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FUTURE OWNERSHIP OPTIONS

By Raymond Peterson,2014-07-10 16:19
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FUTURE OWNERSHIP OPTIONS ...

     Future Ownership Options

    Peter Glassford

    Brown Glassford and Co Ltd,

    Christchurch

Introduction

    Up to five years ago most farmer clients of mine would have been farming as sole traders or partnerships. These structures are generally well understood and relatively

    inexpensive to administer.

    The most significant factors that have bought about changes to the way my clients do business are:

    ? The Matrimonial Act and more recently the Relationship Act.

    ? Rest home subsidies and the fear of the reintroduction of death duties.

    ? Clients having the profitability to deal with succession requiring thought to be

    given to moving forward with more appropriate ownership vehicles even if

    this results in some short term financial cost.

    ? Better taxable incomes and a reluctance to pay higher rates of tax.

    The Workshop held as part of this paper will focus on looking to move from a simple ownership structure (partnerships) to a structure that has more complex entities.

    In order to do this it is helpful to summarise the major features, advantages and disadvantages of the options available.

    These are:

    ? Partnerships and Sole Traders

    ? Companies

    ? Trusts (Non-Trading)

    ? Trading Trusts

    The following commentary summarises these features and is based on the Advanced

    Business Structures papers given by Graham Brown of Brown Glassford andf Co at the SIDE in

    2001.

Partnerships and Sole Traders

    Advantages

    ? Simple

    ? Inexpensive to establish and administer

    ? Decision making and administration kept “in the family”.

    ? Control maintained by founding family members.

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    ? The following aspects of The Income Tax Act do not apply to partnerships and sole ? traders;

    ? Fringe Benefit Tax relating to benefits provided to owners.

    ? Deemed Dividends.

    ? Issues relating to overdrawn Current Accounts.

    ? Carry forward rules regarding losses and imputation credits, which can be lost

    with a change of shareholding in a company.

    Disadvantages

    ? Governance rules may not be adequate for multi owners particularly if they are not

    related. For instance Shareholders Agreements are usually more comprehensive in

    setting the rules for running the business, distributing profits and the future sale by

    one or more owner.

    ? Owners may be exposed to higher marginal tax rates than would apply if taxable

    income was spread between more taxpayers.

    ? Unable to “skip a generation” with the transfer of assets.

    ? Assets are owned personally, leaving the owners open to claims from creditors, and

    to claims under the Relationship Property Act.

    ? Personal ownership of assets leads to higher value of Estates and potentially less

    eligibility for government funded benefits, e.g. rest home care, government

    superannuation, student allowances.

    ? Entry and exit of investors or family members requires the sale and purchase of the

    assets themselves. This can lead to taxation consequences such as taxable

    depreciation recovered on plant, vehicles and buildings, and taxable profit on the sale

    of livestock.

    Companies

    Advantages

    ? Future transfer of ownership of assets becomes easier involves a share valuation,

    then transfer of shares, rather than the transfer of assets themselves. This can lead to

    tax savings relating to the transfer of the assets themselves.

    ? Liability of shareholders is limited to the value of unpaid capital. Main sources of

    potential liability are trade creditors, third parties affected by the company’s actions

    and environmentally related issues (e.g. pollution, fire, contamination, etc). This can

    be severely undermined by personal guarantees being required by Banks and

    landlords.

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? As businesses become larger and more complex, a more formal management and

    governance structure may provide benefits.

    ? Corporate tax rate 33% - Australians now 30% - may fall further. But note salary to

    shareholder employees must be commensurate with work done (may limit salary in

    some cases). ? Easier for off farm investors to invest capital without being involved in day-to-day

    running.

    ? Avoids individual ownership for asset tested benefits.

    ? If a Loss Attributing Qualifying Company, can still offset losses against shareholders’

    other income.

    Disadvantages

    ? Higher compliance costs - slightly higher than for Trusts.

    ? More complex to wind up.

    ? Losses and imputation credits can be lost if shareholding is changed.

    ? Companies Act requires a higher level of care by directors.

    ? Companies Act requires that companies do not trade whilst insolvent.

    ? Potentially more taxation related issues to consider, e.g.

    ? Fringe Benefit Tax because working shareholders become employees.

    ? Non cash dividends to shareholders where goods and services pass at less than

    market value.

    ? Capital gains taxable unless made in the course of winding up (most cases) or

    company is a qualifying company.

    ? Tax losses quarantined in company unless company is a Loss Attributing

    Qualifying Company.

    ? Loss Attributing Qualifying Companies can be a problem with Trusts as shareholders

    because of need to distribute dividends in every circumstance.

