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Inland Revenue

Tax Policy

Chapter 3 – Limiting the interest rate on related-party loans

3.1 This chapter discusses a proposal to limit the interest rate on cross-border related-party loans. While in principle transfer pricing should limit the interest rate on such loans, we are concerned that the rules are not always effective. Their application is also resource intensive for both Inland Revenue and taxpayers.

3.2 Under the proposal, the thin capitalisation rules will limit the deductible interest rate on related-party loans based on objective and readily observable factors, such as the credit rating of the borrower’s ultimate parent.


3.3 New Zealand’s thin capitalisation rules limit the amount of deductible debt a company can have, rather than directly limiting interest deductions. In order for the rules to be effective at actually limiting interest deductions in New Zealand to an appropriate level, allowable interest rates on debt also need to be limited.

3.4 Historically this limitation has been achieved through transfer pricing. However, we are concerned that this approach has not been wholly effective.

3.5 The transfer pricing rules require taxpayers to adjust the price of cross-border related party transactions so it aligns with the arm’s length price that would be paid by a third party on a comparable transaction. The arm’s length interest rate on a debt is affected by a number of factors, including its term, level of subordination, whether any security is offered, and the credit rating of the borrower.

3.6 As discussed in the discussion document BEPS – Transfer pricing and permanent establishment avoidance, the Government is proposing to update and strengthen New Zealand's transfer pricing rules including adopting economic substance and reconstruction provisions similar to Australia’s rules. The proposed transfer pricing rules would disregard legal form if it does not align with the actual economic substance of the transaction. They would also allow transactions to be reconstructed or disregarded if such arrangements would not be entered into by third parties operating at arm’s length.

3.7 Even with these stronger transfer pricing rules, we are not convinced that transfer pricing will be the most effective way to prevent profit-shifting using high-priced related party debt.

3.8 When borrowing from a third-party, commercial pressures will drive the borrower to try to obtain as low an interest rate as possible – for example, by providing security on a loan if possible, and by ensuring their credit rating is not adversely affected by the amount being borrowed.

3.9 These same pressures do not exist in a related-party context. A related-party interest payment, such as from the New Zealand subsidiary of a multinational to its foreign parent, is not a true expense from the perspective of the company’s shareholders. Rather, it is a transfer from one group member to another. There are no commercial tensions driving interest rates to a market rate. Indeed, it can be profitable to increase the interest rate on related-party debt – for example, if the value of the interest deduction is higher than the tax cost on the resulting interest income.

3.10 In addition, related-party transactions are fundamentally different to third-party transactions. Factors that increase the riskiness of a loan between unrelated-parties (such as whether the debt can be converted into shares, or the total indebtedness of the borrower) are less relevant in a related-party context. For example, the more a third-party lends to a company, the more money is at risk if the company fails. However, the risks facing a foreign parent investing in New Zealand do not change whether it capitalises its investment with related-party debt or equity.

3.11 Some related-party loans feature unnecessary and uncommercial terms (such as being repayable on demand or having extremely long terms) that are used to justify a high interest rate. Simply making the related party debt subordinated or subject to optionality may also be used as justifications for a higher interest rate. In other cases, a very high level of related party debt may be loaded into a New Zealand subsidiary to depress the subsidiary’s credit rating, which also is used to justify a higher interest rate.

3.12 It can be difficult to challenge such arrangements under the transfer pricing rules as the taxpayer is typically able to identify a comparable arm’s length arrangement that has similar conditions and a similarly high interest rate. With the proposed stronger transfer pricing rules, the taxpayer would have to provide evidence that the legal form was consistent with the economic substance and that a third party operating at arm’s length would agree to enter the arrangement. These new requirements should limit the use of artificial or commercially irrational funding arrangements. However, we are concerned that they may still provide scope for taxpayers to choose to borrow from related parties using higher-priced forms of debt than they would typically choose when borrowing from third parties.

3.13 In addition, the highly factual and subjective nature of transfer pricing can make the rules complex and uncertain to apply. Assessing compliance with the arm’s length principle requires very detailed and specific information and analysis of how a comparable transaction between unrelated parties would have been conducted. This makes complying with the transfer pricing rules a resource-intensive exercise which can have high compliance costs and risk of errors. Transfer pricing disputes can take years to resolve and can have high costs for taxpayers and Inland Revenue.

