New Zealand corporate debt levels of foreign multinationals

Transcription

1 New Zealand corporate debt levels of foreign multinationals The elusive case for more tax restrictions? August 2016

2 Table of contents 1. Foreword Introduction Overall debt levels are modest The OECD s crackdown on international tax avoidance New Zealand already has tough interest limitation rules OECD s Action Plan proposes and earnings based fixed ratio rule Findings from EY s survey of New Zealand corporates The EY View Proceed with caution What will the fixed ratio be? Dealing with fluctuating corporate earnings Application to MNCs only or to all companies Impact on direct foreign investment Final Thoughts Appendix A Methodology Appendix B Glossary The elusive case for more tax restrictions? EY i

3 1. Foreword Public interest in the tax paid by multi-national corporations (MNCs) has never been higher. The Government is considering a raft of tax changes, including tougher restrictions on the amount of interest expense that can be deducted. Evidence in support of change, or for keeping the status quo, is patchy. To plug that gap, I am delighted to present EY s report setting out corporate debt levels in New Zealand. The report presents our findings from an analysis of the debt levels of 108 New Zealand inbound MNCs and 45 New Zealand-based NZX 50 companies. The facts show that, in the main, overseas corporates do not load undue amounts of debt into New Zealand. They call into question the case for tougher tax rules on inbound debt. The facts show that, in the main, overseas corporates do not load undue amounts of debt into New Zealand. They call into question the case for tougher tax rules on inbound debt. We hope that you find our views stimulating and refreshing. Andy Archer Partner, International Tax The elusive case for more tax restrictions? EY 1

4 2. Introduction Many readers will be aware of the Organisation for Economic Co-operation and Development (OECD) s strenuous efforts to devise a raft of new tax measures to combat tax erosion by MNCs dubbed the Base Erosion and Profit Shifting (BEPS) project. The OECD supports the creation of new rules under a globally coordinated and consistent approach, in contrast to country specific tax regimes built up on a territory-by-territory unilateral basis. During this process, OECD member countries, including New Zealand, have voiced their support for this tax revolution and with this arises the expectation that domestic tax rules will be reformed to adopt OECD-recommended action plans. We believe that New Zealand should only introduce new taxes where the evidence for them is strong. We believe that New Zealand should only introduce new taxes where the evidence for them is strong. That s particularly important for taxes on internationally mobile capital. Foreign direct investment is vital for New Zealand s economy. The OECD recommends imposing limits on the ability of MNCs to excessively debt gear their foreign operations and reduce their tax liabilities with high levels of deductible interest expense. The recommended rule by the OECD is a fixed ratio a form of interest-cover rule that limits deductions for interest to a percentage of the company s earnings. But New Zealand already has a complex set of thin capitalisation rules that deny interest deductions to New Zealand subsidiary companies of MNCs where debt levels exceed a statutory safe-harbour of 60% of the total New Zealand asset value. The risk is that any additional OECD style rule on top of current law will unfairly deny interest deductions here, complicate tax compliance and lead to uncertainty and confusion. To test the case for an additional rule, EY has undertaken market research to discover whether New Zealand subsidiaries of foreign companies are carrying high levels of debt. Based on our analysis, we do not think that New Zealand has any glaring need to beef up its tax laws. With some exceptions, foreign owned companies appear to be well within this existing debt ratio limitation. Furthermore, few companies would be affected by any new rule. Notwithstanding this relative compliance, it remains to be seen whether the Government might want to actively follow the OECD recommendations, whether justified or not. The risk is that any additional OECD style rule on top of current law will unfairly deny interest deductions here, complicate tax compliance and lead to uncertainty and confusion. The elusive case for more tax restrictions? EY 2

