We’ll be completing our review of all QC and LAQC clients over the next few weeks. From the start of the next financial year, LAQCs will no longer be able to attribute their losses to shareholders.
The Government’s strategy behind these changes is to prevent ‘arbitrage’ – the ability for an LAQC to pass losses out to shareholders where they can be used at the shareholder’s marginal tax rate of up to 33% – while retaining any profits in the company where from 1 April they will be taxed at only 28%.
So the new legislation arising from last year’s budget announcement introduces the “Look Through Company” (LTC), which will allow allocation of the company’s losses to shareholders in proportion to their shareholding in a similar fashion as existing LAQCs. But it also requires that profits are taxed in the hands of shareholders resulting in more equal treatment of losses and profits.
The new LTC is an option for people who currently hold loss making businesses or investments in LAQCs. Shareholders are able to elect for their existing LAQC or newly incorporated company to become an LTC between 1 April and 30 September 2011.
Here is a brief summary of the most significant changes and implications:
- As of 1 April 2011, LAQCs will not be able to attribute losses to shareholders.
- A new tax entity, called a Look Through Company (LTC) is now created. Profits and losses (but with some limitations) are passed on to its shareholders. This means that losses and profits will be deducted or taxed at the shareholders’ marginal tax rate.
- Losses in LTCs will only flow through to its shareholders to the extent of the shareholder’s investment in the company (including the share of any debt guaranteed by that shareholder).
- The shareholders of an LTC will be treated as holding the assets of that LTC directly. If they sell their shares in an LTC they will therefore be treated as disposing of their interest in the underlying company property (subject to some exceptions) and will therefore be up for any associated tax consequences. Examples are depreciation recovered and gains on the sale of trading stock.
- If the company exits the LTC regime (which could happen unintentionally) a disposal of the company assets will be deemed to have happened and this will possibly give rise to negative tax consequences.
- LTCs will not pay income tax as all income will be attributed to shareholders and those shareholders will be responsible for their own tax.
- LTCs can only have one class of shares.
But having said all that, the above is merely a tax fiction. An LTC retains its identity as a registered company with limited liability and therefore is still governed by the Companies Act 1993.
The options for those currently operating QCs and LAQCs include the following:
- The default option – which in most cases is unlikely to be the best option – will be to continue as a QC without the ability to attribute losses to shareholders.
- Revoking LAQC status and being taxed as an ordinary company.
- Electing to become an LTC as detailed above.
- Becoming a partnership or a sole trader. Special rules will allow this transition without a tax cost – although if property is involved there will be significant conveyancing, legal and bank costs.
Some of the issues we’re considering during these reviews are these: If the company owns assets of any sort, how long do you intend to own them? Do you intend to introduce other shareholders in the future – or to transfer shares into your trust at any point? Does the company’s activity generate losses? How long might these losses continue – particularly given the changes to depreciation rules? What is your actual economic investment in the LAQC and how might this change in the future?
Depending on our recommendations after reviewing your QC or LAQC, we may make use of the transitional rules and tax concessions which will enable us to transition QCs and LAQCs across to an LTC, a partnership, a limited partnership or a sole trader. We will need to file election documentation with IRD for all LAQCs that are to become LTCs, as well as give written notice to IRD for any LAQCs that choose to transition to another entity type.
For those LAQCs where the recommendation is to transition to another entity type rather than become an LTC, there will be administrative tasks and potentially restructuring and legal costs and issues such as:
- Ensuring that current finance terms are not adversely affected
- Transferring commercial contracts and banking arrangements to the new entity
- The legal transfer of businesses/assets to the new entity with its associated legal costs
- The transfer of employment agreements across to the new entity
- Potentially a raft of Inland Revenue registrations and deregistrations
- Transfer of all insurance covers
- Informing suppliers of the new entity so that you hold valid tax invoices
- Deciding whether the LAQC should be liquidated, or registered as a non-active company, or left as a shell company
Unfortunately this is not as simple as just transferring all of our QC and LAQC clients across to the LTC regime as this would create real tax disadvantages for some. And nor is doing nothing likely to be the best option for all clients. If you have any queries or concerns, do contact us.
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