Commentary on parts of the act - F to G

Commentary on parts F to G of the Income Tax Act 2007.

Part F - Recharacterisation of certain transactions

Part F in the 2007 Act contains a range of provisions related to:

  • apportionment rules for cross-border transactions;l
  • modifications to the interest deductibility rules for certain types of debentures and, under thin capitalisation rules, some foreign-owned organisations and banks;
  • rules for consolidated companies when calculating their income tax liability for a tax year;
  • rules for determining how groups of companies use imputation credits; and
  • modifications to the tax treatment of certain transfers of property and financial arrangements under a relationship agreement or upon death.

If a "modification" rule in Part F applies, a taxation effect that is different from one that would be produced under Parts C to E generally follows.

Apportionment was one of the functions ascribed to Part F in the 2004 Act." But as Part F does not generally perform this function in the 2007 Act, a number of apportionment rules have been moved closer to their related provisions in Parts C, D and E." Examples of apportionment rules moved to a different location in the 2007 Act are:

  • section FB 2, which contains an apportionment rule for tax credits for foreign income tax and a source rule: the apportionment rule for tax credits has been moved to subpart YD (Residence and source in New Zealand); and
  • section FB 7, which is an apportionment rule relating to depreciation, has been moved to subpart EE, making this rule easier to access.

Despite apportionment provisions being located close to their relevant rule, Part F retains the apportionment rules relating to interest deductibility on thin capitalisation." The complexity and detail of these rules has led to retaining them in Part F, rather than moving them to Parts" C and D.

Subpart FA contains rules that alter the tax treatment of certain commercial arrangements by either:

  • recharacterising the nature of, or amounts derived under, the arrangement (see for example, section FA 2 which recharacterises the nature of the arrangement by treating a debenture as shares for income tax purposes); or
  • providing a different form of tax treatment for the parties to the arrangement (see for example, section FA 5 which alters the tax treatment of the party to the transaction).

Section FA 5 is intended to claw back deductions for lease payments that are effectively payments of the purchase price of the lease asset." This rule applies when an asset is leased under an operating lease, and the lessee acquires the asset at the end of the lease, and then sells the asset to a third party." As a result of this sale, the lessee has an amount of income equal to the amount of deductions allowed for the lease payments but only for any profit derived on that sale.

Subparts FB and FC contain the rules that provide for the income tax treatment on transfers of certain property - that is, transfers made under certain settlements of relationship property, and certain transfers of property after the death of the owner of the property.

The thin capitalisation rules that apportion certain interest expenditure between income derived from New Zealand and other income are contained in subpart FE and are directed at:

  • a New Zealand taxpayer who is subject to a certain level or type of foreign control; or
  • a foreign-owned bank that has a lower than prescribed level of equity.

A company's conduit tax relief may be restricted under subpart FF by an amount that correctly reflects the interest deductions of the company that relate to the assets that produce the conduit tax-relieved income.

Subpart FL deals with the income tax consequences when a New Zealand-resident company changes its residence to another country and loses its New Zealand residence.

Subpart FM draws together most of the rules for entry into a consolidated group and the tax treatment of certain transactions between member companies of a consolidated group." However, tax loss rules for consolidated groups are located in subpart ID because of their interrelationship to the more general loss rules in Part I.

Despite this general drafting approach, the application of some specific anti-avoidance rules to a consolidated group has been retained in subpart GB." The consolidated group rules relating to memorandum accounts have been retained in Part O (Memorandum accounts) as they are so closely related with the general rules in that Part.

Subpart FN applies when two or more companies that are part of a wholly owned group of companies form an imputation group to enable a company in the imputation group to pay an imputed dividend when another company in the imputation group has a credit for New Zealand tax paid." This subpart also includes the rules relating to trans-Tasman imputation groups.

Amalgamations involving only New Zealand-resident companies that are not dual resident and do not derive only exempt income are dealt with in subpart FO." These rules generally provide for no income tax consequences on the transfer of property and novation for liabilities that occur under the amalgamation.

Drafting improvements in Part F

A reference to debentures issued before 30 August 1940 contained in section FC 2 of the 2004 Act has been omitted from section FA 2 (Recharacterisation of certain debentures) as it is unlikely that debentures from this time would still exist.