3.14 For these reasons we consider an objective and certain rule such as an interest rate cap is a better option for ensuring the pricing of debt is reasonable.

3.15 We note that we are not alone in these concerns. The OECD’s final report on interest limitation rules notes that thin capitalisation rules are vulnerable to loans with excessive interest rates.[8] This was one of the reasons behind the OECD favouring the EBITDA approach to limit interest deductions.

3.16 Nevertheless, as discussed above, we consider it preferable to attempt to directly limit interest rates on related-party debts. If this is not possible or effective, we may need to consider other possible changes including an EBITDA-based rule.


3.17 We propose amending the thin capitalisation rules to limit the deductible interest rate on related-party loans from a non-resident to a New Zealand borrower. We consider that such a cap is the best approach to ensure that the interest rate on related-party loans is roughly in line with the interest rate the borrower would agree to with a third-party lender. We consider that such a rule would also reduce or eliminate costly disputes over what an appropriate interest rate is under standard transfer pricing.

3.18 Our proposed design of a cap is set out below, but we welcome submissions on alternative approaches.

3.19 No cap would apply to loans from third parties.[9]

Rejected approach: hard interest rate cap

3.20 One approach would be to set a hard cap – either limiting deductible interest rates to some absolute number or limiting them based on yields on corporate bonds at a certain credit rating. This approach has the advantage of clarity and simplicity, but it has numerous drawbacks.

3.21 It would not align well with the objective above of ensuring that the interest-rate on related-party debt is roughly in line with the interest rate the borrower would agree to with a third-party lender. In some cases the cap would be higher than what a taxpayer would have been willing to pay – so would either be ineffective or permit higher interest rates (if the interest rate cap operated as a safe harbour). In other cases the cap would be too low – because of a firm’s particular circumstances, it might be willing to borrow from third-parties at very high interest rates.

3.22 A hard cap would also not be well targeted. While, at first blush, a hard cap may appear to target only firms who have most egregiously structured their related-party loans to get the highest possible interest rates, this is not necessarily the case. The interest rate that a borrower would accept on a third-party loan is a question of fact and circumstance (such as the borrower’s industry, current interest rates, and general economic conditions). A hard cap is not able to take these factors into account.

Preferred approach: cap based on parent credit rating

3.23 We consider a better approach to an interest rate cap is, wherever possible, to base the cap on the interest rate that the borrower’s ultimate parent[10] could borrow at on standard terms. That is, to set the maximum deductible interest rate on a loan from a non-resident to a New Zealand resident to:

  • where the ultimate parent of the borrower has a credit rating for senior unsecured debt, the yield derived from appropriate[11] senior unsecured corporate bonds for that credit rating, plus a margin.
  • where the ultimate parent has no credit rating, the interest rate that would apply if the parent raised senior unsecured debt on standard terms, plus a margin.
  • where there is no ultimate parent, the interest rate that would apply if the New Zealand group raised senior unsecured debt on standard terms (with no margin).

3.24 We consider that the interest rate that a multinational could obtain when raising senior unsecured debt (either determined with reference to its credit rating, or calculated based on other factors) is a reasonable approximation of the multinational’s cost of funds.

3.25 This proposed rule would therefore anchor the deductible interest rate on intra-group debt to a multinational’s actual cost of debt. We consider this reasonable. For example, one funding option available to a multinational would be to raise third-party debt and on-lend the debt to its New Zealand subsidiary. We consider it unlikely that the multinational would have its New Zealand subsidiary borrow from a third party at an interest rate significantly higher than the multinational’s cost of debt, since this would lower its overall profits.

3.26 More detail of how this proposed rule would work is set out below.

Appropriate margin

3.27 When the New Zealand borrower has an identifiable parent, we have proposed that some margin be added. The margin ensures, for example, that the rule does not apply in relation to a loan where there are only small differences between a multinational’s cost of funds and the interest rate on that loan.

3.28 This is similar to the approach taken in the thin capitalisation rules with the worldwide group debt test. The maximum amount of deductible interest is based on the debt to asset ratio of the worldwide group, plus a 10 per cent margin.

3.29 We welcome submissions on what an appropriate margin would be.

3.30 To illustrate, say the allowable margin attributable to the New Zealand subsidiary was limited to that which could be derived from appropriate bond yields one credit rating notch below that of the senior unsecured rating attributable to the ultimate parent. This means if a multinational group had a credit rating for senior unsecured bonds of AA-, the deductible interest rate on an intra-group loan would be based on A+ corporate bond yields.

