Managing Partner Scott Mason reviews the recently released TWG interim report.
The Government-appointed Tax Working Group (TWG) released its interim report on Thursday 20th September, which sets out its initial views on the future of the tax system. Having received 6,700 submissions from the public and interested groups, plus a raft of papers from officials, the TWG had the unenviable task of producing a cohesive view as to the future of the New Zealand tax system. In many ways, their hands were tied behind their collective back given the structure of their imposed mandate, particularly the matters that it was not allowed to address, such as the taxation of the family home and increasing tax/GST rates.
It is our expectation that there will be many more hundreds of pages of material written about the 187-page report as specific professional bodies and targeted sectors come to grips with some of the loose recommendations, and seek to influence and refine the final product.
Crowe Horwath, as one of the leading advisers to medium business and high network individuals in New Zealand, will be actively involved in this process, as NZ seeks to create a tax system that is fair in a broad sense, and still provides sufficient Government revenue.
Our comments below are simply our initial thoughts as to how some of these recommendations may affect our clients across the SME, Agri and property sectors. We are also unsure as to the effect the letter sent by the Ministers of Finance and Revenue around fiscal neutrality will have on final recommendations – such could range from effectively funding the lowest tax bracket being tax free or to extra tax concessions to drive certain behaviours such as earthquake strengthening.
Small to Medium Business
If the proposals around taxing “capital gains” as income were firmed up and introduced as set-out in the TWG paper, small to medium business would seem to be the biggest losers, notwithstanding they are the mainstay of the New Zealand economy. For example, the creation of value over time in the form of goodwill is recommended to be dragged into the tax net, effectively to be taxed at the marginal rate of the ultimate owners, most likely 33%. In addition, any other assets within a business that appreciate in value, such as business premises, plant and machinery, intellectual property, and the likes, will also be pulled into the tax net for the first time. Any gains generated upon disposition would be subject to income tax. There would likely be a deduction of cost for assets that have a cost (often goodwill does not), and for those assets that are owned at the date of introduction of any new regime (likely to be 1 April 2021), such will be able to be valued as at that date to create a deemed cost.
The unfortunate outcome of the Government specifically excluding the family home is that there becomes an adherent bias towards those who invest in passive, non-income producing assets versus those who seek to get ahead and add value to the New Zealand economy by starting up a small business. By way of example, assume two people start with the same amount of capital, one investing in a small business and the other in a house, and that over a five-year period each of these increase in value by $300,000. Notwithstanding the business owner has taken on three staff, paid taxes on profits, and worked 60 hours per week for those five years, they would be taxed on the $300,000 gain, whereas the person who has merely owned a house in a growing market would pay no tax. Thus, at the highest marginal rate, the house owner walks away with just on 50% more upside than the small business owner. On balance, we are not sure how this encourages entrepreneurial enterprise.
The only other material impacts for small business seems to be the erosion of the corporate veil. There is a suggestion that directors and shareholders should be personally guaranteeing the tax obligations of their companies, which seems a significant stretch from the exposures they have at present. Currently, if economic circumstances are such that a business fails, the concept of limited liability should protect the shareholders and directors, unless there has been reckless trading or “bad” behaviour.
There are a couple of threshold changes suggested around deductibility, for example, legal fees, but ultimately it seems to be quite a negative package for small to medium businesses.
Agriculture / Farming
Although it was pleasing to see that a land tax was not recommended, the agricultural industry across all types of farming is likely to be negatively affected by the proposed new rules. Increases in the value of land would become taxable, the herd scheme effectively repealed so gains are also taxed and, as for other small businesses, a greater number of fish hooks around compliance and personal accountability, notwithstanding the legal structures. Of concern to the agricultural industry will be the nature and extent of any rollover relief, which is where sale transactions can be ignored for tax purposes so that the new owner takes on the old owner’s tax outcomes, essentially delaying the tax consequences. It is our fear that if there is not appropriate rollover relief for transactions between related parties, things like transferring the family farm to the next generation will become more problematic, and personal farm ownership undermined to the extent that corporate farming will continue its trend of taking over New Zealand.
Another concern is what happens in terms of those who start off with a small farm and continuously seek to trade up properties as they build their equity base. If there is no rollover relief for reinvestment of funds, then there is a significant leakage through tax on capital gains at each transaction, effectively nullifying a lot of the benefit of the trading up process. Again, this could accelerate the corporatisation of the productive sector.
We expect that farming bodies will be actively engaged in submitting on these points, as will Crowe Horwath.
It appears that the bright-line test is possibly going to be extended to be open-ended for all residential and commercial property that is not the main home. Our initial view is that, whilst the Government may see this as a positive in the context of cooling the housing market, the net result will be that rents will go up for two reasons. Firstly, those that decide to remain as landlords, will suddenly have to charge more rent to not just cover the lost capital gain through taxation upon ultimate disposition, but also the risks associated with being a landlord around healthy home compliance, tenancy risks as other rules evolve that penalise landlords, and a raft of other compliance matters being applied to that space. Secondly, we simply see more of our clients exiting that market entirely, as is happening right now.
It is also noted that the sale of holiday homes will be clearly within the tax net, with any gains arising from disposition being income. However, there is a suggestion that any losses be excluded because they are private assets. We think that this is particularly incongruous, and penalises middle New Zealand unfairly. Having said that, there is a lack of clarity about what rollover relief may exist for the transfer of holiday homes between generations.
There is also a suggestion that a risk-free rate of return tax regime could be applied to residential properties, that are not the main home, which in our mind could be the trojan horse of the entire paper. This is where every year the owners of properties are simply taxed based on a set rate, irrespective of what is happening in the marketplace and irrespective of the ability of the property owner to fund that tax cost. This is similar to the regime currently in place for foreign investments, in a conceptual sense.
What should we be considering pre-introduction?
Obviously, as interested parties and taxpayers, we want to be involved in influencing a system that is ultimately fair, practical, and efficient. Many suggestions in the TWG report are sensible and should be supported. There are also components where we have significant concerns about the way in which they unfairly target middleclass New Zealand, being the owners of most of small businesses and mid-level property.
Crowe Horwath does not recommend that our clients react too adversely to the draft report, but that we watch with interest to see what the final report says as it will drive the legislative process over 2019. It may well be that there are advantages in crystallising gains prior to any introduction, or to consider bringing forward succession plans. At the least, as we do get closer to any “valuation date”, there will be a significant amount of activity and compliance cost, to establish the baseline value of assets.
We are also concerned as to the timing of the effect of this in terms of the economic cycle. There is much commentary which suggests that most NZ assets are well priced currently, and it is possible that by 1 April 2021, we will have gone through an economic correction, in which case the baseline values could be significantly lower than they are today. This may drive certain behaviours and result in positive corrections to value becoming taxable.
In summary, we consider that the TWG has put together a comprehensive package of ideas, many of which are not new and have been covered by previous working groups. This provides the Labour-led Government and its coalition partners a menu of options to contemplate, seek feedback from the electorate, and then influence the final report due next February. We are sure that the Government will be looking to the reaction of the electorate as to where the balance of perceived fairness of these possible changes sits so it is important that we all take the opportunity to feed into that system where we believe particular proposals are either, on balance, fair, or unfair, and/or will have likely positive or negative consequences for the economy. We certainly hold the view that the tax system is about to become much more complicated and the compliance costs are likely to rise, both of which are undesirable outcomes.
If you have any queries in relation to the TWG report, or wish to be involved in any submission processes, please do not hesitate to contact your Crowe Horwath adviser.
Managing Partner – Tax Advisory