As we approach the end of the 2012 financial year, now is a good time to review or prepare for important end of year processes (always better to manage this before the 31^st March, than after!).  Here’s brief short list of matters you may want to attend to (call us if you want to discuss these or other processes in greater detail):

• Stock take on or around 31^st March
• Bad debts on your debtors ledger should be eliminated and cleaned out before 31^st March
• Clear out the stale transactions still sitting in your bank reconciliations
• Update wage or salary A/Ps for any tax changes that have been announced (have a check on the IRD’s PAYE calculator if you are unsure).

Benchmarking your business

How does your business compare to the rest of your industry?  We have now subscribed to a benchmarking service, and can now develop reports that help you keep ahead of the industry average.  Call us for more information on 09-636-3332.

Important Tax Dates

We have updated the important tax dates on our blog site.  Click here if you need to check what dates are coming up.

The case involved two Christchurch surgeons who sold their surgical practices to companies they owned through family trusts. Under arrangements which became effective from 1 April 2000, when the top personal income tax rate was increased to 39%, each surgeon received a salary from their respective companies which was well below the level each had earned when practicing in their own name. The balance of the net practice income was distributed by the companies to the relevant family trust and taxed at 33%. The Commissioner contended that the salaries Penny and Hooper received from their companies were not commercially realistic and the arrangements therefore represented tax avoidance. The estimated tax savings for each taxpayer was in the region of $20,000 to $30,000 a year over the 2001 – 2004 tax years.

The case involved two Christchurch surgeons who sold their surgical practices to companies they owned through family trusts. Under arrangements which became effective from 1 April 2000, when the top personal income tax rate was increased to 39%, each surgeon received a salary from their respective companies which was well below the level each had earned when practicing in their own name. The balance of the net practice income was distributed by the companies to the relevant family trust and taxed at 33%. The Commissioner contended that the salaries Penny and Hooper received from their companies were not commercially realistic and the arrangements therefore represented tax avoidance. The estimated tax savings for each taxpayer was in the region of $20,000 to $30,000 a year over the 2001 – 2004 tax years.

The case has been closely followed by tax advisors because its implications were likely to be significant for the many small businesses which operate through companies owned by family trusts. So the first bit of good news is that the Supreme Court described such structures as “entirely lawful and unremarkable. The adoption of such a familiar trading structure cannot per se be said to involve tax avoidance.”

But if the structure itself wasn’t the problem where did the surgeons go wrong? The answer is in what the Court called “the artificially low salary settings” in combination with the other features of the structure. During the case both surgeons admitted under cross-examination that the salaries they were paid by their respective companies were not commercially realistic. These reduced salaries increased the companies’ earnings which were then effectively made available to each surgeon through their family trusts. As the Court commented, “In reality, the taxpayers suffered no actual loss of income but obtained a reduction in liability to tax”.

Once the Supreme Court also took into consideration the Privy Council’s 1967 decision in Peate v Commissioner of Taxation of Commonwealth of Australia which involved virtually identical facts (a group of doctors sold their practice to a series of companies owned by trusts), then it was all over for Messers Penny and Hooper.

The decision will most affect those businesses whose profitability is dependent on the personal exertions of one or two individuals. Professionals such as doctors, surgeons, dentists, and other consultants with the ability to earn large sums will therefore need to review their current and past salary policies. The Supreme Court didn’t give too much guidance on what would represent an “artificially low salary” but it acknowledged that there would be situations where it would be reasonable for a company to retain a significant portion of its profits.

The recent changes in tax rates have largely eliminated the opportunity which Messers Penny and Hooper attempted to exploit but this does not mean that past salary practices can be ignored. A week after the Supreme Court decision the IRD issued Revenue Alert 11/02 in which it set out the types of situations where it would consider the diversion of personal services income to other entities to be tax avoidance.

In line with the Supreme Court’s remarks, the IRD accepts that use of companies, trusts and other business structures do not of themselves give rise to avoidance concerns. Instead it focuses on whether the “controllers of the business” divert income away from that business. In the IRD’s words:

“We will be concerned with arrangements where the compensation received by the individual is artificially low while related entities benefit (or the individual ultimately benefits), and any commercial reasons for that transaction do not justify the low level of remuneration.”

