Protecting the New Zealand tax base from base erosion and profit shifting
Multinationals shifting profit using related party debt
Examine problems with tax rules (thin capitalisation and transfer pricing) designed to prevent profit shifting by non-residents who fund their New Zealand investment using related party debt
New Zealand’s thin-capitalisation rules are generally more comprehensive and tighter than rules in other countries. However, the taxation of related-party debt is probably the most significant BEPS issue for New Zealand. Interest expenses paid by borrowers are tax deductible. Accordingly, multinationals have tax incentives to fund their New Zealand operations using debt rather than equity. Another way of looking at it is to view the deductions for interest payments as a means of shifting income to the non-resident parent or another related party.
One of the significant ways that multinationals can shift profits offshore is by funding New Zealand operations with excessive levels of debt or by setting a very high interest rate on the debt. Currently we use thin-capitalisation rules to limit the level of debt a New Zealand subsidiary can have.
The thin-capitalisation rules place an upper limit on the amount of debt that multi-nationals can stack into their New Zealand operations. Once this limit is breached, any additional interest deductions are denied. Recent reform has focused on strengthening these rules. In 2011 the thin-capitalisation limit on investment into New Zealand by non-residents was reduced from a 75 percent debt-to-asset ratio to a 60 percent ratio.
As part of Budget 2013, the Government announced measures to further improve the effectiveness of the thin-capitalisation rules. At present the rules apply only to companies that are majority owned (50 percent or more) by a single non-resident. However, there are situations where multiple non-resident investors, such as private equity investors, can coordinate and act together as if they were a single non-resident investor. The rules are being extended to apply to these situations where investors act together. In addition, shareholder debt will be excluded from the “worldwide group” test, as this ensures the rules are still effective in situations where the ultimate investors have little external debt. These measures will apply from the 2015/16 income year.
There may also be other areas, such as with financial intermediaries where, as was the case previously with banks, the existing thin cap rules do not enable an appropriate limitation on the debt funding of the entity.
While the thin-capitalisation rules limit levels of debt, transfer pricing rules can be used to challenge related-party transactions that are not conducted on commercial “arm’s-length” terms (such as excessive interest rates). If the price (including an interest rate) for a related-party transaction is too high, we can replace it with the “arm’s-length” price that would be expected from a similar transaction with a third party.
The concern we have, however, is that transfer pricing is a complex and resource-intensive process, which may only be effective for the most egregious cases. Moreover, there are structures that may allow the “arm’s-length” price of debt to be artificially inflated, potentially defeating the intent of the transfer pricing rules.
An alternative approach could be to directly limit the ability to use high-priced debt. For example, many European countries have thin-capitalisation rules that are based on the ratio of interest deductions to earnings, which effectively combines a limit on the level and price of debt into the one test. New Zealand could consider the pros and cons of this type of rule with a view to possibly bolstering our existing thin-capitalisation rules with a similar approach.
As part of its action plan, the OECD will be doing a similar review of the effectiveness of different types of interest limitations (through Action 4 on limiting base erosion via interest deductions and other financial payments). Our involvement in this work will also inform our thinking on what improvements New Zealand could consider.
Another concern in terms of profit shifting using transfer pricing are investors who are “acting together”. In such cases the transfer pricing rules may not apply, even though such investors may have the ability to manipulate prices in order to shift profits out of New Zealand. We plan to review the scope of the transfer pricing rules. For example, the scope of application of the transfer pricing rules could be aligned with the recently announced changes to the scope of application of the thin-capitalisation rules described above. Further analysis and consultation would be needed to consider what changes, if any, would be appropriate.
Explore whether New Zealand should restrict interest deductions on hybrid instruments where the interest payment is not taxed in the foreign jurisdiction
A hybrid instrument is an instrument that has both equity and debt characteristics. Commonly these instruments will create a tax deduction in one jurisdiction and corresponding untaxed income in another country. This usually is because the country allowing the deduction views the hybrid instrument as debt and the country receiving the payment views it as equity.
Currently New Zealand allows deductions for some hybrid instruments but not others, depending on whether or not they are part of a tax avoidance arrangement.
Last year we looked at this treatment to determine if it is appropriate. Our conclusion was that the current rules should remain unchanged. However, we noted that Australia had announced that it was planning to change its tax law for hybrid instruments. Depending on how Australia implements this change, it may make it even easier to use hybrid instruments between New Zealand and Australia.
Given this, we may need to explore whether New Zealand needs to tighten its rules on when deductions are allowed on hybrid instruments. We note the issue of hybrid instruments has been identified by the OECD as a key area for further work (Action 2 in the OECD’s Action Plan).
Address problems with the application of non-resident withholding tax to related party debt
There are two ways that we tax non-residents who earn income in New Zealand. We tax net profits by applying company tax. We also apply non-resident withholding tax (NRWT) to gross payments of dividends, interest and royalties made to non-residents.
