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Interest Limitation Rules – understanding the basics of the proposals
The Government has recently released a discussion document titled ‘Design of the interest limitation rule and additional bright-line rules’.
It’s a rather lengthy 144 pages, and as the title suggests, the document not only discusses the proposed ‘interest limitation rules’, but also provides commentary surrounding some proposed additional bright-line rules. Before I get into the nuts and bolts of the proposals, it would be useful for the reader I expect, to provide some definitions in advance:
Close company: a company where five or fewer natural persons or trustees directly or indirectly hold more than 50 per cent of the company.
Residential investment property-rich companies: being a company where value of residential investment property divided by value of total assets, is greater than 50%.
‘Tracing’ approach: the value of the borrowed funds are traced to the value of any asset acquired using those funds or, if the funds have been applied to an expense, the cost of that expense.
New build: includes ‘simple new build’ (adding a dwelling to bare land or replacing an existing dwelling with one or more dwellings), ‘complex new build’ (adding a standalone dwelling;attaching a new dwelling to an existing dwelling; or splitting an existing dwelling into multiple dwellings) commercial to residential conversions.
Early owners: a person who acquires a new build off the plans (before a CCC is issued for the new build); acquires an already constructed new build no later than 12 months after the new build’s CCC is issued; adds a new build to bare land; or adds a complex new build to land; or completes a commercial-residential conversion.
Subsequent purchasers: generally defined as a person who acquires a new build more than 12 months after a CCC for the new build is issued.
‘Continued investment rule’: the requirement for a new build to only be used for investment income purposes (not owner-occupied) in order to retain its new build status.
Ok, so with an understanding of those terms now on board, let’s consider the proposed interest limitation rules first.
As a guiding principle, I suggest it is helpful to acknowledge the Government’s reference to ‘in-scope residential property’, which includes property in use as long-term residential accommodation, or property that is easily substitutable for long-term residential accommodation. At the simplest level, it should include a house or apartment, regardless of whether it is used to provide long-term or short-stay accommodation, and a key question should be whether the property is of a type that would normally be available for owner-occupiers. If your property fits within the ‘in-scope residential property’ category, then you are certainly in the firing line for the Government’s interest limitation proposals.
Lesson number 1
The new rules will apply from 1st October 2021. Pre 27th March 2021 borrowings will be subject to a phase out, reductions commencing October 1st, with no further deductions from 1 April 2025, while 27th March and subsequent borrowings will be non-deductible from October 1st.
Lesson number 2
Overseas properties are excluded from the limitation rules. So the interest you are paying on your London apartment remains fully deductible post October 1st.
Lesson number 3
If you’re renting out a room of your home (not including a separate dwelling on your home title) to a flatmate, border or Airbnb, your interest deduction entitlement is not affected by the new limitation rules.
When it comes to interest deductions for a company, most of you are probably aware of section DB 7 of the ITA07, which provides an automatic deduction for interest – in other words, tracing is not required to establish the requisite linking between borrowing and income production to generate a tax deduction. Under the proposals however, section DB 7 will be overridden in respect of residential investment properties owned by either close companies or residential investment property-rich companies. For these entities, tracing will now be required, and where the borrowings are traced to residential investment property purposes, the interest deduction limitations will apply.
Lesson number 4
Companies that are neither close companies nor residential investment property-rich companies, are not affected by the new interest limitation rules.
Lesson number 5
Where the close company/residential investment property-rich company is a developer, it is proposed that residential property under development should still be considered ‘residential investment property’ for purposes of the ‘residential investment property-rich’ threshold. However, the company is likely to qualify for the ‘development exemption’ discussed below, and consequently only true rental properties it owns (unlikely but possible) would be subject to the interest limitations.
