Chapter 7 Answers [0001] Question 1 (a) Spreading Methods The available spreading methods are (s EW 14): International Financial Reporting Standards (IFRS) financial reporting method (ss EW 15B to EW 15I); or Financial reporting method (ss EW 21 and EW 23); or Straight-line method (ss EW 17 and EW 19); or Market valuation method (ss EW 18, EW 19, and EW 23); or Yield to maturity (YTM) method or an alternative (ss EW 16, EW 19, and EW 23); or A determination method or an alternative (ss EW 20 and EW 23); or A default method (s EW 22). A person who uses IFRSs to prepare financial statements and to report for financial arrangements must use one of the following four methods to account for their financial arrangements (s EW 15C): IFRS financial reporting method (s EW 15D); A determination alternative (s EW 15E); Expected value method (s EW 15F); or Modified fair value method (s EW 15G). However, there are important exclusions to application of the above IFRS methods. The exclusions apply where: There is the mandatory use of determination G5C, G22, G22A, or G29. Where these determinations can be used they must be used (s EW 15H); or The mandatory determinations in s EW 15H cannot be used but the following apply (s EW 15I): Includes in part an excepted financial arrangement; Is an equity instrument under IFRSs; or Is an agreement for the sale and purchase of property or services. In this situation the yield to maturity (YTM) method, Determination G26, a determination issued under s 90AC(1)(bb) of the TAA 1994, or an alternative method (not materially different from YTM) must be used. (b) Determinations Determinations are prepared under the Income Tax (Determinations) Regulations 1987, published in the Gazette, and reproduced in Tax Information Bulletins (TIBs) or various tax publications (see Brookers Tax Service). Common Determinations G24: Straight line method (s EW 17); G3: Yield to maturity method (s EW 16(1)); G1: Apportionment of daily income and expenditure;
0002 New Zealand Taxation 2012 Chapter 7 Answers G1A: Apportionment of income and expenditure on a daily basis; G11A: Present value based yield to maturity method (s EW 16(2)); G12: Accounting for a financial arrangement in the absence of a determination; G17B: Deferred property settlements denominated in New Zealand currency (s EW 20). Mandatory use of some Determinations Section EW 15H requires the mandatory use of some determinations and where the terms of the method described in the specific determinations allow its use for that particular type of financial arrangement, the IFRS methods of s EW 15C(1) do not apply. The mandatory determinations (s EW 15H) are as follows: Determination G5C: Mandatory conversion convertible notes; Determination G22: Optional conversion convertible notes denominated in New Zealand dollars convertible to the option of the holder; Determination G22A: Optional convertible notes denominated in New Zealand; Determination G29: Agreements for sale and purchase of property denominated in foreign currency: exchange rate to determine the acquisition price and method for spreading income and expenditure. However, when applying Determination G29, Determination G9C, and not Determination G9A, must be used; or An alternative method to the methods described above, if that alternative has regard to the purposes of the financial arrangements rules under s EW 1(3); is for financial arrangements similar to those arrangements to which the above methods may apply; and results in the allocation to each income year of amounts that are not materially different from the result using one of the methods described above. [0002] Question 2 Current taxation rules are linked to accounting practice in areas such as the financial arrangement rules, the trading stock valuation rules, research and development expenditure rules, and in areas where the courts and tax legislation have relied on generally accepted accounting practice. Tax rules reliance on accounting practice in these areas is continually changing. To the extent that certain tax rules rely on accounting practice, changes in accounting practice arising from the adoption of IFRS are also brought into effect for tax purposes (in other words, they are automatically reflected in tax law). However, some areas, such as the financial arrangements, research and development expenditure and trading stock valuation rules, require legislative amendments to incorporate the specific changes brought about by the adoption of IFRS. IFRS have introduced significant changes to the methods of accounting for income and expenditure of financial arrangements. In many cases these changes bring financial accounting methods closer in line with existing tax timing