Income Tax Amendment Act 1983, Supplement 1

This commentary item was published in Public Information Bulletin Volume 126, Supplement 1, September 1984

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Section 1 - Short Title

This section provides that this Amendment Act is to be read with, and as part of, the Income Tax Act 1976.

Section 2 - Application

This section provides that the Act applies to interest derived from money lent and redemption payments under binding contracts entered into on or after 29 July 1983.

The provisions in this Act will not apply to any money lent where a binding contract was entered into on or before 28 July 1983. A binding contract is one where the performance of a party to the contract can be enforced by any other party.

Any interest arising from a loan in respect of which the Government of New Zealand approved the exemption of interest under the terms of section 61(18)(b) (as it was before it was repealed by this Amendment Act) on the recommendation of the Overseas Investment Commission will also be exempt from income tax.

The position of options, renewals or rearrangements of existing loans will depend on the facts of each case, but essentially if any renewal or rearrangement of an existing loan was provided for by a binding contract entered into prior to 29 July 1983 the provisions of this Amendment Act will not apply to the interest arising from any such renewal or rearrangement. For example, if a credit facility was subject to a contract entered into in 1982 and the contract included an option to renew that facility for a further year, the exercise of the option after 29 July 1983 would be considered to be in respect of money lent under a binding contract entered into before 29 July 1983.

On the other hand, where an existing contract does not provide for any extension or renewal of a loan, any such extension or renewal after 29 July 1983 will be a new loan.

Section 3 - Meaning of Expressions

a. Subsection (1)

This subsection inserts four new definitions into section 2 of the principal Act.

"Interest"

Interest is defined in relation to the deriving of income or non-resident withholding income by any person. This definition is therefore restricted to interest only in the context of income and does not alter the meaning of the term interest in respect of the deduction of interest in the calculation of assessable income. Wherever the term "interest" is used in the principal Act in respect of income or non-resident withholding income, it will now have the meaning of this defined term unless it is expressly provided to be otherwise.

Interest now means every payment received by a lender from and in respect of "money lent" other than the repayment of the principal sum lent or the repayment of a "redemption payment". The effect of this definition is that all returns to the lender, other than the loan capital repayments, will be interest for income tax purposes. This would include any premium received by the lender.

Payments that are interest must be directly related to payments arising from the borrowing of money lent. Interest does not include fees which are paid by the borrower in respect of professional services performed in arranging and/or managing the financial transaction. Examples of such fees would include, legal fees, management fees, procurement fees, brokerage, etc. If there is evidence that fees of this nature are being inflated to avoid income from money lent being taxed as interest, then consideration will be given as to whether section 99 should be applied.

It must be remembered that the imposition of non-resident withholding tax is always subject to the terms of Double Taxation Agreements. Any particular Double Taxation Agreement may exempt certain interest payments or impose a different meaning of the term "interest" for the purpose of the agreement. Before any final decision can be made on the tax treatment of interest paid to a non-resident, both the Income Tax Act 1976 and the relevant Double Taxation Agreement must be taken into account.

"Money Lent"

A definition of "money lent" is also inserted in section 2 of the principal Act. "Money lent" is extensively defined, and while the definition covers the generally accepted meanings of the term in respect of money that is advanced, deposited, or otherwise let out and the giving of credit, it also includes any amount paid to a person in return for an agreement or promise to pay back a greater amount.

Example:

A pays B $80 and receives a promise from B to pay $100 in, say, three months time. The "money lent" is $80.

It should be noted that where there is an agreement or promise to pay an amount by any person, in consideration of a payment to an associated person the payment to that associated person is also "money lent".

"Paid"

The expression "paid" is defined to ensure that interest derived by a person is regarded as paid when it is dealt with for him in the ways set out. "Pay", "payable" and "payment" are correspondingly expanded.

"Redemption Payment"

A redemption payment is defined such that it is the amount paid to any person on the redemption of a commercial bill (as defined in section 65(1)(a) of the principal Act) owned by him, to the extent to which that amount exceeds the amount paid by any person for the issue of the bill.

