Deferred deduction rule

Sections ES 1 to 3 of the Income Tax Act 1994 and sections GC 29 to 31 of the Income Tax Act 2004

Introduction

A further restriction has been placed on the operation of the deferred deduction rule, a revenue protection measure. It does not apply if 70% of an arrangement's assets consist of foreign shares held on capital account.

The criteria for defining limited recourse loans have been restated to clarify that loans from associated persons are generally excluded and, separately, arm's-length loans from New Zealand financial institutions are excluded from the definition. Two other changes ensure consistency or make the rule work as it was designed to.

Background

The deferred deduction was introduced in the Taxation (GST, Trans-Tasman Imputation and Miscellaneous Provisions) Act 2003. The general purpose of the rule is to combat aggressive tax arrangements which provide taxpayers with excessive tax advantages. The tax savings occur regardless of the success of the arrangement.

These changes further target the rule and clarify aspects of it.

Key features

Foreign shares

Section ES 1(1)(e) of the 1994 Act and section GC29(1)(e) of the 2004 Act have been amended to restrict the deferred deduction rule from applying to companies where 70% or more of the arrangement assets consist of foreign shares, if the proceeds upon any disposition of shares are not gross income, other than under the foreign investment fund rules. Comprehensive tax rules surround such investments, and the deferred deduction rule should not impose further potential tax obligations.

Other changes

Section ES 1(1)(e) of the 1994 Act and section GC29(1)(e) of the 2004 Act have been further amended to clarify that the rule will not apply where either:

• limited recourse amounts constitute less than 50% of net arrangement assets; or
• 70% or more of the arrangement assets are assets of the kind listed in sections ES 1(1)(e)(ii) and GC 29(1)(e)(ii).

The criteria in sections ES 2(3)(d) and GC 30(3)(d) for a limited recourse loan have been amended to reflect the original intent.

Loans are caught if:

• they are from an associated person who in turn has borrowed on a limited recourse basis; or
• they are not provided on an arm's-length basis; and
• they are not provided by a lender who regularly lends money and is resident or situated in New Zealand.

Sections ES 1 and ES 3 of the 1994 Act and section

GC 29 to 31 of the 2004 Act have been amended to ensure that references to losses attributed by loss attributing qualifying companies are treated in the same way in both sections and both Acts.

Application date

The amendments apply from the 2004-05 income year, but do not apply to arrangements entered into before the start of the 2004-05 income year, unless:

• at the time of entering into the arrangement, the investor could have reasonably have expected that ten or more people would acquire an interest in the arrangement; and
• 70% or more of the allowable deductions of the investors from the arrangement for the income year arise from an interest in fixed life intangible property or software.

This is the general application date for the deferred deduction rule.