We have seen a number of situations where the salary paid to an owner either coincided with the threshold at which the former highest rate applied or was suspiciously close to it. The IRD is increasingly sophisticated with its data analysis and the chances are that all those taxpayers who received a salary of between $60,000 and $70,000 are highly likely to be investigated. The IRD may investigate prior years’ tax returns, subject to the “time-bar” rules which generally prevent re-opening a previous tax return more than four years after the end of the tax year in which the return was filed. For most taxpayers this would mean that returns filed for the year ended 31st March 2007 and subsequent years are possibly open to re-examination. If you are a business owner who was paid what could be regarded as a non commercial salary in prior years, you may therefore wish to reconsider your position and make a “voluntary disclosure” to the IRD.

If you have any concerns about the implications of the Penny Hooper case please contact Terry Baucher on 09 486 6200 for further advice, or speak to your friendly accountant at Eden Perich Prewett.

Regards

Terry Baucher - Director

Following the issue of Interpretation Statement 10/01 Residential Rental Properties – depreciation of items of depreciable property (IS10/01), the IRD has issued a general depreciation determination to provide a new list of the “Residential Rental Property Chattels” industry category. The new asset classes include; air ventilations systems, awnings, portable dehumidifiers, lawn mowers, mail boxes and stereos.

For a complete list of the asset classes please refer to the determination at http://www.ird.govt.nz/technical-tax/determinations/depreciation/depreciation-deter-dep80.html

Look Through Companies and Interest Deductibility

The Inland Revenue Department (IRD) has recently published their view surrounding the issues with interest deductibility and ‘Look Through Companies’ (LTC). The question involved an LTC that was previously a loss attributing qualifying company (LAQC). The LAQC acquired the taxpayers family home as a rental property. The transfer was done at market value. The property was rented out to a third party on an arm’s length basis. The taxpayer owns 100% of the shares in the LAQC. The LAQC borrowed from a bank to fund the purchase. The taxpayer used the funds from the sale of the property to purchase a new family home. The LAQC then became an LTC.

In IRD’s view, if all that has changed is that the LAQC has become an LTC, then the interest deductions previously allowed will continue to be allowed subject to the limitations in section HB 11 and HB 12 of Income Tax Act. It is the IRD’s view that an owner can have more than one capacity and the effect of section HB 4(1) is to treat the owners as carrying on the activity of the LTC and not the LTC itself. It is not intended that the owner’s actions are substituted for those of the LTC.

For more information please refer Questions we’ve been asked: General Issues on the IRD website at http://www.ird.govt.nz/technical-tax/questions/questions-general/qwba-1103-it-ltc-interest-deductibility.html

The important thing to realise when dealing with a growing business is that growth generally requires cash. If we use a typical importer / distributor business as an example, in order to sell more stock to its customers it first needs to purchase more stock from its suppliers and this will require funding.  Once this additional stock arrives and is sold, it may be several weeks before
the business actually gets paid by the customer.

Typically, as we see sales volumes increase month after month we will see the cash position of a business deteriorate. This is because both stock and debtors levels keep pace with the increased sales activity. The cash generated from growth won’t actually be seen until turnover stabilises.

Some commentators have predicted that we will see significant business failures as we come out of the recession simply because business owners won’t be able to fund their growth. So, how do you make sure that you don’t become a casualty of your own growth?

Here are a few strategies to consider:
• Once you know how much cash you are likely to need, approach the bank early to discuss options. You don’t want to be discussing extending your overdraft facility the day before you need to make a big payment to a supplier.

• Make sure that your bank is on-board with your long term plans for growth.  You don’t want to have to approach the bank every few months to extend facilities as your business grows. Explain your plans to them and find a solution that will work as the business grows.

• Talk to your advisers and get their input.  As accountants, we know what financial products the different lenders have available and will be able to help find a solution even if your own bank seems unable to assist.  Obviously the impact of growth on cash will be different for every business and they can be reduced by methods such as negotiating payment terms with suppliers, getting up-front payments from customers and having great stock and debtor controls in place. The important thing is to plan for your growth and understand what effect it will have on the cash position of your business. As the old saying goes, failing to plan is planning to fail.

