In March 2022, Inland Revenue released a government discussion document that contains a proposal that represents a further erosion of the principle that New Zealand does not tax capital gains.
Currently, if a person sells shares in a company and the shares were not purchased with the intention of resale (such as by a share trader), the amount derived should comprise a non-taxable capital gain. However, IR is proposing a change in which a sale of shares could trigger a taxable dividend.
The background to the change is publicised as an ‘integrity measure’ to support application of the 39 percent tax rate, but it would apply irrespective of the applicable tax rate.
The logic is that companies and trusts can earn income on behalf of high-income individuals. In the case of a company, it can derive income that is taxed at 28 percent and this income could accumulate to the company over time and not be paid out as a dividend to be taxed at the shareholder’s marginal tax rate. If the shares in the company are then sold to a third party, the vendor derives a non-taxable capital gain. The concern is that the value of the shares is partly tied to the amount of the retained earnings of the company, so the individual should be treated as deriving those retained earnings, i.e., a deemed taxable dividend should be triggered.
As evidence that such a change is necessary, IR refers to the fact that since the top personal tax rate first increased to 39 percent in 2000, NZ has seen “a notable increase in the imputation credit account balances of non-listed companies”. This would suggest that people are using companies to store value and avoid the higher personal tax rates.
The detailed proposal is that share sales by ‘controlling shareholders’, (being someone who holds more than 50 percent of the voting interests in the company - including shares held by associated persons), will trigger taxable income based on the higher of:
- the accounting retained earnings, less non-taxable capital gains, plus imputation credit account (ICA) balance, or
- the ICA balance divided by the tax rate.
If a controlling shareholder only sells a portion of their shares, the taxable amount is pro-rated. To the extent the company’s imputation credits feature in the above calculation(s), the shareholder will claim the amount of the credit against their tax liability and the company’s ICA balance will be reduced.
Some exceptions are proposed, such as for the sale of shares in listed companies or shares held by Portfolio Investment Entities.
Finally, IR is also proposing that companies are required to maintain a record of their ‘available subscribed capital’ (ASC) and capital gains. Currently, distributions by a company are not taxable to the extent they are a return of ASC or if on liquidation, a capital gain. Because companies do not have to keep a record of their ASC and capital gain amounts, it becomes difficult for the IR to verify the non-taxable amount on a share repurchase or in a liquidation.
There is a lack of acknowledgement by the Government that profits are often retained by a company and reinvested for future growth or acquisitions. It is common for ‘value’ to be retained in a company for decades with no need or occasion for it to be distributed. The fact a share sale gives rise to a tax-free capital gain is a feature of our tax system. The proposals appear to be driven by a philosophical drive to recharacterise a capital gain into a taxable gain.
We’ll be keeping an eye on this proposal and when and if it becomes more than a proposal, we’ll be in touch.