On 3 May the Taxation (Annual Rates for 2016-17, Closely Held Companies, and Remedial Matters) Bill was introduced to Parliament. Included in the so-called “Remedial Matters” are significant changes to the tax treatment of a range of financing transactions. In many cases these changes will introduce additional complexity and compliance costs, and increase the cost of borrowing in the international capital markets.
Some other proposals are remedial in nature. A retrospective amendment is proposed that would deem intra-group debt remission not to result in income to the borrower. And an amendment is proposed to confirm that GST on capital-raising costs may be creditable, confirming the view held by many advisors, and reversing an interpretation advanced by Inland Revenue.
The Bill contains a range of other changes to income tax, GST and tax administration. In this update, however, we focus on the withholding tax, debt remission and GST proposals, being the proposals of greatest significance for financing arrangements.
Interest withholding tax changes - overview
The interest withholding tax changes will:
- extend the scope of non-resident withholding tax (“NRWT”) on interest in the case of related party financing arrangements (excluding arrangements to which a member of a banking group is party) so it may apply when a deduction for interest expenditure is allowed, even if no interest has been paid;
- further restrict the availability of the option for borrowers to pay the 2% approved issuer levy (“AIL”) in lieu of NRWT;
- extend the scope of NRWT to apply to certain interest paid to a non-resident lender that has a New Zealand branch but is not lending through that branch;
- extend the scope of NRWT and AIL to apply to the interest expense on notional inter-branch loans, and on interest paid by a foreign branch on borrowings that are on-lent by the branch to a New Zealand resident.
Imposing NRWT at the time interest expenditure is allowed (even if no interest has been paid) in certain cases
Under current law, the liability for NRWT on interest is triggered by the payment of that interest. By contrast, interest deductions to the borrower are usually calculated on an accrual basis, in accordance with the financial arrangements rules. To address a concern that related party lending can be structured to defer the NRWT liability it is proposed that where the timing mismatch between interest payments and interest deductions on a related party funding arrangement exceeds a prescribed materiality threshold, NRWT will instead be payable by reference to the interest deductions claimed by the borrower, shortly after the end of the income year in which the deductions are claimed.
Where this proposed new rule applies, the borrower will be required to fund the NRWT liability in circumstances where it may not be making any interest payments. Further, it would be necessary to consider the foreign tax credit rules in the lender’s jurisdiction to determine whether a credit would be available for NRWT paid in circumstances where no interest has yet been received.
These proposals would apply to all arrangements entered into after enactment and to existing arrangements from the first income year commencing after enactment. Further, these proposals would apply the proposed new expanded definition of Tax Bill proposals to have significant impact on financing transactions associated persons (outlined below).
Restricting the availability of the option for non-bank borrowers to pay the 2% AIL in lieu of NRWT
The AIL regime allows the rate of NRWT to be reduced to 0% where a 2% levy is paid by the borrower in respect of interest paid to a foreign lender, provided that the borrower and lender are not associated. Under current law any borrower can register as an approved issuer and any lending transaction can be registered for AIL. However, even if the borrower and transaction are registered for AIL, the payment of AIL will only reduce the rate of NRWT to 0% where the parties are not associated. The Bill proposes restricting availability of the AIL option in two ways: first, through new criteria for registering for AIL, and second, by expanding the definition of “associated” for AIL purposes.
Inland Revenue has been concerned that some borrowers are paying AIL in lieu of NRWT in relation to interest on related party loans, in breach of the law, and considers that it is difficult to identify and enforce the law against such borrowers. To address this concern the Bill proposes to introduce restrictions on the ability to register for AIL. Under the proposals, a transaction would be able to be registered for AIL only where:
- the borrower is a widely held company, a wholly-owned subsidiary of a widely held company or certain public sector entities; or
- at least 75% of the lending under the transaction is provided by a widely held company (or a wholly-owned subsidiary thereof) and/or a foreign PIE equivalent; or
- the transaction involves money lent by a financial institution that is in the business of lending money to the public and has outstanding lending to 100 or more persons; or
- the transaction is arranged by a regulated peer-to-peer lender; or
- the borrower’s wholly-owned group pays or expects to pay more than $500,000 of interest to non-residents in a year; or
- the lender and the transaction meet the requirements of a determination issued by Inland Revenue.
