IRD Reply on LTC Submission to PAD – (Subtitle: Disappointment).

Honourable Mr Dunne, below I have (re)posted a technical submission I made to IRD Policy and Advice (PAD) on 8 November, to which I have now received a reply. You will note in my submission I have made reference to previous advice from IRD Legal and Technical Services (LTS): the problems I had with that advice were the subject of my second submission to PAD, particularly regarding how the Owner’s Basis in the LTC regime is structured around a deductions limitation, not a loss limitation, that will unjustly catch some few taxpayers out in the manner I have stated in my submission, but more importantly, about how that is a mechanism philosophically anathema to a Western nation with the rule of law, and as such it must be fought on principle. To this concern, I have received the following unsatisfactory reply from PAD:

The extract from the LTS reply that you cited on page 1 of your 8 November letter explains the policy rationale for allowing an owner to claim deduction only to the extent of their economic risk. There is nothing further I can add from a policy perspective.

When you read my submission below, you will see PAD never attempted to answer my closing query. Yes, PAD explained the policy rationale, but that rationale is flawed, as it is based, when dealing with the cash flows of shareholders in LTC’s, on an absurdity flowing from the Department over-analysing the notion of ‘economic risk’ into the mathematics for the LTC regime. So I’m asking you to read the below; I’ve shortened it (you can read the Orwellian closing comparison on the original post here if you wish), but I would appreciate your opinion, please, on the operation of the deduction limitation on which the LTC regime is foundered, and why you are allowing the unfairness of this, over the mechanism that would be fair to all parties: a loss limitation (as the Department continues to mistakenly refer to this deduction limitation in my correspondence with them, and their literature). Note it’s a philosophical answer required, as much as a technical one – possibly why PAD had trouble with this, but heaven help us when the most powerful department in the land deposes the guidance of the philosophical principles underlying a free, Western society, and thus loses sight of the need for principled outcomes in policy formation. Note I’m not asking if this situation concerning the LTC regime is ‘manageable’ by the tax profession – although unlike some, over the long term, I don’t believe it is – I’m asking is it right that legislation is framed as unfairly as this, when there is a reasonable and fair alternative?

LTC Submission to IRD’s Policy and Advice Division.

I would like PAD’s response to the below flaw I see with the Look Through Company (LTC) legislation, which, for the record, in so many ways is awful legislation, especially because it has taken the  usefulness of Qualifying Companies 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 (L)ost (T)he (C)ompanies that business is now stuck with. Note I write the below without having had a single Loss Attributing Qualifying Company (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/risk' 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. And before continuing, let’s correct IRD’s erroneous reference to a ‘loss’ limitation: if it was so, there would be no problem – the Owner’s Basis works on a deduction limitation; though IRD’s continual use of ‘loss limitation’ when it’s not, indicates the problem. Further, note the deduction limitation not only can turn a loss into a profit, it can turn a profit into a bigger (fictitious) profit.

I can demonstrate the problem from [the Department’s] 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. (Note, those readers unfamiliar with LTC regime may prefer to go direct to the overly-simplified example in the postscript, below, then come back to here). 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.

To give a second example of the above, but assuming the bank is not funding the shareholder with the Owner’s Basis problem, consider the more likely scenario that two hands-length 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 the 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. (If readers are struggling understanding what’s happening here, again, please refer to the simplified example in the postscript at the end of this post. For the Minister I ask you at least read the closing bold paragraph of it).

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 three replies to that: firstly, even one taxpayer caught out by this would be unacceptable, secondly, it’s the principle here I’m really interested in, and thirdly, 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 (at the date of writing this it’s looking as if roughly one third of LAQC’s are transitioning to LTC’s). 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 little fairness.

The Solution:

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.

Failing this, in the examples I’ve given, and my solution (plus the postscript below), can you please tell me how I’m wrong, and how the operation of the deductions limitation, as opposed to a loss limitation, meets the Minister’s oft quoted principle of fairness? What I do not understand is why the legislation has gone with a deduction limitation which can produce these aberrant, unjust results, rather than a loss limitation, which provides certainty when operating a business (you can’t get ‘caught’ out in complex mathematics), and is fair on both the taxpayer and the government?

