What is Thin Capitalisation and does it affect me?
For both companies and private investors, debt is commonly used as a tool for tax management when operating in more than one tax jurisdiction.
In the case of New Zealand, the Thin Capitalisation rule was introduced in 1996 as a part of the Income Tax Act, with the purpose of limiting the scope to which multinationals and offshore investors can use debt to offset against their New Zealand tax base.
What does the Thin Capitalisation rule entail?
Under the current rules, foreign entities will only be able to claim tax deductions for interest payments on debt for up to 60% of their local asset value (down from 75% pre 2011/12 income year).
Two key changes that may affect property investors are:
- The extension of the rule to cases in which non-residents are acting together when investing in New Zealand (currently Thin Capitalisation only applies when a single non-resident controls 50% or more of the investment).
- The extension of the rule to apply to all resident trustees if 50% or more of settlements made on the trust were made by a non-resident, non-residents acting together, or other entities subject to the rule.
These changes have applied from the beginning of the 2015/16 tax year.
Does this rule apply to me?
The Thin Capitalisation rule currently applies to non-resident individuals, and companies in which a single non-resident individual owns 50% or more of the company.
However, with the incoming changes to the qualification rules, Thin Capitalisation will also apply to a group of non-residents acting together to invest in New Zealand, as well as companies/trusts if a non-resident or a group of non-residents own/settles 50% of more of the company/trust.
If you belong to any of the above categories and your debt relative to property value is in excess of 60%, the Thin Capitalisation rule will apply to you.
What if I hold my properties in a trust?
The Thin Capitalisation rule does not currently apply to New Zealand trusts, even in the case of a trust being settled by non-residents. However, one of the proposed changes to the Thin Capitalisation rule is the extension of the rule’s application to trusts where 50% or more of the trust is settled by an entity subject to the inbound Thin Capitalisation rule.
The impending rule changes mean you will still be subject to the Thin Capitalisation rule if you are a non-resident, regardless of whether you hold your properties in a trust or not.
How am I affected?
Generally you should consider the impact of the Thin Capitalisation rule if you are either:
- A New Zealand resident with rental properties in New Zealand but thinking about moving overseas, or
- A non-resident looking to purchase property in New Zealand.
If you are subject to the Thin Capitalisation rule, you will only be able to claim interest deductions for up to 60% of your property’s cost or market value (you may elect to choose the basis). The effects of the Thin Capitalisation rule will be demonstrated via three examples shown below.
Example 1
Andy (Australian resident) is looking to purchase a $500,000 rental property in New Zealand with the help of a $400,000, interest-only loan at 6% interest per annum. Assuming he has no other New Zealand properties, his debt percentage is 80% ($400,000 / $500,000), which subjects him to the Thin Capitalisation rule since it is over the 60% threshold.
The total interest he pays each year is $24,000 ($400,000 x 6%), however the interest deduction that he is able to claim will be restricted to $18,000 ($500,000 x 60% x 6%). In this case, Jack’s interest deduction has been reduced by $6,000 due to the Thin Capitalisation rule.
(Note: The loss of $6,000 is in terms of interest deduction. The full extent of losses of tax savings will depend on Jack’s personal income tax rate.)
Example 2
Andy has changed his mind about buying the property by himself, and instead chooses to form a company with a New Zealand couple, Jack and Jill, to buy the property. When forming the company, they decided to go with equal shareholding for each person. In this case, the company will not be subject to the Thin Capitalisation rule even though the debt percentage is 80%, due to the non-resident control of the company being less than 50%.
Since the company is not subject to the Thin Capitalisation rule, the total interest deduction claimable by the company each year will be the full $24,000.
Example 3
Five years later, Andy has moved to New Zealand and became a New Zealand tax resident. On the other hand, Jack and Jill has relocated to the UK. Over the course of five years, the property has appreciated in value to $640,000. In this case, non-residents control 50% or more of the investment as Jack and Jill are no longer New Zealand tax residents. The debt percentage of the company however has decreased to 62.5% ($400,000 / $640,000), which is still over the 60% threshold.
Looking at the numbers:
The total interest paid is still $24,000 ($400,000 x 6%), however the interest deduction claimable is now $23,040 ($640,000 x 60% x 6%) as it is possible to choose the market valuation as the asset base from which debt percentage is calculated.
What does this mean for you?
Overall the Thin Capitalisation rule may not be of great concern for most property investors. However prospective non-resident investors and local investors who are thinking of moving overseas should be wary of potential tax implications and their effect on the after-tax income stream from New Zealand investment properties if their debt percentage is over the 60% threshold.
However, one further point to bear in mind is that your ability to utilise any potential foreign tax losses will depend on your tax residency status. For more information, please refer to our articles on tax residency.
Disclaimer
The information provided in this article is not intended to provide a comprehensive statement of tax laws and should not be used as a substitute for legal advice.
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