The former US Secretary of Defense Donald Rumsfeld died recently. In the run up to the Iraq war he mused that there were things that we didn't know we didn't know. I was reminded of Rumsfeld's quote yesterday when a new client approached me in something of a panic.
Their accounting system was picking up on unrealised foreign exchange movements, but they weren't aware of the relevant tax for treatment. It was something of a shock to them when I ran through the provisions of the financial arrangements rules probably the biggest ‘didn't know that we didn't know’ in the New Zealand tax system.
To recap because there's not much on the Inland Revenue website about these rules, a financial arrangement is broadly defined as an arrangement where a person receives money in consideration for money to be provided in the future. Bonds and mortgages are two of the main types of financial arrangements caught. But the regime also applies to term deposits because there is a promise to apply pay interest at a later date. The regime also covers foreign exchange accounts such as those held by my client
Unfortunately, the rules have proved particularly troublesome for holders of overseas mortgages for example people who may have migrated here from overseas but rent out their previous property in Australia, the UK, or the US over which they have a foreign mortgage. Although they are reporting the rental income as they should, they get caught by the foreign exchange movements on the mortgages
The most extreme example I ever encountered was for one client who had a $300,000 positive movement in one year resulting in income and tax payable which subsequently reversed entirely in the following year. They still had to pay the tax in the first place, a very frustrating result for all concerned.
So these financial arrangements rules are nightmare for the unwary as it’s an incredibly comprehensive part of the act but it is not at all well known.
Fortunately, by and large most people are not subject to the rules because they are within the exemption for what we call a ‘cash basis holder’. But that exemption itself has a couple of traps in it and this is what unfortunately has caught my client.
Generally speaking, you can be a cash basis holder and you don't have to calculate income on an unrealised basis if either the absolute value of all your income and expenditure in a foreign arrangement for an income year is $100,000 or less.
Remember that's adding income and expenditure together; the rules do not operate on a net basis. When calculating these limits that still needs to be kept in mind as it's one of the other traps that people fall into. For example, if you had $500,000 on term deposit and you had a $500,000 mortgage overseas so although your net financial position is nil, for the purposes of the financial arrangement you have $1,000,000 of financial arrangements so you're outside the cash basis holder exemption.
By the way, the $1,000,000 limit applies if on every day in a particular income year the absolute value of each of each of the persons financial arrangements added together has a total value of $1,000,000 or less.
Now as I said most people should be able to be within those limits. The problem is there's another clause which trips people up which they need to be aware of. This is where if the difference between the income which would be calculated on an unrealised basis (what we call accrual income) and income calculated on the cash basis, that is what you've actually received or realised, exceeds $40,000 at any time then you cannot be a cash basis person. What this means is that sudden movements in exchange rates can pull people into the financial arrangements regime the classic example here being what happened following the Brexit referendum vote.
The financial arrangements rules are very much a trap for the unwary. How well it's enforced of course is another matter because these are fairly arcane provisions and I'm not entirely sure Inland Revenue has all the resources to keep on top of what's happening in this space.
Of course, it might help if Inland Revenue and the Government reviewed these thresholds and adjusted them more frequently. The $1,000,000 exemption threshold has not been adjusted since 1999. Quite frankly the financial arrangements regime should not really be pulling in small businesses into its net simply because of an out-of-date threshold.
This is one of the practical matters around the operation of the Income Tax Act which seems to be get left lying around until someone somewhere in Inland Revenue realises, we haven't actually done anything in this space for 22 years. Anyway, the lesson is to be wary of financial arrangements regime it applies much more widely than people realise and can trigger unexpected tax consequences.
Bypassing the proper review process
Speaking of unexpected and unintended tax consequences, submissions closed on 12th July for the Government's discussion document on its interest limitation proposals. It’s fair to say that the proposals have generated a fair bit of controversy. I understand Inland Revenue's received several hundred submissions so far and very unsurprisingly the majority are opposed to the proposals.
