Chapter 2 - Framework for considering company taxation

Introduction

2.1 In reviewing the various aspects of the LTC rules we have considered how they fit within the desired policy framework for entity taxation. Accordingly, before discussing our suggested changes, we outline the policy framework below.

Policy framework for considering company taxation

2.2 A business can be run in a variety of different ways – as a sole trader, a partnership, a trust, or a company. Likewise, the tax treatment can vary in practice depending on the entity used to conduct the business.

2.3 The tax system contains a number of flow-through entities including LTCs, ordinary partnerships and limited partnerships, as well as quasi flow-through entities, such as trusts, grand-parented QCs and portfolio investment entities (PIEs). The entities sometimes parallel commercial law and in other cases have been introduced into the tax law to achieve particular policy purposes. A comparison of the various entity treatments is provided in Table 1.

2.4 Having a variety of treatments can create economic distortions. Accordingly, it is desirable to minimise the areas of difference.[5] However, having a single tax treatment for all business entities is impractical.[6] Therefore, we see a minimum of at least two types of tax treatment: the individual and the standard company tax approaches.

Individual taxation approach

2.5 Under this approach, all the net income is attributed to the underlying individuals and is taxed at their marginal tax rates. If certain forms of income derived by the business are free of tax, the individuals receive the income tax-free. If losses are generated within the business, the losses can be used to reduce tax on the other income of the individuals, or can be carried forward by them. When the individual sells all or part of their interest in the business, it can trigger tax consequences such as claw-back of depreciation.

  Direct ownership General partnership Limited partnership LTC LAQC (no longer available)[7] QC Trust Company
Table 1: Comparison of entity tax treatments
Ownership rules N/A No restrictions No upper limit on number of partners but must have at least one general partner, and one limited partner Five or fewer look-through owners (under review) Was five or fewer shareholders including associates No new QCs allowed
Existing QCs must have five or fewer shareholders including associates
No restrictions on settlors or beneficiaries No restrictions
Different ownership rules / class of shares N/A Partnership agreement could provide for different rights for different partners Partnership agreement could provide for different rights for different partners Only one class of share allowed Multiple classes of shares allowed Multiple classes of shares allowed Trust agreement could provide for different rights for different beneficiaries Multiple classes of shares allowed
Owner’s liability Unlimited Unlimited Limited Limited Limited Limited Limited for beneficiaries, unlimited for trustees Limited
Tax rate Owner’s tax rate Partners’ tax rates Partners’ tax rates Shareholders’ tax rates Company tax rate on accrual, adjusted to shareholders’ tax rates on distribution Company tax rate on accrual, adjusted to shareholders’ tax rates on distribution Trustee income taxed at equivalent to top personal rate, beneficiary income taxed at beneficiaries’ tax rates Company tax rate on accrual, adjusted to shareholders’ tax rates on distribution
Losses Available to owner Available to partners Available to partners subject to loss limitation rules Available to shareholders subject to loss limitation rules (under review) Available to shareholders Quarantined to company Quarantined to trust Quarantined to company
Capital gains Never taxed Never taxed Never taxed Never taxed Never taxed Never taxed Never taxed Not taxed on accrual, may be taxed on distribution
Ownership changes / restructures Owner taxed on revenue account gains / losses and depreciation adjustments Partners taxed on share of revenue account gains / losses and depreciation adjustments subject to de minimis rules Partners taxed on share of revenue account gains / losses and depreciation adjustments subject to de minimis rules Shareholders taxed on share of revenue account gains / losses and depreciation adjustments subject to de minimis rules Not taxed (unless shareholder holds shares on revenue account) Not taxed (unless shareholder holds shares on revenue account) Not taxed (beneficiaries’ rights could be changed by varying trust agreement) Not taxed (unless shares are held on revenue account)
Shareholder continuity requirements apply – if breached, losses and imputation credits are forfeited

2.6 This approach applies not only to individuals but also to partnerships[8] and LTCs as they are closely controlled by individuals. In their case, the income earned and the expenditure incurred by the company are allocated to the partners and shareholders on the basis of their respective ownership. The LTC rules allow the business to still have the commercial benefits of a company, such as limited liability and the ability to contract in its own right. Conceptually, this type of integration is ideal for closely held companies as it meets one of the goals of closely held company taxation, which is to reduce the tax impediments and/or unintended benefits of migration from an unincorporated business to a business carried on in a company. That is, the tax consequences should be similar regardless of the form in which the business is run. However, a number of practical constraints limit its desirability as a tax vehicle for all small to medium sized companies.

Standard company taxation approach

2.7 The second main approach is company taxation. The company is taxed on the income it earns. When company profits are distributed as dividends to shareholders, imputation credits can be attached as a credit for the tax paid at the company level, to ensure that there is no double taxation.

