The adoption of international financial reporting standards for taxation purposes

2007 amendments to the Income Tax and Tax Administration Acts incorporate the adoption of IFRS for taxation purposes where appropriate.

Sections DB 26, DB 27, EB 6, EB 9, EB 12, EB 19, EB22, ED 1, EW 14 to EW 24, EW 25B, EW 26, EW29, EW 31 and EW 48B of the Income Tax Act 2004; sections DB 34, DB 35, EB 6, EB 9, EB 12, EB 19, EB 22, ED 1, EW 14 to EW 24, EW 25B, EW 26, EW 29, EW31 and EW 46B of the Income Tax Act 2007; section141B(1C) of the Tax Administration Act 1994

Some taxpayers adopted international financial reporting standards (IFRS) for financial reporting purposes from 1 January 2005. For certain other taxpayers, the standards became mandatory from 1 January 2007. The Income Tax Act 2004, Income Tax Act 2007 and the Tax Administration Act 1994 have been amended to incorporate the adoption of IFRS for taxation purposes, where appropriate.

Background

Current taxation rules are linked to accounting practice in areas such as the trading stock valuation rules, research and development expenditure rules, and in areas where the courts and tax legislation have relied on generally accepted accounting practice. Tax rules' reliance on accounting practice in these areas is "ambulatory" in principle. To the extent that certain tax rules rely on accounting practice, changes in accounting practice arising from the adoption of IFRS are also brought into effect for tax purposes (in other words, they are automatically reflected in tax law). However, some areas, such as the research and development expenditure and trading stock valuation rules, require legislative amendments to incorporate the specific changes brought about by the adoption of IFRS.

IFRS have introduced significant changes to the methods of accounting for income and expenditure of financial arrangements. In many cases these changes bring financial accounting methods closer in line with existing tax timing rules. The legislative amendments clarify that taxpayers who adopted IFRS methods can rely on the same methods for taxation purposes. They also provide alternative methods that these taxpayers can adopt. Consequently, Determination G30, which provides the transitional rules for IFRS taxpayers, is expected to be withdrawn later thisyear.

Key feature

A number of technical changes have been made to the research and development expenditure rules, the trading stock valuation rules and the financial arrangements rules in the Income Tax Act 2004 and Income Tax Act 2007. The Tax Administration Act 1994 has also been amended to provide a legislative relief from the unacceptable tax position penalty in some circumstances. These amendments:

  • update the existing trading stock rules and research and development expenditure rules to reflect changes following the adoption of IFRS;
  • modify the existing financial arrangement timing rules to allow taxpayers to use the method they adopt under IFRS, with alternative spreading methods provided to limit the volatility of income and expenditure calculated for taxation purposes; and
  • provide legislative relief for taxpayers who adopt IFRS before the 2007-08 income year from unacceptable tax position penalties, in some circumstances.

Detailed analysis

Research and development expenditure

Sections DB 26 and DB 27 of the Income Tax Act 2004 and sections DB 34 and DB 35 of the Income Tax Act2007

The research and development expenditure rules in sections DB 26 and DB 27 of the Income Tax Act 2004 and sections DB 34 and DB 35 of the Income Tax Act 2007 have been updated to reflect changes brought about by the adoption of IFRS. The amended rules rely on IFRS accounting standards, instead of the old accounting standards, to determine when research and development expenditure is deductible for taxation purposes.

Under IFRS, the treatment of research and development expenditure is dealt with under the general accounting standards on intangibles (NZ IAS 38). The core standards for capitalisation of development costs under NZ IAS 38 (paragraphs 54 to 67) are substantially the same as the old accounting standards and should be appropriate for taxation purposes. However, some provisions in the old standards (such as paragraphs 2.3 and 5.4 of FRS-13) are no longer applicable and the Acts have been amended accordingly.

Application dates

The IFRS-based accounting standards on research and development expenditure must be adopted for taxation purposes from the 2007-08 income year or the first income year for which a person adopts IFRS for financial reporting purposes, whichever is earlier.

Trading stock

Sections EB 6, EB 9, EB 12, EB 19, EB 22 and ED 1 of the Income Tax Act 2004 and the Income Tax Act 2007

IFRS have been incorporated into the trading stock valuation rules in sub-part EB and the valuation rule for excepted financial arrangements in section ED 1. The old accounting standards that have been used in these provisions have been replaced with new standards NZIAS 2 and NZ IAS 8, under IFRS.

Section EB 6(1B) has been inserted in the Income Tax Act 2004 and Income Tax Act 2007. This provision allows primary sector producers to continue valuing their trading stock at cost.

Application dates

The amended valuation rules for trading stock and excepted financial arrangements apply from the 2007-08 income year or the first income year for which a person adopts IFRS for financial reporting purposes, whichever is earlier.

Financial arrangements rules

Sections EW 14 to EW 24, EW 25B, EW 26, EW 29, EW31 and EW 48B of the Income Tax Act 2004; sections EW 14 to EW 24, EW 25B, EW 26, EW 29, EW31 and EW 46B of the Income Tax Act 2007

The financial arrangement spreading rules have been amended for taxpayers who adopt IFRS for financial reporting purposes (IFRS taxpayers). These taxpayers would generally be required to use IFRS accounting methods for taxation purposes but alternative spreading methods are available in some circumstances. Taxpayers who do not prepare IFRS accounts will continue to apply the current spreading rules for financial arrangements.

