Bad debt deduction and application of the capital limitation

Clauses 84(4), (7) and 257

Issue:   Clarifying that the general capital limitation will not prevent a deduction for a bad debt of a financial arrangement

Submissions

(Corporate Taxpayers Group, KPMG, Russell McVeagh)

The Group strongly supports the proposed amendments to clarify that the general capital limitation will not prevent a deduction for a bad debt of the principal amount of a financial arrangement (subject to the Group’s comments on aspects of the proposed amendment).  (Corporate Taxpayers Group)

KPMG supports the remedial amendments to the bad debt deductibility rules to clarify that the capital limitation does not apply to prevent a bad debt deduction for a loan if the lender has entered into the debt in the normal course of business.  (KPMG)

Russell McVeagh agrees with the need to clarify, with retrospective effect, the application of the capital/revenue distinction to the deductibility of bad debts (subject to their comments on aspects of the proposed amendment).  (Russell McVeagh)

Comment

In general terms, the principal amount of a financial arrangement (for example, a loan) is on capital account.  This was explicitly stated in the Income Tax Act 1976.  Again in general terms, a bad debt deduction is not allowed for a loss of capital.  To achieve that policy outcome, the current bad debt deduction rule is subject to the capital limitation (which denies a deduction for an expenditure or loss of capital).

An exception to the capital limitation for bad debts applies to taxpayers (business holders or dealers) who carry on a business of holding or dealing in financial arrangements.  This is because, under common law, the principal amount of loans entered into in the ordinary course of a moneylending (banks, for example) or dealing businesses are on revenue account and not on capital account.

The Commissioner applies the law consistent with the policy objectives, so that:

• financial arrangements entered into in the ordinary course of carrying on a holding or dealing business are not considered to be subject to the capital limitation; and
• financial arrangements held by a business holder or dealer outside the holding or dealing business are subject to the capital limitation.

While the current law achieves the intended policy outcome, the Rewrite Advisory Panel recommended the amendment in the bill as an improvement to the legislation to clarify the policy intention of the relationship between the bad debt deduction rule and the capital limitation.  This followed a submission to the Panel that the current bad debt deduction rule contained a potential unintended legislative change arising from the rewrite of income tax legislation.

The amendment is made at the recommendation of the Rewrite Advisory Panel to limit the application of the capital limitation rather than leave that to a matter of interpretation.  This is intended to reduce compliance and administration costs.

Recommendation

That the submissions be noted.

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Issue:   Consistency of bad debt deduction rule with pre-2004 position

Submissions

(Chapman Tripp, Corporate Taxpayers Group, Russell McVeagh)

The proposed new test is not consistent with the position prior to 2004 and not appropriate for financial arrangement debt.  (Chapman Tripp)

The Income Tax Act 2004 removed the 1994 automatic exclusion from the capital limitation for deductions determined under part E, which included financial arrangement bad debts.  (Chapman Tripp)

The amendments to section DB 31(6)(b)(iii) of the Income Tax Act 2007 and section DB 23(6)(b)(iii) of the Income Tax Act 2004 should be omitted.  (Chapman Tripp)

Section DB 31(6)(b)(iii) of the Income Tax Act 2007 and section DB 23(6)(b)(iii) of the Income Tax Act 2004 be replaced with “the general limitations apply, except that subsections (2) and (3) override the capital limitation.”  (Chapman Tripp)

The test of “entered into in the ordinary course of business” is not consistent with the position prior to 2004.  (Chapman Tripp)

The words “for a financial arrangement entered into in the ordinary course of business” should be removed from proposed new section DB 31(6)(b)(iii) (and the equivalent amendment to the 2004 Act) on the basis that these words introduce a new requirement not present in the pre-rewrite section, and which appear to defeat the purpose of the proposed amendment and substantially limit its effectiveness.  (Corporate Taxpayers Group)

Amendments addressing the bad debt deduction and the capital limitation do not achieve their stated purpose.  (Russell McVeagh)

The words “for a financial arrangement entered into in the ordinary course of business” should be omitted from clauses 84(4) and 257.  (Russell McVeagh)

Comment

The drafting of the bad debt deduction rule in the Income Tax Act 2004 (and re-enacted in the Income Tax Act 2007) was intended to clarify the policy intention for financial arrangements of a business holder or dealer not entered into in the course of carrying on their business.   Such clarifications were considered to be within the scope of the rewrite of income tax legislation.

