Taxation (Neutralising Base Erosion and Profit Shifting) Bill

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1 Committee Secretariat Finance and Expenditure Committee Parliament Buildings Wellington February 2018 Taxation (Neutralising Base Erosion and Profit Shifting) Bill Dear Sir / Madam Thank you for the opportunity to submit on the Taxation (Neutralising Base Erosion and Profit Shifting) Bill (the Bill). We appreciate that targeting base erosion and profit shifting (BEPS) to ensure multinationals are paying an appropriate amount of tax in New Zealand is a key focus for the Government. The Government wants to introduce measures to protect the New Zealand tax base, as well as fulfil its commitment to actively and cooperatively work alongside the OECD and G20. Foreign investment into New Zealand will be put at risk due to the complexity and rigidity of these new tax regimes We have serious concern as to the scope and drafting of the measures to be introduced and the speed at which they are progressing. The wide reaching proposals are contrary to the longstanding and well supported Government policy on inbound investment: A priority for the Government is ensuring that New Zealand continues to be a good place to invest and for businesses to be based, grow and flourish. Excessive taxes on inbound investment can get in the way of this happening. It is also important that inbound investment takes place in the most efficient ways. Poorly designed taxes can hamper investment from occurring in the ways which provide the best returns to New Zealand. 1 The new tax regimes proposed by the Bill are the most complex, both in principle and in legislative drafting, that New Zealand has seen it cannot be overstated how complex these rules are and how difficult it will be to understand the practical implications. Taken together, the changes fundamentally impact the way in which taxpayers with cross-border relationships are taxed. Further, the drafting in the Bill is generally too complicated and contains a number of areas where there are errors or significant uncertainty, mostly due to it being too rushed. Finally, how the proposed changes work together, and their cumulative effect on taxpayers, has not been fully considered in a practical sense, and are instead driven by the tax theory of Inland Revenue Policy Officials. Our team of tax experts has spent considerable time already trying to interpret and decipher the drafting. Our universal view is that deciphering the drafting and considering how the rules will 1 New Zealand s taxation framework for inbound investment, Policy and Strategy, Inland Revenue and the Treasury, June PricewaterhouseCoopers, 188 Quay Street, Private Bag 92162, Auckland 1142, New Zealand T: , F: , pwc.co.nz

2 apply to practical situations is very difficult and extremely time consuming, to a level New Zealand has not experienced before. In our view, the cumulative effect of all of the proposed changes contained in the Bill are onerous, overly complex and rigid tax rules that put at risk New Zealand s ability to attract inbound investment even when compared with other countries such as Australia who are also introducing BEPS legislation. Application date needs to be pushed out We strongly urge the Government, at a minimum, to delay the effective date of the proposals in the Bill. The application date for changes contained in the Bill should be no earlier than the first income year after 31 March 2019 so that taxpayers have sufficient time to interpret, assess and prepare to apply the new rules. The current timeframe of the potential application date of 1 July 2018 (for 30 June balance date groups) is unacceptably short when the finalised version of the legislation will not be known until mid-june at the earliest. Whilst we acknowledge that some of the new rules have been foreshadowed for some time, their precise scope was not known until the Bill was released in December As such, and bearing in mind the complexity and errors contained in the current drafting, taxpayers are not being given sufficient notice of the proposed changes and to determine practically how they will be impacted. The proposals in the Bill will need to be considered by all New Zealand entities with offshore parents or subsidiaries. Taxpayer groups need significantly longer than 1 July 2018 (which, for many, will be the current start date) to seek advice on and understand how the rules work and then consider how those rules may apply to current ownership structures and what restructuring is needed. It is imperative that time is taken to ensure the drafting is correct and captures what and who is intended so that taxpayers have clarity going forward. As mentioned above, these combined sets of potential new tax regimes gives rise to the most complex legislative drafting proposed by New Zealand, but the current timeframe to the effective date does not recognise this, and instead is much shorter than what good generic tax policy process requires. A number of areas of the proposed new tax regimes are significant overreaches by New Zealand and potentially will be significantly detrimental to ordinary commercial arrangements A key example of where the rules overreach when considered with our international tax framework is the proposed introduction of the Restricted Transfer Pricing Rule (RTP Rule). At the CAANZ conference in November 2017, Hon Stuart Nash commented: I know that good relations already exist between the IRD and the private sector. I also know that the IRD is currently undertaking work to try to improve how it engages with the sector. This is good. Of course, there will always be areas where full agreement cannot be reached, but it shouldn t be a fundamental disagreement on crucial tax legislation. The RTP Rule is a key area where there is fundamental disagreement, and we are strongly of the view that it should not be adopted. In our view, the proposed RTP Rule is unnecessary if the general transfer pricing rules are strengthened as proposed, and proper consideration has not been given to Page 2