A summary of the spreading methods available to taxpayers under the amended financial arrangement rules is presented in Figure 1.

Figure 1: New financial arrangement spreading rules

A summary of the spreading methods available to taxpayers under the amended financial arrangement rules

Larger version of Figure 1

An amendment to section EW 26 of the Income Tax Act 2004 and the Income Tax Act 2007 further clarifies that taxpayers can change between one of the pre-IFRS spreading methods and the new spreading methods for IFRS taxpayers when they start or stop preparing IFRS financial statements. IFRS taxpayers can choose to delay using the new spreading methods for taxation purposes until the 2007-08 income year.

Spreading methods

IFRS taxpayers are required to use one of the new spreading methods in sections EW 15B to EW 15E of the Income Tax Act 2004 and sections EW 15B to EW 15I of the Income Tax Act 2007. These methods include the IFRS method, alternative methods set out in specific determinations, expected value method, modified fair value method and mandatory non-IFRS methods.

IFRS method

An IFRS taxpayer must use the IFRS method in section EW 15C of the Income Tax Act 2004 and section EW 15D of the Income Tax Act 2007, unless the mandatory non-IFRS methods apply or the taxpayer elects to use the alternative spreading methods. Under the IFRS method, the taxpayer would calculate income and expenditure of a financial arrangement using the IFRS accounting rules.

Different methods are used to calculate income and expenditure of financial arrangements depending on their classification under IFRS. These IFRS accounting methods are accepted for taxation purposes under section EW 15C of the Income Tax Act 2004 and section EW 15D of the Income Tax Act 2007. For example, NZ IAS 39 allows income and expenditure of a financial arrangement to be calculated using either the "fair value method" or the "effective interest method" as appropriate.

Furthermore, income and expenditure calculated under the IFRS method would include fees that are "integral" to the financial arrangement. Sections EW 15(1) and EW31(7) of the Income Tax Act 2004 and the Income Tax Act 2007 have been amended accordingly.

Taxpayers who adopt the IFRS method for taxation purposes are expected to make two modifications. First, income and expenditure reported under IFRS in both the income statement and the statement of changes in equity must be included for taxation purposes. Secondly, credit impairment adjustments made to a financial asset under IFRS must be reversed out for taxation purposes. Credit impairments of financial arrangements will only be deductible for taxation purposes in accordance with the bad debt rules in section DB 23 of the Income Tax Act 2004 or section DB 31 of the Income Tax Act 2007.

Specific determinations

An IFRS taxpayer can elect to use the alternative methods in the specific determinations listed in section EW 15D of Income Tax Act 2004 and section EW 15E of the Income Tax Act 2007:

  • Determination G9C - Financial arrangements that are denominated in a currency other than New Zealand dollars: an expected value approach;
  • Determination G14B - Forward contracts for foreign exchange and commodities: an expected value approach; and
  • Determination G27 - Swaps.

In addition, the Commissioner may issue further determinations when this is necessary.

These methods are available if the IFRS taxpayer is able to meet the conditions in the relevant determinations and the anti-arbitrage requirement (which is discussed in a separate section below), subject to a specific modification to the election criteria in Determinations G9C and G14B.

(i) Method in Determinations G9C and G14B

An IFRS taxpayer that adopts Determinations G9C and/or G14B must comply with the principles in paragraph 4 of these determinations. Broadly, the basic principles under these determinations are:

  • income or expenditure from a financial arrangement is the total of an expected component and an unexpected component;
  • the expected component must be measured at the time a financial arrangement is entered into. The expected component is measured by converting expected payments under the financial arrangement into New Zealand dollars on the basis of forward rates;
  • the net expected New Zealand dollar amount should be spread over the term of the financial arrangement based on the yield to maturity method;
  • the unexpected component must be recognised when it is realised as the difference between the actual New Zealand dollar payments and the expected New Zealand dollar payments.

An IFRS taxpayer has to meet the terms set out in paragraph 3 of Determinations G9C and G14B. However, the election criteria in Determinations G9C and G14B have been relaxed for new companies that begin operation part-way through a year and companies that enter into a transaction that is covered by the determinations part-way through a year. The amendment allows these companies to use Determinations G9C and G14B if an election is made in writing on or before the 63rd day after they enter into the financial arrangement, or a later date allowed by the Commissioner (section EW 15D(3)(b) of the Income Tax Act 2004 and section EW 15E(3)(b) of the Income Tax Act 2007). For example, it is envisaged that an election at a later date would be allowed for the 2007-08 income year because the amended legislation was enacted part-way through that income year and taxpayers may not be in a position to make an election within the 63-day period.

Contracts for differences

The definition of "forward contract" has been amended for the purpose of section EW 15D of the Income Tax Act 2004 and section EW 15E of the Income Tax Act 2007. This is to clarify that "contracts for differences" are forward contracts even though it is not anticipated that the property or services that are the subject of the contracts would be delivered or performed.

This amendment allows "contracts for differences" and other similar contracts to be treated as forward contracts. The example below illustrates how a contract for differences might be dealt with in accordance with the principles set out in Determination G14B.