The Commentary on the bill noted that the policy for the bad debt deduction rule for a business holder and dealer was recommended by the Consultative Committee on Accrual Tax Treatment of Income and Expenditure (the Brash Committee).[4]  The policy is that the bad debt deduction rule for financial arrangements should maintain the common law position in relation to bad debt deductions, except for bad debts entered into between associated persons.

Under the common law, a bad debt suffered by a business holder or dealer which related to a financial arrangement entered into in the ordinary course of business was considered to be on revenue account.  In this circumstance, common law held that a bad debt deduction was allowed for a loss of principal and accrued interest, provided some procedural requirements were satisfied.

Common law also considered that a debt entered into outside the normal or ordinary course of business would be usually treated as a non-deductible capital loss as a result of applying the capital/revenue tests.

Chapman Tripp suggests the comments in the Commentary on the bill referring to Brash Committee recommendations are simply referring to the fact that deductions for losses were not to be universally available.  Officials note that the comments in the Commentary are directly concerned with the policy for bad debt deductions.  A statement relating to the deductibility of expenditure and losses (that is, economic interest costs) under the financial arrangement rules was set out later in the Brash Committee’s report.[5]

Officials agree that the bad debt deduction rule in the Income Tax Act 2004 and Income Tax Act 2007 has the potential to produce a different outcome for financial arrangements held outside a holding or dealing business from that given by the Income Tax Act 1994.  Officials consider that non-deductibility of a bad debt for a business holder or dealer would be a rare occurrence.

Officials also agreed with the Panel, that there is some uncertainty over whether a special purpose vehicle that is a holder of financial arrangements would be allowed a bad debt deduction under the existing law.  The amendment is intended to clarify the law to address this uncertainty.

The following examples illustrate the type of situation when it could be considered appropriate that no deduction be allowed for a loss of capital.

Recommendation

That the submissions be declined.

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Issue:   Financial arrangements are on revenue account

Submission

(Chapman Tripp)

Financial arrangements are necessarily on revenue account.

Comment

The principal amount of a financial arrangement is generally considered to be an item of capital.  This was very clearly stated in the Income Tax Act 1976 and the policy remains unchanged from that time.  The only exceptions to this general principle are:

• the principal amount of financial arrangements entered into in the ordinary course of a holding or dealing business, which are treated as being on revenue account;
• discounts or losses on disposal that are part of the economic interest return or cost of the arrangement.

The policy of the financial arrangement rules is primarily to determine the timing and quantification of income and expenditure relating to the economic interest arising under a financial arrangement.  The economic interest under a financial arrangement is the return or cost to the lender and borrower respectively over the term of the arrangement.  These returns or costs include a discount to face value.

For income tax purposes, the economic interest incurred or derived from a financial arrangement is treated as being interest and placed on revenue account, and spread over the life of the arrangement.  The deductibility of economic interest incurred under a financial arrangement must satisfy the general permission (the business test or nexus with income test).  Economic interest derived is always income of the recipient.

Recommendation

That the submission be declined.

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Issue:   Clarifying the application of the capital limitation to bad debts

Submissions

(Chapman Tripp)

It is not clear how the test of “entered into the ordinary course of business” is to be applied.

It is not clear when the “carrying on a business of dealing/holding” test would be met.

The proposed “ordinary course of business” test would apply to deny a deduction.

Comment

Officials consider it is a matter of fact of whether and when a financial arrangement was entered into in the ordinary course of business.  Officials think this test is implied in the current law when considering the bad debt deduction rule.  Officials consider the wording is intended to reflect that implied test but accept that the new wording can be interpreted as a separate test.

Officials agree that the proposed “ordinary course of business” test would deny a deduction for a bad debt on capital account.   This is an intended policy outcome.

Recommendation

That the submissions be accepted, subject to officials’ comments.

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Issue:   Application of the capital limitation to bad debts

Submission

(Chapman Tripp)

The capital limitation is not intended to apply to bad debts and this is reinforced when a person sells a debt for a loss because of a decline in creditworthiness:

• the same test as that set out in section DB 31(3)(b) and (c) applies; and
• there is no capital limitation.

Comment

When a loan is disposed of at a discount because of a decline in creditworthiness of the borrower, the policy intent is that a decline in value on disposal due to creditworthiness factors is not normally deductible.  However, an exception to this general rule applies for a business holder or dealer if the loan was held within a holding or dealing business.

Officials consider the law allows a bad debt deduction to a business holder or dealer for a decline in creditworthiness for a financial arrangement held within that business (but not otherwise) and this outcome is entirely consistent with the policy intention.

