Financial arrangements subject to Determinations G22 and G22A
Determination G22A, replacing Determination G22, denies artificial deductions on optional convertible notes being claimed by NZ subsidiaries of overseas companies.
On 26 September 2006 Determination G22 was replaced with Determination G22A. The stated purpose of the replacement was to deny artificial deductions on certain optional convertible notes (OCNs) that were being claimed by New Zealand subsidiaries of overseas companies. Many of these arrangements are currently the subject of litigation between Inland Revenue and the taxpayers concerned.
At that stage the tax Act in force was the Income Tax Act 2004. That Act and its replacement, the Income Tax Act 2007, provide that when a determination is cancelled" it remains in force for another four years for arrangements (the grandparented OCNs) that were in place when it was cancelled.
Under black letter law, tax deductions are available in respect of the grandparented OCNs until G22A becomes effective in respect of the grandparented OCNs.
Specifically, for the grandparented OCNs there is a need to ensure that:
- the change of spreading method adjustment that would have effect when the G22 expires for the grandparented OCNs in September 2010 does not claw back any deductions taken under G22 that are eventually allowed; and
- when the base price adjustment (BPA) is eventually calculated on the grandparented OCNs, it does not claw back any deductions taken under G22 that are eventually allowed.
Sections EZ 52C and EZ 52D have been inserted into the Income Tax Act 2007 to achieve these objectives. Inland Revenue consulted extensively with interested parties and their advisors on the provisions necessary to amend the legislation.
Changing from G22 to G22A
Section EZ 52C provides that when a taxpayer has been using G22 for a financial arrangement and is changing to G22A for that arrangement, a change of spreading method adjustment under sections EW 26 and EW 27 is not performed. Instead the taxpayer will apply the spreading method that has been followed in previous years under G22 for the portion of the income year up to the date of change in that income year. For the remainder of that income year and the following income years it will apply a spreading method under G22A to the financial arrangement. For the grandparented OCNs that means there will be no tax deductions for the remainder of the income year in which the change is made from G22 to G22A and for all subsequent income years.
BPA where both G22 and G22A have applied
As stated above, the BPA performed at maturity of a grandparented OCN to which both G22 and G22A have applied should not claw back any deductions taken under G22 that are eventually allowed. This has been achieved by making an adjustment to the consideration to be used in the BPA calculation for OCNs to which both G22 and G22A have applied.
The consideration for a financial arrangement in these situations has been amended by section EZ 52D for both the issuer and the holder in terms of G22 and G22A. The consideration in both cases is amended by an amount calculated as follows.
- "X - Z"
- where X": is an amount equal to the items in Determination G22, clause 6(1), if that item were calculated in accordance with that determination at the time immediately before the change of spreading method described in section EZ 52C(2).
Item s in clause 6(1) of G22 is the present value of the cash flows in respect of the OCN and the person. In G22 item s is used as part of the calculation of the core acquisition price of a convertible note attributable to the option to buy or sell shares (which is an excepted financial arrangement).
Therefore the amount for X in Section EZ 52D is the present value of the cash flows in respect of the OCN and the person calculated up to and including the day before the taxpayer starts using G22A. It is effectively what items would be if the OCN were to start at that moment and consisted of only the cash flows which were to occur from that moment into the future. In respect of grandparented OCNs that moment is effectively midnight of the day being 25 September 2010, as G22A applies from 26 September 2010; and
- where Z": is an amount equal to the item s in Determination G22, clause 6(1), if that item were calculated in accordance with that determination at the time when the determination first applied. So Z is therefore the original amount of s (being the present value of the debt component of the OCN on its date of issue) when the taxpayer started applying G22 to the financial arrangement.
When calculating the BPA for a grandparented OCN, the amount of X - Z is added to all consideration paid/payable by the issuer and added to all consideration paid/payable to the holder. This will mean that the resulting BPA will not reverse deductions taken by the issuer under G22 that are eventually allowable. It will also mean that revenue returned by the holder is not reversed.
For a grandparented OCN with a term of 10 years and a face value (FV) of $1 million, under G22 the warrant (equity) component of the OCN is determined to equal $491,650.71 in accordance with the formula "y - s" in clause 6(1) of G22.
The table below sets out the accrual expenditure and tax book values for the OCN.
|# of days||Starting tax book balance||Accrual expenditure||Ending tax book value|
|Total deemed/implied interest||491,650.71|
|Accrual expenditure up to 25 Sep 2010||280,137.66|
The deemed equity component of $491,650.71 is deducted from the total consideration paid for the OCN of $1 million, which leaves the amount attributable to the financial arrangement of $508,349.29 (1,000,000 - 491,650.71 = 508,349.29).
Over the term of the arrangement the debt component of $508,349.29 tends towards its FV of $1,000,000 at maturity. The difference ($491,650.71) is deemed to be interest and is accrual expenditure calculated on a yield-to-maturity (YTM) basis for each year over the 10-year term of the arrangement.
For G22 deductions which are eventually allowable, the total accrual expenditure that should be allowed according to the example is $280,137.66. This is highlighted on the table above and is the amount, under a YTM calculation process, that would be allowed up to 25 September 2010.
The application of G22A works to disallow any deemed accrual expenditure from 26 September 2010, if the parties to a grandparented OCN are members of the same wholly owned group of companies and the conditions described in clause 4(3) of G22A are applicable.
However, without these amendments and given the definitions and methodology contained in G22A, when a BPA is calculated, the result would otherwise be accrual income to the issuer of $280,137.66.
The reason is that the consideration attributable to the bond component of the OCN would otherwise be $1,000,000, in combination with the accrual expenditure deduction in earlier income years of $280,137.66. This can be demonstrated as follows:
BPA = consideration - income + expenditure + amount remitted
BPA = ( +1,000,000 - 1,000,000) - 0 + 254,545.92 + 0 = 254,545.92
The remedial changes in Section EZ 52D provide for a "consideration adjustment" defined as:
- "X - Z"
- where "X" is the PV of the debt component of the OCN as at 26 September 2010 (up to and including 25 September 2010). From the table above, this amount is shown in red, as $788,486.95.
where "Z" is what "S" would have been under G22 - in other words, the PV of the debt component of the OCN when it was issued at the start. In the example the PV of the bond on the issue date is $508,349.29.
So when the BPA is recast, the following outcome is achieved:
BPA = ( +508,349.29 - 788,486.95) - 0 + 280,137.66 + 0 = 0
The result of the proposed changes is that the BPA will not claw back the $280,137.66 of accrual expenditure claimed up to and including 25 September 2010.
Note also that the G22 deduction eventually allowed for the part year when the change of method from G22 to G22A occurs (assuming a 31 March tax balance date) will be the $25,591.74 amount in the table above, which results from the application of section EZ 52C explained above.
Sections EZ 52C and EZ 52D apply so that a litigant and the Commissioner may not use the application of sections EZ 52C and EZ 52D on or after 26 September 2010 for their positions in respect of Determination G22.
The commencement date for these amendments was 26 September 2010.