Thin capitalisation rules for banks

Sections FG 2, FG 3, FG 4, FG 8, FG 8B to FG 8J FH 1 and OB 1 of the Income Tax Acts 1994 and 2004

New thin capitalisation rules apply to foreign-owned registered banks operating in New Zealand. The rules determine the extent to which interest is deductible to the New Zealand business of the foreign-owned bank as part of calculating its New Zealand income for tax purposes. Banks are denied interest deductions if they do not have sufficient equity for tax purposes to support their New Zealand business.

The rules compare the equity of the New Zealand banking business with a legislatively prescribed level of equity based on 4% of the bank's New Zealand risk-weighted exposures. If there is a deficiency in the New Zealand equity compared with the required equity, interest is denied on the shortfall.

Application date

The thin capitalisation rules for banks apply from 1 July 2005.

Background

The rules were introduced in response to government concerns that tax paid in New Zealand by foreign-owned banking groups appeared insufficient relative to their accounting profits. Of particular concern was the level of debt held by these banking groups in New Zealand compared with their New Zealand-based assets. Two key issues were identified: the first related to the debt funding of a bank's outbound investment given that the income from this investment is generally not subject to full
New Zealand taxation; and the second related to the extent of debt funding of some banks' New Zealand business.

Under the previous tax rules, foreign-owned banks were subject to the same thin capitalisation provisions as other foreign-owned companies controlled by a single non-resident. However, in practice these rules did not limit their interest deductions for tax purposes. This was primarily because of the on-lending concession in the general thin capitalisation rules.

The banking sector was consulted on the development of the thin capitalisation rules for banks.

Key features

The amendments introducing the bank thin capitalisation rules are to both the 1994 and 2004 Income Tax Acts, and section references are identical.

• The new thin capitalisation rules apply to registered banks that are controlled by a single non-resident (sections FG 2(1), FG 3, OB 1).
• Where the rules apply to a registered bank, that bank must determine its NZ banking group (section FG 8C).
• The NZ banking group is required to calculate its NZ net equity at least quarterly (sections FG 8E, FG 8G).
• The NZ banking group must also calculate its net equity threshold at least quarterly (sections FG 8E, FG 8H).
• Where the NZ net equity of the NZ banking group is less than its net equity threshold, interest will be denied (section FG 8B).
• The interest denial will be calculated using an interest rate based on average cost of funds (sections FG 3(2)(b), FG 8B).
• The registered bank will be the reporting bank. The reporting bank must make an adjustment for any interest denial in its tax return (sections FG 3, FG 8D).
• The calculations draw on the accounts prepared by banks for financial and regulatory reporting purposes (sections FG 8F, FG 8I).
• Temporary changes to the amounts included in NZ net equity or net equity threshold as a result of an arrangement to defeat the intent and application of the new rules will not be taken into account for the purposes of the thin capitalisation calculations (section FG 8J).

Detailed analysis

The rules apply to foreign-owned registered banks operating in New Zealand. A registered bank is defined in section OB 1 as having the same meaning as in the Reserve Bank of New Zealand Act 1989.

A registered bank is subject to thin capitalisation rules if it has sufficient non-resident control as set out in section FG 2(1). Under the bank-specific thin capitalisation rules, a registered bank must determine its NZ banking group, calculate the NZ net equity of this group and compare that to the net equity threshold. If NZ net equity of the group is less than the net equity threshold, interest deductions will be denied.

Steps to apply the bank thin capitalisation rule

Step 1. Determine the New Zealand banking group.

Step 2. Calculate New Zealand net equity of the New Zealand banking group.

Step 3. Calculate net equity threshold of the New Zealand banking group.

Step 4. Compare New Zealand net equity and net threshold. Interest deductions will be denied if there is a deficiency in New Zealand net equity.

Step 1: NZ banking group

A foreign-owned registered bank which is subject to thin capitalisation rules is required to determine its NZ banking group under section FG 8C. This group includes all resident entities operating in New Zealand that would be required to consolidate with the ultimate foreign parent of the registered bank for financial reporting purposes. Fixed establishments (generally branches) operating in New Zealand are included in the consolidated accounts.

