New Zealand's Interest Accrual Rules: A ... - Canadian Tax Foundation

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In 1986, New Zealand introduced a comprehensive set of tax rules, known as ... The rules also require foreign exchange variations to be taken into account on ...
New Zealand’s Interest Accrual Rules: A Comprehensive Review 12 Years On Andrew M.C. Smith* PRÉCIS En 1986, la Nouvelle-Zélande a adopté un jeu complet de règles fiscales, nommées « règles sur l’accumulation d’intérêts », visant à contenir l’évitement fiscal grâce à des structures de financement artificielles. Ces règles ont été délibérément rédigées en termes très larges pour comprendre tous les types d’arrangements financiers qui comportaient des écarts temporaires au chapitre des mouvements de fonds. Les arrangements financiers tombant sous le coup des règles doivent être comptabilisés selon la méthode du rendement à l’échéance ou, s’il est impossible de le faire, conformément aux normes de présentation de l’information financière. Selon les règles, il est également exigé que les fluctuations des devises soient prises en considération annuellement sur une base non matérialisée. Dans le cadre de l’application des règles, le commissaire est autorisé à rendre des décisions exécutoires de temps à autre ou par suite de la demande d’un contribuable. Le gouvernement de la Nouvelle-Zélande a récemment entrepris un examen en profondeur des règles sur l’accumulation, donnant lieu à un certain nombre de propositions en vue d’une réforme. Cet article comprend un examen des règles actuelles sur l’accumulation d’intérêts, une description des modifications proposées, ainsi que des commentaires sur les incidences de ces modifications pour les contribuables. Puisque le terme « arrangements financiers » a été défini très largement dans les nouvelles règles, de nombreuses opérations sont assujetties à ces règles, même si aucune politique ne justifie cette inclusion. Pour des motifs de politique ou en raison des frais d’observation, il est proposé que cette définition soit améliorée de sorte que certains types d’arrangements ne soient plus visés par les règles. Durant l’année d’imposition où un arrangement financier échoit ou est aliéné, un calcul final est effectué à l’égard de cet arrangement (le « redressement du prix de base »). Il est proposé de simplifier ce calcul, mais il semble que des ambiguïtés pourraient en découler et que la

* Senior lecturer in accountancy, School of Accounting and Commercial Law, Faculty of Commerce and Administration, Victoria University of Wellington, New Zealand.

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situation des porteurs pourrait être touchée défavorablement si elles subissent des pertes à l’égard de ces arrangements financiers, à moins qu’elles ne soient des courtiers dans le cadre de ces arrangements financiers. Il est également proposé de permettre que les arrangements financiers libellés en devises soient comptabilisés annuellement selon les taux de change à terme, de sorte à éliminer les grandes variations dans le bénéfice et les dépenses déclarés qu’occasionne l’utilisation des taux au comptant pour la comptabilisation annuelle sur une base non matérialisée. D’autres propositions visent les extinctions de dettes, les remises de dettes et les contrats de location-acquisition, ainsi que d’autres sujets de moindre importance.

ABSTRACT In 1986, New Zealand introduced a comprehensive set of tax rules, known as the “interest accrual rules,” which aimed to stem tax avoidance through contrived financing structures. These rules were deliberately cast very widely to encompass all types of financial arrangements that involved a timing difference in monetary flows. Financial arrangements falling within the rules must be accounted for on a yield-to-maturity basis or, if this is not possible, in accordance with financial reporting standards. The rules also require foreign exchange variations to be taken into account on an unrealized basis annually. An integral part of the rules is binding determinations that specify how the rules are to be applied in particular situations. These determinations can be issued by the commissioner on a general basis or in response to a taxpayer’s request. The New Zealand government has recently undertaken a substantial review of the accrual rules, resulting in a number of proposals for reform. This article outlines the existing interest accrual rules and describes the proposed changes, with comments on their implications for taxpayers. Because the term “financial arrangement” has been defined very broadly under the rules, many transactions are caught where there is no policy reason for their inclusion. It is proposed to refine this definition to remove certain types of arrangements from the ambit of the rules on policy or compliance cost grounds. In the income year in which a financial arrangement matures or is disposed of, a final calculation is made in respect of that arrangement (known as the “base price adjustment”). It is proposed to simplify this calculation; however, it appears that ambiguities may be created and the position of holders may be adversely affected if they derive losses from financial arrangements, unless they are dealers in those financial arrangements. There is also a proposal to allow financial arrangements denominated in foreign currencies to be accounted for annually using forward exchange rates, removing the wide variations in reported income/expenditure now experienced through the use of spot rates on an unrealized basis annually. Further proposals are made in respect of debt defeasances, debt remissions, and finance leases, as well as other matters of a more minor nature. (1998), Vol. 46, No. 4 / no 4

