Chapter 2 - Current tax policy and law

2.1 Debt can be remitted when the debtor:

  • is discharged from making remaining payments;
  • is insolvent or liquidated;
  • enters into a deed of composition with its creditors that results in full remission; or
  • has no obligation to make payments when, because of the passage of time, the debt is irrecoverable or unenforceable.

2.2 Section EW 29 of the Income Tax Act 2007 provides that these remissions (and some other scenarios) can trigger a section EW 31 base price adjustment (BPA).[1]

2.3 Under Inland Revenue’s Office of the Chief Tax Counsel’s anti-avoidance analysis (see the Appendix), debt can also be deemed to be remitted when there is a debt capitalisation. This is further discussed below.

The debtor

2.4 Under the financial arrangement rules, a remission of debt owing results in income to the debtor. As stated in the December 1997 discussion document, Taxation of Financial Arrangements, at paragraph 11.3:

The purpose of the debt remission rules is to recognise the fact that the forgiveness of a debt increases the wealth of the debtor. This should, as with all other gains under a financial arrangement, be brought to tax.

2.5 This outcome was considered and reaffirmed as part of the deliberations on the changes to be made as a result of the discussion document and has applied since the enactment of the financial arrangements rules in 1986.

2.6 The section EW 31 BPA produces this remission income as intended.

2.7 This debt remission income is the correct policy outcome when the debt is from a third party, and this is generally accepted by the private sector. Example 1 illustrates the correct outcome of a debt remission.

Example 1

Bank has advanced two loans to Jo Ltd. Jo Ltd has significant liquidity problems and, as part of the reconstruction of Jo Ltd, Bank remits one of the loans. Under the BPA, Jo Ltd has financial arrangement income of the amount of the loan remitted.

Liquidation or insolvency

2.8 The effect of liquidation or insolvency is that debt remission income is not effectively brought to account for taxation purposes. For companies, the remission income is deemed to arise at the conclusion of the liquidation process. At this stage, the company has ceased to exist by way of being struck off and there is nothing left to pay the tax. Similar analysis applies for insolvency. Refer Example 2.

Example 2

Bank has advanced a loan to Joe Ltd. Joe Ltd has significant problems and is liquidated. Thus the loan is remitted. Under the BPA, Joe Ltd theoretically has financial arrangement income of the amount of the loan remitted. However, in practice, because the remission is deemed to happen immediately after the liquidation is finished, there are no assets left with which to pay any resulting taxation liability.

2.9 This was contrary to the initial policy intent.[2] An attempt was made to address this in the 1997 discussion document.[3] However, after submissions were considered, it was decided not to proceed because it would dilute the recovery of the general pool of creditors as any resultant tax liability would rank alongside these creditors, rather than after them.

Debt parking

2.10 Debt parking rules were introduced as a result of the discussion document. Before this it was not uncommon for an associated person of the debtor to buy distressed debt from the creditor and effectively freeze the arrangement in order to defer or prevent BPA income of the debtor while often providing a bad debt deduction for the original creditor.[4] Example 3 is an illustration of this.

Example 3

Bank has advanced a loan to Bill Ltd. Bill Ltd develops significant liquidity problems and, as part of the restructuring of Bill Ltd, the owner of Bill Ltd buys the loan from the bank for 40 percent of its face value. This forces a BPA, and Bill Ltd has financial arrangement income of 60 percent of the loan, being the amount effectively remitted.

Exceptions to the debt remission rule

2.11 There are two legislative exceptions to the general debt remission rule. First, debt forgiven for natural love and affection is deemed to have been fully repaid for BPA purposes. This is typically a family situation and is not within scope of this reform.

2.12 Secondly, when in relation to a financial arrangement, both parties were members of the same consolidated group at all times during the life of the financial arrangement, any remission income under the debtor’s BPA is not taxable.[5]

Certain dividends

2.13 Debt remission income derived by a shareholder debtor from a company, even if the shareholder is a member of the same wholly owned group of companies, is taxable as a dividend under sections CD 5(2) and CW 10(4).

2.14 This law is still current, except for a debt remission that qualifies for the exemption provided by the consolidated group debt remission exemption.[6] See Example 4.

Example 4

Sub Ltd is wholly owned by Parent Co Ltd. Sub Ltd lends $1 million to Parent Co Ltd and, two years later, remits the debt. Parent Co Ltd is deemed to have derived a taxable dividend equal to the amount remitted. This is because the dividend is explicitly excluded from the wholly owned group inter-corporate dividend exemption.


2.15 The amalgamation rules provide that when amalgamating companies are parties to a financial arrangement, the debtor’s solvency must be taken into account.[7] If the debtor is insolvent, and unlikely to repay the loan, a BPA immediately before the amalgamation is required. Under current policy settings this should produce remission income.

OCTC view of the avoidance tax law

2.16 Inland Revenue’s Office of the Chief Tax Council’s (OCTC) finding is that the capitalisation of debt into shares is prima facie tax avoidance in situations when there is no effective change in ownership of the debtor (regardless of whether the debtor is solvent or insolvent).

2.17 Unless this avoidance is found to be merely incidental, the amount of debt capitalised is reconstructed as debt remission income of the debtor. See Example 5.