If the ultimate foreign parent does not include a New Zealand-resident entity or fixed establishment in its accounting consolidation because that entity or fixed establishment is not material in the context of its worldwide consolidation, that entity or fixed establishment will still be included in the NZ banking group.

Section FG 8C gives the bank the option to exclude its life insurance entities from its NZ banking group. Entities that are part of a life insurance entity's group can also be excluded from the NZ banking group, provided they do not have a main activity of banking, financing or leasing, and they are not holding companies of banking, financing or leasing companies. The excluded entities may include a non-resident person or company (with a fixed establishment in New Zealand) whose main activity is the provision of life insurance.

The election to exclude an entity from the NZ banking group is made at the time of filing the annual tax return. There is no specific form of election, nor a requirement to separately notify Inland Revenue. The act of excluding the entities from the banking calculation is the election. This election may be changed annually.

A taxpayer included in a NZ banking group will not be subject to the general interest apportionment rule in section FG 8 or the interest allocation rules in section FH 1. This is to ensure that there is no doubling up of adjustments resulting from insufficient levels of equity for tax purposes.

Companies that elect to be excluded from the banking group will continue to be subject to the general thin capitalisation rules in section FG 8 and interest allocation rules in section FH 1.

The reporting bank, defined in section FG 8D, is responsible for performing the NZ banking group's thin capitalisation calculation. This will be the registered bank in the group. If there are two or more registered banks in the NZ banking group, the banks must elect a reporting bank by notifying the Commissioner within six months after the end of the tax year. Where no notification is given the Commissioner will choose.

Example: Entities included in the New Zealand banking group

In the diagram below the New Zealand entities are all potential members of the NZ banking group. While the ultimate foreign parent is not part of the NZ banking group, it is shown in this diagram because the NZ banking group is determined with reference to the ultimate foreign parent of the registered bank. In this example, the NZ banking group must include the:

• Ultimate foreign parent branch;
• New Zealand holding company 1;
• New Zealand holding company 2;
• New Zealand registered bank company;
• Bank subsidiary company; and
• Leasing company.

New Zealand holding company 3, Life insurance company and Life insurance subsidiary can elect to be excluded. If so, they would not be part of the NZ banking group. The circled area represents the NZ banking group where an election to exclude the life entities has been made. The reporting bank will be the New Zealand-registered bank company

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Step 2: NZ net equity

The NZ banking group must determine its NZ net equity at least quarterly. NZ net equity is defined in section FG8G. This calculation begins with aggregating the NZ banking group's shareholder and branch equity based on their financial accounts. The aggregation of this equity is done in accordance with accounting rules that apply to consolidations.

Certain subtractions are then made from this aggregated accounting equity. Some of these subtractions follow the prudential deductions required by the Reserve Bank's Capital Adequacy Framework. An example of a prudential deduction is goodwill. Another subtraction for the purposes of the NZ net equity calculation is certain offshore assets of the NZ banking group.

For the tax calculation of the NZ net equity of the NZ banking group there is an exception to the rule that requires the subtraction of goodwill. This concerns certain goodwill relating to non-banking business.

Aggregated accounting equity (EQV)

The starting point for NZ net equity of the NZ banking group is the aggregation of the accounting values of shareholders' equity and branch equity included in the financial statements of NZ banking group members. This aggregation is done based on accounting consolidation principles.

The consolidation of the NZ banking group may or may not actually be required for accounting purposes. If there is no requirement to consolidate the NZ banking group for financial reporting purposes, a "notional" accounting consolidation of the NZ banking group for the purposes of the tax rules is needed. This may, for instance, be based on an aggregation of consolidations of sibling groups. This means that where two or more sibling consolidated groups are aggregated, inter-group transactions must be eliminated.

Any amounts considered equity for tax purposes but not for accounting purposes are added to the aggregated accounting amount of shareholders' and branch equity. Equity for accounting purposes that is considered debt for tax purposes is subtracted, as referred to below. Interest-free loans to the NZ banking group from non-resident associates will generally also be included in NZ net equity.

