Signposted for reform: infrastructure tax changes mooted

As part of a pre-Budget tax announcement, Minister of Finance Nicola Willis announced the Government is proposing to remove a tax roadblock to infrastructure investment.

The issues paper released by Inland Revenue proposes attracting more foreign investment into New Zealand by relaxing the thin capitalisation settings using one of two options:

• Option one: A rule targeted at greenfield New Zealand infrastructure projects with third-party limited recourse debt.
• Option two: A more general rule that applies to third-party limited recourse debt within the New Zealand tax base.

The Minister of Finance has allocated $65 million over four years for a change to the rules, pending the outcome of the consultation.

There is a limited time to comment on the proposals in the issues paper. We expect this is so the final proposals can be included in the next omnibus tax bill, which is anticipated to be released in August.

Currently, the rules can effectively deny tax deductions for interest on debt in excess of 60% of the asset value. These changes are positive, as they recognise the commercial reality that infrastructure projects are often highly geared (more than 60%). Infrastructure is capital intensive, and its long-term, predictable revenue streams align with long-term debt repayment profiles.

Debt funding is also typically cheaper and more accessible in this context than equity financing. Under the existing tax settings, denying interest deductions on infrastructure assets only increases their cost, as assets need to generate greater profits to meet equity investors’ required rates of return. The changes will therefore help to remove this barrier to investment.

Potential potholes ahead?

However, some issues do arise.

Firstly, option one is favoured by officials and this only applies to eligible ‘infrastructure’.

This will result in inevitable line drawing exercises and definitional issues and so has the risk of creating projects, which are both demanded by and able to be funded by the market, falling on the wrong side of the pen.

Secondly, option one is intended to be targeted to greenfield investments but leaves the door open for ‘significant upgrades’ of existing infrastructure. In any case where an infrastructure investor incurs a genuine economic cost, it is difficult to see why our tax settings should only allow a tax deduction in a greenfield context.

Excluding brownfield development from the new rules risks distorting investment away from a focus on continuous improvement of the efficiency and resilience of existing infrastructure.

Conceptually, option two overcomes these issues and allows the market to determine the projects which are best to be undertaken and funded.

Overall, the proposals are extremely positive. The question really comes down to whether we want this rule to focus solely on new infrastructure or whether we prefer a rule which is more principle based and so allows investment to find its natural home.