The bad debt deduction rule is an important provision for business because it allows a business holder or dealer to effectively advance the timing of the deduction for the discounted value of the loan to when the loan is considered unrecoverable.  In the absence of the bad debt deduction rule, the business holder or dealer would have to wait until disposal or maturity of the loan to have the deduction for the decline in creditworthiness.

Recommendation

That the submission be declined.

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Issue:   Special purpose vehicles holding financial arrangements

Submissions

(Chapman Tripp, Russell McVeagh)

It is unclear how the capital limitation would apply to bad debts in the context of:

• covered bond arrangements where the provision will only become applicable at the point the covered bond guarantor ceases to maintain Financial Institution Special Purpose Vehicle (SPV) status and is deemed to acquire a financial arrangement; and
• securitisations where the financial arrangements are acquired at the outset of the arrangement and where no further financial arrangements are acquired following that time.  (Chapman Tripp)

A special purpose vehicle may acquire a portfolio of assets and hold those assets until maturity.  As the acquisition of the portfolio would be a one-off transaction, could it be said that each financial arrangement was “entered into in the ordinary course of business”?  (Russell McVeagh)

Comment

These submissions relate to an SPV holding financial arrangements under a securitisation or covered bond arrangement.  The key questions relate to whether:

• the SPV is a business holder or dealer; or
• a financial arrangement for which a bad debt deduction is sought meets the requirement that the arrangement was entered into in the ordinary course of business.

For income tax purposes, an SPV may hold financial arrangements as either:

• a stand-alone taxpayer that acquires and holds a portfolio of loans in consideration for issuing a securitised asset; or
• a transparent entity, where the SPV acquires a portfolio of loans from a bank in consideration for issuing the bank with a securitised asset.  For income tax purposes, if the SPV meets certain requirements, the SPV’s portfolio is treated as continuing to be held as part of the bank’s business.  If those requirements cease to be satisfied, the SPV is deemed, for income tax purposes, to acquire the financial arrangements from the bank.

Chapman Tripp and Russell McVeagh consider that the proposed amendment raises uncertainty about whether a stand-alone SPV is allowed a bad debt deduction for a principal amount of a financial arrangement if the acquisition of the portfolio of loans is a one-off transaction and no other lending activity occurs.  Russell McVeagh comments that this uncertainty would not arise if the law is restored to the position under the Income Tax Act 1994.

As a stand-alone taxpayer, a bad debt deduction for the principal amount of a loan is allowed if the SPV satisfies the requirements of the bad debt deduction rule for business holders or dealers.  This is because financial arrangements entered into, held, or dealt with in the course of a holding or dealing business are normally on revenue account, and the capital limitation would not apply.

The submissions raise the following issues:

• Is an SPV carrying on a business of holding, dealing or carrying on a passive investment activity if it makes a one-off transaction to acquire a portfolio of financial arrangements and does nothing more than hold those assets to maturity carrying on a business of holding or dealing?
• If it is assumed that an SPV carries on a business of holding or dealing, are there circumstances in which a one-off transaction made by the SPV to acquire a portfolio of financial arrangements to be held to maturity is not made in the ordinary course of carrying on that business?

It is a question of fact whether a SPV is a business holder or dealer if it acquires its portfolio of financial arrangements in a one-off transaction.  If such a SPV is not a business holder or dealer, officials consider it would not have been allowed a bad debt deduction for the principal amount of a financial arrangement under any of the bad debt deduction provisions of the Income Tax Acts –1976, 1994, 2004 or 2007.  The SPV should however be allowed a bad debt deduction for accrued interest income that has been written off as a bad debt.

If the SPV is assumed to be a business holder or dealer, it is a question of fact whether the first one-off transaction is made in the ordinary course of that business (on revenue account) or is made to establish that business (a capital transaction).  If the facts show that such a one-off transaction is on capital account, officials consider an SPV that is a business holder or dealer:

• might have been allowed a bad debt deduction for the principal amount of a loan acquired in that one-off transaction under the Income Tax Act 1994; and
• might not have been allowed a bad debt deduction under the Income Tax Act 2004 or Income Tax Act 2007 for the principal amount of a loan acquired.  We are not aware of any circumstance in which this has occurred.

Officials note that:

• The wording of the proposed amendment should be reviewed to ensure that the capital limitation does not deny a bad debt deduction for a financial arrangement held or dealt with within a holding or dealing business.
• This submission raises issues relating to the business test for special purpose vehicles holding securitised loans or covered bonds that would require further analysis as part of the Government’s tax policy work programme.