Section FG 8F(1) sets out the criteria to determine accounting values of the relevant items. Generally there is a focus on external financial reports that are prepared in accordance with generally accepted accounting principles.

The aggregated accounting equity is referred to in the legislation as EQV.

Subtractions from EQV

Following the determination of the group's EQV certain subtractions are made from this amount. Sub-sections FG 8G(2) and (3) ensure that items cannot be subtracted from equity more than once.

The following is a summary of the required subtractions. Included in brackets after each item is the reference used in the legislation. The amounts subtracted are, in general, based on the amounts from accounts prepared for financial or regulatory reporting purposes.

• Intangible assets (INTG): All intangible assets except for:
  • goodwill that relates to a business that is not banking, financing, leasing, or life insurance. The goodwill must have arisen from an acquisition by the NZ banking group member from a person who is not associated with any NZ banking group member;
  • films or film rights;
  • property that is depreciable property for income tax purposes or is expected to become depreciable property.
• Capital gain amounts (CGA): Capital gain amounts, as defined for income tax purposes, where those gains are made in the 2004-05 and subsequent years as a result of transfers of intangible assets to associated persons outside of the NZ banking group.
• Asset revaluation reserves (REV)
• Future tax benefits (TXB): Net future tax benefits if they arise from tax losses or from timing or temporary differences that would result in tax losses, if the item that gave rise to the timing or temporary difference would have been deductible in the current year.
• Certain prudential deductions (CEFA and NAFA): These prudential deductions are defined in the Reserve Bank of New Zealand's Capital Adequacy Framework and relate to certain credit enhancements provided by a NZ banking group member, and certain loans made by a NZ banking group member to a connected person who is not a part of the NZ banking group.
• Fixed rate shares (FRS): Fixed-rate shares, as defined in section LF 2(3), where they are issued by members of the NZ banking group to New Zealand residents. The reason for this subtraction is because fixed rate shares are economically similar to debt in several respects, and they may be used flexibly as a substitute for it. The subtraction from NZ net equity applies to fixed rate shares that have been offered to the public on or after 1 January 2005. Fixed rate shares that have been offered to the public before
  1 January 2005 are not required to be subtracted from NZ net equity until after 1 January 2010.
• Debt for tax purposes (EID): This refers to amounts included in EQV which are considered equity for accounting purposes but which give rise to a deduction for tax purposes.
• Policyholder liabilities (UPB): This applies only to life insurers that are included in the NZ banking group. Where unvested policyholder liabilities have been included as equity for financial reporting purposes, they are not included in EQV under the thin capitalisation rules.
• Cross holdings (AEQ and AEQI): Cross holdings between members of the NZ banking group and any life insurance entities that have elected to be excluded from the group.
• Offshore assets (EOI):
  • Shares in non-resident companies that are held by members of the NZ banking group, or are held by life insurance entities that have elected to be excluded from the group.
  • Shares in a resident company in circumstances where:
    1. the NZ banking group member or potential member holds a direct voting interest of 10% or more in that resident company; and

        

    2. the NZ banking group member or potential member receives a dividend from the resident company that has conduit relief attached to it in the current income year. This ensures that the thin capitalisation rules cannot be avoided by placing shares in offshore companies in a NZ-resident company which is outside the NZ banking group. This will apply only when a NZ banking group member receives the flowed through conduit relief with the dividend from the NZ resident company.

The following offshore assets are not subtracted from EQV

• • interests in foreign investment funds where the comparative value or deemed rate of return methods are used;
  • shares in companies in grey list countries which are listed on a recognised exchange, and are held on revenue account, and would not be "sufficient interest" if the class of shares were the only class of share issued by the offshore company. Sufficient interest is defined in section LF 1(2) and is, in general, an interest of 10% or greater.

Example: Offshore assets subtracted from EQV

In Diagram A, a member of a NZ banking group holds five shareholdings in overseas companies. In Diagram B, the five shareholdings are held by a resident company in which a member holds a direct voting interest of 10% or more and where conduit tax relief is attached to a dividend paid to the member in that year.

