New rules cast a wide net

Press, 20 May 1987, Page 38

New rules cast a wide net

lb the July 31, 1986, Budget statement, the Minister of Finance, Mr Douglas, announced that the rules relating to the taxation of interest and other income on debt securities would be changed. In addition the timing in the deductibility of certain non-interest categories of expenditure would also be changed by legislation. Some of these changes were deemed to take effect on Budget night It was not until March 31, that these changes became law. Before their enactment the proposals were considered by a consultative committee. The committee was established to review public submissions on the consultative document on the new rules which was released in October, 1986.

It was the third occasion on which the Government had used this consultative process for a major tax change. Perhaps too much hastily enacted legislation on important subjects in the past had alerted legislators to the need for more consultation with the business community, including private sector experts, before the passing of legislation. One of the purposes

of the consultative process is to prevent the passing of unworkable legislation. These changes will be workable but again after additional effort and cost. There is no doubt that the legislation on the new rules is worded in such a way to cast a very comprehensive net over the timing of the recognition of a wide range of income and expenditure on “financial arrangements” and .the recognition of expenditure other than interest., The legislation provides for certain exemptions and also for the issue of “determinations” by the Commissioner of Inland Revenue. These determinations or rulings are designed to streamline the application of the rules and hopefully to make their implementation more palatable. The Income Tax Act in its pre-amended form recognised that the claiming of an interest deduction does not necessarily take place at the same time as the corresponding income is returned. It was possible to borrow money for business purposes and to prepay all the interest expense immediately, getting a deduction for that prepayment of interest. On the other side, financing transactions could be arranged in which income would ■be received for tax purposes in a later period to that period in which a corresponding deduction was claimed. For example, the terms of a bank deposit provided that the interest was payable on maturity. That interest income would not have to be recognised for tax purposes.until it was actually paid’ or credited to the customer’s account.

The paying or crediting would have taken place at a later date from the date on which the payer of the interest (the bank) could get a deduction for the portion of the expense. That is because the general principles of tax law provided that the expense could be accrued as a tax deduction although it was not necessarily payable immediately. Therefore, the accounting concepts of “matching” income and expenditure could be avoided for income tax purposes in the past. By legitimate means it was possible to defer taxation. The Revehue had estimated that these legitimate means were resulting in the deferral of hundreds of millions of dollars in tax a year. It should be emphasised that this deferral was totally within the tax regime. At the time of the original announcement concerning the new rules and in various subsequent announcements on the application and extent of the proposed changes the.

Government referred to the changes as “moves against tax avoidance.” Perhaps a more accurate description would have been “moves against tax deferral.” As a result of “fancy footwork” by certain taxpayers we now have new rules as to the accrual tax treatment of income and expenditure. The income tax regime has moved closer to the accounting concept of the matching of income and expenditure. Overview The new rules concentrate mainly on the . tax treatment of income and expenditure from “financial arrangements.” In his original Budget statement the Minister of Finance referred more particularly to debt instruments. In later announcements the type of debt instruments and the dates they were caught by the rules were specified. Basically, the accrual rules provide formulas, one of which must be

services where payment is required by the seller within 63 days after the supply of those goods or services. • Specified preference shares issued before October 23, 1986. ; • Shares or options to buy shares. A withdrawable building society share is not included in. this definition. A unit in a unit trust is deemed to be a share. • A lease. This includes both an operating and a financial lease. • Bets. Those affected All non-natural persons, for example companies and trusts which hold or issue financial arrangements entered into after the various implementation dates (mentioned below), are affected by the new rules. The following individuals do not have to adopt the accrual rules; they may use the cash receipts basis of determining income from those financial arrangements:

This is the first in a series of articles which deal with the new rules for the recognition of income and expenditure. These changes are seen by tax practitioners as the most significant amendment to New Zealand’s tax code for many years. The first article is by JILLIAN LAWRY, who was recently appointed tax manager of Lawrence, Anderson, Buddle in Christchurch. A qualified lawyer, she has had six years legal experience, and joined Lawrence, Anderson, Buddle in 1985.