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INTRODUCTION The increasing sophistication and globalization of capital markets over the past two decades has challenged legislators to keep pace by enacting appropriate tax laws to deal with the wide variety of financial instruments traded in capital markets. In response to this challenge, the New Zealand government in 1986 introduced a comprehensive set of rules to deal with the taxation of financial instruments. These rules, known as the “interest accrual rules” (or “qualified accrual rules”), represent a novel solution to the taxation of financial instruments and have attracted international interest. Twelve years after their introduction, the New Zealand government undertook a review of the interest accrual rules with the objectives of reducing compliance costs and addressing problem areas. This is the first extensive review of the rules since their enactment.1 In December 1997, a discussion document entitled The Taxation of Financial Arrangements 2 was released detailing a number of proposals for change. This article describes the existing rules and discusses the proposed changes. THE NEW ZEALAND INTEREST ACCRUAL RULES The New Zealand government was prompted to address the taxation of financial instruments in 1986 because substantial erosion of the corporate tax base was occurring through the use of tax-avoidance arrangements involving debt instruments. Taking advantage of drafting inadequacies and ambiguities in the Income Tax Act 1976,3 large corporations had entered into financing arrangements that accelerated interest deductions while deferring the recognition of interest income by the lender. The absence of symmetrical tax treatment within the same income year for both the lender and the borrower led to significant tax-avoidance opportunities.4 In the 1986 budget, it was proposed to introduce rules that would require stricter accrual accounting for financial arrangements and other

1 In 1991, the Consultative Committee on the Taxation of Income from Capital (the Valabh committee) released a report entitled The Operational Aspects of the Accruals Regime (Wellington, NZ: Inland Revenue Department, October 1991). However, most of the committee’s recommendations were not acted upon and have been carried over to the current review. A narrower review of the interest accrual rules and trusts/estates was also undertaken around the same time for the commissioner. 2 The Honourable Winston Peters, deputy prime minister and treasurer, and the Right Honourable Bill Birch, minister of finance and minister of revenue, The Taxation of Financial Arrangements: A Discussion Document on Proposed Changes to the Accrual Rules (Wellington, NZ: Inland Revenue Department, Policy Advice Division, December 1997) (herein referred to as “the discussion document”). 3 The Income Tax Act 1976 was replaced with the New Zealand Income Tax Act 1994 (herein referred to as “the Act”). Unless otherwise stated, statutory references in this article are to the Act. 4 In addition, the absence of any international tax rules made it easy to transfer income offshore to no-tax jurisdictions, from which it could subsequently be returned to New Zealand as an exempt intercompany dividend. New controlled foreign corporation and foreign investment fund rules were introduced with effect from April 1, 1988.

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kinds of expenditure. After receiving submissions from interested parties, the government became aware that the issue was much broader than it had initially appeared to be and that a more comprehensive approach would be required to deal with the taxation of financial instruments. Therefore, the government decided to introduce a set of rules to deal with the taxation of all financial instruments, rather than just debt instruments. These rules came into effect in the 1986-87 income year. The cornerstone of the interest accrual rules is the definition of “financial arrangement.” If a “financial arrangement” does not exist, the rules do not apply. The definition of “financial arrangement” is deliberately very broad, including all types of financial arrangements and transactions. Those financial arrangements that are not subject to the rules are removed by specific exclusion. Under this approach, any new or derivative security that may be developed in the future will fall within the rules. Section OB 1 defines a “financial arrangement” as follows: (i) Any debt or debt instrument; and (ii) Any arrangement (whether or not such arrangement includes an arrangement that is a debt or debt instrument, or an excepted financial arrangement) whereby a person obtains money in consideration for a promise by any other person to provide money to any person at some future time or times, or upon the occurrence or non-occurrence of some future event or events (including the giving of, or failure to give, notice); and (iii) Any arrangement which is of a substantially similar nature (including, without restricting the generality of the preceding provisions of this subparagraph, sell-back and buy-back arrangements, debt defeasance, and assignments of income).

While the definition is complex, the essential feature of a “financial arrangement” is that one party provides money in consideration for a promise by another party to provide money at some later date. The term “money” is defined to include “money’s worth (whether or not convertible into money) and the right to money.” 5 Therefore, the term “money” should be understood to be anything of value, rather than just consideration in cash or cash equivalents. There are a large number of exclusions from the rules, which are defined as “excepted financial arrangements.”6 These include, for example, contracts of insurance, legal gambling, superannuation, life insurance, property leases, equity shares, options on equity shares, and other assets or arrangements that clearly were not intended to fall within the rules. In the rules, there is a strong emphasis upon aligning the tax treatment with financial reporting requirements. Financial arrangements are required to be accounted for, wherever possible, using the yield-to-maturity (YTM)

5 Section 6 Defined

OB 1. in section OB 1.

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method.7 Where this method cannot be applied, the taxpayer can adopt other methods that “have regard to accrual accounting and conform with commercially accepted [methods] for financial reporting.”8 Alternatively, taxpayers can apply to the commissioner for a binding ruling as to how to account for the financial arrangement.9 The commissioner also has power to issue general determinations, 29 of which have been issued to date. These determinations specify in considerable detail how the rules are to be applied in particular situations. Thus, taxpayers are provided with considerable guidance as to the application of the interest accrual rules. An unusual feature of the rules is the removal of the distinction between capital and revenue. All gains and most losses or expenditures are treated as being on revenue account. This approach is novel since under existing New Zealand tax law, income and expenditure are often segregated into capital and revenue components. In respect of foreign exchange variations, most taxpayers are required under the rules to account for such variations on an unrealized basis annually. This treatment closely follows financial reporting practice. A key part of the rules is the base price adjustment ( BPA ).10 The BPA is calculated in the income year in which a financial arrangement is sold, matures, or is remitted. The BPA is in essence a final, wrap-up calculation whereby all inward flows derived from the financial arrangement are treated as income to an investor and a deduction is allowed for all expenditures made to acquire the arrangement together with any net income or deduction recognized in respect of that arrangement in earlier income years. A similar calculation is also made for borrowers in reverse. The effect of the BPA is to bring all gains finally to account for an investor and all losses as a deduction to a borrower which were not recognized in earlier income years. One controversial feature of the BPA is that where an amount has been remitted by a lender (for example, owing to financial difficulties of the borrower), the amount remitted becomes income to the borrower. A taxpayer who is financially distressed and has had some of its debts remitted is usually not in a position to pay additional tax on this deemed income. This provision has given rise to many complaints since the introduction of the rules. There are some exceptions for debt forgiveness in a family situation,11 but problems can still arise in situations involving debt forgiveness to a family trust.