Some of these submissions are now available to the public and so it's interesting to look at what other submitters have said. Chartered Accountants Australia and NZ have produced a massive and extremely comprehensive submission which runs to 108 pages. Now remember the discussion document itself was 143 pages so when the commentary on a document that size itself runs to 108 pages we're talking about a great deal of complexity. We're almost certainly heading into a lot of unintended consequences as CAANZ’s submission points out.
This is echoed by its fellow accounting body CPA Australia. It points out that the measures were a surprise and did not go through the normal Generic Tax Policy Process and it foresees considerable confusion and remediation for the rules as a consequence.
CAANZ was also unhappy about the fact that the proposals did not go through the Generic Tax Policy Process (GTPP). This is meant to work out in advance of an implementation date what the issues are and get the legislation to a point where everyone is mostly satisfied with what's being introduced. That didn't happen here and is one of the reasons a lot of tax consultants, larger accounting firms and accounting bodies are unhappy about the proposals.
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It's interesting looking back that where there's been departures from the GTPP these have commonly happened around taxation of property.
There were several unheralded moves by the previous National led Government outside the GTPP. In the 2010 Budget for example depreciation on residential and commercial buildings was withdrawn without any forward consultation. Likewise, the same budget put an end to the loss attributing qualifying company regime partly in response to what was perceived to be issues around tax avoidance. But the depreciation changes and withdrawal of the LA QC regimes were also responses to the tax treatment of residential investment property being perceived to be too generous. Then in 2015 the first iteration of the bright-line test was introduced again outside without prior consultation through the GTPP.
I too agree with CAANZ and CPA Australia that there will be unintended consequences as a result of these changes but it's also interesting to note that the taxation of property has been a headache for governments for some time to the extent they felt compelled to take action outside the normal policy process.
Patching another unreviewed policy
One of the things that hasn't been done and probably should be is a comprehensive look at property taxation legislation. We haven't had a review of the original bright-line test legislation and its consequences. These reviews are quite normal under the GTPP. But now we're putting patches on that legislation and extending its period to 10 years. Meanwhile it's clear there's confusion about whether a property sale is subject to bright-line test or other taxing provisions within the Income Tax Act.
It's against that backdrop Professor Susan St. John and I decided to move forward the idea of what we called a Fair Economic Return. This is building on an idea that was first mooted by the McLeod Tax review in 2001. It suggested applying a deemed rate of return to property as an alternative taxation basis. No-one is particularly sold on a capital gains tax but there was a recognition even 20 years ago that the tax treatment of property was favourable and causing distortions in the tax system. Those distortions have become magnified over the past 20 years resulting in measures such as we've just described attempting to address these issues.
With that in mind Professor St. John and I have produced a working paper suggesting a Fair Economic Return. We haven't formalized a rate that should apply but the working paper has examples of how it would operate whether rate was 1, 2, or 3%.
This rate would be applied to the net equity of all property held by a person.
To get around the definitional issues of what is the main home, we have suggested there should be an exemption available to each person. In our initial working paper, we've suggested that exemption could be $1,000,000.
Here's an example of how it would work for a couple living in Auckland whose only property asset is their house worth $3 million with a $500,000 mortgage. The net equity in the property is therefore $2.5 million. Applying each person's exemption $1,000,000, this leaves $500,000 subject to the Fair Economic Return at a rate of let's say 1%. This results in income of $2,500 for each person.
This is the idea Susan and I have put out there and we've been talking this week on radio about it. It’s obviously going to generate a fair bit of feedback not all of it favourable but that's not unsurprising.
The view we've reached is it's time to try a different approach because patches to the existing tax system such as interest limitation rules, extension of bright-line tests but incorporating exemptions for new builds etc, do not work, these are just patches, it's time for a comprehensive and different approach to the whole issue of property taxation.
We're updating the paper to absorb commentary and we're always happy to take comments on that.
In the meantime, that's it for me for this week. Well, that's it for today. I’m Terry Baucher and you can find this podcast on my website www.baucher.tax or wherever you get your podcasts. Thank you for listening and please send me your feedback and tell your friends and clients. Until next week ka kite āno!