5 Companies 3. Overall debt levels are modest Current thin capitalisation rules allow MNCs to finance their New Zealand operations using a 60% ratio of interest-bearing debt to total assets. These rules set a safe-harbour benchmark within which full interest deductions for tax purposes are permitted since, on a policy level, this amount of debt gearing is not considered to be aggressive tax planning. Figure 1 shows that most foreign-owned MNCs stay well within this 60% safe-harbour (with an average total debt to total asset ratio of just 20%). In comparison, New Zealand based companies in our sample also had an average total debt to total asset ratio of 20%. In fact, many overseas companies carry lower debt levels than their New Zealand-based peers. Figure 1: Total debt to total asset ratio comparison 60% 50% 40% 30% 20% 10% Foreign-owned companies (sample size = 108) NZX companies (sample size = 45) 0% 10% and less 11-20% 21-30% 31-40% 41-50% 51-60% In excess of 60% Total debt to total asset ratio Nor does it appear that the corresponding interest expense is a large fraction of MNC earnings. Figure 2 shows that MNCs are well able to cover their interest costs showing an average interest to earnings, (as measured before interest, taxes, depreciation, and amortisation - EBITDA) ratio of 17%. 1 By contrast, the average interest to EBITDA ratio for New Zealand based companies in our sample is slightly lower at 14%. 1 The foreign-owned companies average interest to EBITDA percentage includes one outlier with an interest to EBITDA ratio of 297% and excludes negative EBITDA companies. The elusive case for more tax restrictions? EY 3

6 Companies Figure 2: Interest to EBITDA ratio comparison 60% 50% 40% 30% 20% 10% 0% 10% and less 11-20% 21-30% 31-40% 41-50% In excess of 50% (including negative EBITDA companies) Interest to EBITDA ratio Foreign-owned companies (sample size = 108) NZX companies (sample size = 45) The elusive case for more tax restrictions? EY 4

7 4. The OECD s crackdown on international tax avoidance Implementing the OECD s action plans will present a whole new era in cross border taxation of trade and business, and for the taxes that corporates pay (or should pay) in the countries they conduct business. The OECD has bolstered the tax morality debate about legitimate tax minimisation versus paying a fair share of taxes. Some countries have raced out of the blocks with selected counter measures, most notably Australia and the UK with the proposed introduction of a Diverted Profits Tax, and also Australia s multinational anti-avoidance law (MAAL) to apply to foreign MNCs generating profits from Australia without having any local permanent establishment. Also, and more poignant for our research, the UK has released proposals for limiting interest expense by corporates from 1 April Significantly, these interest limitation proposals extend beyond the international BEPS-targeted MNCs to also include domestic UK companies. New Zealand has adopted a measured approach to the OECD s action plan. The Government appears intent on preserving what is internationally recognised as a stable tax policy framework. At the same time, it is examining the OECD BEPS action plans and considering how these ought to be introduced, and if so, in what form. At a ministerial level, New Zealand has vocalised its support of the OECD s work on BEPS (and so is towing the party line), but every country has its own different tax system and conventions. It is not simply a case of buying everything off the OECD shelf. New Zealand is a net capital importer. Few MNCs are based here. We cannot afford to treat inbound investors harshly. Other countries export capital, and so face concerns that their tax base is at risk and MNCs may end up paying more tax to foreign Governments. The USA is perhaps the most stoic in its questioning of the BEPS action plans and their potential impact on American business. New Zealand is a net capital importer. Few MNCs are based here. We cannot afford to treat inbound investors harshly. One of the areas targeted by BEPS is interest deductibility, addressed by Action Plan 4 Limiting Base Erosion Involving Interest Deductions and Other Financial Payments. This recognises that it is relatively simple to exploit the fluidity and fungibility of money and create high levels of intragroup, related party debt and interest flows to reduce and shift profits out of a country s tax net. In this manner, some MNCs can structure group debt (third party, bank and related party debt) to move profits from higher tax to lower tax jurisdictions, so reducing the overall tax liability of the MNC. Also, the Action Plan is concerned that the structuring of debt across subsidiaries within a single MNC can result in tax relief being created for interest deductions greater than the actual net interest expense of the group itself. This is not new however. The elusive case for more tax restrictions? EY 5

