Chapter 3 - Problems with definition and recognition of income under the NRWT rules
- Suggestions for addressing the problem
- Further detail on timing mismatches: non-resident financial arrangement income
- Australian provision
- Foreign tax credits
- Application dates
- Questions for submitters
3.1 Liability to NRWT is triggered when New Zealand-sourced “interest” is “paid”. “Interest” is defined as a payment for “money lent”, and “pay” is defined to include, in relation to an amount and a person, distributing to, crediting for, or dealing with that amount on the person’s behalf. These definitions have not been changed since 1983. In the case of a foreign currency loan, the NRWT rules do not take into account the effect of foreign currency fluctuations on the NZ$ value of the money lent.
3.2 The financial arrangement rules, which apply to determine liability to income tax, define financial arrangement income and expense under a completely separate set of rules, based much more on economic substance. These rules require financing income and expense to be determined with regard to “financial arrangements” (rather than “money lent”), and require it to be calculated using either financial reporting methods or economic accrual methods such as yield to maturity or straight line. Using these methods, foreign currency fluctuations are taken into account.
3.3 The predominantly cash basis and single instrument approach of the NRWT rules has a number of consequences, including that:
- what is treated by a New Zealand-resident borrower as a financial arrangement may not involve money lent, and therefore the return on the arrangement may not be subject to NRWT;
- income is not correctly measured or allocated to income years for non-residents; and
- significant mismatches can arise between New Zealand-resident borrowers and non-resident lenders.
3.4 These consequences can be particularly serious for the tax base where the borrower and lender are associated, and can structure their arrangements with less regard for commercial matters and more regard for tax benefits. For example:
- NRWT can be deferred for a non-resident lender for a substantial period, with no effect on the availability to a New Zealand-resident borrower of a deduction on some form of accrual basis under the financial arrangement rules; and
- because NRWT is imposed on a cash basis, it is possible for a non-resident associated lender to earn interest as an economic matter but avoid NRWT altogether by selling a loan shortly before interest is due to be paid.
3.5 Officials have three suggestions for removing the potential for these kinds of mismatches and protecting the tax base more generally. They apply only to arrangements between associated persons. The first broadens the kind of arrangements that will give rise to NRPI, so that there is a better alignment between NRPI and financial arrangement expenditure. The second brings the rules for determining the amount of NRPI more into line with the financial arrangement rules. The third brings the time of recognition of NRPI more into line with the financial arrangement rules, for arrangements that involve a deferral of payments as compared with income measured under the financial arrangement rules.
3.6 NRPI only arises where there is “money lent” as defined in section YA 1. Although the “money lent” definition is broad, it may not apply in all situations where there is an amount of financing provided under a financial arrangement. This means that a New Zealand borrower may incur financial arrangement expenditure where the non-resident counterpart to the financial arrangement has no NRPI.
3.7 In order to prevent this outcome being used to avoid the imposition of NRWT, we propose to widen the definition of “money lent” to include any amount provided to a New Zealand resident by an associated non-resident under a financial arrangement which provides funding to the resident, and under which the resident incurs financial arrangement expenditure. This definition will only apply if the other limbs of the “money lent” definition do not.
3.8 In some cases, the financial arrangement rules may result in a different amount of income being calculated than the amount under the existing “interest” definition. Two examples are:
- a purchase of goods on credit where there is no explicit interest charge but the value of the goods under the financial arrangement rules is less than the amount payable by the purchaser, resulting in financial arrangement income to the vendor; and
- an optional convertible note which pays coupon interest at a rate below the rate specified in Determination G22A.
3.9 In order to prevent this outcome being used to avoid the imposition of NRWT, we propose to widen the definition of “interest” to include a payment (whether of money or money’s worth) received by a non-resident from an associated New Zealand resident, to the extent that the payment gives rise to expenditure to the New Zealand resident under the financial arrangement rules.
