Fundamental changes proposed to thin capitalisation rules
In a brief issues paper innocuously entitled “Review of the thin capitalisation rules”, Inland Revenue policy officials and the Treasury have started 2013 with gusto, proposing significant changes to New Zealand’s thin capitalisation rules.
The changes, if enacted, will extend the ambit of the rules so that they operate as officials consider they were intended to. Although there is a particular focus on private equity investment vehicles, certain aspects of the proposed changes, if implemented, are likely to introduce material uncertainty and potential overreach into the rules. Those currently subject to the thin capitalisation rules may also face increased compliance costs resulting from some of the changes.
There are a number of proposed amendments, but the key changes are to:
- widen the inbound thin capitalisation rules to include companies in which non-residents that are not necessarily associated for tax purposes, but who “act together”, hold an interest of 50% or more;
- exclude related party debt when calculating the worldwide debt-to-asset ratio in applying the 110% safe harbour.
Other proposed changes include bringing certain New Zealand trust structures within the thin capitalisation regime, excluding capitalised interest from asset values and ignoring accounting value uplifts arising from transactions between associated parties.
The focus of the issues paper is “ensuring that more tax is collected in cases where New Zealand-sourced income appears to be escaping tax”, i.e., base maintenance. The changes are proposed to take effect from the income year beginning after enactment of relevant legislation (so, at the earliest, from the 2014 income year).
Non-resident investors “acting together”
The first key proposal is to widen the inbound thin capitalisation rules to include companies in which non-residents that are not necessarily associated for tax purposes, but who “act together”, hold an interest of 50% or more. This is aimed at shareholders who can “collectively act in the same way as an individual controlling shareholder to determine the level of debt the company will hold”, i.e. in a way that “mimics control by a single controlling investor”.
It is not proposed to exhaustively define what constitutes “acting together”, but the issues paper indicates that this will include at least:
- explicit co-operation through a written or tacit shareholder agreement;
- effective co-ordination of investors by a person or group of people, such as private equity managers.
Where this rule applies, the worldwide group for the purposes of the 110% safe harbour will be the New Zealand group.
In an environment where New Zealand is competing for foreign direct investment, such a change will inevitably introduce material uncertainty into our international tax rules. Precisely what aspects of the New Zealand company’s business the relevant investors must be “acting together” with respect to – i.e. the particular subject matter of their “co-operation” or “co-ordination” - is unclear. It is not an easy task to define which such aspects are sufficient, how regularly and to what extent they must be agreed upon, to mimic control by a single controlling investor.
A proposed alternative approach outlined in the issues paper is to prescribe specific and exhaustive criteria indicating when parties are acting together. An example given is “whenever there was a shareholder agreement”. However, this and any approach based on whether a shareholder agreement is on foot risks arbitrary or unintended outcomes and overreach. The mere existence of a contractual arrangement regulating the relationship between co-investors and matters relating to the relevant investment to some extent - and this is where the differences will lie as between agreements - should not necessarily be a proxy for control by a single controlling investor. Officials also do not prefer this approach, given the need for complex criteria in order to avoid easy circumvention.
A further proposed alternative is for the thin capitalisation rules to apply to all companies in which non-residents hold (in aggregate) an interest of 50% or more, whether or not acting together – this is similar to one limb of the equivalent Australian test. Publicly listed companies would be excluded. Officials observe that such a test may include shareholders that are very unlikely to be able to influence a company’s debt level.
Which arrangements should (or should not) be included within the thin capitalisation rules from a tax policy perspective – i.e. how widely should the rules apply - warrants robust consultation and debate before final decisions are made regarding the proposals. In this regard it is relevant that there will always be a degree of “co-operation” under any shareholder agreement, and the extent of “co-ordination” of investors will depend upon the nature of the relevant investment mandate. The impact of uncertainty and overreach ought not to be underestimated, particularly in relation to perceptions of New Zealand as an investment destination compared with other jurisdictions.
Exclusion of related party debt when calculating 110% safe harbour
The thin capitalisation rules limit the deductibility of interest expenditure if the New Zealand group’s debt-to-asset percentage exceeds 60% and exceeds 110% of the worldwide group’s debt-to-asset percentage. Officials observe that, in some cases, the 110% safe harbour is always available as the worldwide group is almost the same as the New Zealand group. This can result in non-resident investors being able to use as much debt (including shareholder debt) in relation to their New Zealand investments as they wish.
