Income tax treatment of the screen production industry under the Income Tax Act 2004: Part IV - Special rules deferring deductions for expenditure in relation to films

Chapter 7 - Deferred deduction rule: sections GC 29 - GC 31

7.1 Deductions otherwise available under section DS 1 or DS 2 will be deferred by sections GC 29 - GC 31 (the deferred deduction rule ("DDR")) if certain criteria are met. The general purpose of the DDR is to combat aggressive tax arrangements which provide taxpayers with excessive tax advantages in the form of large deductions, regardless of the success of the arrangement.

7.2 Broadly, sections GC 29 - GC 31 require a taxpayer who is a party to an arrangement based on a limited-recourse loan to defer the deductions in any of the first 3 years of the arrangement, when assessable income from the arrangement is less than the total deductions. The deferral mechanism operates by denying deductions that would otherwise be allowable to the extent that the limited-recourse loans are outstanding and the investor continues not to be at real risk of having to repay them. For arrangements which are commercially unsuccessful, such deferral can be permanent. Taxpayers involved in film investment arrangements are potentially subject to the DDR if the statutory criteria are met.

7.3 The Commissioner's statement on the DDR under the Income Tax Act 1994 is set out in Tax Information Bulletin Vol. 16, No. 1 (February 2004), pages 58-66. It should be noted that the 2004 Act contains some changes to the DDR, although not major.

Arrangements subject to the DDR - section GC 29(1)

7.4 The statutory criteria contained in section GC 29(1) for the DDR to apply include:

• There is an arrangement under which a taxpayer (called a "participant") is either a party to or is affected by that arrangement; and
• After the arrangement commences, a person sells, issues or promotes the selling or issuing of the arrangement, whether or not for remuneration (section GC 29(1)(a)); and
• As part of or for the purposes of the arrangement, the participant or an affected associate of the participant (as defined in section GC 30(1)) borrows a limited-recourse amount under a limited-recourse loan (section GC 29(1)(d)); and
• The arrangement results in deductions for the participant and the participant's affected associates (section GC 29 (1)(b)(i)); and
• The deductions are for the income year in which the participant or the participant and the associates acquired an interest in the arrangement, or that initial year and the next year, or that initial year and the next two income years (section GC 29(1)(c)); and
• Assessable income resulting from the arrangement (except assessable income arising under sections GC 29-GC 31) is less than the total amount of deductions of the participant and affected associates of the participant (section GC 29(1)(b)(ii)); and
• The total cost of property held by the participant and affected associates on the balance date for any of the first 3 years of the arrangement is:
  1. less than twice the total of the limited-recourse amounts borrowed (in other words, the limited-recourse loans are 50% or more of that total cost) (section GC 29(1)(e)(i)); and

      

  2. more than 142.85% of the total cost of the part of that property is land, buildings, plant, machinery, certain listed company shares, employee share options and certain shares in a foreign company (in other words, the cost of land, buildings and other tangible property, expressed as a percentage of the total cost of all assets held, is 70% or less) (section GC 29(1)(e)(ii)).

Consolidation of assessable income and deductions, and cost of property

7.5 The assessable income and deductions resulting from an arrangement for each person in a group of persons (for the purposes of section GC 29(1)(b) and section GC 31), and the cost of property that is held by each person in the group as part of the arrangement (for the purposes of section GC 29(1)(e)) are consolidated to eliminate intra-group balances in accordance with generally accepted accounting practice (section GC 29(2)).

Calculation of assessable income and deductions, and cost of property

7.6 The assessable income, deductions and the cost of property held by individual members in a group of persons are calculated using the proportionate method in accordance with generally accepted accounting practice (section GC 29(3)). This method applies to members in partnerships or joint venture, and shareholders in loss attributing qualifying companies.

