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Clarifying changes to qualifying company rules

Clarification surrounding changes to qualifying company regimes has emerged, after the original press release caused confusion as to what the proposed changes mean.

Withers Tsang property tax specialist Mark Withers says Monday's release from Revenue Minister Peter Dunne was ambiguous and confusing, as it appeared the government was planning to ring fence losses within qualifying companies.

However, that is not the case and Dunne has released the following questions and answers to provide more clarification on the changes and what it means for investors who currently have LAQCs and QCs. Draft legislation is now due on Friday.

1. What are the main changes?

i. Introduce new flow-through income tax rules for closely-held companies.

ii. Allow existing QCs and LAQCs to transition into the new flow-through tax rules or change to another business vehicle such as a limited partnership, without a tax cost.

iii. Allow existing qualifying companies (QCs) and LAQCs to continue to use the current QC rules without the ability to attribute losses (until a review of the dividend rules for closely-held companies has been completed).

2. What do the new flow-through rules mean?

These new rules mean shareholders will pay tax on the company's profit, and use losses, at their marginal tax rate. This is different from the existing LAQC rules because shareholders are being taxed on the income as well. This reduces arbitrage opportunities between the company tax rate and top personal tax rates.

The introduction of new flow-through income tax rules for closely held-companies who choose to use them was announced in Budget 2010.

The new rules create a new tax entity, called a look-through company (LTC). Shareholders of a closely-held company can elect to become an LTC.

A LTC's income, expenses, tax credits, rebates, gains and losses are passed on to its shareholders, in accordance with their shareholdings in the company.

3. Is an LTC still a company?

Yes. The LTC retains its identity as a registered company, and will keep its corporate obligations and benefits under general company law, such as limited liability.

Look-through treatment applies for income tax purposes only; the shareholders of an LTC are regarded as holding the LTCs assets directly, and carrying on the activities of the LTC personally. Thus, in general, a sale of shares in an LTC is treated as a sale of the underlying assets. There are de minimus rules that limit the application of this treatment. These will be closely modelled on the present partnership de minimus rules.

4. If I am a shareholder in a look-through company (LTC) can I claim all the company's losses against my other income?

Not always. The LTC rules also include a loss limitation rule, which is similar to that of limited partnerships. This means owners can offset tax losses only to the extent the losses reflect their economic loss.

Any losses a shareholder cannot use are carried forward and may be used by the shareholder in later years.

5. Why are the QC rules continuing in the interim?

As part of Budget earlier this year the Government announced reforms to the tax rules for qualifying companies, and sought feedback on the proposals.

Following this consultation, the Government is introducing new rules from 1 April 2011, providing flow-through income tax treatment for closely-held companies who choose to use them.

In response to feedback from small business the Government has also decided to review the tax rules for dividends, with a view to simplifying them for closely-held companies.

It is appropriate that while this review is being conducted, existing qualifying companies and LAQCs can continue to use the current qualifying company rules, but without the ability to attribute losses.

6. What is happening to the current qualifying company and LAQC rules?

Existing QC and LAQCs may continue to use the current QC rules.

The income is taxed at the company level. Dividends will continue to be taxed as before.

  • Only dividends with imputation credits attached will be taxable to shareholders.
  • Any capital gains can be distributed tax free without winding up the company.

However the ability to attribute losses will be removed; this effectively means that the LAQC rules will be abolished.

The current QC rules will remain while the Government reviews the tax rules for dividends, with a view to simplifying them for closely held companies.

7. I have an existing LAQC - what are my options?

If you already have an LAQC you have several options to choose from next year. You can, without a tax cost:

i. Continue as a qualifying company (QC), without the ability to attribute losses (which instead will be used at the company level)

  • This is the 'default' option for all existing QCs and LAQCs.
  • You will no longer be able to attribute losses to your shareholders.
  • This applies until the Government has completed its review of the dividend rules for closely-held companies.

ii. Be taxed as an ordinary company.

  • You will need to revoke your LAQC election.
  • Any new losses will have to be used by the company, not the shareholders.
  • And all dividends will be taxable to your shareholders, although imputation credits may be attached.

iii. Be taxed as a look-through company (LTC)

See answer to Question 2 above for details about being an LTC.

iv. Become a limited partnership, an ordinary partnership, or sole trader

  • Special rules will enable you to transition into a limited partnership, partnership or sole trade, with no tax cost.
  • You will need to restructure your business and either make the company non-active or wind it up. The transition rules provide extended time for this restructuring.

8. I have an existing QC - what are my options?

The options for an existing QC are the same as those for an LAQC. The default option is to continue as a QC.

9. When will the new LTC rules come into effect?

The legislation for the new rules is expected to be enacted before the end of this year. The LTC regime will be available from 1 April 2011.

10. When will the removal of the LAQC rules come into effect?

The legislation for the new rules is expected to be enacted before the end of this year and will come into effect from 1 April 2011. They will apply to LAQCs from the income year starting on or after 1 April 2011.