Example: Contracts for differences

Company A is an energy consumer. It enters into a contract for differences with a strike price of 5 cents per kWh. The contract was entered into with a third party at the prevailing market forward rate for electricity. The contract is set at a volume of 1,000 kWh per month for two years. The counter party to this contract is an energy supplier. Company A chooses to use the expected value method under Determination G14B.

Although the contract is expressed as an agreement to buy and sell electricity, the 1,000 kWh of electricity under the contract will never be delivered. Instead the counter party promises to pay Company A the difference if the market price for electricity is higher than the strike price at the end of the month. Company A promises to pay the counterparty if the market price is lower than the strike price. This ensures that the price Company A would have to pay for its electricity would never be higher (or lower) than 5 cents per kWh for 1,000 kWh per month.

The contract could be seen as a series of forward contracts with settlements at monthly intervals. The expected component of the contract is zero as the strike price for the contract is the prevailing market forward rate for electricity. This means there is nothing to spread under the "expected value" method.

However, the unexpected component must be recognised when payments are made under the contract. In this case, income and expenditure will arise when the contract is settled at the end of each month. Company A would report a gain if the market price for electricity is higher than the strike price at the end of the month, or a loss if the market price is lower than the strike price.

(ii) Methods in Determination G27

IFRS taxpayers can elect to use the methods in Determination G27 if they meet the terms set out in paragraph 3 of that determination. Having elected, they must apply the principles and methodology in the determination.

Methodology in Determination G27

Determination G27 contains a number of spreading methods for swaps agreements. The main spreading method is the method known as Method C in the determination. This method requires a taxpayer to calculate income and expenditure on a swap by treating each side of the swap as a separate, simultaneous and mutual loan between the taxpayer and the other party of the swap. Income and expenditure on these separate deemed loans should be calculated in accordance with normal financial arrangements rules. Paragraphs 6(4) and 6(7) of Determination G27 outline the rules for calculating income and expenditure on these separate loans. IFRS taxpayers that elect to use this determination must comply with these provisions.

Other spreading methods are also specified in Determination G27. It is anticipated that the status of these spreading methods and the availability of other spreading methods for IFRS taxpayers will be clarified as part of the remedial work discussed at the end of this item.

(iii) Alternatives to Commissioner's Determination

IFRS taxpayers can use an alternative method to those set out in Determinations G9C, G14B and G27 or another determination issued by the Commissioner. An alternative method may be used if it:

  • has regard to the purposes of the financial arrangements rules under section EW 1(3);
  • is for a financial arrangement similar to one to which the methods set out in Determinations G9C, G14B and G27 may apply; and
  • results in the allocation to each income year of amounts that are not materially different from those that would have been allocated using one of the methods set out in the determinations.

Expected value method

Section EW 15E(2) of the Income Tax Act 2004 and section EW 15F of the Income Tax Act 2007 provide an expected value method that IFRS taxpayers can use instead of the IFRS methods. A taxpayer that qualifies and wishes to use the expected value method must elect to use this method by notifying the Commissioner at the time of filing a return of income. The election applies to the taxpayer and all the companies in the taxpayer's group.

IFRS taxpayers can elect to use the expected value method to calculate income and expenditure of derivative financial instruments and foreign currency denominated financial arrangements, if the financial arrangements have been entered into in the ordinary course of the taxpayers' business and the taxpayers are not in the business of dealing in the financial arrangements. In addition, the IFRS taxpayers must satisfy the anti-arbitrage requirement (which is discussed in a separate section below).

  • Ordinary course of business
    The amended legislation does not define the term "ordinary course of business". Facts and circumstances of a taxpayer's business would determine whether a financial arrangement has been entered into in the ordinary course of the taxpayer's business. For example, a taxpayer who borrows in a foreign currency, say in US dollars, to fund its subsidiaries in the US would most likely be considered to have entered into the loan as part of its ordinary course of business. A taxpayer who enters into a derivative contract to hedge a particular business risk would also be considered as having entered into the derivative contract in the ordinary course of its business. For example, an energy company may enter into contracts for differences to fix the price of electricity
  • Business of dealing in the financial arrangement
    An IFRS taxpayer cannot apply the expected value method to a financial arrangement if the taxpayer is in the "business of dealing in the financial arrangement". Again, facts and circumstances would determine when a taxpayer is in the business of dealing in the financial arrangement. For example, a company that enters into a financial arrangement to hedge a business risk would most likely not be considered as in the business of dealing in that financial arrangement.
    On the other hand, a company that buys and sells a financial arrangement regularly for profit would probably be in the business of dealing in that financial arrangement. Nevertheless, it is envisaged that taxpayers may have two portfolios of a type of financial arrangements (say swaps) and only buy and sell regularly for profit from one of those portfolios. These taxpayers are not prevented from using the expected value method to calculate income and expenditure of financial arrangements in the "non-trading" portfolio.
  • Expected value methodology
    The amended legislation defines the expected value method by reference to the methodology in Determinations G9C and G14B. This means the principles that apply in those determinations should be relevant here. Broadly, these principles are:
    • income or expenditure from a financial arrangement is the total of an expected component and an unexpected component;
    • the expected component must be measured at the time a financial arrangement is entered into and spread over the term of the financial arrangement; and
    • the unexpected component must be recognised when it is realised as the difference between the actual New Zealand dollar payments and the expected New Zealand dollar payments.
    IFRS taxpayers who adopt a method that is consistent with these principles would be considered to have allocated a reasonable amount for each income year of the term of the financial arrangement, having regard to the purposes of the financial arrangements rules under section EW 1(3).
    The following examples illustrate how the expected value method applies to certain types of futures, options and swaps contracts.

