Deductions for holders of debt – base maintenance change

Issue: Support for base maintenance change

Clauses 26 and 29

Submission

(NZICA, Corporate Taxpayers Group)

The submitters support the principle that holders of debt should only be able to take a deduction for the true economic cost.

Recommendation

That the submission be noted.

---

Issue: Base maintenance change – current law is sufficient

Clause 29

Submission

(NZICA)

The current rules sufficiently achieve the desired outcome of limiting deductions for bad debts to the economic cost and therefore the amendment should not proceed. While the base price adjustment (BPA) may not always be performed in the same year as the bad debt deduction is taken, this is a timing difference only and the overall outcome is appropriate.

If this is not accepted, the BPA formula should be amended to eliminate the timing mismatch rather than the bad debt rules.

Comment

Officials agree that, overall, the BPA (a wash-up calculation that is performed when the financial arrangement comes to an end) will mean the correct tax outcome should eventually be reached under current law. However, as noted by the submitter, the creditor is able to benefit from a timing advantage because the bad debt deductions could be taken well before income from the BPA is recognised. This result is not in line with the current policy settings for bad debt deductions, and it means taxpayers can take a deduction for an amount greater than the cash/economic loss incurred. Furthermore, the timing advantage also presents a risk to the integrity of the revenue base especially if a BPA is never performed meaning the timing advantage becomes a permanent tax advantage. It is these advantages that the base maintenance change is seeking to rectify.

Officials consider the interaction of the bad debt rules and BPA formula result in the correct outcome for taxpayers, and that an amendment to the BPA formula is therefore unnecessary. Bad debt deductions have always been outside the financial arrangement rules. There are two main reasons for this. Firstly they apply to debts other than financial arrangements, and secondly, deductions for bad debts are not part of the usual income/expenditure on financial arrangements and need to be dealt with separately as bad debts.

Recommendation

That the submission be declined.

---

Issue: New regime for bad debt deductions arising from financial arrangements

Clause 29

Submission

(Baycorp)

Given the complexity of the bad debt rules and their interaction with the financial arrangement rules and the base price adjustment calculation, a new policy should be set with one regime rather than the current interaction of two regimes (financial arrangements and bad debt deductions).

Comment

Amending the financial arrangement rules was considered during the policy development. However, officials believe that the (complex) financial arrangements rules generally work well and amending these rules would add additional complexity which may unintentionally affect other arrangements.

Furthermore, as noted in an earlier submission, bad debt deductions have intentionally been placed outside the financial arrangement rules, firstly because they apply to debts other than financial arrangements, and secondly, because deductions for bad debts are not part of the usual income/expenditure on financial arrangements and need to be dealt with separately as bad debts.

Given that officials consider the proposed new rules will achieve the desired outcome, it is considered unnecessary to introduce a new regime to the Income Tax Act.

Recommendation

That the submission be declined.

---

Issue: Incorrect result when the consideration paid for a debt is less than the face value

Clause 29

Submission

(KPMG, Corporate Taxpayers Group, Baycorp)

Where a debt is purchased for less than its face value and is later remitted, the base maintenance change neglects the fact that the “amount remitted” component will potentially produce an income result in the base price adjustment (BPA) formula, and result in over-taxation. This is an unintended outcome of the rules, but one for which the full bad debt deduction is currently needed as an offset. The bill restricts the available bad debt deduction without similarly limiting the corresponding income under the BPA formula. The one-sided nature of this amendment needs to be addressed.

If it is intended that bad debt deductions be taken under two provisions (subsection DB 31(2) for income amounts and subsection DB 31(3) for principal amounts), this should be made clear in the legislation. (Baycorp)

Comment

Officials consider that, together, the financial arrangement rules (including the BPA) and the proposed bad debt deduction provisions will achieve the correct result. That is, the proposed rules sufficiently allow deductions to be taken when a debt is transferred for less than the face value of the loan. This can be illustrated by an example.

Officials have discussed the application of the rules with the submitters, and after further consideration Corporate Taxpayers Group and KPMG are comfortable that the legislation works as intended and that deductions can be taken under both subsections DB 31(2) and (3).

Officials do not consider it necessary or desirable to amend the legislation to clarify the application of the rules. However, the intended application of the rules will be explained in a Tax Information Bulletin following enactment of the bill.

Recommendation

That the submission be declined.

---

Issue: Drafting for limited recourse arrangement rule

Clause 29

Submission

(NZICA, Corporate Taxpayers Group , Baycorp)

The definition of “limited recourse arrangement” as currently drafted is confusing and should be redrafted as it is not clear what the proposed definition is intended to capture.

