Scoop Election 08: edited by Gordon Campbell

Gordon Campbell: Risk Free Tax!

December 9th, 2009

housingOn current indications the Buckle Tax review will provide the final draft of their recommendations to the government just before Christmas – to enable it to digest the content – and then release the document to the public during the third week of January.

While speculation about the report’s likely findings have focused on a capital gains tax or a land tax levied on the unimproved value of all land, very little attention has been paid to a more politically palatable option – a Risk Free Return Method (RFRM) targeted only at the property sector.

Before trying to explain the RFRM, it is worth noting that we have seen it before, as a recommendation by the McLeod Committee Tax review in 2001. Back then, the suggestion was that it should be applied across all forms of investment. This time only the residential rental property sector seems to be in the firing line, for now at least.

Briefly… under the RFRM, a benchmark rate of tax is chosen – as if the actual investment was risk free. (The McLeod Committee recommended that the rate for government bonds be chosen.) If the investment incurs losses greater than the risk-free rate, these cannot be written off against the RFRM. If the investment is high performance, the investor wins, since they are taxed at the RPFM rate, regardless. Compliance is simple, and is levied on the net equity that the taxpayer has in the property, not on its total value. The government gains more certainty about its likely revenue, in that they get a fixed revenue flow, regardless of how the investment fares.

Geoff Nightingale is a tax partner at PricewaterhouseCoopers and a member of the Buckle working group. He explains how the RFRM would work, in contrast to the current tax rules situation. “ If you started say with a $200,000 house and it had a $100,000 mortgage, the risk free rate of return would only be applied to the net equity of $100K. So the method would say we’ll forget what interest you pay, what depreciation you pay, what repairs and maintenance you carry out and what rental you charge.” The officials at IRD, he adds., have done their RFRM modeling on the basis of a [rather high] rate of 6%. So 6% of 100k would give you $6,000 of gross income and that would be taxed at whatever your marginal rate is…So if your marginal rate was 30 % you would pay $1800 of tax on that.”
So to be clear…would the RFRM be levied in addition to the depreciation rules that we currently have, or would it replace them ? “It would replace them, “ Nightingale says. “If this method were adopted it would be the only way in which a rental property was taxed. So it would have an advantage of simplicity …But it would probably mean that that for everybody except the negatively geared people, there would be some tax to pay..”

Yet presumably, it offers the advantage of making loss-making investment less attractive – in that it removes the ability for them to be written off against income ? “Yes. It takes it away.” Nightingale outlines the kind of tax situation that has triggered the Buckle working group’s concern. “The classic issue [at the moment] is that you’ve got a wage and salary earner…sitting with their own home at $500,000 and its debt free, and they go and borrow $500,000 and buy a $500,000 rental property.”

In this scenario, Nightingale explains, the wage and salary earner’s total gearing now is only 50% since it is $500,000 against a million dollars of assets [even though] all of the debt is loaded up against the rental property, which is 100 % geared. Now, lets say the rental property has a 6% rental yield, and thy guy is paying 6% interest, and another 2% on repairs, maintenance, insurance, and a further 2% of depreciation. It is that extra 4% that gets thrown up as a loss on the rental property, and that goes across and gets deducted, against his wage and salary income.” That, Nightingale says, is what currently happens.

Under the RFRM method though, the interest deprecation/expenses would be ignored. In this example, because the guy is 100% geared against the rental property there would be no RFRM tax to pay, since the RFRM is levied only against the net equity. “ But what would be turned off in his case would be the offsetting losses against his PAYE income…Funds that he’s previously been getting, would be turned off.”
On ideological grounds as well, the RFRM could, (or should) be quite attractive to a centre-right government. After all, doesn’t the current taxation system mean that the government is left holding a share in the risks associated with private investment – if only by dint of the tax credits that can accrue ?

“Yes, you’re absolutely right.” Nightingale replies. “ In fact, it’s a one way bet. Because if [the investment] pays off big-time. then you get a capital gain on the sale. And the government doesn’t get a look at that. But yes, there is a level of risk sharing involved, and an underwriting of the cash loss…” Nine years ago, the RPFM solution that the McLeod Committee was advocating it across a wide swathe of business investment. This could have been dangerous for government revenues, and for the economy.

It would for instance, have rewarded safe, blue ribbon investment with a lower tax rate ( and thus for the wealthy, could have served as a handy substitute for either a corporate tax cut or a top income tax rate cut. As well as being regressive, it would have also penalized the sort of venture capital innovations that do carry genuine risks, and offer genuine rewards to the economy and to society, since those losses could no longer be written off, under a widely applied RFRM. Not surprisingly, the Clarek-led government didn’t buy the idea.