3.31 The exception to this rule would be if the New Zealand borrower itself has a credit rating. In this case, we propose that the maximum deductible interest rate would be based on the higher of:

  • the multinational’s credit rating for senior unsecured debt plus the margin; and
  • the New Zealand group’s credit rating for senior unsecured bonds.[12]
Borrowers with no identifiable parent

3.32 Most firms subject to the thin capitalisation rules are controlled by a single non-resident, making it possible to determine the credit rating (or interest rate on senior unsecured debt) for its ultimate parent. However, this is not possible when a New Zealand firm is controlled by a non-resident owning body. Such a firm has no single parent company.

3.33 In this case, we propose that the appropriate cap for related-party debt is determined based on the rate at which the New Zealand borrower could issue senior unsecured debt. This is because it is not possible to base the cap on the cost of funds of the borrower’s parent.

3.34 Similar to when there is an identifiable parent company, we propose that the deductible interest rate be limited to the rate at which the company could raise senior unsecured debt (on standard terms). We believe this is a reasonable requirement as most companies typically raise the majority of their debt on standard senior unsecured terms.

3.35 In addition, this rule ensures that unusual features added to related-party debts (such as convertibility into shares) cannot be used to justify high interest rates.

3.36 However, the proposal to price debt as if it is senior unsecured debt does not prevent a firm’s owners loading it with uncommerical levels of debt, pushing down its credit worthiness and therefore increasing the allowable interest rate on related-party debt. We consider that there are two options for addressing this concern:

  • determine the borrower’s credit worthiness based on an arm’s length amount of debt, as determined under transfer pricing (this is the approach taken in Australia);[13] or
  • deem all related-party debt to be equity for the purpose of determining the borrower’s credit worthiness.

3.37 This first approach is likely to result in higher interest rates, but is more uncertain and would result in higher compliance costs: the borrower would need to be able to justify the quantum of debt and this could be subject to challenge by Inland Revenue (for the purpose of determining the appropriate interest rate). We welcome submissions on this point.

International comparison

3.38 We are not aware of other countries imposing a similar interest rate cap in relation to their thin capitalisation rules. However, many countries are instead adopting an EBIT or EBITDA based interest-limitation rule, in part because of concerns over the difficulty of pricing related-party debt appropriately through transfer pricing.

3.39 As discussed in the introduction, we consider that our proposed approach – implementing a regime to limit the interest rates on related-party debt – to be preferable to adopting an EBIT/EBITDA based rule.

Further detail

Interest rate cap

3.40 Interest rates on corporate debt can either be fixed for a period or floating (i.e. calculated using a benchmark index, such as the interest rate swap curve, plus a fixed margin).

3.41 With fixed interest loans, the interest rate cap would be determined on and apply from the day the interest rate on the loan is struck (or seven days prior to the date on which the funds are committed, if the interest rate on the loan is struck more than seven days from the commitment date).[14] Subsequent movements in bond yields would have no bearing on the allowable interest rate.

Example 1

A New Zealand company is borrowing from its foreign parent in NZD at a fixed interest rate. The parent’s credit rating for senior unsecured bonds is BBB+. With a one notch margin this means the maximum deductible interest rate on the loan would be based on appropriate BBB bond yields.

Say the interest rates on BBB bond yields (swapped into NZD) at the time the related party loan was arranged were:

1 year: 2%
2 years: 3%
3 years: 4%
5 years: 5%

The interest rate on a NZD-denominated related-party loan will be restricted to no more than the above rates. So, a loan with a one year term will be restricted to a 2% interest rate, while a loan with a five year term will be restricted to a 5% interest rate.

Subsequent movements in bond yields will not affect this maximum interest rate.

3.42 For floating-rate debt, the cap would apply to the fixed margin over the benchmark index, again on the day the fixed margin is struck and by reference to appropriate bonds trading at that time. The loan’s margin would be compared to the difference between the rate on the relevant credit curve and the rate on the relevant interest rate swap curve corresponding to the committed term of the loan. If the loan’s margin exceeded this difference, the excess would be non-deductible.

Example 2

Say the company above decides instead to borrow in NZD at a floating interest rate with a term of five years.

