Inland Revenue recently consulted on changes to New Zealand's thin capitalisation rules that could significantly improve the commercial viability of private infrastructure investment for non-resident investors. Two potential options are being considered, and the final proposal is likely to be included in the next omnibus tax bill, expected to be released next month.

Current thin capitalisation settings for infrastructure

As a tax base protection measure, New Zealand’s inbound thin capitalisation rules generally reverse (ie disallow) interest deductions by an entity that is, or is controlled by, a non-resident, to the extent the entity has a debt to asset ratio of more than 60%. In other words, if non-resident investors use high levels of debt and lower levels of equity to fund their New Zealand operations or assets, interest on the debt may not be fully deductible for tax purposes.  

Since July 2018, these thin capitalisation limits have generally not applied to interest on third-party debt incurred by participants in Government-approved public-private partnership (PPP) projects. The concession was provided because of concerns that international participants were at a disadvantage to domestic participants, who are not subject to thin capitalisation constraints on their funding of local assets.

While the concession helped level the playing field for international investors in core Crown PPPs, it currently does not extend to private infrastructure projects (or public projects under different models).

There have long been calls for the concession to extend to a broader range of infrastructure projects given there are genuine commercial reasons for infrastructure projects to be significantly debt funded in excess of the current thin capitalisation safe harbours. In particular:

• As infrastructure projects tend to be highly capital intensive (especially during the construction phase) with low initial returns, they generally rely on large amounts of long-term debt.
• Third party lenders are often willing to lend more than 60% of the project asset value as they view the investment as relatively safe in terms of the borrower’s ability to service the debt.
• This is because the debt is often supported by long term purchase or service agreements or the project is otherwise expected to provide stable and reliable cashflows throughout the operational phase of the project.

Two reform options

An officials’ issues paper released by Inland Revenue puts forward two potential options intended to remove any impediment the current thin capitalisation settings may pose to foreign direct investment in infrastructure projects that do not qualify for the PPP exemption:

• Option 1: A targeted extension of the existing PPP concession for certain qualifying infrastructure projects. This option would allow interest on third-party limited recourse debt for eligible infrastructure projects to be fully deductible.
• Option 2: A more general rule that applies to all third-party limited recourse debt fully used to fund commercial/business activities in connection with New Zealand.

Both options are limited to third-party debt where the lender’s recourse is limited to the project assets and associated income streams (and potentially equity that has been committed by investors but not yet put into the project entity). Only third-party debt will be eligible because related-party debt (ie debt provided by the non-resident owner(s) of the project) is susceptible to being used as a substitute for equity. The limited recourse requirement is intended to prevent the introduction of excessive third-party debt supported by the non-resident project owner’s broader, non-New Zealand balance sheet position.

Targeted concession expected to proceed

As the Government has already allocated funds in the Budget towards concessions to the thin capitalisation rules intended to encourage foreign direct investment in New Zealand infrastructure projects, it is likely that one of these options will be included in the next omnibus tax bill, expected to be released in August 2025.

In our view, option 2 is unlikely to proceed (at least for now) as it represents a fundamental change to New Zealand’s current thin capitalisation settings and may not have been accurately costed (or worked through in sufficient detail) by next month.

We therefore expect some form of option 1 to get the go ahead. The key design feature on which submissions were sought is what constitutes an eligible infrastructure project or investment. It is expected that the targeted concession will only apply to new infrastructure projects constructed after a certain date (“greenfields” investments) but could potentially also apply to projects intended to provide major upgrades to existing assets (“brownfields” investments). It would also likely extend to new investors in eligible infrastructure projects constructed/upgraded after the relevant date, in a similar way to the existing PPP concession.

The more complicated question is how eligible infrastructure will be defined, and it will be interesting to see where the line is drawn in the draft legislation.

I can’t define infrastructure, but I know it when I see it

The main downside of a targeted concession of this nature is that it is likely to add cost and uncertainty in terms of determining whether a particular infrastructure project is on the right side of the line.

The definitional challenge will be more pronounced in some areas than others. Private energy-related projects, for example, should easily qualify and are likely to be specifically listed in the legislation. At the other end of the spectrum, more difficulty might arise if, for example, there was a desire to include some types of large-scale housing development (eg where a majority of social or affordable units is delivered), while excluding others.

Other areas of uncertainty could include projects where the associated public benefit is debatable, such as data centres or distributed networks, as well as certain assets which fall outside the relevant statutory definition but are closely related to qualifying infrastructure assets and funded through the same third-party debt arrangement.

One potential solution to this would be to have a government level approval process where individual projects can be approved on a case-by-case basis at an early stage so that there is certainty from the outset in terms of how the thin capitalisation rules will impact an international investor’s financial modelling of the project.

It also means that there will be some infrastructure projects demanded by the market that are able to secure sufficient third-party funding, but which are not able to benefit from the exemption because they fall on the wrong side of the line (this is the main case for option 2).

The definition of eligible infrastructure projects or investment may also need to be updated regularly to ensure it remains appropriate as public needs and priorities evolve over time.

Despite those concerns, in our view the change is a positive step forward that should increase the commercial viability of private infrastructure investment for non-resident investors.

Broader tax measures required

Given the scale of the infrastructure deficit New Zealand is facing, and the competitive landscape for global investment in this area, we consider that a bolder tax approach may ultimately be required. As discussed in our December 2024 FYI, there are a number of other tax levers that have previously been mooted that could be deployed to improve the commercial appeal of New Zealand infrastructure projects for offshore investors.

While not specific to infrastructure investment, a form of accelerated depreciation has now been approved under the Investment Boost scheme announced as part of the 2025 Budget. Under the Investment Boost Scheme, businesses are entitled to immediately deduct 20% of the cost of most new assets (and certain second-hand assets), with the remaining value to be depreciated under current depreciation rules.

While this is simply a timing benefit in terms of when a deduction is available (other than in relation to commercial buildings with a 0% standard depreciation rate), it is expected to make New Zealand a more attractive place to invest.

However, it is not expected to be a game changer for long term infrastructure projects (except where the project assets include a commercial building, in which case a deduction is available for an asset that is not otherwise depreciable) as such projects typically generate significant tax losses in early periods under current tax settings because of the high gearing and the tax depreciation shield from the new assets constructed. This means that the timing benefit associated with accelerated depreciation is effectively diminished and it is unlikely to materially defer the point at which the project becomes profitable from a tax perspective.

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