7 Section EH 1. Under section EH 1(3), taxpayers with total financial arrangements below NZ $1 million can elect to spread bond discount/premium on a straightline basis on grounds of compliance cost reduction. 8 Section EH 1(5). 9 Section 90 of the New Zealand Tax Administration Act 1994. 10 Section EH 4. 11 Section EH 4(6).

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Shortly after the rules came into effect, a number of practitioners began to identify problems arising with certain transactions that, on policy grounds, were not intended to fall within the rules but were caught under the broad definition of “financial arrangement,” with potentially harsh fiscal consequences. As a result, Parliament found it necessary to expand the list of excepted financial arrangements in 1987 and other subsequent years, sometimes with retrospective effect back to 1986. The additions were mainly in the area of the purchase and sale of property, where a contract is entered into which provides for settlement of the contract at some later date. The purchaser appeared liable to tax on any increase in the value of the property between the date the contract was entered into and the date of settlement of the property. Similar issues have arisen in respect of other transactions, a number of which are considered in the discussion document. On compliance cost grounds, small individual investors within certain monetary limits (known as “cash basis holders”)12 are partially exempted from the interest accrual rules.13 Such investors do not have to spread bond discount on a YTM basis or to recognize foreign exchange variations on an unrealized basis. Cash basis holders recognize interest only when it is received in cash, but they are still required to undertake a BPA in the income year in which the financial arrangement matures or is sold. Thus, foreign exchange variations and bond discounts/premiums are taken into account in the final year on a realized basis. Non-residents are largely exempt from the interest accrual rules unless they are carrying on business through a “fixed establishment” (that is, a permanent establishment) in New Zealand.14 CHANGES PROPOSED IN THE DISCUSSION DOCUMENT The discussion document proposes a large number of changes to the rules. The great majority of these changes are refinements to the existing regime, and very few suggest any major shift in policy. Most aim to clarify parts of the rules where ambiguities have arisen and to reduce compliance costs where possible. The main changes proposed are outlined below. Definition of “Financial Arrangement” It is proposed to redraft the definition of “financial arrangement.” The key part of the definition (quoted earlier) is in the second limb, which refers to a person who provides money in consideration for a promise by another person to pay money in the future. Given this wording, it appears that if the consideration to be provided by both parties is not to be provided until some future date, a financial arrangement does not exist. It is proposed to remove the term “promise” from the second limb of the

12 Defined

in section EH 3. EH 1(8)(a). 14 Section EH 9(e). 13 Section

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definition and to reword the provision so that it will clearly encompass transactions where both parties provide “money” at some future date. Another proposed change is that debts created through operation of law will be specifically included. Under the current definition, there are doubts because the word “agreement” appears to require that both parties consent to the arrangement, and this may not always be the case. Definition of “Excepted Financial Arrangement” It is recognized that the definition of “financial arrangement” was deliberately cast very widely, but over time it has been perceived as “insufficiently targeted.” It is proposed to further expand the list of excepted financial arrangements as described below. Travellers’ Cheques Travellers’ cheques are caught within the definition of “financial arrangement,” and as a result foreign exchange gains and losses must be brought to account when each traveller’s cheque is cashed. Taxpayers required to account for financial arrangements on an accrual basis (accrual basis holders) are also required to account for unrealized foreign exchange variations annually on any traveller’s cheques held at the end of each income year. Such calculations have been largely ignored by most taxpayers since 1986, and the Inland Revenue Department (IRD) has not sought to actively enforce this part of the rules. This exclusion is clearly warranted on compliance cost grounds and because there is virtually no opportunity for income deferral. Interests in Group Investment Funds, Partnerships, or Joint Ventures Interests in partnerships and joint ventures will be excluded because they represent a form of equity, and the interest accrual rules are not intended to apply to equity interests. This change is largely a clarification to eliminate ambiguities. Security Arrangements Relating to Credit Risk Security arrangements relating to credit risk will be excluded from the rules, unless they contain provisions that provide protection against price fluctuations such as foreign exchange or interest rate movements. Insurance contracts that indemnify a person against foreign exchange movements will also remain within the rules for the same reason. This issue is discussed later in this article. Small Variable Principal Debt Instruments Variable principal debt instruments are assets such as bank accounts, cheque accounts, and credit card facilities. It is proposed to exclude these on grounds of compliance costs, since the record-keeping requirements are onerous and there is little opportunity for income deferral. The exclusion will apply to both foreign and NZ dollar denominated accounts, (1998), Vol. 46, No. 4 / no 4

