Consultation sought on related party debt remission

Consultation sought on related party debt remission

In 2014, Inland Revenue issued a draft QWBA (Question We’ve Been Asked[1]) on whether certain scenarios constitute tax avoidance.  One scenario concerned a debt capitalisation arrangement which is explained as follows:

Company D is insolvent.  It has assets of $200 (cash) and liabilities of $700 (being a loan from the shareholder).  The shareholder subscribes for $500 worth of shares in Company D as partial repayment of the shareholder loan, with the remaining amount repaid in cash.

The Commissioner of Inland Revenue considered this to be an arrangement that potentially avoided tax that would otherwise be payable on income arising when debt is remitted under the financial arrangement rules.  This draft conclusion drew much criticism and created much uncertainty as related party debt capitalisation has been a common planning technique used for several reasons – for example, to eliminate loans owed by insolvent subsidiaries, to reorganise a group prior to a sale of a subsidiary, or to reduce a subsidiary’s debt due to thin capitalisation concerns.  A key problem that drives the use of debt capitalisation is that the financial arrangement rules create an asymmetrical outcome for debt remission in the context of wholly-owned group companies - i.e. that debt remission income arises to the borrower for the amount remitted, while the related-party lender is denied a deduction for the bad debt.

Officials acknowledged this issue, and as a result, the policy area of Inland Revenue has undertaken a review as to what the correct policy outcome should be in certain situations.  The Policy and Strategy Group of Inland Revenue has now released an issues paper for consultation on the proposed changes to the law.  The conclusion in the paper is a very positive result in that the Government has agreed that under certain scenarios, debt remission income should not arise.  The core proposal is:

that there should be no debt remission income for the debtor when the debtor and the creditor are in the New Zealand tax base, including controlled foreign company debtors; and

• they are members of the same wholly owned group of companies; or
• the debtor is a company or partnership; and
  
  • all of the relevant debt remitted is owed to shareholders or partners in the debtor; and
  • if we presume that if the debt remitted was instead capitalised, there would be no dilution of ownership of the debtor following the remission and all owners’ proportionate ownership in the debtor is unchanged.

It is further proposed that this core proposal be backdated to apply from the commencement of the 2006–07 tax year, although this is to be confirmed following consultation.  The paper also notes that, subject to this proposal being finalised, Inland Revenue will not be devoting resources to determine whether debt remission arises in situations covered by the core proposal.  It is pleasing to see Officials front-foot the issue of what to do in respect of past positions taken by proposing to backdate the changes - no doubt learning lessons from the way the recent changes to the allowances rules were implemented.

There is still an outstanding and key issue of what the policy answer should be where the owner/creditor is non-resident because the use of related-party inbound debt is a key BEPS (Base Erosion and Profit Shifting) concern.   On the one hand having debt remission income arise in this situation will dissuade non-residents from over-gearing, but on the other hand it may also dissuade non-residents from reducing gearing levels because of the consequences.    Officials will continue to work on this aspect and are seeking comments.

A chapter of the issues paper covers technical issues associated with the proposed reforms.  In particular, there is a concern about the ability of taxpayers to achieve a timing advantage where accrued interest income is written off by the lender but the borrower has not been released from the loan and therefore may continue to accrue interest and claim a deduction under the financial arrangement rules.  The solution proposed by Officials is to disallow a bad debt deduction for the associated person’s interest receivable, but submissions on this are welcome.

Submissions close on 14 April 2015.  For further information on this, please contact your usual tax advisor.

[1] Now finalised as QB 15/01

March 2015 Tax Alert contents

New Tax Bill introduced

GST and Bodies Corporate

"Cash out" of R&D tax losses

Amending return errors: Taxpayer friendly High Court ruling

Consultation sought on related party debt remission

Tax treatment of life insurance policies

Draft re-issue of rulings for interest deductibility