When the loan was entered into, the USD interest swap rate for five years was 1% and five year US corporate BBB bond yields were 3%. The maximum margin on the loan, for the life of the loan, would therefore be 2%.

Since the loan is in NZD and has a floating interest rate, an appropriate benchmark index would be a NZD floating interest rate.[15] Say when the loan was entered into, the NZD floating interest rate benchmark rate was 2%. This means that, when the loan was first entered into, the maximum deductible interest rate would be approximately 4% (2% floating interest rate benchmark index plus the 2% margin).[16]

Subsequent movements in the floating interest rate benchmark index would result in a higher or lower, as the case may be, maximum deductible interest rate. Say six months after the loan was entered into, the floating interest rate benchmark index increases to 3.5%. The maximum allowable interest rate on the loan would therefore be approximately 5.5% (3.5% benchmark index plus 2% margin).

Meaning of “related-party”

3.43 For the purposes of this rule, we propose that a loan be treated as being from a related-party if it originates from a member of the firm’s worldwide group, a member of a non-resident owning body, or an associated person of the group or body.

Treatment of guarantee fees

3.44 When the New Zealand subsidiary of a multinational borrows from a third party, that loan is sometimes guaranteed by the multinational group. In some situations, the New Zealand subsidiary a fee is charged for this – known as a guarantee fee.

3.45 Guarantee fees are calculated based on the difference in credit worthiness of the multinational group and the New Zealand subsidiary. Under our proposal, the maximum deductible interest rate on a related-party loan is based on the credit worthiness of the multinational group, plus a margin. For consistency, we propose that guarantee fees be limited to the margin allowable under the interest rate cap. Otherwise there is a risk that the total cost of debt to the New Zealand subsidiary (third-party interest rate plus guarantee fee) could be significantly higher than the actual cost of debt facing the multinational.

De minimis

3.46 Applying this interest rate cap will likely require the engagement of financial analysts or other subject matter experts, who have access to bond yield data and are able to perform the required calculations. This is no different to the situation at present – firms borrowing from related-parties should be involving subject matter experts to perform comparability analysis and ensure that the interest rate (and the other terms and conditions) of the related-party loan is reasonable.

3.47 We therefore believe this proposal will not result in increased compliance costs; indeed, compliance costs may reduce in some instances.

3.48 However, consistent with current administrative practice to reduce compliance costs for smaller firms,[17] we propose a de minimis for groups where the principal of all cross-border related-party loans is less than NZ$10m. We propose that, for these firms, ordinary transfer pricing rules will apply. This will allow Inland Revenue’s approach to low value cross-border loans to continue, where a specified margin (currently 250 basis points) above the benchmark rate is allowable.

Link to transfer pricing

3.49 We propose that this rule will override the general transfer pricing rules, except as provided for in paragraphs 3.36 and 3.48. This means that related-party loans that are subject to the interest rate cap would not also be subject to adjustment under transfer pricing.

3.50 We propose that all other tax rules would continue to apply as normal. For example, the general anti-avoidance rule (or other anti-avoidance rule) could apply to an arrangement, even if its deductible interest rate has been adjusted under these rules.

Anti-abuse rule

3.51 When market interest rates or borrowing margins increase, taxpayers have an incentive to reset the interest rate on related-party loans, as this increases the deductions available in New Zealand. For example, say a taxpayer has a loan from its foreign parent at 4% with a maturity of 1 April 2020. Say market interest rates increase, such that a new loan with a maturity of 1 April 2020 would have an interest rate of 7%. The taxpayer may have an incentive to break the current loan early and enter into a new loan to take advantage of the now higher interest rate and thus increase New Zealand deductions.

3.52 We are not proposing a specific rule to prevent taxpayers from breaking loans to take advantage of increasing interest rates or borrowing margins. However, such an arrangement would defeat the intention of our proposals. We anticipate that the general anti-avoidance rules could apply to such an arrangement.

Maximum loan term

3.53 It is unusual for a commercial loan to be committed for longer than five years. Most banks are reluctant to commit to funding for a longer period than this. Accordingly, for the purposes of this rule, we propose that a related-party loan with a term of longer than five years will be treated as having a term of five years for the purpose of determining the appropriate interest rate.

Transitional rules

3.54 We do not propose any special transitional rule. This means that, once these rules take effect, related-party cross-border financing arrangements currently under foot will be subject to the interest rate cap.

