2014 amendments including the substituting debenture rule, inflation-indexed bonds, mining permits, offshore oil rigs, foreign fishing crews and amateur sports.

Annual income tax rates for 2014-15 tax year

The annual income tax rates for the 2014-15 tax year are the rates set out in schedule 1 of the Income Tax Act 2007 and are the same that applied for the 2013-14 tax year.

Application date

The provision applies for the 2014–15 tax year.

Repeal of substituting debenture rule

Sections DB 10, DB 25, DP 8, EZ 77, FA 2, HD 14 and YA 1 of the Income Tax Act 2007

The substituting debenture rule previously contained in section FA 2(5) of the Income Tax Act 2007 has been repealed as it is now outdated. There are also a number of consequential amendments as a result of the repeal of the rule.

Background

From the 1940s, the substituting debenture rule recharacterised debt issued by a company to its shareholders by reference to their equity (most commonly debt issued in proportion to shares held), as equity for tax purposes. This recharacterisation meant interest paid in respect of substituting debentures was taxed as a dividend - it was non-deductible to the company and (in recent times) subject to imputation.

A number of tax advisers and commentators recently raised concerns about the rule.

It applied too widely in some circumstances. Arguably, any shareholder loan was caught. It was easy for those not taking advice to inadvertently issue substituting debentures. Often the rule applied to fairly common company dealings which are of no policy concern. Taxpayers who inadvertently issued substituting debentures may have had consequential problems with past tax years, for example, the company may have paid too little tax by virtue of treating the interest as deductible, the incorrect amount of resident withholding tax (RWT) may have been deducted by the company from the payments, no imputation credits would have been attached by the company to the "dividend", and there may have been penalties and use-of-money interest payable as a result of taking an incorrect tax position in past years.

Conversely, the rule was too narrow in other circumstances and was easily circumvented. For example, the rule did not apply where the debt was in the form of a convertible note or when the loan was not made by the direct shareholder, but an indirect shareholder higher in the ownership chain. Taxpayers may have also deliberately structured their funding as substituting debentures to take advantage of the equity recharacterisation. The ease with which the substituting debenture rule could be manipulated had the potential to facilitate cross-border tax arbitrage, as taxpayers could effectively choose whether a debenture is treated as debt or equity for New Zealand tax purposes.

The scope and the application of the rule was also uncertain, which led to increased compliance costs as taxpayers were inclined to seek advice (and sometimes binding rulings) on fairly straightforward transactions.

Furthermore, in light of recent tax avoidance cases, taxpayers were becoming increasingly concerned about standard commercial transactions which seemingly circumvented the rule. It was difficult to determine whether Parliament's intention was frustrated by these arrangements when the policy issue Parliament contemplated no longer existed given that the rule was enacted in 1940 as a specific anti-avoidance rule and under very different tax policy settings (in particular, New Zealand did not have an imputation regime).

The rule originally targeted transactions in which companies were swapping their ordinary equity for debt. These transactions were popular at the time because dividends were paid out of post-tax income and were exempt income to the shareholders, whereas interest was deductible to the company and taxable to the recipient, generally at a lower tax rate than the (then) company rate. Ultimately, the tax burden on dividends was often higher than that on interest. It is also possible that the Government was concerned about the collection of tax from ultimate shareholders as the predecessor of resident withholding tax (RWT) was easily circumvented.

In 1958 the dividend exemption was removed. This meant that dividends were subject to double tax, but interest was not (absent the substituting debenture rule). There was a clear tax incentive to structure investments as debt rather than equity, so the substituting debenture rule continued to serve an anti-avoidance purpose at this time.

Since the introduction of imputation in 1988, the original purpose of the substituting debenture rule ceased to be relevant in many cases—as debt and equity returns are generally subject to the same tax treatment in the hands of a New Zealand-resident in a taxpaying position.

For investors such as non-residents, who still prefer to receive interest rather than dividends for tax reasons, there are targeted rules such as the thin capitalisation and transfer pricing rules which limit the ability to take undue advantage of the preference.

Accordingly, the rule is now outdated and has been repealed. To mitigate any risk to the tax base as a result of the repeal, the application date of the repeal broadly coincides with the strengthened thin capitalisation rules.

