Chapter 5 - Financial arrangements

• Impact of IFRS on the financial arrangement rules
• Impairment of financial assets and bad debts
• Hedge accounting rules

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5.1 Under IFRS, the accounting treatment for financial assets and financial liabilities is governed by NZ IFRS 7, NZ IAS 32 and NZ IAS 39. These standards introduced a number of significant changes to the accounting practice in this area.

Impact of IFRS on the financial arrangement rules

5.2 The financial arrangement rules in Subpart EW of the Income Tax Act 2004 set out a number of spreading methods to ensure that all income and expenditure of a financial arrangement are spread over the term of the arrangement. These spreading methods are set out in section EW 14. The principles governing the operation of these spreading methods are set out in the 1997 government discussion document The Taxation of Financial Arrangements:

“ 1.9 When the financial arrangement is entered into, the expected cashflows (and other consideration) are used in determining what amounts of income or expenditure will be spread. Thus expected income or expenditure is spread over the term of the financial arrangement, but all income or expenditure, expected or unexpected, is taken into account on maturity or disposal. The exception to this is where a market valuation method of spreading is used, because this brings unexpected income or expenditure to account at each balance date.

1.10 The rules provide the methods by which the income and expenditure are spread over the term of the arrangement. The primary method is the yield to maturity method. Other methods are acceptable if they produce a result which is not materially different from yield to maturity, are commercially acceptable, and are used by the taxpayer in its financial reporting. Other spreading methods, including an annual market valuation, are permissible provided certain criteria are met.”

5.3 The primary method of spreading income and expenditure under the financial arrangement rules is the yield to maturity method. Some taxpayers are also allowed to choose the straight line method or the market valuation method.

5.4 Taxpayers who cannot use one of the primary methods can use a method prescribed in a determination or its alternative (section EW 20) provided the specified criteria are met. For example, accrual determinations set out an expected value approach for calculating income and expenditure of financial arrangements denominated in foreign currency and forward contracts. If a determination is not available, taxpayers can use the method they have adopted for financial reporting purposes (section EW 21). If the financial reporting method is not an option because a taxpayer does not prepare financial accounts, the taxpayer may use a method that conforms to commercially acceptable practice (section EW 22) provided the method allocates a reasonable amount of income and expenditure to each income year over the term of the financial arrangement.

5.5 The financial arrangement rules should continue to govern the taxation of financial arrangements, including derivatives, for taxation purposes. Taxpayers can continue to use the methods prescribed under the financial arrangement rules to calculate income and expenditure of financial arrangements. These methods include the expected value approach prescribed in the accrual determinations for financial arrangements denominated in a foreign currency and forward contracts.

Financial reporting methods

5.6 With the adoption of IFRS, the financial reporting treatment of financial assets and financial liabilities is now governed entirely by NZ IAS 39. Most financial assets and financial liabilities that are within the scope of NZ IAS 39 are brought to tax under the financial arrangement rules. Although changes in the accounting practice brought about by NZ IAS 39 should not affect the tax treatment of these financial assets and liabilities in principle, compliance costs could be reduced if the methods used for accounting purposes could also be used for taxation purposes.

5.7 NZ IAS 39 requires gains and losses of financial assets and financial liabilities that are within the scope of the financial arrangement rules for taxation purposes to be reported using either the fair value method or the effective interest method. A derivative instrument, for example, must be measured initially and subsequently at fair value. The gains or losses resulting from fair value movements are recognised in the income statement every year.[5] Even so, many financial assets such as loans and receivables and held-to-maturity investments and financial liabilities that are not held for trading purposes can continue to be accounted for on the basis of the effective interest method.

Consistency with the financial arrangement rules

5.8 The accounting methods prescribed in NZ IAS 39 are generally consistent with the principles of financial arrangement rules for taxation purposes. The effective interest method adopted under NZ IAS 39 is similar to the yield to maturity method prescribed under the financial arrangement rules.[6] In addition, the fair value method under NZ IAS 39 is substantially the same as the market valuation method when there is an active market for the financial instrument or when there is a reliable market price.

5.9 We suggest that when the financial reporting methods under NZ IAS 39 require taxpayers to report gains and losses of financial assets and financial liabilities in the income statement using either the fair value method or the effective interest method, they should be able to use the same method for taxation purposes. However, as discussed earlier, credit impairment adjustments required under NZ IAS 39 will be allowed for taxation purposes only if the bad debt deduction rules in section DB 23 are satisfied.

5.10 This suggestion should result in considerable simplification for taxpayers in the way they account for their financial assets and financial liabilities that are within the scope of both NZ IAS 39 and the financial arrangement rules in the Act.

