It has been a massive week in tax beginning with the G7’s announcement that it had agreed a minimum corporate tax rate of 15% (more here), we had the Climate Change Commission’s release of its final advice to the Government, Propublica releasing Internal Revenue Service data about the tax affairs of the 25 richest Americans, the same day as Revenue Minister David Parker raised the same topic in his appearance before Parliament’s Finance and Expenditure Committee.
But the biggest news, and our topic today, is the release of the Government’s long-awaited discussion document on the design of the interest limitation rule and additional bright-line rules.
You will recall that on March 23rd the Government dropped a huge bombshell by announcing that it was proposing to limit interest deductions for residential rental investment properties starting October 1st.
Now, there's been a flurry of activity since then with Inland Revenue consulting with an External Reference Group discussing the issues that came out of the Government's announcements as part of preparing the discussion document which was released yesterday.
At 143 pages it’s a big document and it's one of the largest such discussion documents issued in recent years. Just for comparison, the issues paper on loss ring-fencing released in 2018 was a mere 20 pages and that for the introduction of the bright-line test back in 2015 just 36.
I was part of the External Reference Group, and it became very apparent very quickly that we were dealing with considerably complex issues, and we would be looking at quite a lot of very detailed legislation. So, there’s a massive amount of detail to consider here.
I don't propose to go through everything in detail today because we're still working our way through the document and consider the implications. Instead, what I'm going to do today is give an overview of the key points in the discussion document points, and then in the coming weeks, focus on specific issues of interest.
Now, the discussion document starts with an overview of the proposals and then works its way through another 13 chapters so there are 14 chapters, including the introductory chapter, in all. And one of the things that I think we might well appreciate is the document has been drafted so that it is not necessary for everyone to read the entire document unless you're a tax adviser like me. But if you have a particular interest, you can go to the chapter that is relevant to you. And each chapter also contains specific questions that Inland Revenue and the Government are looking for responses about.
To summarise, the restriction will happen from 1st October 2021. The amount of the restriction will depend on whether the interest is “grandparented”, and that's going to be one of the first points of interest. This is interest on debt drawn down before 27th March 2021 relating to residential investment property acquired before that. The deductions will be gradually phased out over between 1st of October 2021 and 31 March 2025. For grandparented interest, deductions will be gradually phased out between 1 October 2021 and 31 March 2025 as follows:
|Date interest incurred||Percent of interest you can claim|
|1 April 2020–31 March 2021||100%|
|1 April 2021–31 March 2022
|1 April 2021 to 30 September 2021 – 100%
1 October 2021 to 31 March 2022 – 75%
|1 April 2022–31 March 2023||75%|
|1 April 2023–31 March 2024||50%|
|1 April 2024–31 March 2025||25%|
|From 1 April 2025 onwards||0%|
Chapter 2 looks at what residential property is subject to the interest limitation. Now, there's a good part here is that there are some exclusions.
- Land outside New Zealand
- Employee accommodation
- Care facilities such as hospitals, convalescent homes, nursing homes, and hospices
- Commercial accommodation such as hotels, motels, and boarding houses
- Retirement villages and rest homes; and
- Main home - the interest limitation proposal would not apply to interest related to any income-earning use of an owner-occupier’s main home such as a flatting situation.
Chapter 3 then looks at the entities affected by interest limitation, such as companies, Kāinga Ora and other organisations,
What interest expense is going to be non-deductible?
Then Chapter 4 is one of the ones going to be get into quite a bit of detail involved interest, interest in allocation, which is how do you identify which interest expenses are going to be subject to the limitation?
And the proposal here is to follow the long-established practice that where a loan has been used for a mixture of taxable and non-taxable purposes, we trace the funding through to each purpose to determine the deductibility. The Government's proposal is to use this existing approach for loans used to fund residential investment property. Now, the discussion document also covers refinancing, existing loans and some transitional issues around debt which existed prior to 27th March.
One of the issues considered in the paper is the question of what to do about loans that can't actually be traced. In other words, because previously this wasn't a requirement for many investors, and they don't have the records to be able to trace. What do you do where you want to show that a loan that was taken out prior to 27th March was applied to, say, business use rather than residential property investment? A mixed-use loan, if you like.
