Look-through companies and limited partnerships
2012 amendments to the look-through company rules including the 'loss limitation rule' formula, and the definition of 'income' under the formula.
Sections GB 32, HA 7B, HB 1, HB 11, HG 11, HZ 4B, HZ 4C and YA 1 of the Income Tax Act 2007, and section 55 of the Goods and Services Tax Act 1985
Several amendments have been made to the look-through company (LTC) rules to simplify some administrative provisions, and ensure the rules are consistent with the original policy intent.
The main changes involve the valuation of guarantees or indemnities for the purposes of the LTC deduction limitation formula in section HB 11 of the Income Tax Act 2007 (commonly referred to as the "loss limitation rule"). Changes have also been made to the definition of "income" under that formula.
Similar amendments have been made to equivalent provisions in the limited partnership (LP) deduction limitation formula in section HG 11.
Further changes simplify the initial basis calculation for a former qualifying company (QC) that transitions to either the LTC or LP tax rules, for the purposes of applying the deduction limitation formula under those rules.
There are also several minor remedial amendments to the LTC rules which cover:
- elections, valuation methods and timing methods;
- aggregation of relatives' interests under the look-through counted owner definition;
- benefits provided to shareholders;
- qualifying company amalgamations; and
- GST group-filing rules.
The LTC rules were part of several tax measures introduced by the Government in Budget 2010. The new rules provided an elective look-through income tax treatment for closely held companies, and applied from 1 April 2011.
An LTC's tax treatment is integrated with the tax treatment of the owners. Broadly, the LTC rules provide a transparent tax treatment, similar to that used for partnerships, so that shareholders pay tax on any company profit at their marginal tax rate, and may also use the company's losses, subject to certain limitation rules.
Amendments to the loss limitation rules
- The definition of "secured amounts" provides for the valuation of a guarantee or indemnity given by an LTC owner, or a person associated with the owner, in respect of the LTC's debt. Similar rules exist for limited partners and LPs.
- If more than one guarantee is provided for the same debt, the amount of the debt guaranteed is divided by the number of guarantors.
- If the guarantee provided for an LTC's or LP's debt expressly limits the creditors' recourse by reference to specific property, the secured amount may be limited to the value of the guarantor's interests in that property.
- An owner's share of the LTC income is increased, for the purposes of the loss limitation rules, if an owner's proportionate share of a dividend distributed by a foreign investment fund is higher than their amount of FIF income or FIF loss from that FIF. A similar rule applies for limited partners and LPs.
- The market value method or the accounting book value method may be used by the owner of a transitioning QC for their initial basis calculation, to determine the opening value of the owner's equity or capital contribution. This initial basis valuation applies for the purposes of the LP and LTC loss limitation rules in the year of transition, and in all later years.
- Elections, valuation or timing methods adopted in relation to an LTC's income or property are made or established by the LTC.
- The look-through counted owner test does not aggregate the look-through interests of two people who are connected because one of them is a trustee of a trust under which a relative of the other has benefited or is eligible to benefit.
- Benefits provided by an LTC to a shareholder are treated as a distribution of profits, and not as a fringe benefit of a (non-shareholder) employee associated with the shareholder.
- An amalgamated company cannot use the QC rules following an amalgamation between a non-QC company and a QC.
- An LTC is treated as a company for the purposes of GST group registration.
LTC deduction limitation formula (the "loss limitation" rule)
Sections HB 11 and HB 12 of the Income Tax Act 2007 ensure that owners' deductions are restricted if the amount of their deductions exceeds their owner's basis. These sections are widely referred to as the "loss limitation rules", although, more accurately, the sections provide a limitation on deductions. Under these rules the LTC deductions an owner can claim in an income year are limited to an amount equal to their owner's basis. The purpose of the rules is to ensure that owners can offset tax losses only to the extent these reflect their economic risk.