3 the full effect of the proposed changes as a solution for addressing the Government s overarching concerns. Other countries are not pursuing draconian measures such as this proposed RTP Rule. The practical implications in real life situations if this RTP Rule is enacted cannot be understated. The Bill proposes measures that will be unattractive for foreign investment as they reach far beyond what is commercially reasonable in areas such as the proposed RTP Rule, and changes to the thin capitalisation regime. This includes requirements for each entity in a global group obtaining a credit rating for the purposes of the proposed RTP Rule, or assessing a New Zealand entity s capacity for debt based on assets net of non-debt liabilities, which is inconsistent with the lending considerations imposed by a third party lender. The proposed measures are significantly disproportionate to the concerns that are looking to be addressed. This is also particularly evident in the proposed hybrid and branch mismatch rules where the Bill Commentary acknowledges that legislation is being introduced in some areas where no mischief is known in the New Zealand tax system, but just in case taxpayers find a way to structure around it in the future. The onerous combined nature of the proposals puts New Zealand at a competitive disadvantage globally, and investment into New Zealand at risk. For example, from discussions we have had, multinational corporations will now need to decide between restructuring their New Zealand operations in light of the proposed PE Avoidance Rule or whether it would be more cost effective to simply exit from the New Zealand market and service New Zealand remotely from say Australia, with no physical presence in New Zealand. The New Zealand economy will lose. Also, the cumulative effect of the proposed tax changes on related party debt is too harsh, and puts foreign investors at a further disadvantage to New Zealand investors when looking to acquire and maintain New Zealand operations. This is coupled with the introduction of the risk of double tax (or overtaxation) in New Zealand for all taxpayers with cross-border related party debt, or through the imposition of withholding tax without corresponding interest deductions. While the Government, and Inland Revenue Policy Officials, seem to want to be seen to be leaders in the race to implement the OECD BEPS recommendations (and in a more than fulsome manner in a number of areas), we strongly submit that more caution should be taken to implement measures that are genuinely needed and are not overreaching such as the proposed RTP regime. A number of areas of the proposed new tax regimes are contrary to New Zealand s obligations under its double tax agreements and efforts towards global coordination The proposed RTP Rule and parts of the proposed hybrid and branch mismatch rules are being introduced by New Zealand on a unilateral basis. Furthermore, these changes plus others such as the proposed changes to the thin capitalisation regime and the proposed PE Avoidance Rule are not consistent with New Zealand s double tax agreements. This means that New Zealand will be out of step with the rest of the world, and goes against not only New Zealand s existing international commitments, but the Government s objective to coordinate globally on international tax matters. Compliance costs will be hugely increased The burdens imposed by the Bill extend also to excess annual compliance obligations impacting foreign investors, as well as the resource-constrained Inland Revenue (particularly in the transfer pricing sphere). These compliance concerns could be mitigated by simply introducing better and Page 3

