Tax Treatment of Closely-Held Companies in New Zealand - Assignment Example

Question 1: You are required to trace the history of the tax treatment of closely-held companies in New Zealand. In your essay, you should also give your opinion, supported with reasons, as to whether the existing regime should stay or be replaced by a different tax regime (s). Introduction Closely held companies in New Zealand are those controlled by a small group of shareholders. The current taxation regime in New Zealand has been around for a number of years. Closely held companies have been taxed on this regime for some time now. However the current tax regime for these companies is believed to be faulty and it does not promote business as much as expected. It is necessary for this tax regime to be replaced by a different one which will attract and encourage investment and provide a good environment for business. The tax regime in use for closely held companies is so unfavorable since the company rate of taxation is high. This essay looks at the history of the tax treatment of closely held companies in New Zealand. The essay also has supported opinions on the whether the current tax regime should be maintained or be replaced by a different one. History of taxation Taxation for closely held companies in New Zealand was reviewed in a consultative document that was issued in December in which there were proposals for FIF and CFC regimes. In 1988 the CFC legislation started operating and it started applying to 61 low tax territories or jurisdictions and specific company types in 9 foreign countries. The regime was officially effective starting first April 1993 after several deferrals earlier on. The legislation CFC in New Zealand is applicable to all CFC income anywhere it is located and whatever its establishment motives or business activities. The CFC regime is intended for the elimination of any tax benefits which can be obtained via foreign investments. In 1988 imputation regime of taxation which covered closely held companies was introduced in New Zealand. Before that the country was being served by a double tax or classical system. The income of a closely held company was taxed at only once at the level of the company. The second taxation was done at the level of the share holders when the net of company tax dividend was distributed out to the shareholders. For example if there is a 30 percent company tax rate and a 20 percent shareholder tax rate, the company that earns an income of $100 was expected to pay $30 as company tax to remain with an income of 70 percent as income after tax. When the $70 was distributed out in form of dividends a further $14 as personal tax was supposed to be paid. This would leave behind an aftertax dividend worth $56. In effect a person with a 20% personal tax rate faced a tax rate of 44% on an income that is earned via a company if the profits are distributed fully. With imputation being introduced the domestic shareholders paying tax were given imputation credits for the tax of the company. The implication for this was that at distribution there was one level of impost for tax on the income of the company at the marginal tax rate of the shareholder Claus (2010). In another example it may be taken that a company tax rate of 30% and a tax rate for shareholders of 20% and a company in this case earned $100 of pre tax income and gives out in distribution all the after tax profits in form of dividends. The company was expected to pay $30 as tax and remain with $70 which is distributed as cash dividend. Shareholders were then taxed on gross dividend of $100 which could imply a liability in tax of $20. At that very time the shareholder was allowed to claim an imputation credit of about $30. The net result made the shareholder to get the power to reduce the tax on other incomes $10 and get an after tax dividend worth $80. The system of imputation was a major part of a number of company tax reforms that were meant to reduce the extent with which the taxation system could influence decisions in business. Its introduction was done in an intention that was clearly expressed to widen the tax base and reduce the rates to minimize the bad economic effects on taxation. The goal was meant to ensure that as far as practically possible both capital and labor income were taxed at shareholders’ marginal tax rates. The aim of this was to move as close as possible toward a tax system that is fully integrated in which the income of a company was split between the shareholders and taxed while in the ownership of the shareholders just like partners split the partnership income between themselves. A crucial feature of the full imputation system the way it was designed originally was that the top personal tax rate was aligned with the company tax rate. The meaning of this was that there was nobody paying additional tax at the payment of imputed dividends to shareholders and certain shareholders did benefit from reductions in tax. This gave firms some incentives so that they could distribute profits and have these profits taxed in the hands of the shareholders to the extent at which this mattered. This was important in the effort of making the tax system to work very well just like a company tax system that is fully integrated Dugan, McKenzie, Patterson (2000). There was a concern that full imputation could have caused firms to distribute dividends to provide shareholders with imputation credits even when it could have been efficient if they retained their profits. For this reason issues of taxable bonus were taxed in a similar manner as dividends. This made it possible for a company to have its profits retained and declare a taxable bonus issue instead and at the same time allow imputation credits to be passed out by companies so that shareholders who are on tax rates below the company could receive net deductions on their tax liabilities. Imputation makes a lot of sense with alignment between the company tax rate and top marginal tax rate. For several years the company tax rate was aligned with top personal rate and this happened another time courtesy of the 30:30:30 medium time goal of the government. In