Alternative thin-capitalisation test for some low asset companies

Taxation (International Investment and Remedial Matters) Act 2012 introduces an alternative thin-capitalisation test for some low asset companies, beginning 1 July 2009.

Subsections FE 5(1B), FE 5(1D) and (1E), FE 5(1BC), FE 5(1BD) and FE 5(1BB) and sections FE 6B and FE 12B of the Income Tax Act 2007 and section 65B of the Tax Administration Act 1994

The Act introduces an alternative thin capitalisation test for certain New Zealand-based groups with offshore investments. This will give certain New Zealand taxpayers an option to apply an alternative method under the thin capitalisation rules. New Zealand multinational groups that have a high level of arm's length debt (provided that certain other conditions are met) can choose a test for thin capitalisation based on a ratio of interest expenses to pre-tax cashflows, rather than on a debt-to-asset ratio.

Application date

The alternative thin-capitalisation test applies for income years beginning on or after 1 July 2009. The measure applies retrospectively so that companies that may have experienced difficulties immediately after the extension of the thin capitalisation rules will be able to obtain relief.

Key features

A new thin capitalisation test is available for certain New Zealand-based multinationals.

The test is available to a group if:

  • the worldwide debt of the multinational is more than 75% of its worldwide assets (excluding any recognised goodwill);
  • at least 80% of the worldwide group's debt is from lenders that are not associated with a member of the group; and
  • the New Zealand part of the multinational group and the worldwide group both have net income and net interest expenses (not net losses or net interest income).

The test is not available to entities that are non-residents or controlled by a single non-resident.

If the alternative test can be used, the taxpayer will calculate a ratio of net interest expense to net income, rather than the debt-to-asset ratio used under the existing test.

To the extent that the ratio for the New Zealand group is less than the lesser of 50% and 110% of the ratio for the worldwide group there will be no denial of interest deductions under the rules. If these conditions are not met, some interest deductions may be denied.

Detailed analysis

All references are to the Income Tax Act 2007 unless stated.

Background

The thin capitalisation rules, which limit excessive interest deductions against the New
Zealand taxable income of multinationals, were extended in the Taxation (International
Taxation, Life Insurance, and Remedial Matters) Act 2009.

Previously, they applied only to non-residents and residents controlled by non-residents. The 2009 Act extended the thin capitalisation rules to other taxpayers with controlling interests in foreign companies. As part of the Taxation (International Investment and Remedial Matters) Act 2012, the rules have been further extended to some taxpayers with non-controlling interests in foreign companies.

Extending the rules has created difficulties for a small number of New Zealand-based groups reported to have high indebtedness.

The rules currently deny interest deductions if a group has a New Zealand debt-to-asset ratio that is both more than 75% and more than 110% of the worldwide debt-to-asset ratio of the group.

In other words, some deductions are denied if the group's debt appears to be concentrated in New Zealand.

The problem arises partly from the way assets are measured. Measurement is based on generally accepted accounting principles (GAAP). GAAP does not allow the recognition of some intangible assets, such as internally developed goodwill. Companies that have highly valuable brands, for example, cannot include those in the measure of assets unless they were purchased on the open market. This increases the debt-to-asset ratio and increases the potential for interest deductions to be denied.

A New Zealand company with valuable brands that looks to expand offshore by taking on debt may therefore find itself subject to the thin capitalisation rules, even though it is not unreasonably arranging to have its debts in New Zealand.

There are good reasons for the exclusion of internally developed goodwill and some other intangible assets from the GAAP measure of assets. Primarily, it can be extremely difficult to value intangible assets if there has not been an arm's-length transaction.

However, in cases where a company has significant intangible assets that cannot be counted for the purpose of the thin capitalisation rules, it is possible that a debt-to-asset ratio will be a misleading indication of whether excessive debt has been stacked in New Zealand.

