Peering into tax: bad debts and P2P lending

Tax Alert - March 2016

By Troy Andrews

The Financial Markets Authority (FMA) has been world leading in establishing a regulatory framework for Peer to Peer lenders to operate in New Zealand.  The FMA designed a specific regime for the disruptive new industry, rather than scratching their head with ‘square peg round hole’ syndrome, like other jurisdictions.  On the other hand, the New Zealand Inland Revenue has not yet looked to modernise its policy settings to support the FMA, around the taxation of Peer to Peer loans in New Zealand.

The taxation of investors goes to the heart of the fractionalised peer to peer lending model that some providers offer, like Harmoney.  To recap on this model, investors are encouraged to take small amounts of risk on a large number of borrowers by investing in small loan notes, lending directly through an online platform.  The blended return (i.e. income and losses) on these notes provides an overall yield that is meant to outperform a bank deposit or another instrument that is issued through an intermediary.  The model is supposed to be win-win – as there is no intermediary, the borrower can borrow at lower rates and the investor should receive a better blended return as the saving of having no  intermediary is shared.  In an ideal world, there should be no tax bias for the investor.  The overall “yield” should be subject to income tax, just like any other loan or bank deposit product would be.  Unfortunately, New Zealand is not an ideal world.

The starting point of taxation in New Zealand is not to look at the overall yield from an investor’s portfolio, but to break it up into income and losses and test whether the income or loss on a particular loan is taxable or deductible.  For gains and income (interest), the answer is easy as it is always taxable.  However, for losses it is not straight forward.  A loss for borrower default is only allowed where a bad debt deduction can be claimed.  In order to claim a bad debt deduction for the principal on a loan, the investor needs to establish that they are in the business of holding or dealing in financial arrangements (loans) (among other criteria).  This is not a new test as the rule has been around for a long time.  The rule applied to prevent relief for a lot of investors in failed finance companies last decade.  Inland Revenue also published some uncompromising guidance on how these rules applied at that time.  Investors in other asset classes, like equities, have also had to be conscious of a similar test as to whether their activities might give rise to a “business” (and question whether shares are held on revenue account and be taxable).

There is case law and guidance that helps determine whether a taxpayer’s activities will constitute being in business, but it is not a simple exercise.  There is limited case law that applies the test in the context of bad debts (see Z 21 TRA No. 22/2008 and H27 (1986) 8 NZTC 264).  In both cases the court held that the test was satisfied.  In Z 21, the court set out a number of factors that are relevant to apply, being:

  • The nature of the activity
  • Period of activity
  • Scale of operations
  • Volume of transactions
  • Pattern of activity
  • Commitment of money
  • Commitment of time and effort
  • Financial results.

In Z21, there were only three loan transactions but this was held to be for a material amount of loan capital.  There was little in the way of ‘business infrastructure’ but there was a lot of due diligence and care that was put into each loan (and recovery/collections).   The court found that this was ‘only just’ enough to satisfy the bad debt test and allowed a bad debt deduction.

Peer to peer lending is a disruptive business model.  This means that the traditional factors that might be relevant (e.g. in testing whether you have sufficient activity to constitute a business) may not be appropriate.  In that context, applying these factors to peer to peer lending investors is difficult and brings uncertainty.  If the peer to peer platform takes care of all of these functions, can an investor ever be confident that they meet the test of being in business (unless they also have other lending activities)?  One view might be that the platform is undertaking some activities “on behalf” of the investors.  Another view might be that you still need to consider each investor’s own actions and the amount of activity they have on the platform (and otherwise).  In any case taking a tax position is not clear and will depend on each investor’s own analysis of whether they are “in business” or not.  Investors may also be wary of taking a tax position where a similar amount of activity is undertaken in relation to their equity investments and whether this constitutes a business (where your broker / share registry and share market undertake a lot of the business functions) – bearing in mind that the focus of the test may be different.    

If the above tests do not give rise to a bad debt deduction, the outcome is out of kilter with the fractionalised peer to peer model, which relies on a blended return.  In a bank scenario where an investor has money on deposit with a bank, the ‘risk managing fractionalisation’ (i.e. spreading risk) is undertaken by the bank.  The bank is the taxpayer that needs to satisfy the bad debt threshold, rather than the investor into the bank (they would only need to satisfy this where the bank was in default).  An easy example that demonstrates this tax bias is a scenario where Investor A holds 500 loan notes at $10 each (and let’s say they have a 15% interest rate).  Ten of the loan notes go bad and are written off with nothing collected.  The remaining 490 loan notes return interest income of $735.  The blended return (taking into account the loss of $100) is $635 (or 12.7% on the original $5,000 invested).  From a tax perspective, the interest income of $735 is taxable (at say, 33% being the top marginal tax rate) whereas the loss of $100 may not be available if the bad debt deduction criteria is not met.  In that case, the effective tax rate could be 38%.  This is a sign that the policy settings need to be tested.

Inland Revenue generally encourages taxpayers to approach them and utilise the rulings system to get certainty.  However, a private binding ruling is an expensive exercise for investors (where both Inland Revenue and advisors would charge a fee).  A product ruling is often used where the impact is across a number of taxpayers.  However, this doesn’t work where each taxpayer will have slightly different facts and wouldn’t be appropriate in the context of measuring whether an investor is in business or not.  The other ruling types (like public rulings) and informal publications from Inland Revenue can be useful to understand how they will approach a situation.  However, these are at the discretion of Inland Revenue.  This means that the issue is in competition with a huge amount of other issues.  With a number of resource intensive programmes currently underway at Inland Revenue, most requests are “added to the list”.

There are other peer to peer lending business models that are evolving. In each case, the above tests need to be considered.  This highlights that Inland Revenue need to modernise their framework for peer to peer lending – of all types – so that there is no tax bias for different models.  This will ensure that the FMA’s good work in putting New Zealand at the forefront of this booming global industry is not undone, but instead supported by a sensible and modern tax policy that investors can rely on with certainty.

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