Thin capitalisation calculations in a BEPS world
Tax Alert - November 2019
By Susan Wynne and Annamaria Maclean
As discussed in our related November Tax Alert article, new BEPS disclosure requirements have been introduced by Inland Revenue. These follow the enactment last year of the Taxation (Neutralising Base Erosion and Profit Shifting) Act 2018. The changes from this legislation apply to taxpayers for income years starting on or after 1 July 2018, so are now applicable.
Included in the BEPS changes were updates to the thin capitalisation rules. It is now timely to consider the practical application of the thin capitalisation calculation changes, particularly given the BEPS disclosure requirements for affected taxpayers.
The significant change to thin capitalisation calculations is that debt percentages are now calculated based on debt over assets net of “non-debt liabilities”, rather than debt relative to gross assets as was previously allowed. This change can have a significant impact on the thin capitalisation position of taxpayers.
Taxpayers that are subject to the thin capitalisation rules must calculate the debt percentage of their New Zealand thin capitalisation group. In the case of a taxpayer with inbound debt, if the debt percentage exceeds 60% further calculations are required to test if the debt percentage of the New Zealand group is not more than 110% of the debt percentage of the worldwide group. This subsequent test is designed to ensure that the amount of debt allocated to the New Zealand group is proportionate to the amount of genuine external debt of the worldwide group (i.e. New Zealand is not disproportionately geared compared with the global group).
If both the 60% and 110% debt percentage thresholds are breached a taxpayer will need to calculate an amount of interest expense that will be non-deductible.
The change to the debt percentage formula will require taxpayers to think more carefully about their thin capitalisation positions. This may include undertaking more detailed calculations to determine if the debt percentage thresholds have been breached, including looking more closely at the different options available in the thin capitalisation calculations and also calculating the worldwide group threshold to check whether this is also breached. Taxpayers should also consider whether it is the right time to restructure debt.
When preparing thin capitalisation calculations some of the issues that are useful to consider include:
- What is the New Zealand thin capitalisation group?
- What thin capitalisation measurement date will be used?
- What amounts will be “non-debt liabilities”?
- Can on-lending concessions be applied?
- What about the worldwide group debt percentage calculation?
- BEPS consequences - restricted transfer pricing rules.
We discuss these points below.
New Zealand thin capitalisation group
In general, when determining the members of a New Zealand group it is necessary to identify the top tier company resident in New Zealand (with an immediate non-resident shareholder). Once the New Zealand parent is identified, all companies that are within the control threshold of the New Zealand parent must be included in the New Zealand group. Broadly, the default control threshold is ownership of 66% or more, otherwise an election is required for a 50% interest.
There is also an ability to elect to form a wider New Zealand thin capitalisation group in certain instances, for example, where a non-resident controls two separate chains of New Zealand groups. These elections are made when filing the income tax return.
The rules to determine the membership of a thin capitalisation group can be complex and are spread over several sections in the Income Tax Act 2007. However, given the new debt percentage formula and the consequences of a higher thin capitalisation debt percentage, it may be worthwhile reconsidering which entities are eligible to elect to form a thin capitalisation group and making elections where these are of benefit.
Thin capitalisation measurement date
Measurement for thin capitalisation purposes may be on a daily, quarterly or annual basis. Most taxpayers simply choose to measure the thin capitalisation debt percentage on an annual measurement date at the end of the income year.
If measuring the thin capitalisation debt percentage at the standard annual measurement date results in a breach of the thin capitalisation threshold, then testing the average amount at the end of each day or quarter could produce a different outcome. There are also options to revalue foreign denominated balances at different exchange rates, which can make a difference to the calculations.
Looking at the differences in the calculation using different measurement dates could be particularly relevant if debt or asset balances or exchange rates fluctuate during the year.
However please note that a new avoidance rule was introduced as part of the BEPS legislation that essentially provides that taxpayers cannot substantially repay a loan or enter into a transaction near a measurement date with the purpose or effect of manipulating the thin capitalisation rules. Therefore care will need to be taken if there was a repayment of debt or increase in assets near a measurement date.