3.10 For example, take a zero coupon optional convertible note (OCN) subject to Determination G22A, issued by a New Zealand resident to an associated non-resident. Under this suggestion, the issuer would be treated as paying interest to the OCN holder when the notes were converted into shares or were redeemed in cash. The amount of the interest would be the excess of the cash redemption amount over the deemed issue price of the OCNs, applying Determination G22A, and it would be subject to NRWT (but in advance of the time of payment if the suggestions in this document are adopted).
3.11 It is suggested that for a financial arrangement between a resident and a non-resident associated person which:
- involves a deferral of cash payments (so that income accrues in an economic sense but is not paid); and
- provides funding to the resident,
NRWT would be imposed annually, on an amount equal to the financial arrangement income that would have arisen to the non-resident if it were subject to the financial arrangement rules. However, in the case of a foreign currency loan, the income subject to NRWT would be calculated in the foreign currency, so that the current non-taxation of foreign currency gains and losses under the NRWT regime would be maintained. Doing otherwise might be inconsistent with tax treaty obligations.
3.12 In the remainder of this chapter, we consider in more detail, the rules that would apply to impose NRWT on accruing income, rather than on payments.
3.13 NRWT is payable on (inter alia) payments of NRPI. We suggest retaining this linkage and expanding the definition of interest to include non-resident financial arrangement income (NRFAI), which would be a subset of NRPI.
3.14 NRFAI would arise in relation to financial arrangements involving deferral of income where a non-resident person provides funding to an associated New Zealand resident. The amount of NRFAI would have to be determined according to a YTM or expected value method. In many cases this could be the same method as that used by the borrower to calculate its expenditure.
3.15 The definition of “pay” would also be expanded to include the accrual of amounts of income calculated as NRFAI.
3.16 For the purpose of NRFAI, the existing association test for accessing the AIL regime in section RF 12(1)(a)(ii) would be applied. It would also encompass the back-to-back and “acting together” association suggestions outlined in Chapter 4. The former element is intended to ensure a taxpayer cannot insert a third-party into what is otherwise a related-party transaction to avoid it being subject to NRWT.
3.17 NRFAI would apply only where the payments (as defined under the expanded NRWT rules for interest) under the arrangement are such that they lag behind the economic accrual of income. A typical example is a zero coupon note, issued at a discount.
3.18 There would typically be no need for NRFAI, for example, in relation to a loan where interest is paid semi-annually, and the principal advanced is due to be repaid five years after the date it was lent. However, if the interest is not in fact paid when due, then the income on the loan would become subject to NRFAI.
3.19 In order to differentiate between these two situations, we suggest that NRFAI would not arise in relation to an arrangement if, in all years up to and including the year in question, the interest subject to NRWT is at least 90% of the income that would be calculated either under the YTM or effective interest method using the currency of the arrangement. Allowance would be made for arrangements entered into during the year, to recognise that interest is usually paid in arrears.
3.20 NRFAI on an arrangement that a New Zealand taxpayer is party to during an income year will trigger an NRWT liability for both the payer (as agent) and the payee at the same rates that apply under the current NRWT rules. This liability would arise in the NRWT return period that includes the New Zealand taxpayer’s balance date.
NZ Sub Ltd has a March balance date and is wholly owned by Aus Parent Ltd. On 1 April 2018 NZ Sub Ltd issues a five year zero-coupon bond to Aus Parent Ltd. This bond has an issue price of $100 and a maturity value of $150 on 31 March 2023.
In the year to 31 March 2019, no interest would arise under the traditional interest definition. Accordingly, the difference between NRPI from interest payments and NRPI from NRFAI using YTM is more than 10%. As NZ Sub Ltd and Aus Parent Ltd are associated, the bond gives rise to NRFAI. NZ Sub Ltd’s March NRWT returns include the following amounts:
3.21 To prevent a single amount of interest income being subject to NRWT twice – first as NRFAI and again when an interest payment under the current law is made – it will be necessary to have a carve-out for certain payments that are currently subject to NRWT.