The issues paper proposes amendments to ensure that the 110% safe harbour applies in a meaningful way (i.e. to a foreign parent with substantial foreign operations and third party borrowing). Debt will not count towards the safe harbour if it is linked to the shareholders of group entities. Acknowledging that this is a complex area, officials propose that debt be excluded from the 110% safe harbour calculations where:
- the debt is owed to a person having an income interest in a group entity; or
- the debt is owed to a person that has received funds directly or indirectly from a group entity, a person with an income interest in the group entity, or an associated person, on the condition or expectation of both parties that some or all of those funds would be used to provide the debt (this is to prevent back-to-back loans).
Officials perceive the number of affected taxpayers to be low, as in their view most do not have to rely on the 110% safe harbour.
To bolster this proposal, the issues paper identifies that a specific anti-avoidance rule may be introduced to counter shareholder debt being “transformed into apparently external debt”. In the light of the detailed scheme of the thin capitalisation rules (particularly if the proposals are enacted), and the factors taken into account in any general anti-avoidance analysis following the Supreme Court’s judgment in Ben Nevis, this does seem somewhat excessive.
It is proposed that capitalised interest should be subtracted from the value of assets, to the extent the interest has been deducted as a tax expense in New Zealand (the status quo being “inappropriate”). Officials state they have been advised that this is a “straightforward” compliance exercise with minimal costs.
Calculating capitalised interest on a go-forward basis from the time of acquiring assets should be straightforward. However officials do not seem to have taken into account the time and cost involved in reviewing prior tax returns and supporting material to identify previously capitalised interest, for example where an entity becomes subject to the thin capitalisation rules some years after acquiring an asset. Bearing in mind what should be a relatively immaterial amount of capitalised interest relative to the value of assets, this proposal appears to create a disproportionate compliance burden.
The issues paper discusses three other proposed changes to the thin capitalisation rules.
Generally assets must be recorded at cost and revaluations are not permitted for financial reporting purposes. Officials consider that this restriction is being circumvented by reporting higher asset values after internal reorganisations. In response, the issues paper proposes that, when the total accounting value of an asset of a New Zealand or worldwide group increases as the result of a sale between associated persons, this increase should be ignored.
This proposal appears to constitute the proverbial sledgehammer to crack a nut. It is not clear why a genuine increase in asset value should be ignored, particularly if (for example) an external funder is prepared to lend against the security represented by the increased asset value. In addition, internal reorganisations are often undertaken for genuine commercial reasons.
The issues paper proposes that the thin capitalisation rules should be extended to apply to resident trustees (of complying trusts) where 50% or more of the total settlements are made by a group of non-residents acting together, or by an entity subject to the thin capitalisation rules. Submissions are invited on when it would be normal, for non-tax reasons, to use a trust to hold group companies. This appears to assume a ‘norm’ for structuring the ownership of group companies in New Zealand, despite the Supreme Court’s observations in Penny & Hooper that, generally, the utilisation of trust and corporate structures is not in itself offensive (it was the particular use of those structures to repatriate personal exertion income to the taxpayers that concerned the Court).
The issues paper proposes that New Zealand resident individuals or trustees will be required to consolidate with the holdings of their underlying entities (i.e. outbound groups) when establishing their thin capitalisation position.
Finally, the issues paper signals that officials may undertake future work in relation to the treatment of debt held by finance or insurance companies, and the substituting debenture rule.
A significant omission from the issues paper is any discussion of whether the proposals should only apply to new funding structures entered into on or after enactment (i.e. with existing arrangements being grandfathered). Investors will have made investment decisions based upon the law in force when initially providing funding. Although it is inevitable that tax laws change from time to time, the proposed changes will equally inevitably result in real costs for investors as a result of adjusting their funding mix to preserve full interest deductibility.
The proposals seek to correct “apparent problems” with the thin capitalisation rules that have been identified by Inland Revenue in the course of its audit work. In such circumstances, the issue is whether it is equitable to affect existing investment arrangements through measures aimed at remedying defective legislative design.
The Minister of Revenue has described the foreign investment tax laws as a “delicate balancing act” – on the one hand, ensuring that non-resident investors pay their “fair share of tax” but, on the other, not discouraging investment. Whether the proposed recalibration of the thin capitalisation rules appropriately strikes that balance (in particular, through rules that are clear and appropriately targeted) is certainly worthy of debate.
The issues paper seeks submissions on the proposals by 15 February 2013 and can be accessed here
If you have any questions regarding the proposals, or if you would like to discuss making a submission, please contact your usual Deloitte adviser.
Tax Alert February 2013 contents
- Tax Alert - February 2013
- Fundamental changes proposed to thin capitalisation rules
- GST remedial issues paper released for comment
- Inland Revenue update New Zealand tax residency rules
- Purchases denominated in foreign currency – proposed tax reforms announced
- Japan and New Zealand sign new double tax agreement
- Taxation of Multinational Companies: Report Issued by Inland Revenue