A beginner’s guide to paying less tax (if you’re very rich)

Monday, 1 March 2021

Jacinda Ardern rejects National's suggestion that Labour would bring in the Greens' wealth tax, despite ruling it out, as 'mischievous and wrong'. (First published October 11)

What’s the problem?

A lot of millionaires are paying tax at a rate lower than the lowest earners in the country.

We found this out from a Treasury report (which you can read below), which attempted to measure how wealth is distributed. The key takeaway: 42 per cent of the richest Kiwis pay less than 10 per cent of their total income in tax.

The lowest income tax rate is 10.5 per cent, which earners pay on income up to $14,000.

Some people, including the Green Party, think it’s a big deal and have reiterated that there needs to be tax reform.

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OK. So how does it work?

Most people are taxed on the earnings from their job.

The different bands for typical incomes like salaries, wages and benefits range from 10.5 per cent for incomes up to $14,000 to 33 per cent on earnings above $70,000.

From April 1, a new high-end tax rate of 39 per cent applies on earnings above $180,000.

The very rich don't exactly have normal jobs, so they don’t get taxed like most of us.

Many derive most of their income elsewhere, with wealth tied up, for example, in companies they own, or investment assets.

Different tax rates apply to different types of businesses. But most businesses are subject to a 28 per cent tax rate, and trusts (and trustees) are subject to 33 per cent tax on earnings.

Already you can see a problem brewing … a 28 per cent rate is much lower than the 39 and 33 per cent rates charged (or to be charged) on Kiwis working in high-income jobs.

Tax consultant Terry Baucher outlines a simple example of a person who is paid a salary of $200,000. They’ll pay income tax on that.

But if they (or their company) also hold assets, and those assets increase in value by $800,000 over a year, that person’s economic income is $1m. It’s possible the $800,000 increase may not be taxed at all.

The wealthiest New Zealanders pay most of our tax, says Geof Nightingale, a partner at PwC and a member of the government's 2018-19 Tax Working Group.

“But that tax as a percentage of their economic income is at a lower rate than a lot of us who work in normal salaried jobs.”

It’s important to remember that the wealthy are not doing anything illegal. As Nightingale puts it, they are just obeying the tax policy settings that successive governments have chosen.

The question is: are we as a society comfortable with that? And is that fair?

Imagine you own a company that makes millions every year

Let’s take a very simple example of a company that posts a $2m profit. The company is owned by a single individual who pays him, or herself, a $200,000 salary from the profits.

The rich hold all the cards in the tax game.

That salary is subject to regular income tax, anything above $70,000 is taxed at 33 per cent (and from April, anything above $180,000 gets taxed at a rate of 39 per cent).

The company has $1.8m in profit remaining. If the owner wanted to take this out and pay it to themself as a dividend, they’d be charged tax, so they decide to leave it in the company.

Sure, it's subject to the 28 per cent business tax rate, about the same rate as Kiwis working a job that pays between $48,000 and $70,000. But it’s not subject to 33 per cent or 39 per cent.

Now, let’s say the wealthy owner decides – after running this business for 10 years – it’s time to sell up. They have the company valued, and it turns out to be worth $10m.

The owner, who invested $2m into the company over the years, walks away with a profit of $8m. This is a capital gain and not subject to tax.

The former company owner, seeing a hot property market, then decides to buy four rental properties in Auckland.

They rent those properties out for six years, and finally say enough is enough, it’s time to cash in and retire. Those properties are now worth $16m. As this person has waited for five years, the sale is not subject to the bright line test and is not taxed.

(Some property investors may be captured by the bright line test, which taxes capital gains as income. The rule may affect anyone buying and selling an investment property after October 1, 2015.)

“Suddenly a company making $2m has turned into $16m and the owner does not pay tax,” Nightingale says.

“All of that is totally legitimate under current tax settings, but is that the right outcome?”

But there’s more

If an individual owns two (or more) companies and one is making a profit and one is making a loss, that person can use (or offset) that loss to reduce their tax bill.

So if you own a company that’s making $10m a year and another company losing $1m, you may only pay tax on $9m, Connie Lui, who is director of NZ International Tax & Property Advisors, explains.

And if, for example, the loss-making company was a holiday resort, it may well be turning a loss, but its assets could be appreciating in value. After some time, the owner may want to sell.