applied to income and expenditure from financial arrangements. These formulas determine the extent to which expenditure can be deductible for income-tax purposes in a particular year. It also determines the amount of corresponding income which must be returned in any year. Financial Arrangements The definition of “a financial arrangement” is very wide. Basically the accrual rules apply to:— • Any debt or debt instrument; and • Any arrangement whereby a person obtains money in consideration for a promise by any person to provide money to any person at some future time or times; and • Any arrangement which is substantially similar to the above. Assignments of income have been specifically included in this category. Money has been defined to include money’s worth. Specifically excluded from the new rules are: • Annuities for the benefit for a natural person. • Life insurance and superannuation. Payments resulting from membership of a superannuation scheme are intended to be outside the scope of a financial arrangement, but superannuation schemes are intended to be subject to the accrual rules. • A hire-purchase agreement. • Certain debentures including floating-rate debentures. These are to be treated as equity and thus outside the new rules where there is a direct relationship between the company’s profits and the payment on the debenture. • A debt for goods or

• Have income of $50,000 or less per annum from financial arrangements; or . - , • Hold financial arrangements with a market or face value (whichever is the greater) of less than $400,000 a year. The cash basis may not be used where the difference between calculating income under the new accrual rules and under the cash basis exceeds $15,000. Therefore the calculations would still have to be done for the cash basis holder to ensure that they are not caught by the new rules. A partnership is not a taxpayer in its own right. Each partner is allocated a shafe of the financial arrangement in the proportion to which that person has a share in the partnership. Application Dates There are varying application dates for different types of financial arrangements. The changes do not apply to transactions entered into after the implementation date applicable to that transaction if that transaction has been made pursuant to a binding contract entered into before that date. As a general rule all financial arrangements issued or acquired after July 1, 1986, come under the new accrual rules. The exceptions and their implementation dates are: • Forward or future contracts including contracts for foreign exchange,

commodities, financial arrangements. or excepted financial arrangements, futures contracts, trade credits, annuities and convertible notes — on or after 8 p.m. oh October 23, 1986, • Debt defeasances and assignments of income —. on or aft,er December 20, 1986. , • ■ • A bank deposit account of other financial i arrangement pursuant : to which the bank may advance amounts to the borrower or require the borrower to return .: money lent in either case on demand or call where those sums form part of that deposit amount or facility — April 1, 1987. A. bank overdraft accommodation (whenever originally ... arranged) would come into this latter category at April 1, 1987. Rollovers, extensions or advances provided for in financial arrangements entered into before the above implementation dates and subsequently carried out do not bring that financial arrangement under the new rules. This is provided that the rollover extension or advance occurs before April 1, 1990. • Accrual methods Income and expenditure of the parties to a financial arrangement in each income year is determined by using the “yield to maturity” method. The yield to maturity calculaton apportions over each year of the financial arrangement the economic gain or cost from that financial arrangement. The Commissioner of Inland Revenue has a discretion to accept an alternative method of calculating the income or expenditure. These alternatives include straight line accrual, rule of 78, or market valuation, An alemative method may be used only where it conforms with commercially accepted practice, is the method used for financial reporting purposes and results in an allocation not ’materially different from the yield to maturity basis. There is also a prescribed method where it is impossible to apply the alternative methods. Another method is also available for dealers in particular types of financial arrangements or if the financial arrangement is a forward or futures contract for foreign exchange, or a futures contract. On sale, maturity or other disposal of a financial arrangement the rules have a clean-up provision to ensure the full economic gain or cost is brought within the tax net. This cleari-up provision has the effect of changing the nature of certain capital receipts into assessable income. A more detailed discussion of the methods by which income and expenditure is to be calculated and returned pursuant to the new rules will be discussed in the next article, as well as the treatment of non-interest expenditure. ■