There are two proposals to deal with this issue. One is to take an apportionment based on the value of the loans across the assets, based on the original acquisition costs and the cost of any improvements. The other option is what they call ‘debt stacking’, which is where taxpayers would allocate their pre-27th March loans firstly to assets that are not residential investment properties but qualify for interest deductions.
This is actually quite generous, by the way. The rationale for this is that well advised taxpayers would be able to restructure to achieve the same tax outcome under the tracing approach anyway. This is actually an acknowledgement of the disparity of investors we're dealing with here. Some are quite sophisticated and would be across all the detail. Others, less so, perhaps because they may not have many properties and have not really been as diligent as perhaps they should have been in keeping records. So that's a little bit of a generous exemption there. But the point is you're still dealing with a great deal of complexity in approaches and the Government is asking us to say, well, which one would you prefer to use?
A particular point here to note is that with pre-27th March loans, while interest on those loans will be deductible, subject to phasing out, and any borrowing subsequent to that date will be completely limited. What's proposed to help calculating this proportion is determining a “high watermark”, which is the amount of funding allocated to residential rental property as of 26th March 2021. And then from that point, variations above that are the ones that are going to be most closely subject to interest limitation. As you can see, we're already into quite a lot of detail and we are just getting started.
Non-deductible interest and bright-line test sales
Chapter 5 looks at the proposals for the disposal of property subject to the interest limitation rule. This was the subject of a lot of discussion during the External Reference Group consultation. Because the issue here is if interest has been limited, but the property has been sold and the gain on the disposal is treated as taxable, what are we going to do with the interest that was treated as non-deductible? Can this now be allowed as a deduction on sale? This is targeting people caught under the bright-line test, and remember we are also talking about an extended 10-year period for the bright-line test.
There are several options under consideration. One is that deductions are denied in full stop. Secondly, the deductions are allowed at the point of sale. Thirdly, deductions are allowed at the point of sale to the extent they do not create a loss. And finally, there’s an anti-arbitrage rule to counter attempts to arbitrage the interest deductions available because some people might know they've got a taxable transaction coming up.
The Government's looking for feedback on people’s preferred approach. My impression is that they there will be allowing a deferred deduction of previously denied interest at the point of sale. But what exactly how those rules will operate is what the Government wants to hear more about.
Chapter 6 considers the treatment of property development and related activities. The Government has determined that property developers should be exempt from the proposed rules. So what that chapter looks at what is the definition of development and how far should this development exemption go. It also looks at what do we do in applying that exemption to one-off developments as well as professional developers?
A particular point of interest, because we've got ongoing issues around leaky homes and earthquakes strengthening is remediation work. Will that qualify for the development exemption? So there's a lot to consider in this chapter.
What is a new build?
Chapter 7 is one which also generate a lot of discussion - what is the definition of a “new build”? Under the proposals, new build residential properties are exempted from the proposed interest limitation rules, and they're subject to a five year bright-line test rather than the 10-year test.
The chapter suggests the following could be considered a new build:
- a dwelling is added to vacant land,
- an additional dwelling is added to a property, whether stand-alone or attached,
- a dwelling (or multiple dwellings) replaces an existing dwelling,
- renovating an existing dwelling to create two or more dwellings,
- a dwelling converted from commercial premises such as an office block converted into apartments. This is one which I think is of particular interest. Following the announcement in March we heard one or two of these developments were put on hold so clarity around this is needed.
Chapter 8 then deals with the new build exemption from interest limitation and how long that exemption should apply to new owners? It also proposing that early owners, those who acquire a new build no later than 12 months after its Code Compliance Certificate is issued or add a new build to the land would be eligible for the new build exemption. It then looks at what about subsequent purchases? Maybe the exemption is available for those who acquire a new build more than 12 months after the new build’s Code Compliance Certificate is issued and within a fixed period such as, say, 10 or 20 years. There's a lot to consider in this issue.
Chapter 9 then discussed how the five-year bright-line test will apply for new builds.
A pleasant surprise
Chapter 10 is where we have a pleasant surprise. It deals with what we call rollover relief when the application of the bright-line test and interest limitation is “rolled over”. This is where the property is transferred between two parties and that transfer, which is a disposal for tax purposes, does not trigger an immediate tax charge under the bright-line test provisions.
