KPMG 10 Customhouse Quay P.O. Box 996 Wellington New Zealand

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1 KPMG 10 Customhouse Quay P.O. Box 996 Wellington New Zealand Telephone +64 (4) Fax +64 (4) Internet Team Manager Technical Services Office of the Chief Tax Counsel Inland Revenue P O Box 2198 Wellington Our ref KPMGSubDB5(final) Dear Sir / Madam Deductibility of expenditure incurred in borrowing money Sections DB 5 and DA 1. KPMG welcomes the opportunity to make a submission on the above draft interpretation statement ( IS ). As a general comment we strongly support Inland Revenue providing further clarity on this area of tax law. However, we are concerned with aspects of Inland Revenue s analysis, In particular, we consider the proposed interpretation of expenditure incurred in borrowing money is too narrow and will result in an unreasonable reduction in the type of costs that should be deductible under section DB 5 of the Income Tax Act 2007 ( the Act ). We also do not agree with the analysis in the IS around the deductibility of premiums on life insurance policies used as security for borrowing purposes. We comment on these and other issues below. 1 Summary of the draft IS We briefly summarise below the major conclusions of the IS: To be deductible under section DB 5, expenditure must be incurred in establishing or setting up a loan. Expenditure that is deductible under section DB 5 includes legal fees in connection with establishing the loan, valuation fees, guarantee fees, lenders mortgage insurance, loan procurement fees, survey fees, mortgage brokers commissions, costs of arranging bank overdrafts and expenses arising from debenture issues (i.e. drafting, advertising and printing prospectuses). Expenditure considered not deductible under section DB 5 includes the repayment of the principal/interest and costs incurred over the term of the loan in relation to refinancing, 2012 KPMG, a New Zealand partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity.

2 extending, changing terms or rolling over the loan (unless it creates a new loan), discharging a mortgage and payments made to induce a lender to accept early repayment. Expenditure must relate solely to a loan, and must not be consideration for valuable benefits, other than the loan, to be deductible under section DB 5. The premium paid on a life insurance policy given as security for a loan is considered not to be deductible because it is considered to be capital expenditure incurred to acquire an asset (the policy) rather than expenditure incurred in borrowing money. For borrowing costs that are taken into account in calculating income and expenditure under the financial arrangements rules, the amount and timing of expenditure are determined under those rules, not section DB 5. 2 Interpretation of expenditure incurred in borrowing money is too narrow Section DB 5 applies to expenditure incurred in borrowing money. Our main concern is that the Commissioner has interpreted in borrowing money too narrowly by stating that only expenditure incurred in establishing or setting up a loan should be deductible under section DB 5. This is an artificial and unwarranted distinction between expenditure incurred at the commencement of a loan (i.e. in obtaining or establishing the loan) and expenditure incurred during the course of or the termination of a loan. We believe that the latter types of expenditure have an equivalent nexus with borrowing money, to expenditure incurred at commencement, and should therefore be deductible under section DB Ordinary meaning of in borrowing money The Commissioner considers that the plain meaning of the words in borrowing money focuses on the process of borrowing money. We consider the ordinary meaning of the term borrowing and process involves a series of actions or functions, having a beginning, middle and end to bring about a result. To illustrate, running a race, riding a bike and climbing a mountain are ordinary English phrases which focus on the entire process of a particular activity. Accordingly, the IS conclusion, based on the ordinary meaning of the phrase borrowing money, is too narrow. The Commissioner relies on the decision in Ure to support his view that the term in borrowing money applies only to the establishment of the loan. We consider the intention of Deane and Sheppard JJ in Ure was to illustrate the distinction between the cost of borrowing and the cost of money itself (for example, interest incurred). The expenditure in Ure was clearly cost of money and, therefore, non-deductible under the section DB 5 equivalent. However, Ure does not imply that costs of borrowing (the costs predominantly described below in section 2.2) cannot be incurred throughout the life of a loan. Therefore, we submit there is no legislative or interpretive authority that indicates that costs incurred throughout the life of a loan, such as those in relation to refinancing, extending, KPMGSubDB5(final).docx 2

3 changing terms and discharging a mortgage cannot be borrowing costs, and therefore deductible under section DB Variation and discharge The IS indicates that costs incurred in refinancing or rolling over a loan may be incurred in establishing a new loan (para 52). We agree that the process of rolling over a loan will likely result in the establishment of a new loan. Therefore, these costs are quite clearly incurred in borrowing money (being the new loan) and will be deductible under section DB 5. However, we consider costs (excluding costs of money ) incurred in relation to refinancing of a loan, extending the term of a loan, altering the interest rate and discharging or novating a loan should also be deductible under section DB 5. It is a nonsense to differentiate those costs from the costs incurred when a loan is initially established or rolled-over; all such costs are incurred because borrowing is undertaken and are not costs of money (as payments of interest and capital are). Accordingly, we consider there is no justifiable distinction between the costs Inland Revenue consider are deductible under section DB 5 (see 1 above) and those costs of borrowing incurred in extending the term of a loan, adjusting the interest rate, novating or discharging a loan. We note that all of the cases supporting the Commissioner s position in this regard (Case 31, Riviera Hotel and Neonex) are sourced from foreign jurisdictions. Further Case G50, the one New Zealand case on point, is described at paragraph 65 as being inconsistent with this case law. We do not accept that the Commissioner can simply dismiss Case G50 as being inconsistent because it fails to support his conclusion. In that case, Judge Barber clearly states that the costs incurred in the discharge of a mortgage were not cost of money expenses, but costs falling within the ambit of both (the equivalents of ) sections DA 1 and DB 5. It is interesting to note that in Case G50 the Commissioner agreed with this position at the time. Following the paragraph 65 statement in which the Commissioner considers Case G50 to be inconsistent with the foreign case law, paragraph 66 gives some explanation of the Commissioner s position in this regard: Expenditure incurred in discharging a mortgage is not a cost of obtaining a loan, and is not expenditure incurred under a contractual obligation entered into in connection with the establishment of a loan. In our view, this does not correctly articulate the test laid out in section DB 5 for expenditure incurred in borrowing money to be tax deductible. The test is not whether expenditure has been incurred in obtaining a loan, nor whether it is in connection with the establishment of a loan. The test in section DB 5 is whether expenditure has been incurred in borrowing money; we see no need or requirement to read these words down in the manner in which the Commissioner has set out in the IS. To conclude our submission on this point, it is our view that the words in borrowing money clearly point to the entire process by which money is borrowed, encompassing the period from before the time the loan is drawn down (i.e. costs incurred in establishing the loan), through the KPMGSubDB5(final).docx 3