Although conventional bank lending and lending to large corporates will generally remain eligible to be registered for AIL under the above criteria, many loans from non-traditional lenders and private funding arrangements will cease to be eligible for AIL, even where such loans are between unrelated persons. For example, a borrower owned by a consortium of investors wishing to borrow from non-bank lenders (eg in the US private placement market) would not necessarily qualify to pay AIL, despite the borrowing obviously being between unrelated persons.
It is proposed that the new AIL registration rules would apply to transactions registered on or after 1 April 2017. For securities registered before that date the new rules will apply from 1 April 2018. Transactions that are registered at that date that would not satisfy the new criteria will have their registration cancelled.
As noted above, the AIL regime only applies to reduce the rate of NRWT to 0% where the borrower and lender are not associated. In the corporate context, association generally requires 50% common ownership. The Bill proposes expanding the associated person concept for the purposes of the AIL regime by including situations where a group of non-residents that together own 50% or more of the New Zealand borrower also lend to that borrower and:
- the lending is in proportion to their ownership interest; or
- the lending is in accordance with an arrangement between the members of the group regarding the funding.
The purpose of this proposal is to prevent interest paid on loans from owners from qualifying for the AIL regime where the particular owners may not individually meet the association threshold, but it is considered that they act together in a way that is similar to the way in which a single owner with more than 50% ownership would act. Private equity syndicates and groups of foreign funds are given as common examples.
This proposal would apply immediately for transactions entered into after enactment and from the first income year after enactment for existing transactions.
Extending the scope of NRWT to apply to certain interest paid to a non-resident lender that has a New Zealand branch but is not lending through that branch
Currently, where interest is paid to a non-resident lender that has a New Zealand branch, that interest is not subject to NRWT or AIL regardless of whether the lending is connected with the lender’s New Zealand branch. The lender in those circumstances is required to include the interest in its New Zealand income tax return and pay tax on an assessment basis on the interest net of deductible expenses.
The Bill proposes to amend the rules so that NRWT or AIL will apply to interest paid to such lenders if the lender is not a registered bank (or is a registered bank but is associated with the borrower) and the lending does not relate to the business of their New Zealand branch. (Where the lending does relate to the business of the lender’s New Zealand branch or the lender is registered as a bank in New Zealand then no NRWT or AIL will be payable and the status quo will apply.)
This proposal will require changes to be made to the terms of various lending documents, in particular the terms of debt instruments issued to non-bank lenders (for example, wholesale and retail note issuances), as well as to the tax summaries of the offer documents for such instruments. In addition, borrowers will be required to obtain additional information about the lenders in order to be able to apply the correct withholding tax treatment. As well as knowing whether or not the lender has a New Zealand branch the borrower will need to know whether the lender has made the loan or holds the debt instrument through that New Zealand branch and whether the lender is a registered bank. For widely held debt, such information will likely need to be obtained from initial holders through the application process and by the registrar or other agent or intermediary in the case of holders acquiring instruments in the secondary market. For private placements and syndicated debt such information will also need to be obtained, for example through representations being made in the lending documents.
This proposal will apply immediately to arrangements entered into after enactment and arrangements between related parties. For existing arrangements where the parties are not related, the proposed new rules will apply to income years of the borrower commencing more than five years after enactment.
Changes affecting bank funding arrangements
Certain of the changes proposed in the Bill will affect the NRWT and AIL consequences of interest paid by a bank or member of a New Zealand banking group. For example:
- Interest paid on funds raised by foreign branches of New Zealand companies (for example, in the European capital markets) and on-lent to the New Zealand group (or any other New Zealand borrower) will be deemed to have a New Zealand source and therefore be subject to NRWT or AIL.