Example:

A issues a bill with a face value of $100 to B and receives $80 in return. B then sells the bill to C for $95 who is the holder when it matures and receives $100 from A. The "redemption payment" is ($100 - $80), i.e., $20.

A redemption payment is excluded from the definition of "interest" in section 2 of the principal Act because the income arising from commercial bills is specifically included in assessable income under section 65(2)(k). However, a redemption payment is included in the definition of interest for the purposes of Part IX of the principal Act.

Subsection (2)

This subsection inserts a new definition of interest for the purposes of Part IX of the principal Act. This definition only extends the meaning of interest (as defined in section 2 of the principal Act) for the purposes of non-resident withholding tax. Furthermore, the meaning of interest includes a redemption payment which is made to a non-resident who is not a person engaged in business in New Zealand through a fixed establishment in New Zealand (essentially operating a branch in New Zealand). The effect of this definition is expanded in detail in subsection (1), together with its relationship to the other defined terms.

Subsections (3) and (4)

These subsections are merely two consequential amendments arising from the definition of "money lent" being inserted in section 2 of the principal Act.

Section 4 - Incomes Wholly Exempt from Tax

1. Subsection (1)
2. This subsection substitutes a new subsection 61(18) into the principal Act. The new subsection only exempts income (being interest or redemption payments) derived by non-resident lenders, and where that income is payable outside New Zealand, in respect of:
   • Money lent to the Government of New Zealand.
   • Money lent to local or public authorities for non-commercial activities, and where the Government of New Zealand has agreed the interest is to be exempt.

2. Subsection (2)
3. This subsection sets out the transitional measures in respect of exemptions from interest under the previous section 61(18)(b).

Section 5 - Items Included in Assessable Income

This section inserts a new paragraph (ka) in section 65 of the principal Act, to cover a "redemption payment". A "redemption payment" will be assessable income where the redemption payment is in respect of a commercial bill that:

• At the time of issue or at any time thereafter is acquired by a non-resident (but not where it is acquired in the carrying on by the non-resident of business in New Zealand through a fixed establishment in New Zealand); and
• At the time or redemption is owned by a New Zealand resident, or by a non-resident in the course of carrying on by him of a business in New Zealand through a fixed establishment in New Zealand.

The new paragraph (ka) will NOT, however, apply where the commercial bill concerned was issued:

• By a New Zealand resident in relation to the carrying on by him of a business outside of New Zealand through a fixed establishment overseas;
• By a non-resident UNLESS the commercial bill was issued in relation to the carrying on by him of a business in New Zealand through a fixed establishment in New Zealand.

This section also consequentially amends section 65(2)(k) of the principal Act to ensure that subsection (2)(k) will not apply where subsection (2)(ka) applies.

Briefly, the effect of this amendment is that, subject to the two exceptions explained above, where a bill is issued by a New Zealand resident, redeemed from a New Zealand resident and at any time during its existence traded overseas, then the income of the person who holds that bill on maturity will be the "redemption payment", notjust the difference between the cost of the bill to that holder and the full amount received on redemption.

Section 6 - Classes of Income Deemed to be Derived from New Zealand

A. Subsection (1)

This subsection repeals the definition of "money lent" in section 243(1). This definition was no longer required as the insertion of a similar definition in section 2 of the principal Act also applies to section 243.

Subsection (2)

Subsection (2) repeals the existing paragraphs (l) and (m) in section 243(2) and replaces them with two new paragraphs:

1. Paragraph (l) makes it explicit that income from money lent in New Zealand is "interest" or a "redemption payment" as defined in section 2 of the principal Act. Therefore any return to a lender, where the money is lent in New Zealand, in excess of the money advanced or a redemption payment will now be deemed to be derived from New Zealand.
2. Paragraph (m) deems that income from money lent outside New Zealand to:
   • any resident of New Zealand (not where the money lent is used by him in respect of business activities carried out through a fixed establishment overseas); or
   • any non-resident for use in respect of business activities carried out by him through a fixed establishment in New Zealand,

3. shall be derived from New Zealand.

