Adopting NZ IFRS: Some Tax Consequences

March 2005

While companies have been able to adopt International Financial Reporting Standards (IFRS) voluntarily since 1 January 2005, adoption will become mandatory in 2007 for all reporting entities. 

Much has been written about the accounting, reporting and capital-raising effects of adopting NZ IFRS. In this newsletter, we examine some of the consequences for income tax and dealings with the IRD.

You could be forgiven for thinking that NZ IFRS adoption will have little impact in this area, as the tax system imposes its own rules for measuring income and deductible expenditure. 

However, specific areas of income tax do stray into the accounting measurement area and are worth considering.

Functional currency

The most obvious effect of NZ IFRS adoption will be for those companies with significant offshore costs – such as exporters – that are required to report in another currency as their functional currency.  As tax returns must be reported in New Zealand Dollars, translational paper gains/loans may arise due to differing rules under IFRS and the tax regime for converting currencies. 

Although this is not a big deal in most situations, in certain circumstances this may have a significant effect, and in particular in the area of thin capitalisation.

Thin cap

New Zealand's thin cap rules deny interest deductions where:

• a company is at least 50% controlled or owned by non-residents;  and
  
  
• its ratio of total debt to total assets exceeds 75% (or 110% of the worldwide group's ratio, if larger).

These rules require calculations to be in New Zealand Dollars with any conversions made at the measurement date spot rate.

There is a concession allowing the use of forward exchange rates, but this is only available for items denominated in a foreign currency; not for items merely recorded in a foreign functional currency. 

As a result, measurement variations may arise due to different exchange rates being used.

However, currency translation is not the main issue.  The main problem arises in determining the value of debts and assets even where they are recorded in New Zealand Dollars. 

This would occur when the adoption of NZ IFRS results in a change to the values stated in the balance sheet under NZ GAAP.

Under the thin cap rules, "total assets" are valued, at the taxpayer's option, at:

• the value shown in the financial accounts;  or
  
  
• the net current value of the assets;  or
  
  
• if permitted under GAAP, a combination of the above.

Apart from certain trading stock and finance leases (which have their own special rules), a change in accounting values will therefore affect the thin cap asset calculations.

When a foreign-controlled company is close to its 75% limit, adoption of NZ IFRS may result in a partial denial of interest deductions.

Provision for Tax

While the thin cap issue only affects companies controlled by non-residents, the tax provision issue applies to all companies.

The tax provision in the balance sheet records actual tax liabilities.  It has been common practice to include an allowance for tax positions taken which are potentially at risk of challenge in the provision. 

Often these allowances are calculated with reference to their assessed risk exposure - for example, a potential $100 tax liability may be recorded at $40 if it is believed to be 40% at risk of the Commissioner successfully challenging the tax position taken.

Provisions must be recognised in the balance sheet where "it is probable" that the exposure will have to be met.  The inclusion of a potential tax exposure in the provision may suggest that a taxpayer believes payment to the IRD is ultimately probable.

In such circumstances, a taxpayer may have difficulty in meeting the IFRS test that the filing position they are taking is "about as likely as not to be correct" and a taxpayer may risk a 20% shortfall penalty. 

To avoid this, taxpayers should consider only including the tax exposure as a contingent liability, or filing on a conservative basis and then notifying the Commissioner of an intention to adjust the return.

Advice and information

For further advice or information, please contact any member of the tax team listed below.

Auckland

Niels Campbell
Partner

David Simcock
Partner

Willy Sussman
Partner

John Bassett
Senior Associate

Graeme Olding
Senior Associate

Monique Mackie
Senior Solicitor