Chapter 4 - Amendments to the source rules
- The problem
- Permanent establishment source rule
- Anti-avoidance source rule
- Life insurance source rule
- Royalty substitution rule
4.1 This chapter sets out some proposed amendments to the source rules in the Income Tax Act 2007. These amendments are designed to fix current deficiencies with the source rules and to ensure they cannot be circumvented. The proposed amendments are not intended to fundamentally widen the scope of the source rules.
4.2 Under the amended rules, income will have a source in New Zealand if it is attributable to a PE in New Zealand. There will also be a rule to ensure that non-residents cannot structure around the new source rules by dividing their activities between group members. Finally amendments will be made to address some technical issues with the source related rules for life insurance.
4.3 The amendments proposed in this chapter would apply to income years beginning on or after the date of enactment of the relevant legislation.
4.4 In order for New Zealand to tax a non-resident on all or part of its sales income here:
- that sales income must have a New Zealand source under our domestic legislation; and
- we must not be prevented from taxing the sales income under any applicable DTA.
4.5 Whether the sales income has a New Zealand source under our domestic legislation depends on the extent of the business activities carried on in New Zealand by the non-resident. In particular, a non-resident’s sales income will have a New Zealand source if:
- the non-resident’s business is wholly or partly carried on in New Zealand; or
- the non-resident’s sales contracts are either concluded or wholly or partly performed in New Zealand.
4.6 In either case the amount of sales income with a New Zealand source will be limited to the amount a separate and independent person would have derived if it carried out the non-resident’s activities in New Zealand on an arm’s length basis. The non-resident will then be entitled to deduct its expenses from this income in determining the amount of tax payable.
4.7 In order for a non-resident’s sales to have a New Zealand source under these rules, the non-resident must carry out some business activity in New Zealand. There will not be a New Zealand source where goods are simply shipped to the New Zealand consumer by the non-resident. This reflects a fundamental distinction in international taxation between trading “with a country” (which is not taxable in that country) and trading “in” a country (which may be taxed in that country).
4.8 The Income Tax Act 2007 also has a series of further source rules in respect of specific types of income. For example, royalties paid by non-residents have a source in New Zealand if they are deductible to the non-resident payer.
4.9 Under the current rules, a non-resident’s sales income may not have a New Zealand source even if significant sales activity is carried out for the non-resident by a subsidiary here. This is because the non-resident’s sales income will arguably only have a New Zealand source if the subsidiary is effectively an agent for the non-resident, so that the non-resident can legally be treated as carrying on business in New Zealand through the subsidiary. Where the subsidiary is just contracting to provide sales activities for its non-resident parent, the sales activities might not be attributable to the non-resident. If this is the case, then the non-resident would not be treated as carrying on any business activity in New Zealand, and so its sales income would not generally have a New Zealand source.
4.10 The Government considers that this is an inappropriate result. The subsidiary is part of the same economic entity as the non-resident and is effectively under its control. Accordingly, the non-resident is carrying on its business through the subsidiary in substance. The same analysis also applies where the non-resident uses a commercially dependant representative to carry on its sales activity.
4.11 In addition, the current DTA approach to PEs differs from this strict approach. Under the Model Commentary, a person does not need to be a legal agent of the non-resident to carry on its business for the purpose of determining whether a PE exists. The PE definition is also being amended under the Multilateral Instrument to widen the circumstances in which a representative can give rise to a PE for the non-resident. In particular, the representative will only need to play a principal role leading to the conclusion of contracts in order to give rise to a PE under the amendments.
4.12 This raises the possibility that New Zealand may be able to tax a non-resident on its sales income under the PE article of a DTA, but is prevented from doing so under our domestic law.
4.13 There is general international consensus that if income is derived through a PE in a country, then it is sufficiently connected with that country to be taxed there. Accordingly, any income that is derived by a PE should also have a New Zealand source under our domestic rules.