4 wider safe harbour criteria, or leaving out some proposed measures such as the proposed RTP regime or imported hybrid mismatch rules, so that resources are focused on the taxpayers that they should be particularly focused on. Layout of our submissions, with summaries at start of each section Our submissions are divided into three parts: overall comments on the Bill, submissions on each of the proposals are outlined in the attached document, and we also include in an Appendix a number of other drafting suggestions and minor comments on the Bill for the Government s consideration. The drafting suggestions have been identified during the course of our reading, but are by no means a complete list of all recommended drafting amendments. Unfortunately we do not consider the Bill and drafting is at a stage yet where providing fulsome comments on the legislation is beneficial, given the substantial revision / redrafting of the legislation that in our opinion is required. We would be happy to discuss the redrafting of the legislation directly with Inland Revenue Policy Officials as it progresses. Appearance at Select Committee requested We wish to appear before the Select Committee. Please contact us to arrange the date and time. We have 3-4 people in our team that we would like to participate in the discussion if possible. Please contact us if you have any questions regarding our submission. Yours faithfully Peter Boyce Erin Venter Sandy Lau Partner Partner Director peter.boyce@nz.pwc.com erin.l.venter@nz.pwc.com sandy.m.lau@nz.pwc.com T: T: T: Helen Johnson Briar Williams Director Director helen.n.johnson@nz.pwc.com briar.s.williams@nz.pwc.com T: T: Page 4

5 Section 1: General comments Application dates: need to be pushed further out as they are currently unacceptably short Proposal Generally, the provisions contained in the Bill will apply for income years beginning on or after 1 July Comment and submission Clause 2 We submit that the application date for the proposed changes should be no earlier than the first income year after 31 March The current proposed application date of 1 July 2018 for the majority of proposed changes is too soon. The quality of drafting as currently included in the Bill is not yet to a standard that taxpayers would be able to digest any resulting legislative changes, assess their impact, and appropriately act (if required) before the rules come into effect. Such steps can only be undertaken when revised wording is made available, and this is not likely to occur with sufficient time before the effective date, placing undue burden on taxpayers. The complexity of these rules and the difficulty in assessing the application to practical situations cannot be understated. This adds even more weight to the problem the short lead time to the effective date is creating. This needs to be taken in the context that the very nature of the rules being proposed are international in nature. Given the changes will impact taxpayers with capital from / to a number of jurisdictions, there is inherent complexity to the proposed regimes that needs to be considered from both tax and commercial perspectives by taxpayers. It is in the interests of continued investment from overseas to properly allow for a delay in the application date. This point is important for New Zealand as a capital importing country. The proposed changes will affect a significant number of taxpayers, and not just those few who may be viewed as having adopted unacceptable tax practices. We are not convinced that the Government truly understands this. It is sensible and reasonable to allow taxpayers sufficient time to consider how best to deal with any resultant impact, and to rearrange their affairs if they decide it is necessary. Such restructuring was envisaged by the OECD, and also in the Bill Commentary, however, insufficient time allowance has been made to actually undertake this restructuring (after understanding the scope of the draft legislation), which is not a straightforward process. For example, a number of taxpayers may choose to restructure their operations in New Zealand as a result of the proposed PE Avoidance Rule. Those taxpayers will need time to do so as they will likely be required to renegotiate contracts with customers and upgrade current business systems. In many cases, systems will be global systems, and a bespoke solution will be required to take into account New Zealand s tax rules. Corporate groups we have spoken to have all said 12 months is the usual timeframe their corporate groups need for a proper restructuring process. Taxpayers who were not expecting to be within the proposed new rules but nevertheless appear to be caught (at least from the complex drafting in the Bill), need more time to consider the impact. Page 5