The lack of a comprehensive rollover test was something that has been an issue before this interest and limitation issue arose. What's proposed in here is some limited relief from the interest limitation and bright-line test in relation to transfers to trusts and transfers where there is, quote, “no significant change of ownership.”
What this means is in those circumstances, the taxing point will be deferred until there is a future disposal of the property that does not qualify for rollover relief. So, if the transfer qualifies for rollover relief, then the disposal of the residential land would be at cost to the transferral or original owner rather than market value, which is the current rules. The recipient would then be deemed to have the same acquisition date and cost base as the transferor.
Now, the critical thing is disposals where there is non-zero consideration, either at market value or not, will not be eligible for rollover relief. That means if you are transferring property into a trust you mut gift it in. If there's any consideration received for the transfer you won't qualify for rollover relief. (That may also mean the bright-line test applies and a tax charge on transfer arises).
There's also a clarification here that rollover relief will apply where property is transferred between look through company or partnership and its owners so long as the property continues to be owned in the same proportion.
Now, all this is, as I said, is actually a pleasant surprise. It may be limited, but it does deal with an issue that had been of some concern previously. So it's welcome to see the matter being addressed.
Chapter 11 then looks at the question of what to do with interposed entities. This is a quite technical point as they're proposing new rules to ensure that taxpayers can't claim interest deductions for borrowings used to acquire residential property investment property indirectly through a company or other interposed entity.
As I said it’s quite technical and as part of it involves one of the new definitions we're going to see appearing in the Income Tax Act, what’s called the “affected assets percentage” as part of defining the terminology of a residential interposed entity. Basically, the idea is to stop people claiming a deduction for borrowing to buy shares in a company which then buys residential investment property. This is unsurprising, but just adds more complexity to the matter.
How does this fit with loss ring-fencing rules?
Chapter 12 deals with a particularly interesting issue which has cropped up about the implications for the rental loss ring-fencing rules. The chapter looks at the overlap between the ring-fencing rules and the proposed interest limitation rules. What it's saying is the interest limitation rules should apply first to determine whether interest is potentially deductible in income year and then the ring-fencing rules will apply on the balance.
Now, if you've been working in this space, you'll be aware that the loss ring-fencing rules can be applied on either a portfolio basis, that is across the entire portfolio, or on a property-by-property basis. Now, that's not such an easy fit when you consider that the rules about tracing the purpose of loans really work on a property-by-property basis. So that chapter confirms that that is the intention that the interest limitation rules must be applied on a property-by-property basis.
Finally, Chapter 13 looks at the question of property, subject to an existing set of interest and deduction restriction rules called the mixed asset rules. When we started talking about this in the External Reference Group, quite a few brains, including my own, went clunk because we really are into very great technical detail.
And then finally, Chapter 14 looks at compliance administration and how are we going to manage these? What information is going to be required by Inland Revenue in order to enforce these rules? Does Inland Revenue need more powers? The likelihood is that the amount of detail to be included in a tax return will increase. That seems inevitable.
So that's a brief overview of a highly complex position. I’m particularly concerned about how this is going to impact small investors with one or two properties. Unless they happen to be debt free, they face significantly increased compliance costs relative to the size of their portfolio.
It's not just taxpayers who face an increased risk. Tax agents and advisers face greater risks because there's so much more detail to get across. If we get the deductibility of an issue deductibility issue wrong, we could be liable. So one of the things that the Government's saying is we do want to try and minimise compliance as much as possible.
So, I would urge people to submit. In doing so I think you should focus on what making the proposals as workable as possible. So be constructive. I know a lot of people are very unhappy about these rules. The Government knows you're unhappy, I've discussed it with the Parliamentary Under-Secretary to the Minister of Revenue, Deborah Russell. The Government knows that people are unhappy about it but telling them that and railing against the proposals is just not going to make any difference.
So be constructive in your approach. Submissions have now opened, and they close on 12th July, because the whole thing has to come into force by 1st October. Now, we'll be tracking this and as I say, we're going to come back and pick up particular points of interest. And I'm very, very interested in hearing your feedback on this.
Well that’s it for today. Next week, barring any more tax bombshells, we’ll take a closer look at the G7 tax announcements and what the Climate Change Commission had to say about tax.
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.