The Inland Revenue Department recently released a draft on tax avoidance.
OPINION: The item covered four separate scenarios, but the scenario on debt capitalisation has triggered considerable criticism. I suggest that it has also triggered much angst for some advisers.
The scenario is:
1. A qualifying company (QC) was formed with $100 capital.
2. There is a shareholder advance to the QC of $700.
3. The QC has insufficient assets and is unable to repay the debt in full.
4. The shareholder subscribes for further capital of $500 in the QC.
5. The QC repays some of the debt.
6. The transactions in 4 and 5 are made by way of offset and no cash actually changes hands.
7. The balance of the shareholder advance is repaid using the QC's only assets.
Inland Revenue state that the commissioner's view is that the anti-avoidance provision in section BG 1 "would potentially apply to this arrangement". That view is based on the assumption that "the apparent objective of this arrangement is to eliminate the loan owed by [the] company to its shareholder in circumstances where the company is unable to repay it".
Inland Revenue's view has been depicted as a wide-ranging extension to the tax net.
Further, such capitalising of debt was business as usual changes made to clean up balance sheets during restructuring.
The scenario depicted above may well have arisen from the QC originally having been a loss- attributing qualifying company (LAQC) that passed through losses, such as rental losses, to the shareholders.
The shareholders have had to "prop the company up" through advances or loans.
If the QC was wound up or struck off without dealing with the debt there would be debt remission income. As the Court of Appeal noted in a recent case, "the financial arrangement rules were intended to give effect to the reality of income of income and expenditure - that is, real economic benefits and costs. The [legislation] was designed to recognise the economic effect of a transaction, not its legal or accounting form or treatment".
Given that the shareholders of a QC are responsible for the QC's unpaid income tax debt the supposed "standard accounting treatment" of debt capitalisation, in my view, appears to be a tax avoidance arrangement. Of course, each situation must be judged on its own facts.
In my view, Inland Revenue's draft position accurately reflects the legislation and is not an extra- statutory change. It may, however, reflect a change in Inland Revenue's attitude to past practice.
Given that the standard time-bar provision does not apply to situations of tax avoidance Inland Revenue may seek to review many past transactions and if need be reinstate companies that were QCs and LAQCs.
If you are concerned about possible exposure to back taxes, interest and penalties, I strongly suggest that you seek appropriate advice.
Murray McClennan is director of Tax Central Ltd, a specialist tax consulting firm. He can be contacted by emailing firstname.lastname@example.org
- The Southland Times