Impairment of financial assets and bad debts

5.11 The accounting treatment for credit impairments of financial assets is governed by NZ IAS 39.[7]

5.12 Allowance must be made for credit impairments for all financial assets under NZ IAS 39 if there is objective evidence that impairment losses have been incurred. Impairments can arise from an event or a combination of events that impact on the estimated future cash flows of the financial assets. These events include significant financial difficulty on the part of the issuer or obligor, a breach of contract and other subjective assessments about when it is becoming probable that the borrower will enter bankruptcy or other financial reorganisation. Impairments can also be claimed when there is observable information indicating a measurable decrease in the estimated future cash flows from a group of financial assets even if the decrease can not yet be identified with the individual financial assets in the group.

5.13 The reporting entity is required to recognise impairment losses, which can include both specific and general provisions for doubtful debts, in its income statement for financial reporting purposes. Any subsequent reversal is recognised as income in the income statement.

Tax treatment of credit impairments

5.14 The deductibility of bad debts for taxation purposes is entirely governed by section DB 23. General provisions for doubtful debts that have been recorded for financial reporting purposes are currently not deductible for taxation purposes. Specific provisions for bad debts are allowed as deductions for taxation purposes only if they have been written off as bad and the relevant requirements of section DB 23(2) through (5) are satisfied.

5.15 Bad debts associated with financial arrangements are allowed if the taxpayer satisfies the provisions in section DB 23(2) or DB 23(3). Section DB 23(2) allows bad debts as deductions if they have been written off and the amount is attributable to the income of the financial arrangement. Section DB 23(3) allows bad debt deductions for amounts owing under a financial arrangement when the taxpayer is in the business of dealing in or holding the financial arrangements. These restrictions are consistent with bad debt deductibility rules in Australia.[8]

Aligning tax and accounting treatment of credit impairments

5.16 The process of recognising credit impairments under NZ IAS 39 is triggered by the objective evidence that credit impairments have occurred. Nevertheless, the process of determining the nature and quantum of credit impairments involves subjective judgement. Officials believe that allowing deductions for provisioning of credit impairments creates inconsistency in the tax legislation because tax legislation does not normally allow deductions for items that are in the nature of provisions.

5.17 A complete alignment of the tax treatment of bad debts and the accounting treatment of credit impairments under NZ IAS 39 would mean that all provisions for doubtful debts would become deductible for taxation purposes. Although NZ IAS 39 provides a more stringent approach to the provisions of bad and doubtful debts than current accounting practice does, this new approach will still carry significant revenue costs that are unacceptable to the government. We estimate that the revenue costs to the government of a complete alignment between accounting and tax treatment of credit impairments would be over $250 million in the transition year if the complete alignment applied only to the major banks in New Zealand. The full revenue costs would be higher if the complete alignment applied more generally to all taxpayers.

5.18 While these revenue costs could be limited by specifying an upper limit for provisions for doubtful debt allowed as deductions for taxation purposes, we do not consider this to be a good policy design. Specifying an upper limit for allowable bad debts for taxation purposes would encourage taxpayers to take the full amount as deductions regardless of the commercial reality. The upper limit would also unduly penalise taxpayers who have actual bad debts that exceed the limit for commercial reasons.

5.19 We do not suggest any changes to the existing tax treatment for bad debts. An impairment of a financial asset that has been written off under NZ IAS 39 should be allowed as a deduction for taxation purposes only if the bad debt deduction rules in section DB 23 are satisfied.

Tax treatment of fees

5.20 For taxation purposes, all contingent fees paid in relation to a financial arrangement are subject to the financial arrangement rules and spread over the term of the financial arrangement. Non-contingent fees that are payable whether or not the financial arrangement proceeds are excluded from the financial arrangement rules and are brought to tax as these fees are “derived” or “incurred”.

5.21 For financial reporting purposes, fees that are an integral part of the effective interest rate of a financial instrument are generally treated as an adjustment to the effective interest rate. Even so, fees that are integral to a financial instrument that is measured at fair value are recognised for accounting purposes when the instrument is initially recognised.

5.22 Our view is that the accounting treatment of fees that are an integral part of a financial arrangement is similar in substance to the current taxation rules for contingent fees. We suggest replacing the distinction between “contingent” and “non-contingent” fees for taxation purposes with the distinction between “integral” and “non-integral”. Legislative amendment is likely to be necessary to align the tax treatment explicitly with the financial reporting treatment.

5.23 Other fees that are not an integral part of a financial arrangement will continue to be subject to tax in accordance with the general taxation principles of “derivation” and “incurred”. As discussed in the next chapter, fee income will almost always be brought to tax as revenue based on the accounting treatment.

