Chapter 5 – Bilateral Action
The role of bilateral tax agreements
Defining the international tax base
Reducing undesirable double taxation
Dealing with international tax problems
Implications for policy making and treaty negotiation
Effect of DTAs
Review of existing DTAs
Criteria for assessing DTAs
International relations considerations
Mechanisms for reform
There is a limit to the international taxation objectives New Zealand can achieve alone.
While domestic law will always be the primary source of any country’s international tax rules, there are instances where a country has to work with another country to achieve a desired taxation result. In principle, two countries working in concert can obtain better investment patterns than each can obtain working in isolation.
This chapter discusses bilateral tax agreements and the bilateral actions New Zealand plans to take in the near future.
A country’s domestic laws form the basis of its international tax system. As there are no international laws allocating taxing rights, countries can claim the right to tax any income earned anywhere.
New Zealand’s rules for imposing tax on international income flows, like those of all countries, are found in domestic law.
The inevitable result of having any international taxing rules is that New Zealand and other countries will in some cases assert taxing rights over the same persons and transactions. Thus, a secondary issue is whether it is in New Zealand’s interest as a whole to relieve instances of double taxation.
Double taxation should be relieved where it is distorting business decision making away from New Zealand’s overall interests. But the extent of the relief should be limited to that necessary to remove the distortion. In some circumstances, this will require some double taxation to remain.
In seeking to reduce the adverse effects of double taxation, New Zealand needs to remember that taxes paid to foreign governments are of no benefit to New Zealand or its residents. Taxes paid to foreign governments are no different from any other cost of doing business in a foreign country (see footnote 3).
In contrast, taxes paid to New Zealand, by either residents or non-residents, are of benefit to New Zealand as a whole.
Co-ordinated action by two countries to impose similar tax burdens on investment funds flowing between them to the tax burdens applying to purely domestic investment can, however, yield benefits to both.
In particular, it can lead to a pattern of investment which yields higher pre-tax returns to aggregate investment within the two countries, notwithstanding that higher taxes will be required elsewhere to make up the revenue foregone by reducing international double taxation.
Once any undesirable double taxation has been identified, the best way to reduce that double taxation must be found.
The only way that double taxation can be relieved is by governments giving up the right to tax certain types of income or agreeing to limit the taxes they impose on other types.
As part of being co-operative members of the community of nations, many countries including New Zealand reduce double taxation unilaterally in domestic law. This usually takes the form of a foreign tax credit or an exemption for foreign-source income. In New Zealand’s case, it is a credit system.
Section 293 of the New Zealand Income Tax Act provides a New Zealand tax credit for foreign taxes paid by the taxpayer up to the New Zealand rate of tax applicable on that income. This is a unilateral provision applying to all foreign income taxes.
Bilateral measures can also be used to reduce undesirable double taxation. The most common form of bilateral action is a double tax agreement or DTA.
DTAs involve a government agreeing to give up or limit its taxing rights, in exchange for reciprocal action by the other government. DTAs can also aid tax administration; for example, by allowing for the exchange of information between tax administrations and by containing dispute resolution procedures.
Where states have taken unilateral measures to alleviate undesirable double taxation, DTAs by and large refine and adapt these general domestic rules in the context of two particular tax systems.
DTAs allow countries to divide the cost of reducing undesirable double taxation in a manner that may make both countries better off.
DTA provisions which limit taxing powers prevail if there is any conflict between the DTA provisions and domestic rules imposing taxes. However, DTAs do not impose taxes.
As DTAs involve bilateral negotiation, they tend to be more difficult to amend than domestic law and give investors a greater degree of certainty than if the rules merely appeared in legislation.
With modem developments such as the globalisation of the world economy and the removal of exchange and other government controls, countries are finding it increasingly difficult to protect their income tax bases. The problem is particularly acute in relation to the multinational corporate groups that are responsible for much international investment and trade.
As a result, a country with an open economy like New Zealand needs to consider what, if any, its response should be to issues such as:
- the setting of artificial prices between related parties as means of shifting profits to low-tax countries - ‘transfer pricing’
- the practice of non-residents over-funding resident companies with debt in order to reduce company taxes -‘thin capitalisation’
- the structuring of transnational financial leases in order to take advantage of the tax bases of several countries to lower the cost of capital.
Should New Zealand decide that it needs to act against thin capitalisation, transnational financial leases or any other international tax problems in the future, it will need to do so by enacting more domestic rules.
Bilateral action, however, may be needed to help harmonise the unilateral provisions of two countries and make them more effective.
Where a DTA is contributing to a problem in New Zealand’s tax system it will be necessary to seek amendments to the DTA.
In relieving undesirable double taxation and dealing with current international tax problems, domestic tax rules have a primary role and DTAs play a secondary but important role.
This has implications for prioritising work on international tax and developing DTA negotiating objectives and strategies.
The first task is to identify New Zealand’s international tax goals. These goals have been set out in broad terms in the preceding parts of this paper.
The second is to determine how to implement those goals. In most cases that will be in domestic law, taking into account any impediments that might exist in DTAs.
Where New Zealand is unable to persuade another country to accept a New Zealand policy goal in the DTA, we should at least make sure that the DTA does not prevent us acting unilaterally to safeguard our essential interests through our domestic law.
