Issue 3/2015 Related parties debt remission Related parties debt remission Inland Revenue has released an Officials Issues Paper seeking feedback on proposed legislative changes intended to make the debt remission rules more certain for taxpayers. The Issues Paper acknowledges that this uncertainty has been created by the release of a draft Inland Revenue Questions We ve Been Asked (QWBA) in May 2014. The QWBA suggested that capitalisation of a debt (as opposed to remitting the debt) would potentially be avoidance and the amount would be treated as taxable remission income to the debtor. The finalised QWBA is included as an appendix to the Issues Paper. There are no material changes to the conclusion. The Issues Paper seeks submissions on proposed changes to legislation to eliminate taxable income from arising in certain circumstances from debt remission between related parties. Background Under current tax law, debt can be remitted when the debtor: is discharged from making remaining payments; is insolvent or liquidated; enters into a deed of composition with its creditors that results in full remission; or has no obligation to make payments when, because of the passage of time, the debt is irrecoverable or unenforceable. These scenarios trigger a base price adjustment (BPA), which results in taxable income for the debtor. Inland Revenue s published analysis of the tax avoidance provisions concludes that debt can also be treated as remitted when there is a debt capitalisation. The result is that taxable income will arise for the debtor but no corresponding deduction will be available to the lender. Page 1 PwC Tax Tips March 2015
Summary of the Officials Issues Paper The Issues Paper discusses proposed changes to the tax consequences of the following related parties debt remission: Stewart McCulloch Executive Director debt recapitalisation inside a wholly owned group, debt remittance (or capitalisation) where the shareholders are New Zealand resident (New Zealand company held by an individual shareholder or trust; New Zealand JV company; New Zealand partnership), remittance (or capitalisation) of debt held by a controlled foreign company (CFC) of a New Zealand resident, and remittance (or capitalisation) of debt by a New Zealand company with a nonresident corporate shareholder. This scenario is considered to be an outstanding policy issue needing further consideration. We outline these scenarios in more detail below. The Issues Paper proposes legislative change to ensure that there should be no debt remission income for a debtor when the debtor and creditor are both within the New Zealand tax base (including CFC debtors) and either the debtor and creditor are members of the same wholly owned group, or the debtor is a company or partnership and certain other features are met. The changes are proposed to have retrospective application from the commencement of the 2006-07 tax year. Elizabeth Elvy Senior Associate Debt recapitalisation inside a wholly owned group The Issues Paper considers that, within a wholly owned group of companies, consolidated financial reporting reflects the economic result of the group as a whole. That is, the group is viewed as a single unit. As a result, where the debt that is recapitalised/remitted is within the wholly owned group, the overall wealth of the group does not change as a result of the debt remission. The Issues Paper illustrates that there are already a number of concessions in place for intragroup transactions within a wholly owned group. Generally, these concessions reflect the economic reality that the group is a single economic unit. Inland Revenue concludes that debt remission or capitalisation within a wholly owned group situation where the companies involved are New Zealand resident should not result in taxable income as there is no change in the wealth of a wholly owned group. Page 2 PwC Tax Tips March 2015
Officials considered a number of policy arguments in relation to this scenario, which included: Consideration that intragroup debt is often advanced to enable an otherwise insolvent subsidiary to pay off its third-party creditors. It therefore seems inappropriate for a group to be penalised for any rationalisation of the intragroup debt by remission/capitalisation. When an insolvent subsidiary is liquidated there is no extra tax payable. Therefore, it seems inappropriate that there would be a bias towards liquidation over debt remission/capitalisation. The conclusion reached should make the tax outcomes symmetrical for the debtor and the creditor in a New Zealand wholly owned group situation. Debt remittance/capitalisation where the shareholders are NZ resident The Issues Paper considers three additional scenarios where the shareholders are New Zealand resident: New Zealand resident individual shareholder or trust, New Zealand joint venture, and New Zealand partnership. Non-corporate single New Zealand shareholder Similar to the wholly owned group scenario, where the shareholder is an individual or a trust, the shareholder s economic wealth does not change when they remit/capitalise a debt owed to them by a wholly owned company. Again, it is considered that the remission (either directly or via capitalisation) of the debt should not result in income as the overall wealth remains the same. Officials conclude that the tax outcome should be symmetrical for the individual shareholder/trust and the company. That is, no debt remission income should arise. The Issues Paper notes that, where there is debt forgiveness by the company of a loan to a non-corporate shareholder (i.e. the loan is in the opposite direction), it should continue to be taxed as it is economically a dividend. Page 3 PwC Tax Tips March 2015
