Interest allocation rules

Subpart FE of the Income Tax Act 2007

Subpart FE has been amended to apply the interest allocation rules to New Zealand residents with interests in CFCs. These rules are designed to prevent excessive interest deductions being allocated against the New Zealand tax base.

Key features

Interest allocation rules have been extended to outbound entities: New Zealand residents with an income interest in a CFC. The existing safe harbours apply. Interest deductions are not restricted unless the New Zealand group debt percentage is more than 75 percent (and, for a company or a trustee, is also more than 110 percent of the worldwide group debt percentage).

An outbound entity will not typically be required to apportion interest expenditure unless New Zealand group assets are less than 90 percent of the assets of the worldwide group and the total interest deductions of the New Zealand group are more than $250,000. In addition, an adjustment mechanism has been introduced for outbound entities with finance costs of less than $2 million. This eliminates apportionment for outbound entities with finance costs of up to $1 million and provides tapered relief for those with finance costs between $1 million and $2 million.

Various changes have been made to the definitions of "debt" and "assets" in subpart FE. Fixed-rate foreign equity and fixed-rate shares held by New Zealand residents are now included when determining total group debt for the New Zealand group. Equity investments in CFCs are no longer included within the total group assets of the New Zealand group. The rules for measuring the debt of the worldwide group have been aligned with those for measuring the debt of the New Zealand group.

Detailed analysis

Application of rules to outbound entities

Previously, the interest allocation rules only applied to New Zealand taxpayers controlled by a single non-resident. Subpart FE has been amended so that the rules also apply to outbound entities - New Zealand-resident companies, individuals and trustees with an income interest in a CFC (sections FE 1(1)(a)(i) and FE 2(1)(e) to (f)).

The safe harbours set out in section FE 5 apply to outbound entities as well as to entities controlled by non-residents. Thus, an outbound entity will not be subject to restriction of its interest deductions under subpart FE unless it has a New Zealand group debt percentage that is more than 75 percent (and, for a company or a trustee, is also more than 110 percent of the worldwide group debt percentage).

Additional carve-outs apply to outbound entities by virtue of section FE 5(1B). There is an exemption from the requirement to apportion interest expenditure if:

• the value of New Zealand group assets is 90 percent or more of the value of the assets of the worldwide group; or
• total interest deductions of the New Zealand group are not more than $250,000 and the group does not include an entity with an income interest in a CFC that derives rent from land in the country or territory in which the CFC is resident.

Apportionment of interest

Section FE 6 contains the formula for apportioning interest for an excess debt entity. The effect of the formula, when it applies, is to produce an additional amount of income for the entity. As well as interest, the formula includes dividends paid in relation to fixed-rate foreign equity or fixed-rate shares (subsections (2) and (3)(ab)).

An adjustment mechanism has been introduced for outbound entities with finance costs of less than $2 million (subsections (2) and (3)(ac)). The effect of the adjustment is to eliminate apportionment under this section for outbound entities with finance costs of up to $1 million. For outbound entities with finance costs of between $1 million and $2 million, tapered relief is available, gradually reducing as costs increase towards the $2 million cut-off point.

Determination of New Zealand group

For an outbound entity that is a company (an excess debt outbound company), the New Zealand group is determined by reference to the New Zealand parent (section FE 12(4)). The group comprises those companies for which control can be traced from the parent (section FE 28). The meaning of "control" for these purposes is determined under section FE 27. The New Zealand parent is identified under section FE 26 by tracing ownership interests up the chain of companies on a tier-by-tier basis until no New Zealand-resident company has an ownership interest of 50 percent or more in the last company in the chain (subsection (4B))

For an outbound entity that is an individual or a trustee, the New Zealand group is determined under section FE 3. It includes all associated persons who are resident or have a fixed establishment in New Zealand or who derive New Zealand-sourced income that is not relieved under a double tax agreement. Excess debt outbound companies, and those within the New Zealand group of such companies, are not included.

The associated persons rules prevent the use of non-arm's-length arrangements to undermine the intent of the income tax legislation. In the context of the interest allocation rules, the application of these rules is intended to stop the use of close associates to bring excessive levels of debt within the New Zealand tax base, contrary to the policy intent. The rules governing when a person is associated with an individual or a trustee are set out in sections YB 1 to YB 16. Those provisions are discussed in detail elsewhere in this report.

Section FE 29 provides that companies or groups owned by the same natural person or trustee are to form a single New Zealand group.

Determination of worldwide group

It may also be necessary to determine the worldwide group of a company or a trustee that is an outbound entity, for the purposes of calculating the worldwide group debt percentage. For a company, the worldwide group is determined under sections FE 31B and FE 32 and includes the company, its New Zealand group, and its worldwide GAAP group (being all non-residents required to be included with the company in consolidated financial statements under generally accepted accounting practice). For a trustee, the worldwide group is determined under section FE 3 and includes the trustee, the trustee's New Zealand group, and all CFCs in which either the trustee or another member of the New Zealand group has an income interest.

Measurement rules

The general measurement rules set out in subpart FE apply to outbound entities for the purposes of calculating total group debt and total group assets of the New Zealand and worldwide groups. In particular, the New Zealand group debt percentage can be measured on various dates (section FE 8). Various bases for the valuation of total group assets may also be used (section FE 16), and the on-lending concession under section FE 13 applies to arm's-length debt provided by an outbound entity to its CFCs.

Various amendments have been made to the definitions of debt and assets in subpart FE. In particular:

• Fixed-rate foreign equity and fixed-rate shares held by New Zealand residents are now included when determining total group debt for the New Zealand group under section FE 15.
• Equity investments in CFCs are now excluded when determining total group assets for the New Zealand group under section FE 16.
• The rules in section FE 18 for measuring the debt of the worldwide group have been aligned with those for measuring New Zealand group debt. Accordingly, non-interest bearing liabilities and liabilities that do not provide funds are no longer treated as debt for the worldwide group, even if they are included as debt under generally accepted accounting practice.