Chapter 2 – Tax Planning
2.1 - OVERVIEW
(ITA Schedule 1 Part A)
“Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible... for nobody owes any public duty to pay more than the law demands.”
Judge Learned Hand (US -1935)
This applies equally in New Zealand where tax planning is part of the wider topic of financial planning which in turn should be considered in the context of life goals for individuals and organisational goals for incorporated bodies. You may find a more tax-efficient place to live, for example, but do you really want to move?
Tax rates have come down in the past several years, but rates still vary for different taxpayers such as individuals, companies and trusts. There are also special rules that apply to certain taxpayers and not to others. While this is so, opportunities will exist to structure your affairs to benefit from the different rules and tax rates.
Current rates are summarised below.
2.1 - OVERVIEW
2.1.1 - Tax Rates for Individuals
2.1.2 - Partnerships and Look Through Companies (LTCs)
2.1.3 - Companies other than LTCs
2.1.4 - Trusts
2.2.1 - Anti-avoidance Provisions
2.2.2 - Tax Planning Techniques
2.3.1 - Business Structure
2.3.2 - Get the Order Right
2.3.3 - Income Splitting
2.3.4 - Reducing Income
2.3.5 - Utilising Allowable Deductions
2.3.6 - Deferring Income or Tax
2.3.7 - BEPS
2.1.1 - Tax Rates for Individuals
(ITA Schedule 1 Part A 1)
The current income tax rates for individuals are as follows:
2.1.2 - Partnerships and Look Through Companies (LTCs)
(ITA s HG2, HB1)
Partnerships and LTCs are not taxed as separate entities. Instead, income flows through the partnership or LTC into the hands of the individual partners or LTC shareholders where it is taxed at the above individual rates (See Chapters 12 and 13).
2.1.3 - Companies other than LTCs
(ITA Schedule 1 Part A 2, 6a)
Companies other than LTCs are taxed at a flat rate of 28%. This also applies to unit trusts that are taxed as companies.
Sole traders, partnerships and trading trusts may consider restructuring into companies depending on profitability and the level of income that is retained in the business. Profits will be taxed at 28% rather than the higher trust or top marginal rates.
2.1.4 - Trusts
(ITA Schedule 1 Part A 3, 4)
There are three tax classifications of trusts (complying trusts, foreign trusts, non-complying trusts) with different tax rates and treatments applying to each. (See 13.2.2.4).
Complying Trusts
Most New Zealand trusts are complying trusts and are taxed at a flat rate of 33% on income retained in the trust. Trust income that is distributed to beneficiaries during the income year in which it was earned,or thereafter in terms of ITA s 6H, will be taxed in the hands of the beneficiaries at their marginal tax rates. Minors under the age of 16 are taxed at 33% on their distributions (See 13.2.3.1).
Foreign Trusts
These are taxed on New Zealand sourced income at 33%. Taxable distributions are taxed in the hands of NZ beneficiaries at their marginal rates subject to the minor rule (above).
Non-complying Trusts
Distributions from non-qualifying trusts are taxed at 45%.
2.2 - APPLICATION
2.2.1 - Anti-avoidance Provisions
(ITA s BG1, GA1 & YA1 - Defs: tax avoidance and tax avoidance arrangement)
Tax planning must always be considered in the light of the anti-avoidance provisions of the Income Tax Act. An arrangement may be set aside as void if it has as any one of its purposes to directly or indirectly:
Alter the incidence of any income tax;
Relieve any person from liability to pay income tax; or
Avoid, reduce or postpone any liability to income tax.
The effect is to reconstruct the arrangement so as to eliminate any tax advantage that may have arisen. Severe penalties may also apply in the case of an unacceptable or abusive tax position being taken (See Chapter 24).
The provisions are wide and likely to catch and set aside sham transactions and schemes that avoid tax and make no real sense otherwise. The Courts have helped to establish principles to determine whether an arrangement is likely to be set aside or not.
For the most part, when one enters into a legally binding arms-length arrangement, the Courts will uphold the effect no matter what the tax or economic consequences. The Courts tend to weigh up the purpose of avoiding tax against other purposes by reference to ordinary business or family dealing and they look at the way in which the transaction was carried out. There must be more than a “merely incidental” purpose or effect of tax avoidance for the provisions to be invoked.
