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Loss limitation rules - the sow's ear

Legislation governing the transition from an LAQC to an LTC is problematic.

 

The loss limitation rules in the Look Through Company (LTC) regime are one of those things that NZICA members are trying to get their heads around, before advising their clients on LTC elections.

But the combination of big broad policy statements, the desire of accountants to do the best that they can for their clients, and cryptic drafting doesn’t make this an easy task. 

We have identified some of the difficulties and pitfalls that you may need to be aware of. (For a detailed Q&A see: Example of Loss QC-LTC transition from Qualifying Companies Course).

The purpose of these rules is: “to ensure that owners can offset tax losses only to the extent that these reflect their economic losses.”1 

This idea is variously couched in Inland Revenue’s Tax Information Bulletin as: “New section HB 11 ensures that owners’ deductions are restricted if the amount of their deductions exceeds the adjusted tax book value of their investment in the LTC (the ‘owner’s basis’). This is an anti-avoidance provision and will generally only apply if a company’s tax losses are not matched by the owner’s contributions.”

As John Hart notes2, the starting point for the IR was that an LTC should be taxed as if it were a limited partnership – however, the tricky part is that it is not an exact replication. This means that any interpretation or analysis applicable to limited partnerships needs to be taken very carefully if applied to an LTC, as the two vehicles are not treated identically. So the utility to be obtained from referring to the limited partnership rules is greatly diminished.

THE INITIAL BASIS

When a taxpayer first seeks to transition from a qualifying company (QC) to an LTC, their initial basis is determined under section HZ 4C(2) by using one of the following three options3.

 

  • The market value in the year before the transitional year of the amounts in section HB 11(3).
  • The accounting book value in the year before the transitional year of the amounts in section HB 11(3).
  • The amount determined by applying section HB 11(3) as if the company had always been an LTC.

Section HB 11(3) brings in the formula “investments – distributions + income – deductions – disallowed amounts”. Each of those terms is then further defined, for example “investments” is defined in section HB 11(5) as the total of:

 

  • the market value of a person’s shares in the LTC at the time that the person purchases or subscribes for them
  • amounts that the LTC is debtor for in relation to the person, including a loan to the LTC and a credit balance in a current account
  • the secured amounts, if not accounted for under the debt provision above.

So if you were to apply the legislation literally to determine the “initial basis” for a QC that transitions to an LTC, the options under section HZ 4C for (say) the first element of “investment” in section HB 11(5) would include:

 

  • the market value of a person’s shares in the LTC in the year before the transitional year at the time that the person purchases or subscribes for them
  • the accounting book value of the market value of a person’s shares in the LTC in the year before the transitional year at the time that the person purchases or subscribes for them
  • the amount determined by applying the market value of a person’s shares in the LTC at the time the person purchases or subscribes for shares as if the company had always been an LTC.

There are one or two problems with these outcomes (apart from the fact that these rules don’t make sense).

 

  • In the year before the transitional year, the company was not an LTC, it was a QC, so the answer for the first two options must be nil.
  • The valuation methods to be applied in the first two options are a mystery (ie the market value of the market value or the accounting book value of the market value).
  • There are two alternative times at which the valuation test is to be applied in the first two options – is it in the year before the transitional year or at the time the person purchased or subscribed for the shares? 
  • Of the three options, for this particular element, only one of three options gives any outcome at all. 
  • What do you do with the first two options that don’t make sense? Do you apply the principle that the specific overrules the general – ie the transitional elements (ie section HZ 4C) should override the general (section HB 11) where they conflict, because the specific was designed to deal with this situation? Or do you take the view that because section HZ 4C summons the application of the “amounts described in section HB 11(3)” that automatically brings into play subsections HB 11(5) –(9) as mandated by section HB 11(4)?
  • Perhaps (as a long shot) we could look to the transitional rules in section HZ 3(3) for the change from special partnerships to limited partnerships for inspiration – whoops no, those are applied a year later (ie in the transitional year itself) so there is a different statutory context.
  • It is all very well for IR to chant its mantra that you look at the intention of the legislation – but in these circumstances, what was the legislation trying to do? If we are considering the market value or the adjusted tax book value options – would you include any increase in the value of an asset (say for example the increased value of a house in the case of a rental property) in the share value? Or do you look at the other IR statements that say you only take into account the shareholder’s contributions? In the case of the former, this can still be justified on the basis that the shareholder has the market value of the property at risk – so there is an economic risk to the owner.

