Related party debt has long been an issue for issue for taxpayers who extend loans to companies.
The Cabinet has signed off proposals to change the law retrospectively.
The Current Situation
To use a simple example, suppose you loaned $1,000 to a friend – let’s call her Sally. As time went by you decided to forgive that debt from Sally. Technically Sally now has tax to pay as she has received income. She is economically better off having received the money. Sally should pay tax on that $1,000.
However, if Sally was your daughter, you could avoid this issue by forgiving the debt through “natural love and affection”.
Many self-employed clients have devote considerable time and energy to their wholly owned companies but the IRD doesn’t accept that you can have natural love and affection for a company, only people.
This can create unfair tax outcomes.
For instance, if you decided to forgive a loan extended by you to your company the IRD treat this loan as income in the books of the company. You don’t receive a corresponding deduction.
This is unfair as your overall economic wealth remains unchanged.
Under current law, debt can only be remitted when the debtor:
- is insolvent or liquidated:
- is discharged from making remaining payments;
- enters into a deed of composition with its creditors that results in full remission; or
- has no obligation to make payments when, because of the passage of time, the debt is either irrecoverable or unenforceable.
The new proposal approved by Cabinet will make the following changes:
1. Wholly owned Group
Where money has been loaned between two companies in the same group of companies, the overall ‘wealth’ of the group is not in any way impacted.
The lender has suffered a loss and the borrower a gain but overall there is no change in the overall ‘wealth’ of the owner – the parent company.
The IRD proposes that no tax liability should exist when one company in a wholly owned group forgives it’s debt to another company within the group.
In some instances, the solvent company will extend funds for the insolvent company to pay off its creditors. The IRD agree that it doesn’t seem fair to penalise the group by rationalising inter-group debt. The alternative is just to place the insolvent company in liquidation which currently has no tax consequence. The change will equalise incentives for groups to repay creditors in this circumstance.
2. New Zealand Resident Shareholders
It is common to encounter the following situations with shareholdings.
Shares owned by a resident trust and/or shareholder
As with a company, the shareholder’s overall ‘wealth’ remains unchanged when they capitalise or remit a debt owed to them by a wholly owned company. As such, no debt remission ‘income’ should arise for the company and there should be no tax consequences.
What about the other way round?
When a company forgives a debt to a shareholder, this will continue to be taxed as it is effectively a dividend to the shareholder.
The most common example here is an overdrawn current account.
New Zealand partnership
Under current tax law, where debt from partners to a partnership is remitted, the partnership (and therefore the partners) will derive debt remission income from the BPA. However, the partners do not get a corresponding bad debt deduction. The IRD concedes that this is unfair. They refer to the outcome as asymmetrical.
IRD propose to rectify this anomaly by making the transaction symetrical by removing the imposition of debt remission income for the partners provided that this debit is remitted on a pro-rata basis for the partenrship.
This change is likely to impact Look Through Companies as well.
Where to from here?
Legislation is likely to be introduced to the Parliament in 2016 and will apply retrospectively to 1 April, 2006.
A select committee will examine public submissions.