Peter Speakman: Unwanted extras lurk within new rules for LLP

Frequently we hear Government rhetoric pronouncing its wish to promote foreign investment in New Zealand, particularly in our virgin venture capital industry. The newly proposed limited liability partnerships (LLPs) deliver on that rhetoric. Yet there lies a medley of poison pills lurking within the proposed new rules for LLPs.

Ostensibly, the LLP regime promises instant wealth as a result of the streams of foreign dollars that it is hoped the regime will bring to New Zealand. In truth, it disguises a number of unwelcome and previously unheralded trappings.

New loss limitation rules are one example. For example, you may finance a new manufacturing or import and distribution business with a mix of $40,000 of your own money and $60,000 borrowed from a financier. Naturally you want to protect yourself against losses in the event that the business collapses. An LLP offers you that protection and, unlike a company, offers flow through tax treatment. Hence, you choose an LLP structure for your business.

If the business succeeds, no problem. If not, the business will have lost the full $100,000. The loss limitation rules, however, limit the amount of loss that can be claimed for tax purposes to the $40,000 that you contributed yourself. No tax allowance is permitted for the loss that is debt funded.

This result contrasts vividly with the tax result that flow-through tax vehicles presently offer, where a tax deduction may be claimed for the full $100,000. Inherent in the change is the thinking that not all losses should qualify for a tax deduction. In some cases, fair enough. But there is a misplaced premise in denying a business loss just because it has been funded by borrowings and not by an investor's own savings.

Another in the catalogue of unwelcome trappings is the proposal to liken an interest in a partnership to a share in a company. Dealers in shares have long accepted that gains they make on the sale of shares, like any other property, are taxable. That will now also be the case with an interest in a partnership, notably for investors who are unable to persuade the IRD that they acquired their interest in the LLP for the long term.

The rules are worse for New Zealand investors in foreign partnerships. Two sets of rules apply here, depending on the nature of the particular partnership. In the absence of a narrow set of exemptions for investments in so-called grey list countries, both sets of rules result in a tax liability for the New Zealand investor based on his or her share of the income from the partnership. The best thing that can be said about this is that, unlike Dr Cullen's proposed new offshore investment rules regime, this regime does not seek to tax unrealised capital gains. Nevertheless, all this demands a high degree of care in managing any interest in a foreign partnership.

Worse still, however, is the potential side effect of the LLP regime, namely abandonment of the qualifying company and loss attributing qualifying company (LAQC) regimes. Those regimes, particularly LAQCs, have become commonplace and are widely used by many New Zealanders. Take, for example, the owner of a rental property. He or she will likely have borrowed heavily to purchase the rental property. The rent received from the property will be used by the owner to meet his or her interest payments to the bank.

Often the interest expense exceeds the rent received, resulting in a loss. In addition, the owner will suffer depreciation of the property that increases the amount of the loss. The owner can claim a tax break for the loss. Holding the property in a LAQC enables the person to shelter the property from his or her other assets whilst at the same enabling him or her to write off the loss against other income, thereby reducing his or her tax bill. That loss is taken on the chin in the expectation of a future capital gain on selling the property.

There is a hint in the material that contains the new LLP regime that the LAQC regime may be repealed, on the basis that our tax system should not permit a proliferation of flow through tax vehicles. In short, it is a distinct possibility that the new LLP regime will be at the cost of forsaking the LAQC regime.

That would be of huge significance not only because LAQCs are now so endemic, but also because the alternative of using an LLP has the disadvantage of the loss limitation rules which LAQCs do not suffer from.

There is no doubt that the LLP regime is a step in the right direction and has potential to offer huge advantages.

The trappings that come with it, however, are both unnecessary and unwelcome.

* Peter Speakman is a partner at Kensington Swan, specialising in taxation.