Optional adjustment to assets under thin-cap rules

2012 Canterbury Earthquake related legislation provides an optional adjustment to how group assets are measured for the purposes of the thin-capitalisation rules.

Section FZ 7 of the Income Tax Act 2007

New section FZ 7 provides an optional adjustment to how group assets are measured for the purposes of the thin-capitalisation rules. The adjustment mitigates a timing problem that arises because insurance proceeds are recognised at a later date than damage caused by the Canterbury earthquakes.

Background

The thin-capitalisation rules are based on accounting measures of assets. For accounting purposes, damaged assets are immediately impaired or derecognised. In contrast, insurance proceeds cannot be recognised until they are reasonably expected (for example, can be given a confirmed value).

Section FZ 7 is designed to mitigate this timing difference by allowing certain taxpayers to carry-back known insurance proceeds to the date on which an asset was impaired or derecognised as a result of damage caused by the Canterbury earthquakes. The amount that can be carried back is limited to the lesser of the amount of damage or the related insurance proceeds.

Key features

Before a person can choose to use the optional adjustment, they must first satisfy the conditions in section FZ 7(1).

These conditions are that:

  • an asset of the person's New Zealand group has been damaged as a result of the Canterbury Earthquakes;
  • the asset has been impaired or derecognised under generally accepted accounting practice as a result of that damage; and
  • insurance for the damage has been recognised at a later date under generally accepted accounting practice.

In such cases, the New Zealand group is able to choose to carry-back the insurance amount and regard this as an asset. The amount that can be carried back is limited to the lesser of the amount of damage or the related insurance proceeds. For impaired assets the damage is measured as the amount the asset has been impaired (as long as the impairment was a result of the earthquake damage rather than other reasons). For derecognised assets the damage is the amount of the derecognised asset (again, as long as the asset has been derecognised as a result of earthquake damage).

Section FZ 7(2) provides for this additional asset to exist for a temporary period beginning on the day that the relevant asset is impaired or derecognised and ending on the day that the corresponding amount of insurance is recognised for accounting purposes.

Section FZ 7(3) requires that if a person chooses to use section FZ 7(2) to increase the assets of their New Zealand group they must also increase the assets of their worldwide group by the same amount for a corresponding period. This ensures the worldwide group test continues to operate on a consistent basis.

A person could receive insurance pay-outs for several different events. In such cases, each insurance pay-out is treated separately and can only be carried back to the date of the related damage.

Example

A company has $1 million of impairment as a result of an earthquake that occurred during its 2010-11 income year. In its 2011-12 income year there is a further $500k of impairment relating to a different earthquake. It receives $1.5 million of insurance pay-outs for both events in the 2011-12 income year. The company would only be able to claim an asset of $1 million in the 2010-11 income year.

Under generally accepted accounting practice the insurance may be recognised all at once if it is for a certain amount. Alternatively, if the person is entitled to reimbursement of costs actually incurred in repairing an asset, then the insurance revenue could be recognised gradually as the repair costs are incurred.

In cases when the insurance is recognised gradually, the amount that is available under the provision should also be reduced gradually, at the same time that the insurance is recognised.

Example

A company has $2 million of impairment, $500k of which is repaired and reimbursed by insurance in 2011-12 and the remaining $1.5 million is repaired and reimbursed in 2012-13. In 2011-12 the company can claim $1.5 million of additional assets under section FZ 7 ($2 million - $500,000 = $1.5 million) and in 2012-13 all the impairment has been met by insurance so section FZ 7 no longer applies ($2 million - $2 million = 0).

Notification requirement

Section FZ 7(4) requires a person who chooses to use section FZ 7(2) to inform the Commissioner that they are applying this rule and to provide some information on its effect, including:

  • notice to the Commissioner that section FZ 7 of the Income Tax Act 2007 has been applied;
  • the amount of income that would arise under section CH 9 of the Income Tax Act 2007 in the absence of section FZ 7; and
  • the amount of income that arises under section CH 9 by applying section FZ 7.

This information should be e-mailed to competent.authority@ird.govt.nz by the later of 30 November 2012 or the day that the person is required to make a return of income for the corresponding tax year.

Application date

Section FZ 7 applies for income years ending after 4 September 2010 and before the 2016-17 income year.