Income tax - look-through companies, rental properties and avoidance

All legislative references are to the Income Tax Act 2007 unless otherwise stated.

This question we've been asked applies in respect of s BG 1.

Question

1. We have been asked whether s BG 1 would apply to the following arrangement:
   • a person sells their family home to a look-through company (LTC);
   • the home is used by the LTC as a rental asset and is rented to a third party on an arm's length basis;
   • the person owns 100% of the shares in the LTC;
   • the sale of the home is at market value;
   • the LTC borrows from a bank to fund the purchase;
   • the person then uses the funds raised from the sale to purchase a new family home;
   • the person, in their capacity as holder of an effective look-through interest in the LTC, is able to deduct the interest incurred by the LTC on the loan.

Answer

2. As the property has been rented to a third party on an arm's length basis, the Commissioner's view is that s BG 1 would not apply to the above arrangement.
3. If an arrangement were to vary materially from the arrangement outlined in the question above, or if there were other relevant facts that might materially affect how the arrangement operates, then the Commissioner would need to consider the matter further and a different outcome might apply.

Explanation

Background

4. In 2011, the Commissioner published QB 11/03: "Income tax - look-through companies and interest deductibility" Tax Information Bulletin Vol 23, No 10 (December 2011):16.
5. This item considered whether interest deductions previously allowed would continue to be allowed where a loss-attributing qualifying company (LAQC) becomes a LTC if:
   • a person had previously sold their family home to a LAQC as a rental asset;
   • to be rented to a third party on an arm's length basis;
   • the person owned 100% of the shares in the LAQC;
   • the sale of the home was at market value;
   • the LAQC borrowed from a bank to fund the purchase;
   • the person then used the funds raised from the sale to purchase a new family home;
   • the LAQC becomes a LTC.
6. QB 11/03 concluded that interest deductions previously allowed would continue to be allowed, subject to the limitation on deductions in ss HB 11 and HB 12. The item also commented that the position would be the same where a person sells their family home at market value directly to the LTC.
7. Since the publication of QB 11/03, we have been asked whether s BG 1 would apply where a person sells their family home at market value directly to a LTC.

Discussion

Interest deductibility

8. QB 11/03confirms that, on the facts set out in the item, interest is deductible under s DB 6. This is because, in the Commissioner's view, there is a sufficient connection between the interest incurred and the assessable income.
9. The fact that the LTC is tax transparent for income tax purposes does not affect deductibility. Section HB 1(4) attributes the actions of the LTC to the person in their capacity as holder of an effective look-through interest. This means that for income tax purposes the person is treated as borrowing the funds to acquire the rental property. As a result, the person is entitled to the interest deductions, subject to the limitation on deductions in ss HB 11 and HB 12.
10. Section HB 1(4) does not operate in reverse. The person's use of the borrowed funds in their personal capacity (in this case, to purchase a new family home) is not attributed to the LTC. The person's use of the borrowed funds in their personal capacity is irrelevant to the issue of interest deductibility on the borrowed funds.