    Trusts (Non-Trading) [i.e. owns passive assets - usually land and buildings]

    Advantages

    ? A Trust separates ownership into legal ownership (the trustee) and beneficial

    ownership (the beneficiaries).

    ? ACC levies are not payable on income received from a Trust. However, care should

    be taken to arrange alternative accident insurance if it is required.

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? FBT may be avoided as this only applies where benefits are provided to employees.

    Note however there is another school of thought which considers that provision of

    services to the Trust constitutes an employer / employee relationship.

    ? The effective tax rates for income allocated from a Trust will be the tax rates for the

    individual beneficiary - if an adult, subject to a minimum rate of 19.5%, or 33% if a

    child under 16 for the full year. Alternatively, income retained in a Trust is taxed at

    33%.

    ? Provides a mechanism for skipping a generation with the transfer of assets -

    maximum life 80 years.

    ? An increase in the value of underlying assets and investments made from

    retained profits will accrue to the Trust rather than individuals.

    ? If the Trust is discretionary, the trustees will have absolute control over

    allocation of income and capital and beneficiaries can include children and

    grandchildren. This potentially provides protection from claims by creditors

    and spouses / partners.

    ? Transfer of assets may lead to potential avoidance of asset testing on benefits.

    Disadvantages

    ? Duties placed on trustees are onerous and include:

    ? Act personally, loyally and diligently in administering the Trust.

    ? Consider all beneficiaries when making decisions.

    ? Preserve the Trust property.

    ? Inform the beneficiaries of their entitlement. ? Complexity re bank securities - may mean personal guarantees needed, which dilutes

    the asset protection objective to some extent.

    ? Also, trustees can be held personally liable for Trust liabilities. This is why

    historically Trusts have not traded.

    ? Infant beneficiaries may accumulate significant Current Accounts which they can

    demand to be paid out to them once they are no longer minors.

    ? The circumstances of all beneficiaries must be considered by trustees - potential for

    claim/action by excluded beneficiaries?

    ? If Trusts are non-trading, there will be a limit to the amount of income which can be

    transferred to the Trust - related to market rental of assets owned.

    ? Higher compliance costs than sole trade and partnership.

    ? “Modern” (post December 1992) Trusts with husband and wife as settlor, trustee and

    discretionary beneficiaries would not have been effective under the old Estate Duty

    rules (Estate Duty was abolished in December 1992). If such legislation becomes a

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    consideration again, these Trusts may have to be re-settled, although this can be

    provided for in the Trust Deed. Care should be taken with the Trust Deed to avoid the

    Trusts being treated as a sham (see below).

    ? In a similar vein, there is some concern that widespread use of Trusts, e.g. to own

    family home, has potential to cause Government to legislate to protect the tax base

    and reduce the opportunity for participants to qualify for state support. Accordingly,

    if a Trust is used, I suggest it should be robust - for example, using a third non-

    relative trustee.

Sham Trusts

    Care must be taken when a settlor (person putting assets into a Trust) is also a trustee and

    a beneficiary. This applies to both trading and non-trading Trusts. In particular, I would

    suggest firstly the use of a third independent (non-related) trustee (or in the case of a

    corporate trustee, an independent director or shareholder). Secondly, I would suggest

    that a person or persons who hold all three positions, do not also hold the power to hire

    and fire trustees. This power should be held by an independent person as well.

Trading Trusts [ i.e. owns both fixed assets and trading assets]

Introduction

    The use of Trading Trusts in New Zealand is relatively uncommon. Advocates of Trading

    Trusts argue that they combine the advantages of using ordinary passive asset owning Trusts

    and a trading company, and overcome some of the disadvantages of both. In order to obtain

    these advantages, Trading Trusts need to:

    ? Be discretionary with respect to the allocation of income and assets; and

    ? Either:

    ? Use a corporate (company) as the trustee because potentially ordinary

    individual trustees have personal liability for trading losses; or

    ? have the capacity for the corporate trustee to contract out of the potential

    liability with creditors - this is probably not realistic.

    Advocates for the use of Trading Trusts usually admit that they have potential problems

    (from the point of view of protecting assets and minimising taxes and avoiding liability to

    creditors and beneficiaries).

Advantages

    ? Whereas the beneficial ownership of shares in a company is a matter of public record

    (through Company Office records), the beneficiaries details / existence is not. 98

? If a corporate trustee is used, then creditors and customers may believe they are

    dealing with a company rather than a Trust.