DTAs are fiscal documents. In addition to their role in removing double taxation, effective DTAs can assist investment and trade. However, particularly where New Zealand is a net capital importer from the proposed DTA partner, concluding a DTA can reduce the amount of revenue available to the Government. The Government needs to consider, therefore, whether the gains from a DTA in terms of increased investment and trade outweigh the fiscal cost.
The interaction of the unilateral provisions of the two countries’ tax systems often means that the total tax burden of a taxpayer does not change as a result of a DTA being concluded. In practice, all that changes because of a DTA is the government to which those taxes are paid. This is illustrated in the Annex.
New Zealand grants a unilateral foreign tax credit for income taxes paid by New Zealand residents to foreign governments. This applies regardless of whether there is a DTA or not. In this context, the use of the term ‘double tax agreements’ is a misnomer. New Zealand’s unilateral action is the primary means of relieving double taxation. The DTA refines the relief granted. DTAs mainly distribute the cost of relieving double taxation between Governments.
While DTAs concern all types of income (including investment, trade and personal services income), their major impact is in respect of investment income. One reason is the magnitude of international capital flows. For example, annual international capital flows are now around 40 times higher than the value of international trade flows. In addition, DTAs can have a clear impact on the overall taxation on investment income. For example, DTAs often lower rates of NRWT on gross interest payments. This can ensure that a financial intermediary’s net profit on a transaction is not entirely taxed away in the source country (see Chapter 3). The impact of DTAs on the overall taxation of trade income, however, is often limited. (See the Annex .)
The Government is considering instigating an ongoing review of each of New Zealand’s 24 existing DTAs to ensure that they are in line with current taxation and economic policy and are contributing to New Zealand’s economic growth.
Highest priority will be given to the DTAs with New Zealand’s major trading and investment partners.
The taxation aspects of the the 1992 Review of the Closer Economic Relations Agreement with Australia are discussed in greater detail below.
New Zealand will seek to re-negotiate DTAs that have fallen out of line with current policy.
In addressing international tax matters, the Government will first identify any taxation problems before going on to identify the possible solutions and, importantly, their cost.
If New Zealand is considering a new DTA or is re-negotiating an existing DTA, it should ask:
- What are the tax problems that the DTA will overcome?
- How will a DTA correct these problems?
- What will be the fiscal cost of the DTA?
- What are the risks to the New Zealand tax base of the DTA?
- What will be the benefits to New Zealand as a whole from the DTA?
- What alternative solutions exist to solve the tax problems the DTA will correct, and what are the costs and benefits of those alternatives?
Once it has answered these questions, the final decision will be based on an assessment of the relative costs and benefits of the available options.
DTAs can be valuable demonstrations of the good relations between nations.
New Zealand will continue to seek to strengthen its ties with other nations through DTAs.
However, DTAs concluded largely for foreign policy reasons should include provisions for termination in the event that changing circumstances (for instance, changes in the tax system of the DTA partner) result in the DTA causing an unacceptable fiscal cost.
The same criteria that are used to assess proposed changes to domestic tax laws will be used to assess proposed DTAs.
Within these constraints, New Zealand will continue to use DTAs where they can provide a positive effect on investment and trade.
New Zealand’s most important bilateral economic relationship is with Australia.
With the achievement of free trade in goods and near free trade in services under the Australia-New Zealand Closer Economic Relations Trade Agreement (CER), the remaining major area of unfinished business under CER is investment. Beyond both governments agreeing to consult on specific issues as they arise, investment has effectively remained outside the CER agenda to date.
An efficient trans-Tasman investment regime is important to achieving and realising the full benefits of an integrated Australia-New Zealand market.
The tax regime has been identified in both countries as a critical impediment to rational investment and efficient trans-Tasman equity/debt markets. The current rules and high compliance costs are seen as particularly detrimental.
The New Zealand Government is committed to reforms of the trans-Tasman tax system.
The New Zealand Minister for Trade Negotiations has agreed with his Australian counterpart that tax should be high on the agenda of the 1992 Review of CER.
New Zealand officials have been instructed to pursue trans-Tasman tax reform as a priority issue. Face to face discussions with Australia will begin soon.
Many trans-Tasman tax issues arise from the CER free-trade zone and, therefore, are outside the scope of a traditional double taxation agreement.
The New Zealand Government is committed to finding the best solution to trans-Tasman tax problems.
Reforming trans-Tasman tax brings new challenges to the way taxation policy is developed.
The New Zealand Government has no preconceived ideas about whether an expanded DTA, a separate tax treaty under the CER umbrella or reciprocal legislation presents the best solution.
New Zealand’s approach is to start with the problems, look for possible solutions and think about possible mechanisms last (e.g. a new double tax agreement, reciprocal legislation, administrative action or unilateral legislation).
In thinking about solutions, New Zealand will keep in mind its tax design criteria of efficiency, fairness and simplicity. The fiscal cost and likely benefits of each option will also be important factors.
8 New Zealand is an overall net capital importer, although it is a net capital exporter to a small number of individual countries. Therefore, the overall fiscal effect of New Zealand’s DTA network is negative - New Zealand has given up more revenue than it has gained.