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provided that the balances in such accounts in the aggregate do not exceed NZ $20,000 at any point during the income year. While this exclusion appears to be useful, it is not likely to be of much value to business taxpayers. First, the NZ $20,000 limit is very low, and the aggregate balances may exceed NZ $20,000 on just one day. Second, even if the taxpayer does fall within the de minimis limit, the tax treatment proposed will depart from accepted financial accounting treatment, resulting in increased compliance costs. This exclusion would be more appropriate if it were offered as an option to taxpayers or limited to “cash basis persons” 15 who are not carrying on a business. Employment Contracts Employment contracts are another example of financial arrangements that are brought within the accrual rules when there is no policy reason for their inclusion. Since there is no opportunity for income deferral using employment contracts, they will be specifically excluded.16 On-Demand Loans Without Interest, Discount, or Premium A common feature of estate planning and family arrangements in New Zealand is for loans to be made between family members or to a family trust on an interest-free, repayable on demand basis. It is proposed to exclude loans made by cash basis persons in NZ dollars which are interestfree and issued without any discount or premium. Small Prepayments for Goods and Services and Short-Term Agreements Currently “short-term trade credits” and “short-term agreements for the sale and purchase of property” are excluded financial arrangements. “Short term trade credits” are debts arising from the supply of goods and services where payment is required within 63 days. “Short-term agreements for the sale and purchase of property” cover agreements for the sale and purchase of land/property with certain time limits. 17 Further exclusions are also made for some agreements of this type entered into for private and domestic purposes.18

15 “Cash basis person” is a proposed revision of the “cash basis holder” definition, referring to natural persons with total financial arrangements (both assets and liabilities) not exceeding NZ $1 million. 16 Special rules apply to the timing of deductions for remuneration paid to employees under section EF 1(6). 17 Settlement of such agreements is required to take place within 93 days of the date on which the agreement was entered into for real estate and 63 days for an agreement covering non-real (personal) property. 18 Provided that settlement takes place with 365 days of the date on which the agreement was entered into and the value of the property does not exceed NZ $750,000 for real property (that is, land) or NZ $250,000 for non-real property.

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A limitation of these definitions is that where there is a prepayment for services, a financial arrangement still exists. Therefore, prepaid 10-trip bus tickets, advance purchase discounted airline tickets, and prepaid travel packages are all caught as financial arrangements, and any discount enjoyed by the purchaser from early payment appears to constitute taxable income to the purchaser (although it is unlikely that any purchaser has returned such amounts as income). It is proposed to repeal the definition (and exclusion) of “short-term trade credit” and instead extend the definition of “short-term agreement for the sale and purchase of property” to include services. Prepayments for goods and services not exceeding NZ $20,000 will also become excepted financial arrangements. This change is long overdue. There was no sound policy reason for subjecting arrangements such as the prepayment of bus and airline tickets to the interest accrual rules, and the IRD has never attempted to enforce such requirements, obviously on grounds of compliance costs and public credibility. The problem of prepaid services highlights the disadvantage of a broad, inclusive definition for “financial arrangement” and demonstrates the need for expansion of the list of exemptions when anomalies are discovered. Certain Loans in Foreign Currencies Under the current definitions, where persons have borrowed money in a foreign currency for private and domestic purposes, they are required to account for unrealized foreign exchange variations annually. It is now proposed to exclude such financial arrangements if they were entered into for private and domestic purposes. Thus, New Zealand residents who borrow money in a foreign currency to purchase foreign real estate for private use will not be liable to account for exchange variations. Again, this exclusion is warranted on compliance cost grounds. This proposal will further ensure that such borrowers do not obtain a deduction for interest payable on private (non-income-earning) debt denominated in foreign currencies. Such a deduction can potentially be obtained under the interest accrual rules because foreign exchange gains are always taxable and are offset against interest payable within the accrual rules to obtain net interest expense or net income. If an issuer has reported net income in respect of a loan in earlier income years, it appears that a deduction will be permitted for expenditure deemed to arise under the BPA because they were incurred in the production of “gross income” reported earlier. Deductions for interest payable on private loans denominated in NZ dollars are not permitted under the interest deduction section DD 1(b), and this proposal will ensure that private loans in foreign currencies will be treated on the same basis. Another difficulty with this proposed exclusion is that the tax status of foreign exchange gains derived from excepted financial arrangements is uncertain. This matter needs to be clarified because it would be most inequitable if foreign exchange gains earned in a private capacity were to (1998), Vol. 46, No. 4 / no 4

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be taxable on the basis of common law principles without the provision of a similar matching deduction for losses. If such variations derived in a private capacity are treated as non-taxable/deductible, it will mean that exchange variations on a foreign house mortgage will be placed on the same basis as exchange variations in respect of the house (that is, on capital account). Warranties There is confusion about whether a warranty supplied with the sale of goods or services constitutes a financial arrangement in its own right. It is proposed to exclude such warranties if they do not represent, in economic substance, debt or debt substitutes. These warranties will be regarded in the same way as other contingent contracts such as insurance and guarantees. This proposed change will remove an area of uncertainty and is consistent with the underlying policy goals of the rules. Other Changes and Concerns It is also proposed to remove some types of arrangements currently listed as excepted financial arrangements. For example, debentures with certain equity characteristics19 that fall within sections FC 1 and 2 are to be removed from the list on grounds of redundancy, since they are taxed as equity shares and there is already an exclusion for equity shares. The issue of redundancy in tax legislation has not been given a high priority by legislators in the past, and it seems desirable to leave this exclusion unchanged, since it helps to clarify the legislation at very little cost and with little additional complexity. Furthermore, sections FC 1 and 2 do not reclassify such debentures as equity but simply deny a deduction for any interest payable. While such debentures are treated as equity in other specific regimes within the Act, there is no comprehensive provision that reclassifies them as equity; thus, the current exclusion removes any doubt. Another issue is that the current definition of “financial arrangement” catches a series or group of subordinate financial arrangements. This inclusion is necessary because the interest accrual rules could be avoided if a financial arrangement were separated into a group of excepted financial arrangements. Under section EH 2, income derived from that part of a wider or composite financial arrangement which is attributable to the excepted financial arrangement portion is excluded from the rules. It is proposed to clarify this treatment by amending section EH 2 to exclude only income that is “solely attributable” to an “excepted financial arrangement” to the extent that the income could have been expected to arise without the support of the wider financial arrangement.

