LTC Submission to IRD’s Policy and Advice Division.

IRD Policy and Advice Division

PO Box 2198

Wellington

To Whom it May Concern

Re: LTC Regime Flaw: General mumblings and a specific gripe and query.

Sub-Re: (L)ost (T)he (C)ompany Regime: Where ‘you’ went wrong.

The Complaint and Query Bit.

I would like PAD’s response to the below flaw I see with the Look Through Company (LTC) legislation, which, for the record, in every way is awful legislation, especially because it has taken the  usefulness of QC’s away from the planning kit. Ring fencing of domestic rental losses, no matter the entity, would have achieved all of the Government’s stated aims without yet further layers of complexity in our tax system, and these dreadful Lost The Companies that business is now stuck with. Note I write the below without having had a single LAQC on my client base with a domestic rental property in it.

The flaw with LTC’s - apart from the whole overriding idea of doublespeaking a company into a partnership - pertains to how policy makers have over-analysed the notion of 'economic loss' that informs the ‘Owner’s Basis’ component of the calculations on which the mathematics of the regime are constructed; and over-analysed to the point of an absurdity in the manner it has been implemented on smaller, closely held companies. Note that I have already corresponded with IRD Technical and Legal to establish your thinking behind the way the offending section of this legislation is worked out - quote:

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.’

I would have hoped both the Minister and IRD’s Policy and Advice Division might have got to ‘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’ …and realised, they had overshot the mark, and bypassed sense here.

I can demonstrate the problem from your over-thinking in no better way than by using IRD’s own example given in the guide to the 2012 Partnership (including LTC) tax return, IR 7G, 2012. That example can be fleshed out, and in one respect, simplified, by deleting a layer of shareholders as follows (worksheet attached at end of this correspondence with the Owner’s Basis calculation). Take a hypothetical company with share capital of $1,000, that has a single shareholder ; the shareholder 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). From this the problem then becomes, per the attached worksheet, the Owner’s Basis calculation gives a result of only $1,000, meaning that by the time these figures flow through to the single shareholder, that shareholder can claim just $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 $6,000 income - $1,000 only allowed deductions = $5,000 profit.

Yikes. Who said bureaucrats aren’t entrepreneurial: but this is wealth wrecking innovation that destroys economies, rather than builds them, which should have alarmed the Minister.

The problem, clearly stated, is, yes, the shareholders literal economic interest in the deductions may be only that amount, $1,000, but who financed the rest in this small, closely held LTC? In this case, it was the bank, hence the perilous overdrawn cash position. Some might say that can’t happen, no bank would finance that: but, actually, this does happen ­ (more on this below). Where this has thus gone 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 was used to physically pay the non-allowed deductions, for them to pay the tax from: which is a nonsense, in the case of a close company such as shall comprise the majority of the companies elected into this regime, as with the one in this example. That income is not sitting in an account, it, and an overdraft, were used to pay the non-allowed expenditure. Assuming, realistically, this company was the shareholder’s sole source of income, ‘their entire living’, then 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, that breaks all the laws of accounting profit or loss. This unjust outcome of the LTC policy drafting, has resulted from tracing through the notion of economic loss to deductions, while disregarding the nature of income and the structuring of balance sheets, especially in small and close, struggling firms, in a manner that pays no regard to the commercial realities of operating business. The shame of this is it will particularly affect firms that have negative retained earnings, and problematic shareholder current accounts because in some years shareholders will need to draw more for their living than they are making, and with no recourse property held by them because they are operating ‘on the edge’, even, technically insolvent: and believe me they do exist.

Note, I can tell from the resultant legislation that during policy formulation you were only looking at property (domestic rental) investment companies, which are being operated as a side-line to a taxpayer’s main activity, thus the Recourse Property component of the Owner's Basis is likely to always save them, and make this regime manageable for such investors. However this simply highlights how the government’s intentions should have been enacted via means of a simple ring fencing of rental losses, regardless of the structure incurred in, for, as already stated, I had LAQC’s on my books, but not one of them was a domestic rental property investor: that structure was useful across industries, and particularly this country’s lifeblood, rural industries, and not just the ‘rich prick’ – to use a phrase coined by a former finance minister who didn’t believe in knighthoods, then took one - landowners, but rural contractors who have their money invested in expensive, depreciating machinery, plus share and lower order milkers, and so forth. Which brings me to my final point.

