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Inland Revenue

Tax Policy

Chapter 3 - Core policy analysis

3.1 When the separate positions of the debtor and the creditor are considered in isolation from each other, it is understandable that we have ended up with the present associated persons asymmetric tax result.

3.2 Alternative suggestions to this debt remission rule were discussed by the Valabh Committee which suggested, among other things:[9]

[to] retain restrictions on [associated persons] bad debts deductibility but remove the inclusion of debt remission income in assessable income.

3.3 No legislative change resulted from this.

3.4 The 1977 discussion document canvassed aspects of debt remission, including associated persons debt remission, but again no legislative changes resulted.

3.5 Alan Judge’s 1997 paper, The accrual rules, prepared for the (then) Institute of Chartered Accountants of New Zealand (now known as Chartered Accountants Australia and New Zealand) tax conference that year contains the most comprehensive discussion of debt remission and debt capitalisation and potential avoidance concerns on pages 31–51. The points he made in both the context of associated persons debt remission and more generally include: “The varying treatment of debt remission and extinguishment in different circumstances is unsatisfactory”.

3.6 It seems fair to conclude that policy analysis of the combined result in related party debt remission has not been fully considered until now. Presumably this is because until recently, related party debt capitalisation was understood to be acceptable.

Economic consequence of certain related parties debt remission

3.7 Economically, it does not matter how related party debt is remitted – either by direct remission or indirectly via debt capitalisation. As long as the remission or capitalisation is pro rata by owners, or within a wholly owned group of companies, the outcome is the same – there is no net change in the owners’ wealth.

3.8 The best example of this is a wholly owned group of companies, where economically, the consolidated result or wealth of the owners of the group does not change because of a debt remission or debt capitalisation within the group.

Debt capitalisation inside a wholly owned group

3.9 Within a wholly owned group of companies, the financial reporting consolidated profit and loss and balance sheet result is the same at NIL. This consolidated financial reporting result directly reflects the economic result of the group as a whole, which is that the net worth or wealth of the group does not change as a result of debt remission where the debt has always been inside the group. See Example 10.

Example 10

Parent Ltd advanced wholly owned Sub Ltd a loan of $500. Sub Ltd’s trading was poor and Parent Ltd had to advance a further loan of $400 so Sub Ltd could pay off its third-party creditors. Sub Ltd now has shareholder funds of negative $900.

At this stage Parent Ltd has lost $900 (plus any equity investment in Sub Ltd).

Sub Ltd then capitalises the Parent Ltd loan of $900 into more shares. This capitalisation does not change the net wealth of Sub Ltd and Parent Ltd. Parent Ltd and Sub Ltd’s intra-company entries effectively cancel each other upon consolidation.

3.10 Further, if the parties are in the New Zealand tax base, debt and equity are generally economically substitutable.[10] This is certainly the case within a group of companies when viewed from the perspective of the group.

3.11 Within a wholly owned group there is a range of concessions and adjustments for intra-group transactions. Within a consolidated group there are even more. In general, these concessions and adjustments reflect the economic reality that the group (or consolidated group) is one economic unit.

3.12 Examples of these can be illustrated:

Intra-group transaction Wholly owned group Consolidated group
Dividends Generally exempt Exempt
Trading stock, livestock and excepted financial arrangements Intra-group profit not taxed Intra-group profit not taxed
Other revenue account property No special rules – intra-group profit taxed Intra-group profit not taxed
Financial arrangements Generally symmetric under ordinary rules, but no special treatment except for bad debt deduction prohibition Symmetric
Depreciable property No cost base uplift, but depreciation recovered/loss on sale are accounted for Transfer at TBV (cost and accumulated depreciation transfer)

3.13 Some of these results seem to be historical anomalies (for example, “other revenue account property”); others are more deliberate (“financial arrangements”, for example). However, given the general use of the consolidation regime, and the fact that it has never been seriously reviewed, there is no reason not to address apparent inconsistences, such as the rules around intra-group debt remission.

3.14 There also seems to be a public benefit argument – as previously noted, intra-group debt is often advanced to enable an otherwise insolvent subsidiary to pay off its third-party creditors – why should the tax system then penalise any subsequent rationalisation by way of debt remission or capitalisation?

3.15 Another policy question that has been asked is why should the timing of the equity contribution matter? It is not tax avoidance if it is put in at Day 1, but if put in later, it may be tax avoidance.

