Legal complexity puzzles rental properties

The July ‘BNZ-REINZ Residential Survey’ indicated that the property market is firming up.

Apart from first homebuyers, there are others shifting from small family homes to larger houses, converting the former as rental properties.

The structure used in the past was a Loss Attributing Qualifying Company (LAQC).

As LAQCs have now been replaced with Look Through Company (LTC) with complex rules, an important consideration is whether it is worth transferring the family home as a rental property into LTC in view of the interest deductibility and tax avoidance provisions in the tax laws.

The Inland Revenue Department (IRD) recently considered a situation in which a person sells his or her family home at market value to a LTC, which then rents the property to a third party on ‘an arm’s length’ basis.

Deduct or pay?

The LTC borrows from a bank to fund the purchase and then the person uses the funds to buy a new family home.

The questions raised to IRD were (a) whether interest paid on the borrowings by LTC would be allowed as deduction in calculating the rental income; and (b) whether this arrangement could be considered as tax avoidance arrangement.

The IRD’s view would be that the LTC borrowed funds to acquire the rental property and used this property to derive assessable rental income.

Interest incurred on the borrowed funds would be deductible for income tax purposes, with the rental property becoming an income-earning asset of the LTC.

The LTC’s use of the borrowed funds is to fund an income-earning asset.

LTC liability

Legal provisions relating to LTC do not treat the owner’s use of the funds in their personal capacity to purchase their family home as LTCs use.

Hence, interest paid on the borrowed funds is effectively incurred by the LTC.

Deduction of interest paid by LTC on the borrowed funds would be based on the use of the funds by LTC. The fact that the previous family home was transferred to LTC at market value and the receipt of non-taxable amount will not make the interest as non-deductible expense for the LTC.

The IRD considered this situation from the tax avoidance perspective and concluded that as the property was rented to a third party on an arm’s length basis, this scheme would not be considered as a tax avoidance arrangement.

Parliament Test

In arriving at this conclusion, the IRD relied on a Supreme Court decision propounding ‘Parliamentary Contemplation Test’ (PCT), which checks whether the tax outcomes of the scheme are what Parliament would have intended after considering the commercial reality and the economic effects of the arrangement.

There is sufficient nexus between the interest paid to the lender on the funds borrowed to finance the purchase of the property and the rental income earning process. Thus, interest is incurred in deriving the rental income.

While setting out the law relating to LTC, our Parliament intended that taxpayers could use LTC as a company structure to limit their liability simultaneously enjoying the benefit of lower personal tax rate.

LTC is recognised as a separate legal entity since it is a company, treated as transparent for tax purposes.

Applying this Test to the above situation, the loan taken by the LTC was used for the purchase of the rental property at market value and the interest was genuinely paid to the lender.

Thus, it met the commercial reality and the interest paid was economically incurred.

Welcome clarification

The above situation can be contrasted with an arrangement mentioned in Revenue Alert RA 07/01.

Indian Newslink will remember having read my article on this issue (January 15, 2010). This was a situation wherein a person sells a family home to a LAQC and rents back the same property at market value to him or her.

Many taxpayers tried to claim income tax deductions for the losses incurred under such an arrangement. It was then indicated in the ‘Revenue Alert’ that this situation would be treated as a tax avoidance arrangement.

Applying the above PCT, the commercial and economic effects of this arrangement was to claim private expenses as a deductible.

The Income Tax Act did not intend to allow such private expenses as deductible and hence such arrangements were treated as tax avoidance.

This clarification from the IRD is a welcome ruling so that taxpayers can plan their tax affairs with certainty, which is a fundamental principle of tax law.

Vijay Talekar is Director of Tax Experts Limited, Chartered Accountants with an office at 208 Great South Road (Level 1), Papatoetoe in South Auckland.

Phone: (09) 2792987; Email: vijay@taxexperts.co.nz; Website: www.taxeperts.co.nz

The above article and answer to reader query should be considered only as a guideline and not as specific advice. Mr Talekar absolves himself and the management and staff of Tax Experts Ltd and Indian Newslink of any responsibility or liability that may arise from the above article. Readers should seek professional advice before acting upon any information contained above.

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