I have been debating, online, with one accountant who believes this aspect of the regime is manageable, and would only affect a minute number of LTC’s. I have two replies to that: firstly, even one taxpayer caught out by this would be unacceptable, and secondly, the accountant concerned belongs to a CA firm that specialises in rental and property investment (I’ve just heard their ad on the radio as I’m typing this), so, as I’ve already intimated, I suspect he was only thinking the issues through from that angle. Whereas there will be a lot of LTC’s transitioning from LAQC’s which will not be property investors. Indeed, I have had a phone conversation to another accountant in a large rural firm, and I know that firm has elected some number of their dairy equity partnership LAQC’s into the regime. I reckon they, particularly, will be in for a shock, in some future year, given that type of investor, farmer, tends to have all of their asset, including the farm house, in their company, so there will be no recourse property for such shareholders to use in their Owner’s Basis, which is a problem in the way that calculation works: I would not want to be delivering the tax returns for some of them if the milk pay-out should happen to drop much further … ‘um, here you go, you made a $400,000 loss, but you’ve all got tax to pay. You have no cash? Oh dear …’ Furthermore, ‘managing’ this aspect of the Owner’s Basis will in some cases involve costly restructuring out of the regime, which, in tax terms given this will be the dissolution of a partnership, and even just in terms of the professional fees involved, should not need to be borne if the legislation was designed sensibly (especially, again, as this cost is likely to be forced on the very firms that have not the wherewithal to afford it).

However, I believe there is a relatively easy solution to this which would put back into LTC’s none of the sense required, but at least in this respect, a very little of that word the Minister seems to have fallen in love with, despite evidently having little idea what it means: fairness.

The Solution Bit:

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. This ensures the cash is available to cover the tax liability, while still ring fencing losses from being claimed against other sources of income. To state this in another way: we need an actual loss limitation, not a deduction limitation. That would not be hard to enact.

Or, in the example I’ve given, and my solution, can you please tell me how I’m wrong?

The Postscript, Philosophical Bit – Why? Because it’s Cup of Tea Time:

Author, George Orwell, a socialist who was ironically the most significant writer on demonstrating how socialism always fails, unfortunately seems to have foretold ‘your’ LTC legislation as long ago as 1946.  In his novel, 1984, about a nightmare police-state society - which this legislation raises misgivings that you may be converting into a manual - the protagonist, Winston Smith, is tortured into submission to the Big Brother state: this torture was not by being made to read our taxation legislation, attend your yearly compliance update, TEO courses, or even becoming a victim of the Department’s increasing use of retrospective enforcement: no, the process was rather to take away his sense of reality, of self, by the torturer holding his fingers up and asking Winston how many there were. Whenever he gives the correct answer - the answer of a free, blameless man - he has pain inflicted on him, until, a crying wreck by the end, such as some unfortunates will be with their LTC returns in hand, he states he’ll say any number of fingers Big Brother wants him to see, yet he is still never able to get the answer right by his antagonist, which gave the ultimate chilling reality of that society: 'If you want a picture of the future, imagine a boot stamping on a human face — forever.’

The passage concerned from the novel is well worth reading, and is as follows:

'Do you remember,' he went on, 'writing in your diary, "Freedom is the freedom to say that two plus two make four"?'

'Yes,' said Winston.

O'Brien held up his left hand, its back towards Winston, with the thumb hidden and the four fingers extended.

'How many fingers am I holding up, Winston?'

'Four.'

'And if the party says that it is not four but five -- then how many?'

'Four.'

The word ended in a gasp of pain. The needle of the dial had shot up to fifty-five. The sweat had sprung out all over Winston's body. The air tore into his lungs and issued again in deep groans which even by clenching his teeth he could not stop. O'Brien watched him, the four fingers still extended. He drew back the lever. This time the pain was only slightly eased.