Sections FA 6 and FA 12 (which relate to amounts derived under finance leases or hire purchase agreements) are clearly linked to the valuation provisions in the financial arrangement rules." This link makes explicit how a lessee determines their cost base for a lease asset for all purposes of the Act and simplifies the drafting of the lease and hire purchase rules.

An ambiguity in section FC 10(4) of the 2004 Act has been clarified in section FA 18(3) (Treatment of amounts paid in income years after agreement ends) by making it clear that the expenditure incurred by a lessee from hire purchase payments refers just to the interest component of those payments.

In section FB 13 (Trading stock), the period to which the provision relates has been changed from "tax year" (31 March) to "income year" (31 March or approved alternative balance date)." This change was necessary to ensure that the provision aligns correctly with the trading stock provisions in Part E, which are based on the income year rather than the tax year.

Section FB 16, which rewrites section FF 10 of the 2004 Act, removes repetition of language contained in section EC 31 of the 2004 Act.

In sections FB 19, FB 20 and FB 21 (which relate to leased assets, mining assets and depreciable property), the transfer values have been rationalised with the depreciation provisions by using the defined terms "adjusted tax value" and "base value".

In section FB 21(7), the relationship with the depreciation provisions has been clarified to show that subsection (7) applies only for the purpose of determining the correct depreciation rate.

Under the thin capitalisation or conduit rules, a person may have a reduction in the amount of interest that is taken into account in determining his or her net income for a tax year." This adjustment is structured as an amount of income in section CH 9, with the detailed calculation retained in section FE 6." No change in outcome is intended from the 2004 Act.

The consolidated company rules are set out in subpart FM and the amalgamation rules are located in subpart FO." Moving the rules together into one Part supports the overall objective of the Rewrite project of reducing compliance costs.

Intended changes in Part F

Section FA 3 - Share dealing

Section FA 3 rewrites section FC 3 of the 2004 Act." The section is an old provision, introduced in 1959 in response to sales of shares involving a dividend-stripping arrangement structured to create a loss on sale for tax purposes.

This rule deals with the situation where a person enters into an arrangement to buy shares on revenue account, strips out a dividend from those shares, and then sells them." In the absence of section FC 3, the person would be able to generate, for income tax purposes, a loss on the sale of those shares which would then be taken into account determining the person's net income for the tax year." This outcome offsets the artificially created loss against assessable income.

This rule was originally enacted in 1959 (as section 136A of the Land and Income Tax Act 1954) to deny the loss for tax purposes." The rule was also drafted to ensure that the dividend continues to be treated as it normally would, for tax purposes, under the dividend rules.

An ambiguity in the proviso to the 2004 Act was identified in the rewrite of this provision." This ambiguity potentially allowed the "stripped-out" dividend to be counted twice in applying the proviso, and would have resulted in the rule being largely ineffective.

The intended change clarifies that the "stripped-out" dividend is counted only once in applying the rule." This is achieved in section FA 3 by creating an amount of income no less than the stripped dividend but no greater than the artificial loss arising because of the dividend stripping arrangement." The effect of this rule is that the income created effectively "offsets" the loss on sale created through the dividend-stripping arrangement.

Sections FA 5(6) and FA 9(3) - Finance leases and operating leases

The lease rules in sections FC 5 and FC 8E of the 2004 Act provide that when a leased asset is disposed of to a person who is associated with the lessee of that asset, and that associated person then disposes of the asset, the lessee is taxed on any profit on disposal." The policy intent of this rule is to ensure that the disposal rules applying to the lessee cannot be circumvented through transactions with associated persons." However, these rules are not clear about when the test of association applies.

Sections FA 5(6) and FA 9(3) place this test of association at the time the leased asset is disposed of to the associated person.

Transfers of property on death

Sections FC 2 to FC 6 have been drafted to make it clear that the transfer on death to the executor/administrator and the subsequent transfer from the executor/administrator to the estate are treated as one transfer.

Part G - Avoidance and non-market transactions

Part G contains two types of provisions - those dealing with avoidance, and those dealing with certain transactions treated as taking place at market value.