The company tax and NRWT mechanisms work together to tax non-resident investors at appropriate levels. In the absence of NRWT, there would be an increased incentive and ability for multinationals to shift profits offshore by charging interest on borrowing from a related party. This would reduce the amount of profits that would be subject to company tax in New Zealand.
Inland Revenue has identified a wide range of arrangements that can be used to defer or circumvent NRWT on related-party interest payments. The concern is that such payments can be used to shift profits out of New Zealand and into low-tax countries or entities.
Our concern is that tackling particular arrangements through the disputes process or through specific legislative amendments can be complex and resource-intensive and may not be effective if taxpayers are able to switch to another technique.
We propose to explore options for dealing with these issues in a comprehensive way. Any change would need to be carefully designed and consulted on to ensure it did not lead to unintended outcomes.
More generally, any reform would need to strike an appropriate balance between reducing the potential for companies to shift profits out of New Zealand and ensuring that New Zealand companies can raise funds for investment, particularly in cases where the funding is ultimately sourced from third-parties.
Removing tax advantages from certain investment vehicles and effective taxation of offshore investments
Explore the need for an anti-arbitrage rule for offshore entities who seek double non-taxation of income or double deductions of expenditure by taking advantage of differences between countries’ tax rules.
Inland Revenue investigators have identified revenue risks associated with the use of offshore hybrid entities, which are treated as a separate company for foreign tax purposes but are considered to belong to the New Zealand investor (for example, are seen as a partnership) for New Zealand tax purposes. This type of offshore investment can be used to claim the same deduction in two countries. For example an interest payment would be deductible for the foreign company and also deductible for the New Zealand investor. The ability to claim such double deductions can lead to additional deductions being taken in New Zealand and a corresponding reduction in New Zealand income tax.
Some other countries prevent these situations from arising by having anti-arbitrage rules for offshore hybrid entities. For example, they classify offshore entities in a way that is consistent with the classification in the country where the entity is formed. Australia has a rule that treats offshore hybrid entities as partnerships for Australian tax purposes.
It is important that any measure New Zealand develops is compatible with approaches taken in other countries. The OECD’s action plan includes reviewing hybrid entities and other hybrid mismatches. This review will help guide our work in this area.
Examine incoherence relating to different tax treatment of “look through vehicles” and structures
New Zealand has a variety of vehicles that are either legally or effectively fiscally transparent. That is, the vehicle or structure enables income from an investment to “flow through” to an investor without any tax imposed at the level of the vehicle. Cross-border, these vehicles can potentially allow overseas investors to earn foreign income via New Zealand without any New Zealand tax. These vehicles include some limited liability companies, look-through companies (LTCs), limited partnerships (LPs), foreign portfolio investment entities (foreign PIEs) and foreign trusts (discussed below).
The concern we have is that different tax treatments or consequences arise depending on the type of vehicle used for the investment. In other words, there is a lack of overall coherence across the different sets of rules, and we think this should be explored further.
More specifically, rules that apply to protect the New Zealand tax base when either a foreign PIE or ordinary New Zealand company is used, may not apply when an LTC or LP is used.
For instance, in 2011 the Government decided to introduce “foreign PIEs” that allow foreign investors to earn foreign income tax-free via New Zealand. But entities must meet certain criteria to become foreign PIEs and are subject to a number of base protection rules (as are companies).
Similarly, under some of New Zealand’s tax treaties, a New Zealand subsidiary is able to pay a dividend to a non-resident parent company without paying any NRWT. If that dividend was funded by exempt foreign active income, no New Zealand tax will have been payable. The result is effective flow-through treatment. However, the New Zealand tax base is protected in this scenario by a number of measures that are designed to prevent profit shifting and other abuses, including:
- the active/passive distinction in the CFC rules
- the thin-capitalisation rules, which limit the amount of interest deductions the New Zealand company can make against any New Zealand income
- limitations on the use of foreign losses to offset New Zealand income
- “anti-treaty-shopping” rules in our tax treaties, which mean that artificial investment structures cannot access the lower NRWT rates
- exchange-of-information articles in our treaties that would allow us to obtain relevant information regarding the non-resident shareholder.
The base protection rules that are relevant to foreign PIEs and to New Zealand companies with foreign shareholders or offshore investments don’t always apply to investors in New Zealand LPs or LTCs. This may be because when LPs and LTCs were introduced, it was not expected that they would be used by foreign investors earning foreign income. However, because LPs and LTCs can be substituted for companies, they can be used to avoid the base protection rules that apply to ordinary companies. That is, they can be used to achieve tax results that could not be obtained through the use of a company or a foreign PIE. We consider that this apparent incoherence in the tax system should be examined.
Design the active income exemption for offshore branches to ensure it does not facilitate profit shifting through repatriation of losses
New Zealand companies looking to expand into new markets will normally adopt one of two structures. The firm may set up or acquire a separate company in the foreign country, such as a subsidiary or a joint venture with a foreign investment partner. Alternatively, the company may set up a branch office in the foreign country, which would still be part of the New Zealand company.