2.8 Under this approach, if a company earns lightly taxed or tax-free income, this tax preference is clawed back when dividends are paid because there are no corresponding imputation credits. Two key examples of preferences that are clawed back are controlled foreign company (CFC) dividends which are exempt at the company level, and capital gains made by the company. Under standard company tax treatment, capital gains can only be distributed tax-free to shareholders on the liquidation of the company. This aspect is discussed in more detail later in this chapter.

2.9 Also under standard company taxation, losses of a company must be carried forward to be offset against future company income and cannot be used by the shareholders to offset against their other income. When a shareholder sells their shares in the business or new owners are introduced, in many cases it does not trigger tax consequences.

2.10 Examples comparing the individual and company approaches are provided below in Table 2.

  Individual treatment Standard company treatment (simplified to ignore RWT)
Table 2: Examples comparing individual and company treatment
Taxable income An individual earns $100 of taxable income. This is taxed at their marginal tax rate (33% in this case), which means that the tax is $33. The individual is the sole shareholder in company A. Company A earns $100. This is taxed at the company tax rate of 28%, making the tax $28.
The company distributes the balance of $72 as a dividend, with $28 in imputation credits attached, making a gross dividend of $100.
The shareholder includes the $100 dividend in their taxable income and a further $5 of tax is payable after allowing for the $28 imputation credits.
Overall, there is no double taxation and the tax is based on the individual’s tax rate.
Note that if the shareholder is on a marginal tax rate of 17.5%, the tax liability on the $100 dividend is $17.50, so that the balance of the imputation credits ($28 - $17.50) can be used towards meeting the tax on other income.
Capital gain An individual earns $100 in capital gains (say on the sale of land). This does not form part of the individual’s income and no tax is payable. If a company earns a capital gain of $100, there is no company tax.
If it distributes the $100 as a dividend there would be no imputation credits to attach.
The individual shareholder includes the $100 dividend in their taxable income and has $33 tax to pay.
This means that under the company treatment, capital gains made at the company level are clawed back on distribution to shareholders (except where the company liquidates).
Losses An individual makes a tax loss of $100 on an income earning asset (say a rental property). This loss can be offset against the individual’s other income, or carried forward to offset against future income. A company makes a tax loss of $100.
This loss can be offset against the company’s other income (if any) or can be carried forward to offset against future company income.
The loss cannot be distributed to shareholders, but it can be offset to other group companies.

Mixture of the two approaches

2.11 As Table 1 illustrates, for some types of entity the income tax treatment is a mixture of the above two approaches. For example, under the QC rules profits are taxed at the standard company tax rate with any subsequent distribution of those profits being taxable at the respective shareholders’ tax rates (with imputation credits attached), but with capital gains and any other untaxed amounts being able to be passed through to shareholders tax-free. Previously, LAQC losses could also be passed through to shareholders to offset against any other income they earned.

2.12 When the company and top personal tax rates were aligned, this mixed approach was generally appropriate. However, once the top personal rate became higher than the company rate there was concern that the QC/LAQC regime went beyond the objective of removing the tax disadvantage from incorporation,[9] and in fact provided a tax advantage.[10]

2.13 The treatment of trusts is also a hybrid, with the income earned being either taxed as trustee income at equivalent to the top personal rate or, if distributed, taxed at the personal tax rates of the beneficiaries. Losses are quarantined within the trust, to be used against future trustee income.

Boundary between the approaches

2.14 Having two different tax treatments will always create some distortions. It raises the question about where the line should best be drawn between them. There is no perfect solution to this question so a degree of pragmatism is required, while trying to minimise likely distortions. Since LTCs (and QCs) sit on this boundary (a LTC being legally a company but with individual flow-through tax treatment) it is important to know the target audience for the LTC rules as this influences the criteria that are applied to LTCs.

2.15 Individual treatment should be applied to company situations when the investment could have genuinely been owned directly by the individual or family trust shareholder(s) but they wish to have the protection of limited liability. This prevents tax being a distorting factor in what would otherwise be a commercial decision to incorporate.

2.16 Allowing the pass-through of losses also raises the possibility of loss trading.[11] As a matter of policy the eligibility criteria are an important way of reducing the possibility of such trading. Focusing on the number of shareholders seems a useful method of reducing this risk. It is also consistent with the approach that LTCs are only intended for investors who have a realistic option of operating as individuals or through a company.

2.17 A subsequent question is whether this individual treatment approach should apply to companies operating cross-border. In terms of outbound investment, there is a policy case for applying corporate treatment to most, if not all, overseas businesses owned either directly (branches) or indirectly (CFCs) by New Zealand companies, in order to better align the treatment of cross-border investments in different forms. This raises the issue of whether it is consistent to allow outbound investment to receive look-through tax treatment. On the other hand, there is the general point that LTC taxation is intended to be similar to the taxation of direct investment by shareholders.[12]

2.18 There is also the general issue with conduit investment and, consequently, the related risks to the tax base and base erosion and profit shifting (BEPS) concerns. These international aspects are discussed in Chapter 4.