    Example 1: Futures contracts

    Company A enters into a futures contract to buy 1 million USdollars against delivery of New Zealanddollars. The futures contract has a standard settlement date of 31 December 2010. The contract was entered into on 30 April 2008 for no consideration. The contract rate is US$0.76 to NZ$1, which is the market forward rate. Company A qualifies and elects to use the expected value method to spread income and expenditure under the futures contract.

    At the time Company A becomes a party to the futures contract, the expected New Zealand dollar net amount is zero. Therefore, the futures contract has no expected income or expenditure and there is nothing to spread under the expected value method. Company A will recognise the unexpected income or expenditure from the futures contract when it is realised

    Example 2: Options contracts

    Company A enters into an options contract to buy 100 units of commodity at $15 per unit. The option is exercisable in two years. Company A paid a premium of $175. The market interest rate is 8% per annum. Company A qualifies and elects to use the expected value method.

    Under the expected value approach, the expected gain under the option contract for Company A is equal to the difference between the amount of the premium paid and the forward price of the option. Broadly, the forward price is equal to the spot price on issue plus the cost of carrying to maturity. In the example above, the forward price of the option contract is $204 (being 175 x 1.08 2 ). The $29 difference between the premium paid ($175) and the forward price ($204) is the expected gain of Company A. This expected gain should be spread by Company A under the expected value method over the two-year period. Company A would have income of $14 in the first year resulting from the expected component.

    If at the end of year two the spot price of the commodity is $18 per unit, Company A will realise an unexpected gain of $96 (which is the difference between the $300 gain that Company A will derive from exercising the option, less the $204 expected gain). In addition, Company A would have income of $15 from the expected component in the second year. The total of $111 would be income of Company A in the second year. This amount will show up as a result of the base price adjustment:

    consideration - income + expenditure + amount remitted
    ($300 - $175) - 14 + 0 + 0 = $111

    Example 3: Swaps

    Company A enters into a swaps agreement under which it promises to pay a variable rate of interest in exchange for receiving a fixed rate of interest. The swaps agreement will be settled every six months until 31 December 2010, when the last payment will be made. The contract was entered into on 30 April 2008 at the prevailing market rate for no consideration and the variable rate under the swaps agreement will be re-fixed regularly. Company A qualifies and elects to use the expected value method to spread income and expenditure under the futures contract.

    As the swaps agreement has been entered into at the prevailing market rate for no consideration, the expected NZD net amount is zero when Company A enters into the swaps agreement. Therefore, the swaps agreement has no expected income or expenditure and there is nothing to spread under the expected value method. Company A will recognise the unexpected income or expenditure from the swaps agreement when payments are made at the six-monthly interval.

Modified fair value method 23

Section EW 15E(3) of the Income Tax Act 2004 and section EW 15G of the Income Tax Act 2007 provide another alternative spreading method for IFRS taxpayers. An IFRS taxpayer who qualifies can elect to use this method by notifying the Commissioner at the time of filing a return of income. The election applies to the taxpayer and all the companies in the taxpayer's group.

As with the expected value method, the alternative method in this section is only available for derivative financial instruments and foreign currency denominated financial arrangements that have been entered into in the ordinary course of an IFRS taxpayer's business and the taxpayer is not in the business of dealing in the financial arrangements. In addition, the anti-arbitrage requirement (which is discussed in a separate section below) must be met.

An IFRS taxpayer who elects to use this method must use the IFRS method to calculate income and expenditure of a financial arrangement, but the amount which has been allocated to equity reserves under IFRS can be excluded from tax. For example, income and expenditure of a derivative instrument that is a cashflow hedge may be reported as part of equity reserves in IFRS accounts. This amount would ordinarily be included if a taxpayer relies on the IFRS method for taxation purposes. However, the modified fair value method in section EW 15E(3) of the Income Tax Act 2004 and section EW 15G of the Income Tax Act 2007 would allow this amount to be excluded from tax.

Compulsory non-IFRS methods

Sections EW 15B(3) to (5) of the Income Tax Act 2004 and sections EW 15H and EW 15I of the Income Tax Act 2007 preserve the existing, pre-IFRS spreading methods for some financial arrangements. It is mandatory for IFRS taxpayers to apply these spreading methods instead of the methods they have adopted for financial reporting purposes. These compulsory methods apply to a financial arrangement that includes an excepted financial arrangement, a financial arrangement that is treated partly or wholly as an equity instrument under IFRS, or an agreement for the sale and purchase of property or services.