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In both diagrams, shareholdings 1 to 5 fall under EOI because they are offshore shareholdings. At first glance, they would be subtracted from the NZ net equity of the NZ banking group. However, Shareholding 2 represents an interest in a foreign investment fund where the comparative value or deemed rate of return method is used. Shareholding 5 represents an interest in a company which operates in a grey list country, is listed on a recognised exchange, is held on revenue account, and would not be a "sufficient interest" if the class of shares were the only class of share issued by the offshore company. This means that Shareholdings 2 and 5 fall under the exceptions to EOI and are included in the NZ net equity of the NZ banking group.

• Notional offshore investment amount (NOIA):
  A notional offshore investment amount is subtracted from EQV. Foreign tax credits claimed by the NZ banking group against their income tax liability are used as a basis to calculate this amount. The notional amount effectively represents the offshore investment that the group would have made to generate the foreign tax credits it received.
  The NZ banking group can claim up to $5 million of foreign tax credits before it is required to calculate a notional offshore investment amount. This minimum threshold allows for a reasonable level of debt funded offshore investment that would not be subject to the thin capitalisation banking rules, while capturing significant offshore lending that does not result in tax payable in New Zealand.
  
  The notional offshore investment amount is calculated according to a formula which essentially "grosses up" foreign tax credits in excess of the minimum threshold.

Example: Notional offshore investment amount calculation

This calculation of a notional offshore investment amount is based on foreign tax credits of $5,033,000.

Transitional rules cover foreign tax credits on income after 1 July 2005 to take account of a part year situation. Correspondingly, the minimum threshold applying to foreign tax credits is pro rated for the first year the rules apply.

Regulation-making power

In situations where it is unclear whether an instrument is debt or equity for the purposes of the NZ net equity calculation, a regulation can be made by Order in Council that clarifies its treatment for the purposes of the thin capitalisation rules. This uncertainty may arise where a new instrument has some debt characteristics and some equity characteristics, such as where the legal form of an instrument is equity but has some economic characteristics normally associated with debt.

Clarification of the status of the instrument should take into account:

• the underlying policy reflected in the legislation; and
• accounting and regulatory concepts of equity.

In a situation where there is uncertainty about whether an instrument is debt or equity for the purposes of NZ net equity, the Policy Advice Division of Inland Revenue should be contacted. Correspondence should be addressed to:

The Deputy Commissioner
Policy Advice Division
Inland Revenue
PO Box 2198
Wellington
New Zealand

Where possible, there will be consultation following the generic tax policy process prior to the introduction of any Order in Council.

Step 3: Net equity threshold

Section FG 8H measures the net equity threshold of the NZ banking group in order to compare it to the groups NZ net equity calculated in step 2. The net equity threshold is based on 4% of the NZ banking group's aggregate risk-weighted exposures (RWE).

RWE is a regulatory concept and includes the regulatory values of on and off-balance sheet assets of the NZ banking group adjusted for risk. Under section FG 8F(2), regulatory values are determined by applying the Reserve Bank of New Zealand's Capital Adequacy Framework, which sets out the methodology and rates for risk-weighting assets.

The calculation of the total of RWE is reduced by the value of assets (in aggregate referred to as DEQ in the legislation) that are subtracted from shareholder and branch equity for the purposes of determining NZ net equity. The subtraction from RWE uses regulatory values of the relevant assets. The notional offshore investment amount is not deducted from RWE. Because the amount is notional there is no corresponding separately identifiable asset to include in DEQ.

Resident entities and fixed establishments that are members of the NZ banking group that do not currently risk-weight their assets for banking regulation purposes will need to carry out this risk-weighting exercise for the new thin capitalisation calculation.

Step 4: Compare NZ net equity and net equity threshold

Section FG 3 requires a reporting bank to calculate its annual total deductions based on the calculation in section FG 8B. Reporting bank is defined in section FG 8D. Under section FG 8B if, for any quarter (or more frequent measurement date that the bank chooses), NZ net equity is less than the net equity threshold based on 4% of RWE, there will need to be an adjustment to the reporting bank's annual total deductions for that measurement period. These adjustments for any measurement period must be included in the reporting bank's tax return for the income year in which the adjustments arise.

