Chapter 4 – Treatment of non-debt liabilities
4.1 This chapter proposes a change to how total assets are determined under the thin capitalisation rules. Currently the thin capitalisation rules are based on a firm’s gross assets; however, we consider that a better measure would be a firm’s assets net of its non-debt liabilities.
4.2 We consider that requiring this adjustment for non-debt liabilities would be more consistent with the core objectives of the thin capitalisation rules.
Background
4.3 New Zealand’s thin capitalisation rules are based on a company’s debt to asset percentage. A company’s assets are, in most cases, the value of its assets disclosed in its financial accounts. In contrast, a company’s debts for thin capitalisation purposes are much narrower than its liabilities for accounting.
4.4 Debt in the thin capitalisation rules is limited to financial arrangements that provide money and that give rise to deductions under the financial arrangement rules.
4.5 The remaining liabilities on a company’s balance sheet (its non-debt liabilities) do not count as debt for thin capitalisation purposes. Examples of non-debt liabilities are trade credits, provisions, out-of-the-money derivatives and interest free loans.
Example 3
ABC Co has the following balance sheet:
| Assets | 100 |
| Debt | 60 |
| Shareholder capital | 40 |
ABC Co’s current thin capitalisation ratio is 60 per cent – reflecting that its assets are 60 per cent funded with debt and 40 per cent funded with equity.
Say ABC Co makes an after-tax profit of $50. Its balance sheet then becomes:
| Assets | 150 |
| Debt | 60 |
| Retained earnings | 50 |
| Shareholder capital | 40 |
ABC Co’s thin capitalisation ratio falls to 40 per cent, reflecting its higher level of assets and equity. ABC Co could pay out a dividend of up to $50 without breaching the thin capitalisation safe harbour.
Say instead ABC Co makes an after-tax loss of $25. Its balance sheet would become:
| Assets | 75 |
| Debt | 60 |
| Retained earnings | (25) |
| Shareholder capital | 40 |
ABC Co’s thin capitalisation ratio would increase to 80 per cent. It would have to pay down some of its debt, inject more equity, or face interest denial on some of its debt.
The problem
4.6 We are concerned that this treatment of non-debt liabilities is inconsistent with the core objectives of the thin capitalisation rules. At present the rules limit an entity’s debt relative to its gross assets. However, we consider that a better basis for the rules is to limit debts with reference to its assets net of its non-debt liabilities (its net assets) – which is the same as its equity plus its interest-bearing debt.
4.7 The thin capitalisation rules have three interrelated objectives:
- to restrict companies’ interest deductions to interest on only a commercial level of debt;
- to ensure that only a reasonable portion of a multinational’s worldwide debt is allocated to New Zealand; and
- to restrict the ability for companies to shift profits out of New Zealand using interest.
4.8 These three factors all suggest that net assets, rather than gross assets, would be a better basis for the rules.[18]
Commercial debt levels
4.9 The thin capitalisation rules are intended to, in part, restrict the level of deductible debt to the amount a third-party would lend to an entity on reasonable terms (that is, a commercial level of debt).
4.10 In reality, third-party lenders consider numerous factors when considering how much to lend. However, the nature of thin capitalisation rules means only a single factor can be considered: the value of an entity’s assets.
4.11 We consider that third-party lenders would be more concerned with an entity’s net assets than its gross assets. The presence of non-debt liabilities reduces the assets the company may have available to repay its debt. The existence of non-debt liabilities may also impact on a borrower’s solvency and therefore whether it can continue to trade.
4.12 Measuring a company’s assets net of non-debt liabilities seems more consistent with the objective of ensuring commercial levels of debt.
Worldwide apportionment
4.13 Multinational companies often borrow from external parties through a central treasury function. The central treasury then on-lends funds as needed across the multinational’s operations.
4.14 The purpose of the worldwide test in New Zealand’s thin capitalisation rules is to ensure that the amount of debt that has been on-lent to New Zealand is a reasonable portion of the multinational’s total debt, having regard to the relative size of its New Zealand operation. Interest deductions are denied if it appears too much debt has been placed in New Zealand.