Hedge accounting rules

5.24 A derivative instrument that has been designated as a hedge and is an effective part of a hedging relationship is subject to special hedge accounting rules under NZ IAS 39. Special accounting treatment also applies to the underlying items being hedged.

5.25 Under the hedge accounting rules, income and expenditure on both the hedge instrument and the hedged risks of the underlying items in a fair value hedge are recognised on an unrealised basis. For example, when a firm commitment to purchase raw materials in US dollars is the underlying hedged item of a fair value hedge, the fair value movements in the US dollar commitment are recognised as profits or losses on a fair value basis, together with the derivative instrument even though the costs of the raw material can not be recognised yet.

5.26 On the other hand, hedge accounting rules also allow the deferral of income or expenditure on hedge instruments that are part of the cash flow hedges and hedges of net investments until the underlying hedged risks are realised. For example, if a forward rate agreement is used to hedge a cash flow interest rate risk on a floating rate loan, the gains or losses on the forward rate agreement can be deferred until the underlying cash flow risk impacts the income statement.

5.27 The hedge accounting rules are intended to create a matching effect for the accounting treatment of the hedge instrument and the underlying hedged item. This is achieved for accounting purposes by accelerating the recognition of gains or losses on the hedged items in a fair value hedge and deferring the recognition of gains or losses on the “effective” component of a cash flow hedge or a hedge of net investments in a foreign operation.

Current taxation rules for items in a hedge relationship

5.28 Current taxation rules do not incorporate hedge accounting rules. Gains or losses on the derivative hedge instruments are reported in accordance with the financial arrangement rules in the Act. Gains or losses on the hedged items are reported in accordance with general taxation principles on income and expenditure, unless these items are within the scope of the financial arrangement rules. This means that there is no explicit matching of gains and losses arising from items in a hedge relationship. Nevertheless, a degree of matching is already possible for taxation purposes, since many items in a hedge relationship are within the scope of the financial arrangement rules.

5.29 Table 1 summarises the accounting and tax treatment of different types of hedge relationships. Matching will result from the application of the financial arrangement rules for examples 3, 4, 5 and 7, when the hedge instruments and the underlying hedged items are all financial arrangements under the financial arrangement rules. Matching is also possible in example 2 when a forward currency contract is used to hedge a forecast purchase of raw materials if the taxpayer elects to use Determination G 14B. Determination G 14B effectively allows the gains and losses on the forward currency contract to be deferred until the contract matures. As the financial arrangement rules already provide for methods of calculating income and expenditure that could create a matching effect for items in a hedge relationship, specific hedge accounting rules are unnecessary in these circumstances.

Table 1: Accounting and taxation treatments of different hedge relationships

Examples	Hedge Instrument[9]	Hedged Items[10]	Accounting Treatment under NZ IAS 39	Taxation Treatment
1	Derivative Instrument – forward currency contract	Firm commitment to purchase capital asset in USD[11]	Fair value hedge – FX risk	No matching
2	Forward currency contract	Forecast raw material needs (e.g. oil) in USD	Cash flow hedge – FX risk	Matching possible under Determination G14B
3	Currency swaps	Fixed rate FX Loans	Fair value hedge – FX risk	Matching possible within the financial arrangement rules
4	Interest rate swaps	Fixed rate domestic loans	Fair value hedge – interest rate risk	Matching possible within the financial arrangement rules
5	Interest rate swaps	Floating rate domestic loans	Cash flow hedge – interest rate risk	Matching possible within the financial arrangement rules
6	Currency futures (USD)	Investments in USD shares	Fair value hedge – FX risk	No matching
7	Currency futures (EURO)	Investments in fixed rate, held to maturity debt securities in EURO[12]	Fair value hedge – FX risk	Matching possible within the financial arrangement rules

5.30 For taxation purposes, no matching is possible in examples 1 and 6 when a derivative instrument is used to hedge a firm commitment to make a purchase of capital asset or a portfolio of share investment. The lack of matching in these scenarios for taxation purposes exists because although the hedge instrument is within the financial arrangement rules, the taxation of the hedged item depends on whether the underlying item is on revenue or capital account. Hedge accounting rules cannot be introduced for taxation purposes unless we are also prepared to review these fundamental tax principles that govern New Zealand taxation laws.

Complexity of hedge accounting rules

5.31 International experience suggests that if hedge accounting rules are adopted for taxation purposes, the guidelines governing the designation and effectiveness of hedges in NZ IAS 39 will have to be modified and incorporated into the tax legislation.[13] These guidelines are necessary to limit the opportunities for taxpayers to abuse the hedging rules for taxation purposes. However, the rules are very complex and could increase compliance and administrative costs significantly.

