Extending the thin-cap rules to active and Australian FIFs

Taxation (International Investment and Remedial Matters) Act 2012 - extending the thin capitalisation rules to active and Australian foreign investment funds.

Subsections FE 1(1)(a), FE 2(1)(e) and FE 3(2)(b), and sections FE 5(1C) and FE 16(1B)

The Act modifies the thin capitalisation rules so that investments in FIFs for which the investor uses the attributable FIF income method or the section EX 35 Australian exemption are treated the same as investments in CFCs.

In the absence of such rules there could be an incentive for businesses to reduce their taxable income by stacking additional debt against their New Zealand operations when in fact they are using these funds to equity finance their exempt offshore investments.

Application date

The changes apply to income years beginning on or after 1 July 2011.

Key features

The Act modifies the thin capitalisation rules so that investments in FIFs for which the investor uses the attributable FIF income method or the section EX 35 Australian exemption are treated the same as investments in CFCs.

When the thin-cap rules apply

The thin-cap rules apply to New Zealand persons that are controlled by a single non-resident or that have an interest in a CFC or an interest in a FIF for which they use the attributable FIF income method or that use the section EX 35 exemption for FIFs resident in Australia.

Sections FE 1(1)(a) and FE 2(1)(e) have been modified so that the thin capitalisation rules in subpart FE apply to persons with CFCs or with FIFs for which they use the attributable FIF income method or the section EX 35 exemption for FIFs resident in Australia.

Note that a person is considered to “use the attributable FIF income method for a FIF” when the FIF passes the active business test so that no income is attributed, as well as when the FIF fails the active business test and income is attributed under the attributable FIF income method.

It is expected that the new legislation will have limited impact in practice, as most investors in the affected FIFs will also have CFC investments and already be subject to the thin-capitalisation rules.

Special rules for excess debt outbound entities

A person is regarded as an excess debt outbound entity if they:

  • have an interest in a CFC or in a FIF for which they use the attributable FIF income method, or use the section EX 35 Australian exemption for FIFs resident in Australia;
  • are not a non-resident;
  • are not controlled by a single non-resident; and
  • are not a bank.

An excess debt outbound entity is excluded from applying the thin capitalisation rules if it is part of a New Zealand group which has less than $1 million of interest deductions (section FE 6(2)(ac)) or if the assets of the New Zealand group are 90% or more of the assets of the worldwide group (section FE 5(1B).)

In other cases, excess debt outbound entities are subject to the thin-capitalisation rules, although there are several concessions that apply only to excess debt outbound entities. These concessions are:

  • The ratio of New Zealand debt to New Zealand assets must exceed 75% (compared with 60% for excess debt inbound entities) before interest deductions are denied.
  • The portion of interest deductions that are denied is reduced to the extent to which the New Zealand group has less than $2 million of interest deductions.

An alternative thin-capitalisation method may be used if the excess debt outbound entity meets certain requirements (see the next section, Alternative thin-cap rule for low-asset companies).

New Zealand group assets

In general, assets from investments in CFCs and investments in FIFs which qualify for the section EX 35 Australian exemption, or for which a person in the New Zealand group uses the attributable FIF income method (section FE 16(1B)), are excluded from the New Zealand group's assets for the purposes of determining the New Zealand group's debt-to-asset ratio. The only exceptions are if the New Zealand group has on-lent debt to the CFCs or FIFs, or if the CFCs or FIFs derive income from a source in New Zealand which is not relieved under a double tax agreement. In such cases, the assets can be included only to the extent to which they are on-lent debt or relate to New Zealand-sourced income which is not relieved under a double tax agreement.

Worldwide group assets

In respect of companies, the new legislation does not change how the assets of the worldwide group are measured. This means that if a New Zealand company owns shares in a CFC or a FIF for which they use the attributable FIF income method or the section EX 35 Australian exemption, these shares would still count as assets of that company's worldwide group, even though these shares would be excluded from the assets of the company's New Zealand group.   

For individuals and trustees of trusts, the worldwide group includes that person's New Zealand group plus the group's interests in CFCs and interests in FIFs which qualify for the section EX 35 Australian exemption or for which a person in the New Zealand group uses the attributable FIF income method (sections FE 3(2)(b) and FE 5(1C)).