3.16 When an insolvent subsidiary is liquidated, under current practice the tax policy outcome is that no extra tax is payable – the policy question then arises over why the Income Tax Act should have a bias towards liquidation as an alternative to debt remission or capitalisation.

3.17 We conclude that the asymmetric debt remission tax result should not generally apply in the intra-wholly owned group situation when all companies involved are resident in New Zealand. This is because there is no change in the wealth of the group, and therefore no economic transaction to tax. The proposed outcome is illustrated in Example 11.

Example 11

Parent Ltd advanced wholly owned Sub Ltd $500. Sub Ltd’s trading was poor and Parent Ltd had to advance a further $400 so Sub Ltd could pay off its third-party creditors. Sub Ltd now has shareholder funds of negative $900.

At this stage Parent Ltd has lost $900 (plus any equity investment in Sub Ltd).

Sub Ltd then capitalises the Parent Ltd advance for $900 more shares. Under current tax law, and presuming that the avoidance was not incidental, Sub Ltd would have $900 debt remission income, which would also be the group result as Parent Ltd does not get a bad debt deduction.

The proposal put forward in this issues paper is to make the tax outcome symmetric.

Other related party debt remission

3.18 Under the OCTC analysis, a key issue on whether debt capitalisation may be reconstructed as debt remission is that the capitalisation does not result in any proportionate change in ownership. From a tax policy perspective, this extends to owners’ debt remission when the remission is pro rata around all owners. Thus other scenarios should be part of the discussion – for example:

  • a corporate debtor with a non-corporate New Zealand shareholder (individual or trust) who wholly owns his/her/its company and remits debt owing by the company to them;[11]
  • a corporate debtor with pro rata debt and equity held by New Zealand shareholders when the debt is remitted (or capitalised) pro rata;
  • a pro rata debt advanced by shareholders or partners when the debt is then remitted (or capitalised) pro rata; and
  • a non-resident corporate shareholder who wholly owns a New Zealand company (or group) when the debt is remitted (or capitalised).

3.19 Other scenarios exist (for example, a non-resident non-corporate with a wholly owned New Zealand company), but analysis of the four scenarios above should provide sufficient information to apply universally.

The corporate debtor, non-corporate single New Zealand shareholder scenario

3.20 In this scenario, the shareholder could be an individual or a trust. From the perspective of the shareholder, the shareholder’s economic wealth does not change because they have remitted debt owed to the shareholder by his/hers/its wholly owned company.

3.21 The analysis is similar to the wholly owned group debt capitalisation discussion immediately above, and the policy outcome follows as well – debt remission by the shareholder should not cause debt remission income in these circumstances. Example 12 illustrates this point.

Example 12

John has advanced a $500 loan to his wholly owned company, John Ltd. This loan is treated as a financial arrangement. Later, John Ltd has financial difficulties and the loan is remitted.

John Ltd derives $500 loan remission income from the BPA. However, John is denied a bad debt deduction because he is an associated person.

The proposal in this issues paper is to make the tax outcome symmetric.

3.22 However, care will have to be taken to ensure that any debt forgiveness by the company to a non-corporate shareholder is taxed, as it is, economically, a dividend.

Pro rata debt capitalisation when the debtor is a corporate

3.23 In this scenario, the company could be a corporate joint venture (JV) or similar, the shareholder debt is pro rata to ownership, is all held by New Zealand-resident shareholders, and the subsequent debt remission (either directly or via debt capitalisation) is also pro rata.

3.24 Again, economically, nothing has happened because from the owners’ perspective, all they have done is remit some debt, or swapped some debt for equity. The owners’ “consolidated” wealth has not changed from what it was before the debt remission or capitalisation. Again, the tax result should not be asymmetric, as shown in Example 13.

Example 13

Mike and Judy each own 50 percent of JV Ltd. They have also each advanced $500 to JV Ltd. JV Ltd trades unsuccessfully and Mike and Judy each remit the $500 debt owing to them by JV Ltd.

Under current tax law, JV Ltd would have $1,000 debt remission income, and Mike and Judy would be denied bad debt deductions.

The proposal is to make the tax outcome symmetric.

3.25 If a company remits debt owed by shareholders, this amounts to a return to owners – that is, the analysis works for owners’ debt advanced to the company, but not vice versa. This remission is, economically, a dividend.