19 Interest paid on debentures that varies according to the underlying profitability of the issuer and any dividends paid by the issuer are treated as non-deductible under section FC 1. Interest payable on debentures issued in substitution for shares also is non-deductible under section FC 2.

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The exact effect of this proposal is unclear, although taxpayers have good reason to be wary. The likely effect is to bring more income attributable to excepted financial arrangements within the tax net. A good example of a wider financial arrangement is a convertible note that possesses both debt and equity characteristics. Under the current approach, that part of the return which is attributable to the underlying equity component of the note is excluded from the rules. The effect of the proposed change is that the equity component could be brought within the interest accrual rules. Thus, an increase in the market price of a convertible note which reflects the increase in value of the underlying shares could become taxable (possibly on an unrealized basis), while gains on the ordinary shares of the same issuer would remain exempt.20 Issuers and Holders of Financial Arrangements and the BPA The calculation of the BPA requires classification of the two parties to the financial arrangement into “holders” and “issuers.” Holders are essentially lenders or investors, and issuers are borrowers or investees. While the classification is applied easily to debt instruments, parties to other types of financial arrangements may not be so easily classified. Sometimes parties to certain financial arrangements are specifically deemed to be “holders” or “issuers” outside the general definitions.21 The distinction between issuers and holders is important because different BPA formulas apply to each category. 22 The classification is also critical because of the different tax treatment for “holders” and “issuers” of any expenditure (for example, net loss) derived under the BPA . If a holder derives a negative BPA , 23 an automatic deduction against gross income is permitted. Issuers are not entitled to an automatic deduction for

20 New Zealand does not tax capital gains comprehensively. Gains from the sale of equity shares are taxed as ordinary income if the taxpayer carries on a dealing business (that is, where there is a regular purchase and sale of shares); if the shares were acquired for the purpose (as distinct from intention) of resale or other disposition; or if the shares form part of a profit-making scheme or undertaking. (See section CD 4.) Gains from the sale of shares by taxpayers carrying on investment businesses and by insurance companies are taxed as business income under common law principles. Introduction of a comprehensive capital gains tax applying to individual taxpayers is unlikely because of political considerations. Virtually all New Zealand governments, however, have extended the capital gains net through backdoor means that were largely invisible to the average voter. The proposal relating to wider financial arrangements is consistent with this strategy. 21 Such a deeming provision is included in the definition of “holder” (in section OB 1) in respect of forward and futures contracts, agreements for the sale and purchase of property, and options to buy property. In section OB 1, “issuer” is defined in a residual fashion to mean any party to a financial arrangement who is not a “holder.” 22 Section EH 4(1). Cash basis holders undertake a “cash base price adjustment” under section EH 4(2). 23 Holders are likely to derive losses under the BPA only if too much income has been recognized in earlier income years or if foreign exchange losses exceed the interest derived from the arrangement.

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expenditure arising under the BPA and are required to meet the interest deduction test in section DD 1(b). Although the treatment of holders and issuers is, in some respects, not symmetrical, there are good reasons for this difference, which are explained later in this section. The treatment is symmetrical, however, for foreign exchange gains and losses derived by holders, since all gains from a financial arrangement are taxable and all losses (other than bad debts) are deductible. It is proposed to remove the current distinction between holders and issuers and to put them on the same footing using one BPA formula. With this change, it will no longer be necessary to identify the issuer and the holder of a financial arrangement. For both parties, if a loss is derived under the BPA , a deduction will be granted only if further tests of deductibility in the core provisions of the Act are met.24 For holders, the automatic deduction now available will be eliminated. There will remain a separate automatic deduction for holders, but only to the extent of income recognized from the financial arrangement in earlier income years. This amendment is the most significant change proposed in the discussion document. Whether a holder will be permitted a deduction for a net loss suffered from a financial arrangement is uncertain. Holders who are not carrying on a business may not be able to obtain a full deduction for foreign exchange losses, although all foreign exchange gains will be taxable. This uncertainty arises because of difficult and complex issues surrounding the deductibility of expenditure determined under the rules on a net basis (interest income combined with foreign exchange variations) when the rest of the Act imposes tax on a gross/global basis. There is also a risk that inconsistent treatment of deemed expenditure and gross income derived by holders could arise between income years. Accrual basis holders who derive expenditure (that is, whose unrealized foreign exchange losses exceed interest derived) in income years before the calculation of the BPA may find that these amounts are not deductible but that any gross income arising under the BPA is taxable. A similar issue currently exists for issuers who derive taxable income from a financial arrangement but in earlier years derived expenditure that did not qualify for a deduction under section DD 1(b). In this case, some offsetting of the net amount of income and expenditure earned between income

24 It is not clear from the discussion document which deduction section in the core provisions is being referred to. It could be either the general deduction provision in section BD 2(1)(b) or the interest deduction provision in section DD 1(b). It may appear strange that a taxpayer could have to apply an interest deduction test in respect of a financial arrangement that the taxpayer (that is, an investor) holds, but under section DD 1(b), expenditure deemed to be incurred under the interest accrual rules is deemed to be interest expense for purposes of the interest deductibility test.

