The government intends to block the ability for those with annual incomes above $180,000 to divert income to entities taxed at a lower rate to avoid the top 39% tax rate.

The Inland Revenue department has issued a discussion document that focuses on "dividend integrity and income attribution measures" and is the first of three such documents planned.

"This discussion document proposes:

  1. That any sale of shares in a company by the controlling shareholder be treated as giving rise to a dividend to the shareholder to the extent that the company (and its subsidiaries) has retained earnings
  2. That companies be required, on a prospective basis, to maintain a record of their available subscribed capital and net capital gains, so that these amounts can be more easily and accurately calculated at the time of any share cancellation or liquidation
  3. That the '80% one buyer' test for the personal services attribution rule be removed," it said.

The motivation for increasing the top rate to 39% while keeping all other rates on individuals, trusts and companies unchanged "was to raise extra revenue in a way that is progressive and does as little as possible to increase taxes on low to middle-income earners", it said.

Suitable measures

"For this and other tax rates to be effective, it is important that suitable measures are in place to ensure the tax rules are not circumvented."

While there are many good reasons for the use of entities such as companies and trusts, they can sometimes reduce the amount of taxable income of those subject to either the 33% or 39% tax rates, the paper said. Companies are taxed at 28% and trusts at 33%. 

The gap between the top rate and the company rate of 11 percentage points "is smaller than the gap in most OECD countries", it said.

"However, New Zealand is particularly vulnerable to a gap between the company tax rate and the top personal tax rate because of the absence of a general tax on capital gains."

The biggest area of concern relates to closely-held companies and trusts and there is much less concern with widely held and listed companies, the paper said.

"This is because they are not under the control of an individual, and so generally cannot be used as a conduit to achieve a lower tax rate on what is really the individual's own income."

Bunching at trigger points

The paper includes a graph showing a huge spike in non-PAYE (pay as you earn) income at about $70,000, where the 33% tax rate applies to additional income, and a smaller spike at about $48,000, where the 30% tax rate applies to additional income up to $70,000.

But it notes that such "bunching" isn't evident at $180,000, where the 39% tax rate kicks in.

IRD analysed data it holds on 350 high-wealth individuals – individuals and families with more than $50 million in net assets – and found they used or controlled 8,468 companies and 1,867 trusts.

"For 2018, these 350 individuals paid $26m in tax, while their companies and trusts paid $639m and $102m respectively, showing a significant amount of income earned through lower-tax-rate entities," the paper said.

"An inconsistent rate structure makes it harder for courts to find tax avoidance when the different rates mean it is difficult to determine whether a structure undermines what parliament intended," it said.

"Perceptions of arbitrary outcomes, such as when some taxpayers can structure to avoid the 39% rate, will erode public confidence in the integrity of the tax system and the perception that all taxpayers are treated fairly."

Without measures to prevent it, more income of high-wealth individuals and others with substantial capital income is likely to flow to lighter-taxed entities.

Disproportionate impact

"This suggests that the impact of the 39% personal tax rate will disproportionately fall on less wealthy salary and wage earners."

The paper said the policy options the government is considering wouldn't attribute all income earned through companies and trusts to individuals and tax that income at individual personal rates.

"However, they would create the potential for a significant amount of income (a large proportion of which is derived by comparatively few families and individuals) to be recharacterized and taxed at the appropriate rate," it said.

The later papers will look at trust integrity and company income retention and the possible third paper will look at portfolio investment income including the current portfolio investment entity (pie) regime – the top tax rate for pies is 28%.

"However, given that pies are used by large numbers of low and middle-income New Zealanders, and their taxation is a component of savings policy as well as tax policy, this is not as urgent a concern" as the company and trust issues, the paper said.

The paper notes current law and practice offer shareholders a number of routes to directly or indirectly realise cash or other property relating to earnings of a company without triggering any tax liability.

Share sales

"The first issue considered in this document is sales of shares. A sale of shares offers an alternative way for a shareholder to realise cash, often but not always representing the earnings or capital gains of the company, with no, or a substantially deferred, tax cost," it said.

When a company is sold currently, the vendor's payment is treated as capital but, because the change of ownership eliminates imputation credits, any subsequent distribution of retained earnings would be taxable for the purchaser.

"However, if the purchaser adopts the simple expedient of acquiring 100% of the target using a holding company, this taxation is permanently eliminated by the inter-corporate dividend exemption," the paper said.

The government is also concerned about practical issues that arise when a company cancels shares or is liquidated.

That's the point at which net capital gains need to be determined in order to determine the amount of the dividend on liquidation.

"However, there is currently no requirement for a company to have kept any record of these amounts during its life. This can make accurately determining the amount of a dividend on share cancellation or liquidation highly problematic."

Submissions on the discussion paper are due by April 29.