4.15 The treatment of non-debt liabilities is relevant when considering the relative size of a multinational’s New Zealand operation. Again, we consider that the best approach is based on net assets. This is because, as discussed above, we consider net assets to be a better measure of a company’s commercial borrowing ability than gross assets. It is therefore a better measure of how the multinational’s total debt should be spread across all its operations.
Restrict profit shifting
4.16 The final objective of the thin capitalisation rules is to prevent companies from shifting profits out of New Zealand through excessive interest deductions.
4.17 An increase in a company’s non-debt liabilities with no change in its debt liabilities will also bring about an increase in its assets or a reduction in its equity. If equity is reduced, this means that the company’s shareholders’ investment in the company has decreased. However, at present this decrease has no impact on the allowable level of debt under the thin capitalisation rules.
4.18 Alternatively, if assets increase, the level of allowable debt increases even though the shareholders have not increased their investment in the company.
4.19 We are therefore concerned that the current treatment of non-debt liabilities means companies are able to have high levels of debt (and therefore high interest deductions) relative to the capital invested in the company by shareholders.
4.20 We are also concerned that this treatment does not produce equal outcomes across companies. As illustrated below, firms earning the same level of profit or loss can have very different thin capitalisation outcomes, depending on their non-debt liabilities. In addition, some companies naturally have high levels of non-debt liabilities, such as distributors that generally have large trade payable balances. The current treatment of such liabilities under the thin capitalisation rules means a much smaller percentage of the company’s assets need to be funded with shareholder equity compared to a company with no non-debt liabilities.
Example 4
Mining Company has the following balance sheet:
| Assets | 100 |
| Interest bearing debt | 60 |
| Shareholder capital | 40 |
Mining Company opens a mine and earns $100 after tax; however, in the future Mining Company will be required to close the mine at a cost of $50 (which it records as a provision in its accounts). Its profit is therefore $50, and its balance sheet will be:
| Assets | 200 |
| Interest bearing debt | 60 |
| Non-debt liability – provisions | 50 |
| Shareholder capital | 40 |
| Retained earnings | 50 |
Mining Company has made $50 profit and so is $50 more valuable. However, at present the thin capitalisation rules treat the company as if its value has increased by the full $100 cash it has earned, so its thin capitalisation ratio falls to 30 per cent (= 60/200). The company would be able to distribute its $100 of earnings without breaching the safe harbour (that is, pay out its $50 profit plus reduce shareholder capital to -10).
This is in contrast to ABC Co in Example 3, which also made $50 after-tax profit. However, in that case ABC Co was only able to distribute its actual profit of $50 before breaching the thin capitalisation safe harbour. The treatment of non-debt liabilities is not neutral across firms.
If instead the thin capitalisation rules were based on net assets, Mining Company’s thin capitalisation would have fallen only to 40 per cent (= 60/(200 – 50)). Accordingly, the company would only be able to distribute its actual profit of $50 without breaching the thin capitalisation safe harbour.
Example 5
Instead, say Mining Co had opened a mine and earned $25 after tax. As above, however, it would be required to close the mine at a cost of $50 in the future.
Mining Co would have an after-tax loss of $25. However, this is not captured in the current rules. Mining Co’s thin capitalisation ratio would fall to 48 per cent (= 60/125). It would be able to distribute its $25 of earnings (effectively withdrawing $25 of shareholder capital) without breaching the safe harbour.
This is in contrast to ABC Co in example 4, which also made a loss of $25. However, in that case ABC Co’s thin capitalisation ratio increased to 80 per cent. It would have had to repay some of its debt, received an equity injection, or would face interest denial on some of its debt.
Example 6
Say Distributor Co has the following balance sheet:
| Cash | 30 |
| Other assets | 70 |
| Interest bearing debt | 60 |
| Retained earnings | 30 |
| Shareholder capital | 10 |
Distributor Co’s thin capitalisation ratio is 60 per cent.