6 Cumulative effect and interaction of changes have not been adequately considered to date Comment and submission We submit that substantial work is still required by the Government on the Bill to properly consider the cumulative effect and interaction of the proposed changes, both in light of changes within the Bill as well as the impact on existing tax legislation. Based on our reading of the Bill, the cumulative effect and practical impact that the proposed changes, if enacted, will have has not properly been thought through (with real world structures and examples in mind). For example, the interaction of the proposed hybrid and branch mismatch rules with the proposed PE Avoidance Rule has not been provided for in the Bill, where a group has both a formal branch and a deemed permanent establishment (PE) in New Zealand under the new rules. Further, related party debt is being attacked and actively discouraged under the combination of the tightening of the transfer pricing rules, the introduction of the RTP Rule, and amendments to thin capitalisation. This overall impact is unwarranted (particularly the impact of the proposed RTP Rule) given evidence provided by Inland Revenue indicates that foreign-owned companies are generally not highly geared. The combination of rules also means that in some circumstances foreign investors may be disadvantaged when compared with New Zealand investors. Taken together, the proposed PE rules (including the proposed domestic source rule) are complex and based on discussions we are having with a range of corporates, it is likely to be unclear based on current draft wording which (if any) PE rule applies in what circumstances to their business activities. This is further complicated by the interaction of the proposed PE changes with New Zealand s double tax agreements, and New Zealand s pending commitments under the Multilateral Instrument. The practical reality for a New Zealand business subject to both the proposed RTP Rule and outbound transfer pricing regimes has not been sufficiently considered by the Government, and could produce ambiguities in the pricing of the same transaction under the different tax regimes. The approaches in drafting of the various proposed regimes within the Bill are also fundamentally different. The proposed PE rules have been drafted in a very broad manner, making it necessary to rely on the Bill Commentary to understand its scope. In stark contrast, the proposed RTP Rule is too prescriptive (and unsatisfactory) in its drafting, which will lead to unintended outcomes (including applying the rules to low-risk structures) and making it difficult to rely on the Bill Commentary/IR guidance. Within our submissions on the specific regimes included the Bill, we have highlighted further work required to ensure consistency and coherence within the changes. To achieve this, a thorough review of the Bill with a top-down view is required by the Government. Inland Revenue supplementary guidance is required in numerous areas Comment and submission We submit that given the complexity of the changes included in the Bill, to be effective and to provide clarity to taxpayers once enacted, Inland Revenue needs to provide detailed supplementary guidance (with more detail and examples than are in the Bill Commentary). Such guidance must be Page 6

7 provided with sufficient time to be read by taxpayers in conjunction with their review of the application of the proposed rules before they apply. In our submissions on the specific proposed regimes in the Bill, we have noted on several occasions the areas where further guidance from Inland Revenue will be critical to the operation of the new regimes (if enacted), given how fundamental the changes are. These areas include the following: For the proposed hybrid and branch mismatch regime, significant guidance is required for this overly complex set of rules. We have listed a number of areas where guidance is required, including but not limited to, examples of when an arrangement may be considered a structured arrangement, when a counterparty is resident in a jurisdiction with equivalent hybrid and branch mismatch rules, and also, for the practical operation of the imported mismatch rules. For transfer pricing purposes, guidance is strongly recommended as to when the Commissioner may exercise her powers to disregard or replace what are viewed as commercially irrational transactions. This power is essentially giving Inland Revenue the ability to tell a taxpayer how to conduct its business commercially, and therefore, should be applied in extremely limited circumstances. For the proposed RTP Rule, if this proposal proceeds (contrary to our submission that it be removed), further definition and guidance is needed in a number of areas, including around the concept of a credit rating. This guidance should include, for example, reference to accepted credit rating methodologies (i.e. Moody s, S&P, or Fitch) and their application, as well as how implicit parental support should be taken into account. For the proposed thin capitalisation anti-avoidance rule, significant guidance is needed on its intended application including, for example, when an increase or decrease in value is attributable to a seasonal factor, one-off transaction or standard end-of-year procedures. For the proposed PE avoidance rule (as with PEs generally), urgent guidance is needed in relation to how the attribution of profits to the deemed PE should be applied. Drafting of the Bill needs to be thoroughly reviewed and revised Comment and submission We submit that the drafting of the Bill needs to be thoroughly reviewed again and revised. The language used in the Bill is difficult to follow and at times vague, which results in further unwarranted uncertainty in the future for taxpayers. As noted above, the cumulative effect and interaction of changes does not appear to have been considered adequately from a real world and practical compliance and complexity perspective. In our view, any resulting legislation needs to be easy to understand and provide a high level of certainty for taxpayers, especially given the large number of taxpayers that the Bill will affect. The current drafting is far from that level in a number of areas. There are a number of drafting errors contained in the Bill. We have included some of these in the Appendix, however, as mentioned in our covering letter, the Bill is not yet at a stage where providing fulsome comments on the legislation is beneficial, given the substantial revision / redrafting of the legislation that in our opinion is required. We would be happy to discuss the redrafting of the legislation directly with Inland Revenue Policy Officials as it progresses. Page 7

