Government 'twisting knife' with new building tax review

Inland Revenue is examining banning depreciation on fixtures and fittings. Photo / Janna Dixon

Private commercial property owners, corporates and listed property trusts could be big losers if there are further changes made to depreciation rules, according to an investment expert.

Craig Tyson, ING (NZ) investment manager, said the fallout from last month's Budget could be even more severe for commercial property investors.

There were risks that the quality of New Zealand's office blocks could deteriorate and earnings from listed landlords could fall if further building tax changes are ushered in.

After April next year, landlords will be unable to claim building depreciation but Tyson, who manages more than $300 million of funds invested in the New Zealand listed real estate sector, said he was worried the Government would go further.

Inland Revenue is examining banning depreciation on fixtures and fittings and Tyson said that would be more damaging than the changes announced in May.

Changes announced in the Budget - particularly the denial of depreciation on building structures from April 1, 2011 - are expected to reduce earnings for listed property vehicles by 5 to 7 per cent in the 2012 financial year.

But Inland Revenue is now reviewing what constitutes building structure and broadening the definition to include fixtures and fittings would make things worse, Tyson said.

"We are concerned that further changes to the tax regime will not only damage returns to investors in our funds but also discourage further development and investment in New Zealand commercial property.

"This IRD review on top of the changes already announced creates significant uncertainty and comes on the back of a tough few years in which the sector has been buffeted by the global financial crisis, tight credit markets and falling asset values.

"Three-year compound annual gross returns for the sector have been a very disappointing -8.5 per cent. What the sector desperately needs is a period of calm and certainty around taxation so that we can focus back on fundamentals."

Analysts predict that a worst-case scenario could see vehicle earnings and distributions fall by as much as 10 per cent if new rules are adopted, Tyson said.

Lifts, wiring, ceiling panels and air conditioners could be considered fixtures and fittings but these were items which often only had an economic life of 15 to 25 years, he said, so it was crucial to be able to claim tax deductions.

If assets like these could not be depreciated, New Zealand would be virtually on its own internationally, Tyson said.

"New Zealand commercial property landlords would suffer the most severe tax regime of any OECD country. Indeed, only Britain, Ireland and Singapore currently deny depreciation on building structures.

"We are not aware of any country that has denied both depreciation on building structures and a significant portion of what is normally considered fixtures and fittings. This will have a damaging effect on investment in our market by international investors who are important in maintaining liquidity in the sector and increase the relative attractiveness of international real estate investment trust markets, which will in turn receive the lion's share of our KiwiSaver flows, depriving the domestic market of vital equity capital needed to grow," he said.

"More damaging will be the effect that this potential tax regime will have on the quality of building stock.

"Changes to classification of fixtures and fittings as structure would discourage developments of new property and investment in existing properties and likely lead to a deterioration in the quality of the domestic property stock over time.

"Indeed, recent trends towards 5-star green-rated buildings, which tend to cost more to build but cost less to maintain, are likely to be impacted.

"We have been encouraging the managers of domestic listed property trusts to move towards only paying out free cash flow rather than the full 100 per cent of accounting earnings, recognising that capital expenditure needs to be spent on maintaining the quality of their portfolios. This capex is unlikely to be maintained at current levels if the definition of building structure is broadened to include fixtures and fittings," Tyson said.

Analysts are also predicting huge profit reductions in NZX-listed vehicles such as Kiwi Income Property Trust and Goodman Property Trust after next April's tax changes.

Stephen Ridgewell of Maquarie Equities Research predicted the already-announced building tax changes would push NZX-listed real estate entities' earnings down 7.4 per cent. The Government was "twisting the knife" further in its building tax review due out in September, he said.

"The first key issue is where the IRD draws the line on what is defined as fit-out," he said.

"We do not believe the market fully appreciates the downside risks from the tax review," he wrote.

A Kiwi analysis by UBS Investment Research analyst Lance Reynolds flagged the tax changes saying a "worst case scenario" would be a Government change to classify fit-out assets as part of the building shell.