Traps for the unwary in qualifying company changes

Since the Budget there has been plenty of discussion regarding changes in tax rates, loss of building depreciation claims and the increase in the GST rate.  What seems to have slipped under the radar is the proposed changes to the Qualifying Company (QC) and Loss Attributing Qualifying Company (LAQC) rules. 

The Government has proposed a substantial overhaul to the QC/LAQC rules to stop what it believes are a number of tax advantages of LAQCs, which will apply to most LAQCs from 1 April 2011.  These types of entities are now very common throughout New Zealand, being used for property investment, farming, manufacturing, tourism and retail.

In simple terms, the proposed changes will combine the LAQC and QC regime into one ‘QC regime' and will treat these companies the same as partnerships for tax purposes while retaining the benefits of limited liability for non-income tax purposes under company law.  However, the changes do go deeper; although all of the detail has not yet been confirmed.

• Losses will be limited to the amount that the shareholder has at risk in the QC, meaning a possible restructure of shareholder advances to share capital may be required. Alternatively a personal guarantee for bank debt may satisfy the at risk requirement for claiming losses. Losses unable to be offset immediately will carry forward and offset against future taxable income from the QC.
• QC income will flow through to shareholders - the same as losses flow through -, meaning that income will be taxed at the shareholders personal tax rate (soon to be 33%) compared to the company tax rate (soon to be 28%).
• For property investors, transferring QC shares to existing or new shareholders will potentially trigger depreciation recovery income as the shareholder will be deemed to sell their share of the underlying QC assets. This will also occur if a QC ceases to be a QC, which will increase the tax risk of inadvertently falling out of the QC rules. There will be special disposal concessions but these may not apply to the majority of the QCs that operate.

 QC shareholders will need to carefully consider their options leading up to the proposed start date of the new rules; 1 April, 2011 for most QCs.

If a QC is loss-making then the shareholder's at-risk money should be reviewed to ensure all losses can be used by the QC shareholder. 

If a QC is profitable then, before the new rules apply, the shareholder may choose to opt out of the QC rules and become a normal company for tax purposes - resulting in profits being taxed at the new 28 percent company tax rate.  There may still be reasons for staying in the QC regime - for example, the ability to extract capital gains tax-free without liquidating the QC.

If the QC shareholder is contemplating transferring their shares to a trust or other shareholder, it may be beneficial to opt out of the new QC rules before they apply, as a sale of shares in a QC under the proposed new rules would result in a sale of the underlying QC assets and possibly depreciation recovery income.

Time will tell whether our love affair with QCs will change following the proposed changes.  Significantly the Government is proposing to remove the many features of the QC regime that has made them so popular with business owners, particularly property investors.  QCs may have their place, but more care will be needed in their use; they won't be the off-the-shelf solution that they have so frequently become.

Don't wait; start planning for the proposed changes now.

Alan Scott is Tax Partner BDO Wellington and Technical Tax Director BDO New Zealand, a network of independent Chartered Accounting and Business Advisory firms.