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Income Streaming through Partnerships – Why won’t the IRD listen?

Tax advisors finally have some decent weekend reading now that the Income Tax Bill has been reported back to Parliament.

lf you feel like sharing a few moments of exasperation with us, take a look at the Officials’ cursory dismissal of our submission that the anti-streaming rule for partnerships in section HG 2(2) be abolished.

Section HG 2(2) was enacted in 2008 as part of the partnership / limited partnership reforms and is intended to prevent a partnership from allocating income of a particular kind or source to a particular partner based on that partner’s tax status (for example, allocating interest income to a partner with carried forward losses and fully imputed dividends to a partner in a tax-paying position).  As a matter of policy we have no issues with a provision that voids that type of arrangement. Section BG 1 would do the job. Section HG 2(2), however, is too mechanical in its application, too difficult to comply with, and ultimately not fit for the purpose for which it was designed.

Section HG 2(2) requires that the total income, tax credit, rebate, gain, expenditure or loss of a partnership from a particular source or of a particular nature be allocated to partners by reference to each partner’s “partnership share in the partnership’s income”.

Not only does the rule in s. HG 2(2) not fit with the flexible nature of income allocation typically made under a partnership, the rule is arbitrary and can be easily manipulated. Section HG 2(2) is also difficult to apply and our experience is that the income allocation mechanics in most partnership agreements are not up to the task, particularly when carried interests are involved.

Nonetheless Officials have opted to retain section HG 2(2) in its current form. So be it.  You can’t help people who refuse to help themselves.

What is exasperating is the example used by the Inland Revenue to illustrate why the rule in s. HG 2(2) should be retained.  It is exasperating because, when the language of the section is actually applied to the example, it indicates precisely why the rule should have been repealed.

The example considers two partners on different marginal rates each owning 50% of a business that earns $100 of taxable income and $100 of capital gains.  Officials first basic mistake is to describe capital gains as “non-taxable income”.  It is no such thing. Receipts from capital gains are not income.  You don’t have to read very far through the Tax Act to know that.

The example states that s. HG 2(2) would require each partner to be allocated $50 of taxable income and $50 of capital gains. In fact the section would require all the capital gain in the example to be allocated to the low-tax partner (for tax purposes only) because the low-tax partner has a 100% partnership share in the partnership’s income.  The result of applying the actual words of HG 2(2) is that tax is payable on all the partnership income at the lower rate i.e. the exact result which Officials say HG 2(2) was designed to prevent!

This issue is not new.  As a firm we have raised it twice before various Select Committees and with the Inland Revenue directly.  The issue was also flagged in the 2008 NZLS tax conference paper on partnerships.  We expect that legislative change will come eventually but, until then, taxpayers will have to live with a provision that is far from perfect and apply it as best they are able.

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