The owner's basis is calculated for each owner using the following formula:
investments - distributions + income - deductions - disallowed amounts
The amendments in the Taxation (Annual Rates, Returns Filing, and Remedial Matters) Act concern items included in the "investments" and "income" categories of this formula only. Tax Information Bulletin, Vol 23, No 1, February 2011, has more information on the owner's basis formula and the mechanics of the loss limitation rules in general.
Investments and secured amounts
The "investments" category of the owner's basis formula is the sum of the equity, assets introduced, or services provided, to the LTC, or any amounts paid by the owner on behalf of the LTC. This includes any loans, including shareholder current account credit balances, made by the owner to the LTC. It also includes the owner's share of any LTC debt for which they, or their associate, have provided a guarantee or indemnity; these are known as "secured amounts".
The inclusion of secured amounts within the investments category is intended to reflect that an owner may be at economic risk in respect of guarantees or indemnities that they (or an associate) have provided on the LTC's behalf, although these are not always reflected in the company balance sheet or the shareholder's loan account.
Amendments have been made to the definition of "secured amounts". These ensure that the secured amounts definition includes only appropriate guarantees or indemnities, and clarifies the amount an owner may include in their owner's basis in respect of a guarantee provided by an associated person.
The amendments also simplify what happens in the event that a creditor's recourse under a guarantee is expressly limited to particular property of the person providing the guarantee. Such guarantees are referred to in this guidance as limited recourse guarantees.
Guarantees or indemnities in respect of loans advanced by an owner of an LTC
An owner may include the value of a guarantee or indemnity they provide in respect of an LTC's debt in the "investments" element of the owner's basis calculation. They may also include the value of a guarantee or indemnity given by an associate.
Section HB 11(5)(c) has been amended to ensure that this does not apply to a guarantee or indemnity provided by an owner or an associate in respect of a loan made to the LTC by another owner. This is to prevent double counting, because loans made by an owner are included in that owner's basis under section HB 11(5)(b).
There are several important definitions that are critical to calculating the amount of a guarantee or indemnity that an owner can include in their owner's basis under "secured amounts". A key definition is the definition of "guarantor".
An owner of an LTC will be a guarantor (an "owner guarantor") if:
- the owner provides a guarantee or indemnity for the LTC debt; and/or
- an owner's associate provides a guarantee or indemnity for the LTC debt.
An owner's associate is a person connected with the owner, such as a relative, or a trustee who is associated in their capacity as trustee (see examples 1a and 1b). An owner's associate cannot hold shares in the LTC (see example 1c).
A person who is not an owner of an LTC, and is not an owner's associate will be a guarantor (a "third party guarantor") if they provide a guarantee or indemnity for the LTC's debt (see example 1d).
Secured amounts - lesser of
The secured amounts definition provides that the amount of a guarantee or indemnity that an owner may include in their owner's basis is the lesser of two possible amounts, described at paragraphs (a) and (b) of the definition.
It is expected that paragraph (a) will be the operative provision for nearly all LTC owners.
Paragraph (b) concerns guarantees under which the creditor's recourse is expressly limited, which is atypical, and so paragraph (b) is unlikely to apply in most standard guarantee situations.
If paragraph (a) and paragraph (b) both apply, the amount an owner will include in their owner's basis is the lesser of the amounts calculated under each paragraph.
Secured amounts - paragraph (a)
Under paragraph (a) of the secured amounts definition, the amount an owner may include in their owner's basis is the amount of the LTC's debt for which the owner is a guarantor. As explained in the previous section, an owner will be a guarantor via their own guarantees, and guarantees made by an associate (examples 2a and 2b).
When there is more than one guarantor for the same debt, the amount of debt is divided between the number of guarantors (examples 2b and 2c). This includes a third-party guarantor, although they do not, themselves, have any owner's basis (example 2d).
The reason the debt amount is divided in this way is because the guarantors each have equal exposure under their respective guarantees. Apportioning the guaranteed debt amount between them on an equal basis is a way of accounting for this shared risk.
It is important to identify the LTC debt (the "secured debt") to which a guarantee relates. If guarantors provide a guarantee for different debts, or for differing proportions of the same debt, this will affect what is apportioned, and who is included within the apportionment (example 2e).
