LTC Regime: Reprise – Fairness for Dummies, Mr Dunne. (For NZ Readers Only).

Premise: As only bureaucrats could, they’ve over-analysed the criteria of economic loss, into a loss limitation absurdity, that mistakes the nature of income and has careened, totally, off the road of commercial reality and onward down our road to serfdom …

I have now received back a reply from IRD Legal and Technical Services regarding questions I submitted pertaining to LTC’s. As ever, IRD are always helpful on these matters. My queries related to a number of different issues, but this post relates only to the issue of the deduction limitation employed by this regime. The following should stand alone, though knowledge of my previous LTC post here might fill out some of the details. The point of that post was my chagrin at how the Look Through Company (LTC) regime employs a deduction limitation rule, rather than a loss limitation rule. This means, per example given in that post, that although a LTC may earn a loss, by the time that flows through to the shareholders, some shareholders may be in a position whereby they still have to pay tax on a positive income amount, because they may not be able to utilise all of their share of the LTC’s deductions in any year. It’s worth giving the example again (without getting bogged in the specifics of the calculations):

The hypothetical company has a single shareholder with share capital of $1,000; the owner had a nil balance in his current account with the company at the start of the year, but over the year drew out $6,000 to live on. Over the year’s trading the company made total sales of $6,000, and incurred legitimate expenses/deductions of $10,000, meaning it made a bone fide loss of $4,000. Let’s assume no non-cash depreciation, nor debtors or creditors at year end, thus the company’s bank account, on nil at the start of the year, is now $10,000 overdrawn (being the $4,000 loss, plus the owners drawings of $6,000).

The problem is that what is known as the Owner’s Basis calculation means that by the time these figures flow through to the single shareholder, that shareholder can only claim $1,000 of the $10,000 total deductions, in this instance, with the balance of $9,000 having to be carried through to the next year. This then means that though the company earned a loss of $4,000, the shareholder, in the year of the loss, has to pay tax on an ‘income’ of $5,000. As I shall demonstrate again, via the advice from IRD technical, which clearly informs me, quote, ‘Inland Revenue’s Policy Advice Division (PAD), and the Minister, are fully aware of the issues [I] raise’, this is batshit crazy; but another issue first.

My original post was posted to propertytalk.com, where in the comments fields accountant Matt Gilligan, from Gilligan, Rowe & Associates (recommended if you’re looking for an accountant for your property investment – he knows what he’s doing), stated, under disadvantages of the LTC regime:

Possible impact of deduction limitation rules (less of an issue in 99% of cases and easily worked around with a bit of thinking and pre-planning if an issue)…

This was one of only two points Matt made I disagree with. My response to that was simply: ‘I suspect, but only time will tell, that number will be lower than 99%, and the pre-planning may be more hopeful, than actual, and in many instances will involve significant transaction cost which is not 'good legislation'. I do believe that some companies elected into the LTC regime will ‘over time’ come to grief on the provisions of the deduction limitation. But, actually, that was not the point of my original post, or this one. Let’s give Matt the point and say this may be so rare – it won’t be, but let’s pretend - it only happens to one taxpayer a year: well that’s one too many when properly thought out legislation, fair legislation, could have avoided it. And so to my remaining point, proper, the nonsense that is the deduction limitation.

Here’s what the deduction limitation is attempting to do, I’m copying it directly from IRD Technical’s correspondence with me because it sets it out well:

The intention is to measure an individual’s ‘economic amount of risk’ over the lifetime of a business; so overall an individual will be able to claim in deductions only what they have personally funded by taking on an economic risk … I note your comments that the rules are not truly ‘loss limitation’ because in certain circumstances they can lead to taxable income for a shareholder even if the company overall … has made a tax loss … This is the intended outcome of the loss limitation rule. This is in keeping with the policy rationale discussed above, because it indicates that the company’s losses are not being ‘funded’ by that particular owner. In this example, the current rule is operating with the intended policy that their tax deductions should be restricted to their economic loss.’

Right, now look above at that example I’ve given, again. And look what happens when your life is voted over to the policy making of bureaucrats.

Yes, the shareholders economic interest in the deductions may be only that amount, in my example, $1,000, but who financed the rest? In this case, it was the bank, hence the perilous cash position. Some might say that can’t happen, no bank would finance that: but, actually, this does happen. Where this then goes wrong is that to limit the shareholders’s deductions to that lesser amount, IRD are assuming that shareholder has access to the whole gross income that is covered by the non-allowed deductions, for them to pay the tax from: which is a nonsense. That income is not sitting in an account, it, and an overdraft, were used to pay the non-allowed expenditure. There is no cash this shareholder has access to pay tax on what is an artifact that can (and will) result sometimes from these calculations: effectively, an artificial income amount.

As stated at the start of the policy advice, ‘PAD (and the minister) are fully aware of the issues raised’ – well in that case, I question the judgement of this Minister; because this situation is not acceptable. I would have hoped that any politician who saw it was possible under his legislation to end up paying tax on a $5,000 ‘profit’ when a business generates a $4,000 loss, would have realised he had stuffed up. Just look at this one simple result of a worked example: how could that, to a sane person, possibly be right? For someone who keeps twittering about fairness, the Minister has achieved the opposite. And here’s where it happened: the calculations involved with the loss/deduction limitation, are the result of bureaucrats, unsullied by the real world of business, completely over-analysing theory, the theory of economic loss, through to an absurdity, which may well, now, wash up some poor taxpayers on the reef of bureaucratic cruelty. This result of tracing through economic loss to deductions, while disregarding the nature of income, the structuring of balance sheets, bears no regard to the commercial realities of operating business. Mind you, that’s taxation, and the enforcement of it, period.

This is not good legislation, and there needs to be an amendment that ensures enough deductions are allowed, to at the least mean a shareholder need return no more than their share of the profit made by the underlying LTC, and no less of a loss, than a nil result in their own tax return. That would not be hard to enact.

Tell me how I’m wrong?

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Final Post on LTC's: Legislating Orwell.