4.14 In addition, in order to tax a non-resident on its New Zealand sales income, it is currently necessary to show that the income has both a New Zealand source and is attributable to a PE under a DTA. This increases the administrative requirements of assessing multinationals on their sales income here.
4.15 There is also a further issue concerning possible future attempts by taxpayers to circumvent the source rules. A consequence of strengthening some rules is that taxpayers may try to circumvent other rules to avoid paying tax. Therefore the Government intends to strengthen our source rules against potential attempts to circumvent them in the future.
4.16 Finally, there is an issue with how the source related rules for life insurance interact with a small number of DTAs.
4.17 The following proposals are intended to address these issues.
4.18 A new source rule is proposed under which income will have a New Zealand source if it is attributable to a PE in New Zealand.
4.19 If a DTA applies in respect of the income, then the definition of a PE in that particular DTA will be used for this purpose. The effect of this will be that where income is attributable to a PE in New Zealand under an applicable DTA, that income will automatically have a New Zealand source. The income will also have a New Zealand source where a PE is deemed to exist under the proposed new PE avoidance rule (discussed in chapter 3).
4.20 This is the same approach Australia currently takes. However Australia deems most of the income it can tax under a DTA to have a source in Australia (for example, including dividends, interest, royalties, etc.). The proposal at this stage is only that income attributable to a PE and royalties that New Zealand can tax under a DTA will automatically have a New Zealand source under the new rule. This is because the Government is only aware of issues with the source of these kinds of income.
4.21 If there is no DTA which applies in respect of the income, then the proposed rule will still apply. The Act will be amended to incorporate, for residents of countries with which New Zealand does not have a DTA, the definition of a PE in New Zealand’s model PE article. Therefore the income will have a New Zealand source if it is attributable to a PE in New Zealand, as that term is defined in the Act. A similar amendment would also be made in respect of royalties. It is important to include this rule so that residents of countries without a DTA with New Zealand are not in a better position than residents of countries with a DTA.
4.22 Whether income is attributable to a PE for the purposes of the new source rules will be determined under the normal PE profit attribution principles (as applied by New Zealand). A deduction would also be permitted for any expenditure incurred in deriving the New Zealand sourced income (subject to the usual deductibility rules) in determining the non-resident’s New Zealand tax liability.
4.23 A new rule is proposed stating that a non-resident’s income has a source in New Zealand if it would have a source, treating the non-resident’s wholly owned group as a single entity. This would prevent non-residents from avoiding having New Zealand sourced income by dividing their activities between wholly owned group members.
4.24 It is not appropriate for non-residents to be able to avoid New Zealand sourced income in this way. Given that a wholly owned group is a single economic entity, any income in such a case would have a New Zealand source in substance. Consequently it should also have a New Zealand source under our rules.
4.25 The proposed rule is similar to the existing rule contained in section CV 1 of the Income Tax Act 2007. Section CV 1 provides that an amount is income of a member of a wholly owned group if it would be income if the group were a single company.
4.26 The proposed rule is also consistent with the OECD’s BEPS measures which counter PE avoidance strategies, in particular the measures aimed at:
- Contract-splitting. This involves a non-resident splitting a single contract into several contracts, each of which is then carried out by a related party. Contract splitting is intended to avoid the application of DTA provisions which deem a non-resident to have a PE in a country if they carry out certain activities (such as mining or construction) in that country for more than a specified period.
- Fragmentation of activities. This involves a non-resident dividing a single business undertaking between related parties. This is intended to prevent a PE from arising by taking advantage of the exemption for preparatory or auxiliary activities in the PE article of most DTAs. The non-resident argues that each part of the business undertaken by a related party is only preparatory or auxiliary, and so it does not give rise to a PE. This is despite the fact that a PE would arise if all of the related parties’ activities were carried on by a single entity.