New Zealand corporate joint venture (JV) The Issues Paper considers a scenario where the company is a corporate JV held by New Zealand resident shareholders and shareholder debt is pro rata to ownership and any subsequent debt remission/capitalisation is also pro rata. As in the previous scenarios, the Issues Paper considers that, from an economic perspective, the owners overall wealth remains the same on remission of debt as the debt has either been remitted or been swapped for equity. Again, it is noted that where there is debt remission by the company of a debt owed by shareholders, it should be taxed as it is technically a dividend. Page 4 PwC Tax Tips March 2015
New Zealand partnership In a partnership scenario, it is presumed that an advance by a partner to the partnership can be a financial arrangement as the partner can be acting in their capacity as an owner or as a lender. If the debt is a financial arrangement, debt remission issues are relevant. Under current tax law, where debt from partners to a partnership is remitted, the partnership (and therefore the partners) will derive debt remission income from the BPA. However, the partners do not get a corresponding bad debt deduction. Officials propose amending this to make the tax outcome symmetrical where no debt remission income will arise for the partnership provided the debt is remitted pro rata to the ownership of the partnership. This outcome should apply equally to lookthrough companies. Page 5 PwC Tax Tips March 2015
Debt remittance/capitalisation of debt held by a controlled foreign company (CFC) Remission of debt owed by a CFC may result in an active CFC becoming passive for tax purposes. If the CFC is passive (or becomes passive as a result of the debt remission) taxable income will arise. The Issues Paper considers that the same principles apply to CFCs also. Therefore, when owners debt is remitted/capitalised pro rata to the owners interests, no remission income should arise for tax purposes. It is not expected that this will present any unexpected or inappropriate taxation results. Page 6 PwC Tax Tips March 2015
Debt remittance/capitalisation of debt by a New Zealand company with a non-resident corporate shareholder The Issues Paper considers the analysis of inbound cross-border loans to be complex as the creditor is not within the New Zealand tax base. Currently, policy analysis is underway on this situation, but the use of related party inbound debt is seen as a key base erosion and profit-shifting (BEPS) concern. Hence, submissions are being sought on this scenario and further analysis is required. We summarise the key arguments considered for and against this scenario resulting in debt remission income below: Arguments that the scenario should give rise to debt remission income If debt remission/capitalisation is allowed to be non-taxable, subsidiaries of foreign companies could be encouraged to manipulate the 60% debt/asset thin capitalisation threshold by capitalising debt when they are close to the threshold. This effectively provides some debt protection. The taxation of debt capitalisations may discourage companies from excessive gearing. The situation Inland Revenue is concerned with is where a foreignowned New Zealand subsidiary has been geared to the point they cannot to pay the interest on the debt. The result is that the interest is added to the company s debt and then effectively capitalised to equity. Arguments that the scenario should not give rise to debt remission income: The owners economic wealth has not changed as the owner has remitted debt owed to them by their wholly owned New Zealand subsidiary. Page 7 PwC Tax Tips March 2015
The New Zealand tax base is not negatively impacted by the conversion of debt to equity because the obligation to pay off deductible interest ranks higher than the obligation to pay dividends (and dividends are paid out after tax). The thin capitalisation rules and transfer pricing rules should stand alone. As a result, it may not be principled to use the related parties debt remission rules to reinforce these rules. Specific technical issues addressed by the Issues Paper The Issues Paper identifies four technical issues that Inland Revenue has considered in relation to the proposed changes: Accrued interest The outcomes from the scenarios covered in the Issues Paper should be symmetrical in a domestic context. One area where asymmetry may arise is if the creditor has taken a bad debt deduction for an interest accrual. It is also considered that crossborder transactions further complicate the analysis. For example, where a parent has a loan in place to an insolvent subsidiary, the parent takes an annual bad debt deduction for the interest income and the subsidiary accrues its interest expense. In this situation, the group is seen to have two available deductions (the bad debt write-off and the interest deduction), against which there is a single income stream (the interest income of the parent). Under current law, any advantage is eventually cancelled by the BPA. However, this still results in a timing advantage, which Inland Revenue does not consider appropriate. A possible policy solution considered is to disallow a bad debt deduction for interest receivable from associated persons. The outcome is then symmetrical as the debtor will likely be taking a deduction for the interest accrual. Debt parking Debt parking is where debt is acquired (typically from an external lender) by a person associated with the creditor for less than 80% of the market value of the debt. The difference between the acquisition cost and the debtor s carrying value is income to the debtor and the debt is reset to the acquisition cost in the debtors books. The Issues Paper considers that, in order to ensure the proposed amendments deal with debt parking issues, the consolidated group debt parking rule will need to be extended to cover debt affected by the proposals included in the Issues Paper. Certain dividends The Issues Paper notes that upstream debt remission remains a transfer of wealth and should continue to be regarded as a dividend. Amalgamations Currently, consideration is given to solvency when amalgamations occur between a debtor and a creditor. When the debtor is insolvent, a BPA is performed resulting in debt remission income to the debtor. When the companies involved are members of a wholly owned group, the proposal in the Issues Paper makes the amalgamation rule redundant. Therefore, a consequential amendment will be required. Page 8 PwC Tax Tips March 2015