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years is warranted too.25 This matter in respect of issuers is being partly addressed in the discussion document by the proposal to take private loans in foreign currencies outside the interest accrual rules. 26 The discussion document justifies this proposed change on the grounds of treating both issuers and holders (borrowers and lenders) on the same basis. This argument, however, is fallacious because the New Zealand tax regime has never treated issuers and holders on the same basis in respect of interest. All interest received by a taxpayer is always taxable irrespective of the context in which it was received (that is, private investment or business). Interest paid by a taxpayer is deductible only if it was paid in respect of capital employed in the production of income.27 In the case of holders (lenders), all returns from debt are taxable; it is impossible to derive a non-taxable gain from such arrangements. Therefore, it follows that any losses suffered in respect of the instrument should be deductible.28 As interest rates and expected foreign exchange variations are closely tied to international capital markets, it is inappropriate to treat each component differently. The current interest accrual rules were based on the approach that exchange variations and interest income should be treated the same, and the proposals appear to try to place large foreign exchange losses on capital account and to make them non-deductible. It appears from the discussion document that this is a deliberate policy objective, but the proposal has been presented as a remedy for high compliance costs and difficulties in identifying issuers and holders of financial arrangements. One suspects that the latter problems are not as great as alleged in the discussion document. Another proposed change relates to cash basis holders. Currently, cash basis holders are individuals who hold financial arrangements in the aggregate under NZ $700,000. This concession applies only in respect of holders, but the commissioner has issued a determination (G 15) that permits similar treatment for small debtors subject to much lower monetary limits.29 It is proposed that the cash basis holder category be extended to small issuers who are natural persons and that this category be renamed “cash basis persons.” Such persons would have the option of electing to become

25 If the issuer was deemed to derive income in an earlier income year, it may be possible to obtain a deduction for deemed expenditure (interest expense) in later income years. (See the earlier discussion regarding private loans denominated in a foreign currency.) 26 See the earlier discussion regarding private loans denominated in a foreign currency. 27 Section DD 1(b). 28 The current rules have one restriction on deductibility, where the loss arises from a loss of capital or downgrading of the issuer’s credit rating. Deductions are available for these types of losses only where the taxpayer is carrying on a business of dealing in or holding such financial arrangements. 29 Total liabilities that are financial arrangements and are used for income-producing or business purposes cannot exceed NZ $200,000.

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accrual basis taxpayers. The election would be made one year in advance and would apply to all financial arrangements held or issued by the taxpayer. This proposal will probably make little difference to taxpayers, other than possibly opening up income-shifting opportunities for small individual issuers who prepay interest. The accrual basis option is unlikely to attract taxpayers who are net holders of financial arrangements because of additional compliance costs and because it will likely accelerate the reporting of income from a financial arrangement. In addition, the requirement to make an election one year in advance is unattractive and impractical. Taxation of Loans in Foreign Currencies and Forward Contracts The interest accrual rules recognize that foreign exchange variations are an integral part of returns or expenditure in respect of debt instruments. It is for this reason that foreign exchange gains are brought to account annually on an unrealized basis. A problem under this approach is that, owing to significant shifts in exchange rates, the amount of income or expenditure that is brought to account may vary substantially from year to year. These fluctuations may cause cash flow problems where taxpayers are required to recognize large exchange gains on an unrealized basis and also may give rise to difficulties under the provisional tax regime for the self-employed and companies, given that taxpayers have to estimate their income many months ahead of the end of the income year. It is therefore proposed to bring to account only expected exchange variations as anticipated by forward exchange rates. Unexpected variations will be brought to account only when realized. The effect of this change is to remove some of the volatility of income/expenditure brought to account in each year using spot rates and to reduce cash flow difficulties when taxpayers are required to report large unrealized foreign exchange gains. This proposal represents a significant change to the current rules and will make the rules more commercially acceptable. The new approach will be workable only where there are set repayment dates; where there is no set repayment date, spot rates will continue to be used. The proposed change is also likely to add to compliance costs if the taxpayer has to prepare financial statements for external shareholders using different accounting methods. Whole and Partial Assignments of Income and Debt Defeasances Debt defeasances and assignments of income fall under the rules,30 although how such financial arrangements are to be accounted for under the rules is uncertain. This uncertainty has created high compliance costs for taxpayers. It is proposed to clarify the rules so that absolute assignments or

30 In

the third limb of the definition of “financial arrangement” in section OB 1.

