Andy ArcherTax Director, EY+64 274 899 052
Government shadow boxing with tax changes
"On Monday, the Government announced tax reforms to treat debt issues under so-called "stapled securities" as equity. With this, the Government has potentially scuttled the capital raising plans of the Canadian Pension Plan for its partial acquisition of Auckland Airport. The announcement states "if these instruments were to become common in New Zealand the amount of debt deductions against our tax base could increase significantly". The Government also states, "the commercial constraints that operate to moderate the level of gearing are effectively removed with these instruments[sic]. That is because what is debt for New Zealand tax purposes is equity for accounting and other purposes, meaning that tax debt could be much higher than what commercial constraints would normally allow". Is the Government shadow boxing?
On Tuesday I received emails from parties concerned about the Government's announcement. Two of these involved UK and Australian businesses looking at potential capital raisings for their New Zealand businesses.
The perceived problem situations are these. A trans-Tasman group needs to raise $100 million of capital for its New Zealand business. The New Zealand Subsidiary has good liquidity and a robust balance sheet. The Australian Parent has set debt covenant levels it does not wish to disturb. So, the New Zealand Subsidiary raises capital by issuing debt securities into the market, and takes advantage of its branding and the larger size of the Australian market by issuing directly to Australian investors. To overcome the Group's overall debt covenants, and not receive an adverse down rating, the Group makes the debt notes long term, if not perpetual, and "staples" the debt securities to the Australian Parent company shares that it issues at the same time. The debt securities may convert into the issued shares. The advantage of this "stapling" is that while the arrangement is debt for New Zealand tax purposes (and the coupon interest deductible), commercially it is treated as an equity capital raising. For accounting purposes, rating purposes, and market reaction, the whole capital raising package is regarded as equivalent to equity with significant commercial advantages.
In essence, the Group has taken a debt offering, and turned it into a much superior offering by linking it with its shares. This is not tax avoidance, it is a sound business strategy. Everyone is happy. Except the IRD is now not happy.
The New Zealand Subsidiary must comply with New Zealand's rules that limit the amount of debt gearing. Any 50% foreign owned New Zealand company is subject to thin capitalisation rules which limit the amount of its debt gearing to no more than 75% of the company's total assets. This is the Government's own accepted debt level, to prevent a strip out of the New Zealand tax base with exceptionally high debt levels. So the Government's concerns are not justifiable for foreign owned New Zealand businesses since adequate protection already exists. How companies gear up to the thin cap debt level is not a risk to the tax base but a purely commercial decision. Even for New Zealand companies outside of the thin cap rules, the Government’s perspective is confusing. There are several reasons why.
Firstly, these measures are unlikely to stop or reverse existing debt levels, since companies will simply go on with New Zealand issued debt, albeit at less attractive rates. Companies will raise debt with or without these rules. Under the changes the Government may force up interest rates for New Zealand businesses since they have outlawed deductible debt that is linked to its shares. Wouldn’t this be counter-productive to the Government's intentions?
Secondly, the Government is interfering with capital markets, and with groups of companies that generate a lot of wealth to New Zealand. This level of interference will become head-shakingly painful if, as a result of an already filled up Tax Bill, the Government's changes do not see the light of day for another year. In the meantime corporate groups will be seriously hamstrung in raising capital because of the risks that interest is non-deductible under rules that are unclear in their reach or application. For example, might these rules extend to some forms of convertible notes or mandatory convertible notes? Does a New Zealand loan from a Group company that is backed by an Australian "stapled security" all issued in Australia fall within the changes? Many uncertainties have been created.
To the Government's credit, they have not said that these changes will be retrospective, so "stapled security" capital raisings already in place are unaffected. This applies only to publicly held instruments that were issued before Monday. However, will the law be retrospective and deny interest deductions to stapled security debt raisings privately placed?
I'm not sure what has triggered this Government intervention in capital markets, given there seems limited justification for an intervention of such wide reaching affect? Perhaps the particular profile of Auckland airport in having a large proportion of shareholders able to treat the debt interest receipts as tax exempt was just too rich for the Government? I do think that the Government has underestimated the depth of challenging questions that this reform will pose for IRD legislators, and (regrettably) the time it will take to resolve. You can bet that the architects of the Canadian Pension Plan stapled stock arrangement will be frustratingly suspicious. If this deal doesn’t proceed, it could most certainly be seen as if the Government is simply shadow boxing.
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