Distributor Co then acquires $30 of trading stock, which it purchases on trade credit. At the same time, Distributor Co pays out its retained earnings. Its balance sheet is now:
| Cash | 0 |
| Other assets | 100 |
| Interest bearing debt | 60 |
| Non-debt liability – trade credits | 30 |
| Retained earnings | 0 |
| Shareholder capital | 10 |
Under current rules Distributor Co’s thin capitalisation ratio is still 60 per cent, even though its owners have withdrawn $30 of their capital from the company.
If, however, the thin capitalisation rules were based on net assets, Distributor Co’s thin capitalisation ratio would increase to 86 per cent (= 60/(100 – 30)).
Proposal: non-debt liability adjustment
4.21 We propose that a company will be required to measure its assets net of its non-debt liabilities.
4.22 For a company’s New Zealand group, we propose defining non-debt liabilities as:
- all liabilities (as shown in the company’s financial accounts) that are not counted as debt under section FE 15; less
- any interest-free loans from a shareholder in the group, or person associated with a shareholder, as such a loan is more akin to equity.
4.23 We propose a similar definition of non-debt liabilities for a company’s worldwide group, being:
- all liabilities (as shown in the company’s financial accounts) that are not counted as debt under section FE 18; less
- any debt that is excluded from being counted under section FE 18(3B), as such debt is effectively treated as equity for the purposes of the worldwide group debt test.
Example 7
Z Co’s balance sheet is as follows:
| Assets | 100 |
| Interest-bearing debt | 20 |
| Non-debt liability – trade credits | 10 |
| Interest free loan from parent | 20 |
| Equity | 50 |
Under the proposed change, Z Co’s thin capitalisation ratio would be 22 per cent.
Its debt for the purposes of thin capitalisation rules is $20. Its total liabilities are $50, but $20 of this is an interest-free loan from Z Co’s parent company. Its non-debt liabilities are therefore $10 and its thin capitalisation calculation is 20/(100 – 10).
International comparison
4.24 Like New Zealand, Australia has thin capitalisation rules that limit a company’s deductible debt based on a debt to asset test. However, unlike in New Zealand, Australia requires assets to be measured net of non-debt liabilities.
4.25 Indeed, New Zealand’s approach to basing a thin capitalisation rule on gross assets, rather than net assets or equity (which are equivalent),[19] appears to be unique. A recent study by the IMF[20] looked at 28 countries with thin capitalisation rules. It shows that, apart from New Zealand, all countries base their rules off either net assets or equity.
4.26 This reinforces our view that the proposed adjustment for non-debt liabilities is appropriate.
Impact of the proposals
4.27 We do not expect this change to affect most companies, who either have low levels of non-debt liabilities, low thin capitalisation ratios, or both. However, we expect that as a result of this proposal, a small number of companies will face interest denial without a reduction in the level of debt, or injection of new equity.
4.28 As discussed in chapter 5, we do not propose to grandparent existing arrangements. As with previous changes to the thin capitalisation rules, we consider that the delayed application of these proposals will give companies sufficient time to rearrange their affairs as required.
4.29 As noted above, certain types of companies – such as distributorships, mining companies, and insurance companies, tend to have relatively large non-debt liability levels. We have considered whether specific rules are required for any industry but have concluded they are not necessary. We note that Australia does not have special rules for these industries.
18 The exception to this is interest-free loans from a parent or other associated person as they are in substance equity.
19 Assets = debts + non-debt liabilities + equity, or A = D + NDL + E. This means that if a country has a D/E limit of 1.5, this is the same as requiring equity to be at least (A-NDL)/2.5. This is equivalent to limiting debt to 60 per cent of A-NDL.
20 Blouin, J, Huizinga, H, Laeven, L, and Nicodeme, G, Thin Capitalisation Rules and Multinational Firm Capital Structure, IMF Working Paper WP/14/12.