Chapter 8 – Thin-capitalisation considered
8.2 Parameters of an effective thin-capitalisation regime
8.3 Description of a possible effective thin-capitalisation regime
8.4 Debt:Equity ratio
8.5 Thin-capitalisation rules - issues for submissions
Thin-capitalisation rules should aim to accurately determine interest expenses that are properly attributable to New Zealand, without interfering with normal commercial behaviour, at minimum compliance cost, within the self-assessment system.
The range of possible approaches include:
- a regime along the lines of that operating in Australia (which covers interest-bearing debt from foreign direct investors which exceeds equity from those investors by more than 3:1); or
- a more general regime which is designed to go beyond the most extreme cases of thin- capitalisation abuse and determine the proportion of interest that should properly be attributed to the host country; or
- a regime whose ambit falls between these two positions.
The Government is proposing, via this discussion document, to raise the issues surrounding thin-capitalisation and seeks submissions on the most appropriate approach; in particular on whether a thin-capitalisation regime is feasible and necessary.
Interest income derived from New Zealand by non-residents is subject to markedly lower aggregate New Zealand tax rates than is income from equity. Even after the proposed extension of the FITC regime, income from equity will face an aggregate tax rate of 33% compared with the 10% maximum that typically applies to interest income. The more generous tax treatment afforded debt in comparison with equity provides an incentive for non-residents to highly gear their New Zealand operations, thereby attributing high interest costs to New Zealand.
An effective thin-capitalisation regime would limit the ability of non-resident investors to artificially reduce their net New Zealand-sourced income by allocating excessive interest costs to New Zealand. Such a regime would need to apply equally to non-residents earning New Zealand-sourced income themselves and to non-residents operating in New Zealand through a subsidiary.
Other countries with transfer-pricing regimes similar to that proposed in this document have buttressed those regimes with measures to reduce the opportunity for thin-capitalisation, which allows non-residents to lower their net taxable income.
There is logic in this. However, if New Zealand were to follow this path, the Government would need to be satisfied that an effective and acceptable thin-capitalisation regime could be put in place that would not impose excessive compliance costs on businesses. The feasibility of this is addressed in this Chapter and submissions are invited. If submissions are negative, consideration should be given to how the underlying problem of variable tax on debt and equity should be tackled.
An acceptable and effective thin-capitalisation regime should:
- determine the amount of interest expense properly attributable to New Zealand in a manner which is flexible enough to have regard to the normal variation of commercial finance, while nevertheless being effective when excessive debt finance is used;
- operate in the self-assessment system (that is, without the need for a Commissioner’s discretion); and
- impose the minimum compliance costs necessary to achieve the above objectives.
8.2.2 Other countries’ thin-capitalisation regimes
A number of other countries have already implemented thin-capitalisation measures. These countries include Australia, Canada, Japan, USA, Germany, Sweden and Norway, while the UK administers thin-capitalisation restrictions within the broad ambit of its transfer-pricing legislation.
These overseas precedents do not, however, appear to meet the objectives stated for an effective and acceptable thin-capitalisation regime. Australia is an example. Under the Australian regime, if interest-bearing debt finance from foreign direct investors (those owning 15% or more of the equity in an Australian company) exceeds equity finance from the same investors by more than 3:1, then interest paid on the excess debt to the foreign direct investors is disallowed as a deduction.
The Australian rules provide a look-through for back-to-back loans from the foreign direct investors, but do not treat debt finance from a third party that is guaranteed by a foreign direct investor as debt from a foreign direct investor.
While the Australian rules may capture extreme cases of thin-capitalisation, they do not appear to operate as a more general rule for determining the amount of interest properly attributable to the host country and deductible with respect to that country. This is because:
- the Australian rules operate with an arbitrary 3:1 debt:equity ratio only, which may be too high in some cases because the entire group operates with a lower ratio; and
- the Australian rules only regard debt from foreign direct investors, whereas given the fungibility of debt, all debt should ideally be considered for determining the amount of interest properly attributable to the host country.
The following example uses New Zealand as the host country to illustrate this point.
Consider a group that initially comprises a non-resident parent company. The company has shareholders’ funds of $100 and no debt. It proposes to set up a subsidiary company in New Zealand which will require total capital of $100. The desired debt:equity ratio for the New Zealand operation is 4:1; that is, $80 debt and $20 equity. The group obviously needs to borrow money to finance its expansion into New Zealand and can do so either by:
- the parent company borrowing $100, which it uses to inject $20 equity into the New Zealand subsidiary and to extend an $80 loan to the subsidiary; or
- the parent company borrowing $20 for its equity injection and the subsidiary company borrowing the remaining $80 from a third party.