In 2009, offshore companies controlled by New Zealand investors were granted tax relief through a new active income exemption. Most business income earned through an offshore subsidiary is no longer subject to New Zealand tax. Passive income is still taxable which limits the ability to use foreign subsidiaries for profit shifting. Similarly, business losses incurred by the offshore subsidiary would not be available to the New Zealand company. The overall effect of these reforms was to bring New Zealand’s international tax rules into line with international norms. In 2011, the new rules were extended to joint ventures and other offshore companies that New Zealand companies had a substantial interest in but did not control.
Officials are currently preparing an issues paper on extending the same tax treatment to New Zealand companies which operate offshore branches. This will put New Zealand companies with offshore branches on an equal footing with New Zealand companies with offshore subsidiaries. That is, active business conducted through offshore branches will be exempt from New Zealand tax.
What this also means is that key base maintenance features that apply under the new international tax rules will be extended to the new offshore branch rules. Under both the existing active income exemption available for offshore subsidiaries, and the proposed exemption for offshore branches, the “passive” income of the business (such as interest, royalties and rents) remains liable for tax. This removes the incentive that firms would otherwise have to shift this highly mobile income out of New Zealand and into a low-tax jurisdiction.
Importantly, net losses of active branches would become non-deductible in New Zealand. Currently, net losses may be deductible in the country where the branch is located and in New Zealand.
This would also prevent a common tax planning technique, where foreign operations by a New Zealand company are first undertaken in branch form, generating losses deductible in New Zealand, but then shifted to company form when the business becomes profitable, so the profits of the same activity are not subject to New Zealand tax.
It also follows that New Zealand companies with interests in offshore companies are not able to offset New Zealand income with losses generated in those entities. Offshore branches will be subject to similar rules to prevent their losses being used to reduce New Zealand income.
Furthermore, New Zealand firms with significant shareholdings in offshore companies are also subject to the thin capitalisation rules. These rules place a cap on the amount of interest that can be deducted against New Zealand income. The rules will be extended to New Zealand firms with offshore branches.
Overall, the application of the key base maintenance features of the international tax rules is the quid pro quo of an active income exemption for branches. It also ensures that the decision of whether or not to invest through a subsidiary or a branch is not affected by tax considerations.
Ensuring tax rules keep pace with changes in the global economy
Review the tax treatment of foreign trusts
New Zealand taxes trusts if the settlor is, or was, a New Zealand resident. Accordingly, the question of whether the income of a trust is in the New Zealand tax base turns on the residence of the settlor as opposed to the trustee. These trust rules were originally intended to prevent New Zealand settlors avoiding tax on foreign-sourced income by establishing trusts with foreign trustees.
It follows from the general design of our trust rules that a “foreign trust” is a trust that does not have a New Zealand-resident settlor. Consistent with the general policy of not taxing the foreign-sourced income of a non-resident, the trustee income of a foreign trust is not taxable in New Zealand if it has a foreign source. (A foreign trust is therefore only taxed on New Zealand-sourced income, or if it has New Zealand-resident beneficiaries.) A foreign trust may be established under New Zealand law and/or be administered from New Zealand. It may also have one or more New Zealand resident trustees.
The fact that New Zealand does not tax the foreign income of foreign trusts has resulted in the development of a significant “offshore trust” industry in New Zealand. Other factors also contribute to the development of this industry, such as the fact that New Zealand is a stable, English-speaking country, with a strong rule of law and a well-developed body of trust case law.
There is no central registry for trusts in New Zealand. Given the size of the offshore industry that has developed, Inland Revenue introduced disclosure and record-keeping requirements for foreign trusts in 2006. These rules were intended to maintain transparency and to enable us to fulfil our exchange-of-information obligations under our tax treaties.
However, our foreign trust rules continue to attract criticism, including claims that New Zealand is now a tax haven in respect of trusts. This is largely because the mismatch between our rules and those of other countries may result in income not being taxed either in New Zealand or offshore. To protect our international reputation, it may be necessary to strengthen our regulatory framework for disclosure and record-keeping. This would result in increased administration costs for Inland Revenue and divert compliance resources away from the general business of collecting New Zealand tax. This, in turn, raises the question of whether our foreign trust rules are sustainable. We will report to you on this matter, including whether keeping the existing tax treatment of foreign trusts is sustainable in the long term.
Explore options to collect GST on goods and services bought online
The internet has made it possible for certain business activities (such as internet sales) to be performed anywhere in the world.
The OECD’s action plan includes a project (action 1) to consider whether special rules are needed to tax digital goods and services. The OECD will establish a special taskforce on the digital economy will look at a range of income tax issues, as well as “how to ensure the effective collection of VAT/GST with respect to the cross-border supply of digital goods and services.”
Inland Revenue, the Treasury and the New Zealand Customs Service are currently preparing an issues paper examining the growth of online shopping, its impacts on the tax system, and the potential options for improving the collection of GST on online sales. This work includes looking at physical goods that are purchased from offshore websites as well as at digital goods and services.
The issues paper will be released later this year and is intended to be the starting point for a full and open discussion on the issue. Feedback received on the paper will inform how we proceed.