- AIL will be permitted to be paid (in lieu of NRWT) on interest paid by a member of a New Zealand banking group regardless of whether the lender is an associated person. This is an exception to the general rule that AIL does not apply to interest paid between related parties.
- AIL or NRWT will apply to the notional loans by a foreign bank to its New Zealand branch (ie within the same legal entity). The AIL or NRWT will in this case be calculated by reference to the deduction claimed by the New Zealand branch for the notional interest.
On the face of it, the extension of the source definition to catch certain interest paid by a foreign branch, and the imposition of NRWT or AIL on notional interest income of the head office of a foreign bank with a New Zealand branch, raise questions as to consistency with certain Double Tax Agreements to which New Zealand is party. It will be interesting to see how Inland Revenue’s position on this matter evolves as the new rules take effect.
Related party debt remission
This proposal is one that can legitimately be called a remedial matter. Under current law, where a loan between related parties is remitted (ie forgiven), this can result in taxable income to the borrower but no offsetting deduction to the lender (as bad debt deductions for principal are not permitted for related party lending). An alternative and relatively straight-forward solution, which did not trigger income for the borrower, was for the lender to subscribe for shares in the borrower, with the subscription amount then applied to repay the loan. However, Inland Revenue recently published a statement expressing the view that such an arrangement could be considered to be tax avoidance.
The Bill proposes to remove the asymmetry outlined above by deeming an amount remitted on a related party loan to have been paid by the borrower. This means that no income will arise for the borrower under the financial arrangements rules, and the debt can therefore be remitted with no adverse tax consequences.
Where the amount remitted includes interest, a change to the provision governing bad debt deductions will deny a bad debt deduction to the lender for the unpaid interest even where the interest has been returned as income. Under current law a bad debt deduction could be claimed for the interest, even on related party debt. Although this will result in overall symmetry where the borrower has been entitled to an interest deduction, an issue can arise where the borrower is a foreign subsidiary and the applicable foreign law does not allow, or claws back, any interest deductions in such situations. In that case the bad debt deduction for the accrued but unpaid interest component currently available to the New Zealand lender (which is necessary to offset the interest income that has previously been returned) will no longer be allowed. To that extent, the asymmetrical outcome the rules seek to overcome will remain, as the lender will have recognised income for an amount it will not receive, while the borrower will have no corresponding allowable deduction.
The proposed rule that deems remitted amounts to have been paid by the borrower will have retrospective application to the 2006-07 income year. This will have the effect that where related party loans have been capitalised as an alternative to being forgiven, Inland Revenue’s interpretation that this may amount to tax avoidance should fall away. That interpretation proceeded on the basis that subscribing for shares to facilitate repayment of the debt was a means of avoiding the income that the borrower would derive if the debt were instead forgiven. If (following the retrospective amendment) no income would arise on forgiveness, then the capitalisation cannot be said to avoid that result. The amendment to the bad debt deduction provision will apply from the 2017-18 income year.
GST input credits on capital-raising costs
The Bill also proposes an amendment to the GST Act that would allow a taxpayer that carries on a taxable activity for GST purposes to claim input credits for costs incurred in connection with the issue of debt or equity securities, provided the funds raised are used in the taxable activity. Inland Revenue’s view of the current law, which is not necessarily shared by taxpayers and their advisors and is contrary to the policy of the GST Act, is that whether input credits are available depends on who the securities are issued to, meaning that in many cases (for example, expenses associated with domestic retail issuances) input credits will not (in Inland Revenue’s view) be available.
It is proposed that this amendment will apply from 1 April 2017.
This publication is intended only to provide a summary of the subject covered. It does not purport to be comprehensive or to provide legal advice. No person should act in reliance on any statement contained in this publication without first obtaining specific professional advice.