Section EW 15B(3) of the Income Tax Act 2004 and section EW 15H of the Income Tax Act 2007 list the following determinations that must be applied if the financial arrangement is covered by the determinations:

  • Determination G5C: Mandatory conversion convertible notes;
  • Determination G22: Optional conversion convertible notes denominated in New Zealand dollars convertible at the option of the holder;
  • Determination G22A: Optional convertible notes denominated in New Zealand dollars;
  • Determination G29: Agreements for sale and purchase of property denominated in foreign currency: exchange rate to determine the acquisition price and method for spreading income and expenditure.

An alternative method may be used instead of those set out in the determinations above if it:

  • has regard to the purposes of the financial arrangements rules under section EW 1(3);
  • is for a financial arrangement similar to one to which the methods set out in the determinations above may apply; and
  • results in the allocation to each income year of amounts that are not materially different from those that would have been allocated using one of the methods set out in the determinations.

For financial arrangements that are not covered by the determinations listed above, sections EW 15B(4) and (5) of the Income Tax Act 2004 and section EW 15I of the Income Tax Act 2007 require one of the following spreading methods to be used:

  • the yield to maturity method;
  • Determination G26: Variable rate financial arrangements; or
  • a determination made by the Commissioner under section 90AC(1)(ba) of the Tax Administration Act 1994.

Again, an alternative method may be used instead of those set out in the determinations above if it:

  • has regard to the purposes of the financial arrangements rules under section EW 1(3);
  • is for a financial arrangement similar to one to which one of the methods above may apply; an
  • results in the allocation to each income year of amounts that are not materially different from those that would have been allocated using one of the above methods.
Example: A financial arrangement with an excepted financial arrangement

An IFRS taxpayer is a party to a financial arrangement that includes an excepted financial arrangement. How should this financial arrangement be treated under the amended financial arrangements rules?

There are two possible routes for determining the tax treatment of this financial arrangement under the amended rules. If the financial arrangement is covered by determinations G5C, G22, G22A or G29 in section EW 15B(3) of the Income Tax Act 2004 and section EW 15H of the Income Tax Act 2007, income and expenditure of the financial arrangement must be spread in accordance with the relevant determination. The taxpayer's IFRS treatment may be accepted as an alternative if it produces results that are not materially different from the method in the relevant determination.

If the financial arrangement is not covered by determinations G5C, G22, G22A or G29, then the excepted financial arrangement should be separated from the financial arrangement in accordance with section EW 6 of the Income Tax Act 2004 and the Income Tax Act 2007. The taxpayer must apply to the remaining financial arrangement one of the methods in sections EW 15B(4) and (5) of the Income Tax Act 2004 and section EW 15I of the Income Tax Act 2007. This means that the taxpayer would have to use the yield to maturity method, or a method provided in Determination G26: Variable rate financial arrangements, or a method in a determination made by the Commissioner, or an alternative method. Again, the taxpayer's IFRS treatment may be accepted as an alternative if it produces results that are not materially different from the yield to maturity method, the method in Determination G26 or another method in a determination made by the Commissioner, whichever is relevant.

Example: An agreement for the sale and purchase of property or services

An IFRS taxpayer is a party to an agreement for the sale and purchase of property. How should this agreement be treated under the amended financial arrangements rules?

An agreement for the sale and purchase of property or services in which the settlement is deferred is a financial arrangement if the deferral is more than 93 days (that is, a long-term agreement). This rule has not been amended.

If the long-term agreement is denominated in a foreign currency, income and expenditure on the agreement must be spread using one of the methods under Determination G29. If the agreement is denominated in New Zealand dollars, then it is expected that the yield to maturity method in section EW 15B (5) of the Income Tax Act 2004 and section EW 15I of the Income Tax Act 2007 would apply.

The taxpayer's IFRS treatment is not, prima facie, an acceptable spreading method under the amended financial arrangements rules. This is because the taxpayer's IFRS treatment does not necessarily recognise the interest element in a long term property agreement. However, the taxpayer's IFRS treatment may be accepted as an alternative in some circumstances if it produces results that are not materially different from Determination G29 or the yield to maturity method, whichever is relevant.

Example: A financial arrangement treated as equity instrument under IFRS

An IFRS taxpayer issues an instrument that is a "financial arrangement" under the financial arrangements rules but the instrument is treated as equity in its IFRS financial reports. Payments made under this instrument are also treated as dividends for financial reporting purposes. How should this financial arrangement be treated under the amended financial arrangement rules?

If the financial arrangement is covered by determinations G5C, G22, G22A or G29 in section EW 15B(3) of the Income Tax Act 2004 and section EW 15H of the Income Tax Act 2007, income and expenditure of the financial arrangement must be spread in accordance with the relevant determination. The taxpayer's IFRS treatment may be accepted as an alternative if it produces results that are not materially different from the method in the relevant determination.

If the financial arrangement is not covered by Determinations G5C, G22, G22A or G29, then the taxpayer must apply one of the methods in section EW 15B(5) of the Income Tax Act 2004 and section EW 15I of the Income Tax Act 2007. This means that the taxpayer would have to use the yield to maturity method, or a method provided in Determination G26: Variable rate financial arrangements, or a method in a determination made by the Commissioner, or an alternative method. The taxpayer's IFRS treatment may be accepted as an alternative method under this provision if it produces results that are not materially different from the yield to maturity method, the method in Determination G26 or a method in a determination made by the Commissioner, whichever is relevant.

