Repeal of the substituting debenture rule
Clauses 38, 40, 51, 83, 84, 105 and 123(13) and (40)
Issue: Support for the proposal
(Corporate Taxpayers Group, Deloitte, Ernst & Young, KPMG, New Zealand Institute of Chartered Accountants, PricewaterhouseCoopers)
The submitters support the repeal of the substituting debenture rule.
That the submission be noted.
Issue: Transitional provision and application dates
(Ernst & Young)
The application date based on income years should be clarified and revised. Parties to the same debenture may have different balance dates. This could cause uncertainty where, for example, the issuer has a 30 June balance date and pays a “dividend” in April. Because the substituting debenture is still treated as a share from the issuer’s perspective, the payment is treated as a dividend and may be imputed. If the holder has a 31 March balance date, then the new regime will apply, the debenture will be treated as debt and the payment by the issuer will be treated as interest. There is uncertainty over whether the holder can use the imputation credit.
Officials considered two ways of dealing with the transition date:
- an “income year approach” where all instruments transition from equity to debt at the end of each affected taxpayer’s 2014–15 income year (the exact date of transition will therefore vary depending on the taxpayer’s specific balance date). This is the approach currently in the bill. The rationale for the income year approach is to make the transition as clean as possible for taxpayers and to prevent the need for potentially complicated part-year adjustments that may be required if a single date (such as 31 March 2015) was chosen. Under the income year approach, a taxpayer who is party to a substituting debenture will have an equity investment for the whole of the 2014–15 income year and a new debt investment for the whole of the 2015–16 and later income years. The income year approach does, however, have the disadvantage identified by Ernst & Young where the balance dates of the parties to the substituting debenture are different and there is a payment under the debenture (or some other event such as a remission/cancellation or repayment) in the period between their balance dates; or
- a “tax year approach” where all instruments transition from equity to debt at the end of the 2014–15 tax year – 31 March 2015. The tax year approach has the benefit of setting a single transition date for all taxpayers who are parties to substituting debentures and eliminates the potential for mismatches in debt/equity treatment between parties to the same arrangement. However, it does mean that some taxpayers may have a transition part-way through their income year which may increase compliance costs associated with what is intended to be a taxpayer-friendly measure.
Ernst & Young has not identified a preferred solution to the problem it has identified. One way of dealing with the submitter’s concern would be to include provisions specifying how payments (or other actions/events) under the substituting debenture should be treated where the parties’ balance dates do not align. This would add significant complexity to the legislation. The alternative would be to adopt the tax year approach.
Ernst & Young considers that the complexity and compliance costs of doing a part-year adjustment should be minimal (given people already have to calculate their outstanding principal at year-end). Accordingly, adopting the tax year approach should not make any taxpayers worse off and would solve a potential problem for parties to substituting debentures with non-aligned balance dates. This approach is also consistent with the goal of eliminating any potential tax treatment mismatches generally.
Officials therefore support adopting a tax year approach to the repeal of the substitution debenture rule and the transitional provision. This means that the substituting debenture rule will be repealed on 1 April 2015 for all taxpayers and the transitional provision will apply to deem a redemption of shares on 31 March 2015 and the advance of a new loan on 1 April 2015.
That the submission be accepted, subject to officials’ comments.
Issue: Transitional provision – clarifications
(Ernst & Young)
The “outstanding principal” concept in the transitional provision should be clarified to explicitly include any accrued but unpaid interest.
The transitional provision should clarify that the deemed repayment and re-issue of the debenture applies to both the issuer and the holder of the debenture.
Officials agree that these clarifications would be useful.
That the submissions be accepted.
Issue: Transitional provision – effect on shareholder continuity
(Ernst & Young)
Some debentures carry voting rights. When these debentures cease to be treated as shares for tax purposes, taxpayers could potentially suffer a shareholder continuity breach, thus forfeiting tax losses and/or imputation credits. Specific “savings” provisions are needed in relation to the measurement of voting interest in determining continuity for losses and imputation credits to ensure no adverse tax consequences arise.