Secured amounts - paragraph (b)
Paragraph (b) of the secured amounts definition will only be relevant if a guarantee is provided for an LTC's debt and the creditor's recourse is expressly limited under that guarantee. Such a guarantee is referred to in this guidance as a "limited recourse guarantee". Paragraph (b) is concerned with limited recourse guarantees provided by owner guarantors only, that is, guarantees made by an owner or an owner's associate. Guarantees by third-party guarantors are not taken into consideration.
A key definition is "recourse property". When a person provides a guarantee, but the creditor is expressly limited to taking legal recourse only against particular property and has no ability to seek reimbursement over and above what can be realised from that property, the property is referred to as "recourse property".
Note: A creditor may require a mortgage or similar charge to be placed over property owned by the person providing the guarantee, to provide some collateral security. The mortgage charge by itself offers some level of protection to a creditor, but it does not limit the creditor's ability to take legal recourse against any of the guarantor's other assets if necessary, to meet the outstanding loan amounts. In these situations, the property under mortgage charge is not "recourse property". Such guarantees will be dealt with under paragraph (a) of the secured amounts definition.
When there is a limited recourse guarantee, the secured amount under paragraph (b) is the net market value of the recourse property; that is, the market value of the property on the last day of the relevant income year, less any other charges against that property that would have a higher creditor priority.
The net market value of the recourse property is attributed to each of the owner guarantors to the extent of their ownership interest in the recourse property, or, where the limited recourse guarantee is provided by an owner's associate, to the extent of the associate's interests in the recourse property.
If there is more than one owner guarantor linked to, or using, the same recourse property for their guarantees, the net market value of the recourse property will be divided amongst the relevant owner guarantors.
|Extent of interest in holiday home (recourse property)||Limited recourse guarantee(s) provided by||Number of owner guarantors||Amount included in owner's basis|
|Peter and Paul||2||$200,000||$200,000|
| Tenants-in-common |
Peter's share = 40%
|Paul's share = 60%||Peter and Paul||2|| |
The amendment applies from 1 April 2011.
The income category of the owner's basis calculation includes the owner's share of the LTC's income, including exempt and excluded income, and capital gains from the current and any preceding tax years (in which the company was an LTC).
New section HB 11(7)(ab) provides for the owner's share of the LTC income to be increased where an owner's proportionate share of the dividend actually distributed by a foreign investment fund (FIF) to the LTC is higher than their amount of FIF income as calculated using the owner's chosen FIF calculation method. Any excess is added to the owner's "income" for the purposes of the owner's basis calculation. In the case of a FIF loss being calculated under the FIF rules but FIF dividends being received, the actual dividend amount will be counted.
This is achieved through the formula in section HB 11(7B):
- dividend - FIF amount
- dividend is the amount of the actual dividend received by the LTC from a FIF (ignoring section CD 36(1))
FIF amount is the amount of the owner's FIF income for the relevant income year and FIF. If the owner has a FIF loss, the FIF amount is zero (see example 6c).
If the calculation under this formula produces a negative result, then there is no increase in the owner's basis for dividends received from a FIF (see example 6b).
If an owner does not use the FIF rules, they will not have FIF income or a FIF loss. Instead any actual foreign dividends received will already be included as income under section HB 11(7)(a) and no adjustment will be necessary under section HB 11(7)(ab).
The amendment applies from 1 April 2011.
QCs transitioning to LTC or LP rules - initial basis
When the LTC rules were introduced, special transitional rules were included for companies that were QCs or LAQCs in the income year immediately before the income year starting on or after 1 April 2011. These are designed to provide a smooth transition for existing QCs to start using the LTC rules if they wish to do so. There is also an option for a QC to transition its business structure into a limited partnership (LP).
After a transition to either an LTC or an LP, the shareholders of the former QC will need to apply the loss limitation rules to determine their owner's or partner's basis respectively. This will require them to determine the amount of equity they have in the LTC or LP. Under the special transitional rules their equity amount "at risk" includes any retained reserves built up during the company's pre-QC and QC years.
