Most of us are familiar with the phrase "six degrees of separation". It refers to the theory that everyone on Earth is no more than six "degrees" away from every other person. The new “associated persons” definitions in the Taxation (International Taxation, Life Insurance and Remedial Matters) Bill bring this concept into the realm of tax law so that a taxpayer may be deemed an "associate" of people and entities he or she may not even know exist. The aim of the Bill, according to the IRD, is to target "elaborate" avoidance transactions with respect to property. But in our view, the provisions are unworkable and so wide that they apply to standard commercial arrangements which the policy-makers did not intend to catch. This Counsel looks at some of the potential consequences of the Bill as currently drafted and proposes some practical solutions.
Status of the Bill
The Taxation (International Taxation, Life Insurance and Remedial Matters) Bill (the Bill) was one of many Bills caught by the dissolution of parliament on 3 October. Its fate will now be decided by the new National-led government. As it is part of much wider legislation to amend New Zealand’s international tax regime, it is likely that the incoming government will choose to carry the Bill through into law.
Technically, submissions have closed but we consider that there is a very good prospect the new Finance and Expenditure Select Committee will re-open them – especially given the drafting difficulties which have been identified with the Bill. Chapman Tripp will be happy to make a submission on your behalf.
The new “associated persons” rules
It is very important to know when two persons are associated for tax purposes. The tax treatment of certain transactions can differ significantly and certain concessionary tax regimes are not available if the parties involved are “associated persons” for tax purposes. The proposed new definitions of “associated persons” will not achieve the policy makers’ intentions:
- they will not capture all the behaviours they are designed to capture
- they will capture entirely legitimate transactions which they were not intended to capture, and
- they cast the net so wide that they associate people with no substantive or relevant connection, and who may not even know of each other’s existence.
We hope that many of these issues can be addressed before the Bill is passed. Still, there is value in discussing their potential application at this stage so that people are alert to the risk and can consider whether they wish to make a formal submission on the Bill.
If the Bill passes in its current form, there will be many circumstances when it comes to determining the tax treatment of your personal or business investments, in which you will need to ask – with whom am I associated?
You may be:
- selling a property and want to know whether you will be liable to tax on the proceeds of the sale
- arranging for your company to sell some of its land and want to know whether the company can distribute the capital gain from the sale tax-free upon liquidation
- borrowing from an overseas lender and want to know whether you can use the approved issuer levy (AIL) to reduce the withholding tax on your interest, or
- investing in shares in an overseas company and needing to know whether you can use the fair dividend rate (FDR) method to calculate your foreign investment fund (FIF) income.
We thought it easiest to illustrate by example some of the fish hooks in the proposed provisions and invite you to imagine that you have found a beach house in Hahei that you love and have decided to buy.
Scenario one: Hahei through a trust
Imagine you decide to buy the bach through a family trust and that your wealthy Great Uncle Bob, who is a property developer and has settled a number of property development trusts as part of his business, decides to support the purchase by giving your trust a low interest loan.
This makes Bob a settlor of your trust for tax purposes and exposes the transaction to the new common settlor rule under the Bill so that, if you sell the bach within 10 years, you will be liable for capital gains tax.
The mesh of “associations” which gives rise to this liability is depicted in Diagram 1. (see pdf)
The Bill significantly strengthens the associated persons definitions for trusts. Generally, the new definitions will associate:
- a person and a trustee for that person’s relative
- a trustee and a beneficiary of the trust (this test does not apply for the land provisions in the Income Tax Act 2007 (Tax Act))
- two trusts with a common settlor
- a trustee and a settlor of the trust
- a settlor and a beneficiary of a trust (this test does not apply for the land provisions of the Tax Act), and
- a trustee of a trust and a person with the power of appointment or removal of the trustee.
While these rules may seem logical in the abstract, in practice (and applied on top of other association and deeming rules in the Tax Act) they can be very wide reaching and have illogical results.
Particularly controversial is the “universal tripartite test”. This associates two persons if they are each associated with a common third person and, in the case of our example in Diagram 1, means that your family trust will now be associated with the appointor of Bob’s development trust.
The chances are very good that you will not know who this person is, let alone share any economic interests with him or her. This defeats the intention of the Bill which is to target non-arm’s length property dealings between people who have a common economic interest.
Deciding that this is all too difficult, you elect instead to buy the bach with Bob’s help through a company. Problem solved? Yeah, right. Unfortunately, you may be about to fall victim to the aggregation provisions in the Bill.
Scenario 2: Hahei through a company
Your family trust incorporates a company, Beach House Ltd, to buy the bach and – again – Great Uncle Bob comes to the party with a low interest loan, becoming as a result a settlor of your trust for tax purposes.
Bob has also settled his own trust, which is a 50 per cent owner of Developer Ltd. Your family trust is a 100 per cent owner of Beach House Ltd.
These two companies will now be associated under the aggregation rule.
The new rules aggregate the interests of associates when determining whether two companies are associated and deem a person (including a trustee) to hold all the interests in the company held by that person’s associates, even if the person does not hold any shares in the company in question.
What this means for you is that, even though your family trust does not own any shares in Developer Ltd and may never benefit under Bob’s trust, because your trust and Bob’s trust are associated, your trust will be deemed to hold 50 per cent of the shares in Developer Ltd. Which in turn means that, if it sells the Hahei bach within 10 years of purchase, it will have to pay capital gains on the proceeds of the sale.
Exclusions and exceptions
Some exclusions are provided in the Bill to ameliorate some of its effects. The "trustee and beneficiary" test and the "settlor and beneficiary" test do not, for example, apply for the purposes of the land provisions of the Tax Act.
But for the purposes of all the non-land provisions (e.g. the international tax rules, the AIL regime and whether capital gains can be distributed by a company tax-free upon liquidation) all the beneficiaries of a trust will be associated with one another through their common association with that trust – including, if the Bill is passed in its present form, all 300,000 Vector customers who are beneficiaries of the Auckland Energy Consumer Trust!
A more workable approach
The elaborate avoidance transactions which the IRD has in its sights could be dealt with more effectively under the general anti-avoidance provisions of the Tax Act.
The solutions proposed in the Bill will not work. The new associated persons definitions are far too broad and will “associate” people who have no shared economic interests or control and who may not even know of each other’s existence.
These measures, combined with the application of the aggregation and universal tripartite rules, will make it difficult, if not impossible, for taxpayers to determine who they are in fact associated with for the purposes of the Tax Act.
Further, they may create a compliance risk as many taxpayers will never be sure whether they comply or not, and may give up trying.
If the new government elects to continue with the Bill and if the Bill proceeds to schedule, the new associated persons definitions will apply to the 2009-10 and later income years for all provisions of the Act except the land provisions. For the land provisions, the new definitions will apply to land acquired on or after 1 April 2009.
Issues you should consider are:
- who you, your trusts and companies will be associated with under the new definitions, and
- whether any existing business structures you have in place need to be reviewed in light of these new definitions.
To know more about the issues raised in this Counsel, please contact us for our full paper on the proposed changes to the associated persons definitions. Chapman Tripp can also assist with submissions and advice.