In the first case, the New Zealand company’s debt is to a related party; in the second, to a third party. In both cases, total group indebtedness is $100.
The example is stylised, but this does not affect the validity of its basic argument: non-resident companies can use genuine third party debt to thinly capitalise their New Zealand subsidiaries or branches. This means that, to be effective, thin-capitalisation rules must ideally cover third-party debt as well as related-party debt.
The following broadly focused thin-capitalisation regime has been designed to be effective in limiting the excess allocation of interest expenses to New Zealand operations.
8.3.1 Main features of the proposal
The regime has the following main features:
- it would apply only to entities or operations that are controlled by a single non-resident. That is because the policy concern is to restrict the ability of non-residents to exploit the debt/equity distinction to under-report net New Zealand-sourced income;
- it would have a safe-harbour debt:equity ratio set at a level that excluded most operations with a commercially-normal debt:equity ratio. The objective would be to reduce compliance costs and limit the extent to which the measures increase aggregate tax rates on non-resident investors operating with commercially-normal capital structures;
- entities whose debt:equity ratios exceeded the safe-harbour ratio would be subject to the regime only if their debt:equity ratios also exceeded 110% of the worldwide debt:equity ratio of the group to which that entity belonged; and
- entities which failed these two debt:equity ratio tests would not be permitted to deduct their excessive interest expense. Excessive interest expense would equal
Total Interest Expense x
|Actual debt — Threshold debt
where threshold debt is the maximum amount of debt that would be consistent with the higher of the safe-harbour and 110% of the consolidated group debt:equity ratios.
The regime would apply to any taxpaying entity, such as an individual, company or trust. The legal form of the taxpaying entity should not determine whether or not a substantive provision, such as a thin-capitalisation rule, should apply. The rules would need to apply individually to each partner of a partnership.
8.3.3 Non-resident control
The regime would apply only to non-residents deriving New Zealand-sourced income (such as a branch of a non-resident company) and to New Zealand resident entities controlled by a single non-resident. Non-resident would include persons defined as resident under the Act, but treated as non-resident for purposes of a DTA. For the purposes of such a regime, a trust that would be a qualifying trust if it made a distribution on the last day of its income year would be treated as resident for that income year; other trusts would be treated as non-resident.
Non-resident control of a resident company would be defined as a single non-resident entity with ownership of 50% or more of the controlling interest in the resident company, as defined for the CFC regime. Attribution and look-through rules would apply to determine ownership of a controlling interest. These rules would be similar to ss.245B and 245C which are used to attribute control interests of foreign companies for the CFC regime.
8.4.1 Safe-harbour ratio
A safe-harbour proposal would seem desirable in order to:
- reduce compliance costs by excluding most taxpayers from the ambit of the regime;
- target the regime at cases giving rise to the greatest tax-base concerns; and
- reduce the extent to which the regime would force non-resident investment to be heavily weighted towards highly taxed equity investment, thereby markedly increasing effective tax rates on such investors.
All three objectives would require a safe-harbour ratio set at a level that would exclude most entities. To keep compliance costs to the minimum, the regime must be targeted at levels of activity that would reasonably be seen as abusive. Business operating at a normal commercially acceptable gearing level should definitely be excluded by the safe-harbour rule.
Many overseas countries have a safe-harbour debt:equity ratio. Provided that this ratio is not breached, businesses are not affected by the thin-capitalisation rules. If this ratio is breached, interest deductions are generally denied. Under the general scenario proposed by this document, however, further provisions would still allow the interest payments to be deducted, even when the safe-harbour is breached.
In Australia, Canada, Japan and Germany the safe-harbour debt:equity is 3:1 (25% equity regime). In Spain it is 2:1 (33% equity regime). In USA it is 1.5:1 (40% equity regime). Because of significant differences in the regimes, it is difficult to use these as automatic precedents. The choice of the safe-harbour level is essentially a judgment. It has no basis in any hard taxation theory. The aim, as stated above, is to stop abuse.
It is envisaged that the New Zealand safe-harbour ratio would be within the range that other countries use. This should exclude most companies from the regime, for example, the average debt:equity ratio of the top 40 companies listed on the New Zealand Stock Exchange (November 1994) is about 1:1 (median 53% equity, mean 45% equity).
The Government seeks submissions on the most appropriate ratio for New Zealand.