When a QC transitions to an LTC, shareholders need to make an initial valuation of their equity amount, that is, for the shares acquired during pre-transition. This is known as their initial basis, and is used in section HB 11(5)(a) in the transitional year, and in all future years.
So, for example, the reference in section HB 11(5)(a) to "the value of shares at the time the person purchases or subscribes for them" will be, for a shareholder in an LTC that has transitioned from being a QC, the value of his or her shares as determined under the initial basis calculation, in all future years when the shareholder applies section HB 11(5)(a) to those shares.
Likewise, for a transition to an LP, a limited partner must make an initial valuation of their equity contribution, which forms the starting point for determining the valuation of their "capital contribution" under section HG 11(5)(a) for all future years.
A shareholder in a transitioning QC has two options for determining their partner's or owner's initial basis under sections HZ 4B and HZ 4C respectively. They can use either:
- the market value or the accounting book value of the relevant items on the last day of the income year before the QC transitions; or
- the historic basis, as if the LP or LTC rules had always applied, and the LP or LTC had always existed.
The "market value" and the "accounting book value" options in this method are broadly the same. However, under the former, shareholders need to obtain a formal market valuation of their shares.
Amendments have been made to the market value or the accounting book value methods of the initial basis calculation to clarify that:
- The valuation of shares is used in determining the amount of an owner's or limited partner's "investments" under the loss limitation formula, for all relevant future years.
- Any change in the value of assets included in the initial basis valuation of equity will be determined using this initial basis valuation, for the purposes of the loss limitation rules. For example, the calculation of a "capital gain" or "capital loss" via sections HB 11(7)(b) and HB 11(8)(b) (see example 7).
- An initial basis calculation, under either the accounting book value or market value method applies only to shares or capital contributions included in the investments category of the loss limitation formula. It is not relevant to other items included in the investments category, such as loans and secured amounts where the valuation is likely to fluctuate each year.
The amendment applies from 1 April 2011.
Amendments have been made to the "investment" and "income" categories of the calculation for a partner's basis in the limited partnership rules in section HG 11. These are broadly similar to the amendments to the LTC rules, which are discussed in detail above.
Investments - capital contribution
The definition of "capital contribution" has been amended to clarify that loans made by a limited partner to the limited partnership are counted as an investment under section HG 11(5)(a). This amendment clarifies the existing position.
The amendment applies from 1 April 2008.
Investments - secured amounts
Amendments have been made to the definition of "secured amounts", which mirror the amendments described above for LTCs.
There are two points to note:
- A general partner is only considered to be a guarantor of the partnership's debt under the new definition if the general partner provides a guarantee. The general partner is not otherwise considered to be a guarantor simply by being liable for the debt as a general partner.
- The definition of "partner's associate" is a company in the same wholly owned group as the partner, and a relative of the partner. For the latter purpose, the definition of a "relative" excludes a trustee connected with the partner simply by being the trustee of a trust under which a relative of that partner has benefited or is eligible to benefit.
These amendments apply from 1 April 2012.
Income - FIF income and FIF loss
Amendments have been made to the income category of the partner's basis calculation, which mirror the amendments described above for LTCs.
These amendments apply from 1 April 2008, being the date on which the limited partnership rules first applied.
LTC remedial amendments
Tax elections, and valuation and timing methods
Various provisions in the Income Tax Act 2007 require elections to be made for a particular tax treatment for an asset or class of assets, or to apply a particular valuation method to certain assets. Elections relating to the assets of a company would usually be made by its director or other relevant officer.
However, under the LTC rules, each owner is regarded as holding the company's assets directly, and carrying on the activities of the company. This could require each owner to make an election in respect of their portion of the LTC's assets.
New section HB 1(6) simplifies this administrative burden by providing that elections concerning the tax treatment of an LTC's income or property, or any valuation or timing methods adopted in relation to an LTC's income or property, are made or established by the LTC. The election, valuation method or timing method used by the LTC is binding on the owners in respect of their look-through interests in the LTC's property.