8 Section 2: Thin capitalisation rules Non-debt liabilities and anti-avoidance provision Proposal The Bill proposes a number of changes to the current thin capitalisation rules including a change that the debt percentages is to be based on an entity s assets net of its non-debt liabilities, and a new anti-avoidance rule. Comment and submission We submit that: Clauses 10, 11, 18, 19, 22 to 29, 31, 33 and 43(25) the treatment of non-debt liabilities in assessing capacity for debt of an entity needs to better reflect how they would be treated by a third party lender. For example: deferred tax liabilities should be excluded from being a non-debt liability; specific carve-outs should be included for certain industries and scenarios; the proposed anti-avoidance rule is too wide and better Inland Revenue guidance is needed as to its application; and a mechanism to carry forward denied interest deductions should be included. The treatment of non-debt liabilities is not supported by commercial lending practices As stated in the Bill Commentary, one of the core objectives of the New Zealand s thin capitalisation rules is to ensure that taxpayers are limited to a commercial level of debt in other words, the amount of debt that would be provided by a third party. It follows that the rules should be based on factors that would be taken into account by a third party lender. Such an approach also accords with the approach outlined in the OECD s BEPS Action 4 Report, 2 which refers throughout to third party debt. Furthermore, the Government has acknowledged OECD guidance which states that thin capitalisation regimes are consistent with the arm s length principle insofar as they aim to approximate an interest expense that would arise in third party situations 3 in other words, to be consistent with double tax treaties, a thin capitalisation regime should be set by reference to commercial lending principles (rather than by reference to a different measure, such as trying to evaluate the true equity investment (which is a comment made recently by Inland Revenue Policy Officials)). Currently, in applying the thin capitalisation rules, taxpayers are required to consider their debt capacity as a proportion of total assets. The Bill currently proposes that taxpayers will measure assets net of non-debt liabilities, with non-debt liabilities being all liabilities shown in the company s financial accounts that are not debt for the purposes of section FE 15. In our view, this change is too wide and will result in the thin capitalisation regime being applied to non-debt 2 OECD, Limiting Base Erosion Involving Interest Deductions and Other Financial Payments, Action Final Report, October 2015 (Action 4 Paper). 3 BEPS Strengthening our interest limitation rules: A Government Discussion Document (March 2017), paragraph Page 8

9 liabilities in a way that is more stringent than would be the case in a commercial third party lending situation. We agree with the proposal to exclude certain shareholder funding arrangements from non-debt liabilities on the basis that such funding is equity like in nature. However, we submit that additional carve outs from non-debt liabilities are needed as there are a number of other accounting provisions that a commercial lender would not overly focus on (e.g. remediation cost provisions). The existence of such provisions would therefore have limited impact on the borrowing capacity of a taxpayer. In our experience, commercial lenders primarily focus on the level of nondebt liabilities only when other creditors have better priority over specific significant assets. Deferred tax should be excluded from being a non-debt liability In particular, we strongly submit that deferred tax liabilities should be excluded from being a nondebt liability, because: third party lenders would generally not take deferred tax liabilities into account when making lending decisions as even if the liability represents an actual future cash cost to the borrower there is normally a high level of uncertainty as to when such a liability may, or may not, crystallise; and there is inherent uncertainty and complexity within both the concept of deferred tax liabilities and the limited exclusion currently included in the Bill. We understand that after discussions with us and other interested groups over the last 6 months, Inland Revenue Policy Officials were relaxed about accepting original submissions and not having deferred tax liabilities as non-debt liabilities for thin capitalisation purposes. However, it appears that Inland Revenue Policy Officials view has changed again, and instead a cumbersome and complicated half-way house for excluding some deferred tax liabilities will be available (but on very restricted terms) (proposed section FE 16B(1)(e)). We disagree with this approach and still consider that all deferred tax liabilities should be outside non-debt liabilities. As discussed previously with Inland Revenue Policy Officials, we do not consider the limited deferred tax exception appropriate as currently drafted because we are very concerned that it is not wide enough, is overly complicated, and will be impossible to use for a number of taxpayers. As noted above, the complexity is not needed, and seems to be aimed at creating a very high compliance threshold for taxpayers to be able to use the exemption. Examples of the vague drafting implications of the exception include the following: Practically, it will be difficult for many taxpayers to undertake the analysis required to be able to use the exception due to lack of information or poor records, particularly where deferred tax liabilities have been accumulating over many years such taxpayers should not be unfairly penalised by legislation that is subsequently introduced that has the effect of requiring more fulsome record keeping. Proposed subparagraph (ii) of section FE 16B(1)(e) applies where a non-taxable gain arises on the disposal of the asset. This assumes that any gain on the disposal of the asset will consistently remain either taxable or non-taxable. This may not be the case and it is possible that a particular asset can switch from being taxable to non-taxable or vice versa. For example, under the land taxing provisions an asset may flip from being taxable to non-taxable, or vice Page 9