rules. The legislative amendments over the last years clarify that taxpayers who adopted IFRS methods can rely on the same methods for taxation purposes. They also provide alternative methods that these taxpayers can adopt. It is hoped that by allowing a closer relationship between financial accounting reporting standards and taxation legislation, compliance cost will be reduced and understanding improved. There is also a risk that further confusion will result. See: http://www.ird.govt.nz/technicaltax/legislation/2007/2007-97/2007-97-adoptioninternational-reporting-stds/ See: Ward E, Financial Arrangement Rules, The 2009 Tax Conference (Institute of Chartered Accountants of New Zealand, Christchurch, 16 and 17 October, 2009). [0003] Question 3 (a) Approve. A clearly intended consequence of the accruals regime was to expand the tax base to ensure that all forms of gains on financial Brookers 2
Chapter 7 Answers New Zealand Taxation 2012 0004 arrangements are brought to account for tax purposes. The introduction of the regime has meant that a number of gains which may previously have been regarded as capital in nature, and therefore tax free, such as gains on the maturity of government stock, are now taxable to all taxpayers. For a financial arrangement, all consideration paid and any amounts remitted are assessable income [ss EW 16 - EW 22 and EW 29]. (b) Disapprove. The accruals regime applies to all taxpayers, whether a business is involved or not. Subsections EW 10(1) - (3) state that it applies to all parties to a financial arrangement, to the extent to which a person is a party to the arrangement; therefore it does not affect just business taxpayers. (c) Disapprove. Whether or not a taxpayer is a cash basis person is relevant only in determining the period in which income or expenditure under a financial arrangement is to be reported. It has no impact in determining whether the regime applies. Section EW 54 defines a cash basis person, by reference to s EW 56 and s EW 60. Section EW 57 gives the threshold formula to determine whether the exception in s EW 55 applies. Section EW 63 gives the method for calculation of the cash basis adjustment for a cash basis person. This cash basis adjustment applies whenever a person moves from an accrual basis of accounting to a cash basis or vice versa. Although a cash basis person does not have to use a specified method of calculating income each year (possibly straight-line method, yield to maturity, or market value) they must still do a base price adjustment in the year of maturity, disposal or remission. Even if you are a cash basis person, you must calculate a base price adjustment when your financial arrangement is sold, transferred, matures or is remitted [s EW 29], unless s EW 30(1) applies [Cash basis person who ceases to be a temporary New Zealand resident]. [0004] Question 4 This is an open-ended question which requires the student to consider the fundamental objectives of the financial arrangements regime. Ideally, taxation of income on an accrual or earnings basis should achieve close matching of revenue derived and expenditure incurred in the same transaction especially in the case of debt instruments (ie, contracts to lend and borrow money). (a) The purpose of the financial arrangements regime is to require parties to a financial arrangement to accrue, over the term of the arrangement, a fair and reasonable amount of income derived from, or expenditure incurred under, the arrangement, and so prevent deferring income and advancing expenditure [s EW 1(3)(a)]. Section EW 1(3), the purpose statement for subpart EW, also requires the parties to a financial arrangement to disregard any distinction between capital and revenue amounts and to calculate a base price adjustment when the rights and obligations of the party under the arrangement cease [s EW 1(3)(b) and (c)]. This is an important distinction from the concept of accrual accounting, used in financial reporting by accountants, which distinguishes between capital receipts and expenditure (eg the sale and purchase of fixed assets) and revenue receipts and expenditure (eg the sale of goods or services and the expenditure related to these sales, eg selling expenses, insurance etc). Generally this distinction is maintained in recognising income in New Zealand taxation, but there are at least three distinct taxation regimes where capital receipts and expenditure are not separated but become part of the normal income and expenditure that is taxed. These are the financial arrangements, land transactions and foreign investments regimes. When it is decided that a financial arrangement to which the regime applies exists, it is then necessary to decide which method