Those kind of possible impacts, Nightingale replies, is why the Buckle working party has kept its own version of the RFRM focussed very tightly indeed. “The working group has only looked at using the RFRM on the rental property market. We haven’t considered and I don’t think we will consider, expanding it. The hierarchy in the way we thought about it was : you start with a capital gains tax on a broad basis across all kinds of assets, apart from perhaps owner occupied housing. And you say what are the pros and cons of doing that ? ‘

‘And if you weren’t to do that, you might look at something like a land tax…If you decided that was too hard, or not politically tenable then – essentially as a third order [option] – you might fire at the rental property market which unconditionally, is not properly taxed at the moment. The RFRM is that rifle shot. You might sometime [later] consider expanding that to other classes of assets, but its not being considered as a model to tax business activity [in general.]….We have simply considered it as a rifle shot into the residential rental property market. Because we do have a consensus in the working group that this is a sector that has a tax problem. It is not being properly taxed.”

With any tax change, there is always a potential for collateral damage. Can Nightingale foresee any virtuous casualties of an RFRM levied on residential rental property investment ? “I wouldn’t have thought so, but we’ve done no work on that. All the data that we’ve looked at has been in aggregate for the sector.” By and large, Nightingale estimates somewhere around 5% would be ‘ not miles away’ from what the net rental stream would be for landlords, if the properties were being rented properly.

In 2001, the McLeod Committee had fixed the RFRM at the relatively safe ‘
risk free’ level as government bonds. Nowadays, wouldn’t any RFRM level need to be something of a sliding rate, sensitive to a range of externals ? “I agree,” Nightingale says. “I think we would have to adjust that number from time to time..Because it is designed to get at the risk free returns. So by definition, it must move around.” To ensure certainty and ease of compliance though, a degree of certainty – perhaps an RFRM rate reviewed every two years – would probably be required.

Finally, the IRD’s choice of a 6% rate in its modeling seems to have been arbitrary, and optimistically based on the direction in which the economy seems to be headed. “ I don’t think there’s any science behind it. That was the figure modelled, on the basis that if any reform came in, it would be next year, or the year after…and that will be a reflection of where we will be, once the economy starts to recover.,”

In the weeks and months ahead, the RFRM will doubtless receive a makeover, before being readied for public consumption – but increasingly, it looks more politically viable than either a capital gains tax, or a land tax.

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    1. 12 Responses to “Gordon Campbell: Risk Free Tax!”

    2. By stuart munro on Dec 9, 2009 | Reply

      It looks a bit dubious to me – this tax encourages high gearing rates – investing borrowed money. By contrast, someone who actually saved the price of their rental property, pays more. As such it goes nowhere towards addressing the perennially touted low savings rates of New Zealanders, whereas a capital gains tax paid on sale would not only realize a great deal more, it would positively shift investment activity away from rental housing – a much needed reform.

    3. By Joe Blow on Dec 9, 2009 | Reply

      This appears to basically be the government axing LAQCs while putting a set tax on equity in residential properties. I think this is a positive move. There is no point in putting in a capital gains tax if the tax insentives are still in place. It seems logical to rip out the insentive [LAQCs] first and see what happens. Its definitely a step in the right direction which is surprising for any government whether centre-left or right. If you notice the approach was not taken up by Labour when it was recommended by the McCleod Tax Committee review in 2001. Of course the average price of a house had not doubled by that time and did not look set to keep rising…

    4. By Joe Blow on Dec 9, 2009 | Reply

      Oops sorry I meant residential RENTAL properties above.

      One last thing in relation to what you said Stuart. As for it encouraging high gearing I think this over looks the fact that it only would do this if mortgage rates were lower than the tax rate as the less equity you have means the more you have to pay in interest on what you’ve got loaned and if that was more than what the tax rate would be there would be no incentive to reduce equity in the rental.

      I can’t help but like the idea of all these fat cats with their 80K plus incomes finally having to pay their personal income tax after dodging it for years through an investment in a couple of rental properties which are now worth upwards of 30% of what they were 6 years ago. It’s a pity Labour didn’t go with the Committee’s recommendations in 2001.

      I say bring it on!

    5. By Joe Blow on Dec 9, 2009 | Reply

      Stuart I just realised that if the tax rate is set at the same rate as government bonds as recommended by the McLeod Committee then mortgage rates would never go below the tax rate because the bond market sets all long-term rates. Therefore, it would always be preferable to pay the lower tax rate on equity than the interest on a mortgage hence the system would not encourage high gearing as it would be preferable to pay the lower tax on equity in the property than the higher mortgage rates to the bank.