“The capital gains from selling the holiday resort may well offset all the losses the company had in the past,” Lui says.

Again, that capital gain is not taxed.

Tell me more about capital gains

New Zealand has been talking about taxing capital gains forever but despite significant pressure, it’s been ruled out by Prime Minister Jacinda Ardern.

In a nutshell, if you buy some assets (like shares or a property), you may not be liable to pay tax if you make a profit when you later sell.

The rules also say if you’re buying and selling assets regularly, that’s essentially how you’re making an income, and you should be taxed accordingly.

Section CB 4 of the Income Tax Act 2007 reads: “An amount that a person derives from disposing of personal property is income of the person if they acquired the property for the purpose of disposing of it.”

The key words are highlighted. If you bought an asset with the intention of later selling it on, you’re looking to make money and should pay tax.

Here Lui offers the example of a $1m painting. If a person bought a $1m painting, planning to sell it in a year's time for $2m, that gain would be taxable.

But this is a really grey area. Surely you could buy the painting and not signal, or tell anyone, you were planning to sell it? And in a year’s time decide you tell everyone you were sick of looking at it, and cash out.

The question is then: Will you pay any tax?

Just ramp up the company tax if that’s where the rich folks’ money is?

You could sell this jet and not pay tax on it.

It’s not that simple, Nightingale says. The argument is that a 28 per cent tax rate encourages people to invest money in businesses and doing that creates jobs.

The Greens have proposed a wealth tax or a charge on rich people’s assets to get around this. (There’s a good explanation here.)

The issue with this approach is that you’re looking to tax an asset that may not necessarily be generating enough cash to pay taxes.

Consider the example above where an individual’s money is tied up in four houses in the Auckland property market. Sure, those houses are generating rent, but they won’t be generating the cash necessary to pay the tax bill.

“If there was a wealth tax of, say, 5 per cent, you’d have to find $1m of cash flow a year to pay for assets worth $20m. And you might not have it. You have the wealth, but not the cash flow,” Nightingale says.

What about trusts?

There are about 250,000 family trusts in New Zealand. They work by allowing a person to transfer assets into a trust to benefit other individuals (legally called the beneficiaries).

Income earned by a trust can be either retained by the trust or it can be distributed to the trust’s beneficiaries.

That income is taxed at a rate of 33 per cent – the same as the personal income tax rate. But remember on April 1, the highest income tax goes up to 39 per cent.

So let’s go back to the example of the $2m business. Let’s say this the company’s shares are held in a trust.

The trustees (those running the trust) could decide to take the $1.8m profit the company paid and pay it out. It would be taxable at a rate of 33 per cent on it, not 39 per cent.

“So even after the tax rate goes up to 39 per cent, the owner could legitimately keep their income taxed at 33 per cent,’’ says Nightingale.

The Government says it will act if trusts are being used to dodge tax, but it does not want to.

The issue, Nightingale says, is that the very rich don’t even need to use trusts like this.

“Unlike most of us, they don’t generally consume all their incomes every year. And so the income that they don't consume, they can accumulate inside the companies.”

So what do we do?

“All of this drives me back to the forbidden territory of capital gains, on a realisation basis [when you sell your asset],’’ Nightingale says.

In the case of the person who bought four Auckland properties, someone has bought assets, someone has sold assets, there’s cash exchanged to pay, and the person who makes a gain is required to pay tax on it.

Baucher agrees: “The answer is some form of capital gains tax.”

All the examples cited above are very simple and not exactly reflective of real life.

When Baucher speaks he outlines the reality of the tax system. A muddled maze of opportunity and confusion, where people are taxed on bonds and forex accounts, on term deposits, on gold and crypto, but not necessarily on gains from property they buy.

He points out that New Zealand is unique globally. We don’t tax inheritance, capital gains or wealth.

On introducing capital gains, he says: “There’s been a canard promoted: capital gains is complicated. It’s not.”

Most Western countries tax one, two, or three of those things. We don’t.

“Capital gains tax is very simple. You bought something. You sold something. We’ll tax the difference. What amount we tax and how is where complexity comes in. But the idea around taxing the gain is simple.”

It all comes back to property, Baucher says. It’s the extremely easy option which distorts investments as a whole in New Zealand.

“To make money in New Zealand, it’s pretty simple. Borrow off the bank. Buy a piece of land and sit on it. Job done. That’s not productive, but it makes perfect tax sense.”