this case there is small distortion in the decision of if to invest in an unincorporated enterprise or to invest through a company. While the closely held company tax rates in New Zealand are not aligned, biases to business organization choice, decisions of debt and equity and choice of portfolio may be smaller compared to what they would be under certain other company taxation systems. Opinion on tax regime From April 1986 and 1987 the company tax rate for New Zealand was 48 percent and this was around the norms of OECD countries. In 1988 April the tax rate of the company dropped to 28 percent and one year later it was raised to 33 percent. It remained there until April 2007 but also reduced to 30% from April 2008. The tax rate was low in comparison to the rest of the OECD countries from the late 1980s to around 2000. From the mid 1980s company tax rates have registered a downward trend all over the world. The rate of New Zealand is higher than the average of OECD countries. Globally the tax rates of companies have been on the decline. In the year 2006 out of the 30 countries in OECD only 8 except New Zealand had tax rates for companies that were higher than 30% Dugan, McKenzie, Patterson (2000). This is an indication that the tax regime in New Zealand does not flow with what is being used in the other countries around. These company tax rates need to be harmonized so that no one country remains behind the others. The tax regime for closely held companies in New Zealand moves a way from a coherent strategy. It is good if the taxes can be based on a strategy that is coherent. Through this type of coherence simplicity and certainty is promoted. Looking at the standards in OECD countries the company tax rate is high. The tax rate structure and company system have no integrity and are exposed to tax sheltering. Taxes for revenue are supposed to raise revenue to be used for financing government spending in an efficient manner consistent with the equity objectives of a company. Efficient taxation should reduce the excess burden or dead weight loss of tax. These are the costs to the society of the taxes above the tax revenue that is raised. Excess burdens are inclusive of compliance and administration costs incurred in running tax systems. They include the costs that come from the way taxes may bias decisions far from those that can be favored if there was no tax. In principle those taxes that are very efficient are not those which are broad based with low rates but those with high rates with less sensitive activities. The ability of the country to have taxes structured in this way gets constrained by the ability of measuring elasticity and the consideration of fairness Claus (2010). In the New Zealand tax regime there is high taxation on capital income. Since New Zealand has a small but open economy there is a lot of mobility in capital. The implication is that taxes on capital income at times may be very inefficient. The New Zealand problem is that both capital and labor are mobile meaning that taxes on labor could be distorting. The goal of corrective taxes as opposed to revenue taxes is to ensure that private taxes consider social benefits and costs meaning the account of externalities. Contrastingly with revenue taxes corrective taxes aim at practical difficulties since externalities are difficult to measure and that widespread existence of externalities offers a platform for any lobbyist agenda. In principle the incentives like measures for improving international competitiveness must be measured while referring to tax sensitivities and if activities bring about externalities. The difficulties in measuring sensitivities in tax and externalities means that a tax system that is of low rate and broad based is a theoretically second best approach but first best approach practically Dugan et al (2000). The full imputation tax system for companies that is currently in use helps in supporting the low rate broad based approach. It helps to ensure that the income of the company is taxed at only at very marginal rates of resident shareholders that pay tax when profits are given out. As opposed to other tax systems for companies like dividend reduction system, it also helps to ensure that corporate profits made by non residents and are sourced in New Zealand are subjected to company tax when they are earned. This is inclusive of economic rents meaning profits above an ordinary return on capital. At the introduction of imputation the tax rate of companies, the personal marginal tax rate and trustee tax rate were aligned. The meaning of this was that trusts and companies couldn’t be used in sheltering income from higher personal tax rates. This made it possible for trustee taxation and company taxation to provide extremely crucial functions in supporting personal tax system integrity. Company tax has a double role. Together giving integrity to the personal tax system it acts as a source of basis tax on money earned by non residents. In the year 2000 the rate of top personal tax grew from 33% to 39% because of the equity concerns of the government at that time. At that very time the tax rate of companies and the trustee tax rate were maintained at 33% Walker (2005). Not long ago the tax rate for companies was lowered to 30% due to competitiveness and international concerns. These changes in tax opened up a major gap between the trustee tax rate currently at 33% and the company tax rate currently at 30% and the top personal marginal rate of tax. Since that time the top personal marginal tax rate was lowered to 38%. There is still a major gap between the top personal marginal tax rate and the trustee tax rate or company rate of tax. Moving away from a tax system that is aligned undermines the broad base low rate strategy. This makes the company tax system in New Zealand to be less coherent. Many other countries have abandoned imputation. Among the OECD countries only New Zealand and Australia plus another country have imputation systems. The reason is not so because it is believed that imputation is an unattractive system of company taxation. The main reason why countries in Europe have abandoned