8 5. New Zealand already has tough interest limitation rules Well before the OECD came up with BEPS, our tax policy framework has applied base protection measures against excessive debt levels. New Zealand has had a thin capitalisation regime since 1997, with the regime being tightened and extended on numerous occasions, notably in 2010 by lowering the safe harbour level from 75% to 60% and in 2013 expanding its application. Total debt includes all debt third party and related party. Interest amounts paid on an excessive portion of debt (i.e. greater than 60%) are apportioned, and are not tax deductible. This interest deduction limitation is a permanent interest denial since that excess portion cannot be put aside for deduction in future periods where the company has lower debt levels. With a long established thin capitalisation regime, we question whether additional rules are necessary. With a long established thin capitalisation regime, we question whether additional rules are necessary. The OECD approach limits interest deductions based on a fixed ratio rule. While New Zealand currently has a 60% ratio with our thin capitalisation, debt/assets regime, the OECD believes that a best practice approach would use a ratio based on economic activity (earnings) rather than asset values. A clear correlation generally exists between earnings and taxable income. The OECD did recognise that some pros and cons did exist for either approach. In reaching this view, the OECD has recommended that this fixed ratio rule can be adopted in combination with any country s existing interest limitation rules. The elusive case for more tax restrictions? EY 6

9 6. OECD s Action Plan proposes and earnings based fixed ratio rule A fixed ratio rule would limit a company s deduction for interest to a percentage of EBITDA. The OECD considers that countries adopt a fixed ratio somewhere between 10% and 30%, with countries own circumstances driving this selection. In commercial parlance, this is akin to an interest cover measure that banks apply to borrowers ability to service debt levels. Interest that exceeds this percentage threshold will be non-deductible, but the proposals suggest that this interest denial be able to be restored where in future years the entity s actual net interest deductions are below the maximum ratio permitted. Table 1 shows that for a fixed interest ratio of 20%, deductible interest would be limited to only one-fifth of EBITDA. Table 1: Fixed ratio rule in practice % interest/ebitda 10% 20% 30% 40% EBITDA $100 million $100 million $100 million $100 million Interest limitation $10 million $20 million $30 million $40 million As well as the central question around the ratio, the design of any fixed ratio rule will affect how it works in practice. These include base, de minimis, interest rate safe harbour settings, group level tests and carry over rules. As an example, the UK, surprisingly, intends to apply its rule to all corporates MNCs, and domestic companies. To simplify the new rules, it recommends a de minimis amount of interest before which debt levels and interest amounts will be subject to the new limitation regime. It is also looking at a fall-back rule, whereby a corporate s level of interest may exceed the adopted statutory ratio (e.g. 20% or 30%) where at a total group level, the consolidated accounts reveal higher levels of interest expense relative to group profit. The elusive case for more tax restrictions? EY 7

10 7. Findings from EY s survey of New Zealand corporates EY has started to explore the case for a fixed ratio rule in New Zealand. Our desk top survey shows how a fixed ratio rule might apply to existing levels of interest and revenue. We also compared existing debt to asset ratios to gauge how the current thin capitalisation rules measure up, relative to a fixed ratio rule. Will any new rule deny interest deductions that otherwise fall well within our existing interest limitation rule? Our research shows that most foreign-owned MNCs can clearly operate within our existing interest limitation rules. Only 10 companies of 108 exceeded the statutory 60% thin capitalisation safeharbour threshold. And, as we re reviewing publicly available information only, timing or other differences between accounting and tax numbers may mean that even fewer face interest denial. We then assessed those 10 companies using a fixed ratio approach. We extrapolate: One company in this category has a negative EBITDA so would be denied interest deductions in full (unless some carry over allowance is made). That s a lot harsher than facing a fraction of interest disallowed under current rules. However, as the company is in loss, there will be no immediate cash-flow effect. Nor will the Government get more money in the short term. Three companies that exceeded the 60% threshold have interest / EBITDA ratios in excess of 30. Depending on design, they will likely continue to apportion their interest deductions. Whether they ll be worse off is unclear. Six companies that exceeded the 60% threshold have interest / EBITDA ratios of less than 30% (and of these, three are less than 10%). That suggests that, even though carrying high debt levels, they are highly profitable so in commercial terms not thinly capitalised. While these six companies may satisfy the fixed interest ratio limitation (if the fixed ratio is not less than 30%), a portion of their interest deductions will remain non-deductible under the existing 60% debt percentage limitation rules. As Figure 3 shows, New Zealand MNCs claim similar interest tax deductions to the OECD norm. The elusive case for more tax restrictions? EY 8

