Non-resident owning body
Issue: General comment on the definition
(New Zealand Institute of Chartered Accountants, Corporate Taxpayers Group)
Whether a company owned by several non-residents will be subject to the thin capitalisation rules will turn on the definition of a “non-resident owning body”.
This definition is too vague. A significant degree of uncertainty exists about how the tests will apply in practice to the various forms of investment vehicles and commercial arrangements that are commonly used by international investors. (New Zealand Institute of Chartered Accountants)
If appropriate clarity cannot be provided in the definition of “non-resident owning body”, the concept should be removed and replaced with a rule that specifies that the thin capitalisation rules would apply to all companies where non-residents in aggregate hold greater than 50 percent of a company (with carve-outs for widely held companies). (Corporate Taxpayers Group)
Officials have recommended several amendments to the definition of a “non-resident owning body”. These changes should increase certainty over when a group of non-residents will form a non-resident owning body.
Based on this, officials do not believe it necessary (at this stage) to replace the concept with a broader rule as suggested by the Corporate Taxpayers Group. However, we will continue to monitor the application of these rules to ensure they are working appropriately.
That the submission be noted.
Issue: Use of “ownership interests” and “direct ownership interests”
(Ernst & Young)
The definition of “non-resident owning body” currently refers to members that have debt in a company in proportion to either their ownership interests or direct ownership interests in the company. This could potentially create confusion as the definition of “ownership interests” includes direct ownership interests.
The reference to both ownership interests and direct ownership interests is intentional. The provision is intended to catch situations when, for example, a non-resident has debt and equity in the same proportion as other shareholders when considering their direct ownership interests, but not their indirect ownership interests. This might arise if, say, the non-resident also had a minor shareholding through a subsidiary.
That the submission be declined.
Issue: Use of the term “approximately”
(Corporate Taxpayers Group, Deloitte, Ernst & Young, KPMG, New Zealand Institute of Chartered Accountants)
The definition of “non-resident owning body” includes non-residents that hold debt in a New Zealand company that is approximately in the same proportion to the equity they have in the company. While it is clear that the drafting is trying to catch situations where taxpayers have structured their affairs to intentionally avoid the application of the section, the language is too vague and provides no real guidance on what constitutes “approximate proportionality”. The wording should be made more certain.
As submitters have correctly noted, the purpose of the word “approximately” was to capture situations where taxpayers have structured their affairs intentionally to avoid having proportionate debt and equity, such as having debt and equity that are very close, but not exactly, in proportion.
Officials consider more certainty could be provided by omitting the word “approximately” and changing the rule so that:
- it works off proportionality of any of the four kinds of ownership interest, so non-residents cannot say, have proportionate rights to receive income from the company but slightly different voting rights; and
- a specific anti-avoidance provision is included, providing that an arrangement that has the purpose or effect of defeating the intention of the proportionality rule can be disregarded.
This type of wording proposed for the specific anti-avoidance provision is found in several places throughout the Income Tax Act – including elsewhere in the thin capitalisation rules (section FE 11). This similarity in wording should help provide guidance on when the rule might apply.
The modified test is also more certain as it invokes the purpose of the proportionality rule. That is, to target situations where taxpayers are entitled, in substance, either directly or indirectly, to the same proportion of dividend income and interest income from a company.
That the submission be accepted.
Issue: Proportionality does not imply acting together
The issues paper on the thin capitalisation changes in the bill stated that a key issue was non-residents who can “collectively act in the same way as an individual controlling shareholder”. This concept is not reflected in the definition of “non-resident owning body”. One of the key tests in that definition is whether shareholders hold debt and equity in the same proportion. This is not an indication of acting together. There could be many situations where shareholders hold debt in proportion to their equity but have no effective interaction with each other.
The thin capitalisation rules are designed to apply to companies with shareholders who have the ability to easily manipulate its debt levels or use debt funding in place of equity funding.
When there is proportionality, the level of debt in a company does not change shareholders’ exposure to the risk of holding equity in the company or shareholders’ overall return. As debt levels increase, the makeup of the return will change (fewer dividends and higher interest payments) but the sum of interest and dividends will be unchanged. Proportionality is therefore a key situation where shareholders have the ability to replace equity with debt.
It is also arguable that at least some degree of coordination among shareholders is required in order to arrive at proportionate debt and equity. Indeed, many of the investment structures looked at by Inland Revenue involving non-residents that appear to be acting together have involved proportionate debt and equity.
Accordingly, officials consider proportionality to be a reasonable indicator of when non-residents are acting together, albeit an objective test rather than a subjective one.
That the submission be noted.
Issue: Shareholder agreement clause is too wide
(Corporate Taxpayers Group, Ernst & Young, KPMG, New Zealand Institute of Chartered Accountants, New Zealand Law Society, PricewaterhouseCoopers, Russell McVeagh, Staples Rodway)
A non-resident owning body includes a group of shareholders in a company who fund the company under an agreement amongst themselves (such as a shareholder agreement).