4 term of the loan, to the point where the loan is discharged (and potentially afterwards, depending on the facts). Accordingly, we consider costs (excluding costs of money ) incurred in relation to the refinancing of a loan, extending the term of a loan, altering the interest rate and discharging or novating a loan all have sufficient nexus with borrowing money and should be deductible under section DB 5. 3 Deductibility of life insurance premiums The IS asserts (in paragraph 79), that to be deductible under section DB 5, expenditure must relate solely to a loan and must not be consideration for valuable benefits other than the loan. It concludes in paragraph 114 that premiums paid under a life insurance policy that are used as security over a loan are considered to be expenditure incurred to acquire a capital asset (the policy, or the right to be paid under a policy) rather than expenditure incurred in borrowing money. Accordingly, the view expressed in the IS after considering a number of cases decided in overseas jurisdictions is that expenditure incurred on life insurance premiums used as security for a loan are non-deductible. We disagree with this view. In the line of cases dismissed by the Commissioner, which include Côté-Reco, Yonge-Eglinton and Economy Carriers, it was held that expenditure incurred on life insurance policies as a condition of borrowing was deductible under legislation equivalent to section DB 5. In some cases, the wording of the equivalent legislative sections was substantially similar to that of section DB 5. We consider that the New Zealand courts, on application of section DB 5, would likely reach a conclusion consistent with these cases rather than deciding differently. Our rationale for this view is: 1 Life insurance policies do not necessarily give rise to an asset for a beneficiary under the policy, as asserted in the IS. This is particularly true of term life insurance. Under term life policies, the insured pays a premium for a certain level of life cover over a finite period of time (payments may be made as regularly as once a month under these policies). If at the end of this term the event covered by the policy has not occurred, the beneficiary under the policy is entitled to nothing. If the expenditure incurred has utility only during the period to which the policy relates, then this seems to us to clearly represent period or revenue expenditure as no enduring benefit or identifiable asset has been created by reason of the expenditure. 2 Given that expenditure incurred on life insurance premiums does not give rise to an enduring asset, the principles espoused in the Côté-Reco, Yonge-Eglinton and Economy Carriers cases are applicable and strongly suggest that the expenditure should be deductible under section DB 5. Accordingly, during the period in which a contract of life insurance is used as security for a loan used to derive taxable income, premiums in respect of that life insurance contract should be deductible under section DB 5. This is because there is a KPMGSubDB5(final).docx 4

5 sufficient nexus between the expenditure, the borrowing of money, and the generation of taxable income. 3 A distinction can be drawn with the cost of an asset such as land or depreciable property when used to secure a loan. This is on the basis that those assets will have other commercial uses, and that this will continue to be the case even if that asset is also used as security for a loan. In contrast, the life insurance policy s sole purpose will be to provide security for the money borrowed. 4 The IS concludes that the difference between a life insurance policy entered into as security for a loan, and a guarantee or lenders mortgage insurance, is that no asset (being repayment of the loan with no further liability) is created for the guaranteed/insured party under the latter (as the guarantor/insurer can step into the shoes of the lender). Although the guarantor/insurer steps into the shoes of the lender and has a right against the borrower, practically, the borrower will be discharged. By definition the borrower is unable to repay so the borrower has paid for the protection. Therefore, we do not believe that it is correct to distinguish between life policies used as security and these other security instruments on the basis of the benefits of the former to the insured party. 5 As noted above, there is no difference in principle between expenditure incurred on life insurance policies and that on general insurance policies (e.g. lenders mortgage insurance) or guarantee fees (which the IS signs off as being deductible under section DB 5). The IS does not argue for non-deductibility of general insurance premiums or guarantee fees. 4 Relationship with the financial arrangements rules Our final comment concerns the relationship between section DB 5 and the financial arrangement rules contained in part EW of the Act. We believe that the relationship between section DB 5 and the Financial Arrangements rules should be given greater prominence in the IS. Our concern is that without addressing the relationship up front and in fuller terms than is currently the case, taxpayers could lose sight of the fact that although expenditure incurred in borrowing money may not be deductible under section DB 5, fees that are integral or contingent within the meaning of the financial arrangement rules may nevertheless be deductible via a spreading method or the base price adjustment formula KPMGSubDB5(final).docx 5

6 5 Further information Please do not hesitate to contact us, John Cantin on , or Darshana Elwela on , if you would like to discuss our submission in greater detail. Yours sincerely John Cantin Partner Darshana Elwela National Tax Director KPMGSubDB5(final).docx 6