Craig Elliffe: Bright-line test for house sales lacks lustre

Unless exempted, every gain on the sale of a residential property within two years of acquisition will be caught. Photo / Michael Craig

Craig Elliffe is a professor of law at the University of Auckland.

We now have some details about the new "bright-line test" for taxing the sales of residential property. This was contained in the officials' issues paper released last week by Inland Revenue and the Treasury; an interesting set of rules on which the public is invited to provide comments by July 24.

Everyone knows this new test applies to residential property sold within two years of acquisition where the purchase (entering into an agreement for sale and purchase) takes place after October 1. Here are some observations on these rules.

First, despite protestations to the contrary, this is a tax on capital gains. Okay, so it's not a comprehensive capital gains tax but unless exempted every gain, capital or otherwise, on the sale of a residential property within two years of acquisition will be caught.

This is made clear by the exemptions. It appears there will be no exemption for a property acquired as a long-term capital investment which is sold within two years because the owner runs into financial difficulties. Calling the tax a "bright-line" test and suggesting it only applies to "property traders" is disingenuous; it's a short-term capital gains tax on residential property.

The main exemption is for a New Zealand individual buying or selling their "main home".

The exemption creates some important new definitions. A "main home" for a person is the home mainly used as a residence by the person and any member of the person's family living with the person and with which the person has the greatest connection. There is only one main home. So even though a trust may own this main home and claim the exemption, if the settlor themselves claims the main home, the trust may not.

However, as indicated by the Taxation (Land Information and Offshore Persons Information) Bill, when a New Zealand individual sells their third main home in a two-year period they must supply their IRD number. It seems this information will be used to bolster taxation under other existing provisions, which tax the sale of land and property where a person has established a regular pattern of acquiring and disposing of houses.

The officials' paper also indicates an exemption will apply when you inherit a property from a deceased estate or have transferred as part of the relationship property settlement.

One proposed feature is that losses generated as a result of the bright-line test are ring-fenced, meaning they can't be offset against other income but can be offset against similar residential property sales income.

The rationale behind this is to protect the revenue base from the selected realisation of losses - taxpayers are incentivised to sell within the two-year period only if they can generate losses rather than taxable income. If they sell outside the two-year period, they arguably can generate non-taxable gains. Once again, this is a commonly found, if not universal, feature of capital gains taxation.

Second, the bright-line test needs to tax companies that hold residential property. Otherwise a person simply incorporates a company for each residential property they acquire and then sells the shares to the purchaser rather than the property itself.

Since the residential property is not itself sold, it is necessary to tax the sale of shares of the company when the ownership of the company (and hence its asset, the property) is transferred.

It's an obvious loophole so it's essential the new tax be designed this way. The proposed method of taxation is a special anti-avoidance rule deeming the disposal of property held by a company to have occurred if there is a disposal of company shares with the purpose or effect of defeating the bright-line test.

Presumably the tax liability accrues to the company for this deemed disposal. If so, let the buyer of the company beware. Suddenly they will own a company that has both a house and an unexpected tax liability. The non-resident vendor who receives full value for the shares will be laughing all the way to bank.

Taxing the company on the deemed sale of the property neatly circumvents a technical problem as taxing the sale of shares held by non-residents in a country where New Zealand has a double tax treaty was almost certain to cause interesting issues. In some of our treaties it's arguable the international agreement prohibits taxation of gains made on the sale of shares.

Using a trust to transfer ownership beneficially will also be subject to specific anti-avoidance rules.

A change in the trustees (including the ownership of a corporate trustee), a change in the beneficiaries or a change in the power of appointment can generate a deemed disposal of the property by the trust.

Lastly, it seems relatively clear the new rules will have some of the features viewed as completely unacceptable by critics of capital gains taxation - they are administratively cumbersome with complex definitions, numerous exemptions and little revenue generation. A two-year period seems easily negotiable for most property speculators leading to the suggestion that revenue collected will be small.

The point has been made that if someone acquires property with the intention of resale they can still be assessed under existing provisions if they sell after this second year of ownership, but that's no thanks to the new provisions.

In summary, I'm not sure whether to applaud this brave decision or condemn it for its hypocrisy. As the details emerge I'd be concerned that this response is too little, too late.