And a second question out of pure curiosity: was the option to go with a deduction limitation, rather than a loss limitation, decided at a political level from elected officials (yourself and Mr English), or by the unelected boffins in PAD? Because the unprincipled money-grab in this one is showing more clearly than usual.

My email for correspondence – and I prefer hard-copy - is: mhubbard@ihug.co.nz

Postscript: Simplified Example of Operation of Deduction Limitation.

This is for those having trouble understanding what is going on here. Getting really simple, how does the deduction limitation work to produce an absurd result? For simplicity, I’ll forget structures, etc, and just look at this on a transactional level.

Little Jimmy (LJ) wants to start his own business selling widgets. He has no security, so he gets a bank loan by his parents guaranteeing him with the bank. He needs start-up capital of $300 which the bank gives him.

His opening balance sheet now shows $300 cash in the bank as his total asset, financed by a bank loan of $300. The bank terms are the loan is repayable over three years, $100 a year.

Year one LJ spends $200 on legal, accounting fees, advertising and some stationary, and $100 on buying his first widget, which he sells for $200. Thus year one he’s made a loss of $200 sale - $300 deductions = loss of $100.

This gives him a balance sheet of $200 cash in the bank account (from sale of widget), financed by a $300 loan still, and negative retained earnings of $100. He uses $100 of the cash in bank to pay first instalment of loan, leaving $100 cash in the bank (enough to buy another widget to make the profit on the next widget which will repay the bank instalment next year, and purchase a third widget).

Regarding tax, normally, no issues: there’s a $100 loss, no tax payable. However, in this instance, LJ’s Owner’s Basis is nil because he has put none of his own money in, and has no recourse property (his security is his parents), thus he can claim none of the $300 deductions in year one, instead these must be carried forward, meaning he has to pay tax effectively on the whole sale price of the widget, $200, breaking all accounting – real world - rules. It doesn’t matter what the tax rate is now, once he pays tax on that out of the $100 cash he has left in the bank, he can no longer afford to buy the second widget in year two to make more profit. The $300 of carried forward deductions are useless to him. Because the tax regime was not based on how he earns his net income, thus his accounting profit, he’s out of business. Worse, his parents are out of pocket, as they will now have to make good on their guarantee to the bank, which LJ, with no business, has no way of repaying. Note under a bone fide loss limitation, or ring fencing, all that would have fairly meant was that if LJ had other income, he could not have claimed the $100 loss he made against it, he would simply have carried the loss forward, effectively, until he could use it within this operation: no tax would have been payable, as he made a loss. Whereas the LTC rules have destroyed his cash flow, the loss limitation wouldn’t have (yet while still protecting the Department from abuse of offsetting losses against other income).

Note there are some who say there’s no problem here – PAD didn’t say that, note, they simply didn’t say any damned thing - LJ should not be structured as a LTC. But that’s not good enough. The deduction limitation will be operating in a much more complex world than LJ: some will go into the LTC regime quite prudently (actually they won’t, it’s awful, Monty Pythonesque legislation, but let’s play the game here), and if events turn against them, etc, over a period of time, they won’t be able to control how this works on them (nor their professional advisors). And that is not fair, because it is the mechanism that is absurd, indeed, repugnant, no fault of the businessman, especially given this is so easy to fix with a loss limitation that would have fulfilled the Government’s stated policy objectives. Catering for such legislative misadventure, should not have to form part of a taxpayers business plan, and if the Minister’s argument ends up they do, then that will confirm what I shall be showing on my next post, regarding another piece of tax law, that New Zealand has serious problems surrounding this Minister’s Department, and the rule of law, under which citizens must have certainty before the law (which they don’t anymore). The next issue has much greater import, though even the issue in this submission, which might seem a small issue to some, is not a small issue: it’s unfair, it’s unnecessary, and it’s always about the principle.

(Why do I get so angry over this ‘stuff’, when nothing is going to change? That one's rhetorical, Minister.)