imputation is that decisions made by the European court of justice needed countries to give imputation credits to those who are not residents if they are also given to residents. Nevertheless, considering the high company tax of New Zealand and its strange system of company taxation it is advisable if the country can let go of imputation and try a different tax regime. It can make use of any revenue to help reduce the tax rate of companies. The rate of company taxation in New Zealand is above the OECD country average. In the world tax rates for companies have been on the decline. In 2006 just 6 out of 30 OECD countries apart from New Zealand at that time had their tax rates for companies going above 30% Dugan et al (2000). Impact on inbound investment In an economy that is globalized it is possible for company tax to discourage investments meant for the country. On certain strong assumptions for an economy that is small and open with the ability to import a very high amount of capital at a fixed after tax return, that tax cannot be borne by residents from outside. Instead it reduces the capital investment in the particular economy. With a lesser number of tracks, buildings and computers workers and other production factors like land are likely to produce less. The tax may be passed to factors of production like workers but in a less efficient manner than if there was direct taxation being done. This is at times called the ‘production efficiency proposition.’ This can sustain an argument against whatever company taxation rate that is bigger than zero. However there are other considerations in opposition to this. The proposition of zero tax works on the assumption that capital is mobile among countries and that a small economy that is open such as New Zealand can get as big capital as it wants without the return it has to pay being affected. In practical terms capital looks like it is not perfectly mobile Claus (2010). Again if investment comes into the economy from those countries that have foreign credit tax systems the lower taxes levied on income within New Zealand can be offset by the higher taxes in foreign countries. In this case the taxes in New Zealand must not discourage investment in the country. Foreign inbound investments can at times generate economic rents meaning higher returns than the minimum which can be necessary to justify that investment. Biases caused by treatment of taxed and untaxed income There could however be reasons as to why one should worry if the company tax rate for New Zealand is higher than expected. In spite of the broad company tax base in New Zealand, there are problems in having accurate measurement of income. There will also exist biases between business income that is taxed at the company rate and other untaxed forms of income like the imputed income which people get by owning and residing in their houses. These biases can be minimized by a reduction in the company tax rate. There is also another crucial consideration. A high company tax rate could attract multinational companies to stream profits from New Zealand to be taken to countries with lower taxes. This can be achieved by companies thinly capitalizing the operations in New Zealand or using arrangements of transfer pricing where entities in New Zealand pay very high prices and charge very low prices on transactions with overseas companies Walker (2005). There are ways to avoid thin capitalization and transfer pricing but these measures are not fully effective. Incentives of streaming profits from New Zealand to overseas will arise most likely when the company tax rate for New Zealand is higher compared to other countries or when there is an imputation system in the other country. A particular concern area for the case of New Zealand is the imputation scheme in Australia and because of the point that 54.5% of foreign direct investment coming to New Zealand at March 31 2008 came from Australia. Currently the tax rates for Australia and New Zealand companies are in alignment at a 30% rate. However the parent companies for Australia with shareholders from Australia have incentives to stream profits from subsidiaries in New Zealand back to parent companies. The reason for this is that shareholders are given imputation credits for Australian but not taxes for New Zealand companies. One way of overcoming such pressures is through mutually recognizing New Zealand imputation credits and the franking credits of Australia. Practically to determine the best company tax rate for New Zealand is to make judgments on the advantages and disadvantages of cutting the rate of taxing companies in the face of considerable uncertainty. The decisions to be taken should be informed by what is being done by other countries as well. For example if there is a continued cutting of company tax rate in other countries or even Australia considers a major cut in its company tax rate it becomes important to ask if New Zealand should go on with its 30% company tax rate which when viewed through thee standards of OECD it is high Jones (2007). Domestic taxation should be balanced on international pressure to lower company tax. A company tax rate which is less compared to the higher personal tax rates give people opportunities for people to make use of companies to shelter their own incomes from high personal tax rates. According to reports the government of New Zealand intents to move to a 30% tax alignment for the top personal, corporate and trustee tax rates. With social assistance abatement there would still be higher effective marginal tax rates. A set of tax rates that is aligned combined with a full system of imputation is a way of making sure that corporate income for resident shareholders is taxed one time at their appropriate marginal tax rates Walker (2005). Assessment of an aligned system with imputation A company tax system that is aligned can possibly increase tax system efficiency in several ways. Reduced top personal tax rates can lower the distorting effects that the higher rates cause on working decisions. They can as well encourage residents that are highly mobile and skilled to stay in New Zealand while those that