Alternative test

To address the problem that some New Zealand-based groups are facing, a new test has been developed as an alternative to the existing debt-to-asset ratio test. It uses a measure that approximates an interest coverage ratio (interest-to-cashflows). Arm's-length lenders may be prepared to lend against cashflows even when recognised assets are low (interest coverage is often used in lending covenants).

Requirements for use of alternative test

Paragraph FE 5(1B)(ab)

An "excess debt outbound entity" is, broadly speaking, a person who is subject to the thin capitalisation rules solely by reason of a direct or indirect outbound investment from New Zealand.

Paragraph (ab) of section FE 5(1B) provides that an excess debt outbound entity is not required to apply the existing thin capitalisation rule in section FE 6 if it is able to choose, and does choose, to apply the alternative rule in section FE 6B.

Subsection FE 5(1BB)

This subsection provides that a person can choose the alternative rule in section FE 6B if all of the following four requirements are met:

  • Both the New Zealand group and the worldwide group of the person must have a positive amount of adjusted net profit for the year (adjusted net profit is further defined in subsection FE 5(1BC) and is determined mainly using financial accounts).
  • Both the New Zealand group and the worldwide group of the person must have a positive amount of net interest expense, determined using the rules in the Income Tax Act as if there were no thin capitalisation rules, as if the relevant members of the worldwide group were residents, and as if the group were consolidated to eliminate internal balances and transactions (see commentary on section FE 12B).
  • The worldwide group's debt-to-asset ratio, excluding any recognised goodwill but otherwise determined using the existing thin capitalisation rules, must be 75% or more.
  • 80% or more of the worldwide group's debt (calculated in the normal way under the thin capitalisation rules) must be from people that are not associated persons of a member of the group.

The first two requirements are to prevent distortion when the formula in section FE 6B is applied. The third requirement is that the worldwide group is highly indebted if all of its recognised goodwill is disregarded. If the group is not highly indebted in this circumstance, the existing test is more likely to work (it is less likely to be difficult for the company to push some debt offshore, for example). The fourth requirement is to ensure that most of the debt is genuinely arm's-length debt, and not, for example, capital injected by shareholders in the form of debt.

Definition of adjusted net profit

Subsections FE 5(1BC) and FE 5(1BD)

The adjusted net profit of a group is a proxy, albeit an imprecise one, for net cashflow from operations. It corresponds approximately to the "earnings before interest, tax, depreciation and amortisation" measure used in financial markets, usually referred to by its acronym EBITDA.

The formula begins with net profit before tax for the relevant group (New Zealand or worldwide), determined using generally accepted accounting principles (GAAP) and consolidating companies for the purposes of eliminating intra-group transactions (see commentary on section FE 12B). A net loss is treated as a negative net profit. A pre-tax measure is used partly because the measure of tax expense used for GAAP purposes is unlikely to be a meaningful indication of current tax liabilities (or associated cashflows).

For the New Zealand group, certain income arising from an interest in a foreign company is then removed, again using generally accepted accounting principles to measure this income. The income is removed if the interest is an income interest in a controlled foreign company, or an interest in a foreign investment fund that qualifies for the Australian exemption in subsection EX 35(1), or an interest in a foreign investment fund for which the attributable FIF income method is used.

This income is removed because it is typically not subject to tax in New Zealand. An important purpose of the thin capitalisation rules is to prevent excessive deductions being allocated to income that is not taxable in New Zealand.

Net interest deductions (deductions less income), as determined under the Income Tax Act but again on a consolidated basis, are then added to the remaining net profit. This gives an estimate of cashflows before interest expense. In the case of the worldwide group, relevant members are treated as if they were resident for this purpose.

Depreciation and amortisation, measured under GAAP, and again on a consolidated basis, are then added back. These are non-cash expenses.

When there is no interest apportionment (no denial of deductions)

Subsections FE 5(1D) and (1E)

An excess debt outbound entity is not denied any interest deductions under the apportionment rule in section FE 6B, if its New Zealand group's ratio of net interest to adjusted net profit is below the lesser of 50% or 110% of the worldwide group's net interest to adjusted net profit ratio.