As noted above, the thin capitalisation rules were strengthened as part of the BEPS initiatives. The key change was the amendment to the debt percentage formula so that assets are now measured less non-debt liabilities. The new formula provides that the debt percentage is calculated as:
Group debt / (Group assets – Non-debt liabilities)
Broadly, non-debt liabilities are all liabilities in the financial statements less:
- Interest bearing debt included as group debt in the debt percentage formula;
- Certain interest free loans from shareholders;
- Certain shares from shareholders that are liabilities in the financial statements, e.g. preference shares;
- Provisions for dividends;
- Certain deferred tax liabilities.
The intent is that all liabilities will reduce the value of group assets in the debt percentage formula except for interest bearing debt, shareholder funding that is effectively equity, or certain deferred tax liabilities. However the exclusions from non-debt liabilities are somewhat limited.
For example, non-debt liabilities can be reduced for certain interest free loans from shareholders. However, this exclusion does not apply to wider interest free related party loans (e.g. by entity’s in the same group as the shareholder) nor does it apply to trade liabilities with shareholders or related parties. The new legislation only refers to arrangements “with a shareholder” and the Inland Revenue commentary specifically makes the point that “as drafted, the exclusion only applies to a loan from a shareholder”.
The on-lending concession has sometimes been overlooked in the past if the debt percentage has been low. But with the changes to the debt percentage formula it is worthwhile considering if the on-lending concession will reduce the debt percentage.
The concession for on-lending represents assets which are financial arrangements that provide funds to an unrelated person or related party outside the thin capitalisation group. These are most commonly cash deposits and other loans on-lent outside the group.
The worldwide group debt percentage calculation is relevant if the New Zealand debt percentage is over the 60% threshold, or if the “high BEPS risk” taxpayer 40% threshold is breached (see discussion on BEPS consequences further below).
However, there are some differences between the calculation of a New Zealand group debt percentage and a worldwide group debt percentage.
The worldwide group generally comprises all entities that are required to consolidate with the New Zealand companies’ ultimate non-resident parent under generally accepted accounting practice (GAAP), or an equivalent standard in the country where the ultimate parent resides.
The debt, assets and non-debt liabilities of the worldwide group must be calculated under GAAP, or the financial standard of the country in which the ultimate non-resident parent company resides, as this applies for the consolidation of companies for the purposes of eliminating intra-group balances.
The measurement date under the thin capitalisation rules for the worldwide group can be on a daily, quarterly or annual basis. However if an annual measurement date is used this is based on the last day of the accounting year of the worldwide group ending immediately before the income year of the taxpayer's New Zealand group.
The new debt percentage formula must also be used for the worldwide group debt percentage. For a worldwide group, total group non-debt liabilities for an income year are more widely defined.
BEPS consequences – restricted transfer pricing rules
The broader implications of the thin capitalisation percentage should also be considered given the BEPS measures that now apply.
In particular, under the restricted transfer pricing rules, New Zealand taxpayers may be classified as “high BEPS risk” taxpayers if they exceed a 40% thin capitalisation debt percentage threshold and the 110% worldwide debt test. Therefore, even if the 60% debt percentage threshold is not breached, if the 40% threshold is breached, it will be useful to test the 110% worldwide group debt threshold, as this could exclude taxpayers from being classified as “high BEPS risk”.
Based on the BEPS disclosure guidance that was recently released by Inland Revenue, it appears that taxpayers subject to the thin capitalisation rules will be specifically asked if the New Zealand group debt percentage is 40% or higher at any measurement date during the year. This disclosure requirement will apply for tax returns for income years commencing on or after 1 July 2018. In addition, the components of the thin capitalisation calculations will need to be provided to Inland Revenue so taxpayers need to be prepared to provide this information.
The thin capitalisation debt percentage calculation has become a more complex calculation with potentially significant implications for taxpayers. Our recommendation is that the impact of the new debt percentage formula is considered before year end, if possible, and given careful consideration. Taxpayers should also be aware of the requirement to provide thin capitalisation information to Inland Revenue as part of the new BEPS disclosures. Please contact your usual Deloitte advisor if you would like further information.
November 2019 Tax Alert contents
· Thin capitalisation calculations in a BEPS world