are non residents but are highly skilled to come to New Zealand. Lower top personal rates can reduce the bias in the direction of consumption and raise the level of domestic savings. This could make it very attractive so that capital can flow to SMEs ahead of investments that are lightly taxed among them houses occupied by their owners. Reductions in the rates of tax apply to investments that are taxed more heavily and one cannot expect substitution from these investments that are more heavily taxed into SMEs. All normal profits and economic rents are taxed at one rate. When the system is aligned it means that the company tax rate would be higher than would be allowed by some other systems. To the extent that specific location rents are being taxed it is efficient. It can be inefficient as well since marginal investment is being discouraged from taking place and tax cost is shifting to domestic factors like labor. This reform direction should involve the retention of an amputation system. The amputation system will have some good neutrality properties specifically treating investments equally through entities and of debt vs. equity financing. This leaves the possibility of mutual recognition open for imputation and franking credits in Australia. Mutual recognition increases bilateral efficiency for trans-Transman investment Lessambo (2009). In spite of all these advantages an aligned system can point to a higher company tax rate compared to what any other tax system can allow. To the point that there exists enough foreign investment due company tax rates that are unattractive the attractiveness of labor would go down. Aligning the tax system would improve on horizontal equity in the tax system or regime by making sure that the income that is earned via the various entities and different types of income are taxed with the same rate. To reduce the 33% and the 38% personal tax rates and the 33% trustee tax rate to 30% is believed to be about $ 1.4 billion dollars every year Schanz and Schanz (2010). Revenue integrity A system that is aligned with imputation can easily increase the integrity of a tax system. Shareholders look for dividends that are fully imputed and there is very low incentive for avoiding or deferring tax by shifting assets or personal activity to trusts or closely held companies. This increases efficiency by reducing dead weight costs as well as equity. Sheltering income in order to avoid a high marginal rate of tax resulting from the abatement of social assistance is still a problem. However the company rate of tax may remain high may be due to the absence of a source for replacement revenue that for offsetting reductions in top personal rates then there would be incentives for streaming profits from New Zealand. This puts pressure on thin capitalization rules and transfer pricing Dugan, McKenzie, Patterson (2000). A system that is aligned would be simple administratively hence lower compliance costs relative to the current and alternative systems. There would then be no need for distinguishing between various income types and no requirement for complex rules to hinder the sheltering of income in companies. An aligned system is coherent but a person is taxed on every form of income that is via any entity at similar rates would be vulnerable. The reason is if the reason of the company is reduced for reasons such as competitiveness then top personal rates need to be reduced properly. Reduction of the top personal rates is expensive and there could be a limit on the level of what can be raised via other means Ness, Voges (1991). The tax regime for closely held companies in New Zealand needs to be replaced. This is because of the reasons highlighted in the essay. The regime in use is of a high rate of taxation and this is hostile to businesses as it does not favor investment. This is also coupled by the fact that the nations around and especially the OECD countries have low rates of company taxation. This being the case, these countries are likely to move a way investment from New Zealand to other destinations. As shown in the essay the tax regime must be revised in order to suit the interests of business people. Conclusion In conclusion the essay has examined the history of taxation in New Zealand for closely held companies together with opinions and propositions for change. From the observation and examination of the existing taxation regime the essay has given the way forward based on the opinion of the writer. It is therefore clear that taxation for closely held companies has not has not had a long history in New Zealand. However the tax regime in New Zealand is unfit and should be changed. Other countries in the OECD or those that are close by such as Australia have adopted tax regimes that have low rates of company taxation. New Zealand must follow suit if it wants to attract investments and maintain a good business environment within the country. A new system of taxation that is aligned with imputation will be more recommendable for the country. This is because it has coherence, integrity, efficiency among other qualities that are desirable. References Dugan R, McKenzie P., Patterson J. 2000; Closely Held Companies, Legal and Tax Issues New Zealand Master Tax Guide for students 2009; CCH editors New Zealand Limited Claus I. 2010, Tax Reform in open economies; International and country perspectives; Edward Edgar Publishing Walker G. 2005, Commercial applications of company Law in New Zealand New Zealand Income Tax legislation 2009; Income Tax Act 2004 CCH Editors 2009 Bond University School of Law 2002; Bond Law Review Volume 13 CCH editors 2009; International master tax guide 2009/10; Crowe Horwath International Jones C. 2007, Principles of Business Taxation: Finance Act 2006 Butterworth Heinneman Schanz D. and Schanz S. 2010; Business Taxation and Financial Decisions; Springer Lessambo F. 2009 Taxation of International Business Transactions; iUniverse Campbel D. 2007, International Taxation of Low Tax transactions (2007) Low tax; Lulu.com Ness T., Voges E. 1991 Taxation of the closely held corporation; Issue 1 Warhen, Gorham and & Lamont; Business and Economics Read More