Consistency requirements

An IFRS taxpayer who elects to use one of the spreading methods under the amended financial arrangements rules must comply with the consistency requirements in section EW 25B of the Income Tax Act 2004 and the Income Tax Act 2007.

Consistency over time

A change of spreading method is allowed if the IFRS taxpayer has changed its accounting method for financial reporting purposes. For example, an IFRS taxpayer who has been using the IFRS method may wish to change method if the IFRS treatment changes and the taxpayer considers the new method to be inappropriate for taxation purposes. Conversely, an IFRS taxpayer who has been using one of the alternative spreading methods may wish to change method if its accounting treatment changes and the taxpayer considers the new treatment to be appropriate.

The change of method in these circumstances has to occur in the same income year as the change in IFRS accounting treatment. The IFRS taxpayer must also meet the relevant legislative requirements for the new method. These conditions are set out in section EW 25B(2) of the Income Tax Act 2004 and the Income Tax Act 2007.

An IFRS taxpayer who does not qualify for a change of method must use the same method over time.

Example: Change of method

An IFRS taxpayer is a party to a foreign currency denominated financial asset which has been classified under IFRS as a "held to maturity" investment. The effective interest method (which is similar to yield to maturity) would apply under IFRS and the taxpayer has decided to use the same method under the financial arrangements rules. When the IFRS classification for this financial asset changes to "available for sale", the IFRS method would become the fair value method. The taxpayer has decided to change method for taxation purposes. Is this allowed?

Yes. The IFRS taxpayer can change method under these circumstances, as long as the change of method occurs in the same income year as the change in IFRS accounting treatment. The new spreading method could be the method in Determination G9C or the expected value method if the taxpayer can meet the relevant legislative provisions. A change of method adjustment would be required.

If the taxpayer is unable to meet the legislative criteria to use one of these alternative methods, the taxpayer would have to continue using the IFRS method. The income and expenditure recognised under IFRS would be income and expenditure under the IFRS method in section EW 15C of the Income Tax Act 2004 and section EW 15D of the Income Tax Act 2007. This includes any income and expenditure associated with the change of accounting method recognised for financial reporting purposes. No change of method adjustment would be required in this case.

Change of spreading methods

An IFRS taxpayer who changes spreading methods is required to perform either a change of method adjustment under sections EW 26 and EW 27 of the Income Tax Act 2004 and the Income Tax Act 2007, or a base price adjustment.

A change of method adjustment is required when IFRS taxpayers change their spreading methods. This adjustment is also required when non-IFRS taxpayers become IFRS taxpayers or vice versa, and have to change their spreading methods. The change of method adjustment would produce income and expenditure for the first income year taxpayers adopt IFRS for taxation purposes.

A base price adjustment is required when IFRS taxpayers change from a fair value method to another spreading method. Section EW 29(13) of the Income Tax Act 2004 and the Income Tax Act 2007 has been inserted to ensure that this is the case. Section EW 48B of the Income Tax Act 2004 and section EW 46B of the Income Tax Act 2007 have also been added to deem the IFRS taxpayer who is changing out of the fair value method as having been paid an amount equal to the market value of the financial arrangement on the date of change.

Example 1: Forward contract for five years

Company A is a party to a forward contract with settlement in five years. The fair value of the forward contract is 0 at inception, ($100) at the end of year 1 and $50 at the end of year 2. The forward contract was settled at the end of year 5 with a gain of $100 for Company A.

Company A uses the IFRS fair value method in the first income year and recognises a loss of $100. Company A meets the criteria for changing method and decides to change out of the fair value method at the end of the second year. Company A elects and is able to use the expected value method as the new spreading method.

Company A is required to perform a base price adjustment in the second income year. The base price adjustment would produce income for the second year of $150, which is calculated as:

consideration - income + expenditure + amount remitted
($50 - $0) - 0 + 100 + 0 = $150

The expected value of the forward contract will be spread under the expected value method. There is no expected income or expenditure to spread in this example because the forward contract has no value at inception. Therefore, Company A would have no income or expenditure in the third and fourth income years. The expected value method would not be applied retrospectively to the first and second income years because the base price adjustment has already been performed at the end of the second year.

The real base price adjustment would be required at the end of the fifth year, producing income of $50, calculated as:

consideration - income + expenditure + amount remitted
($100 - $0) - 150 + 100 + 0 = $50

Example 2: Same example, different fair value pattern

What if the fair value of the forward contract is 0 at inception, $50 at the end of year 1, ($100) at the end of year 2 and the forward contract was settled at the end of year 5 with a gain of $100 for Company A?

If Company A uses the IFRS fair value method in the first income year, it would recognise income of $50. In the second income year, Company A would be required to perform a base price adjustment because of the change of method. The base price adjustment would produce expenditure of $150, which is calculated as:

consideration - income + expenditure + amount remitted
(-$100 - $0) - 50 + 0 + 0 = ($150)

As the forward contract has no expected component, Company A would have no income or expenditure to spread in the third and fourth income years.