While the 2010-11 compliance focus was based on customer groups (individuals, non-profit groups, small to medium enterprises, employers and other taxpayers), the 2011-12 compliance focus is grouped around four key themes:

1. Everyone pays the right amount of tax
2. The IRD receives the right amount of tax at the right time
3. Everyone files and pays tax on time
4. The IRD provides confidence and certainty to their customers.

This change in grouping reflects that most people don’t belong in just one customer group. The four key themes are summarised below:

1. Everyone pays the right amount of tax

The areas of focus include:
• Diverting personal income to minimise tax and child support obligations or increase entitlements
• Complex financing and cross border funding arrangements
• Loss generation and usage such as creating deductions which are not real economic losses
• Misuse of charities tax exempt status
• Offshore and international issues such as use of offshore bank accounts and offshore schemes (18 tax information exchange agreements have been signed with more to follow)
• False information and fraudulent refund claims
• Identity protection to reduce creation of false identities and falsely accessing other peoples accounts
• The hidden economy – focus on industries, such as hospitality, scrap metal, fishing and aquaculture, tourism and agriculture, construction and ACC providers.  Monitoring of online trading and short-term property rentals ahead of major events (i.e. the Rugby World Cup). IRD to issue industry benchmarks for small businesses.
• Organised crime and cross-border transactions
• Income from property focussing on property speculators and dealers

2. IRD receives the right amount of tax at the right time

The areas of focus include:
• Changes to families and individual circumstances affecting Working for Families Tax Credits (WfFTC)
• Cessation of business or employment – notification and final returns
• Employer monthly schedules not filed on time
• Resident Withholding Tax (RWT) deducted at incorrect rate
• Non-resident contractors and their employees failing to declare income in New Zealand

3. Everyone files and pays tax on time

The areas of focus include:
• Accuracy of personal tax summaries submitted by intermediaries
• Tax agent’s tax filing percentages and tax agent’s personal tax obligations
• Filing returns on time
• Keeping on top of debt: individuals, child support, student loan borrowers, businesses, employers, KiwiSaver obligations

4. IRD provides confidence and certainty to their customers

The areas of focus include:
• Ensure new Controlled Foreign Company (CFC) and Foreign Investment Fund (FIF) rules are complied with
• Ensure new life insurance providers tax rules are complied with
• Large enterprises tax compliance
• Property – IRD is notified of all property transfers and will focus on “land banking” taxpayers
• Central and local government – focus on GST and remuneration
systems
• Transfer pricing – focus on losses, groups with above average debt, NZ-owned multinationals and import of overseas losses
• High wealth and high income individuals – IRD is building a profile of high-income earners to establish the level of risk to the tax system; will be undertaking two-yearly reviews of high-income earners
• Losses – common errors with loss utilisation and carry forward
• New immigrants tax obligations

View the full Compliance Focus report is available on IRD’s website

A large part of keeping cash flow under control is managing your debtors. In these challenging times businesses will generally take as much time as possible to pay their accounts, after all, why pay interest on an overdraft facility when they can use your cash for free?

Good debtor management starts with a very simple calculation to measure ‘debtor days’. By dividing the month end balance of your debtors by your average daily trading, you get a simple measure that you can monitor on an on-going basis. If the number of days goes up, you know that people are taking longer to pay you, prompting to you to investigate why. If the number of days goes down, you know that you’re becoming more efficient at collecting your debtors.

As a simple example, let’s say a business is turning over $10,000 per day and has a month end debtors balance of $600,000. This would equate to having 60 days trading revenue tied up in receivables. If, over time, you could get this down to say 45 days, the business would have another $150,000 in the bank account rather than tied up in debtors.

