Chapter 4 - Defining when payments are to a related person

• Back-to-back loans
• Other multi-party arrangements
• Addressing the problem
• Acting together
• Application dates
  • Transitional treatment of existing financial arrangements
• Questions for submitters

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4.1 New Zealand borrowers that meet the requirements of section RF 12(1)(a) of the Income Tax Act 2007 can pay AIL on a payment of interest that is NRPI. When AIL is paid this NRPI qualifies for a zero-rate of NRWT.

4.2 The requirements of section RF 12(1)(a) include that the borrower is not associated[9] with the lender. The reason for this restriction is that related-party lending can be a substitute for equity from a parent and be used to increase interest deductions thereby reducing the taxable profit that would arise if the parent invested with equity. AIL at 2% on related party interest would be inappropriately low when that interest deduction reduced the New Zealand borrower’s taxable income, which is generally subject to a 28% or higher income tax rate.

4.3 We consider the current restrictions on related parties accessing the AIL rules are not sufficiently robust, which allows associated persons to structure into the AIL rules when the policy intention is that the interest payments should be subject to NRWT.

4.4 This chapter explores changes to ensure NRPI (including NRFAI as discussed in the previous chapter) paid directly or indirectly to an associated non-resident cannot access the AIL rules. These suggestions would also be used to determine whether NRFAI was generated by that arrangement.

Back-to-back loans

4.5 Unlike some other areas of New Zealand’s tax legislation,[10] the AIL rules do not look through to the ultimate lender to a New Zealand borrower. This allows a New Zealand borrower to interpose one or more third parties into what would otherwise be a loan from an associated person. An example of such an arrangement is a back-to-back loan.

4.6 Under the current legislation, subject to the potential application of the general anti-avoidance provision, a New Zealand borrower can claim it has borrowed from a non-associated third party and therefore access the AIL rules even when that third party has itself borrowed from a company that is associated with the New Zealand borrower.

4.7 In practice, due to the fungibility of money, it will often be difficult for Inland Revenue to identify specific funding flows through a third party.

4.8 However, we do not intend that all interest paid by a New Zealand borrower should be unable to access the AIL rules just because an associated person has deposited with or lent money to the person lending money to the New Zealand borrower.

4.9 The two main reasons for this are:

• the New Zealand operations of a worldwide group may only be a minor part of the entire operation. It would often be impractical for the New Zealand group entity to keep track of all worldwide financing decisions of their group to ensure no other part of the group had lent money to a person whom the New Zealand entity had borrowed from; and
• where a New Zealand company borrows from the same entity that another part of their worldwide group has deposited/lent money to without the New Zealand company’s knowledge, it is more difficult to argue that this funding is a replacement for equity funding that would have otherwise been provided to the New Zealand company.

Other multi-party arrangements

4.10 Arrangements have also been entered into which are not back-to-back loans in the conventional sense but which also involve the indirect provision of funding by a non-resident lender to a resident associated borrower without the imposition of NRWT, while maintaining an income tax deduction calculated under the financial arrangement rules. A typical structure involves:

• a loan from a New Zealand-resident bank to a New Zealand borrower. The loan is interest only with a bullet repayment of principal, and has a five year term; and
• shortly thereafter, the assignment by the bank of the right to receive the loan repayment on maturity to the non-resident parent of the New Zealand borrower. This assignment is contemplated at the time the loan is made.

4.11 In substance, this is a loan to the New Zealand borrower from:

• the bank, for an amount equal to the amount of the loan less the amount received from the non-resident parent for the assignment. This loan is repaid on a principal and interest basis (like a table mortgage) by way of the interest payments; and
• the non-resident parent, for an amount equal to the assignment price. This loan is in the nature of a zero coupon bond issued at a discount, where both “principal” and “interest” are repaid on maturity of the loan.

Addressing the problem

4.12 To deal with both back-to-back loans and other multi-party arrangements, officials suggest that payments by a New Zealand resident to another person be deemed to be in whole or in part NRPI paid to an associated person when the following requirements are present:

• a New Zealand resident (the borrower) is provided with funds by a lender (the direct lender) under a financial arrangement; and
• a non-resident associate of the borrower (the indirect lender) provides funds, directly or indirectly, to the direct lender in order for those funds to be passed on to the borrower; and
• an arrangement was entered into between any two of the borrower, the direct lender and the indirect lender or anyone associated with any of them, by virtue of which either provision of funds, or the terms of either provision of funds, is dependent on or related to the other provision of funds.