So what are the likely outcomes, aside from:

 

  • cursing the policy officials involved
  • a curse at the government for passing this as a supplementary order paper, rather than using the generic tax policy process, which sometimes cures these snafus
  • smugness that it is such a bugger’s muddle that just about any figure could be justified
  • a wry smile that the transitional periods will be over before IR form a view on the legal interpretation of the transitional provisions
  • waiting for the traditional game of “IR volleyball”, where the various silos within the department decide whether this is an operational issue, an interpretation issue or a remedial matter, before the perennial remedial amendment appears to fix this up
  • an intra-office sweepstake on whether this will be a retrospective amendment on the basis that “everyone knew what Parliament intended” or at least the policy officials would have known what Parliament had intended – if someone had asked them the question.

The most likely outcome is that you are able to claim the increase in value of a rental property since its original purchase. I prepared a worked example for NZICA’s course on Qualifying Companies run by Frank Owen (Nov-Dec 2010). This was an example we prepared and then ran past officials before the course was held. We have put that example on the NZICA website (nzica.com) at “Technical & Business” then “Tax” then “Articles and Media” where it is labelled as “Example of Loss QC-LTC transition from Qualifying Companies course”.

So what happens after the first year?

The formula in section HZ 4C is used to determine the owners’ initial basis for the first (or transitional) year. This is obtained by applying either the market value or the accounting book value as at the end of the income year before the transitional year or by applying section HB 11(3) as if the qualifying company had always been an LTC.

What happens in the second year when the LTC owner needs to calculate their loss limitation? More particularly, can an LTC owner use the value that they obtained under the section HZ 4C formula which referred to the “market value or accounting book value… as at the end of the income year before transitional year” or are they bound by the wording of (say) section HB 11(5)(a) which refers to the “market value of person’s shares… at the time that the person purchases or subscribes for them”. 

This is another drafting snafu as the time that the person purchased or subscribed for the shares, may have been when they first acquired the shares in the qualifying company. The shares at that stage may have only been worth a nominal amount, and would not necessarily reflect the economic risk of the LTC owner, ie before any assets were purchased by the QC. 

A further letter from policy officials reveals that they intend that for QCs changing to LTCs, the “transitional year” becomes the “base year” from which “all relevant items in section HB 11 are then calculated”.

So therefore, the words in section HB 11(5)(a) “the market value of a person’s shares in the LTC at the time that the person purchases or subscribes for them” are to be read as reference to the market value of shares a person holds in a QC at the end of the year before it transitions to an LTC.

SECURED AMOUNTS

Another area that has caused much grinding of the molars is definition of “secured amounts” contained in section HB 11(12). 

To give this a context, the “secured amount” forms part of the “investments” under section HB 11(5) and is broadly the amount of the LTC’s debt that a shareholder guarantees. 

The first point to note is that something only becomes included as a “secured amount”, when it is not already counted as a debt that is owed to a shareholder under section HB 11(5)(b). 

The definition of “secured amount” then provides:

 

  • “secured amounts means, for the person, the lesser of—
  • (a) the amount of the look-through company’s debt ignoring section HB 1 (the debt) that the person or an associated person secures by a guarantee or indemnity:
  • (b) the amount that results from dividing the amount described in paragraph (a) by the number of persons who secure by guarantee or indemnity on similar terms to the 1 described in paragraph (a), excluding the look-through company:
  • (c) the amount that is the market value of property against which the guarantee or indemnity described in paragraph (a) may be enforced, treating the person’s owner’s interests as having a market value of zero:
  • (d) the proportion of the amount described in paragraph (c) that is attributable to the person in the case of a number of persons securing the debt by guarantee or indemnity on similar terms to the 1 described in paragraph (a), excluding the look-through company.”

So in essence, the “secured amount” for the purposes of this definition, is the lowest of those four options, (unless it was already counted as a debt to the shareholder under section HB 11(5)(b)). 

How do these four options apply? To decide that, you first need to decipher what they mean – which again is not an easy task. 

PARAGRAPH (a)

It is suggested that this paragraph applies to the amount of the LTC’s debt which an individual LTC shareholder or a person associated with that shareholder secures by guarantee or indemnity. 

This is done on the basis that for paragraph (a), section HB 1 is ignored, which for these purposes, (it is suggested) means that the pro-rating or dividing by the individual look-through owner’s effective look-through interest is not used. So (as an example) where an individual shareholder (and any associates) have taken on liability for a debt of the LTC, which is secured by guarantee or indemnity, under this paragraph, the full amount of the LTC debt that is covered, is taken into account. 