Officials estimate it would be fairly unusual to have voting debentures that were originally held in proportion to equity, but have ceased to be so held such that their subsequent redemption could affect shareholder continuity. However, the repeal of the substituting debenture rule was not intended to have any adverse tax consequences, therefore a savings provision is appropriate.
That the submission be accepted.
Issue: Tailoring the transitional provision
(Corporate Taxpayers Group, New Zealand Institute of Chartered Accountants)
Corporate Taxpayers Group supports the transitional provision, however notes that there may need to be some amendments to ensure individual taxpayers are not adversely affected. Corporate Taxpayers Group expects affected taxpayers would submit separately on this matter.
New Zealand Institute of Chartered Accountants submits that the transitional provision should be tailored to ensure individual taxpayers are not adversely affected (for example, in relation to available subscribed capital (ASC)). New Zealand Institute of Chartered Accountants advises that officials are aware of how taxpayers could be negatively affected.
Officials note the submissions. Other submitters have drawn officials’ attention to the specific amendments needed to transitional provisions to ensure taxpayers are not adversely affected and these have been separately considered.
There have not been any submissions on how ASC may be affected. Officials considered the effect of the transitional provision on ASC in drafting the transitional provision. The transitional provision is intended to ensure that the deemed redemption – an “off-market cancellation” – of the “share” has the same tax consequences as the redemption of a non-participating redeemable share that is:
(a) no dividend arises to the “shareholder” to the extent the redemption payment does not exceed ASC; and
(b) the company’s ASC is reduced by the amount of the principal repayment (being a component of “returns” in the ASC formula in section CD 43(2)).
The original subscription for the “share” should have generated ASC equal to the loan principal and this should be sufficient to shelter the dividend arising on redemption. Assuming the full loan balance is outstanding at the transition date, the original ASC should be equal to redemption proceeds/principal repayment, and there should be no dividend and (appropriately) there should be a reduction in the ASC equal to redemption proceeds/principal repayment.
If the outstanding principal on the transition date is less than the amount originally lent (because some of the principal has been paid down), we would expect the ASC to have been reduced by previous loan repayments (that is, the ASC would have been used to shelter “dividends” arising from previous repayments). So, for example, if one hundred $1 debentures were originally issued, this would have generated $100 of ASC. If $30 has been repaid to date (treated as a cancellation of thirty $1 debentures), this repayment will not have been a dividend to the extent covered by ASC and, consequently, the ASC should have been reduced by $30. This means when the deemed repayment of $70 occurs on the transition date, the remaining ASC of $70 should shelter the dividend. The ASC will also be reduced by $70. If there was only a single debenture issued for $100, the previous $30 repayment cannot have been sheltered by ASC (because the debenture was not cancelled). This means that the $30 repayment would have been a dividend and ASC would not have been reduced by $30. On the transition date, because the debenture is cancelled, the $70 repayment is sheltered by ASC of $70 and this leaves the company with $30 ASC (which may only be applied in future to amounts paid in respect of shares of the same class).
That the submissions be noted.
Issue: Grandparenting of existing transactions
(KPMG, New Zealand Law Society, PricewaterhouseCoopers)
Some taxpayers may have deliberately issued substituting debentures and changing the tax treatment/classification of the debentures part-way through their life could have adverse consequences for issuers and investors. Some of these taxpayers may have sought binding rulings. While tax law is always subject to change, holders and issuers may have taken long-term positions based on the tax treatment at the date they entered into the transaction. A savings provision is therefore warranted to preserve the existing tax treatment (as equity) if the taxpayer so desires.
The substituting debenture rule is an anti-avoidance provision. It is slightly unusual for a taxpayer to structure into an anti-avoidance rule. However, the repeal is intended to be a taxpayer-favourable reform and was not intended to have any adverse consequences.
Accordingly, officials support the elective grandparenting of existing transactions on the following basis:
- The transaction must have been entered into before the introduction of the bill.
- The transaction must have been subject to a binding ruling which would continue to apply in the absence of the repeal of the substituting debenture rule (that is, the facts disclosed in the binding ruling continue to be correct for the entire term of the transaction and all ruling conditions met).
- An electing party must notify the Commissioner by 31 July 2014 that it elects to continue to treat the debentures as shares.
That the submission be accepted, subject to officials’ comments.