should be used to allocate the income and expenditure relating to this financial arrangement over the appropriate income tax years. That is, which mechanism should be used to achieve the more equitable allocation of the income and expenditure resulting from the financial arrangement. Figure 7.3 illustrates the process a person should follow to determine which spreading method to use. These include the straight line, yield to maturity, and market valuation methods. However this is a complex process, and s 90 of the TAA 1994 was introduced to allow for further rules and explanations to be made in financial arrangement determinations. While these determinations have the force of the law, they do not require an Act of Parliament for their instigation. The determinations provide detailed rules for Brookers 3
0005 New Zealand Taxation 2012 Chapter 7 Answers applying the provisions of the accruals legislation, together with detailed examples. Most determinations are published in TIBs or in various publications (see Brookers Tax Service). Table 7.3 lists a selection of determinations and sections of the ITA to which they apply. Examples of determinations are given in Table 7.3 and include: G24: Straight line method [s EW 17] G3: Yield to maturity method [s EW 16(1)] G1: Apportionment of daily income and expenditure G1A: Apportionment of income and expenditure on a daily basis G11A: Present value based yield to maturity method [s EW 16(2)] G12: Accounting for a financial arrangement in the absence of a determination [s EW 21] G17B: Deferred property settlements denominated in New Zealand currency [s EW 20] (b) A main purpose of the accrual rules is to standardise the timing of income and expenditure associated with financial arrangements so as to reduce economic distortions and opportunities for tax avoidance. Under this financial arrangements regime, the timing for recognition of income should not be deferred and the expenditure incurred under any debt instrument should not be brought forward. With the accrual basis of financial accounting, revenue is recognised in the period in which the in-flow of economic benefits can be reliably measured (eg, when the invoice is issued). Expenses are recognised in the period in which the consumption of goods and services can be reliably measured, rather than when they are paid for. Due to the complicated methods by which financial arrangements are bought and sold they do not fit easily within these financial accounting rules. For taxation purposes it has therefore been necessary to design extra methods and rules. Figure 7.3 illustrates the spreading methods which should be used, including the straight line, yield to maturity, and market valuation methods. Extra rules are also given in the Determinations. Examples which explicitly include rules for the timing of the recognition of the income and expenditure are: G24: Straight line method; G3: Yield to maturity method; G1: Apportionment of daily income and expenditure; and G1A: Apportionment of income and expenditure on a daily basis. The purpose of these rules is to provide a systematic framework and methods which can account for all the complex and sometimes obtuse types of financial arrangements that are used. When applied correctly, they will allocate an approximation of income and expenditure on a timely basis that will result in an equitable payment of taxes on the financial arrangement. [0005] Question 5 Election to treat excepted financial arrangements as financial arrangements A person may choose to treat as financial arrangements all the excepted financial arrangements to which the person is a party that are described in any of ss EW 5(21) - (25) [s EW 8(1)]. These subsections are: where all of the prepayment for property or services is of less than $50,000 (s EW 21); short-term agreements for the sale and purchase of property (s EW 22); short-term options (s EW 23); travellers cheques (s EW 24); and variable principal debt instruments of less than $50,000 (s EW 25). The election for short-term agreements for the sale and purchase of property or services can be made for different classes of short-term agreements on the basis of the currency or term [s EW 8(2)]. However, when electing to treat the other excepted financial arrangements listed above as financial arrangements, the election must be made in respect of all such financial arrangements. For example, a taxpayer who has interests in several short-term options and several travellers cheques wishes to treat the travellers cheques as financial arrangements. The taxpayer can elect to treat all travellers cheques as financial arrangements and continue to treat the short-term options as excepted financial arrangements. Brookers 4