For example, section EE 8(1) of the Income Tax Act 2007 provides that a person may elect to treat an item of depreciable property they acquire as not being depreciable property. When such an election is made for an item of depreciable property acquired by an LTC, the election will be made by the LTC. The consequences of that election on the LTCs allowable deductions will be reflected in the LTC's tax return, which will automatically flow through to the owners' tax returns.
Section HB 1(6) applies only to elections made, or valuation or timing methods adopted, in relation to an LTC's income or property. It does not apply to a tax position taken by a shareholder. This is because tax positions will take into account a shareholder's interests outside of the LTC - for example, in determining whether the cost of a person's attributing interests in a foreign investment fund (FIF) are more than $50,000, for the purposes of applying section CQ 5 or section DN 6, attributing interests in a FIF that are held by the shareholder in a personal capacity, as well as their attributed interests via the LTC must be taken into account.
The amendment applies from 1 April 2011.
Aggregation of relatives' interests under the "look-through counted owner" definition
An LTC must have five or fewer "look-through counted owners". The shareholdings of look-through owners who are relatives are aggregated, and they are treated as one look-through counted owner.
The definition of "relative" in section YA 1 has been amended, for the purposes of determining the number of look-through counted owners, to exclude a person connected with another person simply by being the trustee of a trust under which a relative has benefited or is eligible to benefit.
The amendment applies from an LTC's first income year starting on or after 2 November 2012, being the date of Royal assent.
Benefits provided to an employee's associates
Under the LTC rules, a shareholder of an LTC may be treated as an employee for PAYE purposes, if he or she elects to be treated as a "working owner".
A working owner is not treated as an employee for fringe benefit tax (FBT) purposes. This is because the cost of providing fringe benefits and paying FBT is borne by the employer. Under the LTC tax transparency rules this would give all of the LTC's shareholders a deduction for the benefit provided to the "working owner" shareholder, which is, strictly, a distribution of profit and not a business expense.
Under section GB 32 of the Income Tax Act 2007, if a benefit is provided by an employer to a person who is associated with an employee, and the benefit would have been a fringe benefit if provided to the employee, the benefit is treated as provided by the employer to the employee for the purpose of the fringe benefit tax (FBT) rules.
Section GB 32 has been amended to ensure that it does not apply to a benefit provided by an LTC to one of its shareholders. This means that the benefit provided to the shareholder will not be treated as a fringe benefit of a (non-shareholder) employee who is associated with the shareholder.
Instead, the benefit provided by the LTC to the shareholder will be considered as a distribution of profits to that shareholder.
The amendment also applies to benefits provided to a partner by their partnership or limited partnership.
The amendment applies from 2 November 2012, being the date of Royal assent.
Qualifying company amalgamations
When the LTC rules were introduced, the QC rules in subpart HA of the Income Tax Act 2007 were grandparented so that only companies that were already QCs or LAQCs before 1 April 2011 could continue to use the QC rules. No new companies could start using the QC rules after 1 April 2011.
However, it was possible that in an amalgamation that was not a resident's amalgamation an ordinary company could amalgamate with a QC, and this amalgamation would effectively have enabled a new company to start using the QC rules after 1 April 2011.
Section HA 7B of the Income Tax Act 2007 has been amended to ensure that a new company cannot enter into the QC rules through an amalgamation that is not a resident's amalgamation. The amended section means that following an amalgamation between a non-QC company and a QC, the resulting amalgamated company cannot use the QC rules.
The amendment applies to amalgamations on or after 2 November 2012, being the date of Royal assent.
GST group-filing rules
Under the Goods and Services Tax Act 1985, an LTC is generally regarded as a company and as the registered entity for GST purposes. The company is responsible for complying with any GST requirements, not each individual owner.
Section 55 of the GST Act has been amended to ensure that an LTC can also be regarded as a company in order to meet the "group of companies" requirements for GST group registration. This will reduce compliance costs for LTCs and their owners.
The amendment applies from 1 April 2011.