NZ tax changes allow corporates to rationalise their inter-company loans

 Introduction

Corporate groups from SME’s to public corporations, all move funds around their entities as and when the need arises, which can almost be a daily occurrence. Typically, the build up of inter-corporate loans reaches a level that intervention occurs to reconcile and unravel this web of tangled intra-group funding. This intervention to clean up group company balance sheets and eliminate the long build up of group debt typically confronts a number of complex issues – gearing and liquidity stress; balance sheet solvency; what best way to repay or assign; accounting consequences; commercial outcomes; and taxation.

For many years, New Zealand tax law and practice has been an uncertain minefield for group debt rationalisations that has demanded intricate and lengthy planning to fulfil this corporate endeavour without tripping up.

However, the passage of tax law in 2017 has finally brought some common sense and certainty to the outcomes from debt remission and, with this, paved the way for New Zealand corporates to rationalise and unwind their accumulated inter-company loans with impunity.

The amendments are long overdue, and are also a rare example of the Inland Revenue Department (“IRD”) acknowledging that they ‘got it wrong’.

The catalyst for law change was an IRD release in 2014/15 (referred to as QB 15/01[1])  advocating that certain corporate debt capitalisations[2] could potentially be ‘tax avoidance arrangements’, on the basis that the arrangement was in effect a debt remission which would otherwise be subject to tax as financial arrangement (loan) income to the debtor. The sting in this tail was that the same financial arrangement rules denied any deduction to the creditor where the parties are related (as is the case for group loan funding). The result generates an inequitable asymmetrical outcome, equivalent to double taxation.

This position was devastating for corporate groups who as a matter of common commercial practice would rationalise and restructure inter-company debt by way of debt capitalisation.

Significantly, the IRD has stated that this tax law change “means that QB 15/01 no longer applies”.

What are the core tax law amendments?

The policy underlying the tax law change starts from the premise of whether a transaction creates an increase in wealth (or value), and proceeds on the basis that where there is no resulting change in ownership, no increase in wealth / value can economically arise.

Tax law amendments are made to the primary financial arrangement rules and invoke a core rule change so that no taxation consequences should arise from group debt remission. These amendments apply to debtors who are companies; look-through companies; and partnerships. In essence, the debt will be treated as having been repaid in full by the debtor, including any unpaid interest, and, the creditor treated as having received full payment, on the date of the debt forgiveness.

The rules apply to wholly owned group companies, and to other specified ownership and debt structures.

What structures do these new tax-free debt remission rules apply to?

The new tax law applies where there is an effective single economic group.

This includes:

  • Creditors and debtors within the same wholly owned group of companies;
  • A single non-corporate owner, and their wholly owned group;
  • Multiple shareholders and a company, or partners and a partnership, or limited partnership, when the debt is remitted in the same pro rata proportion[3] as the equity held (ownership).

Of note here, are that:

  • The new tax-free debt remission rules apply to inbound and outbound (CFC’s) investment;
  • It can apply between natural persons and companies / partnerships;
  • It can extend to trusts that satisfy the ‘natural love and affection’ rule.

Key features of the law change

  • The method of debt forgiveness is not material;
  • Deemed repayment under the provisions occurs at the time of forgiveness;
  • The law change applies “retrospectively” from the 2006-07 income years (and thereby protects past tax positions taken);
  • The dividend rules are amended to exclude debt remissions from constituting a dividend to the debtor shareholder, however, for non-resident shareholders that benefit from a NZ creditor debt remission, an outbound dividend with potential withholding tax consequences may still apply;
  • The bad debt rules have been amended to prevent a deduction being taken for the interest component of remitted debts between related parties;

Going forward – debt capitalisation, or, debt forgiveness?

From a taxation point of view, these law changes now mean that as a general rule, a group can rationalise its inter-corporate debt arrangements by either way of a debt-for-equity capitalisation, or, debt forgiveness. There is no real immediate difference in the tax outcomes. Therefore, groups can strictly adhere to what method best suits their commercial objectives.

However, several other considerations are worthy of mention here.

First, one matter that may have some bearing is in the creation of what is called ‘available subscribed capital’ in the debtor company. This term refers to what tax law identifies within a company as tax recognised shareholder capital. Interestingly, a remission of debt will for accounting purposes be credited to reserves. The new tax rules provide that in certain circumstances, a debt remission will be included in the debtor company’s available subscribed capital since this is similar to a company debt-for-equity capitalisation which already creates such corporate tax capital.This result can deliver value to companies and shareholders in certain situations.

The significance of this is two-fold, and, fact dependent.

Available subscribed capital enables a company to make tax-free distributions to its shareholders. No imputation credits are required.  In addition, available subscribed capital is permanent, unlike imputation credits which do not survive ownership changes.

Another point here is that shareholders in a debtor company that records available subscribed capital get a step-up in their cost of shares (which will be of material value where shares are held on revenue account and taxable on disposal).

The new rules make changes that recognise an uplift in debtor company available subscribed capital where an eligible debt remission occurs. The problem however is that this is not automatic for all situations, and tax policy has decided that this shall not apply within wholly owned group situations (although where the creditor forgiving the NZ company debtor is not a NZ company, the new rules do recognise available subscribed capital in the debtor company from debt remissions).

Following from this, debtor companies that do not qualify for available subscribed capital treatment of a debt remission may instead opt for a debt capitalisation method to rationalise loans and thereby capture potential downstream value from tax-free returns of capital to shareholders.

Second, is the tax treatment for an offshore creditor shareholder under a debt remission (versus a debt capitalisation). Where a foreign creditor company may obtain home country tax relief for the write off of its loan receivable, debt remission may be favoured given that the new rules will not recognise taxable income in the NZ debtor company.

There is a catch however. This situation could potentially be treated as a Hybrid Mismatch arrangement under the new Tax Bill introduced to neutralise certain mismatch arrangements[4], although this is not entirely clear at this stage. If this is the case, the advantage is countered with income being deemed to arise in the NZ debtor company, although such impact could be of no cash effect if unutilised tax losses existed.

Summary

The new tax rules for debt remission clarify, and demystify the IRD’s treatment of corporate debt rationalisation by debt/equity capitalisations, and/or debt forgiveness. By putting such transactions on a tax-free basis for qualifying economic groups and removing this tax risk and exposure, a significant barrier has been eliminated for group companies looking to rationalise their inter-corporate loan positions.

Lastly, and as a caveat and matter of prudence, taxpayers should check the rules and eligibility criteria, and seek professional advice as appropriate before embarking on wholesale debt rationalisations.

 

AUTHOR:

Andy Archer

Director

ACUMEN Limited

1 February 2018

[1] Questions We’ve Been Asked – QB 15/01, February 2015 (income tax: tax avoidance and debt capitalisation)

[2] Involving the capitalisation of existing debt owed by a company to its shareholders, via the new issue of shares in satisfaction for the release of the debt.

[3] In these instances, the legislation looks to equivalence between the “proportional debt ratio”, and, the “proportional ownership ratio”, as the underlying policy justification is that there be no change in wealth / value of the owners.

[4] The Taxation (Neutralising Base Erosion and Profit Shifting) Bill; December 2017, introduced as part of the international tax package agreed by OECD member countries under the BEPS project.

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