4.27 These BEPS measures will be introduced into New Zealand’s existing DTAs (provided the other country agrees) under the OECD’s Multilateral Instrument, which New Zealand intends to sign in mid–2017. If New Zealand’s domestic law does not include a similar anti-fragmentation rule, then New Zealand may be prevented from taxing a non-resident’s income from its New Zealand activities despite having the agreed right to do so under a DTA.
4.28 The proposed new source rule would not apply if the income already has a source under another provision of the Income Tax Act 2007. The rule would also only apply to the non-resident who derived the particular income from New Zealand (so it could not apply to a non-resident higher up the corporate chain).
4.29 New Zealand has special rules for taxing life insurance. These include source rules which provide New Zealand with a taxing right on any life insurance contract which is entered into or offered in New Zealand by a non-resident life insurer (sections YD 4(17) and EY 48 of the Income Tax Act 2007).
4.30 Because life reinsurance premiums can be used to shift income out of New Zealand, section DR 3 is intended to deny a deduction for life reinsurance premiums when the corresponding premium income is not taxable in New Zealand. This is achieved by providing that no deduction is available under section DR 3 for the reinsurance of a policy unless the policy is offered or entered into in New Zealand.
4.31 Life insurance can also be used as a type of investment savings. For this reason, the foreign investment fund (FIF) rules apply to life insurance policies owned by New Zealand residents. However, the FIF rules do not apply if the life insurance is offered or entered into in New Zealand. This is because in these cases New Zealand would typically tax the premium income earned by the non-resident (see section EX 28).
4.32 Under Article 7 of our DTAs, New Zealand is prevented from taxing business profits earned by a non-resident unless they are attributable to a PE of the non-resident in New Zealand. To ensure that the life insurance rules can continue to operate for non-resident life insurers without a New Zealand PE, New Zealand typically excludes insurance income from the scope of the business profits exemption in Article 7 of our DTAs.
4.33 However, New Zealand’s DTAs with Canada, Russia and Singapore include life insurance income in Article 7. Under these DTAs, New Zealand is unable to tax a non-resident life insurer on its New Zealand sourced premium income unless that premium income is attributable to a PE of the non-resident in New Zealand.
4.34 New Zealand’s inability to tax life insurance premium income under these DTAs means that the rules denying reinsurance deductions under section DR 3 and the application of the FIF rules may not work as intended when the premium is paid to a non-resident life insurer or reinsurer from these countries. These outcomes are contrary to the policy intent and provide a more favourable tax treatment for life insurance businesses operating out of Canada, Russia and Singapore compared with those operating in New Zealand or other countries.
4.35 The Government therefore proposes amending section DR 3 to specifically provide that no deduction is available for the reinsurance of policies if the premium income on that policy is not taxable in New Zealand (including under a DTA). The definition of a FIF in section EX 28 of the FIF rules would also be amended to specifically provide that New Zealand residents are subject to the FIF rules in respect of any policies that are not subject to New Zealand tax under the life insurance rules or any applicable DTA.
4.36 The Government is aware of attempts in Australia to circumvent royalty withholding tax, for example by re-characterising royalties as distribution fees (see the ATO Taxpayer Alert TA 2016/2). An additional anti-avoidance rule for royalties was considered. This would have provided that a royalty includes any amount that it is reasonable to conclude is paid in substitution for a royalty (and is not subject to withholding tax) under an arrangement.
4.37 However the Government does not wish to introduce a new rule that would reduce business certainty about the tax treatments of payments unless the rule is necessary. In this regard, the current definition of a royalty in the Income Tax Act 2007 is very broad. In particular, the definition specifically states that it does not matter how a payment is described or computed in determining whether it is a royalty. Royalty substitution schemes also do not seem to be a significant issue in New Zealand at this time.
4.38 Accordingly at this stage the Government does not consider that an additional royalty substitution rule is necessary. However we will reconsider this if royalty substitution schemes become a problem in New Zealand in the future.
8 See the officials’ issues paper New Zealand’s implementation of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS, March 2017, http://taxpolicy.ird.govt.nz/publications/2017-ip-beps-mli-nz/overview.