This analysis is, in part, drawn from analysing the other paragraphs in this definition and seeking to make sense of the definition as a whole (rather than by the plain words of the provision). 

PARAGRAPH (b)

The purpose of the second paragraph seems clear, in that it involves prorating the guarantee or indemnity between the shareholders and the associated persons, who have provided the guarantee or indemnity. However, the prorating doesn’t include a guarantee provided by the LTC itself. Where this paragraph is not clear, is that it states that it is to be prorated between “persons who secure by guarantee or indemnity on similar terms to the 1 described in paragraph (a)”. There are at least three questions that arise out of this.

 

  1. What is meant by “similar terms” – does it mean that it covers the same risk, or does it refer to the quality of security provided?
  2. If they are not on similar terms, does that mean that you don’t include those persons as part of the denominator (the number you use to divide) when you prorate the guarantee or indemnity?
  3. If you have different degrees of security offered by the various parties, which of those parties are ignored for the purpose of this paragraph?

Running with that analysis a little further, the denominator is the number of persons who secure by guarantee or indemnity “on similar terms to the 1 described in paragraph (a)”. There is an inherent assumption in the wording of paragraph (b) that there is only “1” guarantee or indemnity described in paragraph (a). But under paragraph (a) the secured amount that we are required to take into account is the amount that the person or an associated person secures by a guarantee or indemnity. 

This raises the spectre that “the amount” in paragraph (a) could be made up of more than one guarantee or indemnity because “the person” could provide a number of guarantees or indemnities, and an associate(s) could offer additional guarantees or indemnities. So the reference to “a guarantee or indemnity on similar terms to the 1 in paragraph (a)” may be a reference to more than one guarantee or indemnity.

Paragraph (b) provides that the numerator (the total we divide into) that is to be prorated is “…the amount described in paragraph (a)…”. Therefore, the numerator includes the total of all amounts of the LTC’s debt that the person or an associate secures by a guarantee or indemnity. 

So what was paragraph (b) envisioning? The “secured amount” term is seeking to determine (broadly) the amount of the LTC’s debt that a shareholder guarantees. So this term is seeking to measure the economic exposure of the particular shareholder arising from the risk of guaranteeing or indemnifying the debt of the LTC. A possible suggested explanation of the reasoning behind paragraph (b) is that paragraph (a) is a seeking to measure the total exposure of the LTC shareholder and any associates:

 

  • whereas paragraph (b) is prorating that risk
  • that risk is prorated by the number of people who carry that risk
  • the number of people who that risk is prorated between, could include non-associated people (because paragraph (b) does not require association with the shareholder)
  • However, for the risk to be divided by the number of people in paragraph (b), it has to be the same type of risk that was assessed in paragraph (a).
  • The secured amount that an individual LTC shareholder can claim is limited to the amount that the individual shareholder guaranteed (ie the averaged amount), even though the amounts guaranteed by an associate are “pooled” under paragraph (a). 

We have looked to the limited partnership rules for assistance, but they are of little use in these circumstances, as:

Although both partners and associates were brought into the equivalent paragraph (a), paragraph (b) was limited to “partners”. So associates of partners are not included in the denominator when the debt is prorated.

The form of liability under the limited partnership rules is specified to be “joint and severally liable for the debt”.

PARAGRAPH (c)

This includes the market value of the property which is offered as security or indemnity against which the debt is secured. This paragraph excludes the value of the owner’s interests as having a market value of zero – it is suggested that this expression was included to prevent the possibility of double counting, if those interests (say) included the value of the shares (which is already included under section HB 11(5)(a)).

Another interesting issue that has emerged from discussions with the Policy Advice Division, is their interpretation of meaning of the expression “the amount that is the market value of the property against which the guarantee or indemnity described in paragraph (a) may be enforced”. 

What would that expression mean to the average person? Most of us would mutter something like: “The estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s-length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently, and without compulsion.” 

However, IR’s policy officials take a balance sheet view to this expression, and treat this as meaning something closer to the “net realisable value of the property”. That is, they take the view that you take the market value of the property, less any amounts that would be due under (say) a mortgage to a third party.

A further question about the meaning of paragraph (c) could be raised if you consider that paragraph (b) will only apply when the particular LTC shareholder concerned holds a relevant guarantee or indemnity (which is supported by the opening words of the definition of “secured amounts”) and that paragraph (b) would apply to a guarantee or indemnity offered by the shareholder and associates at the same level. Do you take paragraph (c) as applying where someone (say an associate) has offered a higher level of security (ie a secured interest in property against which the guarantee or indemnity can operate)? Or do you go back to the opening words of the definition which state “for the person” – which must mean the particular LTC shareholder whose limitation is being determined?