10 versa, depending on the length of time the asset is held or the activities of the taxpayer s associates. It is not clear what subparagraph (iii) of section FE 16B(1)(e) is intended to achieve the draft words used could have multiple meanings (and no guidance has been given). The words could be read as requiring taxpayers to use the asset s adjusted tax value for financial reporting purposes, which would not be possible under IFRS. We assume this meaning is not intended. Subparagraph (iii) could also be read as requiring taxpayers to undertake some form of valuation exercise to calculate the value of the asset on a theoretical liquidation / disposal event which may or may not ever occur. The reality is the real world of buying and selling assets rarely works like that. A sale price is agreed, but in our experience the impact that the depreciation deductions have on the negotiated purchase price is difficult to assess. In order to apply the exception taxpayers will need to test annually if the specified requirements are met. This is likely to result in dramatically increased compliance obligations for all taxpayers. By way of practical example to illustrate the complexity, say a taxpayer owns a building, which is held on capital account, and the building is revalued annually in its financial statements, but it also has pre-may 2010 tax depreciation deductions and the commercial fit-out pooling regime has been applied. The deferred tax liability position for this single building could include non-taxable gains, depreciation recovery income (pre-2010 and on the fit-out) and a make-good provision. The deferred tax liability for this building will therefore include a non-taxable portion (being the revaluation gains), a taxable portion (being the depreciation recovery income) and a portion that may or may not crystallise, being the make good provision. So for a single asset the taxpayer will need, on an annual basis, to split its deferred tax liability in order to apply the exemption criteria. This will be complex and have high compliance costs. We note that the Australian thin capitalisation legislation has specifically excluded deferred tax from non-debt liabilities for many years. We strongly expect it was carved out for similar reasons as set out above. Further carve-outs are needed for some industries and liabilities We have provided numerous client examples of industries that would be severely adversely affected by the adoption of a blanket approach to what is considered a non-debt liability during consultation with Inland Revenue Policy Officials to date, for example the securitisation, securities lending, retirement village and the forestry industries. In our view specific carve outs for some of these industries or scenarios are needed, e.g. non-interest bearing deposits should be excluded from non-debt liabilities for thin capitalisation purposes even if not provided from a shareholder. The anti-avoidance rule is wider than necessary and Inland Revenue guidance is needed as to when it will apply We submit that: the proposed thin capitalisation anti-avoidance provision is wider than necessary to address the concerns expressed in the Bill Commentary and will result in significant uncertainty for taxpayers; Page 10