Furthermore, an arrangement will not be set aside if it avoided tax using legislation that was designed to give the option of reducing tax in that way. (Supreme Court in Ben Nevis).
Throughout this book, we discuss options in the legislation and case law that provide opportunities to meet your tax liability without paying any more than you have to.
New Zealand is bound by the international Convention on Mutual Administrative Assistance in Tax Matters. This provides administrative co-operation between tax authorities in the assessment and collection of taxes. The IRD’s powers to discover evasion and pursue tax debt overseas has been greatly strengthened. This applies, for example, to collecting outstanding tax debts from taxpayers who have moved overseas.
2.2.2 - Tax Planning Techniques
The following techniques can be used to reduce the amount of tax paid:
Structure your business activities most effectively
Order your transactions correctly
Income splitting
.Reduction of income
.Utilising allowable deductions
.Deferral of income or tax payments
The concepts with examples are introduced in this chapter. This will help focus on opportunities as tax rules are discussed throughout this book.
2.3 - Practical Hints
2.3.1 - Business Structure
Owners are free to choose the most suitable legal structure for their business. Here is a simple example to show how structure can affect the level of tax payable.
Example
Joe Temp is a freelance bookkeeper who takes on assignments to help businesses with accounting problems. These typically range from 3 to 6 months. He has the option to join the businesses as a temporary employee for the period or to register for GST and invoice clients, charging on a hourly basis. As an employee, benefits include paid annual and public holidays but the opportunities to reduce tax are limited to income-protection insurance and the cost of someone to prepare his tax return (which he is likely to do himself anyway).
As a GST-registered contractor he could have any number of legitimate business expenses that are tax deductible. If he often works from a home office, he could deduct a portion of his mortgage repayments, depreciation on his equipment and furniture, business vehicle expenses and so on. This could make a huge difference to his take-home pay. Furthermore, GST is deductible on work-related expenses and there could be cash flow benefits from GST, especially if he files returns every 6 months (See Chapters 17 and 20). We look at the question of employee vs contractor in more detail in Section 26.2.2.
In Chapter 11 we consider the question of choosing the right structure for your business. One of the factors to consider is the tax consequence. Different rules apply to different entities as will become apparent throughout this book. Different tax rates apply too as we have shown above.
2.3.2 - Get the Order Right
Sometimes the way in which you go about business can affect the tax implications. In particular, it is important to carry out transactions in the right order otherwise it is possible to lose out on significant benefits. Consider the following example:
Example
Ona Rolle owns a home worth $700,000 with a mortgage of $200,000. She also owns a business and has saved up $100,000 to invest. She purchases a city apartment for $300,000 as an investment, with $100,000 deposit and borrowings of $200,000 Smart move? Not really. She now has total borrowings of $400,000 but only the interest on $200,000 is tax deductible.
Instead, she should have used the $100,000 savings to reduce her home mortgage which is not tax deductible. She should then have borrowed $300,000 to purchase the new apartment using her new apartment and spare equity in her home as security. While her new total debt would still be $400,000, the interest on $300,000 (full cost of the apartment) would have been tax deductible. This is because the $300,000 was borrowed to acquire an income producing asset. She could have saved over $1,800 cash per annum with a mortgage interest rate above 5.5% and a marginal tax rate of 33%.
This simple example shows the impact of concluding contracts in the right order.
The example also highlights how important it is to be well informed when making investment decisions or entering into substantial transactions. We strongly recommend that you recognise your limitations and seek timely advice from a suitably qualified business advisor as required to make the best financial decisions. The information here should help you to ask the right questions.
2.3.3 - Income Splitting
This is a tax-saving technique that involves channelling income to taxpayers with lower marginal tax rates.
Example
A trust earns $100,000 net taxable income in a year. If the income is held in the trust it will be treated as Trustee income and taxed at the trust rate which is currently 33% equating to tax of $33,000. If the income is distributed to beneficiaries, it will be taxed at their marginal rate which can be considerably lower than 33%. If the income is split between 8 beneficiaries, each of whom is on a marginal rate of 10.5%, the total tax payable will be $10,500 giving a tax savings in the year of $22,500!