Chapman Tripp has raised a concern that the proposed amendment gives rise to uncertainty about the tax treatment of the SPV in relation to bad debts after the SPV loses its “transparent status”.

We note that the “transparency” provisions in the Income Tax Act 2007 were enacted after the Reserve Bank introduced its Residential Mortgage-Backed Securities scheme in 2008 in the wake of the Global Financial Crisis.

From this time, securitisation and covered bond arrangements entered into by banks were after enactment of the Income Tax Act 2004 and Income Tax Act 2007.  The bad debt deduction provision in both of these Acts is clear that the capital limitation applied to the bad debt deduction rule.

Officials note that:

• this submission raises the same issues for the application of the bad debt deduction provision to an SPV that is a stand-alone taxpayer;
• the wording of the proposed amendment should be reviewed to ensure that the capital limitation does not deny a bad debt deduction for a financial arrangement held or dealt with within a holding or dealing business;
• this submission raises issues that would require further analysis as part of the Government’s tax policy work programme; and
• the Panel recommended that a review of the application of the financial arrangements rules in relation to securitisation vehicles be a matter that is placed on the tax policy work programme.

Recommendation

That the submissions be accepted in part, subject to officials’ comments.

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Issue:   Application to “mum and dad” investors

Submission

(Mark Scott)

The clauses as proposed represent a back-dated narrowing of existing law that will unfairly penalise taxpayers such as Mum and Dad investors who have already returned taxable income arising under financial arrangements before the creditor company became unable to repay its debts and was placed into liquidation (for example, failed finance companies).

Comment

Officials consider the amendments to the capital limitation in the bad debt deduction rule have no effect on investors who are not carrying on the business of holding or dealing in financial arrangements.

An example of this type of investor would be those who have derived interest income that has been accrued by the borrowing company (such as a finance company) and would be paid out on maturity of the investment.  If the borrower is liquidated, the accrued income would never be paid out.  The investor is normally allowed a bad debt deduction for unpaid interest on liquidation of the borrowing company.  We note that recent amendments relating to this deduction mean that the “write-off” procedural requirements do not apply to such investors.

If the investors are carrying on the business of holding or dealing in financial arrangements, as discussed above, the investor is normally allowed a deduction for the principal amount of a “bad” financial arrangement that was entered into in the course of carrying on that holding or dealing business, provided that certain procedural requirements are satisfied.

Recommendation

That the submission be declined.

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Issue:   No regulatory impact statement

Submission

(Chapman Tripp)

There should be a regulatory impact statement on the amendment given the departure from the position before 2004.

Comment

The current bad debt deduction rule has been in place since the beginning of the 2005–06 income year, a period of almost 10 years.

The amendment to the bad debt deduction rule proposes to amend the law to better reflect the long-standing policy intention.  The amendment is therefore remedial in nature.

Recommendation

That the submission be declined.

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Issue:   Retrospectivity and savings

Submissions

(Chapman Tripp, Russell McVeagh)

If the new “ordinary course of business” test is to be enacted, then:

• The capital limitation for bad debts should be repealed with retrospective effect to 2004.
• The capital limitation should be applied prospectively from the income year beginning 1 April 2016.  (Chapman Tripp)

The retrospective application would call into question the treatment of bad debts under previous tax positions.  (Russell McVeagh)

Comment

The Panel did not recommend a “savings” provision for taxpayers who have relied on the application of the bad debt deduction rule in the Income Tax Act 1994.  This is likely because it is anticipated that very few taxpayers would be affected by the Income Tax Act 2004 drafting of the bad debt deduction rule.

Under the bad debt deduction rule for business holders or dealers in the Income Tax Act 1994, it is necessary to consider whether the bad debt relates to a financial arrangement connected to the ordinary course of holding or dealing business.  The purpose of the proposed amendment is to clarify that the capital limitation applies to a bad debt arising in the rare circumstance that a business holder or dealer holds a financial arrangement outside the ambit of its business.

These submissions seem to be concerned that a risk exists for taxpayers who have previously taken a tax position that a bad debt deduction is allowed for the principal of a financial arrangement not connected with the carrying on a holding or dealing business.  To take such a position, the taxpayer must have assumed that the application of the bad debt deduction rule remained constant through the 1994, 2004 and 2007 Income Tax Acts.

The Finance and Expenditure Committee commented on such assumptions in its report on the Income Tax Bill 2002 (which became the Income Tax Act 2004) as follows:

The provisions contained in the Income Tax Act 1994 are unclear and frequently subject to understandable misinterpretation.