11 at a minimum, a safe harbour time frame should be included, after which an increase or decrease in a value would not be considered to have the purpose or effect of defeating the intent or application of the thin capitalisation rules; and there is already an anti-avoidance provision which allows temporary reductions in debt and subsequent increases post balance date to be ignored for thin capitalisation calculations, if changes were tax motivated. This existing provision should be sufficient. We appreciate the need for anti-avoidance rules to be appropriately general in nature so as to capture tax outcomes which contradict policy rationale. However, the proposed rule as currently drafted is far reaching and could be erroneously applied to challenge tax outcomes that are supportable by ordinary commercial arrangements and not motivated at all by thin capitalisation implications, including but not limited to revolving credit, working capital and other short-term funding facilities. Furthermore, in our experience it is not uncommon practice for multi-national groups to use the year-end financial audit process to tidy up inter-group provisions, accruals and other balances that have arisen during the income year. Such commercial practices are not undertaken with tax motivations and therefore should not be at risk, as they currently could be based on the Bill, of falling foul of the proposed anti-avoidance rule. We reiterate that the current anti-avoidance provision in the thin capitalisation regime should be sufficient. If the proposed provision is maintained, in our view, at a minimum, it should include a safe harbour time frame beyond which an increase or decrease in a value would not be considered to have the purpose or effect of defeating the intent or application of the thin capitalisation rules. Allowance should also be made for immaterial movements in the values. The proposed provision, if enacted, will need to be accompanied by significant Inland Revenue guidance on its intended application. In our view, the proposed provision should not capture an increase or decrease in value that is attributable, co-incidentally or otherwise, to a seasonal factor, one-off transaction or standard end-of-year procedures. An example of this is a retail taxpayer who generates significant cash flows within close proximity to its measurement date, and is therefore able to temporarily reduce the value of debt drawn down from its working capital facility. Given the potentially far-reaching impact of the proposed provision, if enacted, taxpayers will need adequate comfort that ordinary commercial arrangements will not be challenged nor considered to have been entered into for the purpose or effect of defeating the thin capitalisation rules. An interest carry forward rule should be included We submit that: an interest carry forward rule should be introduced to offset and balance the volatility and uncertainty that arises as a result of the proposed legislation. Taking non-debt liabilities into account in calculating an entity s capacity for debt will introduce potentially material volatility and uncertainty to that entity s thin capitalisation calculations. This uncertainty will be compounded due to the currently drafted thin capitalisation anti-avoidance legislation. Page 11

12 We consider that this volatility is a similar concern to that recognised in the Bill Commentary as a problem with an EBITDA-based test and that taxpayers should be afforded protection from such unpredictability. Given the volatility is similar to that under an EBITDA-based test, protection similar to that suggested by the OECD (that is, the ability to carry forward denied interest deductions) should be adopted. 4 Such a mechanism is intended to smooth out the effect of such volatility over subsequent income years. Infrastructure project finance Proposal The Bill proposes amendments to allow entities carrying on eligible infrastructure projects a limited exemption from the thin capitalisation rules by allowing them to claim deductions on debt that exceeds the thresholds set out in section FE 5(1). Comment and submission Clauses 5, 17, 20, and 43(18) We support the proposed carve out for infrastructure projects undertaken by public-private partnerships (PPPs). However, the eligibility criteria for the carve out should be broadened to ensure the concession can be accessed by all taxpayers for whom the concession is intended to apply. In particular: The requirement for public project asset to be owned by the Crown or a public authority is likely to unnecessarily restrict the concession from being accessed by taxpayers engaged in public projects for example, recent social housing projects have been entered into on terms where some or all of the assets may become private property at the end of a project. At a minimum, flexibility and discretion should be given to Inland Revenue for the concession to be provided to any taxpayer engaged in PPP projects for public good. The type of excess debt entities for which the carve out could apply for is too restrictive. In our view, the carve out should be made available to all taxpayers to whom the general thin capitalisation rules could apply for, provided the remaining eligibility criteria are also met. Currently, the exemption drafted is effectively further limited to a company controlled by a group of non-resident persons who are acting together ( non-resident owning body concept, extended to a group of non-residents acting in concert ). This restrictive criteria should be relaxed, provided the other PPP criteria are satisfied. 4 Action 4 Paper, Para 159 to 166. Page 12

