The Government announced in the 2010 Budget that changes will be made to the QC / LAQC regime with effect from the first tax balance dates commencing on and after 1 April 2011. Legislation for the changes is expected to be passed by Parliament by year-end.
Shareholders will have the following options in the transitionary rules under the proposed QC changes:
(a) Elect for the company to become a “Look Through Company” (LTC)
If you elect LTC, any profits of the company will be taxed to the shareholders at the shareholder’s marginal tax rate based on their shareholder interest in the company. Any tax loss transfers to shareholders based on their shareholding in a similar manner to LAQC losses, provided the shareholder’s share of the tax loss does not breach the loss limitation rules being similar to that applied to limited partners in limited partnerships. Any unused tax loss carries forward to the next tax year. The sale of shares in the LTC will be treated as a sale of that person’s share of the underlying assets and liabilities subject to a de minimus rule.
For existing QCs and LAQCs, the election to be a LTC must be signed by all shareholders and filed with Inland Revenue within six months of the existing LAQC legislation ceasing to apply, i.e. by 30 September 2011 for a 31 March 2011 tax balance date company and 30 June 2012 for a 31 December 2011 tax balance date company.
The election must be signed by all shareholders and, for under 18 year old shareholders, a guardian, and shareholders with legal incapacity, their guardian, holder of Power of Attorney or legal representative.
To be a LTC the company must have:
- one class of share;
- must be a New Zealand resident company;
- must have five or fewer shareholders where relatives are counted as one person.
Where a QC’s shareholders’ elect the company to be a LTC, the shareholders are jointly and severally liable for any unpaid PAYE and treated as one employer for PAYE purposes using the company’s name.
Any tax losses carried forward by an existing QC will be transferred to the shareholders in the LTC based on their effective interest. The shareholder can only use the QC tax losses against taxable income from interests held in LTCs.
(a) Transfer the QC / LAQC activity
Existing QC’s / LAQC’s can transfer into a limited partnership, ordinary partnership or natural person sole trader with no tax cost. The assets will transfer at tax values where the acquiring person is deemed to own the asset from the date the QC originally purchased it. The QC / LAQC will need to either be liquidated or be registered as a non-active company following transfer.
For shareholders in QC’s / LAQC’s with negative equity (insolvent companies), it may be necessary to recapitalise the QC /
LAQC to avoid taxable income arising on liquidation from debt remissions.
The QC status must be revoked and, prior to this, the Commissioner must receive notice that the transfer to sole trader or partnership is intended. The sole trader must be the only shareholder on 31 March 2011 or the first balance date falling after 31 March 2011 for those companies with non-31 March approved balance dates.
Similarly, the partnership acquiring the company’s activity must be made up of the same persons with the same percentage entitlements they had in the QC.
Care will need to be taken if this option is being adopted and professional advice sought.
(a) Revoke the existing QC status
Revoke the existing QC status effective from 1 April 2011 and have the company treated as a normal company for income tax purposes.
(b) Do nothing
Do nothing in which case the company remains a QC and is no longer a LAQC. This means the company pays tax on its profits (28% tax rate) and retains any tax loss for use against future taxable income. Dividends from the QC will continue to be taxable to the extent the dividend can be fully imputed and be exempt tax to New Zealand resident shareholders to the extent the dividend cannot be fully imputed.
From the announcements to-date we expect many shareholders in QC / LAQCs would likely decide to take no action and maintain the existing QC status. For those companies that are trading at a loss, and solvency issues are arising as a consequence, we would suggest shareholders / directors consider increasing the share capital of the company to such an extent that company borrowings can be repaid / reduced to a level that the company can then operate at a net profit.
The interest on bank debt that a New Zealand resident shareholder incurs in order to acquire the new shares on issue should be tax
deductible to the shareholder. Any non-cash dividend that the shareholder benefits from sourced from a QC is offset against any interest deduction or share finance to fund shares in a QC that the shareholder is entitled to for income tax purposes.
For QC / LAQCs owned by trusts, the preferred option may be to revoke the QC status effective 1 April 2011 so that the company is taxed under normal rules and take appropriate action to ensure the company’s debt is reduced sufficiently to enable the company to trade at a profit. This aspect can be discussed further with us.
The nature of a LAQC’s business activity will determine the action to take. For a trading company where limited liability is important, the options are either to elect LTC status, limited liability partnership status or remain as a QC. Converting to a limited partnership may be costly as the existing LAQC must be either liquidated or be registered as non-active with the result there may be legal expenses on conveyance of property and refinancing loans from the LAQC to the limited partnership.
For those LAQCs with rental properties, if it is not possible to refinance loans to the company to shareholder loans to acquire shares, then a conversion to either LTC registration or sole trader / partnership consisting of existing shareholders in the LAQC within six months of LAQC status ceasing may be the appropriate option.
The Government is proposing a review of the tax rules for dividends paid by closely held companies and further changes to the taxation of QCs may arise at that time. In brief, a closely held company is a company where five or fewer natural persons hold a combined voting interest in the company of more than 50% which is similar to the rules to be a QC (i.e. shareholders limited to five, treating parents and their children as one shareholder).
A review of QC / LAQCs should also be made prior to 31 March 2011 to ascertain whether dividend distributions of equity should be made prior to the new rules coming into force, especially where the company has unimputed retained earnings and capital gains and the shareholders / directors will likely elect to revoke the company’s QC / LAQC status.