Labour’s Tax Policy – A fair go?
It is important that franchisors and franchisees understand what Labour’s recently announced tax policy means for them if implemented. There is potential for the promised changes to inflict a “double whammy”, given the capital gains tax (CGT) proposal and the reintroduction of a higher income tax rate for high income earners.
Labour’s policy, which was launched by leader Phil Goff and opposition spokesman, David Cunliffe, on 14 June 2011, contains a number of key points that may particularly affect franchisors and franchisees.
Capital Gains Tax
“The (CGT) tax will be set low flat (sic) rate of 15%”
Capital losses will be ring-fenced so they can only be offset against capital gains. There will be no indexing for inflation.
There are numerous exemptions, including the family home and personal assets. In addition, small business assets, up to $250,000, will be exempt provided the owner is over 55 and has owned the business for at least 15 years. The last exemption on the above list will be of interest to franchisors and franchisees, as they contemplate how the proposed tax will affect any future sale of their business.
Franchisors and franchisees should consider the earning of a suitable return from their regular trading activities as a prime driver. In other words, the trading profits should be commensurate with the quantum of investment that has been made and the risk of the business. Some franchises require greater levels of capital investment than others to set up and, as such, require greater levels of profit to sustain the business and reward the owners appropriately.
Both franchisors and franchisees may also seek to earn a capital gain on the sale of their business. In a business context, such capital gains are most likely to be represented by goodwill. There are many definitions for goodwill but the most suitable is that it is the part of the consideration for the sale of a business that exceeds the value of the net tangible assets acquired. For example, a business sale might comprise plant, equipment, the unexpired portion of an assigned franchise agreement and stock that has a value of $250,000; yet the purchase price might be $600,000. The additional $350,000 can be thought of as the extra amount that the purchaser is willing to pay to acquire the future income stream.
Franchisees should think about this advance. Although running a business that generates good profits is reward in itself, proven consistent profits also helps maximise the value that might be obtained on sale of the business. Even though it is common for franchise agreements to include a “sale fee” (such that part of any goodwill or sale price might be payable to the franchisor) there is still incentive for a franchisee to maximise the goodwill.
A franchise agreement may allocate the franchise fee on some other basis. Whether it is a sale fee or an allocation of goodwill, such amounts are more likely to already be taxable to the franchisor because it forms part of their normal business income. For a franchisee, the current tax treatment of amounts received on the sale of goodwill is generally, that it is capital in nature and, as such, tax free. Introduction of a capital gains tax would change that.
The introduction of CGT might prompt a franchisee to seek its recovery through lifting the sale price. Although that may well work, ultimately the market will set the price through the meeting of a willing seller and a willing buyer. In other words, forcing the price too high may dissuade potential purchasers and force the owner into a longer than desired period of ownership.
Franchisors should provide assistance and guidance in this situation. As with any franchisee acceptance procedure, the franchisor should consider the ability of any new franchisee to meet their obligations, including debt servicing; they may be adversely affected if the purchase price for the business is higher than the franchisor’s gearing can sustain. Franchisee failure is not a good outcome for any franchise system.
Although much is made of the fact that New Zealand is one of the few OECD countries not to have a CGT, in fact tax is already charged on capital gains in a number of situations, including unrealised gains, such as shareholdings in foreign companies.
It will take time for CGT to bring in any serious cash for the Government. The tax will not be imposed until realisation of assets. As implementation of CGT will be grand-fathered, unrealised capital gains earned up to “V day” are not taxed. Some concession will be given for assets in Canterbury, where “V day” values may be adversely affected due the earthquakes.
CGT is agreeable in that it accords with the Tax Working Group’s recommendation for a broad based, low rate system. The numerous exemptions will be problematic and will add to the complexity of the regime.
GST changes
“Labour will take the whole GST off fresh fruit and vegetables from 1 April 2013.”
It is questionable what effect this will have on the stated policy objective of encouraging healthier eating habits for low income families. There are many factors that influence dietary choices; reducing the price by 15% on food items that already fluctuate wildly due to seasonal effects is unlikely to change bad habits.
Of greater certainty is the additional complexity that will be introduced to the GST system through retailers having to adapt point of sale and reporting mechanisms, and the arguments that will develop as the minutiae of food classification becomes relevant for tax purposes. This will be particularly relevant for franchisees who deal with fresh fruit and vegetables.
Many franchisors and franchisees will already be aware of the fine distinctions created in the Australian GST system. The most quoted example is the difference for a super market selling fresh chicken (GST-free) and a cooked chicken (GST applies). The UK has similar issues. A famous case (that is, a real case that went to Court) concerned determining whether a “jaffa cake” was a biscuit (and as such, a basic food item not subject to VAT) or a cake (a luxury food item subject to VAT). Business is hard enough without being distracted by such arguments.
New Zealand’s GST system is lauded internationally for its simplicity and freedom from excessive exemptions. GST will be the start of a “slippery slope” and open the door to further exemptions.
Personal income tax rates
“Labour will … put the top tax rate back up to 39 cents for income earned over $150,000”.
The top personal tax rate was last at 39% during the 2008/09 year. The current government reduced it to 38% for the 2009/10 year, and then down to 33% from 1 October 2010. At present, the top rate takes effect on income over $70,000.
The simplicity of the 33% rate is that it is the same as the trustee rate of 33%. That reduces the incentive to use trusts to structure out of higher tax rates. It means that earners and business owners can focus their efforts (and the efforts of their advisors) on growing their businesses rather than trying to find clever ways to minimise their tax bills.
The argument for increasing the top tax rate is that it ensures “everyone is paying their fair share”. Yet the report of the Tax Working Group, issued in January 2010 reported that the top 10% of earners were paying 44% of all personal income tax paid. If the effect of Working for Families, superannuation and other benefits was taken into account, the top 10% of earners were effectively paying 76% of net income tax.
While the Tax Working Group saw fairness as being a key feature of a good tax system, the main thrust of their report was that it was best achieved through a broadly based, low rate tax system. Increasing the tax rates of individuals who sacrifice or take risks to succeed, and as a result earn good incomes, is a disincentive to the sort of entrepreneurship that New Zealand needs to prosper as a nation.
At the other end of the scale, “We’ll (make) the first $5000 … tax free”. This would apply to all earners. The Working for Families (WfF) system means many taxpayers already enjoy a tax-free environment. For example, families earning at around the average wage with two children receive roughly the same amount in WfF entitlements as they pay in tax.
Conclusion
In terms of achieving the stated objective of “creating a fairer tax system”, Labour’s tax offering is a mixed bag. It is difficult to argue against some form of CGT, but it will place additional cost on the productive sector, both in terms of the tax cost itself, as well as the administrative burden.
Both franchisees and franchisors will need to consider what effect the introduction of a CGT will have on their businesses, particularly as they consider the effects on any sale proceeds.
Increasing the top personal tax rate and tinkering with GST will do little to achieve fairness, and only add to the complexity of the tax system and the incentives to structure ways out of it.
Further enquiries, please contact:
Geordie Hooft
Partner, Tax
T +64 (0)21 670 330
E geordie.hooft@nz.gt.com