The proposed changes to the associated persons rules in the Income Tax Act (the Act) could have far reaching and unforeseen consequences for those involved in the property sector. The changes shift the boundary between what should be legitimate non-taxable capital gains and taxable income.
The Act currently has numerous definitions of associated persons to be applied in different circumstances. The IRD has long argued that the associated persons test to be applied to property transactions is too easily avoidable and accordingly a threat to the tax base. The new definitions are far wider and could result in a person being taxed on gains in the value of property due to an unknown or unforeseen association with another person.
Generally there is no capital gains tax in New Zealand but in some circumstances defined in the Act capital gains are deemed to be income. Examples of such circumstances are: -
Gains on the sale of property acquired for the purpose of disposal;
Gains on the disposal of property acquired by a person for the purpose of dealing, subdividing, developing, or building on land; or
A property has increased in value due to rezoning or a resource consent.
A person can also be taxed for gains made on the disposal of property even if not acquired in the circumstances provided for in the Act, if associated with someone involved in the defined circumstances.
The existing associated persons tests include the following; -
Two companies with 50% or more common shareholding or control;
A company and a person (or spouse, infant child of the person or trust where the child or spouse benefits) which has at least 25% voting interest or control of the company;
A partnership and any of its partners and any person associated with a partner; or
Any person and spouse, infant child or trust for spouse or infant child.
It is common knowledge that it is relatively straightforward to break the association by correct structuring of ownership. Under the above rules it is difficult to associate two trusts even though both trusts may be associated with the same person such as the Settlor. This means a person involved in developments can legitimately also hold (through a separate trust) investment property that won’t be subject to tax on gains on disposal.
It is proposed to broaden the associated person rules to include the following: -
Two companies with 50% or more common shareholding or control – largely unchanged;
A company and a person (or spouse, infant child of the person or trust where the child or spouse benefits) which has at least 25% voting interest or control of the company – largely unchanged;
Relatives – marriage, de facto and infant children;
Different trusts settled by a common settlor;
A settlor of a trust with the trustees of a trust. A settlor is very widely defined for the purpose of the Act;
A trustee and a person with the power of appointment and removal of trustees;
Partners in partnership (Partners in limited partnerships will not be associated unless they have 25% or greater interest); or
Tripartite Test –If A is associated with B and B is associated with C then A and C are associated.
The association of two trusts with a common Settlor alone will make it extremely difficult for a builder, dealer or developer to disassociate investment properties from development or trading properties. This means that such a person will have to pay tax on the gains of all property disposals within 10 years of acquisition regardless of the purpose they were acquired for (there is an exception for the family home). This effectively discriminates against builders, dealers and developers as they cannot enjoy the tax free status on the gains on the disposal of investment properties that the rest of the population enjoys.
Of even more concern is the Tripartite Test. Put simply, if A is associated with B and B is associated with C under the above association tests then A and C are associated. In other words A and C may know nothing or very little about each other but may be associated creating unforeseen tax liabilities on a person who had no intention of being involved in building, dealing or developing.
If the associated persons rule changes are enacted in their current form, the boundary between tax free capital gains and taxable income will be further eroded, in many cases in unforeseen and unintended ways whereby what should be legitimate capital gains will be deemed taxable income.
To finish on some positive notes. There are limits to the Tripartite Test, for example it does not apply to the company association tests or the association of relatives. Dispositions are generally only caught for tax purposes if disposed of within 10 years of acquisition and existing structures or re structuring now under the current rules will remain effective after the new rules come into effect.
It was originally proposed that the new rules come in to effect on 1 April 2009. It was thought the Bill proposing the new rules would have been enacted by then. With the change in Government the Bill has been delayed and is unlikely to be passed prior to June this year. The current Minister of Revenue has recommended that the aspects of the Bill relating to land transactions come into force at the time the Bill is enacted meaning there is still time to rearrange your affairs prior to that date.