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legal defeasances of financial arrangements will be deemed not to create a new arrangement for the assignor or defeasor, and such assignments or defeasances of a financial arrangement will be treated as if the arrangement had matured. This change is proposed because absolute assignments and legal defeasances have no accrual consequences, and payments under such transactions will be taxable under other provisions in the Act. Assignments and defeasances of excepted financial arrangements will be similarly treated. Any other type of defeasance or assignment, such as in-substance defeasances, will be treated as having created a new financial arrangement. This rule will result in different treatment for financial reporting than for tax purposes. Partial assignments and defeasances will be treated as variations to a financial arrangement. Debt Remissions The controversial treatment of remitted debt as being deemed income to the debtor is to continue despite continued lobbying pressure over this issue since the rules were introduced. This deeming of income does not apply where a person has been released from the obligation to make payment under the Insolvency Act 1967 (which applies only to individuals) or under any revenue acts. However, it still applies to companies. Some taxpayers have adopted debt-parking schemes to avoid this deeming of income where there is agreement between a debtor and a creditor to remit debt. Debt parking involves the sale of a debt that cannot be fully repaid, to an associate of the debtor at a discount. It is proposed to introduce debt-parking rules that will treat debts that are “parked” as having been discharged (hence, partially remitted). These rules will apply if a debt is sold to a company that has at least 50 percent common ownership with the debtor and the debt is sold at a discount of 20 percent or more of its face value. Similar rules are understood to apply in Australia and Canada. Removal of this debt-parking option may heighten lobbying pressure on the whole debt remission issue. A problem exists in taxing the income arising from the remittance of debt if the company is a debtor. Since the remittance occurs only when the company is liquidated, there is no taxpayer in existence to collect the tax arising from the debt remittance. It is proposed to treat such amounts remitted as having arisen immediately before the winding up in order to put the commissioner on the same basis as other unsecured creditors. A circularity problem could arise, because the amounts paid to creditors will be reduced (owing to the commissioner’s claim), resulting in further remittances by each creditor and hence further income. To prevent such circularity, the rule will require the remission of all debts, including the income tax liability, to occur only once at the point of bankruptcy. This proposal has drawn adverse comment from the commercial community because it means that amounts available to satisfy creditors of bankrupt companies will be shared with the commissioner, leaving less cash available to meet each creditor’s claim. (1998), Vol. 46, No. 4 / no 4

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Financial Leases Financial leases have been subject to their own taxing regime 31 since 1982. Such leases are defined as “specified leases” and are required to be accounted for as a sale and purchase of an asset with a loan provided by the lessor. There is no reason why such leases should be taxed outside the interest accrual rules, and it is proposed that the rules be revised to apply to financial leases. The specified lease regime will continue to apply to financial leases entered into before April 1, 1999. Leases entered into after March 31, 1999 will be brought within the accrual rules and will be known as “finance leases.” Finance leases will be more narrowly defined than are specified leases. The definition of “specified leases” catches certain leases that neither transfer economic ownership nor provide financing because the lessee is responsible for repairs to and maintenance of the leased asset. A “finance lease” will be defined to be a lease where either • the lease provides for ownership of the leased asset to transfer to the lessee (or to an associate of the lessee), whether at the option of the lessee or not, on concessional terms at the end of the lease; or • the asset is leased for a major portion (75 percent or more) of its economic life, using the same estimated economic lives adopted in the depreciation regime. The new definition will apply to both personal and real property. Under the specified lease regime, the lessee is required to obtain the cost of the leased asset from the lessor. This requirement is often impractical owing to issues of commercial secrecy. For finance leases falling within the interest accrual regime, the deemed acquisition price of the leased asset will become • the cash price for which the property could have been purchased from the lessor; or • the lowest price for which the property could have been acquired under a short-term agreement for the sale or purchase of property; or • the discounted amounts payable under the lease in accordance with the commissioner’s determination. The proposals for finance leases will treat the leased property as if it had been sold to the lessee with financing provided by the lessor. A potential problem area is the interface between these deemed purchase rules and sections CD 1 and 4, which tax certain sales of land and other property. The deemed purchase of real estate by a lessee who is in the business of land dealing or development could give rise to numerous complications and has led to submissions that land should be removed from the scope of finance leases.

31 Sections

FC 6 to 8.

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The new definition removes a major loophole in the specified lease regime, where leased assets transferred to an associate of the lessee at a bargain price at the end of the lease fall outside the definition of “specified lease.” Owing to this loophole, many financial leases have been arranged so that they qualify as operating leases for tax purposes. Security Arrangements A consequence of the broad definition of “financial arrangement” is that security arrangements relating to credit risk are included within the rules. Problems have arisen from this inclusion with respect to the accounting for such arrangements where cash flows are contingent in nature and no consideration is provided for the guarantee. It is proposed to exclude such security arrangements from the rules except for those relating to prices and interest rates. The latter remain included because they can act as substitutes for derivative transactions. Excluded guarantee arrangements relating to credit risk will be taxed according to the usual revenue/capital distinction elsewhere in the Act. It is proposed that for the guarantor the tax status of the guarantee arrangement will depend upon whether the guarantee is on revenue or capital account. It is proposed to retain the current restrictions on deductions for bad debts between associated parties in section ED 5, so as to prevent creating incentives for subsidiaries to be financed with debt. A subsidiary that failed would give rise to a deduction, but if the subsidiary performed well, any gains would be on capital account through appreciation in the value of the subsidiary’s shares. Trusts and Estates Upon the death of a taxpayer, all financial arrangements owned at the date of death will be deemed to have been sold, and a BPA calculation must be made. This proposed change will remove doubts that exist under the current rules. There will be a further requirement to undertake a BPA when financial arrangements are transferred to beneficiaries from an estate. This income will be taxed as trustees’ income. There are also problems relating to forgiveness of debt to family trusts. Under section EH 4(6), amounts forgiven in consideration for natural love and affection are deemed to have been repaid so that such forgiveness will not become income in the hands of the debtor under the BPA. Under a ruling issued by the commissioner in 1996,32 this treatment was extended to forgiveness of debt in a will and to forgiveness by a trust’s settlor or creditor where the creditor would have had a relationship of natural love and affection with the trust’s beneficiaries. It is proposed to clarify the status of forgiveness of debt in favour of a trust’s trustees and to include the rule in legislation rather than leave it as a commissioner’s determination.