Two structural matters were identified in rewriting Part G:

  • It was not entirely clear in what circumstances a provision's anti-avoidance nature merited locating it in Part G." In many cases, technical base-maintenance remedial provisions could be viewed as dealing with matters of avoidance.
  • As other Parts of the Act also contain many provisions treating transactions as occurring at market value, the rationale for having valuation provisions in Part G was unclear." As a result, the provisions proposed to be retained in Part G are those that do not have a suitable alternative location or which have an anti-avoidance element.

The rewritten legislation locates in subparts GA and GB only those provisions that, in broad terms, apply to arrangements that are aimed at avoiding tax.

Subpart GC contains the rules that provide for the substitution of market value for the values adopted in a transaction where, in policy terms, the market value is regarded as being the more appropriate outcome.

Drafting improvements in Part G

Subpart GA contains the rules giving the Commissioner the general power to adjust a person's income tax liability when an arrangement is void under section BG 1.

Section GA 1 rewrites section GB 1(1) to (2C) of the 2004 Act." The drafting is simplified to refer to an adjustment in any way to taxable income." This approach is consistent with the law in section 99 of the 1976 Act and section BG 11 of the 1994 Act (before enactment of the Taxation (Core Provisions) Act 1996)." The amendments to section BG 1 by the Taxation (Core Provisions) Act were intended to complement the global/gross approach adopted in the core provisions, rather than change the outcomes under the law.

While there have been some drafting changes to this provision, there is no intention to change the outcome." For example, the section no longer contains the words "without limiting the generality of the preceding subsections" as these words seemed to have no practical effect on the Commissioner's powers under the section.

Section GA 2 rewrites section GB 17B of the 2004 Act." This provision permits an adjustment to a person's excluded income, which is affected by an arrangement altering the incidence of FBT.

In a number of sections in subpart GB, objective tests replace a discretion to be exercised by the Commissioner." Having the application of these provisions rely on an objective test provides an improvement in the relationship and consistency with self-assessment." For example, section GB 4 (Arrangements for grouping tax losses: companies) no longer requires the Commissioner to form an opinion on whether the section applies but provides a list of objective tests for the application of the section." Other examples are sections GB 6, GB 33, GB 36(1) and"GZ 1.

Section GB 26(3) (Arrangements involving repatriation of commercial bills) makes explicit the time of the "deemed" redemption as the time at which the actual redemption was originally provided for under the commercial bill facility." This timing was implied in the corresponding rule (section GC 14A(2) of the 2004 Act)." By making this explicit, the relationship of this rule to the financial rules is clarified: this timing rule overrides the financial arrangement rules because of the reference to "necessary implication" in section EW 2(1).

Section GB 27(3) (Attribution rule for income from personal services) clarifies that the exclusion is not intended to apply to an individual who is a trustee acting as such." The rewritten provision relies on the definition of "trustee" in section YA 1 for this effect." Section GB 27 now refers to the income year of the associated entity to give consistency to the value of "substantial business assets" in section GC 14C(6) of the 2004 Act, which was measured at the end of that entity's accounting year.

An uncertainty existed under section GC 15 of the 2004 Act in relation to benefits provided to an employee's associate over whether an associated person or the actual employee was treated as receiving the benefit." It is clarified in the 2007 Act that the fringe benefit is treated as received by the actual employee under section GB 32.

Intended changes in Part G

Section GB 27(2)(c) - Attribution rule for personal services

The 2004 Act rule in section GB 14B(2)(c) is ambiguous on whether the threshold of $60,000 should include income that is available for attribution." The rewritten provision confirms the policy intention that the threshold amount of $60,000 net income includes amounts that would be attributed under the attribution rule.

Sections GB 35(2)(d) and GB 42(2)(d) - Multiple purposes in arrangements

Sections GC 22(1)(a)(iv) and GC 27A(1)(d) of the 2004 Act refer to an arrangement that has "the purpose" of obtaining a tax advantage." The context of these rules is that this purpose should not be an incidental purpose, indicating that the section actually contemplates there may be more than one purpose for the arrangement." The use of "the purpose" is thus inconsistent with the context and application of the drafting and is linguistically incorrect.

It is clear from the drafting of these two sections that they are intended to apply when one purpose of the arrangement is to obtain a tax advantage, irrespective of the number of purposes of the arrangement. As a result, in both rewritten provisions, the term "the purpose" has been clarified as "a purpose".