Generally speaking it makes sense for tax to be paid on profits, but is it fair that tax should be paid on losses…
Within New Zealand’s tax legislation there is a set of provisions called the financial arrangement rules. These rules basically identify gains and losses that arise on certain financial instruments (such as interest on loans) and treat them as taxable or deductible. But there is a known and arguably harsh outcome that can arise under these rules, which is commonly referred to as ‘debt remission income’.
Imagine a generic New Zealand business operated by a ‘Mum and Dad’ company. They operate for a number of years, supporting their modest lifestyle until one day the economy takes a turn for the worst and sales decline. They try to make it through the downturn by lending money to the company sourced from savings that they have built up over their working lives. Before they know it the company is insolvent and it is placed into liquidation.
Under the financial arrangement rules, if a person lends money to another person and that debt is forgiven (excluding for ‘natural love and affection’), the amount forgiven is deemed to be taxable income to the borrower.
When the company is placed into liquidation there is arguably a deemed forgiveness of the debt and remission income arises. Practically speaking, the IRD doesn’t pursue companies in this situation. This is likely to be because the company is insolvent, so there is little to be gained from such an action. In some cases, shareholders will try to avoid the debt remission outcome by buying shares in the company, enabling the company to repay its debts, i.e. a cash merry go round. However, this in itself is potentially tax avoidance.
The legislation that governs this situation is quite complex and there is arguably a blind eye being cast by the IRD as it doesn’t pursue these situations. However, turning back to the example above, imagine for a moment that the Mum and Dad company is a ‘look through company’ (LTC). An LTC is a company that has elected to be treated as a partnership for tax purposes. Income derived by such a company is deemed to be derived by the company’s shareholders. This potentially means that the debt remission income that arises on liquidation of the company is deemed to arise to Mum and Dad. It is unknown whether this outcome was intended by Parliament or not. Regardless of the intention, it is potentially the outcome as the legislation currently stands and any decision to liquidate an insolvent company, whether it is an LTC or not, needs to be carefully considered.
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