New Thin Capitalisation Rules for Foreign-Owned Banks in New Zealand: New Rules That Target Excessive Debt Funding by Banks Are Expected to Result in Significant Additional Tax Payable and Produce Substantial Capital Inflows to New Zealand by Foreign-Owned Banks Operating There

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From 1 July 2005, New Zealand is introducing new thin capitalisation rules for foreign-owned banks. These new rules are designed to ensure that foreign-owned banks operating in New Zealand pay enough tax on their New Zealand income and the changes are expected to result in additional tax payable of $360 million per year.

The new rules are a policy response by government in relation to concerns about excessive debt funding by banks, both in terms of inward and outward investments. The fundamental objective of the proposals is to measure more effectively the income associated with the New Zealand activities of banks, ensuring that excessive debt cannot be allocated to the New Zealand operations of a multi-national bank.

The new rules will deny foreign-owned banks interest deductions unless they have sufficient capital in New Zealand to support their New Zealand business and their offshore investments made through New Zealand. In particular, the rules effectively mean that their offshore investments will need to be fully equity funded.

The introduction of the new rules is likely to mean there will be a substantial inflow of capital into New Zealand by foreign owned banks operating in New Zealand prior to the first measurement date of 30 September 2005.

The proposed new thin capitalisation rules for foreign-owned banks and their New Zealand groups differ from the current thin capitalisation rules applying to other taxpayers in three main ways:

* The rules are based on a minimum level of equity rather than a maximum level of debt;

* Equity is measured net of offshore assets; and

* The rules require banks to have at least a 4 per cent level of capital, rather than effectively a 25 per cent level of capital.

The new thin capitalisation rules are conceptually similar to those that were introduced in Australia in 2001, however, there are some technical differences between the rules in the two countries.

The rationale behind the new rules

There are two policy concerns underlying the introduction of the new thin capitalisation rules for banks.

The first concern relates to outbound investment. The concern is that taxpayers have been using debt funded cross-border financing arrangements to generate income that is not subject to New Zealand tax as a result of the application of New Zealand's international tax rules, while a deduction is being claimed for the interest expense on the funding of the financing arrangements.

The second concern, relating to inbound investment, is that there is potential for banks to substitute debt for equity in financing their New Zealand businesses. This can be achieved through the use of bank branches and holding companies.

Effectively, the current thin capitalisation rules do not apply to banks, primarily because of the on-lending concession.

How do the new rules work?

The new thin capitalisation rules are, to a large extent, based on the regulatory requirements of the Reserve Bank Act 1989 and on accounting concepts. The rules compare the equity associated with the New Zealand banking business with a prescribed level of required equity. The prescribed equity is based on 4 per cent of the banks' New Zealand risk-weighted exposures.

Although the equity is based on the accounting equity, several adjustments are made for the purposes of the thin capitalisation rules. Adjustments will be required for any instruments that are treated as equity for accounting but as debt for tax purposes, or vice versa. To the extent that there is interest-free debt from the parent company, this will also be considered as equity for the purposes of the thin capitalisation rules.

The equity of the New Zealand banking business is reduced to take into account certain offshore equity investments in nonresident entities and notional offshore investment amounts. The value of the adjustment for notional offshore investments is based on the foreign tax credits generated. …