'How many fingers, Winston?'

'Four.'

The needle went up to sixty.

'How many fingers, Winston?'

'Four! Four! What else can I say? Four!'

The needle must have risen again, but he did not look at it. The heavy, stern face and the four fingers filled his vision. The fingers stood up before his eyes like pillars, enormous, blurry, and seeming to vibrate, but unmistakably four.

'How many fingers, Winston?'

'Four! Stop it, stop it! How can you go on? Four! Four!'

'How many fingers, Winston?'

'Five! Five! Five!'

'No, Winston, that is no use. You are lying. You still think there are four. How many fingers, please?'

Until finally, reality is defeated:

In the end the Party would announce that two and two made five, and you would have to believe it. It was inevitable that they should make that claim sooner or later: the logic of their position demanded it. Not merely the validity of experience, but the very existence of external reality, was tacitly denied by their philosophy. The heresy of heresies was common sense. And what was terrifying was not that they would kill you for thinking otherwise, but that they might be right. For, after all, how do we know that two and two make four? Or that the force of gravity works? Or that the past is unchangeable? If both the past and the external world exist only in the mind, and if the mind itself is controllable—what then?

Well, it appears you’ve finally answered ‘what then’: New Zealand tax law, apparently.

Translating this to the issue at hand; the reality that New Zealand businesses must operate under to survive has to be expressed under the real world mathematics of:

2 + 2 = 4

This can never change, otherwise business death has to be the result. Thus needless to say, when reality is turned on its head, as with morality, no business can survive for long when real world mathematics is replaced by the police-statematics of:

2 + 2 = 5

Well, and I hope you’re putting the pieces together here, you’ve just similarly taken the footing out from real world accounting profit of:

$6,000 income - $10,000 deductions = ($4,000) loss

And subverted into the police-statematics of:

 $6,000 income - $10,000 deductions = $5,000 profit.

I ask you to step back from the statematics you’ve magic’ed up from the totalitarian hive-mind, and please think on that real world financial mathematics businesspeople have to trade under. I know you’ll see sense: look at me, I sometimes sit here hating politicians for binding and destroying the West’s birth-right since 1776, the free, prosperous classical liberal society, but sometimes I’m prepared to give the odd one their dues, such as Maryan Street’s Euthanasia Bill, (given euthanasia may well be an option after dealing with tax policy from the Fortress of Legislation for a lifetime).

And returning, finally, to fingers held in the air, it’s hard not to get the impression the State has got only two held up in this legislation, and they’re not giving the taxpayer that proud classical liberal, Winston Churchill’s, ‘V’ for victory sign. A fair fix to the Owner’s Basis please, or tell me why not.

Yours faithfully

Update 1:

Darn. My plan had always been to add the below second example to the one given above, but I got busy and forgot it. Too late now, I’ve posted the submission, but for the record, and to make the point.

Again, the problem with the deduction limitation is, ‘IRD are assuming (a) shareholder has access to the whole gross income that was used to physically pay the non-allowed deductions, for them to pay the tax from …’

The first example was of a single shareholder LTC where the bank had financed the operation. Consider now the even more likely scenario that two third parties invest via a LTC. The operation (whatever it is) goes through a bumpy patch, and only one of the investors has the wherewithal to put more money in to get them through, putting the cash in as a loan (good for his Owner’s Basis), the shareholdings don’t change. Let’s assume the other shareholder now has problems with the Owner’s Basis, so that he can’t claim all of his deductions, and as with the above example, though the LTC generated a loss, this shareholder has to return a profit in his tax return.

Same problem: where’s the cash for him to pay the tax from? There is none, unless he now borrows from bank or the other shareholder (but he’s just put the last of his money into the LTC). That cash was used to pay the non-allowed deductions, so is not available.

The only 'fair' solution to this is to legislate for LTC’s an actual loss limitation, not this Orwellian deduction limitation.