PARAGRAPH (d)

This paragraph attributes the proportion of the market value of any property in paragraph (c) that is used as security or indemnity to the particular LTC shareholder under consideration, where there are a number of people securing the debt by guarantee or indemnity. This guarantee or indemnity must be on similar terms to the one in paragraph (a) – but the people that are counted (ie the denominator) excludes the LTC itself. 

This paragraph is better targeted, in that the amount is the proportion of the property in paragraph (c) that is attributable to the person. However, the amount in paragraph (d) is not averaged with any guarantees or indemnities provided by an associate, as occurs in relation to paragraph (b). Despite this, a similar set of issues arise under paragraph (d) as occurred under paragraph (b):

 

  • What is meant by “similar terms” – does it mean that it covers the same risk, or does it refer to the quality of security provided?
  • If they are not on similar terms, does that mean that you don’t include those persons as part of the divisor when you prorate the guarantee or indemnity?
  • If you have different degrees of security offered by the various parties, which of those parties are ignored for the purpose of this paragraph?

LEGISLATIVE DESIGN OF “SECURED AMOUNTS” PROVISION

Aside from the issues above, that are specific to those particular paragraphs, a more general set of issues arise which involve the legislative architecture or the thinking involved in the design of the “secured amounts” definition. 

There are four matters giving rise to concern – all of which are interrelated:

At a more mundane level – the “secured amount” which a LTC shareholder has, is the lowest of the amounts determined under any of the four paragraphs. So at a very simple level, what happens if a particular paragraph does not apply to an LTC shareholder? Is that treated as a “not applicable” (n/a) or a “zero” when it comes to determining which is the paragraph with the lowest figure under this test? 

For the legislation to function, it must be possible for individual paragraphs not to operate in some instances. For example, paragraphs (b) and (d) only apply where there are multiple parties. In a situation where there is only one LTC shareholder who has provided a guarantee or indemnity, then paragraphs (b) and (d) would have no application – so it must be possible to register an “n/a” for paragraphs (b) & (d). 

However, what occurs when a shareholder has given a personal covenant on the debt of the LTC, but has not tied it back to particular assets? Is the figure in paragraph (c) treated as a “zero” or is it a “n/a”? As a matter of logic, you would say this should also be classified as an n/a – on the basis that if a zero is recorded, then paragraphs (a) and (b) are rendered nugatory. 

At a policy level, does the application of this test give a correct reflection of the amount of exposure that an LTC shareholder carries in respect of the debt of the LTC? In many instances, the lowest figure may not be commensurate with the likely exposure of an LTC shareholder in the event of default by an LTC on its debt obligations – it is a matter of chance. For example, a husband and wife LTC is owned 1% by the husband and 99% by the wife. Both have guaranteed a loan to the LTC. The husband has put up a personal guarantee to repay the $100,000 of the debt, and the wife has given a $1,000,000 mortgage over some real estate which is her separate property under a prenuptial agreement. The amount owed by the LTC is $1,000,000. 

Under the secured amount definition, the likely outcome for the wife would be as follows:

 

  • Paragraph (a) 1,000,000 (assuming the LTC’s debt was $1,000,000)
  • Paragraph (b) $500,0004
  • Paragraph (c) $1,000,000
  • Paragraph (d) N/A.

From a policy perspective, the wife in this case should have a secured amount $1,000,000, (or at the very least $900,000) as she is the person that most creditors of the LTC would be likely to pursue in the event of a default by the LTC. However, her “secured amount” is averaged down due to the design of the secured amount provision.

The third issue is that, at a purely mechanical level, what is the interrelationship between the figure derived under the “secured amount” definition and the figure that is recorded for the purposes of subsections HB 11(3) and (5)? Under section HB 11(5) the first two elements of the definition of “investments” are personalised to the particular LTC shareholder. However, section HB 11(5)(c) rather baldly states “the secured amounts, if not accounted for under paragraph (b)”. Using the figures from the example, in the previous bullet point, we will assume that the wife records $500,000 (which is the figure derived from the “secured amounts” definition). What would her husband record? 

Based on the worked examples we have seen, which were reviewed by IR, the answer would be:

 

  • Paragraph (a) $1,000,000 (assuming the LTC’s debt was $1,000,000)
  • Paragraph (b) $500,000
  • Paragraph (c) N/A
  • Paragraph (d) N/A.