Target audience for the LTC rules

2.19 What does this boundary imply for the target audience for the LTC rules? Our conclusion is that the LTC target audience is any investment that can be done by an individual or small group of individuals. This means the focus is on tight control of the entity by individuals rather than on the size of the entity, even though in practice small unsophisticated businesses are likely to make up the majority of LTCs. As Chart 1 illustrates later in Chapter 5, the majority of LTCs fall into the -$20,000 to +$10,000 annual income range and 90 percent are within the -$50,000 to +$50,000 annual income range.

Treatment of capital gains

2.20 We have concentrated our review primarily on streamlining the rules for LTCs. However, a number of issues with the current wider policy settings have been raised by stakeholders, including the extent to which closely held companies should be able to distribute capital gains tax-free.

2.21 There is a case for allowing capital gains to flow through tax-free in certain circumstances when there is a genuine parallel to direct ownership. This is because those gains would be tax-free if earned directly (or through a partnership) by the owner. Similar considerations were behind the Valabh Committee recommending the QC regime in the early 1990s.[13] Like QCs, the LTC regime provides a vehicle for capital gains to be distributed tax-free throughout the life of a company, not just on liquidation.

2.22 Issues such as whether to allow closely held companies outside of LTCs and existing QCs to distribute capital gains tax-free during the course of business are complex and cannot be considered in isolation. It would be premature to contemplate changes in these areas without significant further work, which could be handled through the standard tax policy work programme process at a future date.

2.23 To illustrate their complexity, we note that the issue of the tax status of capital gain distributions is intricately tied up with the tax treatment of dividends. Dividends can be classified as distributions from revenue reserves and distributions from capital sources. If only certain types of dividend were exempt, such as those paid out of capital profits, there would be pressure to convert company income into the preferred form. Refraining from permitting the pass-through of tax preferences therefore helps to ensure the robustness of the company tax base.[14] Similar considerations apply to limit a company’s ability to return capital to ensure that what is in effect a dividend from retained earnings is not “dressed up” as a return of capital.

2.24 The tax treatment of capital gains on liquidation provides a further complication. In practice, businesses can distribute capital gains tax-free through forming multiple companies to hold specific assets and liquidating those companies as the capital gains on the assets are realised. In doing so, however, they incur additional compliance costs. We acknowledge the compliance cost concerns but arguably the ability to get out capital gains tax-free on liquidation is a distortion, at least for those companies for whom company tax-treatment is appropriate.

 

[5] In designing the appropriate tax treatment for entities, and in particular closely held companies, some key issues are:

  • when to allow tax preferences generated by an entity to flow through to the owners of the entity;
  • if tax preferences are allowed to flow through, should there be restrictions on the ability to earn offshore income because when an ordinary company earns tax preferred offshore income this preference is clawed back on distribution; and
  • how to treat losses, and to ensure that only true economic losses are deductible.

[6] One tax treatment for all entities would require a fully integrated company tax system whereby company profits are attributed to shareholders and taxed directly in their hands in a similar way to the profits of a partnership being taxed in the hands of the partners. Full integration was rejected as an option in the mid-1980s and we would not recommend revisiting this issue.

[7] Loss attributing qualifying companies (LAQCs) were a form of QC that enabled losses to flow through to shareholders. Most QCs (around 95 percent) were LAQCs. As Table 9 in Appendix 1 shows, around half of LAQCs have retained their QC status, around a third have become LTCs while the rest are either carrying on business in another form (for example, as an ordinary company) or have ceased business.

[8] For tax purposes a partnership includes not only relationships covered by the Partnership Act 1908 but also certain joint ventures and the co-ownership of property.

[9] This was compared with the treatment as a sole trader or partnership.

[10] The non-alignment of the company tax rate and top personal rate provided a potential incentive to defer distributing a QC’s taxable income to shareholders on personal rates above the company rate, whereas losses could be automatically passed through to those shareholders to be offset against their other income.

[11] Loss trading occurs when an arrangement is made whereby taxpayer(s) who do not hold an economic interest in an entity, such as a LTC, that has made a tax loss are able to deduct the loss against their other income. The arrangement is invariably tax driven rather than related to any wider commercial return. The government loses revenue as a result of the sheltering of the income of the unrelated taxpayer(s).

[12] Although typically individuals do not carry on overseas business through branches and do not very often carry out business through directly owned CFCs.

[13] The Valabh Committee favoured the qualifying company approach over directly attributing the income and expenditure of closely held companies to individual shareholders because they considered that it would be simpler and cover a potentially wider group given that some companies would have more than one class of share.

[14] The taxation of capital gains was suggested even on liquidation in the Government Consultative Document on Full Imputation (December 1987) but was recommended against by the subsequent Consultative Committee (see Full Imputation – Report of the Consultative Committee (April 1988)).