By way of background, both the Income Tax Act and the Goods and Services Tax Act have definitions of associated persons and special rules that apply to transactions between associates. Property dealers, developers and investors are often party to transactions with associated persons (for example, restructuring ownership of existing property).

Trap 1 — GST

Walter is a property investor who purchased a residential property five years ago on 1,200m2 of land. The intention at purchase was to hold it long term. Under the Auckland Unitary Plan there is potential for eight terraced houses on the land.

Walter wants to proceed with this but doesn’t have the funds. He approaches his friend, Skylar, to take up a 25% stake to help with funding. As a result of this, a new company is set up with the shares split 75/25 in Walter’s favour and the property sold into the new company. Walter’s existing company is not registered for GST (as he bought the property as a residential rental), but the new company is registered for GST. Naturally Walter expects the new company to be able to claim GST. No problems so far, right?

In fact, there is a big problem. Where land is sold from one party (who is not GST registered) to another party (who is GST registered), there are restrictions around the ability to claim GST. In particular, if the original owner did not pay GST on purchase, then no GST claim is available to the associated purchaser.

Despite this, the development company will still have to account for GST on sale. You may wonder whether there is any way to structure around this trap. In the context of GST, the definition of the association is extraordinarily wide and near impossible to structure around.

‘The associated persons rules are a genuine danger for property dealers, developers and investors’

One possible solution is for the original owner to make a “change of use” GST claim and become GST registered before transferring the property. However, that is a process that needs to be carried out very carefully.

Trap 2 — Tainting

Many readers are likely aware of the “tainting” provisions. If you are carrying on a business of property dealing, development or erecting buildings and buy a property to hold in an associated entity, the hold property can be “tainted”, which is to say taxable on sale. That said, there are timing requirements.

In particular, the business of property dealing and development needs to exist at the time the hold property is bought. This means that you cannot retrospectively taint property that you acquired prior to becoming a property dealer or developer.

However, retrospective tainting can occur if you are engaged in a business of erecting buildings. Take Hank who acquired a rental property 12 years ago and rented it ever since. Hank now actively erects and sells spec buildings (i.e. buys sections in order to sell house and land packages).

This sees Hank as being in the business of erecting buildings. He now decides to knock down the existing rental and build a new rental dwelling in its place. Aware of the fact that tainting generally does not occur retrospectively, he does not see how this property could be affected by the building activity which he has only carried on for the past few years.

Unfortunately, tainting does occur in these circumstances because at the time that the building work is done on the long-term hold property, an associated entity is in the business of erecting buildings.

Therefore, not only is this existing property tainted – despite the fact that it was originally acquired 12 years ago – but the tainting continues to exist for 10 years following completion of building.

Investor Beware

In closing, the associated persons rules are a genuine danger for property dealers, developers and investors. You should always seek advice before engaging in transactions within your structure. Next month I will continue in part two with more traps in the context of such transactions.