Latest News [index] Look Through Companies - new company regime
Budget 2010 heralded changes for qualifying companies (QCs) and loss attributing qualifying companies (LAQCs). On 11 October 2010 the Government announced its intention to introduce new rules that will prevent an LAQC from passing losses on to the company's shareholders.
These rules were enacted in late 2010 and will apply from 1 April 2011.
Under the new rules a new tax entity, a look-through company (LTC) will largely take the place of LAQCs. The LTC will allow losses (subject to a loss limitation rule), tax credits and rebates to pass to shareholders. However, unlike the case with QCs and LAQCs, income and other gains will also be passed through to the shareholders. The new LTC regime will prevent the utilisation of the benefit of the lower company tax rate while passing losses through to shareholders to offset against income subject to a higher marginal rate.
Transparent entity
An LTC will be a transparent entity, all profits and allowable losses of which will be allocated to the owners in proportion to each owner's effective interest in the LTC. The effective interest will be measured by reference to decision-making rights. An LTC will pay no tax in its own right as all tax liabilities will be met by the owners.
For tax purposes the shareholders of a LTC will be regarded as holding the LTC's assets directly, and carrying on the activities of the LTC personally. This means that subject to proposed thresholds that will be modelled on the present partnership threshold rules, a sale of shares in a LTC will be treated as a sale of the underlying asset for tax purposes.
However, an LTC will be an ordinary company for company law purposes. This means that a LTC will retain corporate obligations and benefits (such as limited liability) that apply in accordance with company law. An LTC will also retain its own separate identity for other tax purposes including GST, PAYE and withholding tax purposes.
Elegibility
A company will be become a LTC by election. The shareholders of a company that elects to apply the LTC rules will be referred to as "owners" for the purposes of the LTC rules. The owners can be natural persons or trustees. To enter the LTC regime all owners of look-through interests must sign the LTC election. Where a trustee signs an election in the capacity as trustee for a trust there is no requirement for any beneficiaries to sign the LTC election.
To be able to enter the LTC regime a company must be tax resident in New Zealand and have a single class of shares. There is no obligation for trustees with ownership interests in LTCs to allocate all LTC income as beneficiary income, unlike the QC rules, which require a trust to pay all QC dividends as beneficiary income. However, the distribution of LTC income does have other implications.
As with the existing QC regime, a count test will apply that looks through certain owners and aggregates related interests. An LTC will be permitted a maximum of five look-through counted owners. The term "look-through counted owner" will be a defined term that that only applies for the count test.
For the purposes of the count test a natural person who is not a trustee is counted as a single look-through counted owner. Relatives to the second degree also count as a single look-through owner.
The trustee or trustees of a trust are also counted as a single look through counted owner for an income year unless all of the income from the LTC is distributed as beneficiary income in that income year, or in any of the five preceding income years.
A beneficiary of a trust will be counted as a look-through counted owner if any income from the LTC is distributed as beneficiary income in that income year, or in any of the five preceding income years.
If a company (including a QC) is a beneficiary of a trust, that company is not counted as a look-through counted owner if any income from the LTC is distributed to that company as beneficiary income in that income year, or in any of the five preceding income years. Instead, the test will count all natural persons who have a direct or indirect voting interest in the company.
There is no restriction on the amount of foreign-sourced non-dividend income that an LTC may receive and there are no restrictions on the interests an LTC can hold in controlled foreign companies or foreign investment funds.
A company will exit the LTC regime if the LTC election is revoked or if the company ceases to meet the LTC regime criteria. There will be no revocation by event (as is the case with the QC regime) and so no further elections will be required once a company enters the LTC regime.
Where a revocation does occur, the revocation will have prospective application. This means that for a revocation for an income year to be effective, the revocation must be made before the start of the income year.
Loss Limitation
A loss limitation rule will apply to shareholders in LTCs. This rule, which will be similar to the loss limitation rule that applies to limited partnerships, will limit the loss an owner can claim if the overall deductions exceed the adjusted tax book value of the owners' investment in the LTC ("the owner's basis"). The owner's basis is the sum of the owner's investment in the LTC less distributions plus income less deductions and disallowed amounts.
The effect of the loss limitation rule is to limit losses to reflect economic risk actually incurred by the shareholder.
Losses that cannot be offset can be carried forward. However, these losses will be ring-fenced insomuch that the losses can only be offset against income from the LTC.
Transition rules
Transitional rules will allow existing QCs and LAQCs to transition to either a LTC or to adopt a new structure at no tax cost for the year commencing 1 April 2011. Shareholders of existing QCs and LAQCs can elect to become an LTC, a partnership, a limited partnership or a sole trader.
To transition to a LTC an LTC election must be made within 6 months of the first income year of the new regime. For the duration of the transition period there will be no tax cost associated with exiting the QC or LAQC regime. When an existing company enters the LTC regime its owners will usually be deemed to have an amount of income equal to their proportionate interest in the company's reserves that would be taxable on a liquidation. Under the transitional provisions no income amount will arise. However, other costs may arise where, for example, property is conveyed to a new ownership structure.
If the election is made to transition from a corporate structure, it will be necessary to restructure the trading business and either make the company non-active or wind it up. The transition rules will provide extended time for this restructuring.
If a QC or LAQC transitions to an ordinary company it will be necessary to revoke existing QC or LAQC elections.
If no election is made an existing LAQC will become a QC. The QC rules will remain available pending the outcome of the government's review of the dividend rules for closely held companies. This means that income will continue to be taxed to the company and there will be no change to the taxation of dividend income. This means that, as is the case at present, only dividends with imputation credits attached will be taxable to shareholders; and any capital gains can be distributed tax free without winding up the company.
The current QC rules will remain while the Government reviews the tax rules for dividends, with a view to simplifying these for closely held companies.
Moving On
If you have any questions about the new rules, contact a member of the Ayres Legal team.