For non-company taxpayers, the interest tracing approach will be used, so if borrowings have been used for residential investment purposes, interest deductions on those borrowings will no longer be deductible (subject to exemptions such as for new builds and developers, and the phase out rules for pre-27th March borrowings). Borrowings for residential investment purposes include not just the borrowings to fund the purchase of a residential investment property, but also borrowings to fund expenses incurred in deriving rental income – rates, repairs & maintenance etc.
Lesson number 6
There is a proposed exception for refinancing pre-27 March loans which applies to property held (or acquired) before 27 March 2021. When a residential rental property owner draws down a new loan to repay a pre-27 March loan, it is proposed that the treatment of interest on the existing loan will carry through to the new loan (most likely subject to phase out therefore). Naturally, any additional lending will be subject to the tracing approach.
The tracing approach does have potential difficulties for those who previously had no requirement to trace (so may not hold sufficient records) or who have facilities like revolving credit or other variable loan types. The Government has outlined what it considers are workable solutions in this regard, including the potential use of a ‘high water mark’ rule, however your feedback has been requested as to whether there may be a better mechanism to achieve the desired outcome.
Lesson number 7
Foreign currency loans to finance a residential rental property in New Zealand are out from October 1st, regardless of whether the borrowing is pre or post 27th March – so no phase out for interest on foreign currency loans full stop. However, there will be a concession provided for where you convert that foreign loan into a NZD loan at any time post 27th March, the interest on the NZD loan becoming subject to phase out once in place.
Lesson number 8
Two main exclusions from the new limitation rules – the development exemption and the new build exemption.
The Government’s position is that the development exemption should be wide enough in scope to encompass development activity which may result in the construction of a new build. If a development meets the requirements of the exemption, the exemption will apply whether or not the person holds their property on revenue account (taxable on sale). The exemption will apply on a property basis, rather than on a taxpayer basis. The exemption is intended to cover land being developed by persons in the business of developing or dealing land or erecting buildings (captured under section CB 7 ITA07), and other developments which may not be covered under section CB 7 but contribute to the creation of a new build – one-off developments to sell or hold to rent.
The development exemption would apply while the property is being developed until the earlier of when the property is sold (settlement date) or until the CCC for a new build is issued. If the property is being held for rental or sale after the CCC is issued, the developer may qualify for the new build exemption from the time the CCC is issued until the property is sold.
The second exclusion is the new build exemption – interest that would have been deductible absent the interest limitation rule will continue to be deductible for debt relating to new builds. This includes interest on borrowings to acquire residential land that a new build is on, to construct a new build, or to fund other expenses relating to a new build such as maintenance, rates, or insurance.
Lesson number 9
If a new build receives its code compliance certificate (‘CCC’), indicating that a new dwelling has been added to the land, on or after 27 March 2021 then the new build exemption applies to an early owner (and potentially also subsequent purchasers). Note that there is also a new build exemption transitional rule, for certain new builds acquired on or after 27 March 2021 that received their CCCs before 27 March 2021. For these new builds, the new build exemption will apply to an early owner provided the new build is acquired on or after 27 March 2021 and no later than 12 months after it received its CCC.
The exemption would apply to early owners of new builds. However interestingly (and my first thought here is that the Government is simply resetting the playing field), the new build exemption is also proposed to extend to subsequent purchasers (note the proposed ‘continued investment rule’ however), and could last for 20 years.
Lesson number 10
Therefore, provided the property is never owner-occupied for its first 20 years (if that is confirmed as the final ‘new build’ qualifying period), any owner of the property during this timeframe would qualify for the new build exemption and all interest on their borrowings to acquire the property would remain fully deductible. Note that the subsequent purchaser’s rule is proposed to only apply for new builds that receive their CCCs on or after 27 March 2021.