The legislative outcome would seem to be that the “secured amounts” figure in section HB 11 (5) is determined by a mechanical application of the definition in section HB 11(12). It is “personalised” for an individual LTC shareholder in that the opening words of the “secured amounts” definition are “means, for the person, the lesser of –”. The mechanics of paragraph (a) are that an individual LTC shareholder has their risk aggregated with their associates and paragraph (b) turns this into an average. The average may overstate or understate a particular LTC shareholder’s risk. 

Policy officials have commented that an owner’s shareholding level in an LTC will not necessarily affect their liability under a separate guarantee, so from that perspective (they would argue) the individual shareholders ownership level is not relevant to applying the “secured amounts” definition. We agree that the level of security provided by individual LTC shareholders, does not necessarily mirror their percentage of shareholding in the LTC. However, the current outcome would not seem to be in accord with the underlying policy, which is that a shareholder should record the amount of exposure that the particular LTC shareholder carries in respect of the debt of the LTC. 

The fourth issue is really the incorporation and the relevance of the debt guaranteed by associated persons, to the level of risk ascribed to a particular LTC shareholder. 

As noted in the previous bullet point, the mechanics of paragraph (a) are that an individual LTC shareholder has their risk aggregated with their associates and paragraph (b) turns this into an average. Paragraph (c) is also aggregating the secured risk of an individual shareholder with that of their associates, as it is taking guarantees or indemnities in paragraph (a) that have property secured against them. So therefore, paragraph (c) could represent interests which are only held by an associate. However, paragraph (d) only applies when there is more than one person with property secured against their guarantees, and then the part that is brought in as the amount under that paragraph, is the proportion of the amount in paragraph (c) that is attributable to the particular LTC shareholder. There are really three questions that come from this:

 

  • Why is the debt guaranteed by an associate relevant to the risk assumed by an individual LTC shareholder? That is, the risk is brought in under paragraph (a) and averaged out under paragraph (b).
  • If an associate’s debt is relevant and is to be averaged under paragraph (b), why is it not averaged for secured debt under paragraph (d)?
  • What happens when the LTC shareholder does not have a guarantee that is secured against property and an associate has a smaller amount that qualifies under paragraph (c)? 

Further:

 

  • What happens if paragraph (c) is the lowest figure (should an n/a be registered)? That is, can the lowest figure for the “secured amount” be an associate’s figure?
  • How could something which is averaged out under paragraph (b) become the deciding factor under paragraph (c)?

WORKED EXAMPLE

This is a worked example that IR sent to a member, which deals with quite a common set of facts. 

A husband and wife (“the H&W”) own an LTC which owes $500,000 to a bank. The residential home in which the H&W live is held in a family trust. The family trust gives a mortgage over the family home, to guarantee the debt for the LTC. The H&W have also provided personal unsecured guarantees. The market value of the residential home is $750,000. See table 1.

Overall, the IR came to the conclusion that the secured amount was $166,667 – but that is subject to the guarantee or indemnities being “on similar terms”. 

 

Table 1

SUMMARY

We feel sorry for our members who have had to deal with this legislation, as it is difficult and obtuse. The only way we have been able to obtain confidence in the intended outcomes is to have discussions with policy officials, which is a very unsatisfactory outcome given that New Zealand nominally adopts a self-assessment system. Not all our members are able to ring policy advice officials and I doubt whether the Policy Advice Division would be in a position to handle all those calls. 

The standard of the legislative drafting is poor, and the relevant Tax Information Bulletin doesn’t effectively deal with an existing QC transitioning to an LTC. We consider that the type of issues we have raised are relatively common and could have been foreseen, if officials had some practical experience in tax.

We appreciate the fact that policy officials are prepared to discuss these issues with us, but that is no substitute for either appropriate legislation or Tax Information Bulletins, especially if the decisions we have made now are reviewed on audit in two or three years time. 

There are still a number of outstanding issues, which we are raising with IR and we will update you when we get further answers.

 

1 Refer Tax Information Bulletin Vol 23 No. 1 page 53.

2 Refer NZLS Seminar – Cradle to Grave- The Interface between Property and Family Law March 2011, “Implications of the LAQC Restructure – the New LTC Regime” John Hart at paragraphs 47 – 49.

3 Refer section HB 11(11) which states that section HZ 4C modifies HB 11.

4 Note this depends on how you analyse whether the guarantees are on “similar terms”.

September 2011 - Aylton Jamieson CA is NZICA's Tax Counsel.