Section BG 1 - tax avoidance

11. Section BG 1 applies to void a tax avoidance arrangement. It is the Commissioner's view that s BG 1 will not apply to the arrangement outlined in the question above. However, if an arrangement were to vary materially from that outlined, or if there are other relevant facts that would materially affect how the arrangement operates, then the Commissioner would need to consider the matter further and a different outcome might apply.
12. The Supreme Court in Ben Nevis Forestry Ventures Ltd & Ors v CIR; Accent Management Ltd & Ors v CIR [2008] NZSC 115, (2009) 24 NZTC 23,188, set out the approach to be used to determine whether an arrangement is a tax avoidance arrangement under s BG 1. The approach, known as the "Parliamentary contemplation test", is to ask whether the tax outcomes are what Parliament would have intended for the provisions used or circumvented, having regard to the commercial reality and economic effects of the arrangement.
13. The first step in this test is to identify the commercial reality and economic effects of the arrangement.In the arrangement outlined in the question above, a LTC borrows from a bank to buy a rental property. The rental property is purchased by the LTC at market value. The LTC then carries on a genuine rental activity, renting to a third party on an arm's length basis. The reality is that interest is incurred on funds borrowed to purchase a rental property. The interest is economically incurred, in that the arrangement is not structured in a way that allows the person to be reimbursed for the interest paid out. This is not a situation where the loan or the interest paid is not at arm's length or not at market value. In other words, the loan really is used to purchase a rental property and the interest is genuinely incurred.
14. The second step is to identify Parliament's purpose for the provisions used. Parliament's purpose for the general deductibility provision was discussed in Accent Management Limited & Ors v CIR [2007] NZCA 230, (2007) 23 NZTC 21,323. The Court of Appeal said the deductibility provision applies when a person "incurs real economic consequences" of the type contemplated by Parliament when the rules were enacted. Case law has established that there must be a sufficient nexus between the expenditure incurred and the income earning process for the expenditure to be deductible (see, for example, CIR v Banks (1978) 3 NZTC 61,236). Therefore, the purpose of the deductibility provision is that income that is otherwise taxable should be reduced by any expenses that are truly incurred in deriving that income to arrive at the amount of net income received.
15. Parliament's purpose in enacting the LTC regime was to introduce an income tax treatment for closely-held companies that allows an owner of a company to obtain the benefits of limited liability while permitting that owner to be taxed at their own marginal tax rate. Shares in a LTC can only be held by individuals, trusts or other LTCs. Furthermore, a LTC can only have five or fewer look-through owners. So it was clearly envisaged that LTCs would be used by taxpayers (some who might own 100% of the shares in the LTC) who wanted the protection of limited liability while at the same time being able to take advantage of lower personal tax rates.Parliament intended that the LTC regime apply to closely-held companies and that, despite the entity being "transparent" for income tax purposes, the company would be recognised as a separate entity.
16. Putting the two steps of the "Parliamentary contemplation test" together: the reality is that the LTC suffers a real economic cost in incurring interest, and it is incurred in the derivation of income. The shares in the LTC are held by one person so the company is closely-held. This is the type of shareholding that the LTC regime was intended to apply to. Accordingly, the commercial reality and economic effects are within Parliament's purpose for the deductibility provision and the LTC regime.
17. The nature of the asset (the house) fundamentally changes for tax purposes. It changes from a private asset (accommodation for the person and their family) to an income-earning asset (a rental property). This is so, even though the funds borrowed by the LTC are ultimately used by the person to purchase a new family home, and even though, were it not for the existence of the LTC in this case, the interest deductions would not be allowed.
18. The arrangement outlined in the question above can be contrasted with the arrangement in Revenue Alert RA 07/01 where a person rents their family home back to themselves. In more detail, the facts in Revenue Alert 07/01 were that a person, who was also the sole shareholder of the LAQC, sold their family home to a LAQC. The person then rented back their family home from the LAQC at a market rate. Following this, the LAQC tried to claim income tax deductions for the related property costs. It is the Commissioner's view that s BG 1 would apply in this situation. The commercial reality and economic effects of this arrangement is to make private expenses deductible by purporting to engage in a rental activity. The Act does not intend that private expenses should be deductible. Therefore the deductibility provision is not being used as Parliament intended.
19. The Commissioner's view is that the situation in the Revenue Alert is quite different from the facts in the present question. In this question, the person has structured their arrangement in a way that achieves deductibility. The person has sold their family home to a LTC. The property is then used by the LTC as a rental property, rented to a third party on an arm's length basis. The borrowing to fund the purchase is deductible because the property is used by the LTC to derive assessable income.

References

Related rulings/statements
QB 11/03: "Income tax - look-through companies and interest deductibility" Tax Information Bulletin Vol 23, No 10 (December 2011):16
Revenue Alert RA 07/01

Subject references
Look-through companies
Interest deductibility
Tax avoidance

Legislative references
Income Tax Act 2007, ss BG 1, DB 6, HB 1, HB 11, HB 12

Case references
Accent Management Limited & Ors v CIR [2007] NZCA 230, (2007) 23 NZTC 21,323
Ben Nevis Forestry Ventures Ltd & Ors v CIR;
Accent Management Ltd & Ors v CIR [2008] NZSC 115, (2009) 24 NZTC 23,188
CIR v Banks (1978) 3 NZTC 61,236