Chapter 6 - Default future value and discounted value interest calculations
6.1 As previously discussed (see chapter 4), the tax rules require foreign currency agreements for the sale and purchase of property to be effectively taxed as two separate components.
6.2 The second component of an agreement can be an interest-bearing loan in foreign currency (an FX loan). These loans can result from both prepayments and deferred payments made under agreements. The loan value is identified primarily by one of two methods. The original method is essentially the difference between the cash payments and the lowest price that would have been agreed at the time the agreement is entered into for full payment at the rights date. It was originally aimed at deferred payment situations. The second method is the difference between the future or discounted values of the payments before or after the rights date and the present value of those payments at the rights date. Any FX loans are now taxed under Determination G9C, which is an expected value method.
6.3 The calculation of interest under the first method is appropriate when the parties have agreed on a lowest price applicable at the rights date.
6.4 Section EW 32(5) of the Income Tax Act 2007 is the relevant legislation:
Future or discounted value
(5) The value of the property or services is the future value, or the discounted value, or a combination of both the future and discounted values, of the amounts paid or payable on the date on which the first right in the property is transferred or the services are provided, as determined by the Commissioner under a determination under section 90AC(1)(i) of the Tax Administration Act 1994.
6.5 The future or discounted value (FV/DV) approach is the third alternative in section EW 32 for determining the relevant values. However, if neither of the first two alternatives applies, the FV/DV method automatically applies. This means that in many cases either Inland Revenue or taxpayers are able to impute a loan and interest into agreements irrespective of whether the parties have negotiated or agreed an interest component.
6.6 The discussion which follows applies to both foreign currency and New Zealand currency agreements.
Policy rationale and history of the current law
6.7 The background to the current law is summarised in the statement in the Taxation Information Bulletin, Vol 7, No 9 (February 1996) outlined in chapter 3.
The FX loan component
6.8 The inclusion of any loan component in agreements is an inherent part of the policy purposes in the original accrual rules and is not disputed. The loan component was included in the policy makeup to apply when the parties include interest in the payments. The original policy discussion implies that any interest will apply when there are deferred payments (after the rights date).
FV/DV calculation of the value of property or services
6.9 When the tax treatment of these agreements was examined by the property consultative group in 1988, its conclusions emphasised that tax law should not impute/force interest into agreements where the parties did not contemplate there was any interest. The group noted that this was also the original policy outlined in the 1987 report of the consultative committee on the accrual rules. The group did acknowledge that any prepayments or deferral of payments would usually have a time value-of-money aspect. However, it emphasised that it was not up to tax law to force the recognition of interest if the parties considered there was no loan/interest in the agreements.
6.10 Despite this, a “back-up” alternative to calculate the value of the property in an agreement was provided, being the discounted value of amounts paid for the property in a determination made by the Commissioner. This may have been in response to a concern that there had to be a mechanism for interest to be recognised for tax when it had been hidden in the payments by the parties.
6.11 In 1999, the discounting alternative was enhanced to allow future valuing of payments made before the rights date so that the value could be calculated by using either the DV or FV methods, or a combination of both. The motivation for the change was the absence of a FV method to deal with prepayments when there was no agreed lowest price. It does not appear that there was a re-examination of the overall policy framework about the FV/DV alternative at that time.
6.12 The result is that the DV or FV method of calculating the value of property can be used when there is no lowest price agreed between the parties or they simply do not address it. The latter is very likely when non-residents are a party to the agreement and have no interest or knowledge of New Zealand tax matters.
6.13 A taxpayer may be able to choose to use the DV/FV alternative to get the best tax result for the agreement. When a foreign supplier is involved and there is a deferral of payment, the DV method could be used to always impute interest into an agreement. This situation is likely to be very common and could apply to any agreement for a term greater than 93 days, with those less than 93 days being excepted financial arrangements. Given that New Zealand is a net importer of capital equipment, the imputation of interest in these agreements is likely to work against the revenue base. For trading stock and services this is of less concern because of the short-term nature of the relevant agreements.
6.14 In reverse, Inland Revenue could attempt to impose interest on a DV/FV basis on any or all agreements over 93 days if it considered there was no agreed lowest price.
6.15 It is unclear how the policy development over the years has resulted in the current default approach being FV/DV in all cases. However, it appears that the current position goes beyond the original policy intent.
6.16 In its support is the concept that inherently there is a time value-of-money in all prepayments and deferred payments under these agreements. As well, the second alternative in the hierarchy of methods to value property or services in an agreement is the cash price if the agreement is a credit contract. That implies that payments in excess of the cash price are interest for tax in those cases.
6.17 It is also noted that IFRS GAAP will probably impute interest on a DV basis into long-term and large monetary liabilities resulting from these agreements in some circumstances when there are deferred payments.
6.18 We suggest that it is not appropriate that this method be potentially available for all agreements with a term greater than 93 days which are not for trading stock and where there is no recognition of interest in the agreement by the parties. If it were removed both Inland Revenue and taxpayers would not be able to impute interest into agreements on this basis.
How have overseas jurisdictions dealt with the FV/DV issue?
6.19 The tax treatment of deposits/prepayments and deferred payments in various overseas tax jurisdictions is illustrated in the following table and based on the following assumptions/facts:
- an agreement for purchase of equipment for $1,000 for delivery 12 months from the contract date;
- various alternatives ((a) to (e) below) for payment of the $1,000; and
- there is no “agreed lowest price” for New Zealand tax purposes which means either Inland Revenue or the taxpayer have the ability to impute interest into the contract on a FV/DV basis.
6.20 The table describes if there is a loan/s and interest for tax purposes in the five jurisdictions. IFRS GAAP treatment is essentially the UK tax treatment.
a. Pay in full at contract date
b. Pay in full at rights date
c. Payment deferred to 1 month after rights date
d. Payment deferred to 12 months after rights date
e. Progress payments up to and including rights date
6.21 New Zealand appears to be out of step with the other jurisdictions for scenarios (a), (c) and (e). Scenario (d) (payment deferred for 12 months (or longer)) seems to be in step with the other jurisdictions. The IFRS GAAP treatment will probably include interest on an effective interest basis in the case of scenario (d).
Suggested alternative treatments for the default FV/DV of payments approach to calculate the loan and interest components
6.22 We suggest the following options to deal with this:
- Eliminate the ability to use FV/DV altogether as an alternative available to impute interest into an agreement.
This option would remove the ability of both taxpayers and Inland Revenue to impute interest into agreements. Interest would only be included in agreements if the parties explicitly identified the interest component in the agreement. However, this is not our preferred option.
- Follow the IFRS GAAP treatment for agreements which may include the discounted value treatment of the amounts paid for the property/services in some cases when payments are deferred. This option would apply if the IFRS GAAP treatment of agreements is allowed for tax.
This option would retain the discounted value treatment of loans and interest to the extent it was performed for IFRS GAAP purposes. However, it would eliminate the ability of both Inland Revenue and taxpayers to impute interest into any or all agreements.
This outcome would still be consistent with the original policy intentions and be compliance-friendly.
- For non-IFRS taxpayers, modify the existing FV/DV rules to apply only in certain circumstances. For example, they would apply to significant prepayments for property which was in a substantially completed state or for services yet to be performed more than 12 months before the rights date, and to deferred payments made more than 12 months after the rights date.
This treatment would be in line with the suggested treatment for IFRS taxpayers and significantly reduce the imputation of interest into agreements when it is not appropriate.