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Chapter 2 - The current tax treatment

2.1 The taxation of agreements for the sale and purchase of property and services can be summarised as follows:

  • The property or services included in the agreement are valued and the difference (if any) between that value and the amounts paid for the property or services are treated as interest to be spread under the accrual rules.
  • The value of the property or services can be calculated a number of ways: the lowest price that would have been agreed at the contract date for payment in full at the first rights date (usually to possession or income) or when the services are provided; the cash price as per the Credit Contracts and Consumer Finance Act 2003 if it applies; the future or discounted value of the payments made; or by a determination made by the Commissioner.
  • Where the lowest price is expressed in foreign currency, there are a number of exchange rates available which can be used to convert the lowest price to New Zealand currency.
  • Determination G29 sets out the exchange rates and spreading methods to be used for foreign currency agreements for the sale and purchase of property or services.
  • Methods A and B in Determination G29 are available for general use and use the forward rate from the contract date to the rights date or final payment date to convert the value of the lowest price in foreign currency to New Zealand currency. The changes in that value due to FX variations until the rights date or final payment date are taxable. The end result for the lowest price is equivalent to the tax treatment of a FEC.
  • Methods C and D use spot rates at different times and are only available for agreements for trading stock. Method E also uses a spot rate and is available for taxpayers whose gross income does not exceed $2.5 million.
  • The underlying property or services in the agreement are valued at the lowest price for the other provisions of the Income Tax Act 2007 – for example, capitalisation/depreciation of fixed assets, trading stock, sales revenue and revenue account property.
  • Any FEC used to hedge the cashflows associated with the property or services in an agreement is a separate financial arrangement and dealt with separately under the accrual rules.

2.2 Over the past few years some taxpayers and their advisers have raised concerns about the current tax rules for these agreements. These concerns are primarily about the use of Methods A and B in Determination G29 which are difficult to comply with and cause considerable volatility. Some taxpayers have made submissions suggesting alternative methods to the current tax treatment.

2.3 We accept that there are difficulties in applying the legislation for these agreements.

2.4 When agreements are not fully hedged, the use of Methods A and B in Determination G29 can provide very volatile unrealised FX gains and losses for tax at intervening balance dates, as well as recognising items for tax at values which do not represent the cash paid/received under the agreement.

2.5 For example, take the purchase of an asset for US$100 for delivery and payment in full in 12 months’ time which is not hedged with a FEC. Under Determination G29 (Methods A or B), the forward rate from the date the agreement is entered into up to the delivery/payment date is used to measure the value of the asset and any FX gain or loss on the agreement. The forward rate is 0.70 and the spot rate at the date of delivery/payment is 0.80. The asset will be capitalised and depreciated at NZ$143 ([email protected]) for tax and the cash paid for the asset is NZ$125 ([email protected]). The difference of NZ$18 is taxed as a FX gain on the agreement and is progressively taxed on an unrealised basis when the agreement spans income years.

2.6 Some taxpayers have submitted that, at the least, an expected value approach should be allowed for the FX gains and losses, to reduce volatility caused by taxation of the unrealised FX gains/losses in income years prior to maturity of the agreement.

2.7 Because of the compliance problems, we understand that some taxpayers are attempting to comply with the current rules in alternative ways which give results which approximate the Determination G29 calculations. For example, when payments under an agreement are hedged with FECs, they are returning a corresponding gain/loss on the agreement as is returned on the FECs without necessarily doing the full Determination G29 calculations.

2.8 When alternative compliance techniques are being used there is continuing uncertainty for taxpayers and the potential for disputes. It is good policy to address this situation by providing alternative methods that are easy to comply with.

2.9 We are not aware of any significant difficulties with the use of Methods C, D and E in Determination G29. Methods C and D can be used for appropriate agreements for trading stock irrespective of the use of Methods A and B for agreements for other items. Method E is available for use for agreements for any items, provided the taxpayer’s income does not exceed $2.5 million.

2.10 Determination G29 does not currently apply to agreements for services. The changes proposed in this paper should probably be extended to services in an appropriate manner. It is also noted that section EW 35 of the Income Tax Act 2007 does not include services and this appears to be an oversight which should be corrected to be consistent with section EW 32.