Key features

Section FA 2(5) of the Income Tax Act 2007, which defines "substituting debenture", and section FA 2(7), which quantifies the amount of the debenture, have been repealed.

As a result of the repeal, there have been a number of consequential amendments to sections DB 10, DB 25, DP 8, HD 14 and YA 1, primarily to remove references to substituting debentures.

Section EZ 77 contains a transitional provision for substituting debentures that are already in existence when the rule is repealed. Its purpose is to ensure that no adverse tax consequences arise on transitioning from treating the debenture as a share for tax purposes, to treating it as a debt for tax purposes.

For both the issuer and the holder, the transitional provision treats the substituting debenture as having been redeemed for its outstanding principal and outstanding accrued interest on 31 March 2015. On 1 April 2015, the outstanding principal and accrued interest is deemed to have been re-advanced by the lender to the borrower under a new loan.

Any income derived or expenditure incurred in respect of the new loan on or after 1 April 2015 must be accounted for under the financial arrangements rules. Any income and expenditure arising under the substituting debenture on or before 31 March 2015 will not be taken into account under the financial arrangements rules because that income and expenditure will have been dealt with under the tax rules applying to shares.

As this measure is not intended to be adverse to taxpayers, there is limited elective grandparenting of existing transactions (so they may continue to be treated as equity transactions for their term by a party) where:

  • the debenture is issued under a transaction that was entered into before 22 November 2013 (the date the Taxation (Annual Rates, Employee Allowances, and Remedial Matters) Bill was introduced);
  • the transaction was subject to a binding ruling which would continue to apply in the absence of the repeal of the substituting debenture rule (that is, the facts disclosed in the binding ruling continue to be correct and all ruling conditions are met);
  • for the whole of the relevant income year, the total amount and the term of all debentures issued under the transaction are not more than those disclosed in the application for the binding ruling; and
  • an electing party notifies the Commissioner by 31 July 2014 that it irrevocably elects to continue to treat the debentures as shares.

If any of the grandparenting conditions above cease to apply in future, the previously grandparented debentures will transition to shares in the manner described above with respect to substituting debentures transitioning on 31 March/1 April 2015. The only difference will be that the transition date will be the date that the conditions ceased to be satisfied.

Section EZ 77(5) also ensures that the deemed redemption of the substituting debenture does not result in a shareholder continuity breach for the purposes of the continuity provisions, for example, the loss carry forward or imputation credit continuity provisions.

Application dates

The repeal and consequential amendments apply from 1 April 2015.

The transitional provision - section EZ 77 - applies from the date of Royal assent, being 30 June 2014.

Withholding tax and inflation-indexed bonds

Sections RE 2(3), RE 18B, RF 2 and YA 1 of the Income Tax Act 2007, and sections 25(6), 33A(2), 33AA(1) and 51(2) of the Tax Administration Act 1994

The resident withholding tax (RWT) and the non-resident withholding tax (NRWT) rules in the Income Tax Act 2007 have been amended to deal with technical problems relating to the application of withholding tax rules to inflation-indexed instruments. The amendments relate to the timing and the amount of withholding tax to be deducted from the inflation-indexed component of such instruments.

To administer the changes, the record-keeping and filing provisions in the Tax Administration Act 1994 have also been amended.

Background

As part of the 2012 Half Yearly Economic Fiscal Update, the Government announced that it intended to target up to 10-20 percent of total bonds outstanding over time in an inflation-indexed bonds format. The Government had previously issued inflation-indexed bonds in 1996 but suspended their issue in 1999.

Inflation-indexed bonds are intended to diversify the Crown's investor base, by providing long-term, cost-effective funding for the Government. They also provide investors with a hedge against inflation, as recommended by the Capital Market Development Taskforce in 2009, and in accordance with the 2010 Government Action Plan.

Two technical tax problems have been identified with the reissue of these bonds which the amendments seek to address.