Rounding out the discussion on the interest limitation rule proposals, although coming somewhat towards the end of the document (post the bright-line discussion), is commentary on interposed entity rules – akin to the rules that already exist in relation to the residential rental ring-fenced deduction provisions – anti-avoidance mechanisms to prevent taxpayers structuring their borrowings in a way that would avoid application of the interest limitations, because the borrowings are not taken out by the residential rental property owner directly. So, for example, the taxpayer borrows monies to acquire shares in a company, the company then using those funds (now capital) to acquire the residential rental property. Naturally, it is proposed that the interest limitation rules also contain these anti-avoidance measures.
Now I have just attempted to summarise 92 pages of commentary into 2 pages, so clearly a lot of the niceties surrounding the proposals are not covered here, such as apportionment issues (land containing both a new build and existing dwellings), disposals (should all interest then be deductible if land sale taxed) and different types of residential property that may or may not be affected (e.g., employee accommodation, serviced apartments) etc. However, you’re welcome to send me an email with any question or concern, and I’ll respond with my comments accordingly.
Arguably the most exciting component of this discussion document for me, is the commentary on the proposed additional bright-line rules.
I suspect it certainly will not be a surprise for most (because the Government had already announced it), to see included in the proposals the new build bright-line test.
Lesson number 11
The new build bright-line test is proposed to apply to all or part of a piece of residential land that has a ‘new build’ on it, but only if the land is acquired on or after 27 March 2021. The rules will only apply to early owners of new builds and will see the retention of a five-year bright-line test for the new build land, as opposed to the general 10-year bright-line test now in play.
A CCC for the new build must be issued by the time the land is sold by the early owner, for the new build bright-line test to apply. The new build bright-line test could potentially apply to all residential land that has a new build on it, regardless of what the land is used for, unless an exclusion applies (such as the main home exclusion). It does not matter whether a new build is rented out long-term, left vacant, used as a second home or holiday home, or is rented out as short-stay accommodation. The Government proposes that apportionment rules would apply for complex cases, which are when a dwelling is added to residential land that has an existing dwelling on the same title – so a proportion of the land may still be taxed under bright-line if sold within 10 years.
Well now for the biggie – from my perspective anyway.
Since bright-line was introduced in October 2015, many of us have grumbled, that unlike many of the other land taxing provisions where a timeframe is important (for example, section CB 12 – commencing the scheme within 10 years of acquisition date), the bright-line rules contained no concession for the ownership period of an associated vendor. Consequently, an individual who had owned their land for 15 years, could not transfer that land to their family trust, without restarting the bright-line clock – the family trust now subject to taxation under bright-line if the land was sold within the applicable bright-line period, unless the main home exclusion could be applied. This was even though there has been no real change in the economic owner of the land.
Lesson number 12
Rollover relief for family trusts, look-through companies, and partnerships will apply, so that bright-line rules are not triggered (or in fact brought into play, i.e. restart the clock scenarios) in relation to an intervening disposal between these associated parties, by treating the transfer as a disposal and acquisition for an amount that equals the total cost of the residential land to the transferor at the date of the transfer and with the recipient deemed to take on the transferor’s original date of acquisition. Note that the transfer must occur for no consideration in order for rollover relief to apply.
The proposed rollover relief will also apply for the interest limitation rules, both with respect to the interest phase out rules and for the new build exemption (the transferee will just step into the shoes of the transferor).
The discussion document commentary covers the various ownership vehicles the rollover relief is targeted towards – trusts, LTC’s and partnerships, and the types of issues that could arise under each scenario. For example, there is discussion around whether the association person definitions will require amendment to ensure the right beneficiaries are associated with the settlor to ensure the relief for family trusts applies as intended. There is also discussion surrounding joint owners of land, and the implications for both transfers into and out of the joint ownership.
Concluding the document are chapters on the interaction of the proposed interest limitation rules with the existing rental loss ring-fencing and mixed-used asset (residential property) regimes, and finally, administration of the new rules – how will Inland Revenue ensure it has sufficient data collected to be able to effectively monitor taxpayer compliance with the new rules.
As I alluded to earlier in the article, please feel free to reach out to me with any questions you may have on the proposals.