The real base price adjustment would be required at the end of the fifth year, producing income of $200, calculated as:

consideration - income + expenditure + amount remitted
($100 - $0) - 50 + 150 + 0 = $200

Example 3: Same example, non-zero expected value at the beginning of contract

What if Company A paid $50 to enter into a forward contract with a forward/fair value of $100 at inception, $50 fair value at the end of year 1, ($100) at the end of year 2 and the forward contract was settled at the end of year 5 with a gain of $100 for Company A?

If Company A uses the IFRS fair value method in the first income year, it would recognise an expenditure of $50 from the decline in the fair value. In the second income year, Company A would be required to perform a base price adjustment because of the change of method. The base price adjustment would produce expenditure for the second year of $100, which is calculated as:

consideration - income + expenditure + amount remitted
(-$100 - $50) - 0 + 50 + 0 = ($100)

For the purpose of spreading under the new method, Company A would have to calculate the expected component of the forward contract at the inception and spread the expected component based on the yield to maturity method. The expected component in this case is $50 (being the difference between $100 forward value at the inception and the $50 paid by Company A) and has to be spread over the five year period on a yield to maturity basis. This would produce income of $9.8 and $11.3 for the third and fourth income year, respectively.

The real base price adjustment would be required at the end of the fifth year, producing income of $128.9, calculated as:

consideration - income + expenditure + amount remitted
($100 - $50) - 21.1 + 100 + 0 = $128.9

Consistency across financial arrangements

The same spreading method should be applied consistently across all financial arrangements that are the same or similar, unless different accounting treatments apply under IFRS. For example, investments in debt securities can be classified as "held to maturity" investments or "available for sale" financial assets under IFRS. Different accounting treatments can be applied depending on this classification even if the investments are exactly the same in commercial terms. In this case, different spreading methods would be allowed for taxation purposes.

Different spreading methods can be used for taxation purposes if the accounting treatment can be differentiated in one way or another. For example, swaps can be classified as a fair value hedge or a cashflow hedge under IFRS. Although both types of swaps are measured at fair values, gains and losses on the fair value hedge are reported in the income statement while gains and losses on the cashflow hedge can be reported in equity reserves for accounting purposes. Different tax treatments would be allowed for these swaps.

Anti-arbitrage requirement

Sections EW 15D(1)(d) and EW 15E(1)(c) of the Income Tax Act 2004 and sections EW 15E(1)(c), EW 15F(1)(c) and EW 15G(1)(c) of the Income Tax Act 2007 restrict the use of the specific determinations, the expected value method and the modified fair value method. These methods cannot apply to a financial arrangement that is hedging another financial arrangement if the taxpayer has adopted the IFRS fair value method or another IFRS method that accounts for gains and losses related to the hedged risks to account for the other financial arrangement.

This restriction ensures that IFRS taxpayers use similar spreading methods to account for financial arrangements that are in a hedged relationship. Taxpayers are not allowed to apply IFRS methods which take into account market value movements on one side of the hedge and apply the alternative methods that do not bring in market value movements on the other side of the hedge.

Example: Foreign currency loans in a hedge relationship under IFRS

An IFRS taxpayer has a foreign currency denominated borrowing, which is hedged by a forward currency contract. The forward contract qualifies and is treated as a hedge under IFRS. The taxpayer wishes to use the IFRS treatment to account for the foreign currency denominated borrowing and the expected value method to calculate income and expenditure of the forward currency contract. Is this allowed?

No. If the taxpayer uses the IFRS method for foreign currency denominated borrowing, the taxpayer is prohibited from using the expected value method to calculate income and expenditure of the forward currency contract. This is because the IFRS treatment for foreign currency denominated borrowing (under NZ IAS 21) would include foreign exchange gains and losses as income and expenditure. The taxpayer must use the IFRS method to calculate income and expenditure on the forward contract. Alternatively, the taxpayer may choose to use the expected value approach for both the foreign currency borrowing and the forward currency contract.

Example: Floating rate loans in a hedge relationship under IFRS

An IFRS taxpayer has a loan that is paying a floating rate of interest. The cashflow on this loan has been hedged by a series of pay-fixed, floating interest rate swaps. The swaps are not fully effective but they qualify and have been treated as a cashflow hedge under IFRS. The floating rate liability is accounted for under IFRS using the effective interest method, which does not account for the gains and losses related to the hedge. The taxpayer wishes to use the IFRS method to account for the floating rate loan and the method in Determination G27 for the swaps. Is this allowed?

Yes. The anti-arbitrage restriction does not apply in this case because the IFRS method used to account for the floating rate liability is the effective interest method, which does not include gains and losses related to the hedge.24

Treatment of fees

The treatment of fees has been modified to the extent that an IFRS taxpayer adopts the IFRS method under the amended financial arrangements rules. The IFRS treatment of fees is adopted for taxation purposes when the IFRS method is used. This alignment ensures that taxpayers who adopt IFRS methods for taxation purposes do not need to identify different types of fees that have been included in the IFRS calculation and apply tax rules to them individually.

The existing treatment of fees continues to apply to non-IFRS taxpayers and when IFRS taxpayers use the alternative methods that are not based on an IFRS accounting treatment. "Contingent fees" would be spread over the term of a financial arrangement in these circumstances.