Key features

The changes are as follows:

  • Section RE 2(3) has been amended to exclude the inflation-indexed component, which is income that accrues to the bond holder at the end of the tax year, from being interest for the purposes of the general application of the RWT rules.
  • New section RE 18B will:
    • limit the RWT payer's obligation to deduct resident withholding tax on both the interest and inflation-indexed amount to the amount of the interest payment; and
    • require RWT to be deducted from the interest and inflation-indexed amount when the bond coupon is paid.
  • Section RF 2(1) has been amended to treat the inflation-indexed component as being non-resident passive income at the time the coupon interest is paid. This is to ensure that NRWT is deducted at the same time.
  • Section YA 1 has been amended to insert a definition of an inflation-indexed instrument.
  • New paragraphs in sections 25(6) and 51(2) of the Tax Administration Act 1994 require the bond issuer to notify the bond holder of their requirement to file, and the Commissioner of Inland Revenue of any remaining tax liability.
  • New paragraphs in sections 33A(2) and 33AA(1)(l) of the Tax Administration Act 1994 that provide an exclusion from non-filing requirements for a bond holder who has an interest payment capped by new section RE 18B.

Application date

The amendments apply from 30 June 2014, being the date of enactment.

Detailed analysis

An inflation-indexed bond is a bond in which the nominal capital value invested increases by a measure of inflation in any year. The measure of inflation is generally a price index published by Statistics New Zealand and is actually credited when the bond matures, but is taken into account in calculating the coupon payments.

The coupon paid in any year is paid quarterly on the capital value of the bond. The capital value of the bond is the face value or nominal amount of the bond adjusted for cumulative changes in the Consumer Price Index.

Section EI 2 treats the inflation-indexed component as income having been credited at the end of the year.

Tax treatment of inflation-indexed instruments

The tax treatment of inflation-indexed bonds falls within the relevant RWT, NRWT and inflation-indexed instruments provisions in the Income Tax Act.

RWT is due on most forms of interest for New Zealand residents who do not hold an RWT exemption certificate.

NRWT is also due on most forms of interest for non-residents, unless a 0% NRWT rate applies. In most cases where a 0% NRWT rate applies, approved issuers (or a person on their behalf) must pay a levy on the securities they register with Inland Revenue, known as the approved issuer levy (AIL).

Approved issuers are able to pay interest to non-residents without deducting NRWT. Instead approved issuers are required to pay a levy at the rate of 2% for every dollar of interest paid on the inflation instrument.

If RWT or NRWT has been deducted at the wrong rate, the taxpayer may be obliged to file a tax return at the end of the year and make up the difference (or receive a refund). NRWT for the majority of non-resident holders is a final withholding tax.

Problems the amendments seek to address

Two technical tax problems have been identified with the reissuance of these bonds which these amendments seek to address.

The primary problem is the potential for a withholding tax obligation to exceed the coupon amount. In this situation, the issuer of an inflation-indexed bond would have a liability to pay withholding tax, but no administratively workable "payment" to deduct it from.

At present this problem is a potential risk rather than an actual problem. The current coupon rate for the new Government issue of inflation-indexed bonds is 2% per annum and this low coupon rate increases this potential risk. The following table provides an indication of what the rate of inflation needs to be in order for the potential risk to become a problem.

Tax type and rate Coupon rate Annual inflation rate for the coupon payment to be insufficient
RWT at 33% 2% 4.1%
RWT at 30% 2% 4.7%
RWT at 17.5% 2% 9.5%
NRWT at 15% 2% 11.3%

While the risk of withholding tax exceeding the coupon payment is currently perceived to be low, the changes go some way towards mitigating the cashflow and potential tax collection consequences if the inflation risk profile were to change significantly.

The amendments that limit the RWT liability to the amount of the coupon are not extended to NRWT because the risk is considered lower.

The second and related problem stems from a timing issue. The legislation intends that RWT should be deducted annually from the inflation-indexed component. However, the coupon is generally paid quarterly and the administrative practice is to withhold the tax on the inflation-indexed component for the previous quarter, and deduct it from the coupon payment. This can result in an unclear situation where an issuer may be withholding tax from a coupon amount in advance of the bond holder's legal obligation because there is some form of cashflow from which to deduct the withholding tax.

So that Inland Revenue can administer these changes, additional record-keeping requirements for the bond issuer and filing requirements for the bond holder have also been included in the new legislation.

