The new related party debt remission rules
Tax Alert - May 2017
By Iain Bradley and Veronica Harley
Forgiving debt between related parties has very much been a regular topic in our Tax Alert over the past three years. It’s great to finally be able to report that the issue has been brought to a conclusion with the enactment of The Taxation (Annual Rates for 2016-17, Closely Held Companies, and Remedial Matters) Act 2017 on 30 March 2017. We know a lot of readers have been awaiting the final version of these rules in order to tidy up intercompany loans once and for all. In fact in some cases action may be required sooner than later because of an amendment that takes effect from 1 July 2017.
The whole debt remission issue was triggered back in 2014, when Inland Revenue released a draft Question We’ve Been Asked which considered a particular debt capitalisation arrangement which involved a shareholder subscribing for shares in a company as partial repayment of a loan. The Commissioner concluded that capitalising the debt was potentially tax avoidance as it avoided tax that would otherwise be payable (because income would have arisen under the financial arrangement rules if the debt had been forgiven).
Historically, group companies were in fact often resorting to capitalising the debt instead of forgiving it because of the outcome under the financial arrangement rules. If the debt was instead forgiven, the financial arrangement rules resulted in an asymmetrical outcome because under the base price adjustment mechanism, debt remission income arose for the borrower, while the related-party lender was denied a deduction for the principal amount under the bad debt write-off rules (the interest may have been accrued and returned as income but a subsequent write off was allowed as a bad debt deduction). Officials accepted that the debt remission income arising and the asymmetrical outcome in the context of a wholly-owned group of companies was not appropriate and set about determining what the correct policy outcome should be in this context. An issues paper and various versions of draft legislation have since followed in order to find a workable solution.
As a result, the financial arrangement rules have been amended to ensure that debt remission income does not arise in the context of an “economic group”. The first thing to note is that the rule has been backdated to apply from the 2007 income year in order to provide certainty for taxpayers who have essentially taken this filing position in past returns. However if a taxpayer has taken an inconsistent tax position in a prior year, then that position will stand and the taxpayer will not be able to reopen the return to apply this new rule.
The core rule
New section EW 46C has been inserted into the Income Tax Act 2007 and operates in the context of an economic group (as defined) to determine what “consideration” has been paid or received when performing the base price adjustment when debt has been forgiven. Broadly a debtor is treated as having “paid” the amount of debt on the date on which the creditor forgives it and the creditor is treated is having “been paid” the amount of debt on the date the creditor forgives it. This means that the result of the BPA should be nil.
It should be noted that for this rule to apply, debt must be “forgiven”. This requires overt action on the part of the lender.
Broadly the new section operates for the following scenarios:
a. Where the creditor is a member of the same wholly-owned group of companies as the debtor and the debtor is a New Zealand resident company:
b. Where the creditor is a member of the same wholly-owned group of companies as the debtor and, for the debtor, a group of persons who are New Zealand resident companies (the NZ group) hold, before section YC 4 (Look-through rule for corporate shareholders) is applied to the NZ group in relation to their interests,—
- common voting interests that add up to 100%; and
- if a market value circumstance exists for a company that is part of a group of companies to which the debtor belongs, common market value interests that add up to 100%:
c. If the debtor is a company, where the creditor is not a member of the same wholly-owned group of companies as the debtor and the creditor has ownership interests or, as applicable, market value interests in the debtor:
d. If the debtor is a partnership, where the creditor has a partner’s interest in the income of the debtor:
e. If the debtor is a look-through company, where the creditor has an effective look-through interest in the debtor.
Note that the relief provision does not apply if the creditor and debtor are members of the same wholly-owned group of companies and the creditor is a non-resident and the debt has been held by a person that is not a member of the wholly owned group.
It should be noted that for the scenarios above (c) to (e) (i.e. other than in the context of a wholly owned group), the debtor is treated as having paid the amount of debt on the date on which the creditor forgives it only if the “proportional debt ratio” for the amount equals the “proportional ownership ratio”.
The “proportional debt ratio” is defined to mean the percentage that the creditor’s amount bears to the total amounts of debt to which section EW 46C applies at the time the creditor’s debt is forgiven. The “proportional ownership ratio” is defined to mean the percentage of ownership interests, or as applicable market value interests, total partner’s interests or total effective look-through interests for the debtor, ignoring nominal shares. Essentially this mechanism is seeking to ensure that debt remission is made in proportion to ownership so that the debt remission will not cause a dilution of ownership.
In a related change, applying from 1 July 2017, the ability of the creditor to claim a bad debt deduction for interest accrued but not received is being turned off in certain situations. A creditor will only be able to claim a bad debt deduction for interest income previously returned which will not be receivable where the creditor is either:
- Not associated with the debtor, or
- Is associated with the debtor but the debtor has no deductions for the financial arrangement.
The deemed payment of interest accrued
With effect from 1 July 2017, a further change will take effect in that “debt” forgiven under this new rule will be deemed to include amounts accrued, but unpaid at the time of forgiveness (i.e. interest). Thus when performing the base price adjustment, consideration paid to the creditor will also include accrued interest.
The sting in the tail is that Officials consider that section CG 3 (re repaymentof bad debts) would then apply to deem income to arise to the extent the creditor has previously been allowed a bad debt deduction for the interest. This means that a creditor may be subject to tax on accrued interest income that will never be physically received.
Readers will note a delayed implementation date of 1 July 2017 for this particular change. Officials have intentionally given taxpayers a little time to tidy up loans of this sort by either repaying or forgiving them to avoid the lender being treated as having been “paid” the accrued interest.
Whether debt capitalisation is now back on the table as an option to tidy up group loans remains to be seen. There may be some instances where debt capitalisation may still be preferable to forgiving the debt. It is hopeful that Inland Revenue will clarify how QB 15/01 (Income tax: tax avoidance and debt capitalisation) applies post the introduction of these rules, if at all. The argument being that if no debt remission income arises under the new rules, capitalising debt instead of forgiving it cannot be seen to be tax avoidance, although the statement may still be relevant for situations that are not covered by the scope of the new debt remission rules.
What is clear, is that it is important for taxpayers to take advice now with a view to tidying up group loans, particularly before 1 July 2017. For more information, please contact your usual Deloitte tax advisor.
May 2017 Tax Alert contents