Chapter 7 Answers New Zealand Taxation 2012 0006 A taxpayer elects by returning the income or expenditure in respect of the arrangement on an accrual basis in the income year that the election is made [s EW 8(3)]. It is not necessary to give notice to the CIR. The election can only be revoked, however, by giving notice to the CIR [s EW 8(4)]. Once notice has been given the revocation applies to excepted financial arrangements entered into in the year following the income year in which notice is given. [0006] Question 6 Deferred Settlement for Property Purchase The alternative prices at which the land and buildings are sold give a clear indication that credit has been extended where the four-year settlement is offered. Five criteria are required for a financial arrangement to exist [s EW 3]. In relation to this transaction, they can be answered as follows: There is an arrangement, as there is an agreement for the sale of the property; Y Ltd does receive money or money s worth that is, the property; There is consideration. It is not just a gift or donation; and The purchaser is providing money (ie, the payment for the property). Four of the criteria have been satisfied. However, there is a fifth criterion which must be satisfied for there to be a financial arrangement. The question that remains is whether the payment is to be made in the future. If it is an instantaneous sale or purchase of property (ie, the money is paid and the title to the property is given on the same day), it is not a financial arrangement. This is because the consideration is not paid in the future. If the purchaser provides money to the seller at a future time, it could be a financial arrangement. However, it is necessary to consider what is not a financial arrangement [s EW 4] and whether this transaction is an excepted financial arrangement [s EW 5], before this is certain. If it is an excepted financial arrangement, it is not necessary to consider the transaction within this regime. The sale of property can be an excepted financial arrangement if it is a private or domestic agreement for property or services (real property less than $1 million; other property less than $400,000) within 365 days [s EW 5(20)]. As the second option for this agreement is for four years, it is therefore not an excepted financial arrangement. Implicitly, the $700,000 is the lowest cash price to which parties would have agreed at the outset for settlement at first rights date. If so, the $500,000 extra cost to Y Ltd would represent deemed interest over the period. It would have to be split between income years using, for example, a yield to maturity or straight-line calculation or if IFRS were used by the company a method as required by s EW 15C. It normally would be desirable for the contract to clearly state that $700,000 is the lowest cash price agreed between the parties. (This may depend on the full facts, and whether one is representing Y Ltd or X Ltd.) If the $700,000 is taken as the lowest cash price, Inland Revenue would have regard to whether the implied rate is adequate [s EW 32, Consideration]. Extension of Trade Credit The provision of credit on 20 day terms represents an excepted financial arrangement known as a short term agreement for sale and purchase of property or services [s YA 1] (less than 93 days). Accounts requiring settling within that period would not represent difficulties. It does not matter if they happen to be settled after the 93 day mark [s EW 5(22)]. Under s EW 8 a taxpayer may elect to treat certain short-term trade credits as financial arrangements. This is to allow the reduction of compliance costs where short-term trade credit arrangements are not separated from other financial arrangements. The provision of further credit at a charge is a more complex issue. For GST purposes Inland Revenue regards the additional amount as an increase in the price of the goods. For income tax purposes it would constitute a financial arrangement [s EW 3]. This would not present significant difficulties for the wholesale company as it will presumably have already credited the additional charges to income. This would be appropriate treatment as the monthly interest forms part of assessable income. No further adjustments are necessary. Brookers 5