    ? If the corporate trustee owns no assets and has a low level of authorised capital,

    protection of claims from creditors may be achieved. Even though a director has a

    fiduciary duty to the corporate trustee (i.e. duty to act in the best interests of the

    company), and the corporate trustee has a duty to act in the best interests of the

    beneficiaries, arguably the directors of the corporate trustee as individuals do not

    have a fiduciary duty to the beneficiaries. However, this line of argument is not

    without its critics who argue that, whilst this lack of liability to beneficiaries may be

    correct from the point of view of Trustee and Corporate Law, it may not be correct

    from the point of view of the Law of Tort (where one person owes a duty of care to

    another). There has been precedent for the Courts to look through a company to the

    directors, who can then be treated as if they were the trustees.

    ? Capital gains can be distributed tax free. In a company this can only be done if the

    capital gains made in the course of winding up or the company is a Qualifying

    Company (5 or fewer shareholders).

    ? With companies tax losses and imputation credits (tax credits which can be allocated

    with dividends), can be lost if shareholding changes above certain thresholds. ? Non-residents of New Zealand don’t suffer the loss of imputation credits which are

    usually attached to dividends paid by companies from revenue profits.

    Disadvantages [of a Trading Trust]

    ? The need to use a corporate trustee makes establishment, operation and understanding

    more complex for owners. Other parties such as banks may require more complex

    documentation.

    ? Multiple ownership within a family is not well catered for - normally have to use

    multiple Trusts, i.e. one for each family member.

    ? Passive assets, e.g. property, should be held separately from trading assets - to avoid /

    minimise claims against passive assets from creditors, spouses and financiers. This

    may require the use of more than one Trust.

    ? A build up of balances owing to beneficiaries should be avoided. These come when

    the allocation of income exceeds the application or vestment of funds for the

    beneficiary. In a practical sense this may limit the amount of income allocated each

    year - particularly to infant beneficiaries. Accordingly, the tax saving benefits will

    also be restricted. Note for all Trust payments for / to beneficiaries that these should

    not be for necessities of life, e.g. food, clothing and shelter.

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    Note also that to qualify as beneficiary income, payments must either be made to or

    on behalf of the beneficiary during the year, or vested in them (by Trustees Resolution)

    within 6 months of the Trust’s balance date.

    ? Trading Trusts are likely to attract more IRD scrutiny than Non-Trading Trusts.

    ? In Australia, Trading Trusts have been taxed as companies since July 2000. In other

    words, the Trusts pay tax on income, then distribute income to beneficiaries with tax

    credits attached. If beneficiaries have lower income, they cannot utilise all the tax

    credits. Our legislation could follow that in Australia.

    How do I know if I need to change my existing structure?

    ? You need to identify the problems with the existing structure.

    ? This can itself be a problem as without the input of your professional advisers you

    may not be in a position to identify the problems or quantify the financial benefit of

    changing.

    ? In most cases changes in structure take time and are relatively expensive. Will it be

    worth it?

    ? Changes to structure need to be considered in relation to personal and financial

    objectives.

    Considerations when moving to a new structure

    1. Decide on name for new company or trust.

    2. Decide on settlor, trustees, and beneficiaries if Trust.

    3. Decide on Directors, Shareholders and Registered Office if Company.

    4. Establish estimates for legal, accountancy and valuation costs. Make sure bank aware

    of planning as securities may need to be transferred and there may be existing fixed

    interest rate loans to consider regarding early repayment penalties. A new trading

    cheque account may be required.

    5. Agree on most appropriate date for transfer to the new entity.

     Consider: (a) Annual Balance Date of existing entities

     (b) Potential benefits of transferring before existing Balance Date

     re current year’s income.

    (c) GST Return periods for existing entities which may be

     continuing.

    st(d) Deferral of tax payment if transfer left to 1 day of the next

    Financial Year.

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6. Decide on the assets to be transferred after considering potential taxation

    consequences, for example, with respect to profit on the sale of livestock and taxable

    depreciation recovered on the transfer of assets (including buildings). Consider

    leaving expensive items of vehicles and plant, some / all livestock and buildings (if

    on separate title) with current owners. Any fixed assets left would be leased to new

    trading entity. Any livestock left would be made available to the new entity. Bailors

    cannot use NSC. Therefore, a bailment (rental) could be used only if existing owners

    are using Herd Scheme or Market Value. If the existing owners are using NSC, a

    Profit Sharing Agreement must be used rather than a bailment. Some commentators

    consider that a disappearing bailment can be used.

    7. Discuss which farm related shares will be transferred to the new trading entity, e.g.

    fertiliser company shares, meat company shares, dairy company shares, trading

    society shares, etc.

