Transferring assets between related parties should, in theory, be a relatively painless exercise. The use of trusts for asset protection, wealth accumulation and succession planning is becoming far more common. For example, it makes sound commercial sense for an individual who owns a commercial investment property to consider transferring that property to a trust; this obviously raises tax issues.
The tax issues surrounding the transfer of the commercial property to a trust should not be difficult to cope with. The property would need to be sold at market value, otherwise a gift duty liability will arise. The individual would be liable for income tax on depreciation recovered, assuming the market value exceeds the tax book value. So far so good.
The Income Tax Act contains a number of provisions which apply to "transactions" between "associated persons", and deprecation is one example. The associated person definition used for the depreciation rules is contained in section OD 8(3) of the Income Tax Act 1994, and unlike the definition used for land transactions, it is very difficult to break. In this case the individual and the trust will probably be regarded as "associated persons".
On the assumption that the individual and the trust are "associated", the trust is limited to using the same depreciation rate the individual used. The trust can change methods - for example, diminishing value to straight line - however, the trust must use the same rate the individual would use if using the different method. The idea of the trust splitting out the chattels, and depreciating those assets at a higher depreciation rate than the building, does not work if the individual depreciated those assets at the building depreciation rate of 4%. The trust is limited to using the depreciation rate of 4% on those chattels.
Now the fun starts. The trust is limited in the cost base it can use for depreciation. The trust must use the lesser of the cost it paid for the property or the cost to the individual, which in some cases can be substantially less than the current market value. However, section EG 17(2) gives the commissioner discretion to allow the trust to depreciate assets based on the transfer price rather than the original cost price to the individual.
Section EG 17(2) states that in relation to transfers of depreciable property between associated persons
"The Commissioner may permit a deduction in respect of the depreciation of the property to be based on its cost to the taxpayer if the property is not depreciable intangible property and the Commissioner is of the opinion that such treatment is appropriate in the circumstances."
Owing to the tax rate increase and the recent changes to the GST on second-hand goods provisions, there has been a significant increase in the number of transfers of property between associated persons, and family trusts in particular. It should be noted that if approval is not obtained from the Inland Revenue Department (IRD), the depreciation limitation on the cost base applies. It is not optional; application must be made to the IRD if the market value of the asset is to be used for depreciation purposes.
This is where the inconsistencies arise. We have had a number of dealings with the IRD around the country where approval under section EG 17(2) has been declined in respect of transfers of depreciable property to family trusts, and other cases where approval has been granted. The circumstances are the same, so why the inconsistencies?
Most cases involve the purchase price being satisfied by a deed of acknowledgement of debt, and in some cases the debt has been subject to a gifting programme.
The reasons given for declining the requests are that the sale in these circumstances is not at arm's length. In one case the IRD also argued that the cost to the taxpayer for the purposes of the section is the true cost or economic sacrifice to the taxpayer, and that a purchase financed by a deed of acknowledgement of debt followed by a gifting programme does not satisfy this concept of cost.
The problems primarily lie with the Waikato region, where we understand cases are currently progressing through the disputes process. However, we have also encountered difficulties in our dealings with Auckland North, where the "true cost" argument was raised. Common sense has prevailed in Auckland South, with approval granted provided there is a bona fide transfer, and there is evidence that the transfer price is at market value. We consider the approach taken by the other offices is inconsistent with both the IRD's policy in this area and the relevant case law.
The commissioner's policy statement on the application of section 111(2) (now section EG 17(2)) is contained in TIB Volume 4, Number 5 (December 1992).
This states that the commissioner will normally exercise discretion where:
The leading case on section 111(2) is CIR v Lys (1988) 10 NZTC 5,107.
This case involved the sale of land and buildings at market value by Mr Lys to a family trust of which his wife and children were beneficiaries. The purchase price was satisfied by a vendor mortgage which was repayable on demand with interest payable only if demanded. No interest was demanded for the first five years following the transfer, and during this period the principal owing was reduced by a series of gifts from Mr Lys.
The court determined that the application of section 111 hinged on whether the transfer was at arm's length. In finding for the taxpayer, Judge Jeffries said a transfer to a family trust is not necessarily less than at arm's length and, although the terms of the vendor mortgage indicated that the transaction was a family dealing rather than a commercial one, this did not affect the genuineness of the transaction or price.
The court held that the exercise of the commissioner's discretion must be related to normal commercial and conveyancing practices. Where the transaction proceeds in accordance with proper practices, and the price is low rather than high, there is no reason to decline the exercise of the discretion in section 111(2).
In relation to the transfer to a family trust, Judge Jeffries commented that where assets are settled on trust, and that trust is properly constituted and properly operated, there is not a retention of virtual ownership which would be relevant to the forming of the commissioner's opinion under section 111(2).
I believe these comments clearly indicate that the commissioner is unreasonably declining requests for discretion to be exercised under section EG 17(2) in cases where there has been a bona fide transfer of the property to a family trust at market value. The existence of an acknowledgement of debt and/or gifting programme does not provide sufficient grounds to determine that the sale is made otherwise than at arm's length.
It is extremely frustrating when application is made to the IRD for approval under section EG 17(2) for a number of clients and some are approved and others are not. The cost of disputing cases declined by the IRD can be significant. More frustrating is the fact that IRD national office is aware of the issue and has not yet moved to clarify the position. We can only hope that a policy statement, consistent with the principles established in the Lys case, will be forthcoming in the near future to promote a uniform approach among all IRD offices when exercising the Commissioner's discretion under this section. In the meantime, we sympathise with those experiencing unexpected difficulties in obtaining approval.
Phil Walker is a director of
NSA Ltd in Auckland
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