By Terry Baucher*
They say “ignorance is bliss” but that is certainly not so with tax and most definitely not so when dealing with financial arrangements.
The financial arrangements regime represents one of the more curious conundrums in New Zealand’s tax system.
As Aaron Quintal of EY pointed out last week it is “the most pervasive” of the several specific regimes contained in the Income Tax Act which tax capital gains.
Yet despite having been around since 1986, the regime is largely unknown to the general public in my experience.
The financial arrangements regime apply to all “financial arrangements”.
These are broadly defined as any investment or financial instrument under which a person receives money in consideration for providing money to any person at a future time or on the occurrence or non-occurrence of an event.
The regime covers financial instruments such as bonds (both in New Zealand and overseas), forex contracts and other such derivatives, bank deposits and mortgages.
The general principle of the financial arrangements regime is to tax the economic return over the period the financial arrangement is held.
This capital/revenue distinction largely disappears so any gain will be taxed. However not all capital losses are tax deductible. Usually, a financial arrangement’s gain or loss for each year is calculated on an accrual basis (which is why the financial arrangements regime is sometimes called the “Accrual Rules”).
When a financial arrangement is disposed of, such as on maturity, or sale, a wash-up calculation is carried out (a “Base Price Adjustment”). This calculation compares the total return of the financial arrangement with the amounts treated as taxable income or deductible expenses in previous years. Any positive balance represents taxable income with any negative amounts usually being deductible.
Fortunately, the requirement to calculate income and expenditure on an accrual basis doesn’t apply to the majority of taxpayers. A person doesn’t have to apply the financial arrangements regime where the total value of his or her financial arrangements never exceeds $1 million at any point during a tax year. Such persons are known as “cash basis persons” and return income and expenditure from financial arrangements on a receipts or “cash” basis. As this exemption covers the majority of taxpayers it is perhaps one reason why the financial arrangements regime is not more widely known and understood.
Where the risk is
Where many taxpayers are most at risk in not complying with their obligations is in respect of foreign exchange gains.
Consider the example of Maree who buys £20,000 of UK bonds yielding 4% in April 2013 when the exchange rate is 0.55. Her total cost is therefore $36,363. In November 2013 Maree receives interest income of $1,600 which she includes in her 2014 tax return. She then sells the bonds in October 2014 for £20,000 when the exchange rate is 0.48, realising $41,667.
Maree’s base price adjustment calculation is as follows:
|Amount received on sale||$41,667|
|Plus interest received||$1,600|
|Less income returned||-$1,600|
|Less purchase cost||-$36,363|
|Base price adjustment||$5,304|
Maree should therefore include $5,304 (effectively the foreign exchange gain) as income in her 2015 tax return.
Inevitably, Inland Revenue is busy reminding taxpayers of their financial arrangements obligations.
A tax on offshore unrealised capital gains
One specific initiative is in relation to the treatment of overseas currency denominated mortgages used to purchase overseas rental properties.
Although most taxpayers will be covered by the cash basis person exemption there is an important proviso to this rule. The exemption does not apply if the difference in taxable income between that under the cash basis and that calculated under an accruals basis is $40,000 or more.
For example, Peter has a London rental property with an interest only mortgage of £300,000. At 1st April 2011 based on an exchange rate of .4745 the mortgage’s NZ dollar value was $632,244. Peter has no other financial arrangements so as the value of his financial arrangements is below $1 million he should qualify as a cash basis person.
On 31st March 2012 the exchange rate is 0.5123 so the £300,000 mortgage is now valued at $585,594. Under the accruals basis Peter has made an unrealised gain of $46,750 and as this is above the $40,000 limit, he no longer qualifies as a cash basis person. He must therefore include the unrealised gain of $46,750 in his 2012 income tax return.
It’s probably faint hope for Peter that when he eventually sells the property and redeems the mortgage,the resulting Base Price Adjustment calculation will take into account any income previously returned.
I’m aware of several taxpayers like Peter who are currently being audited by Inland Revenue on this very issue.
The financial arrangements regime is indeed “pervasive” and anyone who has any investments which it could cover should be checking their tax position. Otherwise they could be in for a nasty surprise.