Draft re-issue of rulings for interest deductibility

The Commissioner of Inland Revenue has re-issued drafts of public rulings BR Pub 10/14 – 10/19 concerning interest deductibility applying the Roberts and Smith principle.  The rulings specifically concern interest deductibility for partnerships and some companies under section DB 6 of the Income Tax Act 2007 (the Act).  The rulings won’t be relevant for companies that are allowed an interest deduction under section DB 7 of the Act where a nexus to income derived is not required.  The rulings will be relevant for those companies that cannot rely on section DB 7 of the Act.

Overall, the re-issue makes significant editorial changes to the rulings and commentary but is not intended to change the scope of the arrangements, reasoning or conclusions in BR Pub 10/14 – 10/19.

The Roberts and Smith principle (the principle) stems from a decision of the Australian Full Federal Court in FC of T v Roberts; FC of T v Smith 92 ATC 4,380 which concerned the deductibility of interest incurred by a partnership that had borrowed to repay partners part of their capital contributions.  Whilst the case is Australian, it is relevant in New Zealand because the legislative income tax provisions concerning interest deductibility in both countries are similar.  The Court held that the interest was deductible, irrespective of how the partner used the funds that were repaid to them.  This is because the new funding takes on the character of the existing funding that is replaced, and the existing funding was used in the partnerships’ business for the purposes of deriving income.

The principle provides that a sufficient nexus will exist where:

• a partnership or taxpayer incurs interest on borrowed funds;
• the borrowed funds are used to replace existing funding and to repay that funding to the person who invested or lent the funds; and
• the existing funding had been used by the partnership or taxpayer to derive income or in carrying on a business for the purpose of deriving income.

The nexus is established through the new funding replacing existing funding. The existing funding must have had a sufficient connection with income, or interest must have otherwise been deductible under other provisions (such as sections DB 7 or DB 8 of the Act).

The re-issued rulings cover six scenarios.  Interest will be deductible in five of the scenarios where the funds are borrowed:

• by a partnership to return capital contributions to a partner;
• by a partnership to return past years’ profits to a partner;
• by a company to repurchase shares;
• by a company to pay dividends; and
•  to repay debt.

It should be noted that these rulings expressly deny deductions for funds borrowed to pay current year income, unrealised asset revaluations or internally generated goodwill.

The oddball is the last of the six rulings which states the principle does not apply to allow a deduction for interest incurred in borrowings used by a company to make a subvention payment.  The Commissioner considers that in this scenario, there is no replacement of an amount previously advanced by the recipient company or an amount repaid to shareholders for amounts invested in the paying company and so the principle does not apply.  However section DB 7 will, in most cases, provide a deduction in any event.  This particular ruling therefore clarifies that the principle does not apply in this scenario when interest is not deductible under section DB 7.

The rulings are intended to have the same scope as the previous versions; however the commentary to the draft rulings now makes it clear that these rulings do not apply to a look-through company.  This is mostly due to the fact that other rulings have been published on interest deductibility scenarios for look-through companies, as well as the fact that both the look-through and closely-held company regimes are presently under review.

Submissions can be made to public.consultation@ird.govt.nz. The deadline for comment is 20 March 2015.

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Draft re-issue of rulings for interest deductibility