So how do businesses get people to pay on time? Here are a few practical points that may help:

• Make payment expectations clear on all your invoices and Terms of  Trade.
• In your Terms of Trade include a time frame within which any queries relating to your invoice must be raised. It is always frustrating for a query with your account to only be raised when payment is already several months overdue!
• Reserve the right to charge interest on all overdue accounts and specify the rate that will be charged. You should also advise that any other costs incurred in the collection process will be passed on.
• Send invoices out promptly, preferably at the time of supplying the goods or services or if invoicing monthly, very shortly after month end.
• Make it as easy to pay you as possible. Many businesses no longer chequebooks, so providing your bank details on invoices and is essential. Allowing payment by credit card is also a valid
option, which can have great results, although take into account the that you will incur.
• Make sure that you have a documented collections system and follow it. A standard process will include a time line of follow-up letters, emails and phone calls that ultimately lead to interest and collection costs added and the account being handed to a collections agency.
• Get tough! If you give someone a final date on which the account will handed to a collections agency, actually hand the debt over for if it remains unpaid. Many businesses talk tough but will then not actually follow through.

As with all things in business, a bit of common sense and compassion also goes a long way and while not ideal sometimes you may have to bend your own rules on collections when a good client or customer is struggling and needs a bit more time than usual to pay. As long as your customers are communicating with you, being honest and making the payments that they have committed to, then be prepared to cut them some slack occasionally to preserve good relationships. However, the moment those commitments are broken or communication stops, it’s time to move quickly to secure payment.

At EPPL we have skills and systems that help you to improve your cash cycle.  Why not call us to arrange a time to meet with us to discuss a plan that would work for you?  09-636-3332.

In a typical business the cash cycle looks something like this:

In the above model you start your business by using cash to purchase stock. You then sell some stock (hopefully for more than it cost!), converting your stock into debtors.  Once you are paid by your debtors the cash returns to you and the cycle begins again. Obviously in some businesses (for example a service business), stock in the above model can be replaced with work-in-progress and in others there may be no debtors as all sales may be paid for in cash. However, regardless of the business, a variation of this model will apply.

The more you can accelerate the cash cycle outlined above, the faster you turn your profits into cash and the easier it is to manage your working capital position. Aside from the obvious issues, such as generating sufficient sales and having suitable margins, the areas that typically cause cash flow problems are the following:

• Carrying Too Much Stock – ideally a business should carry no more stock than it needs in order to maximise sales. Slow moving or obsolete stock needs to be liquidated and turned back into cash. Monitor stock turn rates, create sound relationships with suppliers to shorten lead times and know your market so that you don’t end up with hard to move items. It is also worth noting that there is a proven link between high stock levels and an increase in both stock theft and damage.
• Inadequate Debtors Control – take a look at the way you manage debtors and here the payment process can be tightened up. Monitor your debtors’ days and implement a robust collection system. Late payers need to be brought under control now to minimise the impact on your cash flow. In this market customers will take every opportunity to delay payment and those businesses without tight credit controls are invariably the last to be paid. Don’t forget that it’s costing you money every day to fund your overdue debtors, so charging interest is a valid option.
• Capital Expenditure – be wary of paying cash for any significant capital items unless you have robust cash flow forecasts in place that show the purchase can safely be done. Many businesses run into trouble because they used their cash to fund asset purchases and then later couldn’t pay their tax bills or their suppliers. Remember, you can finance or lease your equipment purchases so that you are not putting pressure on your cash flow. A good rule is to match the life of the loan with the life of the asset.
• Drawings – as a business owner, how much money are you taking out of the business on a monthly basis? Many business owners are shocked to see the  annual level of drawings that they take and are unaware of the pressure that this can put a business under. Set yourself a budget that is acceptable to both you and your
  business and stick to it.

One of the simplest and most valuable business tools you can have is some solid cash flow projections.  For some businesses they find that they can operate on projections that show a month end cash position only while others need weekly or even daily cash projections to keep things on track. Projections let you see potential cash flow problems in advance and deal with them before you reach a crisis point.

There are many aspects to the business cash cycle that can be managed. EPPL currently has the specialist systems and the expertise to help you manage your cashflow to your specific goals.  Contact us to find out how info@eppl.co.nz or call us 09-636-3332.

At Eden Perich Prewett we’re not just accountants – we’re loving and caring spouses
too!  Scott’s better half Belinda was recognised for her art last week at the NZ Art Show in Wellington.  Read more about it here.