Exploring the Government’s discussion document on dividend integrity and personal services income attribution
The introduction of the 39% tax rate on 1 April last year caused a flurry of activity, which was to be expected. Common sense meant it was prudent for companies to pay a dividend before the rate increase.
And common sense would further suggest that declaring such dividends before a known personal rate change was beneficial to the Government as it accelerated the collection of Resident Withholding Tax on those dividends. The anticipated rate change encouraged companies to pay dividends before 31 March 2021.
If this was the plan, then it worked. Dividends paid by companies in the year to 31 March 2021, as compared to 31 March 2019 and 31 March 2020, look to have increased by almost three times.
The contrary view, which has been well publicised in the media, is that declaring dividends before the rate change could be seen as unsavoury behaviour from an income tax perspective and an unwelcome attack on the 39% tax rate.
In reaction, the Government has issued a discussion document on dividend integrity and personal services attribution. Three proposals are up for discussion to prevent perceived side-stepping of the 39% tax rate.
1) Taxing the sale of shares in a closely-held company: Treating a sale of shares in closely-held companies (companies controlled by few) to trigger a “notional” dividend to the shareholder to the extent the company has retained earnings. This will treat a portion of the sale proceeds received by the exiting shareholder - which is normally tax-free - as a taxable dividend.
2) Changing the personal services attribution rules: We have specific anti-avoidance legislation, which seeks to prevent the individual from sheltering income, that is earned through their personal efforts, in an entity with lower tax rates, such as a company. These rules are quite specific to personal services and are consistent with similar rules in other jurisdictions. Briefly, they aim to tax an individual where they provide personal services through a company, but 80% of the income earned by the company is from personal services provided to a single customer or generated by a single person. The discussion document proposes to remove this 80% rule.
3) Mandating share capital and capital gains recording: Require companies to maintain a record of share capital (as defined by tax) and capital gains.
What’s our immediate reaction?
There is a lot to unpack in this discussion document. At first blush it appears to be an overreaction to the dividends declared before 31 March 2021. Especially when shares in many companies are held by family trusts with a trustee tax rate of 33%. Aspects of these proposals could have unforeseen consequences and need to be carefully analysed and considered.
The proposal to tax the sale of shares in a closely-held company is the most contentious of the three options and is likely to have a significant impact on many commercial transactions. It is a capital gains tax by another name. Its focus is to prevent tax avoidance referred to as a ‘dividend strip’, where structures are used to effectively convert taxable dividends to non-taxable capital gains. However, there are already specific anti-avoidance provisions that can be applied by Inland Revenue - so are the new rules truly necessary?
We witnessed a reluctance of closely held companies to declare dividends when the RWT top up on fully imputed dividends went from 3% to 5%. A top up to 11% will drive closely held companies to hold back paying dividends and reinvest in other income producing assets - thereby delaying the collection of tax. This should not be a problem provided the assets a company invests in are not of a private nature.
The Income Tax Act has plenty of provisions to tax funds being drawn out from a company to fund shareholders private spending. A new set of rules to try and protect the 39% tax rate seems misplaced and unnecessary.
Family Trusts may not be ‘flavour of the month’ for the current Government, but when used properly, they remain the most effective tool for allowing family groups to protect their assets, build inter-generational wealth and provide for the future of their mokopuna.
The proposed change to the personal services attribution rule is a step towards aligning specific anti-avoidance legislation and general anti-avoidance (as determined by the Penny and Hooper Supreme Court case). It is designed to ensure the personal services attribution rule applies to all personal services income and not just situations which were more akin to an employment relationship. As a default, if you roll your sleeves up and aren’t “adequately” rewarded for your efforts by a company you control, then be prepared to receive a call from Inland Revenue!
The recommendation to maintain adequate records of share capital and capital gains reflects some of the complexity created by the proposals, where adjustments are required to deem available subscribed capital to be created to avoid double taxation. However, it is currently a good thing to do. It is best practice to adequately track third party capital as it can be distributed tax-free on liquidation. Similarly, it is important to keep a record of the available subscribed capital as it can be returned to shareholders tax-free, subject to specific share repurchase rules. Hopefully this proposal isn’t too onerous, other than introducing another box to tick.
It looks complicated; rules are needed to prevent double taxation. We’ve got lots of questions.
Will it force companies to pay dividends more regularly to remove the complexity, when perhaps they should be reinvesting? Are the proposed rules too wide, capture too much and just another quasi-capital gains tax?
How long will it be before we remove all choice and deem all entities (that are closely-held) to be transparent for tax?