The provision should be changed to refer explicitly to debt funding and exclude provisions relating to borrowing from third parties or equity funding. The provision should be targeted at agreements that set out how the shareholders will act together to fund the entity with related-party debt.
It is common for investors to enter into a shareholder agreement. Doing so should therefore not be an indication of shareholders acting together. The rule will also have high compliance costs. Determining whether the words used in a shareholders’ agreement constitutes an agreement of how an investment is to be funded may be difficult. This in turn may lead to taxpayers explicitly avoiding clauses on funding in their agreements to circumvent the test. (Staples Rodway)
The bill Commentary states that an agreement that sets out how an investment should be funded in the case of a specified event will not constitute meeting this provision if or until that event happens. This is not clear in the proposed legislation. (Corporate Taxpayers Group, New Zealand Institute of Chartered Accountants)
Officials agree that the shareholders’ agreement clause in the definition of “non-resident owning body” could be tightened along the lines suggested by submitters. The area of greatest concern is when non-residents have acted together when deciding how to fund the entity with related-party debt or guaranteed debt. Such an agreement would allow the shareholders to easily use debt in place of equity to fund the New Zealand company, or to put debt that truly belonged elsewhere into the company.
Officials recommend that an agreement between shareholders should create a non-resident owning body only if the agreement sets out how a company will be funded with owner-linked debt (as defined by proposed section FE 18(3B)).
Officials disagree with the submitter than a shareholders’ agreement should not be an indication of shareholders acting together. The presence of an agreement between shareholders demonstrates that they are coordinated.
This submitter also raised the possibility that taxpayers may structure arrangements to intentionally avoid the application of this rule. Officials will monitor this and will strengthen the rule if necessary to prevent taxpayers structuring to avoid its application.
Finally, officials agree that the exclusion for contingent funding clauses in a shareholder agreement is not clear in the current drafting. This should be made more explicit.
That the submission be accepted, subject to officials’ comments.
Issue: Rights exercised as recommended by a person
(Corporate Taxpayers Group, Ernst & Young, KPMG, New Zealand Institute of Chartered Accountants, New Zealand Law Society, Russell McVeagh)
A non-resident owning body also includes a group of non-residents who exercise their ownership rights in a New Zealand investment in a way recommended by a person, or where a person acts on the group members’ behalf to exercise their ownership rights.
These provisions are uncertain and potentially excessive. Arguably the provisions could apply if the ownership rights were exercised as recommended by a person on only one occasion in relation to any matter, no matter how insignificant or immaterial. (Ernst & Young)
At the least, guidance needs to be provided on what “in a way recommended by a person” means. (KPMG)
The provisions could be satisfied if shareholders exercised their rights consistent with recommendations of a company’s board of directors, or if several shareholders appointed the same proxy for the purposes of a given resolution. (New Zealand Law Society, Russell McVeagh).
Our understanding is that all members of a non-resident owning body would need to be taking recommendations from the same person. This is not clear in the legislation. (Corporate Taxpayers Group)
Would a private equity firm promoting a particular investment to a group of non-resident investors be caught under these provisions? Similarly, a private equity manager may manage an underlying investment vehicle but this should not be taken as managing the underlying business. These provisions should be changed to apply only when a group of non-resident investors are required to act on the instructions of a person. (Ernst & Young)
These provisions should be changed to refer to situations when a company is “effectively coordinated by a person or group of people”. (New Zealand Institute of Chartered Accountants)
Officials believe these provisions could be amended in a similar manner to those relating to shareholders’ agreements. The provisions would only apply if shareholders exercise their rights on the recommendations of a person, or a person acts on shareholders’ behalf, in relation to owner-linked debt.
This would significantly increase certainty over when the provisions apply and ensure they do not apply in relation to small or trivial matters. This amendment should also ensure that an investment manager managing their fund will not be misconstrued as managing an underlying business they own, unless the investment manager directs their members on how to debt-fund the underlying business.
Officials do not agree that the provision should be changed to refer to when a group of non-resident investors are required to act on the instructions of a person. This would make the provision too narrow.
It is the intention of this section that all members of a non-resident owning body need to be taking recommendations from the same person in order for the provision apply. The submitter’s comment to clarify this will be passed to the bill drafters.
Officials do not believe it necessary to change the specific wording of the section to where investors are “effectively coordinated”. The current wording, together with the other changes to these provisions, should clearly encapsulate when the provisions should apply.
That the submissions be accepted, subject to officials’ comments.
Issue: Exclusion for security interests is appropriate
(New Zealand Institute of Chartered Accountants)
The bill proposes that a trust will be subject to the thin capitalisation rules if a person who is themselves subject to the rules has the power to appoint or remove the trustees of that trust. However, there is an exclusion to this rule if the person holds the power to change trustees as a security interest over a loan. This exclusion is appropriate.
Officials agree. Having the thin capitalisation rules apply to trusts where a person has the power to appoint trustees as a security interest could result in overreach. We understand it is common for banks to request this type of security when lending to a trust. Without the exclusion, a trust that is wholly settled by a New Zealand resident may become subject to the rules if it borrowed from a non-resident owned bank. That would be inappropriate.
That the submission be noted.