Note however, that distributions from a trust to beneficiaries under the age of 16 are taxed at the trustee rate (33%) to prevent the use of young children to split income in this way (ITA s HC 35).
Another reason to divert income is to utilise tax losses. The objective would be to avoid a situation where one taxpayer carries forward a tax loss (with no immediate relief) while another associated taxpayer has tax to pay. Here, it would make sense to find some legitimate means of setting off the loss against the profit if possible.
This is recognised in the Law. For example (ITA Part I), a net loss incurred by one company in a year may be set off against the profit in another company if the two companies have been members of the same group at all times during that income year. This requires a common shareholding of at least 66% (s IC 3), and 49% continuity of minimum voting interest (s IA 5), throughout the period. To offset a net loss carried forward, the companies must be members of the same group for the entire period from the income year in which the net loss is incurred to the income year of offset (s IC 6). The offset is achieved by election in the end-of-year tax return or otherwise in writing to the Inland Revenue Department (IRD), or by making a tax deductible subvention payment before year end (ss IC 5, IC 9), from the profit company to the loss company.
At current tax rates, an individual will pay less tax than a company as long as the person’s average tax rate is below 28%. This break even point is reached at a taxable income of $181,600 with tax of $50,848 for both an individual and a company.
All other things being equal, an individual will not be taxed at a higher rate than a trust, as long as the top individual marginal rate is equal to the trust rate (currently 33%).
Now the following is a very important concept in tax planning:
For the purposes of income splitting, the most important figure to consider is the marginal tax rate of each of the taxpayers involved. This is the tax rate that will be applied to the next dollar of earnings for that taxpayer.
Example
Kay Pable owns a company that pays her a salary of $40,000. Her marginal tax rate is 17.5% because the next dollar she earns would be taxed at 17.5%. As profit rises, Kay is considering increasing her salary, still well within a fair market range. Her decision is not driven by tax but this does need to be considered.
If she raises her salary to $44,000, the increase will be taxed at:
$4,000 x 17.5% = $700
The tax deduction in the company is:
$4,000 x 28% = $1,120
The net tax benefit is $420.
Once her income goes above $48,000, her marginal tax rate jumps to 30%. Kay will pay tax on an increase from $48,000 to $52,000 as follows:
$4,000 x 30% = $1,200
The company tax deduction is:
$4,000 x 28% = $1,120
Instead of a tax benefit, there is now an extra $80 of tax to pay. This highlights the point that the tax effect of diverting income depends on the marginal tax of the taxpayers concerned.
Note there is an exception for personal income levels between $44,000 and $48,000 due to the claw-back of the independent earners tax credit (IETC - See 23.3.7.1). Raising Kay’s salary from $44,000 to $48,000 will give a tax benefit of $420 as in the example above, but she will lose the tax credit of $520, giving a net $100 of extra tax to pay.
An individual’s marginal tax rate is well below the flat company rate for income levels up to $48,000. At higher income levels, the individual tax rate is above the company rate. So, when options arise that would legitimately allow income to be taxed in the hands of one taxpayer or another, compare the marginal tax rates of the different taxpayers to see what rates will be applied to the income in the hands of each of the taxpayers involved. Where the additional income will move the taxpayer into a higher tax bracket, that must also be taken into account.
There are special tax avoidance provisions relating to personal services offered through a company. (See Section 23.3.6. Personal Taxpayers and Attribution Rules). Also, recent case law has confirmed that salaries paid by companies to shareholder employees must be market related. (See 4.2.2.3 and 12.2.4.1).
Nonetheless, as long as there are different rules and marginal tax rates for different tax payers, there will be opportunities to lower tax by spreading income legitimately within the rules.
2.3.4 - Reducing Income
Normally, the higher your income the better, even if you do have to pay more tax. We have discussed income splitting above that enables you to reduce your income by passing it on to a taxpayer who will pay less tax on it. There are other ways of reducing your taxable income without having a negative impact on your overall financial position. Consider the following.
For many years during the property boom, investors have been able to increase their net wealth while incurring tax losses on their investment properties. This has enabled them to reduce their taxable income and substitute non-taxable capital gains in its place.