Deductions for underground gas storage facilities

Sections CT 1, CT 7 and CZ 32 of the Income Tax Act 2007

The Income Tax Act 2007 has been amended to remove from the ambit of the petroleum mining tax rules underground facilities that are used to store processed gas. Transitional provisions have been included to clarify the treatment of any sale proceeds from a sale of an underground gas storage facility that is currently treated as being subject to the petroleum rules and to grandparent an existing permit.

Background

Prior to this amendment, underground facilities for storing processed gas were eligible for concessionary treatment as a petroleum mining asset. This meant that expenditure on an underground gas storage facility was deductible over seven years, instead of over the economic life of the facility (which would be the treatment under the depreciation rules). This was seen as contrary to the policy intent that only expenditure on petroleum exploration and development should be eligible for concessionary treatment. The underground storage of gas that has already been extracted and processed is not considered to be an exploration or development activity.

Key features

Section CT 7 has been amended to prevent underground facilities used to store processed gas being treated as petroleum mining assets. These underground facilities will be subject to the depreciation rules, rather than the petroleum mining rules. The amendment uses the definition of "underground gas storage facility" from section 2 of the Crown Minerals Act 1991.

The proceeds received from the sale of an underground gas storage facility are currently treated as being on revenue account under the petroleum mining rules (section CT 1). Following the removal of underground storage facilities from the petroleum mining rules, the sale of an underground gas storage facility will be treated as being on capital account.

However, section CZ 32 provides a transitional rule for the tax treatment of proceeds from selling an underground gas storage facility constructed before the amendments come into force. This rule overrides section CT 1(2).

Consideration received from a disposal must be apportioned to reflect the amount of expenditure that has been incurred under the existing rules. For example, if an underground gas storage facility is sold for $500 million in 2016, with $300 million of expenditure incurred before the amendments are enacted and $100 million incurred after the amendments are enacted, the amount of income from selling the facility would be:
$300 million ÷ $400 million x $500 million = $375 million.

Section CZ 32(4) provides a grandparenting provision for an existing gas storage facility.

Application date

These changes take effect from the date of Royal assent, being 30 June 2014.

Recipients of charitable or other public benefit gifts

Schedule 32 of the Income Tax Act 2007

The following organisations have been granted donee status from the 2015–16 income year:

  • Every Home Global Concern Incorporated
  • Namibian Educational Trust.

Background

New Zealand-based charities who apply some or all of their funds for overseas purposes and who want donors to receive tax benefits in connection with any donations received, are required to be named as a donee organisation on the list of recipient of charitable or other public benefit gifts in the Income Tax Act 2007.

Donee status entitles individual donors to a tax credit of 331/3 percent of the monetary amount donated to these organisations, up to the level of their taxable income. Companies and Māori Authorities are eligible for a deduction for monetary donations up to the level of their net income.

Application date

The change applies from the 2015-16 and later income years.

Classification of mining permits as real property for income tax purposes

Section YA 1 of the Income Tax Act 2007

A definition of "real property" in section YA 1 has been enacted to clarify that mining permits issued under the Crown Minerals Act 1991 are "real property" for the purposes of the Income Tax Act 2007 and New Zealand's double tax agreements (DTAs).

Background

Under the previous rules, there was some uncertainty about the treatment of mining permits for tax purposes because section 91 of the Crown Minerals Act 1991 states that a mining permit is neither real nor personal property.

The new definition of "real property" will ensure that New Zealand has source-taxing rights over income from these permits under Article 6 of its DTAs, which applies to income from real property. This is consistent with the approach taken in New Zealand's newer DTAs (signed since the 1990s) where mining permits fall within the definition of "real property" contained in those treaties.  

Key features

Section YA 1 now contains a definition of "real property" which includes a permit as defined in the Crown Minerals Act 1991.

Application date

The new definition of "real property" applies from the date of enactment, being 30 June 2014.

Extending the tax exemption for non-resident offshore oil rig and seismic vessel operators

Section CW 57 of the Income Tax Act 2007

Section CW 57 contains a temporary exemption for non-resident offshore oil rig and seismic vessel operators. This exemption was due to expire on 1 January 2015, but has been extended to 31 December 2019. The scope of the exemption has been modified slightly to cater for two particular types of operator. These modifications will apply from 1 January 2015.