8.4.2 Debt:Equity ratio defined
The New Zealand debt:equity ratio is the (related and third-party) debt on which New Zealand interest deductions are incurred, in relation to the equity of the New Zealand entity or branch.
Debt for the New Zealand taxpayer would need to be limited to debt giving rise to New Zealand tax deductions. Where no New Zealand tax deduction is taken, there is no issue of excessive interest costs being attributed to the New Zealand tax base. Thus, an interest-free loan from a non-resident parent to a New Zealand subsidiary should not be included in the debt of the New Zealand subsidiary. For example, a non-resident controlled company has assets of $1,000 funded by an interest-free loan of $500, interest-bearing debt of $400 and shareholders’ funds of $100. Under the proposals, the debt:equity ratio of this company would be 2:3 (60% equity).
Debt would need to be defined widely enough to encompass all instruments and arrangements that are closely substitutable for debt. For example, it would need to include interest-bearing convertible notes. The definition of financial arrangements in the accrual rules covers all such arrangements. However, since the focus is on excessive interest and similar costs, the debt definition needs to be limited to financial arrangements for which a deduction is taken under s.106(1)(h) of the Act or sections such as s.136, which allows a deduction for expenditure incurred by a taxpayer in borrowing money and employing it as capital in the production of assessable income. In other words, financial arrangements for which no interest deduction (or similar) is taken would not be considered as debt.
Equity for the non-resident, or non-resident controlled, New Zealand taxpayer would be the taxpayer’s gross assets (for non-residents, gross assets located in New Zealand or employed in the production of New Zealand assessable income) less interest-bearing debt (using the above debt definition). To reduce compliance costs, assets should be able to be valued at either depreciated cost or market value. However, the valuation method would need to be consistent across all assets unless different valuations are used for financial reporting in a way that is consistent with Generally Accepted Accounting Principles (GAAP).
8.4.3 Determining when the debt:equity ratio should be measured
The debt:equity ratio of the non-resident or non-resident controlled taxpayer would need to be calculated for an income year. For compliance cost reasons, the same ratio should be used for the entire income year. However, this leaves open the question of when debt and equity should be measured in order to calculate the annual ratio.
One way would be to measure debt and equity on the last day of the accounting year. The problem with such an approach is that companies could manipulate their debt and equity levels for that particular day.
Another option would be to take an average amount of debt and equity over the accounting period. Although this option is more equitable, it would have higher compliance costs as it requires taxpayers to perform detailed calculations.
A further option would be to take the highest debt level and lowest equity level during the year. However, that could be unfair. For example, a company requiring a high level of debt over a short period would be penalised. Since equity is a residual item that is calculated only after completing a full set of accounts, requiring the lowest level of equity to be calculated would impose excessive compliance costs.
A balance needs to be struck between preventing manipulation of debt levels to meet the safe-harbour ratio and the compliance costs involved in an averaging approach.
The best approach for debt may be to calculate debt as the highest amount of debt in the accounting year and allow an option for taxpayers to use the monthly (or possibly quarterly) average amount of debt for the accounting year, if this would give a fairer result. If such an option were provided, it would need to have associated anti-avoidance rules to prevent debt levels from being suppressed on the measurement dates.
Equity would always need to be measured on the last date of the accounting year, when accounts are prepared and this residual item is measurable. Measuring it on any other day would involve high compliance costs.
8.4.4 Calculating debt:equity ratios on a consolidated basis
In many cases, the New Zealand debt:equity ratio of a non-resident, or non-resident controlled New Zealand taxpayer, would flow mechanically once debt and equity were defined. However, in some cases the debt and equity of associated parties may need to be amalgamated to provide one debt:equity ratio for all associated parties. For non-corporates this would seem unnecessary and would incur unnecessary compliance costs.
If the New Zealand debt:equity ratio of a corporate group were not measured on a consolidated basis, it would be possible to meet any required debt:equity ratio simply by establishing a chain of companies, each meeting the required ratio. The problem arises because equity introduced into a corporate chain is counted as equity for each company down that chain. Thus, if company debt:equity ratios were measured separately, the same equity could cover the allowable debt level as many times as there are companies.
It would therefore be necessary to require the debt:equity ratio of a New Zealand group of companies to be calculated on a consolidated basis with the same debt:equity ratio applying to all companies in that group. Clearly, for these purposes the definition of a group should be limited to companies that are non-resident or non-resident controlled. For simplicity, the existing 66% common ownership company group definition in s.191(3) of the Act could be used - provided that each company in the group is non-resident or non-resident controlled. The alternative would be a wider rule such as a group of companies with a common non-resident controller.
