Structuring decisions for the 39% personal tax rate change

For many investors, the dramatic drop in interest rates has meant that their residential property portfolio’s have made the transition from loss making to profit making.

Coupled with the fact that from 1 April individuals who earn over $180 000 will be paying 39% income tax on personal incomes, it is time for many people to revisit the way their property portfolios are structured.

Adding to the complexity is the new Trustees Act which is causing trustees to consider whether a trust is still the structure they want to administer going forward. For now, at least, the government has not signalled any change to the trust tax rate of 33% so for those continuing with their trusts the lower tax rate than the high marginal rate for individuals must be examined in light of rental income that might otherwise be taxed personally.

Many investors have a company in their affairs, some will have Look Through Companies and some will still have Qualifying companies holding their property assets. These structures are both likely to have shareholdings held personally as they hark back to a time when a lot of property structuring was focused on taking advantage of tax losses that simply don’t exist now.

Some investors will also have standard non LTC, non QC companies for their business activities that may also be owned personally.

In any situation where a company’s shares are held personally, ultimately dividends from them will attract tax at the personal tax rate, either immediately, as they are with Look Through Companies, or at the point where retained profits are distributed as dividends in the case of QC’s and standard companies.

In this article we take a look at some of the issues that therefore have to be navigated when shareholdings in companies are moved from individuals to Trusts.

The start point for any transfer is to actually determine the value of the shares in the company. For property companies this will mean determining the value of individual properties and contemplating the liabilities a company has, to its lenders and also to its shareholders with regards to shareholder loan accounts. Having placed a fair value on the company, shares decisions will need to be made about whether the shares will be gifted to the trust outright or whether the trust will be indebted to the individuals for the shares sold. These decisions can impact entitlements to the likes of rest home subsidies and will determine in whose hands the wealth actually lies.

There are also numerous tax issues to navigate when contemplating the sale of shares in a company to a trust.

For standard non LTC, non-Qualifying companies, retained profits may have accumulated and the company may have generated imputation credits associated with the tax that has already been paid at the company tax rate of 28% on these historic profits. There are shareholder continuity rules that must be observed that require a 66% continuity of shareholding if these imputation credits are to be carried forward. A loss of imputation credits will mean that tax has to be paid again on the ultimate distribution of retained earnings so imputation credits will generally need to be attached to dividends before the shares are transferred to a trust. Because the company tax rate is 28% a further withholding tax payment of 5% will be required on these dividends to top the tax up to the 33% shareholder rate.

For standard companies with losses, there is also a 49% shareholder continuity rule to observe if losses are to be carried forward past the shareholding change.

For Look Through Companies, where tax on profits will have already been paid at the personal level the issues are different. Changes in shareholding of LTC’s can restart and trigger Brightline subject to whether changes are made pursuant to relationship property agreements, so this is a huge issue to consider before effecting change.

A change of shareholding with Look Through Companies is considered a deemed disposal of the underlying properties so issues like depreciation recovery will also have to be weighed up.

Qualifying companies also have their challenges. Changes in shareholding require QC status to be re-elected for and there is a 50% continuity of shareholding rule if QC status is to be retained.

Dividends from QC’s must also be flowed through trusts and out to individual beneficiaries if QC status is to be retained, meaning that the trust structure may be ineffective at protecting the income being derived.

For Property companies, QC status is what allows dividends from capital gains to be distributed tax free, so the status is important to preserve whenever possible.

So, at a time when many investors have seen their property portfolio’s change from loss to profit prompting a desire to alter structuring arrangements it has never been more fraught with danger to actually do so.

It's often a case of weighing the pain against the gain but its critical to fully examine all the issues associated with a change of shareholding in a company before actually doing so.

Involve your legal and tax team in these decisions and take advice before you proceed, as in some cases the benefits of making a change like this may not outweigh the drawbacks.