Integral fees and methods based on IFRS

If an IFRS taxpayer uses the effective interest method under IFRS, then "integral" fees would be included as part of the effective yield of a financial arrangement. These "integral fees" would be included as income or expenditure under the financial arrangement rules in the same way.

When a financial arrangement is fair valued under IFRS, fees that are integral to the financial arrangement are recognised immediately as income or expenditure. The same treatment is acceptable under the amended financial arrangement rules for a taxpayer who adopts the IFRS fair value method.

Definition of integral fees

"Integral" fees under IFRS include transaction costs, being incremental costs that are directly attributable to the acquisition, issue or disposal of a financial asset or financial liability. An incremental cost is one that would not have been incurred if the entity had not acquired, issued or disposed of the financial instrument. The IFRS rules for determining whether fees are "integral" to a financial arrangement would be accepted for taxation purposes when the IFRS method is used.

Application dates and transitional rules

The amended financial arrangements rules apply generally from the 2007-08 income year. Taxpayers who had to adopt IFRS for financial reporting purposes from 1 January 2007 can apply IFRS for taxation purposes concurrently. This alignment ensures that taxpayers do not have to prepare two sets of accounts and that any transitional adjustment can be dealt with at the same time. However, taxpayers who are not early adopters of IFRS are in a position to adopt the new spreading methods for taxation purposes from the 2008-09 income year if they have an early balance date between 1 October and 30 December.

Early adopters of IFRS

The amended financial arrangements rules can apply retrospectively to taxpayers who are early adopters of IFRS and have applied IFRS for taxation purposes from the income year beginning on or after 1 January 2005. This allows early adopters of IFRS to use the IFRS method for financial reporting and taxation purposes concurrently.

Alternatively, these early adopters can continue to apply the pre-IFRS spreading methods for the 2005-06 and 2006-07 income years. The transitional rule in section EZ 50 of the Income Tax Act 2004 and section EZ 32B of the Income Tax Act 2007 facilitates this by allowing IFRS taxpayers to rely on the methods in sections EW 16, EW 18 and EW 20, despite being unable to use the same method for financial reporting purposes as IFRS may prescribe a different spreading method.

Unacceptable tax position penalty

Section 141B(1C) of the Tax Administration Act 1994

A legislative relief from an unacceptable tax position penalty is provided for taxpayers who adopt IFRS before the 2007-08 income year. This legislative relief is available for the 2005-06 and 2006-07 income years with respect to an IFRS-related tax position, provided that the taxpayer has adopted an interpretation for tax purposes that is "as likely as not" to represent acceptable accounting practice under IFRS and full disclosures are provided to Inland Revenue.

Further developments

A number of issues have arisen after the enactment of the Taxation (Business Taxation and Remedial Matters) Act 2007. These issues will be addressed by way of remedial amendments, which will be included in the next taxation bill.

The anti-arbitrage requirement in sections EW 15D(1)(d) and EW 15E(1)(c) of the Income Tax Act 2004 and sections EW 15E(1)(c), EW 15F(1)(c) and EW 15G(1)(c) of the Income Tax Act 2007 will be amended to better reflect the policy intention. IFRS taxpayers should only be restricted from using the spreading methods in these sections if the financial arrangement is a hedge of another financial arrangement that has been accounted for using the IFRS fair value method or another IFRS method that accounts for gains and losses related to the hedged risks.

The compulsory non-IFRS methods in sections EW 15B(3) to (5) of the Income Tax Act 2004 and sections EW 15H and EW 15I of the Income Tax Act 2007 will be amended to cover finance leases that are treated as operating leases under IFRS. It is envisaged that IFRS taxpayers will apply the yield to maturity method or an alternative to the yield to maturity method to these finance leases.

Some IFRS taxpayers are allowed to prepare their financial accounts in a functional currency that is not New Zealand dollars. However, it is not intended that these taxpayers would be allowed, for taxation purposes, to calculate their income and expenditure on financial arrangements in that functional currency. The remedial amendment will clarify that if these taxpayers elect to use the IFRS accounting method, they are required to apply IFRS rules as if New Zealand dollars are their functional currency.

A number of minor remedial amendments will also be proposed to ensure that:

  • Early adopters of IFRS can continue to rely on pre-IFRS financial reporting practices under section EW 21 for the 2006 and 2007 income years.
  • Early adopters of IFRS who adopted the IFRS method in 2006 income year will be allowed to change their choice of method in the 2007 or 2008 income year. These taxpayers have made their choice of spreading method for the 2006 income year before the enactment of the Taxation (Business Taxation and Remedial Matters) Act 2007 and may not have information about the full range of methods available to them. It would be fair to give these taxpayers another, one-off opportunity to elect into the new spreading methods.
  • Determination G9A, Determination G14 and the market valuation method referred to in Determination G27 should not be available to IFRS taxpayers. Instead, IFRS taxpayers should be allowed to use the spreading methods provided in the amended rules.
  • IFRS taxpayers should be allowed to change from the straightline method and the market valuation method when they transition into IFRS-based spreading rules. A change of method adjustment or a base price adjustment would be required.

23 This is also referred to as the equity free fair value method under section EW 15E(3) of the Income Tax Act 2004.

24 As noted at the end of this section, the legislation will be amended to better reflect this policy intention.