    6. By Stuart Munro on Dec 10, 2009 | Reply

      Ultimately, there is no reason that any income should be tax exempt. So long as capital gains are not taxed prior to sale, there is no great hardship on property owners or rational landlords. The existing system encourages speculation to an extraordinary degree, and this is profoundly unhealthy for our economy.

      There are any number of measures available to soften the blow of imposing a capital gains tax, from an exemption for private residences, to a capital lower cap, and smoothing periods to make the adjustment seemless, but the government appears to be contemplating none of these.

      In trying to explain the origins of New Zealand’s mordidly inferior monetary and taxation policy, the possibility of stupidity can never be ruled out.

    7. By Joe Blow on Dec 11, 2009 | Reply

      My point is that axing LAQCs and putting even a mild tax on rental properties is better than I expected from any government wanting to survive in a nation of babyboomers hooked on bricks amd mortar.

      Ultimately I’d like to see them axe LAQCs and put in a capital gains tax but not even Labour was brave enough to do that.

      Still last I heard Whitehead wanted a capital gains tax so unless Key changes his mind it’ll be strange for a National government not to follow Treasury’s every beck and call…

      I guess we’ll just have to wait and see…

    8. By John on Dec 11, 2009 | Reply

      Thinking out loud, So I take a mortgage equivalent to my equity (currently 50% or $250,000, then pay out my equity, lend it to a family trust, the family trust then takes a mortgage over the properties and lends it to the company, who then repays the bank, mortgage is interest free repayable on demand, standard marshall clause. Equity now zero, tax now zero, taxable rental income which was $10,000 tax paid $3900 last year is now tax free.
      LAQC’s are not the problem, make the tax system fairer and then we won’t be so creative.
      The law of unintended consequences strikes again.

    9. By Joe Blow on Dec 11, 2009 | Reply

      Mmmmm. Not sure. You might know more about the tax system than me but usually you give money to a family trust which incurs a gift duty if it’s over 27K a year. Okay I guess a trust can grant a mortgage to a person.

      So let me get this straight. You grant a mortgage over your equity to the bank. Then your family trust grants a mortgage to you. Then the family trust grants a mortgage to the company who then repays the original mortage to the banks (back through the trust to you and you pay it to the bank?). I still find it hard to believe that you can wind up with an interest free mortgage out of that set up.

      So when the company repays the bank why is there no interest to be paid on that again?

      Please explain.

    10. By Joe Blow on Dec 12, 2009 | Reply

      I see you pay them back the bank quick smart so there’s no interest. Wait if you pay back the bank then you end up with equity in the property again don’t you?

      Why is there no equity after you’ve paid back the mortgage? Because the trust has a second mortgage over it to the trust? Surely IRD would find a way to screw you on that? Let’s hope they figure out a way to screw your loophole. I’m sure they will.

      You know the problem is loopholes like LAQCs and your trust scam which both need to go in order to make the tax system fairer not the other way round. I hope IRD burns you good!

    11. By Dave on Dec 12, 2009 | Reply

      I’ve read John’s example a couple of times now & I don’t think it works. You can’t lend 100% of your equity to a trust; equity must remain in the property as part of the bank’s security requirements for their loan. 100% Home loans are only approved to people with very high incomes that can afford to repay anywhere from 5-20% of the house’s value within 5 years (on top of the regular loan servicing for the remaing 80-95%). When a bank holds a mortgage over your property, you need their consent to make the types of transactions John’s suggesting – yeah right.

    12. By Joe Blow on Dec 12, 2009 | Reply

      Thanks Dave. I knew something was up but didn’t have the know how to crack it. He says that the trust mortgages the property a second time but does not say to who. I assumed it was to himself because no bank would take a second mortgage of all of the equity that is already mortgaged to another bank. So the trust’d need to get permission from the first bank to even mortgage the property again to himself I guess. Yeah that makes sense as when people transfer property to a trust by way of lending the money ot the trust there can be complications when there is a mortgage already over the property.

      So it looks like John is just fluffing with us then… still it would have been funny to see him try and explain how it works…

    13. By Joe Blow on Feb 23, 2010 | Reply

      I was totally wrong on this one (above). Stuart was totally right that this kind of tax system would encourage high gearing because the benefits of taking out the equity in a rental and stuffing it into buying another rental would outweigh the payments in interest on the mortgages (if the going keeps going good in real estate). No one was listening to me anyway…

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