3.22 The general rule will be that a taxpayer making a payment under an arrangement that generates NRFAI will not be required to withhold NRWT from the payment.
NZ Sub Ltd has a March balance date and is wholly owned by Aus Parent Ltd. On 1 April 2018 NZ Sub Ltd issues a five year 5% annual coupon bond to Aus Parent Ltd. This bond has an issue price of $80 and a face value of $100 on 31 March 2023.
In the year to 31 March 2019, the amount of interest under the traditional interest definition is $5, whereas the amount of financial arrangement income applying YTM is $8.26. As the difference between NRPI from interest payments and NRPI from NRFAI using YTM is more than 10%, and NZ Sub Ltd and Aus Parent Ltd are associated, the bond gives rise to NRFAI. NZ Sub Ltd is not required to withhold NRWT on the cash interest payments to Aus Parent Ltd.
NZ Sub Ltd’s March NRWT returns include the following calculations:
|NRWT return||Cash interest||NRWT on cash interest||NRFAI||NRWT on NRFAI|
|March 2023||$5 + $20 redemption||$0||$9.82||$0.98|
3.23 When a person withholds tax from a payment it is treated as received by the payee under section RA 9. This is necessary so the payer can withhold the amount of tax while still fulfilling their payment obligation under the arrangement. Where a borrower under an arrangement that generates NRFAI pays NRWT on that NRFAI, the borrower will need to determine how to make allowance for that payment in terms of its obligations to the lender. In many cases, the borrower might take account of the payment of NRWT on NRFAI by reducing its next interest payment to the lender. Since the parties will by definition be related, this should be able to be dealt with between them.
For the bond referred to in example 2, NZ Sub Ltd has the following obligations under the current NRWT rules:
|Month||Cash outlay by NZ Sub Ltd||NRWT on interest||Cash interest to Aus Parent Ltd|
|March 2023||$5 + $20 redemption||$0.50 + $2 = $2.50||$4.50 coupon + $18 redemption|
As this bond is now within the NRFAI rules, Aus Parent Ltd and NZ Sub Ltd agree that the total cash interest payments by NZ Sub Ltd should remain the same, and reduce the cash payment to Aus Parent Ltd accordingly:
|Month||Cash outlay by NZ Sub Ltd||NRWT on NRFAI||Cash interest to Aus Parent Ltd|
|March 2023||$5 + $20 redemption||$0.98||$24.02|
Alternatively Aus Parent Ltd and NZ Sub Ltd could agree that the cash interest payments received by Aus Parent Ltd stay the same. This would mean a higher cash cost to NZ Sub Ltd during the term of the bond. In this case the amount paid on redemption would reflect the higher cash cost over the term:
|Month||Cash outlay by NZ Sub Ltd||NRWT on NRFAI||Cash interest to Aus Parent Ltd|
|March 2023||$23.48||$0.98||$4.50 coupon + $18 redemption|
3.24 As with the current rules, the calculation of NRFAI on foreign currency loans would not take into account changes in the NZ$ value of the amount borrowed. It is proposed that where a loan giving rise to NRFAI is denominated in foreign currency, the NRWT obligation be determined by:
- first, calculating foreign currency income applying a YTM or effective interest method;
- second, using the exchange rate on the borrower’s balance date to determine the amount of NZ$ NRPI; and
- third, applying the NRWT rate to the NZ$ amount to determine the amount of NRWT owed.
3.25 Although this method gives the same total amount of foreign currency NRPI as the existing rule, the amount of NZ$ NRPI and hence NRWT may be different because of the different conversion date (since under the current rules, conversion occurs when the foreign currency interest is paid).
3.26 One option would be for this difference to be left unaddressed. The other would be for a wash-up calculation to be undertaken. If the NZ$ value of the amount of interest paid exceeds the NRFAI, the taxpayer would owe additional NRWT, and in the reverse situation, the NRWT previously paid could be adjusted downwards.