Practical Effect of New Definitions

The definition of interest in the context of income received means that for the first time there is a statutory meaning given to the term. Previously the meaning of "interest" was that which the common law had established over the years. From now on, the meaning of interest in relation to the deriving of income or non-resident withholding income is that defined in the Act. The common law meaning of interest remains in relation to the deductibility of interest in calculating assessable income.

The meaning of interest as defined in this Amendment Act is now discussed in relation to certain financial transactions.

Commercial Bills

The changes in this Act will not affect the existing income tax provisions in respect of commercial bills issued, traded and redeemed in New Zealand. However, where commercial bills are redeemed to non-resident holders, the redemption payment (as defined in section 2) will be subject to non-resident withholding tax as it is now included in the meaning of interest in Part IX of the principal Act.

There are several points which must be borne in mind.

• Any income arising from the trading of a commercial bill outside of New Zealand by a non-resident will not be subject to New Zealand tax unless it is in respect of the business operations carried on in New Zealand through a fixed establishment in New Zealand.
• Where the "redemption payment" is received by a non-resident in relation to the business activities carried on by him through a fixed establishment in New Zealand, it is not subject to non-resident withholding tax. This is because in this situation a "redemption payment" is not non-resident withholding income (see section 310(2)(b)). The income arising from the redemption of a commercial bill in these circumstances is assessable under section 65(2)(a).
• A "redemption payment", received by a non-resident holder of a commercial bill, is not subject to New Zealand tax when the funds were used by a New Zealand resident for the purpose of a business carried on by him through a fixed establishment overseas (see section 243(2)(m)(i)).
• Where a commercial bill is redeemed to a New Zealand resident holder on maturity and that bill is one which was issued to, or held at any time by, a non-resident (other than in the course of carrying on business in New Zealand through a fixed establishment in New Zealand), the "redemption payment" will be assessable under section 65(2)(ka) and the provisions of section 65(2)(k) will not apply.

Other than when a bill is held overseas and ultimately redeemed in New Zealand, the effect of the amendments on commercial bills can be summarised in general as:

• If the income arising from the trading and redemption of a commercial bill is taxed in New Zealand under the provisions of section 65(2)(a) or section 65(2)(k) then no further liability will arise from a "redemption payment".
• Where these sections do not apply, and in general terms this is when the bill has been issued by a New Zealand resident to a non-resident and redeemed overseas, then a "redemption payment" arises and could be subject to non-resident withholding tax.

Example:

A is a New Zealand company which, in consideration for $900,000, issues a commercial bill to B (an overseas bank). B then sells the bill to C for $950,000. The bill has a face value of $1M.

If C is a Non-Resident

There is no New Zealand tax liability on the sale between B and C but, on redemption, $100,000 is a "redemption payment" and subject to non-resident withholding tax in New Zealand.

If C is a New Zealand Resident

There is no New Zealand tax liability on the sale between B and C, but C would be assessable in New Zealand on $100,000 under section 65(2)(ka).

Other Lending

A premium can be received by a lender in most financial transactions involving the borrowing of funds. This can take many forms but essentially it is no more than a repayment of an amount in excess of the amount advanced by the lender which is in the nature of interest but may not be interest at common law. A premium is included under the new definition of interest. A premium can also be represented by a discount granted by a borrower or holder of a bill.

The premium that arises from money lent will be assessable when it is derived. This will be a question of fact and regard will be had to the contractual obligations between the parties. A typical example of a premium payment which is now treated as interest is where a mortgagor requires a payment over and above the amount of money advanced to ensure the capital sum maintains its value in real terms, i.e., to compensate for the loss of purchasing power due to the effects of inflations.

The premium or in fact, any amount received by a lender from money lent, over and above the amount of money lent, has a source in New Zealand for income tax purposes under the definition of "interest". This means that where such payments are made to non-resident lenders they are subject to non-resident withholding tax.

Finally, it is essential to remember that these changes do not affect any payments arising from money lent under binding contractual obligations entered into on or after 29 July 1983. The actual lending or issue of a bill may take place after that date but as long as that lending or issue was the subject of a binding contract entered into before 29 July the Income Tax Amendment Act 1983 will have no effect.