11 Companies able to deduct interest in full Figure 3: New Zealand MNCs interest deductions compared with OECD norm 100% 95% 90% 85% 80% 75% 70% 65% 60% 55% 50% 10% 20% 30% 40% 50% Fixed interest to EBITDA ratio OECD data excluding negative EBITDA companies NZ data excluding negative EBITDA companies NZ data including negative EBITDA companies In fact, our analysis of New Zealand based MNCs is almost identical to the OECD research. 2 The OECD has chosen data which only represents companies with positive EBITDA, as it was examining sensitivity to varying ratios. We consider this approach will understate the impact of fixed ratio rules. An MNC with negative EBITDA would only ever have one outcome under a fixed ratio rule no interest deductibility entitlement. Figure 3 therefore, includes New Zealand data both with and without negative EBITDA companies, to show the true implications of the fixed ratio rule. An MNC with negative EBITDA would only ever have one outcome under a fixed ratio rule no interest deductibility entitlement. 2 The OECD working party looked at financial data tabulations of MNCs (using S&P GLOBAL Vantage database) and the relative percentage of EBITDA limit on net interest deductibility. The elusive case for more tax restrictions? EY 9

12 8. The EY View Proceed with caution Tax policy should be evidence based, not tied to political expediency. We give the New Zealand Government credit so far. It has taken a measured approach to the BEPS agenda, contributing technical heft to the OECD s work while moving with caution on the home front. Tax policy should be evidence based, not tied to political expediency. Our data does not reveal that MNC s are overly debt gearing their New Zealand operations, and accordingly the case for a further layer of interest limitation rules seems unwarranted. At best, the Government may extract a few nuggets if it were to adopt a fixed ratio rule, but there is no pot of gold begging. To the contrary, there is a risk of a lose-lose result. New Zealand based business will lose due to the complexity of these tax rules. Foreign investors may be deterred. And complexity will outweigh any revenue gain for the Government. We challenge proponents of change to consider: 8.1 What will the fixed ratio be? The OECD recommends a range of ratios, anywhere between 10% and 30%. The lower the number, the tougher the rule. It identifies the interest rate environment as the sole economic factor worthy of taking into account when setting that ratio. The UK and the European Union (in its Anti-Tax Avoidance Directive) each propose a 30% ratio. We have yet to see any country propose a ratio of less than 30%. We certainly agree on interest rates. We re currently in a low interest rate world, but business financing costs vary a lot at different points of the economic cycle. If financing costs were to increase, a fixed ratio rule could amplify that effect. 8.2 Dealing with fluctuating corporate earnings We re concerned that the OECD s approach is too narrow. It works much better for a service-based MNC with predictable earnings and a clear home base. But consider earnings volatility, particularly relevant for a commodities-based economy like ours, which can be exacerbated by currency swings. By its nature, the fixed ratio rule drives off a key business performance metric EBITDA. The resulting amount of interest expense an entity may deduct will be directly affected by any volatility of its earnings. By contrast, many companies prefer the certainty of a reasonably fixed capital structure split between equity and debt, with the debt component throwing out a predictable interest expense. Corporate CFOs and Treasurers are tasked with locking in efficient capital management. They rarely have control over gross sales and margins, which will be the main driver of volatile earnings performance. The OECD does acknowledge that earnings volatility could make long-term planning difficult and from this, that permanent disallowance of interest expense could result in double taxation, because in most cases the lender party will be taxed on the corresponding interest income. To mitigate this double taxation risk, it suggests carry over rules. Countries may wish to allow entities to carryforward unused interest capacity and to carry forward and/or carry-back disallowed interest expense, subject to certain limitations, such as: Number of years that disallowed interest expense or unused interest capacity may be carried forward or disallowed interest expense may be carried back Fixed reduction in the amount of carry-forward (for example, 10% each year) The elusive case for more tax restrictions? EY 10