We recognise the risk that some practitioners, having previously misinterpreted some provisions in the old Act, may fail to realise that the rewrite Act clarifies the correct interpretation that applies to those provisions, and continue to apply their erroneous interpretation to the new Act.  Such a situation should be minimised as far as possible, and we therefore encourage the Inland Revenue Department to undertake an education programme to inform practitioners that they cannot necessarily rely on their current understanding of the law, and should actively check the provisions contained in the new Act.

This point raised by the Committee was referred to and commented on within the Tax Information Bulletin items for both the Income Tax Act 2004 (Vol 16, No. 6, June 2004) and Income Tax Act 2007 (Vol 20, No. 2, March 2008).

The Finance and Expenditure Committee considering the Income Tax Bill 2002 also noted that Chartered Accountants Australia and New Zealand (then known as the Institute of Chartered Accountants of New Zealand) and the New Zealand Law Society had advised officials on their preferred approach for transitioning from the old legislation to new legislation, as follows:[6]

The transitional provisions should allow the new Act to have effect while preserving, to the extent possible, the usefulness of existing case law and commentary and providing some protection for taxpayers against unintended change.

This means the transitional provisions should be a sign-post and interpretative guide, and provide protection to taxpayers against unintended changes.

We acknowledge that this leaves unintended changes to have effect where the new law is clear and unambiguous.  This means that reliance must be placed on:

1.      the commitments to retrospectively amend unintended changes;

2.      the Rewrite Review Committee process;

3.      Inland Revenue stating that it will continue to apply its published views and that it will only do otherwise on a prospective basis;

4.      protection being provided to taxpayers who rely on either the old or the new law from a penalties and interest perspective.

As noted on the Panel’s website, it has always been anticipated that the Government would decide to either:

• promote an amendment to the rewritten legislation to reinstate the outcome given under earlier corresponding provisions; or
• retain the unintended change in the legislation.

The Panel considered whether a “savings” provision should be implemented but decided against this.

Officials agree with the Panel that a savings provision is inappropriate as we are not aware of any instances in which a person carrying on a holding or dealing business has been denied a deduction for a bad debt that is not connected to that business.

However, officials are aware of some instances where a bad debt deduction was sought under the business holder or dealer rule, but the facts showed in each case that the taxpayer was not carrying on that type of business.  It would be appropriate in these cases that no bad debt deduction is allowed for the principal amount of the loans.

Recommendation

That the submissions be declined.

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Issue:   The new requirement will cause confusion in practice because it overlaps with the existing criteria for claiming a bad debt deduction

Submission

(Russell McVeagh)

The proposed amendments will introduce a new requirement for claiming a bad debt deduction (being that the relevant loan was “entered into in the ordinary course of business”).  That new requirement will cause confusion in practice because it overlaps with (and arguably contradicts) the existing criteria for claiming a bad debt deduction.

Comment

The proposed amendment is consistent with the Commissioner’s interpretation of the “same as or similar to” test in the existing bad debt deduction rule.  The language was recommended by the Panel to explicitly state in the legislation the effect of the test implied in the “same as or similar to” wording in the bad debt deduction rule.

Officials note that KPMG supports the clarification offered by the proposed amendment.

We agree that there is a risk that the proposed amendment may overlap with the existing criteria that allow a bad debt deduction for a business holder or dealer.  We agree the proposed amendment be reviewed to ensure that the potential overlap is addressed.

Recommendation

That the submission be accepted, subject to officials’ comments.

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Issue:   Application of capital limitation to section DB 31(2) and (4)

Submissions

(Chapman Tripp, Russell McVeagh)

Section DB 31(2) should be amended to clarify that the capital limitation does not apply.  (Chapman Tripp)

The amendment should extend to bad debts losses under section DB 31(2) and (4).  (Russell McVeagh)

Comment

The bad debt deduction rules in section DB 31(2) and (4) ensure that taxpayers are not taxed on amounts which may have been derived and included as assessable income – for example, trade debtors.  If those amounts are never actually received, and deductions for bad debts were not allowed, taxpayers would pay too much income tax because they would be assessed on income which substantively was not received.

Recommendation

That the submissions be declined.

 

[4] Report of the Consultative Committee on Accrual Tax Treatment of Income and Expenditure, April 1987, paras 32-41, comment on drafting para 2.632-41, comment on drafting para 2.6.

[5] Report of the Consultative Committee on Accrual Tax Treatment of Income and Expenditure, April 1987, paragraphs 64-67.

[6] Letter from Institute of Chartered Accountants and the New Zealand Law Society to chief drafter, dated 30 June 2003.