3.27 Given that the real economic cost of NRWT under the suggested new rules will be quite different from the cost under the existing rules (because of the different timing of the tax obligation), we do not consider it is necessary to introduce a special rule, with its own complexities, for the purpose of equalising the nominal amounts.
3.28 Officials invite submissions on this point.
NZ Sub Ltd has a March balance date and is wholly owned by Aus Parent Ltd. On 1 April 2018 NZ Sub Ltd issues a five-year zero coupon bond to Aus Parent Ltd. This bond has an issue price of AU$100 and a face value of AU$150 on 31 March 2023.
As the difference between NRPI from interest payments and NRPI from NRFAI using YTM is more than 10%, and NZ Sub Ltd and Aus Parent Ltd are associated, the bond gives rise to NRFAI.
Assume the exchange rate at each balance date is:
|Balance date||NZD/AUD exchange rate|
In NZ Sub Ltd’s March NRWT returns it has to return the following amounts:
|NRWT return||AU$ NRFAI||NZ$ equivalent NRFAI||NRWT on NZ$ NRFAI|
This compares with the current law where NRWT is imposed on actual payments which are:
|NRWT return||AU$ interest||NZ$ equivalent interest||NRWT on NZ$ interest|
Without a wash-up the $0.31 difference will not be payable.
3.29 Under the existing NRWT rules there is no exemption from withholding NRWT just because an amount of interest is not deductible to the New Zealand-resident borrower (for example if the New Zealand borrower is a tax-exempt charity). We suggest that this principle is maintained for arrangements that generate NRFAI.
3.30 A New Zealand borrower who exceeds the thin capitalisation thresholds will derive an amount of income under the formula in section FE 6(2). In substance, this amount is equal to the amount of interest the thin capitalisation rules disallow. Under the current NRWT rules, a New Zealand borrower deriving an amount of income under the thin capitalisation rules is still required to withhold NRWT on the interest payment. We suggest that this principle is maintained for arrangements that generate NRFAI.
3.31 Like New Zealand, Australia has both a withholding tax system based on payments and a domestically applicable regime for taxing some financial instruments on an accrual basis (referred to as “taxation of financial arrangements” or TOFA). Australia also has a provision (section 26-25 of the ITAA 1997) which denies an Australian a deduction for interest paid to a non-Australian if withholding tax is not paid on that interest. This rule has been in place for many years.
3.32 The Australian provision can be viewed as aimed at achieving something similar in broad policy terms as the proposal in this chapter of the issues paper. But rather than accelerating NRWT to (broadly) match the deduction under the financial arrangement rules (as we suggest), the Australian rule is deferring the deduction to match the timing of the NRWT obligation.
3.33 The key difference in terms of the focus of the Australian rule (compared with our proposal) is that the aim is to buttress the borrower’s obligation to withhold NRWT. It may be that at the time this rule was enacted the deduction and the NRWT obligation would generally have fallen in the same year. It is understood that in a case where a deduction arises under TOFA but there is no payment and hence no NRWT obligation until a later year, the deduction is still claimed. However, if NRWT is not paid when the relevant amount eventually is paid, it is possible that the deduction would be reversed.
3.34 If this suggestion were adopted, officials do not believe it would adversely affect a foreign lender’s ability to claim a tax credit for NRWT in its home jurisdiction. It may mean NRWT is paid in a year before there is a liability for income tax on that income in a lender’s home jurisdiction. That earlier time of payment should not affect whether the taxpayer can claim a credit for NRWT paid. For example, under section LJ 2, a New Zealand resident is entitled to claim a credit for foreign tax imposed on foreign-sourced income regardless of when the foreign tax is paid.
3.35 It may also be the case that a foreign lender’s home jurisdiction has its own form of the financial arrangement rules, and that this suggested change in fact brings NRWT closer in line with the timing of the lender’s income tax obligation.
3.36 It is suggested that the reforms outlined in this chapter would apply to financial arrangements entered into, on or after enactment of the legislation. This is expected to be in the second half of 2016.