3.55 Prevailing interest rates change over the economic cycle – current interest rates and floating-rate margins may be higher or lower than when a loan was first entered into. The maximum interest rate should therefore be calculated based on historic interest rate data for the day on which the interest rate was struck.

Consistency with New Zealand’s DTAs

3.56 We believe that our proposed interest rate cap is consistent with New Zealand’s double tax agreements (DTAs), including the articles of our DTAs relating to the arm’s length principle. This is for three reasons.

3.57 The interest rate cap proposed is consistent with our existing thin capitalisation rules, in that it denies deductions by reference to a group formula (debt to asset ratios) rather than by reference to arm’s length amounts. The Commentary to the Model Tax Convention states that thin capitalisation regimes are consistent with the arm’s length principle insofar as their effect is to assimilate the overall profits of the borrower with those which would have accrued in arm’s length situations. This is on the basis that, while a thin capitalisation regime does not expressly refer to arm’s length amounts, it aims to approximate a similar overall level of interest expense for a taxpayer as would arise in arm’s length situations.

3.58 Our current thin capitalisation regime achieves this by allowing the taxpayer to borrow up to 110 per cent of the debt to asset ratio of its worldwide group instead of the safe harbour in determining the maximum amount of debt in respect of which interest can be deducted. Similarly, the proposed interest rate cap sets the maximum rate at which interest can be deducted by reference to the rate at which the taxpayer’s worldwide group can borrow from independent lenders (that is, the parent’s credit rating). In this regard, we note that independent lenders take the credit rating of the group into account when determining the interest rate payable by a New Zealand subsidiary, even without an explicit parent guarantee. Therefore, the interest rate cap should generally produce a similar level of interest expense as would arise in arm’s length situations. Consequently it should also be consistent with the arm’s length principle.

3.59 Second, both the Commentary to the Model Tax Convention and the BEPS Action 6 Report state that, as a general rule, there will be no conflict between domestic anti-avoidance provisions and a DTA. To the extent that it can be seen as going beyond a strict application of the arm’s length principle, the interest rate cap is a domestic anti-avoidance provision intended to stop profits being shifted out of New Zealand through the use of excessive interest payments between related parties. Related enterprises can adjust the legal terms of loans in order to impose higher interest rates, even though those terms do not have economic consequences on a group basis. This means that any departure from the overall profits that would result from application of the arm’s length principle is necessary to address the tax avoidance concerns arising from excessive interest payments (as noted by the OECD in its report on BEPS Action 4). Therefore the interest rate cap is consistent with our DTAs as a domestic anti-avoidance rule to the extent it does not produce an arm’s length amount of interest expense for the borrower.

3.60 Finally, the OECD specifically recommends countries adopt an interest limitation rule in its Report on BEPS Action 4. While the OECD recommends an earnings-based rule (such as one based on EBITDA) rather than an asset-based rule with an interest rate cap, one of the reasons the OECD favoured the approach is because it largely neutralises the effect of highly priced debt. However, as discussed above, we consider that our proposed approach of maintaining an asset-based rule combined with an interest rate cap is a better course of action. Like an EBITDA-based rule, it largely neutralises highly priced debt, but in a more consistent and predictable manner. On this basis we consider that our proposed thin capitalisation regime coupled with the interest rate cap is consistent with international practice and the OECD’s recommendations.


8 Limiting Base Erosion Involving Interest Deductions and Other Financial Payments (2015), OECD.

9 Provided the third-party loan was not part of a back-to-back arrangement.

10 Where the ultimate parent is a holding company and the main operating entity in the group has a higher credit rating, the operating entity’s credit rating would be used.

11 For example, the margin on bonds at the same credit rating can vary across industries. A taxpayer should be able to demonstrate that their choice of comparator bonds is appropriate.

12 If the New Zealand group had a credit rating for another type of bonds, this would be used to calculate a rating for senior unsecured bonds for the purposes of this rule.

13 As in Australia, the overall level of deductible debt would continue to be determined under the thin capitalisation rules. Transfer pricing would be used to determine the level of debt solely for calculating the borrower’s credit worthiness.

14 This is to prevent gaming of the rule in situations where interest rates are viewed as likely to decrease, by striking an interest rate well before funds are committed.

15 For example, the New Zealand three-month bank bill rate.

16 This example is simplified. A 2% margin in USD does not equate to exactly a 2% margin in NZD due to financial market practice – for example, incorporating a basis swap.