    Write to Share Registrars re transfer.

    8. Consider income tax consequences if land being subdivided, particularly if within ten

    years of purchase, and remember that the clock starts again on the ten year rule for

    the new owner regarding possible future subdivision of the land.

    9. Avoid a sale and lease back of land where there is unamortised development, as

    amortisation can only be claimed by a farming business (not a landlord).

    10. Discuss Fringe Benefit Tax issues where using a company.

     Will apply re cars, electricity and any other expenses paid on behalf of an employee

    (including a shareholder, unless the company is a Qualifying Company and the

    shareholder is not a shareholder employee - unusual).

    Note recent increase in complexity of FBT regime and increase in effective rates

    unless benefits are attributed to individual employees. General recommendation

    would be to increase salary and ask employees to pay their own accounts, and

    prohibit private use of motor vehicles owned by the company.

    FBT on cars can be expensive. If relatively high business running may be better to

    leave out of company and reimburse owner for the business running proportion.

    11. Consider key person insurance for farm manager and key staff - mainly applicable for

    Joint Venture Companies. Policy should be owned by the company

Steps

    1. Arrange for valuation of assets to be transferred. Must be at market values, i.e.

    livestock, plant and land. Consider proximity to last rating’s valuation - can

    generally use if less than six months old.

    2. Prepare final estimate of cost of income tax payable on transfer of assets.

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    3. Apply for IRD number and GST registration once Certificate of Incorporation (for

    company) or Deed of Trust (for Trust) has been received.

    ? Consider Group GST Registration. To get this one party must control all

    members. Not permitted where trusts are involved.

    ? Consider whether GST going concern rules apply which would mean the

    transaction could be zero rated.

    ? Consider making company a Qualifying Company and possibly a Loss

    Attributing Company. This can only be done if no more than five shareholders.

    4. Register the new trading entity as an employer. De-register existing trading entity

    from same.

    5. Revise Wills of all parties as appropriate. Consider appointment of replacement

    Directors or Trustees. Consider transfer of controlling shareholding on death or

    incapacity of founding controlling shareholder(s).

    6. Set up gifting programme re residual debts.

     Consider making initial gifts of more than $27 000 at lower duty rates.

     For example: Gift of $36 000 - duty equals $ 450

     Gift of $50 000 - duty equals $ 2250

     7. Arrange insurance.

    Income tax planning ? Income tax benefits must be seen (and documented) as an ancillary benefit and not

    the main purpose of the restructuring. The potential tax savings can be worthwhile

    with the current tax rate regime.

    ? Take care in correspondence and documentation. Transfer assets at valuation. Use

    Sale and Purchase Agreements. Prepare Employment Contracts for employees of

    company or Trust.

    ? Suggest a couple need to have a taxable income of between $150 000 and $180 000

    before tax savings equate to compliance and set up costs of alternative ownership

    structure.

     For example: Husband and Wife Partnerships Taxable Income, say $140 000

     equals $70 000 each

    Potential tax saving to shareholders if income above $60 000 salary,

    taxed in the company, will be: 2 x $10 000 x 6% = $1200 p.a.

    Compare with savings which can be made by paying wages to children who are doing

    the required work. i.e. marginal tax rate for income from wages up to $9500 equals

    15%.

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    For example: 2 children x $5000 wages per annum x 24% (39%-15%) saving equals

    $2400, and no set up costs and minimal additional compliance costs.

    Note that the wages become the property of the child - requires care. Normal

    requirements re deducting PAYE and maintaining wage records will apply.

Case Study

Background

    ? Husband and wife partnership - both in forties.

    ? Owned their property which was a new conversion in 1996.

    ? Currently milking 600 cows on 170 ha [229 000 kg of solids]

    ? Partnership owns all livestock, plant and land and buildings.

    ? Two children 14 and 16.

Assets

    1. Land, buildings and Fonterra shares - Estimated Value $3 800 000

    2. Accumulated Depreciation

     Buildings $ 70 000

     Plant $128 000

     Motor Vehicles $ 32 000

    3. Livestock Av Book Value Market Value

     125 R1yr heifers $619 $ 620

     120 R2yr heifers $800 $ 1120

    480 MA cows $900 $ 1300

    725 _______ _______

     TOTAL VALUE $605 375 $842 556 Difference $230 525

     ====== ====== ======

    4. Profitability

     Taxable income 2001 $280 000

5. Unamortised Development $230 000

     [Mostly irrigation)

Issues

    1. No succession plan in place - do they need one:

    2. No structure to limit relationship claims.

    3. Some potential to increase income by intensification or buying additional land.

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