Interest denial calculation

The adjustment required under section FG 8B, uses an interest rate generally based on average cost of funds. The average cost of funds interest rate is based on the total interest expense of the NZ banking group divided by average quarterly interest-bearing debt for the group over the income year.

The interest expense and total debt amounts are based on financial reporting amounts after aggregation using consolidation principles and, therefore, elimination of intra-group and inter-group transactions. Adjustments are made to exclude equity funding where the amounts count as interest for financial reporting purposes but not for tax purposes, and debt funding where the amounts do not count as interest for financial reporting purposes but is interest for tax purposes. The accounting policies of the group must be consistent with those of the reporting bank.

Measurement periods for NZ net equity and net equity threshold

The reporting bank is required to measure the NZ banking group's NZ net equity and net equity threshold at least four times a year. These four measurement dates align with the reporting bank's quarterly reports to the Reserve Bank of New Zealand. The NZ banking group is
determined at each measurement date.

If a bank is purchased by another bank, separate calculations must be made for any measurement periods before the acquisition, and then a joint calculation will be made for measurement periods after acquisition. Each bank will return its respective calculation pre-takeover. The joint calculation is made and returned by the bank designated to be the reporting bank for that latter period.

The reporting bank has the option, under section FG 8E, to measure the NZ net equity of the NZ banking group and net equity threshold on a daily or monthly basis, rather than on the standard quarterly basis.

Section FG 8J is an anti-avoidance rule targeting temporary changes in equity, assets or RWE where these results have the effect of defeating the intent and application of these rules (see example over the page).

Consequential amendments

A number of consequential amendments have been made. Subsection FG 2(7) has been omitted because its contents were incorporated in amendments to subsection FG 2(1). A series of amendments have been made to sections FG 3, FG 4 and FG 8 to ensure that the bank thin capitalisation rules do not overlap with the general thin capitalisation rules.

Section FH 1 excludes members of the NZ banking group from the subpart FH interest allocation rule as the bank thin capitalisation rules incorporate appropriate interest allocation concepts.

Section FG 8I provides that various values are determined in New Zealand currency and using the appropriate close of trading spot exchange rate.

A number of definitions have been added to section OB 1

Transitional arrangements

Transitional rules are available for the first income year, to take account of part-year application of the new rules for some banks. Transitional rules also apply when a foreign-owned company registers as a bank in New Zealand and when a company ceases to operate as a registered bank in New Zealand.

The bank thin capitalisation rules apply from 1 July 2005. For banks with a September financial year this means that the rules have application for part of their 2004-05 income year, specifically in the last quarter of this year. This has implications, in particular, for the notional offshore investment amount calculation.

In the case of part-year application for the 2004-05 income year, the rules allow for the notional offshore investment amount to be based on foreign tax credits that have been claimed against income tax for the part year. The transitional rule in section FG 8G(3) allows for a calculation based only on the credits attributable to the part of the income year in which the new rules apply. The minimum threshold of $5 million has also been adjusted accordingly.

Where there is a change in the bank treated as the reporting bank, a transitional rule also requires calculations to be made for all measurement periods since the last measurement period included by the former reporting bank in its previous income tax return. This is required when the two banks have different balance dates, which would otherwise cause a gap or an overlap.

Example: Calculations of NZ net equity, net equity threshold and resulting interest denial

Notwithstanding banks are likely to perform this calculation quarterly, and are required to do so at least quarterly, the following calculation for simplicity reasons shows the calculation inclusive of adjustments such as NOIA that are performed, in general, on an annual basis. Likewise any interest denial is determined using an annual interest rate which is then applied to any quarterly shortfalls. The references to steps in the example are to the steps described above.

A NZ banking group has an accounting shareholder equity of $3,000m, debt of $37,000m and assets of $40,000m based on a consolidated balance sheet for the group.