Partners’ advances to partnerships

3.26 The term “partnership” in this paper includes look-through companies and limited partnerships.

3.27 This scenario presumes that an advance by a partner to a partnership can be a financial arrangement because the partner can have different capacities – one as an owner, and one as a lender of monies.

3.28 If the debt is a financial arrangement, similar debt remission issues are relevant – that is, when the debt is remitted or capitalised pro rata to the ownership of the partnership, there is (or for capitalisation, can be) an asymmetric debt remission income. Again, from a policy perspective, this tax result should not be asymmetric. See Example 14.

Example 14

Raewyn and Paul, equal partners in the R & P Partnership, have each advanced $500 to the partnership. In the circumstances, this is treated as a financial arrangement. Later, because the R & P Partnership is not trading well, Raewyn and Paul decide to capitalise the debt.

Under current tax law, unless the debt remission outcome is merely incidental, the R & P Partnership will derive BPA income of $1,000 but Raewyn and Paul do not get a corresponding tax deduction, even although their net wealth is unchanged.

The proposal is to make the tax outcome symmetric.

3.29 There is an associated question to this scenario. When partnership debt is not remitted pro rata by partners, there is a genuine transfer of wealth among the partners and debt remission outcomes apply. However, the question arises whether a partner-creditor that remits partnership debt (a non-deductible loss) should suffer their share of the associated remission income. This issue will be considered as part of a separate project.

Outbound investment into a wholly owned CFC

3.30 Remission of debt owed by a controlled foreign company (CFC) may result in an “active” CFC becoming “passive” from a tax perspective. If the CFC is passive, or becomes passive because of the remission, debt remission income will arise.

3.31 Conceptually, a CFC is inside the New Zealand tax base to the extent that it is owned by New Zealanders (ignoring FIF interests). However, the “active income exemption” effectively means its income is not actually subject to New Zealand taxation. This New Zealand tax-resident presumption can still reasonably be used so that when owners’ debt is remitted or capitalised pro rata to the owners, no remission income should arise for taxation purposes.

3.32 Our analysis indicates that this would not present any unexpected or inappropriate taxation results.

The non-resident inbound investment scenario

3.33 Analysis of this scenario is complicated because the creditor is not in the New Zealand tax base. When the owner/creditor is a non-resident and the debtor is New Zealand-resident, the use of related persons inbound debt is a key BEPS (base erosion and profit shifting) concern.

3.34 From the perspective of the owner, the owner’s economic wealth does not change because the owner has remitted debt owed to them by their wholly owned New Zealand subsidiary company. Also, the New Zealand tax base is no worse off, and may be better off, by not impeding the conversion of debt to equity because the obligation to pay (deductible) interest ranks higher than the obligation to pay dividends, and dividends are paid out after tax.

3.35 Alternatively, there is the question of whether this debt remission rule should buttress the current thin capitalisation boundary of 60 percent and therefore provide some base protection. If we allow debt remission/capitalisation in this context to be non-taxable, would that further encourage New Zealand subsidiaries of foreign companies to push the 60 percent debt/assets boundary by capitalising more debt when they are close to the boundary.

3.36 In this context, we have seen examples of debt capitalisation when a foreign-owned New Zealand company has been geared so that it has not been able to pay the interest owed. The interest has then been added to the company’s debt and subsequently effectively capitalised into equity. Taxing these capitalisations may dissuade this type of excessive gearing.

3.37 However, we acknowledge that it is arguable that both the thin capitalisation and transfer pricing rules should stand alone, and that it may not be principled to use the related parties debt remission rules to buttress them.

3.38 Policy analysis is still underway on this issue, but submissions on matters that taxpayers believe are relevant to this scenario are welcome.

Proposed solution

3.39 There are two ways the related persons asymmetric result could be resolved:

  • turning the debtor’s remission income off; or
  • allowing the creditor a deduction.

3.40 The first option seems more appropriate.

3.41 Inside a wholly owned group of companies the second option could cause problems if the debtor is liquidated as insolvent (with no taxation on the income). This would effectively allow a double deduction (the trading loss and the bad debt deduction) for a single economic loss – presuming that the liquidated company’s tax losses have been transferred around the group.

3.42 We therefore recommend that the debtor’s debt remission income is “turned off”.


9 Operational aspects of the accruals regime,: discussion paper, October 1991, pp 27–38.

10 The imputation regime generally produces this result.

11 Effectively scenario 4 of the draft QWBA avoidance scenarios.