Comment

Officials agree that the definition of “limited recourse arrangement” could be made clearer. The rule regarding limited recourse arrangements is intended to be an anti-avoidance measure to ensure dealers and holders are only able to take bad debt deductions for the true money at risk.

Without this rule it would be possible for one party (party 1) to borrow money from another party (party 2) by way of a limited recourse arrangement (Loan A). The amount borrowed under Loan A could be used to fund the purchase of a debt (the underlying debt). The limited recourse arrangement for Loan A could then be structured so that the borrowed funds were only repayable up to the amount received under the underlying debt. Without a limited recourse arrangement rule party 1 could take a bad debt deduction for the full amount owing under the underlying debt, even though they have not made a true economic loss because the money effectively comes from party 2 and is only repayable to the extent that the underlying debt is repaid. In this situation party 1 should only be able to take a bad debt deduction up to the amount that truly represents an economic loss. If they were able to take a deduction for more than this, they would receive an excessive and unjustified advantage.

Recommendation

That the submission be accepted.

---

Issue: Rationale for limited recourse arrangement rule

Clause 29

Submission

(New Zealand Law Society)

Proposed subsection DB 31(4C), an anti-avoidance provision which limits bad debt deductions for dealers and holders to the amount not subject to limited recourse, should be removed. As currently drafted, it extends too far because it prevents a deduction being taken where a true economic loss has been suffered.

Comment

Officials agree that a bad debt deduction should be allowed where a true economic loss has been suffered. As noted in the previous submission, it is recommended that the drafting of the limited recourse rule be amended to ensure it is clear what the provision is intended to capture. This redrafting will ensure that the submitter’s concern is addressed and that where a true economic loss has been suffered, the limited recourse arrangement rule will not prevent a bad debt deduction from being taken.

Recommendation

That the submission be noted.

---

Issue: Exception to limited recourse arrangement rule

Clause 29

Submission

(Baycorp)

A collection agreement, where the collection is outsourced and a commission amount is paid for that collection service, should not be a limited recourse arrangement.

Comment

Officials do not see how a collection agreement, as described above, would fall within the current definition of “limited recourse arrangement”. The base maintenance change is intended to ensure bad debt deductions are limited to the true economic loss and the limited recourse arrangement rule is a supporting anti-avoidance measure to ensure this result is achieved. A collection agreement would only be affected by this anti-avoidance measure if there is a limited recourse component to the agreement.

Recommendation

That the submission be noted.

---

Issue: Application date of base maintenance change

Clause 26 and 29

Submission

(NZICA, Baycorp)

As currently proposed, taxpayers who have taken excess deductions will be required to return those amounts as income in the 2014-15 year. If the amendment proceeds, it should be prospective only. (NZICA)

The rule which requires certain income to be returned in the 2014-15 year is not appropriate. This is especially so given the submitter considers the application of the current rules does not provide a windfall but is a necessary consequence of how the bad debt rules and the base price adjustment (BPA) calculation are set up to work. As currently drafted, a taxpayer could be overtaxed after receiving both BPA income and income under the proposed claw-back rule. Retrospective legislation should be avoided to provide certainty to taxpayers. (Baycorp)

Comment

Under the current tax rules holders of debt can take bad debt deductions for amounts owing even where the holder has not suffered an economic loss. This result is not in line with the existing policy for bad debt deductions. It also results in an unjustified timing advantage and presents a risk to the integrity of the revenue base.

As drafted, the base maintenance changes will apply from the date of introduction of the Taxation (Annual Rates, Foreign Superannuation, and Remedial Matters) Bill, and there will be a retrospective claw-back rule to require taxpayers who have taken excess deductions (that is, deductions exceeding the cost of acquisition and any income returned), to return those amounts as income in the 2014-15 year. The effect of the claw-back rule is that the rule is retrospective for financial arrangements that are in existence in the 2014–15 year, and affected taxpayers must return extra income prospectively (in the 2014–15 year). Officials consider that this is justified because it puts them back in the same position they should be in, in line with the policy intent. There is no concern with financial arrangements that have ended prior to the 2014–15 year, as the BPA (wash-up calculation) that would have been performed should have squared-up any excess deductions taken.

The reason for the claw-back rule is that, notwithstanding the current legislative wording, it is not considered reasonable for taxpayers to take deductions for more than their economic loss under the financial arrangement. It is not anticipated that a large number of taxpayers will be affected by the claw-back rule; however, it is necessary for base maintenance reasons. There will be a savings provision for taxpayers who are involved in assessments that are subject to the tax disputes process.

Officials agree with Baycorp that there may be some circumstances where the proposed claw-back rule would result in too much tax being paid and therefore recommend a slight amendment to the claw-back rule to ensure the correct policy result is achieved.

Recommendation

That the submission be declined subject to officials’ comments.