Mag says NO NO transfering LAQC shares to trust?

[fudosan]

On page 8 of the Oct issue of NZ Property,Garth Melville, on commenting on merits of LAQC, says:

"Some advisers suggest after the losses have expired, you can transfer your shares to a trust to obtain asset security. I consider this is dangerious because the market value of the shares will then be so much higher, and Inland Revenue may attack on the basis that as your company is now in profit, you are engaging in additional structuring motivated principally by tax reduction considerations."

I always understand that when you transfer LAQC shares to a trust, there is no transaction of properties owned by LAQC. You merely transfer shares to the trust. What is this market value of shares???

[masteraccountants]

Hi Fudosan,

This is a touchy area! But it can be handled properly without incurring the wrath of IRD. When some people see the acronym IRD, they start to shrink. But it doesn't have to be that way.

Firstly, the properties do not change hands. There are no changes on the title. The LAQC company continues to own the properties. So your initial understanding is correct.

Secondly, it is the shares of the company that are being sold. IRD and any investor recognize that whoever owns the company (through its shares) owns the rental properties, so there is an underlying value in the rental properties owned by the company.

Thirdly, the magazine is alerting investors to the need to value the shares at their market value so that IRD do not see it as a convenient restructuring for tax purposes. There must be a commercial reason for what is being proposed to be done. Selling the shares to a Trust not only allows for asset protection for the properties, but may allow for better tax optimization through different beneficiaries (at lower tax rates) than the shareholders in the LAQC. Therefore the interest of IRD.

So, how do we value the shares? We have established that the rental properties in the LAQC are now breaking even. This is a combination of increased rents and lower interest as time passes and the loans are reduced.

Let's say that the properties are now valued at $700 000 and the loans are at $400 000. The rent may be $800 per week, or $40 000 for 50 weeks - allow 2 weeks' vacancy each year. The loan at 7% interest would give an interest charge/claim of $28 000 each year. Let's say the property initially cost $400 000 and was fully financed by bank loans, and that the depreciation is approx $10 000 - it was a new property with a chattels valuation for higher depreciation claims. Other expenses such as rates and taxes at $1 500 pa are minimal. So the property is essentially breaking even.

The net value of the properties are $300 000 ($700 000 less $400 000 loan), so this is what the shares should be sold for to the Trust. The Trust cannot pay this sum of money, so it is recorded as a loan - that the Trust owes the LAQC $300 000.

The debt forgiveness rules, where a debt of a Trust can be forgiven, do not apply to companies, as they are unnatural persons under the law. Only natural persons can forgive loans of a Trust. It is possible for the Trustees of the Trust to loan the money to the Trust to repay the company, and then write off the loan to the Trust at $27 000 per trustee until it is paid off. But do the trustees have the cash or borrowing capacity? What is the LAQC company to do with the $300 000 capital injection? Presumably buy more properties?

There are obvious practical problems to overcome, if one were to comply with the normal rules of selling shares in a company. I suspect that, where anyone has sold shares of an LAQC to a Trust, the sale has gone through as a nominal amount, say $1. If it were challenged, the argument would be that the shareholders of the LAQC and the beneficiaries of the Trust are essentially the same, so it is merely a restructuring of assets between the same beneficial owners. As long as the beneficiaries and shareholders are the same at the time of sale, this argument might be accepted. Later on more beneficiaries could be added to the Trust.

Care would need to be taken that no creditors are disadvantaged. As a rental property operation only has banks as creditors usually, then this would not be a problem. However, if there were vendor financiers, they would need to be paid out or their payments assured, otherwise they could challenge the sale in Court - assuming they are unsecured creditors. If they hold a second mortgage, they can pursue legal remedies if they are not paid.

In most circumstances, it is more likely that the LAQC would continue to buy properties as the existing properties neared break-even.

The theory sounds fine - about transferring shares to a Trust - but the devil is in the detail. How do you actually put it into practice and not open yourself to challenge from IRD or other governmental authorities?

I might have to go back and visit articles that legal experts have written on how to achieve the process. I may be looking only at the problematical side to the issue, and mental block has set in. If I find the article, I will post the solution here.

Chris
www.masteraccountants.co.nz

[muppet]

Hi Chris

Welcome to PropertyTalk.

I have been reading your answers to questions with interest.

I am sure that forumites will appreciate the knowledge that you are imparting, helping those who have questions to ask.

Regards

[masteraccountants]

Thanks Muppet,

It's good to receive feedback. Some of these concepts are complex and technical, and it's often a challenge to explain them in laymen's terms. Or at least in understandable language.

I spent three years as a lecturer in technical college and university, so I gained some skills in reducing the abstract to concrete terms.

Too many times I see someone promoting the latest fad without any idea of the implementation problems.

The last question was just such an example. If IRD asked someone trying to sell shares in their LAQC, "would you sell the shares in the LAQC to someone else on an arms-length basis at the same price, namely $1?" it would be hard to answer in the affirmative.

However, IRD do accept restructuring of loans and assets between parties that are wholly or principally the same beneficial owners, as long as it can be demonstrated that the dominant purpose is asset protection and not tax minimization.

What the magazine article is warning about is that the sale of shares should not be executed as a matter-of-fact thing that cannot be challenged. The parties involved should document their reasons in minutes of meetings and resolutions. Then they have a good prima facie case that what they are doing will be accepted.

The wrong restructuring and/or lack of documentation could invite IRD scrutiny and penalties.

Chris
www.masteraccountants.co.nz

[fudosan]

Thanks Chris for the excellent explanation.