligned with the definition of the same term in section DG 16.
Comment
If a taxpayer generates assessable income from a mixed-use asset in an income year of less than 2 percent of the asset’s value, some of the deductions generated by the asset are quarantined until a future income year. The low relative level of income generated by the use of the asset suggests that the asset is likely to be a predominantly private asset and therefore it is appropriate to suspend tax deductions that could otherwise be used to offset the taxpayer’s income from other sources.
If the income does not reach the 2 percent threshold, any deductions above the assessable income from the asset (the “asset income”) derived in that income year are quarantined, to be accessed in future income years. The effect is that, in a year when a taxpayer derives a low level of assessable income from the asset, the taxpayer is allowed deductions sufficient to offset that assessable income (so no tax is payable in respect of the income from the asset), but is not able to generate a net loss on that asset.
In a future income year, the taxpayer is able to access quarantined deductions if they have income from the use of the asset that exceeds their current year deductions. The amount of quarantined expenditure that can be accessed by the taxpayer is the lesser of the quarantined expenditure and the excess of current year income from the asset (the “asset income”) above current year allowable deductions.
Officials have identified a problem with the definition of “asset income” in the provision that allows taxpayers to access quarantined expenditure (section DG 17).
In the primary quarantining provision (section DG 16), the “asset income” is the total amount of income, other than an amount of exempt income, derived for the income year from the use of the asset. This is the correct approach as taxpayers should not be able to access excess deductions because they have earned exempt income.
In contrast, in section DG 17, which is the section that allows taxpayers to access previously quarantined amounts, the definition of “asset income” is the total amount of income derived for the current year from the use of the asset. There is no exclusion for exempt income. This means that taxpayers can access excess quarantined deductions on the basis of exempt income they derive in relation to the asset (for example, income from associates, which is easily manipulated). Given the income is exempt, accessing quarantined deductions in this way will also give rise to a net loss on the asset for that income year which is contrary to the policy intention of the provision.
Accordingly, officials recommend that the definition of “asset income” in section DG 17 should be aligned with the definition of the same term in section DG 16.
Recommendation
That the submission be accepted.