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Taxing income across international borders - a policy framework

Annex – The practical effect of DTAs on tax paid by New Zealand exporters

Introduction
Cases compared
Exporting goods to a foreign firm in Country X
Setting up a storage warehouse in Country X
Setting up retail shop in Country X
Incorporating the shops trading in Country X
Implications for policy making and treaty negotiation

Introduction

This annex illustrates two points:

  • The effect of DTAs on the overall tax paid by New Zealand exporters on their business profits is often limited.
  • DTAs may have important effects on the respective tax takes of New Zealand and the other country involved.

The examples are highly generalised to draw out what often happens in practice.

It is not possible in a short Annex to deal with all possible impacts of DTAs on New Zealand’s exports. The focus of this Annex is on what generally happens. Exceptions have been ignored, particularly where they involve technical rules.

Cases compared

The Annex compares in broad terms the typical tax consequences for the business profits of a New Zealander trading:

  • with a country with which we have a DTA that follows the OECD Model
  • with a country with which we do not have a DTA.

The examples follow a New Zealand exporter penetrating an export market step by step. They outline the likely tax consequences as the exporter takes each step further into the market. The revenue implications for both countries at each stage are noted at the end of each section.

Exporting goods to a foreign firm in Country X

Much international trade would be covered under this heading. In practice, a typical DTA will not alter the basic domestic tax treatment in both countries of the business profits arising from this transaction.

Country X is unlikely to tax the profits on this transaction. The exporter will be fully taxable on its net sales income in New Zealand.

The DTA business profits article is unlikely to alter the revenue collected by either country on this transaction.

Setting up a storage warehouse in Country X

A typical DTA is likely to result in the same level of taxation as applies when there is no DTA. However, different amounts of tax will be paid to different governments.

A typical DTA would provide that an exporter setting up a storage warehouse does not have sufficient connection with Country X to be taxable there on the business profits attributable to the warehouse. (In technical terms, this warehouse is not a ‘permanent establishment’ of the New Zealand exporter in Country X.) Those profits would be taxable only in New Zealand.

Without a DTA, the business profits of the warehouse are likely to be taxable in both Country X and New Zealand. New Zealand’s tax law, however, permits an offsetting of the tax paid on foreign-source income against the tax due domestically up to the New Zealand tax due on that income. Thus, whether there is a DTA or not, the tax result is likely to be the same unless Country X charges more tax on that income than New Zealand would. In this case, the exporter must pay the excess tax without credit.

In this case, the business profits and permanent establishment rules in the DTA have increased New Zealand’s tax revenue at the expense of Country X’s tax take. The DTA overrode Country X’s source rules that required relatively little presence or activity in that country before the New Zealand exporter was taxed there. In effect, New Zealand can tax those profits and there is no Country X tax for which New Zealand must give credit.

Where New Zealand exports more capital to Country X than vice versa, it is in New Zealand’s interest to negotiate definitions that require relatively more presence or activity before a permanent establishment is said to exist. Where New Zealand is a net capital-importer, it is in New Zealand’s interest to negotiate definitions that require relatively little presence or activity before a permanent establishment is said to exist.

Setting up retail shop in Country X

A typical DTA is unlikely to produce a different tax treatment or result than the two sets of domestic rules would on their own.

A typical DTA would provide that an exporter setting up a retail shop in Country X does have sufficient connection with that country to be taxable there on the business profits attributable to the shop. (In technical terms, this shop is a ‘permanent establishment’ of the New Zealand exporter in Country X.) The shop’s business profits would also be taxable in New Zealand with a credit for Country X’s tax.

Without a DTA, the business profits of the shop would be taxable in both Country X and New Zealand. New Zealand’s tax law, however, permits an offsetting of the tax paid on foreign-source income against the tax due domestically. Thus, whether there is a DTA or not, the tax result is likely to be the same.

In this case, the business profits and permanent establishment rules in the DTA are unlikely to alter the tax takes of Country X or New Zealand, as defined in their respective domestic law.

Incorporating the shops trading in Country X

This is the most common way that businesses, other than financial institutions, operate in other countries. An incorporated business managed and trading in Country X is likely to be taxable on its business profits in Country X alone, whether there is a DTA or not. A DTA, however, is likely to lower the rates of non-resident withholding tax (NRWT) that Country X can levy on profits being repatriated to New Zealand.

However, as New Zealand grants a credit for NRWT, the effect of lower rates of NRWT in most cases is not to reduce the total burden of tax payable but to change the distribution of taxes paid to Country X and New Zealand.

Where New Zealand is the net capital-exporter of the two countries, the general effect of a DTA lowering NRWT rates is to increase New Zealand’s tax take. There will be less foreign tax to credit and, accordingly, more scope for New Zealand taxation. The opposite is true where New Zealand is the net capital-importer of the two countries.

Implications for policy making and treaty negotiation

To sum up, the unilateral foreign tax credit in our domestic tax law often means that DTAs have limited effect on the overall tax paid by New Zealand exporters on their business profits. DTAs, however, may have important effects on the respective sizes of the tax takes of New Zealand and the other country. In order to determine the likely magnitude of those effects, it would be necessary to take into account more factors than has been possible in this short Annex.

The examples also demonstrate how the interplay between the domestic tax system of New Zealand and another country can often achieve a similar result to that achieved by a DTA.

One of the main exceptions is illustrated by the storage warehouse example above. In that example, the DTA was more generous to the New Zealand investor than the foreign domestic-source rules were in determining when the foreign country could tax the profits of the New Zealand enterprise in that country. This may have little net effect for the New Zealand exporter in that where foreign taxes are paid they will generally be creditable in New Zealand. However, for the period that the exporter is deemed not to have a permanent establishment in that country, the exporter is freed from filing a return in the foreign country and paying foreign taxes that would generally be creditable.