13 Capping the amount of the carryover at a fixed amount And/or Eliminating carry-forwards where there is a change in ownership To further address the earnings volatility problem, the OECD encourages countries to consider using an average EBITDA figure, suggested as being from the current and two prior years. The current New Zealand thin capitalisation regime results in a permanent interest denial in respect of the excessive debt position, so the proposed OECD recommendations are less burdensome. How the two interest limitation regimes would co-exist is an open question. Has the OECD gone far enough to devise a workable rule? Only time will tell. 8.3 Application to MNCs only or to all companies Off the back of the UK proposals, will our rules apply to domestic companies as well as international groups? Our research suggests little or no need, with little difference in gearing ratios between MNCs and New Zealand-based companies. We d go further and say that a fixed interest rule would be bad news for start-ups, already hard-pressed with cash-flow and balance sheet management. 8.4 Impact on direct foreign investment New Zealand needs to remain an attractive place to invest and base a business. As an economy, New Zealand is a capital importer, unlike several more influential OECD countries. This is an important bias that demands careful consideration in flexing our regulatory environment. Imposing stricter tax rules on how foreign investment capital is treated has attendant risks for how we compete for global capital looking for a home. In only a brief commentary, the OECD is dismissive of the potential negative impact that debt and interest limitation rules might have on foreign direct investment. We think this coverage is wafer thin, and the conclusions premeditated. Fortunately, New Zealand Treasury, and Inland Revenue, have regularly trod cautiously when it comes to the impact of our tax laws on the country s vital foreign direct investment. The elusive case for more tax restrictions? EY 11

14 9. Final Thoughts Inland Revenue has recently published a draft overview of current tax policy settings for inbound investment. There s much to agree with in that document: New Zealand must remain an attractive place to invest and base a business That means keeping the pre-tax cost of capital as low as possible consistent with the New Zealand Government raising sufficient revenue to fund its priorities Thin capitalisation rules are sensible to protect New Zealand s tax base Many reviews, including one by EY s former Chair, Rob McLeod, have re-affirmed that approach. Nevertheless, effective tax rates on inbound capital in New Zealand are drifting upwards. Recent reforms have almost all aimed to increase the tax take, at the expense of inbound investors. Our research challenges the Government to justify there s a real problem before moving to a complex, ineffective, rule which risks adding bulk to the statute book for no real purpose. The elusive case for more tax restrictions? EY 12

15 Appendix A Methodology In our research we have analysed the thin capitalisation profiles of 108 New Zealand inbound companies and groups representing a broad range of industries and ultimate ownership jurisdictions. Based on publicly available financial information, we have calculated their existing total debt to total assets and net interest to EDITDA ratios. For comparative and illustrative purposes, we have also performed a similar analysis in respect of 45 New Zealand based NZX 50 companies. For most companies in our sample we have used the 2015 financial reports. Banks and insurance companies have been specifically excluded from the above selections as this is a unique sector that operates on the basis of debt in and debt out, like ordinary inventory. A full list of companies included in the research is available on request. The elusive case for more tax restrictions? EY 13

16 Appendix B Glossary Base Erosion and Profit Shifting (BEPS) Diverted profits tax EBIT An OECD-led crackdown on cross-border tax avoidance UK tax designed to counteract contrived arrangements supposedly used by MNCs to avoid source country taxation Earnings before net interest and tax Earnings before net interest, tax, depreciation and amortisation. EBITDA Fixed ratio rule Interest cover Multilateral antiavoidance law (MAAL) NZX 50 Permanent establishment Thin capitalisation regime In our analysis, we have not specifically excluded impairment losses (where applicable) to determine the EBITDA positions (unless any such losses were combined with depreciation and amortisation for New Zealand financial reporting disclosure purposes and no exact split was available). Form of thin capitalisation rule based on interest as a proportion of EBITDA, not currently used in New Zealand Ratio used to determine how easily a company can pay interest on outstanding debt. Calculated by dividing earnings before interest and tax by interest expense. Tax applying to MNCs generating certain profits earned from Australia without an Australian permanent establishment Collective name for the 50 largest, eligible stocks listed on the Main Board (NZSX) of the NZX A fixed place of business which generally gives rise to income tax liability in a particular jurisdiction Restriction over tax deductible interest targeted at MNCs with excessively high ratio of debt to equity The elusive case for more tax restrictions? EY 14

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