In cases where group companies have different balance dates, calculating the debt:equity ratio on a group basis would raise the issue of which date should be used for calculating debt and equity. The obvious date would be the balance date of each company for which the thin-capitalisation rule applies. However, that could require several different debt:equity calculations. To reduce compliance costs there would need to be an option for all members of a company group to elect to use the balance date of one member.
For taxpayers other than companies (individuals and trusts), there would not seem to be the same need to calculate the debt:equity ratio on a consolidated basis.
The Annex at the end of this Chapter provides some examples of using a consolidated basis for calculating the New Zealand debt:equity ratio.
8.4.5 Determining the world-wide debt:equity ratio
After determining that the New Zealand debt:equity ratio exceeds the safe-harbour, it would be necessary to determine whether the New Zealand debt:equity ratio exceeds 110% of the consolidated world-wide debt:equity ratio for the group. This would be used to determine whether the interest incurred in New Zealand is excessive in comparison to the group’s overall debt finance.
Where the controlling non-resident is a company that produces audited consolidated financial accounts in accordance with GAAP, the world-wide debt:equity ratio could be calculated from those accounts. There would need to be a provision allowing a taxpayer to use unaudited accounts if these could be shown to provide a true and fair view of the taxpayer’s position.
Under these rules, the primary difference between calculating the debt:equity ratio of the New Zealand taxpayer and the ratio of the world-wide group is that the group’s ratio would be calculated by treating all legal debt as debt, regardless of whether it is interest-bearing. The New Zealand taxpayer, in contrast, would treat only interest-bearing debt as debt for the purposes of calculating its ratio.
Therefore, the ratios used for comparison would not measure exactly the same types of debt. However, it would not be reasonable to require a multi-national company group to recalculate its debt:equity ratio using New Zealand tax debt concepts. Nor would it be reasonable to include in domestic debt, arrangements on which no interest deduction (or its equivalent) was provided. A compromise based on compliance-cost concerns is required.
There may, however, be circumstances when the non-resident controlling shareholder would prefer to calculate its debt:equity ratio using New Zealand tax concepts of debt and equity. There is no apparent reason to disallow this. In such cases, debt would need to be defined as all financial arrangements that would give rise to a deduction if the non-resident company group had been resident in New Zealand. Consolidated accounts would still be needed. A consolidated debt:equity ratio would be calculated for the non-resident controller and all persons associated with that non-resident, with an associated person test along the lines of s.245B.
Such an approach would be appropriate where the controlling non-resident does not have audited consolidated accounts, or where that person is not a company.
To add flexibility to the regime, taxpayers should be allowed to apply to the Commissioner for a ruling on variations to the above method for determining the debt:equity ratio of a controlling shareholder. The Commissioner would be authorised to provide such a ruling where a variation is in accordance with the principles of the regime. For example, this might be usefully applied where a world-wide diversified business with a low debt:equity ratio operates a bank in New Zealand with a high debt:equity ratio which is normal for such an operation.
There may also be other cases where strict application of the debt:equity ratio could lead to inequitable results. The Government seeks submissions on such cases and suggestions on how to identify them and provide relief without compromising the integrity of the regime.
In the unusual case where more than one non-resident entity or group is considered to control the New Zealand taxpayer, the taxpayer would have the option of choosing which non-resident controlling entity or group to use for determining the group debt:equity ratio.
For simplicity, the debt:equity ratio of the controlling entity would need to be determined on the last day of its preceding accounting year; that is, a year which ends before the New Zealand taxpayer’s accounting year begins. That should be satisfactory for calculating the world-wide debt:equity ratio, since the opportunity to manipulate the amount of world-wide debt and equity is not likely to be significant.
Once the world-wide debt:equity ratio has been determined, it would be increased by 10%, to account for the different times of measurement of the ratios for the New Zealand taxpayer and the group and to allow for a reasonable amount of difference between the New Zealand debt and the world-wide debt. It would then be compared to the New Zealand ratio so that excess interest could be determined.
8.4.6 Deduction disallowance for excess interest
If a non-resident or non-resident controlled entity has an excess level of debt, this would indicate that interest costs are being over-allocated to the New Zealand tax base. In such cases, an interest deduction relating to the excess debt would be denied. All interest and interest-type expenditures deductible under the Act, including the accruals rules (these include foreign exchange losses), would be subject to partial disallowance.
Under such a rule, a proportion of total interest expense, calculated according to the formula below, would be denied:
Total Interest Expense x
|Actual debt — Threshold debt
where “threshold debt” is the higher of:
a) the debt:equity ratio of the controlling entity (plus the 10% margin); and
b) the safe-harbour ratio.
