Chapter 5 – Proposed programme for reform

5.1 Introduction
5.2 The reform package
5.3 Extension of the FITC regime
5.4 New transfer-pricing rules
5.5 Improved source rules
5.6 Consideration of thin-capitalisation rules
5.7 Conclusion

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5.1 Introduction

This Chapter outlines the Government’s proposals for dealing with the problems associated with the international tax regime.

5.2 The reform package

When the FITC regime was introduced, the Government announced that it would consider the existing rules governing the taxation of direct investment by non-residents. These changes are proposed as part of a package of reforms to New Zealand’s transfer-pricing, source and thin-capitalisation rules. The Government also proposes to implement an extended FITC regime. This package should be seen as a whole rather than as a set of separate proposals.

In particular, the Government considers that this package should be a continuation of and consistent with, the previous direction of the reform of international taxation. The proposed transfer-pricing rules and extended FITC regime are part of the strategy of imposing lower, but less variable, effective tax rates on non-residents. Further, the FITC extension for direct investors and the transfer-pricing proposals are mutually reinforcing. The FITC extension will reduce incentives for companies to transfer-price or thinly-capitalise, because New Zealand tax payments will have value to non-resident investors.

5.3 Extension of the FITC regime

The Government proposes that the FITC regime be extended to all non-resident shareholders in New Zealand companies. Applying the regime to non-resident direct investors would involve a simple technical amendment, although some additional minor reforms may prove necessary in specialist areas such as life insurance.

The FITC is a particularly desirable mechanism for reducing tax-related distortions on cross-border capital flows because it applies only where and to the extent that, New Zealand company tax has actually been paid. This is because the FITC is a portion of the imputation credits attached to the dividend.

It is also proposed that the corporate tax rate on the New Zealand branch income of non-resident companies be reduced from 38% to 33%.

The extension of the FITC would apply from the date on which amending legislation is enacted, which is expected to be in the second half of 1995. It is proposed that the removal of the branch profits tax would take effect from the start of the 1996-97 income year.

5.4 New transfer-pricing rules

It is proposed that new transfer-pricing rules be implemented to improve the measurement of New Zealand-sourced income and to reduce the scope for manipulating cross-border transfer prices. The existing transfer-pricing rules contained in s.22 of the Act do not ensure that New Zealand-sourced profits are properly measured. The proposed regime is intended to be narrowly-focused, while protecting the tax base by being difficult to circumvent.

Transfer-pricing rules would require cross-border transactions to be recorded for tax purposes at arm’s-length prices. They are intended to properly apportion income between New Zealand-sourced and foreign-sourced income and between New Zealand residents (within the New Zealand tax base) and non-residents (not within the New Zealand tax base). They are therefore a necessary part of New Zealand source and residence rules. Adequate source and residence rules, including transfer-pricing rules, are desirable for ensuring that the aggregate rate of New Zealand tax on income derived by non-residents is applied as accurately as possible.

The key elements of the proposed new transfer-pricing rules are that:

• the rules would apply to all cross-border transactions in which parties are not dealing with each other at arm’s-length;
• the parties to a cross-border transaction would not be required to have a direct relationship such as common ownership;
• apportionment rules would apply to deemed transactions between a New Zealand branch and its head office, in order to treat the branch like a separate subsidiary of the head office;
• taxpayers would be required to report, for tax return purposes, all cross-border transactions at arm’s-length terms;
• to ease compliance costs, however, submissions are sought on introducing a presumption that transactions by unrelated parties are at arm’s-length;
• the internationally accepted range of arm’s-length transfer-pricing methods would apply. These are transaction-based methods (comparable uncontrolled price, resale price, cost plus) and profits-based methods (comparable profits and profit split);
• the comparable uncontrolled-price method would be available to taxpayers as a safe-harbour. If taxpayers can apply this measure, the Commissioner could not apply any other method;
• outside this safe-harbour, a best method rule would apply to decide the specific method to be used to determine arm’s-length prices in particular cases. Guidance on suitable approaches would be provided by some form of binding determination procedure;
• to reduce compliance costs, it is proposed that taxpayers be required to make only a reasonable estimate of an arm’s-length price, rather than be within a statistically acceptable band of arm’s-length prices; and
• to increase taxpayer certainty, advance pricing agreements would be available from Inland Revenue as part of the binding rulings regime.

The types of transactions to which the proposed rules would apply are those that deplete the New Zealand tax base. They include:

• a non-resident’s sale of goods or services to a New Zealand taxpayer for greater than arm’s-length consideration;
• a New Zealand taxpayer’s sale of goods or services to a non-resident for less than arm’s-length consideration.

Generally, the regime would not apply to wholly domestic transactions between residents, but if such transactions had an offshore connection resulting in a shift in income from a New Zealand resident to a non-resident, they would have to be subject to the regime, to limit abuse.

Like the reforms as a whole, the transfer-pricing regime is a package of measures designed to better measure New Zealand-sourced income and to limit avoidance while keeping compliance costs to a minimum. The elements of the regime should be considered not in isolation, but in terms of their overall effectiveness in meeting these objectives.

Submissions are invited on all aspects of the proposed regime, including:

• the absence of a de minimus rule. Whether compliance concerns are better met by taking a reasonably flexible approach to calculating the required arm’s-length prices;
• whether taxpayers should be required to make only a reasonable estimate of an arm’s-length price, or to use a price within a specified range produced by an acceptable arm’s-length method; and
• the absence of a requirement for a direct relationship such as common ownership between parties to a cross-border transaction, to counter avoidance concerns and whether the breadth of this approach raises concerns about compliance costs and uncertainty that can not be adequately addressed by the introduction of a presumption similar to that referred to above.

It is proposed that the new transfer-pricing rules will apply from the start of the 1996-97 income year.

5.5 Improved source rules

Detailed guidelines governing the application of the general apportionment provision (s.245) are proposed. These will follow the proposed transfer-pricing regime.

Clarification of the source rules and implications of the Valabh committee recommendations regarding apportionment of joint costs should be considered in parallel with the re-write of the Income Tax Act.

5.6 Consideration of thin-capitalisation rules

Thin-capitalisation is the name given to the practice whereby a non-resident investor deliberately loads a New Zealand taxpaying entity with debt, so that large interest deductions will be attributed to the New Zealand tax base. This has the effect of reducing the New Zealand taxable income of the non-resident’s New Zealand operations.

Like transfer-pricing, thin-capitalisation can be used by non-resident investors to artificially reduce New Zealand tax. Rules to counter thin-capitalisation may be required to act as a backstop to the proposed transfer-pricing regime.

The Government has not finally determined whether such rules are absolutely necessary. However, it has determined that, given the context of this discussion, the issue should be thoroughly canvassed. The Government does not want to implement an ineffective package. There is little point in introducing effective transfer-pricing rules if they are defeated in practice by thin-capitalisation. Therefore it has decided that rules to counter this practice should be considered.

The Government seeks submissions on this issue and on whether an effective thin-capitalisation regime is feasible and necessary.

5.7 Conclusion

The reforms proposed above are an integrated package of measures designed to address particular concerns in the taxation regime as it affects non-resident investment in New Zealand. The key components of this package are:

• the extension of the FITC to direct investment;
• transfer-pricing and source rules; and
• consideration of thin-capitalisation rules.