With the Labour Government’s record win at the polls last month, the introduction of a top marginal tax rate of 39% is a certainty. Labour is at pains to point out that it applies only to individuals who earn more than $180,000 per annum (or the top 2% of earners in New Zealand) and that the additional revenue raised will be used to help control debt and protect vital services, like health and education.
All worthy objectives of course, although it’s yet to be seen whether the $550 million of forecasted additional revenue will make any real difference to these areas (let’s not forget the COVID response alone has cost billions of tax dollars to date).
What is also interesting about this policy is that it applies to individuals - not trusts or companies or families, but individuals. New Zealand has long prided itself on a ‘broad-base, low-rate’ system which aims to collect revenue efficiently without distorting economic decisions. The theory being that economic decisions like what structure you earn your income in, or how you decide to invest, are not driven by tax consequences. After all, the previous 39% rate was reduced in an effort to align it to the trust rate, thereby reducing the incentive for tax avoidance.
A top tax rate of 39% on individuals only is not consistent with the broad-base, low-rate philosophy. Instead it raises all kinds of issues. Take for example a family where one person earns a salary of $220,000 while the other person stays home to look after the children. Compare this to a family where both adults work, earning a salary of $150,000 each. Despite earning $80,000 more as a household, they won’t pay the 39% rate whereas the single earning household will. This factor may well determine whether a family chooses for both parties to work or not – a decision that should not be driven by the tax system.
Or another example is a person who earns a salary of $200,000 to support their lifestyle. They will be subject to the 39% rate on their income over $180,000, whereas a person who earns $200,000 from income via investments held in a trust would not be subject to the same 39% rate. The amount of money earned is the same, it is used in the same way (to support the person’s family and lifestyle), but the tax rate is different. Again, those who have the ability to choose whether to earn their income personally or in a trust are likely to make use of a trust irrespective of whether it is the best structure for them, outside of the tax consequences.
Another twist to this is New Zealand’s strong property market and the application of the bright-line property tax rule. Take for example a person earning a salary of $150,000 who, due to a change in circumstances (redundancy, starting a family, getting sick, etc), is forced to sell their rental property within five years of purchase and they make a $100,000 capital gain. They would be subject to tax under the bright-line rule on the gain - $70,000 of which would be taxed at 39%. Despite Labour’s claims that the top rate will affect only the top 2% of earners, I would guess that many more will fall into the top bracket due to tax arising under the bright-line rule.
Anecdotally, we are aware that many people were moving away from trusts due to the more onerous requirements required under the new trusts legislation. However, the prospect of a top tax rate of 39% is likely to see trusts fall back in favour, despite the additional requirements. You may recall the case of the orthopaedic surgeons that went all the way to the Supreme Court (Penny and Hooper). Essentially the Court ruled that their use of trusts to divert personal services income was tax avoidance. This case provided the IRD with a great precedent to argue against perceived tax avoidance, but unfortunately for the IRD it came too late as the disparity between the top tax rate and the trust rate was removed shortly after.
However, with the reintroduction of the top 39% tax rate we are likely to see a re-emergence in both trust structuring as well as renewed IRD scrutiny on those structures – particularly on the strength of the Penny and Hooper precedent. This creates both uncertainty and a compliance headache for all involved.
So, you may be wondering what to do now before the top rate kicks in? The instinct will be to use companies and trusts to earn income and own assets. This may well be appropriate, however before you rush into restructuring it is important to bear in mind New Zealand’s wealth of anti-avoidance rules. Getting the right advice before you do anything is likely to be a lot cheaper and less anxiety-ridden than trying to fix up mistakes while you are facing IRD scrutiny.
Now is the time to consider your options and be proactive, but ensure you get advice upfront. Our job is to save you money and make sure the IRD doesn’t keep you awake at night, and in our opinion, good tax advice is not a luxury – it is essential.
Please contact us if you would like to discuss your situation with our tax team, we would be happy to help.
Maggie is the Tax Director at Nexia Christchurch, and has more than 17 years of experience in providing tax advisory services.
Maggie has dealt with a wide range of entities from large corporates, through to SME's, trusts, ex-pats and high wealth individuals. She is well placed to advise and provide practical and pragmatic solutions on any tax or GST issues.
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