Another example of this would be the sale of a business. Depending on how the business is valued, the seller and buyer may have to pay more or less tax. The seller prefers to maximise the value of goodwill and keep the value of stock and depreciable fixed assets at a minimum, while ensuring that the overall price is fair. This is because goodwill is capital and not taxable while the sale of stock (s CB 2) and depreciation recovered (ss EE 44-52) on the disposal of fixed assets is taxable. The buyer would prefer the opposite to get the benefit of higher tax deductions. This may result in a compromise. However the business is valued, it must be reasonable and well documented.
These examples have indicated the benefits of replacing taxable income where possible with non-taxable gains. This is discussed more in Chapter 4.
2.3.5 - Utilising Allowable Deductions
Chapter 5 examines deductible expenditure. Increasing this is the other side of the coin to reducing income. Whereas it pays for gains to be capital and non-taxable in nature, costs are best if they are not of a capital nature and if they can be recognised for tax purposes to set off against income and reduce the amount of tax payable.
Consider the example of renovating a commercial building. Work to repair and maintain the building will be tax deductible (s DA 1). However, substantial work that brings about significant improvement in the building may need to be capitalised (added to the cost or value of the building) and this is not tax deductible (s DA 2).
Bringing expenditure forward to be recognised in an earlier year can also be achieved by timing purchases before year end. Some expenditure may need to be accrued but there are exceptions (See 5.2.4 and 22.3.6).
Example
When you buy stock for resale, the purchase is a deductible expense (s DA 1). At the end of your tax year, the cost of unsold stock is added back to income for later deduction in the year that it is sold (s CH 1). However, a business can hold up to $58,000 of consumable supplies and any amount of stationery for internal use without being required to include them in the year-end stock take (Determination E12).
For fixed assets, the diminishing value method of depreciation gives a higher deduction in the earlier years than the straight line method.
This book will help you to understand what is deductible. Every legitimate deduction should be taken as it amounts to money in your pocket. If you are unsure, check with FBA through our Question and Answer Service, which is available to subscribers at no extra charge, then bring it to the attention of your accountant.
2.3.6 - Deferring Income or Tax
The strategy of deferring tax is less attractive than eliminating it altogether but the improved cash flow is still worth pursuing. The Tax Act requires income to be allocated to an income year (ITA s BD3). The allocation must relate to the year in which the income is earned and normally this can be clearly established.
There is some leeway around year end when a seller can postpone the completion of a sale for a few days so that the profit is earned in the following income year. Similarly, by placing the lowest acceptable value on stock at year end (Subpart EB), any additional profit from sale of the stock will be earned later, in the year of sale.
In Chapter 17 we discuss provisional tax. A provisional taxpayer using the standard option pays tax in advance, based on income from previous years. If income has increased, this may result in an underpayment of tax that will need to be paid later. The IRD does not charge use of money interest if residual income tax (RIT) is less than $60,000 and obligations are met under the standard method (TAA s 120KE). So for a company, where income that is not taxed at source is less than about $214,000, this exemption applies.
It makes sense for these taxpayers to pay the minimum amount of provisional tax possible and hold back additional payments until terminal tax is due. New provisional taxpayers have an extended period of time to make their first tax payments. This provides them with a cash flow advantage. However, they need to budget for a higher tax burden in the subsequent period when they catch up with tax owing. (See Chapter 17).
Shareholder employees of a close company may, subject to certain conditions, have the choice to receive income from the company with no Pay as You Earn (PAYE) tax deducted (ITA s RD 3). This provides an opportunity to defer the timing of tax payments but should be considered in conjunction with other factors (See 12.2.4).
2.3.7 - BEPS
Base erosion and profit shifting (BEPS) refers to tax avoidance strategies that exploit loopholes and tax differences between countries, so as to shift profits to low or no-tax locations. Over 100 countries, including New Zealand, are collaborating to tackle BEPS.
2.4 - Summary
We have considered some of the basic concepts of tax planning. Special considerations apply to year end and these are covered in Chapter 22. There are also opportunities to arrange your affairs to benefit from options in respect of fringe benefit tax (FBT - See Chapter 19) and goods and services tax (GST - See Chapter 20).
We now move on to the key principles that establish who pays tax, what is taxable and what deductions you can claim.