Background

Offshore rigs and seismic vessels operated by non-residents are covered by an exemption in section CW 57. These rigs and vessels are used to drill for oil and gas and gather data on potential oil and gas finds. There is a worldwide market in rigs and seismic vessels. No New Zealand company owns offshore rigs or seismic vessels, so any company wishing to explore in New Zealand waters needs to use a rig or seismic vessel provided by a non-resident owner.

Section CW 57 was introduced to deal with a problem created by our double tax agreements (DTAs). New Zealand generally taxes non-residents on income that has a source in New Zealand. However, our DTAs provide that non-residents are only taxable on their New Zealand-sourced business profits if they have a "permanent establishment" in New Zealand. Many of our DTAs (such as the New Zealand-United States DTA) have a specific rule providing that a non-resident enterprise involved in exploring for natural resources only has a permanent establishment in New Zealand if they are present for a particular period of time, often 183 days in a year. Once a non-resident has a permanent establishment in New Zealand, they are taxed on all their New Zealand business profits starting from day one.

The issue caused by this DTA provision was that seismic vessels and rigs used in petroleum exploration were leaving New Zealand waters before the 183-day limit was reached so they would not be subject to New Zealand tax. This meant that, in some cases, a rig would leave before 183 days and a different rig was mobilised to complete the exploration programme. This "churning" of rigs increased the cost for companies engaged in exploration and had the potential to delay exploration drilling and any subsequent discovery of oil or gas.

A temporary five-year exemption from tax on the income of non-resident offshore oil rig and seismic vessel operators was introduced in 2004. This exemption was rolled over in 2009 for a further five years and expires on 31 December 2014.

Key features

The temporary tax exemption for non-resident offshore oil rig and seismic vessel operators in section CW 57 of the Income Tax Act 2007 has been extended to 31 December 2019, subject to two modifications:

  • The exemption now excludes operators of drilling rigs of modular construction that are installed on an existing offshore platform. This is because these modular drilling rigs were never intended to be included within the scope of the exemption, which was designed with larger rigs (specifically semi-submersible and jack-up rigs) in mind. Modular drilling rigs do not have the same high mobilisation and demobilisation costs as larger rigs, which means the rationale for the exemption does not apply in relation to these rigs.
  • The exemption now includes operators of electromagnetic surveying vessels. From a policy perspective, it is generally desirable for substitutable products to be given the same or similar tax treatment whenever possible. Because electromagnetic and seismic surveying are two techniques that achieve broadly the same result for the same purpose, the exemption has been expanded to include operators of electromagnetic vessels.

Application date

The exemption takes effect at the expiry of the existing exemption, on 1 January 2015. The modifications to the exemption will also apply from that date.

Tax treatment of foreign fishing crews

Section YA 1 of the Income Tax Act 2007 and sections 3(1) and 33A(1B) of the Tax Administration Act 1994

As a result of the Government implementing changes to the way foreign charter vessels are regulated in New Zealand waters, foreign charter vessels will be required to reflag to New Zealand by May 2016.

Following the reflagging, New Zealand companies that use foreign charter vessels in New Zealand waters will become the employers of the non-resident fishing crews. The New Zealand-sourced income of the crew members will be taxable and subject to PAYE deductions.

Key features

To collect the correct amount of tax from members of non-resident fishing crews, and to reduce the compliance costs on the crew members, the following changes have been made:

  • All non-resident members of the fishing crews are to be taxed on their New Zealand-sourced income at a flat rate of 10.5%.
  • The requirement on the crew members to file tax returns on completion of a fishing season, or at year's end, has been removed.

For simplicity and consistency reasons, all non-resident members of fishing crews will be subject to these changes. This applies without regard to the type of vessel on which they are employed (a foreign charter or a domestically owned vessel), and without regard to the position occupied by them (for example, captain or deckhand).

Detailed analysis

The 10.5% flat tax rate

The 10.5% flat tax rate reflects the fact that the annual New Zealand-sourced income of the overwhelming majority of non-resident fishing crew members is less than $14,000. This 10.5% flat rate therefore accurately reflects the annual tax liability that would arise for members of non-resident fishing crews using annual rates, and the tax payable by New Zealand residents on the same amount of income. If the M tax code were to be used for PAYE, the members of fishing crews would be overtaxed, because this tax code assumes that an employee works, and is subject to New Zealand income tax, for a full year.