32 New Zealand, Inland Revenue Department, Tax Information Bulletin, vol. 7, no. 10, March 1996.

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Other Issues Disclosure Requirements The interest accrual rules contain a number of disclosure requirements, which were included to provide the commissioner with information about certain transactions perceived to be a high risk for tax avoidance. It is proposed to discontinue a number of these disclosure requirements in the interests of reducing compliance costs. The need for such requirements may be diminished since the introduction of the new penalties regime in 1997 and increased emphasis on self-assessment by taxpayers. In-Specie Distributions In-specie distributions of financial arrangements by a company in liquidation are to be treated as a disposition of that financial arrangement, requiring calculation of the BPA . Branches of Non-Residents and Expatriates The current requirement to calculate a BPA when a taxpayer becomes non-resident but continues to carry on a business through a fixed (permanent) establishment in New Zealand will be removed. Temporary residents in New Zealand who become non-resident within three years of becoming resident will be exempted from the requirement to calculate a BPA in respect of financial arrangements owned at the time they became resident in New Zealand. This proposed change will remove the requirement for expatriates in New Zealand to undertake accrual and BPA calculations in respect of loans raised outside New Zealand before their arrival here, such as mortgages on homes retained offshore. Relationship of the Interest Accrual Rules to the Rest of the Act Section EH 8 specifies the relationship of the interest accrual rules to the rest of the Act. The current drafting of this section is ambiguous in parts, giving rise to doubts as to whether the rules override anti-avoidance provisions elsewhere in the Act, such as the general anti-avoidance rule,33 the transfer-pricing rules, 34 and the thin capitalization rules.35 It is proposed to redraft this section to make it clear that the interest accrual rules determine the amount and timing of income and expenditure from financial arrangements, but the core provisions will recognize whether these amounts are taxable or deductible. This revision will be possible because of the proposed removal of the automatic deduction for holders under the BPA . It is also proposed to ensure that the new transfer-pricing rules (and other anti-avoidance provisions) can override the accrual rules.

33 Sections

BG 1 and GB 1. GD 13. 35 Subpart FG. 34 Section

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COMMENT ON THE PROPOSALS The discussion document contains a large number of proposals to revise the interest accrual rules. Most of them are justified on the basis that they will make the rules clearer and reduce tax compliance costs. A number of the proposals reflect the difficulties arising from the adoption of a very broad definition of “financial arrangement.” Such broad definitions inevitably catch transactions that should not be subject to the rules for policy reasons. Some of the proposed exclusions are long overdue and should be made retroactive to the 1987-88 income year, when the rules first came into effect. Among the most significant changes are the proposals to require accrual basis taxpayers to report only anticipated gains/losses on an unrealized basis. This amendment will reduce the wide swings in unrealized exchange variations that are now required to be reported and will assist taxpayers with cash flows. It will address some of the longstanding criticisms of the rules, particularly given the punitive nature of the New Zealand provisional tax system. The removal of the automatic deduction for holders is unwarranted and may result in harsh outcomes for some taxpayers. The reasons given for this proposed change are not valid, and problems of distinguishing between issuers and holders under some financial arrangements can be addressed through other means. The proposal contravenes concepts of equity—an ironic result given that many tax changes in New Zealand are justified by politicians on the grounds that they are “fair.” The proposal also contravenes the established tax regimes governing the taxation of interest income and interest deductibility. It needs to be carefully reconsidered, because there are too many uncertainties arising from the proposed change, as well as the potential for inappropriate outcomes. It is disappointing that a more flexible position was not forthcoming on the issue of deeming income from debt remittances. The current treatment has created many difficulties in practice, which have imposed significant cost barriers to business restructurings. A more lenient approach in this area would not create tax-avoidance opportunities provided that restrictions were applied to debt remittances between associated persons. The reluctance to reform this area reflects a hard-line stance taken by policy advisers on the necessity to tax all “economic” income. One issue not considered in the discussion document is the uncertain tax status of some arrangements that will result from their removal from the ambit of the interest accrual rules. Specific legislation needs to be introduced to govern the taxability and deductibility of foreign exchange variations that fall outside the rules.36 On grounds of certainty and compliance

36 The only other provision that deals with exchange losses is section CZ 1. This provision applies to exchange losses on loans suffered by taxpayers carrying on a business in New Zealand. The loss can be deducted only if it is realized. This section was introduced in 1974 and does not apply to any loan that falls within the interest accrual rules (subpart EH).

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costs, it is not acceptable to leave this issue to the “core provisions” of the Act. The answers will not be easily found there. CONCLUSION The New Zealand interest accrual rules represent a comprehensive approach to the taxation of financial arrangements. A review at this stage is appropriate, given that the rules have been in existence for over a decade. The discussion document proposes to retain the basic framework of the rules and confirms the soundness of their underlying philosophy. A number of the proposals contained in the discussion document are welcome, since they will help to simplify the application of the rules and to reduce uncertainty and taxpayer compliance costs. Some proposals, however, tamper with the existing framework and have the potential to create as many problems as they solve. In these areas, the proposals need further consideration.

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