3.37 Financial arrangements entered into before the enactment of the legislation will be required to apply the new rules for income years following enactment. This is reasonable, since the arrangements are between associated persons. Transitional rules for these arrangements are covered in the paragraphs below.
3.38 A taxpayer with an existing financial arrangement, applying the new rules for the first time, will calculate their NRWT liability for that first year as if they had applied the new rules in previous years.
3.39 In the year that the financial arrangement matures, the taxpayer will be required to calculate a wash-up to ensure that the appropriate amount of NRWT has been paid. Generally, this formula will be:
NRWT liability if financial arrangement had always been subject to new rules – NRWT actually paid on financial arrangement
3.40 This wash-up would also be triggered:
- if the lender ceased to be associated or was replaced by an unassociated lender; or
- immediately prior to the migration of the New Zealand borrower.
3.41 For pre-existing arrangements which would be brought into the NRWT rules by the suggested changes but that do not currently give rise to NRPI, officials do not consider it appropriate to impose NRWT on income arising before the income year following enactment. Accordingly, the wash-up formula in paragraph 3.39 would not apply.
3.42 However, it is possible in relation to such arrangements that the new rules could be circumvented. A borrower could make a prepayment before the beginning of the income year following enactment. This would pre-pay funding costs likely to accrue during and after that year. The prepayment would not be subject to NRWT (subject to possible application of the general anti-avoidance rule), although it economically relates to a period when NRWT is intended to be imposed. Accordingly, we suggest a specific provision which would apply if a New Zealand-resident party to a financial arrangement makes or has made a payment to an associated person, and that payment has the effect of pre-paying for funding provided to the New Zealand resident for a period that ends after the first day of the income year following enactment. For NRWT purposes, the portion of the payment that as an economic matter relates to the period falling on or after that first day will be treated as paid on that day, and would give rise to an NRWT obligation accordingly.
NZ Sub Ltd has a March balance date and is wholly owned by Aus Parent Ltd. On 1 April 2015 NZ Sub Ltd issues a five year 5% annual coupon bond to Aus Parent Ltd. This bond has an issue price of $80 and a face value of $100.
In the 31 March 2016 and 2017 years NZ Sub Ltd had been paying NRWT on the $5 cash interest payments. In the year to 31 March 2018, the amount of interest under the traditional interest definition is $5, whereas the amount of financial arrangement income applying YTM is $8.26. As the difference between NRPI from interest payments and NRPI from NRFAI using YTM is more than 10%, and NZ Sub Ltd and Aus Parent Ltd are associated, the bond gives rise to NRFAI. NZ Sub Ltd is not required to withhold NRWT on the cash interest payments to Aus Parent Ltd.
NZ Sub Ltd’s March NRWT returns include the following calculations:
|NRWT return||Cash interest||NRWT on cash interest||NRFAI||NRWT on NRFAI||NRWT on wash-up|
|March 2020||$5 + $20 redemption||$0||$9.82||$1.66|
3.1 Does an NRWT liability arising in the NRWT return period that includes a taxpayer’s balance date provide sufficient time for a taxpayer to calculate and pay the NRWT owing?
3.2 Do any practical difficulties arise on the effect of obligations to the lender as set out in paragraph 3.23 and example 3?
3.3 Is it necessary for differences between NRWT if calculated on actual interest payments on foreign currency arrangements, and NRWT calculated on NRFAI, to result in an adjustment to NRWT?
3.4 Is the approach of imposing NRWT on NRFAI arising after the beginning of the income year following enactment appropriate?
3.5 Is the suggested wash-up adjustment the best way to bring existing arrangements into the NRFAI regime?
4 We recognise that under the currently applicable Determination G22A, a “low interest” OCN between members of the same wholly owned group does not give rise to any additional discount income to the holder.
6 Separate transitional rules would apply to existing arrangements. These rules are covered in paragraphs 3.37 to 3.42.