ACC earner premium

ACC earner premium should be deducted only from the New Zealand-sourced portion of income of non-resident crew members, with the applicable rate being the rate in force at the time of the deduction.

No return filing requirement

The requirement to file tax returns has been removed, to reduce compliance and administrative costs. Although non-resident members of fishing crews are able to file end-of-year tax returns if they wish to do so, it is not expected that they will do so to a significant degree. This is because the withholding rate of 10.5% accurately reflects their annual tax liability.

Non-resident status

To be covered by these changes, fishing crew members must remain non-resident for tax purposes for the whole duration of their stay in New Zealand. That means that those crew members who are defined as New Zealand tax residents in accordance with section YD 1 of the Income Tax Act 2007, will be subject to standard PAYE rules.

Taxable portion of income

The portion of income that is sourced in New Zealand under section YD 4(4) and is subject to New Zealand tax is based on the actual percentage of time spent by non-resident crew members within New Zealand's territorial limits. "Territorial limits", for the purposes of these changes, include the Territorial Sea, and the land. The Territorial Sea is the belt of coastal waters extending 12 nautical miles (22.2 km) from the New Zealand coast. Employers will need to include only that portion of income earned while within New Zealand's territorial limits on employer monthly schedules.

Example  

A foreign charter vessel with a non-resident fishing crew fishes within New Zealand's Exclusive Economic Zone.1 They come within New Zealand's territorial limits for 11.5 days (rounded to the nearest hour) out of every 31 days.

If the crew members are paid monthly, the proportion of their monthly pay that is sourced in New Zealand and subject to tax is 11.5/31 or 37.1 percent.

The time spent within New Zealand's territorial limits, to determine the portion of income subject to New Zealand tax, includes any time under the employment contract between an employee and their employer, whether or not any physical services have been performed within the territorial limits by the employees.

Amendments to legislation

Income Tax Act 2007

To give effect to the flat tax rate on the income of the members of non-resident fishing crew the following legislative amendments have been made:

  • The definition of "non-resident seasonal worker" in section YA 1 has been amended to include those workers employed under the foreign crew of fishing vessels instructions. This change ensures that these workers can use the "NSW" tax code which deducts tax at the rate of 10.5%.
  • A new definition, "foreign crew of fishing vessels instructions", is inserted in section YA 1. This definition links back to the immigration instructions certified under section 22 of the Immigration Act 2009.

Tax Administration Act 1994

An amendment has been made to section 33A(1B) to ensure that members of non-resident fishing crews are not required to file tax returns, in the same manner as other non-resident seasonal workers.

Application date

The amendments apply from 1 October 2014.

Amateur sports tax promoters' exemption – inclusion of trusts

Section CW 46 of the Income Tax Act 2007

Section CW 46 of the Income Tax Act 2007 has been amended to ensure that trusts can take advantage of the amateur sports promoters exemption.

Background

Previously, section CW 46 of the Income Tax Act provided that the income derived by a "club, society or association" established mainly to promote an amateur game or sport is exempt income. The game or sport must be conducted for the recreation or entertainment of the general public and no part of the funds can be available for the pecuniary profit of a member, proprietor or shareholder.

Inland Revenue's interpretation was that section CW 46 did not apply to trusts that had been established for the purposes of promoting amateur sport. This is on the basis that a trust is not a "club, society, or association". The result of this interpretation was that a trust that had been established to promote an amateur game or sport, and that otherwise met the requirements of section CW 46, was treated differently from other entities established with an identical purpose.

There was no clear policy basis for excluding trusts from the amateur sports promoters' income tax exemption. As a matter of principle, tax exemptions should be applied consistently to organisations with the same objects and purposes, regardless of their legal form.

Key features

Section CW 46 has been amended to include the terms "trustee or trustees of a trust" and "promoter". These amendments confirm that sporting trusts may be eligible for the income tax exemption for amateur sports promoters.

Application date

The amendments are retrospective in nature and will apply for the past four income years, which corresponds to the time in which the Commissioner of Inland Revenue can reassess tax liabilities. This means the amendments will apply from the 2010–11 and later income years.

1 Exclusive Economic Zone comprises an area which extends from the coast to 200 nautical miles (370 km), and includes the Territorial Sea.