Example 5

This is simplified from the example in the QWBA on debt capitalisation. The 100 percent Shareholder has made a $500 loan to Company D. Later, Company D issues $500 more shares to Shareholder and uses the receipt to repay the loan from Shareholder. In the particular circumstances this was found to be tax avoidance and it is reconstructed as the remittance of the $500 loan so Company D derives BPA income of $500.

2.18 Given the current Inland Revenue view that there is only partial transparency between partners and their partnership or limited partnership, and between shareholders and their look-through company, this OCTC finding potentially has very wide application. See Example 6.

Example 6

Raewyn and Paul, equal partners in the R & P Partnership, have each advanced $500 to the partnership. In the circumstances, this is treated as a financial arrangement. Later, the R & P Partnership is not trading well and Raewyn and Paul decide to capitalise the debt. Unless the debt remission outcome is merely incidental, the R & P Partnership will derive BPA income of $1,000.

2.19 Related parties debt capitalisation has been a very common debt management technique in New Zealand. There are a number of reasons why related parties debt might be capitalised, including:

  • group reorganisation immediately before the sale of a subsidiary;
  • reducing a subsidiary’s debt level to a more appropriate level, which may be influenced by thin capitalisation issues if the subsidiary is foreign owned;
  • supporting a technically insolvent company when the alternative is to liquidate or strike off the company – frequently in this case the parent company has paid off the third-party creditors and often this is what has caused or exacerbated the associated persons debt;
  • supporting a partnership that has liquidity issues; and
  • supporting a technically insolvent subsidiary that has to be retained for a period, perhaps because it has given vendor warrantees.

2.20 Anecdotally, when the OCTC avoidance analysis of intra-group debt capitalisations began emerging in about November 2013, intra-group debt capitalisations dropped off rapidly. Currently, insolvent subsidiaries are either liquidated, or, more usually, retained in their insolvent state. Both of these outcomes can have their problems and, in the long term, these approaches do not provide a sustainable solution.

The creditor

2.21 When the parties are not associated (using the usual test), the bad debt deduction for the principal depends on what basis the creditor holds the debt.

2.22 If the creditor is in the business of holding or dealing in such debt, the creditor generally obtains a deduction for a bad debt under the bad debt rules.

2.23 If the creditor in not in such a business, they do not get a deduction for the “capital account” loss resulting from the bad debt. Frequently, debt of the sort that is under discussion in this paper will be on “capital account”. Example 7 illustrates this.

Example 7

Joe has advanced a loan to his company Joe Ltd. Joe Ltd later has significant liquidity problems. Joe decides to write off the outstanding balance as a bad debt. As Joe is not in the business of holding or dealing in such debt he is not entitled to a bad debt deduction.

Alternatively, if Bank had advanced the loan it would be entitled to a bad debt deduction as it would be in the business of holding or dealing in such debt.

Associated persons bad debt override

2.24 The business test described above is overridden when the parties are associated. The associated person creditor is explicitly denied a bad debt deduction for the principal of a debt (see section DB 31(3)(c)). Thus, for example, in an intra-group situation, there is no prospect of the creditor obtaining a tax deduction for the principal of a debt.

2.25 The associated persons rule has been in place in one form or another since the financial arrangements rules were introduced in 1986. A shareholder has a choice of investing in a company or partnership by way of debt or equity. Except for situations when the creditor is non-resident or is otherwise outside the tax base, the investors’ debt and equity investment is economically substitutable. The reason for the associated party bad debt prohibition is that allowing a deduction for a bad debt would bias investment towards debt, as by definition all gains will be attributed to the equity investment only, whereas losses can be attributed over both investments.[8] See Example 8.

Example 8

Using the Example 7 facts, even if Joe was in the business of holding or dealing in these loans, he would still be denied a deduction because of the associated persons override.

2.26 However, associated persons creditors are currently allowed bad debt deductions for “interest” accrued as income that is “bad”.

Asymmetric result

2.27 The fundamental point under consideration in this paper is the asymmetric tax result that can arise from related parties debt remission – the creditor is denied a tax deduction, but the debtor, from the same transaction, has taxable income. This is illustrated in Example 9.

Example 9

Jill has advanced a $500 loan to her wholly owned company, Jill Ltd, which has made a look-through company election. This loan is treated as a financial arrangement. Later, Jill Ltd has financial difficulties and the loan is remitted.

Because of the look-through company election, Jill derives $500 loan remission income from Jill Ltd’s BPA.

However, Jill is denied a bad debt deduction because she is an associated person.

Thus Jill has look-through company attributed BPA income of $500, and no deduction against this. This is the asymmetric result.


1 Unless otherwise stated all section references are to the Income Tax Act 2007.

2 Oliver and Glazebrook, pp 109, 110.

3 See paragraphs 11.22 – 22.26.

4 See paragraphs 11.19 – 11.33.

5 Section FM 8(3).

6 Sections CX 60 and FM 8(3).

7 Section FO 18.

8The Supplementary Report of the Consultative Committee on Accrual Tax Treatment of Income and Expenditure”, paragraph 13.247.