Is legislative change needed?

5.32 Hedge accounting rules modify the character and timing of items in a hedge relationship. Gains and losses on derivative instruments that are part of a cash flow hedge or a hedge of net investments in a foreign operation can be deferred under the hedging rules. This treatment is inconsistent with the purpose of the existing financial arrangement taxation rules, which require expected income and expenditure on a derivative instrument to be spread over the term of the arrangement.

5.33 We consider that all derivative instruments, including those that are part of a cash flow hedge or a hedge of net investments in a foreign operation, should be brought to tax under the financial arrangement rules.

5.34 Hedge accounting rules will also allow a taxpayer to accelerate income and expenditure on the underlying hedged items that have been designated as part of a fair value hedge. Established tax principles, such as the non-taxation of capital gains and taxation timing based on realisation, will be modified to the extent that the gains and losses are arising from an item that has been designated as an underlying hedged instrument in a fair value hedge.

5.35 Our view is that it is inappropriate to modify the general taxation principles for items in a hedge relationship. The hedged items in a fair value hedge should continue to be taxed as if they are not part of a hedge.

Views sought

5.36 The hedge accounting rules are not considered to be appropriate for taxation purposes because they will change the taxation treatment for financial instruments and any items being designated as a hedged item. If hedge accounting rules were incorporated into the tax legislation, they would also likely be accompanied by a set of tax guidelines on the designation and effectiveness of hedges, which are very complex and have significant compliance and administration costs. Furthermore, there are already comprehensive financial arrangement rules that allow many items that could be in a hedge relationship to be brought to tax consistently.

5.37 Submissions are sought on specific instances where the application of general tax principles and the financial arrangement rules to a hedge relationship lacks clarity and thus adversely affect the effectiveness of a taxpayer’s hedging strategy. Special rules may be considered for these special circumstances, when appropriate, to ensure that hedged relationships are not unduly distorted by the tax rules.

5 The exceptions are available for sale financial assets and instruments in a cash flow hedge relationship when their gains and losses are recorded directly in shareholders’ equity.

6 The effective interest method calculates and allocates the interest income and expense of a financial asset or a financial liability over the relevant period based on the effective interest rate, which is the rate that exactly discounts estimated future cash payments or receipts over the life of the asset or liability to the net carrying amount of the financial asset or financial liability.

7 Interest revenue (including interest accrued on impaired debts) is recognised in accordance with NZ IAS 18 if it is probable that the economic benefits will flow to the entity. When uncertainty arises with respect to an amount already included in revenue, the uncollectible amount is recognised as an expense, rather than as an adjustment of the amount of revenue originally recognised.

7 Australia allows a bad debt deduction if there is a physical write-off of the debt and either the debt has been brought into account by the taxpayer as assessable income or the taxpayer is in the business of lending money.

8 A derivative instrument (except for written options) can be a hedge instrument if it has been designated as a hedge and is an effective part of a hedging relationship. Internal hedges do not qualify for hedge accounting treatment in the consolidated financial reports – an instrument needs to involve an external third party to be a hedge instrument. A hedge instrument can be designated partly as a hedge instrument – for example, 50% of the notional amount may be designated as a part of hedge relationship. Two or more instruments can be viewed in combination and jointly designated as the hedging instrument. In addition, a single hedge instrument can be designated as a hedge of more than one type of risk subject to designation and effectiveness requirements.

10 Hedged items can be a single (or a group of) asset(s), liability, firm commitment, highly probable forecast transaction or net investment in a foreign operation. Groups of assets and liabilities are to be aggregated only if the individual assets or liabilities in the group share the risk exposure that is designated as being hedged. A financial asset or financial liability may be a hedged item with respect to the risks associated with only a portion of its cash flows or fair value provided that effectiveness can be measured.

11 A non-financial asset or non-financial liability can be designated as a hedged item for foreign currency risks. If the asset is hedged for all other risks, it has to be designated in its entirety.

12 A held to maturity investment cannot be a hedged item with respect to interest rate risk or prepayment risk. However, a held to maturity investment can be a hedged item with respect to risks from changes in foreign currency exchange rates and credit risk.

13 To qualify for hedge accounting rules under NZ IAS 39, the hedge instrument has to be designated at the inception of the hedge, the hedge has to be assessed and determined to be actually “highly effective” on an ongoing basis, and the hedge effectiveness can be reliably measured. Furthermore, the reporting entity needs to determine the proportion and period in which to assign the derivative as a hedge instrument. For details of the guidelines,