The new associated persons rules for land transactions have caused some angst since coming into effect in August 2009. Associated persons rules were initially applied to land transactions in 1973 in response to a perception that developers were treating their activities as investments rather than taxable activities. The 1973 regime survived until August 2009 – and under those rules with a smart accountant it was still generally possible for developers to hold investment properties in a separate entity without tax on the capital gains on their investment properties.
In March 2007, the IRD released a discussion paper on the subject. This proposed changes to close these perceived loopholes – and after some public debate and a few changes, the new associated persons rules were enacted in August 2009. The main thrust of the new rules is to prevent developers from operating two businesses; a development business where increases in value of the property are taxed – and an investment business where capital gains are not taxed.
Under the new associated persons rules it is almost impossible – without creating a fictional situation – to break the association between an entity in the business of property development and an investment entity where the same people have a degree of control over both entities. Capital gains on investment properties purchased by anyone associated with a developer will almost always be taxable.
One could argue that this is not unreasonable – it does plug a loophole created by poorly drafted legislation in 1973 that allowed accountants to set up structures that completely circumvented the intent of the rules.
However, here is a scenario that we have seen a number of times, which as a direct result of these new rules has a rather detrimental effect on those concerned. Consider this rather common situation:
A person has purchased a block of land – often some years ago – with the intention to complete a subdivision into a number of smaller lots;
Their motive is to make some money on the subdivision – and often also to retain the prime block to later build a family home;
These people may or may not be sophisticated property developers. Often they are not, and this may be a one-off project spanning a number of years;
The project is typically conducted in a GST registered development trust, which will pay tax on its profits as well as GST as the lots are sold;
The lot earmarked for a family home will be sold by the development trust to a family trust at market value when titles are issued – and GST will be paid on the sale price as if it was an arm’s length sale. So far so good;
Where possible, the sale from the development trust to the family trust would have been completed prior to the new rules coming in – after all, we did have plenty of notice. But often this was impossible due to the development being incomplete and titles being some months or years away from being issued;
Under the old regime, there would typically have been no problem with the transfer from a development trust to an investment trust. The development trust would pay tax and GST as the lots were sold – including the lot sold to the family trust. The family trust would eventually build the dream home without further tax implications. Everyone lives happily ever after;
However under the new regime, all capital gains on any lot sold from a development entity to an associated family trust after August 2009 typically remain taxable forever! No ten year exemption – and no family home exemption. Nasty.
This is probably fair enough for new projects where everyone enters from day one with their eyes wide open. But the problem arises for the great many people whose development projects have been happening on the back burner for a number of years. These people often have a real emotional attachment to the site which is to be the family home. Often they have also invested tens of thousands in architect’s plans and professional fees ahead of the dream home project. The prospect of paying tax on all future capital gains on the family home puts them in a rather unenviable position.
For those in this situation, there are a couple of possible arguments that we can run with the IRD in some circumstances. But generally this is a case of being caught out badly by a big movement in the goalposts which couldn’t have been foreseen at the beginning of the project.
Fraser Hurrell is one of three directors of Elevate CA Limited, Chartered Accountants & Business Advisors in Whangarei, New Zealand.
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