Inland Revenue s avoidance analysis The Issues Paper includes a reprint of QB15/01 Income tax: tax avoidance and debt capitalisation in an appendix. It applies Inland Revenue s avoidance analysis to the following situation: Although the company in the example is a qualifying company, Inland Revenue notes that nothing turns on this in terms of the avoidance analysis. Key comments from Inland Revenue s avoidance analysis are included below: Parliament s purpose The avoidance analysis considers Parliament s purpose in respect of the financial arrangement rules. Inland Revenue s view is that parliament s purpose is to require income and expenditure under financial arrangements to be recognised by the parties on an accrued basis over the term of the arrangement. The intention was to give effect to the reality of income and expenditure, which should be real economic benefits and costs. In analysing Parliament's purpose, the QWBA considers whether parties to a financial arrangement should be viewed as a combined economic unit. The conclusion is that, aside from the consolidation and amalgamation rules, there is no indication that Parliament contemplated that the parties to an arrangement should be considered from the perspective of a single economic unit when it comes to a BPA. This finding is misaligned with the conclusions reached in the Issues Paper on scenarios involving wholly owned New Zealand shareholding structures and debt capitalisation/remission. Page 9 PwC Tax Tips March 2015
Commercial and economic reality The QWBA s analysis of the commercial and economic reality of debt capitalisation concludes that there is no actual or economic cost to the company when issuing shares to existing shareholders. As there is no change to the shareholders proportionate interest when receiving more shares in a 100% owned company, the shareholder has not received an economic benefit. When viewed in commercial and economic terms, the company has discharged its obligations under the loan without suffering any economic loss and the parties have not given or received full repayment of the loan. A key point in the analysis is that the conclusion is not dependent on the fact that the company is insolvent and would apply equally to a solvent company. This is a significant finding which has wide-ranging implications to commercial undertakings and group funding decisions. Parliamentary contemplation test Inland Revenue considers that the arrangement to remit/capitalise debt does not appear to include the features that Parliament would expect to see present to give effect to the financial arrangement rules and a BPA. This means the arrangement is outside Parliamentary contemplation as it circumvents debt remission income arising under the BPA. Merely incidental test The QWBA finds that tax avoidance purpose or effect appears to be either the sole or main purpose for the arrangement considered. As such, the tax avoidance purpose/effect is unlikely to be merely incidental to another purpose/effect. The analysis notes that it may be possible for tax avoidance purpose/effect of a financial arrangement to be merely incidental to a non-tax avoidance purpose for example where a regulatory body imposes a certain approach to restore the solvency of a subsidiary. Aside from this, little practical guidance is given as to the types of commercial circumstances which could be considered incidental. Our comments The Issues Paper and appendix sets out Inland Revenue s views in respect of debt capitalisation/remission. Many do not agree with the avoidance interpretation. Inland Revenue s avoidance analysis creates considerable uncertainty for restructuring funding between related parties. While the analysis contained in the Issues Paper is a step in the right direction, legislative change is still required to ensure debt capitalisation/remittance does not give rise to debt remission income, which would otherwise hamper the ability to restructure debt in a commercial manner. We are pleased that the Issues Paper does provide additional clarity and an additional toolkit for businesses to enable the reorganisation of related party debt in some circumstances without generating debt remission income. Submissions on the proposal are due by 14 April 2015. Please contact your usual PwC adviser if you would like to comment. Page 10 PwC Tax Tips March 2015
Contributors: Stewart McCulloch Executive Director T: +64 9 355 8751 E: stewart.j.mcculloch@nz.pwc.com Elizabeth Elvy Senior Associate T: +64 9 355 8683 E: elizabeth.a.elvy@nz.pwc.com Connect with us Join our group on LinkedIn Search for TaxNetWork under Group Follow us on Twitter @PwC_NZ Visit us online at pwc.co.nz Tax Technical Knowledge Centre tax@nz.pwc.com 2015 PricewaterhouseCoopers New Zealand. All rights reserved. PwC refers to the New Zealand member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. Disclaimer: Tax Tips is intended as comment only and should not be relied upon or used as a substitute for professional advice. No liability is accepted for loss or damage incurred by persons who rely on this commentary. Professional advice should be sought in relation to any particular situation or circumstance.