NEW ZEALAND GAZETTE

No. 22

On 12 February 1991 a company borrows $10,000 for 5 years at an interest rate of bank bill plus 2% pa payable half yearly in arrears.

The money is raised by issuing notes at a premium of 5%. The purchaser is a New Zealand company. Contingent fees of 2% are payable by the issuer to the purchaser (holder).

$2,000 of the face value of the notes is to be repaid on each anniversary of the issue. The length of each Period is measured in half years, so b = 1 throughout.

The average principal outstanding over the five years is:
(10,000 + 8,000 + 6,000 + 4,000 + 2,000) ÷ 5 = $6,000

(a) Decide whether Method A can be applied.

The Total Finance Charges Excluding Interest payable to the lender are equal to:

$ 10,000 principal payable

• 200 fees received
  – 10,500 principal paid
  = –300

Ignoring sign, this is less than:
2% × 5 × 6,000 = $600

So Method A of this determination may be applied.

(b) The income deemed to be derived by the holder in a Period is calculated using the formula

x + y

(i) Calculate the value of x

The following table sets out the allocation of the Total Finance Charges Excluding Interest:

Note: x is negative because a premium has been paid.

(ii) y = Interest on the principal outstanding in the half year at the bank bill rate plus 2% pa.

(iii) The income derived by the holder in each half year Period would be:
x (calculated in accordance with the above table) + y

This income would be spread using Determination G1A: Apportionment of Income and Expenditure on a Daily Basis.

(4) Example D (illustrating Method B on a Period Basis)

This example uses Determination G3: Yield to Maturity Method.

A New Zealand company issues notes with a face value of $10,000 for a term of 3 years at a discount of 10% ($1,000). The Interest rate is equal to Libor plus 1% pa, and Interest is payable half yearly in arrears. There are no fees.

The Interest rate is 10% in the first Period after issue.

Assuming that this interest rate holds throughout the term of the notes, the yield to maturity is 14.21% pa, calculated at half yearly rests.

(a) Decide whether Method A can be applied.

$ 10,000 principal payable

• 0 fees paid
  – 9,000 principal received (after discount)
  = 1,000

Ignoring sign, this is more than:
2% × 3 (years) × 10,000 (average principal outstanding) = $600

Because the Small Discount or Premium criteria are not met, Method A may not be applied.

(b) The expenditure deemed to be incurred by the borrower in a Period equal to x + y.

(i) Calculate the value of x (Total Finance Charges Excluding Interest allocated to that Period)
x = e – f

Method B assumes that the Interest rate applying in the first Period (10% in this example) applies throughout the financial arrangement.

“e” is the Total Finance Charge. This is calculated using Determination G3: Yield to Maturity Method (or G10B in conjunction with G11A). The yield to maturity rate is 14.21% pa. (See table for the value of e in each Period.)

“f” is the Interest that would be payable if the rate that applied in the first Period after the date of issue applied to all Periods of the financial arrangement.

Since the initial Interest rate is 10% in this example, f = 500 for each Period.

(ii) y = the actual Interest paid in a Period. Values for this example are shown in the table below.

(iii) The expenditure deemed to be incurred in each Period using Method B is calculated in the following table.

Notes: (1) Based on a yield to maturity of 14.21% pa calculated using Determination G3 and an interest rate of 10% pa throughout.

(2) 10% is the rate applying in the first Period after issue.

Whole dollars and minor adjustments have been made to aid readability. The results still satisfy the requirements of Determination G2: Requirements as to Precision. That Determination allows for the use of results other than those calculated using the Yield to Maturity Method, provided they do not result in a difference of more than $5 per period.

The total expenditure is confirmed as:
$ 1,000 discount (x)

• 2,750 interest actually payable (y)
  = $3,750

(Note: In practice the expenditure in the final income year would be determined using the base price adjustment in section 64F of the Act.)

The expenditure for each Period would be apportioned using Determination G1A: Apportionment of Income and Expenditure on a Daily Basis.

If the fees were payable to a holder who was a New Zealand taxpayer (but not a cash basis holder), this taxpayer would be deemed to have derived similar amounts of income.