The Government is proposing several changes to the dividend and income attribution rules for close companies to address perceived opportunities to avoid the 39% personal tax rate.
Summary of the proposals
The proposals include:
- Treating any sale of shares in a company by the controlling shareholder as a taxable dividend to the shareholder to the extent that the company (and its subsidiaries) has undistributed (i.e., retained) earnings other than from capital gains. Imputation credits, if available, could be used to offset tax payable on the dividend amount. This is called the “sale of shares” rule.
- Requiring companies to maintain a record of their available subscribed capital (“ASC”) and net capital gains, so that these amounts can be more easily and accurately calculated at the time of a share cancellation or liquidation.
- Removing the “80 percent one buyer” test for application of the personal services attribution rule for shareholder employees. (The personal services attribution rule requires the company’s income to be attributed and taxed at the shareholder employee’s marginal tax rate, which may be higher than 28%).
It is worth noting that this is not the full extent of the potential 39% tax rate “integrity measures” being considered. The Government notes that it will also be looking at trusts and retention of company profits more generally, as well as potentially PIE tax rates, in future. In relation to trusts, the new trust disclosure requirements (which apply from the 2021-22 year) is likely to inform potential reform options.
In a bit more detail…
The “sale of shares” rule is aimed at situations where share sale proceeds compensate for undistributed retained earnings which, if paid out as a dividend instead, would be taxable at higher marginal tax rates of the selling shareholder (e.g., 33% or 39%). It is worth highlighting that Inland Revenue has raised tax avoidance concerns around “dividend stripping” generally (including prior to the introduction of the 39% tax rate). The Government considers that a recharacterisation rule, to deem a dividend to arise on sale, would be more effective than relying on the general anti-avoidance rule.
The "sale of shares" rule is aimed at closely-held (i.e., privately owned) New Zealand companies, where there is a share sale by the controlling (e.g., the majority) shareholder. The affected transactions are potentially quite wide – it will capture sale of the shares to related companies, unrelated companies or to an unrelated individual. For corporate groups, sales of subsidiaries and other majority owned group companies may also give rise to a deemed dividend for the ultimate controlling shareholder. Complex rules are proposed for working out the deemed dividend amount as well as corresponding adjustments to imputation credit accounts and ASC.
The second proposal will require companies to track their ASC and capital gain amounts and either report this to Inland Revenue annually (similar to imputation credit accounts) or to retain this information in case it is requested in future (with Inland Revenue able to determine these amounts, in the absence of reliable evidence).
The third proposal is aimed at strengthening the current personal services attribution rule. This currently applies if 80% or more of a company’s income is from provision of personal services by an individual related to the company (such as a shareholder employee) to a single customer or buyer. The core proposal is to remove this single customer/buyer requirement for the personal services attribution rules to apply.
Our quick take
The proposals are significant but not entirely unexpected. The Government (and Officials) hinted last year that there would be more to come to buttress the 39% tax rate change.
The proposed sale of shares rule will potentially have wide impact for private companies and their controlling shareholders. It reflects concern about potential for abuse of the top personal and company tax rate misalignment (up from five to 11 cents in the dollar). However, it is not clear whether a deemed dividend rule this wide is needed. As noted earlier, Inland Revenue can already challenge transactions under the general anti-avoidance rule and has signalled it will do so if they believe there is a dividend stripping risk. Inevitably, if this proposal proceeds, there will be greater complexity and some inaccuracy. For example, the deemed dividend amount will be the higher of accounting retained earnings (adjusted for capital gains and imputation credits) and a gross up of imputation balances at the company rate. The latter can be a very poor proxy for taxable income (e.g., if provisional tax has been overpaid).
The practical effect of this rule will be to tax some proceeds from New Zealand share sales when they would not ordinarily be taxed. It is worth reflecting the Government considered but ultimately decided not to proceed with a general capital gains tax (“CGT”). The sale of shares rule can be viewed as a further backstop for not having a CGT.
Lack of up-to-date ASC and capital gain information can be an issue on company liquidations, in particular. Formalising the need to at least track this information is a useful step. The challenge will be in transitioning to this new approach, particularly for long-lived companies, where historical information may not be readily available.
The personal services attribution rule was originally designed to stop recharacterisation of what is essentially employment income (that would be taxed at higher personal marginal rates) to contracting income (taxed at the company tax rate), by interposing a company. That rule has since been buttressed (and some might say potentially superseded) by case law, most notably the decision in Penny & Hooper which effectively requires key persons involved in a personal services business to derive a market salary. Therefore, any change is likely to have narrower effect than would be the case in the absence of Penny & Hooper.
The Government discussion document provides a six-week time frame for feedback and is one of four consultation documents released in March (which also featured the report back of the September 2021 Tax Bill). There is a real risk that attention will necessarily be focussed elsewhere, as most taxpayers and their advisers will be finalising tax returns (due 31 March), not to mention managing though Omicron. For what clearly will be a series of significant changes to the company and dividend tax rules, further time to provide feedback on these (and the other March) proposals would have been highly desirable.