0007 New Zealand Taxation 2012 Chapter 7 Answers [0007] Question 7 Application of Straight Line Method B $ Amount payable 240,000 Amount received 170,000 Total Expenditure $70,000 Period Length (Yrs) Principal Outstanding Amount paid at the end of year (b c) Expenditure* (a b c) d b c e 1 1 $240,000 $100,000 $240,000 $31,111 2 1 $140,000 $60,000 $140,000 $18,148 3 1 $80,000 $80,000 $10,370 4 1 $80,000 $80,000 $10,370 Total d = $540,000 $70,000 *rounding is to nearest dollars Where total expenditure a is = $70,000 In the above example the total total finance charges are $70,000 ($240,000 - $170,000). In the first period the expenditure is apportioned as follows: ($70,000 x $240,000) / $540,000 = $31,111 For period two it is: ($70,000 x $140,000) / $540,000 = $18,148 For periods three and four it is: ($70,000 x $80,000) / $540,000 = $10,370 In the final year of the financial arrangement it will be necessary to do the base price adjustment calculation. [Section EW 17 and Determination G24] Brookers 6
Chapter 7 Answers New Zealand Taxation 2012 0008 [0008] Question 8 Section EW 31 gives the base price adjustment formula as: consideration income + expenditure + amount remitted where: consideration is the amounts received by the person less amounts paid by the person income is the amount of income already derived (included in the annual accounts). expenditure is the amount of expenditure already incurred (included in the annual accounts). amounts remitted is any amounts remitted by the person by operation of law or otherwise Calculations for X Y Z Borrower Lender 1 Lender 2 As at 31 March X6 31 March X3 31 March X6 $ $ $ All amounts received 200 220 280 Less all amounts paid 320 200 180 equals Consideration 120 20 100 Less Income already derived Add Expenditure already incurred nil 40 60 100 nil nil Amount remitted nil nil nil BPA Income 40 BPA Expenditure 20 20 Brookers 7
0009 New Zealand Taxation 2012 Chapter 7 Answers [0009] Question 9 Frederick provides money to the bank on 1 December 20X1 and receives benefits (interest and principal) at a later date. Consequently, this arrangement would fall within s EW 3(2). Term deposits are not referred to in paras (2) to (23) of s EW 5 which lists excepted financial arrangements. Therefore this arrangement is not an excepted financial arrangement. Consequently, income would be determined in accordance with ss EW 14 to EW 31. Section EW 14 describes different methods that are to be used to determine income. However, a taxpayer is not required to adopt one of these methods if the taxpayer is a cash basis person. Section EW 57 specifies the criteria that must be satisfied in order for a taxpayer to qualify as a cash basis person. Frederick satisfies these requirements, that is: (a) His absolute value of income and expenditure in the income year under all financial arrangements is less than $100,000 per annum (ie interest income [calculated in accordance with the straight-line method] for the year ending 31 March 20X2 would be approximately $6,000 (being $200,000 x 9% x 4/12)). (b) The absolute value of all financial arrangements at any time during the income year is $1,000,000 or less. As this is his only investment it is also probable that the total value of financial arrangement held by Frederick in this income year does not exceed $1 million. calculated, a cash basis person may elect not to use the cash basis rules but instead use a spreading method [s EW 61]. [0010] Question 10 The base price adjustment formula in s EW 31 is: consideration - income + expenditure + amounts remitted Where: consideration = the consideration paid or payable to the person less the consideration paid or payable by the person = (the present value of the property transferred to the person) less (the cash payment made by the person) = $1,435,999 - $1,500,000 = -$64,001 income = the income derived by the person from the financial arrangement in previous income years[s CC 3] and dividends derived by the person from the release of the obligation to repay the amount lent and income derived under s CF 2(2) and (3) [remission of specified suspensory loans] = 0 expenditure = expenditure incurred in previous income years = $12,916 (c) The difference between income calculated by one of the spreading methods (as per s EW 14) and income calculated as if Frederick was a cash basis person is less than $40,000 (the deferral threshold). His income calculated in accordance with the spreading rules of s EW 54 is $6,713.10 (being $300,000 x 9% x 91/366) and income calculated in accordance with s EW 14 is approximately $6,000. Therefore he satisfies the deferral threshold. In any year other than in the last year of the arrangement when the base price adjustment must be amounts remitted = an amount not included in the consideration paid or payable to the person, because it has been remitted by the person, or by law Brookers 8 = 0 consideration - income + expenditure + amounts remitted -$64,001-0 + $12,916 + 0 = -$51,085
Chapter 7 Answers New Zealand Taxation 2012 0010 The result of the base price adjustment is - $51,085. This amount is expenditure incurred in the 20X2 income year. Brookers 9