4.13 For purposes of determining the borrower’s liability to withhold NRWT, it would be treated as borrowing from the indirect lender the amount provided by the indirect lender (except to the extent not provided directly or indirectly to the borrower), and as paying to the indirect lender the total amount paid to the indirect lender under the arrangement (except to the extent not provided directly or indirectly by the borrower). Any excess of the amount paid to the indirect lender over the amount provided by them would be NRPI liable to NRWT, which the New Zealand borrower would have to pay. The deferral test described in Chapter 3 would be applied to determine whether the borrower would have to pay NRWT on the basis of NRFAI or interest payments.

4.14 Our suggestion is that this would also cover funding chains where there are multiple non-associated parties.

Acting together

4.15 The current association tests for accessing the AIL rules rely on the associated persons definition in subpart YB of the Income Tax Act 2007. One of the tests in the associated persons definition states that two companies are associated if a group of persons exists whose total voting interests in each company are 50% or more.

4.16 This means that where two or more companies each have ownership interests of less than 50% in a New Zealand borrower, these companies will not be associated with that borrower unless they are themselves associated.

4.17 There are many instances where this is a desirable outcome – such as portfolio investments in listed companies. For this reason we do not recommend general changes to the associated persons definition.

4.18 However, we are aware of a number of transactions where two or more non-associated persons (investors), each with less than 50% of ownership interests in a New Zealand borrower, together provide debt funding to that borrower under an arrangement. Even though these investors may be genuinely not associated (for example three pension funds with different owners) they may make decisions about the borrower collectively, and in economic substance operate in a similar manner as if they were a single owner.

4.19 By operating in this manner the investors can make decisions in a similar manner to a single owner such as inserting high levels of debt (subject to thin capitalisation requirements) in proportion to their ownership interests and thereby receive a return on their total (equity + debt) investment with a large portion of this being deductible in New Zealand.

4.20 This problem is not unique to the NRWT/AIL rules. Until recently, the same structure could be used without engaging the thin capitalisation rules. Before the recent amendments, two or more non-associated persons (investors) could put high levels of debt into a New Zealand borrower in a co-ordinated fashion without subjecting the borrower to the thin capitalisation rules, as each investor was not associated and did not own 50% or more of the borrower.

4.21 The 2014 amendments to subpart FE of the Income Tax Act 2007[11] introduced the definition of a non-resident owning body, and provided that if a New Zealand company was owned by a non-resident owning body, it would be subject to the thin capitalisation rules. A non-resident owning body includes a group of independent owners acting together to fund a New Zealand resident. A copy of this definition is included in Appendix 2.

4.22 We suggest introducing the same concept for purposes of determining whether interest paid by a New Zealand resident is paid to an associated person. Changes will be made to the concept to the extent necessary to reflect its different application.

4.23 The main change is that the non-resident owning body definition applies to a group of non-residents. The non-resident requirement is necessary for thin capitalisation but is not sufficient for the purpose of the AIL rules. Where a group of investors with a more than 50% share of ownership interests act together to fund a New Zealand borrower and one or more of those investors is a non-resident, that investor should not be able to access the AIL rules even when one or more of the other investors in that group is a New Zealand resident. Therefore the restriction on accessing the AIL rules will apply to non-resident members of a group that is acting together even where other investors in that group are New Zealand-resident.

Application dates

4.24 We suggest that the reforms outlined in this chapter apply to financial arrangements entered into on or after enactment of the legislation. This is expected to be in the second half of 2016.

Transitional treatment of existing financial arrangements

4.25 Financial arrangements entered into before the enactment of the legislation will be required to apply the new rules for income years following enactment.

4.26 As with the ideas explored in Chapter 3, there would be a rule to ensure that prepayments of financing expenses relating to income years following enactment are subject to NRWT.

9 Except by being a beneficiary of a trust established for the main purpose of protecting and enforcing beneficiaries’ rights under the registered security – this exception is not relevant for the purpose of this issues paper.

10 See for example section FE 18(3B)(b) of the Income Tax Act 2007 in relation to thin capitalisation, and article 11(4)(b) of the New Zealand/Australia DTA.

11 Enacted by the Taxation (Annual Rates, Employee Allowances, and Remedial Matters) Act 2014.