For example, if the worldwide group's net interest to adjusted net profit ratio was 40%, the excess debt outbound entity would face some interest denial if the equivalent New Zealand group ratio was more than 44%. If instead, the worldwide group ratio was 60%, the excess debt outbound entity would face some interest denial if the New Zealand group ratio was more than 50%.

Net interest is defined in the same way as in subsections FE 5(1BB) and (1BD). The use of a net interest figure allows entities to reduce their apparent interest deductions for the purposes of thin capitalisation by on-lending their borrowings to foreign companies (pushing some debt offshore) and receiving corresponding interest income. Adjusted net profit is defined in subsections FE 5(1BC) and (1BD).

The apportionment calculation

Section FE 6B

If a person chooses to apply the alternative apportionment calculation and is not excluded by subsections FE 5(1D) and (1E) from having to actually apportion, section FE 6B is the section used to perform the actual apportionment.

The amount of interest deduction denied is given by the formula in subsection (2). In practice, deductions are denied by adding back income rather than reducing deductions. The terms in that formula are based on the interest-to-income ratio given by section FE 5(1E) and the thresholds seen in section FE 5(1D). "Net interest" is the actual amount of net interest deduction for the taxpayer (not the group) in the absence of the thin capitalisation rules.

Parallels with the existing interest allocation calculation in section FE 6 are evident.

Example: Interest deductions denied

X Co, a resident company with a single resident shareholder, owns 100% of Y Co, a foreign company. X Co would have net interest deductions of $1 million in the absence of the thin capitalisation rules, and the worldwide group would have net interest deductions of $3 million. X Co's adjusted net profit is $3 million and the worldwide group's adjusted net profit is $12 million. Assume X Co is able to use the alternative apportionment calculation. Then: net interest is $1 million;
NZ group ratio is 0.333… ($1 million ÷ $3 million);
threshold ratio is 0.275 (1.1 x $3 million ÷ $12 million); and the formula gives a result of $175,000 ($1 million x [0.333... - 0.275] ÷ 0.333...).

Therefore only $825,000 of interest deductions is effectively permitted.

Note that if X Co instead had $825,000 of interest deductions in the first place, and the worldwide group's deductions were unchanged, the NZ group ratio would be exactly equal to 110% of the ratio for the worldwide group, and deductions would not be denied.

Machinery provision

Section FE 12B

Section FE 12B specifies that certain amounts used in the thin capitalisation test are to be calculated using generally accepted accounting principles and on a consolidated basis.

In the case of interest deductions and interest income, there are specific instructions to use tax concepts rather than accounting concepts to calculate the base amounts, but consolidation of these amounts is still undertaken using accounting principles. This is similar to the treatment of debt under the existing thin capitalisation test, in which the relevant debts are determined by the tax rules but consolidation occurs using accounting principles.

Section FE 12B also limits the consolidation of amounts of any non-resident group members to the amount that is attributable to New Zealand-sourced income.

Administrative requirements

Section 65B of the Tax Administration Act 1994

Taxpayers who use the proposed new rule must meet the following administrative requirements:

  • First, the taxpayer must advise the Commissioner, in any manner the Commissioner may specify, that the rule has been applied.
  • Secondly, the taxpayer must provide reconciliations of adjusted net profit to GAAP net profit, and of goodwill to items presented in the GAAP balance sheet, in any manner the Commissioner may specify.

The advice and reconciliations must be furnished to the Commissioner by the due date for the taxpayer's tax return for the relevant tax year under section 37 of the Tax Administration Act 1994. The current procedure is to send these to competent.authority@ird.govt.nz

These requirements will enable Inland Revenue to monitor the extent of use of the alternative thin capitalisation rule and the appropriateness of the measures used in it.