Key definitions - section GC 30

7.7 Section GC 30 further defines some terms for the purposes of the DDR.

Limited-recourse loan - section GC 30(3)

7.8 Limited-recourse loan" is defined in section GC 30(3) and means a financial arrangement that-

1. is not an excepted financial arrangement; and
2. involves the provision of money by a person ("lender") to another person ("borrower"); and
3. has an effect, or has an economic effect that is substantially similar to the effect, of-
   1. relieving the borrower under the financial arrangement from the obligation to repay all or some of the money, whether the relief is contingent or not:
   2. requiring the borrower under the financial arrangement to make no repayment for a period of 10 or more years from the date on which the loan is made, other than repayments for the purpose of defeating the intent and application of sections GC 29-GC 31:
   3. providing that the repayment of the money is in substance secured solely against assets that are employed in the arrangement; and
4. involves money that is [not provided to the borrower on arm's-length terms].

7.9 Loan made by banks and financiers who are regular providers of money to persons on arm's length terms and who are resident in New Zealand or carry on business in New Zealand through a fixed establishment in New Zealand are excluded from the definition of "limited-recourse loan" (section GC 30(3)(d)(i)).

7.10 If the lender and borrower are associated persons under either section OD 7 or section OD 8(3), there will be a limited-recourse loan if the lender obtains the loan funds on a limited-recourse basis as discussed above in paragraphs 7.8 (a)-(c).

7.11 Some examples of a limited-recourse loan are provided in Tax Information Bulletin Vol. 16, No. 1 (February 2004), page 64.

Affected associate - section GC 30(1)

7.12 For the purposes of sections GC 29-GC31, a person is an "affected associate", for the arrangement, of another person if each person is a party to the arrangement or is affected by the arrangement and -

1. one person is a loss attributing qualifying company and the other person is a shareholder in that company:
2. the persons are associated under section OD 7 or section OD 8(3).

Limited-recourse amount - section GC 30(2)

7.13 For the purposes of sections GC 29-GC 31, the limited-recourse amount for a limited-recourse loan means the total for the limited-recourse loan of the amounts for which the obligations of a borrower (as defined in section GC 30(3)(b)) are affected in a way that is described in section GC 30(3)(c).

Deferral of surplus deductions from arrangement - section GC 31

Application - section GC 31(1)

7.14 Section GC 31 will apply to defer surplus deductions resulting from an arrangement to which the DDR applies, if-

• the participant (not being a loss attributing qualifying company), or the participant and the affected associates of the participant (not being a loss attributing qualifying company that has incurred a net loss from the arrangement for the income year), considered together, have from the arrangement assessable income that is less than deductions resulting from the arrangement (sections GC 31(1)(a) and (b)); and
• the arrangement involves a limited-recourse loan for which the participant or an affected associate of the participant is a borrower (section GC 31(1)(c)).

Formula - section GC 31(2)

7.15 Broadly, a participant in an arrangement that is subject to the DDR is treated as deriving an amount of assessable income calculated under a formula provided for in section GC 31(2):

( a / b ) × c

7.16 Such assessable income is, in turn, allowed as a deduction in the immediately following year (section GC 31(3)).

Obligation to repay limited-recourse amount not discharged - section GC 31(4)

7.17 For the purposes of section GC 31(1) and of paragraph (b) of the definition of item "c" in section GC 31(2), an obligation to repay a limited-recourse amount is not discharged by a transaction to the extent that the transaction-

1. involves the use, as part of the arrangement, of-
   1. a put or call option that is not a contract for the sale for future delivery of goods at market value:
   2. a contract of insurance or guarantee; and
2. does not give rise to assessable income for the person who is the borrower of the limited-recourse amount under the limited-recourse loan.

7.18 An example of how the DDR under the Income Tax Act 1994 applies to defer deductions in an arrangement is provided in Tax Information Bulletin Vol. 16, No. 1 (February 2004), page 66. It should be noted that the 2004 Act contains some changes to the DDR, although not major.

Date published: 24 Nov 2005

Back to top