In calculating excess interest costs, it would seem inappropriate to net off interest income received by a taxpayer against the interest expense of that taxpayer. The rationale of such a regime would be to deny interest deductions when a taxpayer is excessively geared. The nature of the income received (interest, dividends or other) as a result of investing the borrowed funds would not be relevant. However, consideration would need to be given to the case where the recipient of an interest payment is also the payer; for example, current accounts moving between debit and credit balance. In such cases, netting off balances might be appropriate. Consideration should also be given to back-to-back loan arrangements with non-resident related companies.
If there is more than one New Zealand company in the consolidated group, excess interest would need to be disallowed in proportion to the interest claimed as a deduction by each company, up to the total amount of interest claimed by the New Zealand group of companies.
It would not be appropriate, under such a regime, to recharacterise as equity excessive debt for which interest deductions are denied, so that the interest payments would be regarded as dividends. For example, Australia adopts this approach of not recharacterising debt as equity when their thin-capitalisation rules apply.
8.4.7 Anti-avoidance rules
A regime along the lines outlined above would need to include anti-avoidance rules to ensure that taxpayers do not:
- structure transactions to circumvent the control test; or
- temporarily or artificially inject or inflate equity to avoid an excess debt calculation.
8.4.8 Reporting requirements and penalties
No special reporting requirements or penalty provisions would be necessary to operate the above thin-capitalisation proposals.
The Government invites submissions on all issues discussed in this Chapter and related matters. In particular, it solicits discussion on the necessity and feasibility of a thin-capitalisation regime and would also welcome submissions in the following areas.
8.5.1 Ambit of the regime
A key issue is whether thin-capitalisation rules should be narrowly focused (as in the Australian regime) or more broadly focused (as in the regime outlined above). A narrowly focused regime has the advantage of being more closely targeted, but the disadvantage of being less effective. An intermediate position may be appropriate.
8.5.2 Safe-harbour ratio
An appropriate safe-harbour, in line with international norms, needs to be set for a broad and effective thin-capitalisation regime.
8.5.3 Third-party debt
The broad regime outlined includes third-party debt as well as related-party debt, both in determining the New Zealand taxpayer’s debt:equity ratio and applying interest deduction disallowance. Some overseas regimes only refer to related-party debt for both purposes. The United States refers to all debt for determining the debt:equity ratio, but refers only to related-party debt for disallowing the interest expense deduction.
In some respects this proposal could be seen as an interest allocation rule rather than a thin-capitalisation rule. The Government in this circumstance faces a difficult issue. Referring to related-party debt only would focus the regime on those cases where debt finance is directly used in substitution for equity finance. However, with that focus, the regime could be avoided with back-to-back loans and related-party guarantees.
There is evidence from overseas that where a limited regime applies this is exactly what happens; that is, the regime is avoided. Unless the consultation process shows that such a concern is not relevant in New Zealand, only a wider rule would seem effective. Certainly, there seems little point in introducing a regime that we know in advance can easily be avoided.
Applying the regime to all debt would obviously avoid such a problem. It would allow the regime to operate effectively as a way of determining the appropriate amount of interest expense incurred in New Zealand. But it would, unless tightly contained, threaten the Government’s goal of reducing compliance cost.
The wider rule would involve what some would see as a significant involvement, perhaps too significant an involvement, of tax rules in normal commercial decisions, made for normal commercial reasons, about the financial structure of a firm. For this reason, the Government has determined that such a regime needs to be focused in a way that addresses abuse only and it therefore seeks submissions on what the final shape of such a rule should be.
8.5.4 Consolidated groups
The regime outlined above would require that New Zealand companies use consolidated accounts for the purpose of the calculations. This may impose additional compliance costs. However, if this is not done the regime could be avoided by multiple counting of equity that is flowed through a chain of companies. Again, submissions are sought on this point.
8.5.5 Inequitable results
Taxpayers may wish to identify cases where they believe application of the rules would be inequitable and suggest a rule which will identify such cases and provide relief without compromising the integrity of the regime.
This Chapter has outlined the elements of a thin-capitalisation regime intended to meet the objectives of being both flexible and effective. The Government seeks submissions not just on the issues discussed above, but on any other relevant issues relating to thin-capitalisation. The Government invites submissions on the extent to which attribution of excess deductions of interest expense to New Zealand is a problem and, if a significant problem, whether an effective thin-capitalisation regime is an appropriate response and if so what should be the ambit of the regime.