13 Section 3: Permanent establishment and source rules PE avoidance Proposal The Bill proposes a new anti-avoidance rule for large multinationals (with over EUR 750m of consolidated global turnover) that structure to avoid having a permanent establishment (PE) in New Zealand (PE Avoidance Rule). The proposed rule will deem a non-resident entity to have a PE in New Zealand in certain circumstances, which will be deemed to exist for the purpose of any applicable double tax agreement (DTA), unless the DTA incorporates the OECD s latest PE article. Related changes include a new domestic law definition of a PE, and new source rules. Comment and submission Clauses 4, 34, 43 (definitions), and 44 to 48 We appreciate that the Government is concerned about the effectiveness of New Zealand s PE rules. The Bill Commentary clarifies the original proposals in response to submissions received as part of the consultation process. We are pleased to see that the Government has taken on board a number of our submissions as to the scope of the new rules from a policy perspective. However, we submit that: the draft legislation requires further clarification in a number of areas, in particular with respect to the scope and application of the proposed PE Avoidance Rule and its application date; the profit attribution methodology applicable to PEs remains an area of concern Inland Revenue needs to properly consider this issue and provide guidance; the Government needs to consider the risk of multinational groups ceasing to operate in New Zealand when deciding whether to enact this rule; there should be a post-implementation review of the proposed PE Avoidance Rule; and taken together with the proposed PE source rule, and New Zealand s pending commitments under the Multilateral Instrument, the Government should provide guidance as to which PE rule applies in which circumstances to provide assistance to taxpayers; and the Government should consider whether potential double withholding tax on royalties attributed to a deemed PE is appropriate policy. In relation to the source rules, we submit that proposed section YD 4(17D) should be deleted as it is unnecessary, and will fundamentally change New Zealand s approach to the interpretation of double tax agreements, which will lead to confusion for taxpayers. We expand on these points below. Further clarity is required in the legislation around the distinction between sales and marketing activities We are pleased to see that the Government has taken our comments from previous consultation into consideration in providing more clarity around the distinction between sales activities (caught Page 13

14 by the proposed PE Avoidance Rule) and marketing activities (not caught). Specifically, the Bill Commentary is helpful in acknowledging that: only activities designed to bring about a particular sale to an identifiable person could potentially result in a deemed PE in New Zealand; activities which do not relate to a particular sale (such as advertising and marketing) would not be sufficient to trigger a deemed PE; after-sales activities (i.e. technical support) would not trigger a deemed PE given they have occurred after the supply has been made; and ordinary distributor arrangements are not within the scope of the proposed rule. However, in our view, the draft legislation does not adequately reflect this policy intention (with the exception of the final point above). Proposed section GB 54(1)(b) captures all activities which are for the purpose of bringing about the facilitated supply to the recipient, unless those activities are preparatory or auxiliary. It is not evident that the activities outlined in the Bill Commentary are omitted from this broad statutory language, and the legislation should be narrowed to more clearly reflect what is intended. The Bill Commentary suggests that any activities designed to convince a particular customer to acquire the supply are caught within the intended scope of the proposed rule. There is a broad spectrum of customer relationship activity (both direct and indirect) in commercial practice. In many cases, it will not be clear (a) whether activity is specifically designed to convince New Zealand customers to enter into a particular sale, or (b) whether an identified activity leads to a particular sale or not. The following examples demonstrate the lack of clarity in whether a deemed PE exists under the proposed PE Avoidance Rule: A multinational has a New Zealand subsidiary, whose staff are contracted to visit existing customers and explain products and the sales process, but refer customers to the multinational s website for orders of goods on standard terms. Given that the activity of the staff may not be tied to a particular supply (and in fact they may not know if a supply has been made), we expect this activity would not be caught by the proposed rule. If the staff are instead contracted to visit potential customers, is the position different to above? Is it intended that any direct customer contact is captured by the proposed rule? We assume this activity is unlikely to be caught by the proposed rule in most cases as it would be preparatory. A multinational has a New Zealand subsidiary, whose staff have initial and ongoing contact with customers, but orders after the first order are placed directly with an offshore sales representative does the ongoing direct contact mean all future orders are within the scope of the rule? We assume the proposed rule is only intended to capture the first order as no subsequent activity is directed towards a particular sale. What if a customer services representative offers training and support to a customer? This activity may be done to influence the customer to continue ordering product, but is this activity direct enough to be caught by the rule? We assume this is not the intention as the training and support will in most cases be auxiliary. Page 14

15 Inland Revenue should provide further guidance and examples to clarify when the proposed PE Avoidance Rule is intended to apply. Urgent guidance is needed in relation to attribution of profits to the deemed PE We understand that the intended outcome of the proposed PE Avoidance Rule is to match tax paid in New Zealand by multinational groups with the economic value created by the activity carried on in New Zealand. However, we do not consider the proposed approach to profit attribution will achieve this intended outcome. We have previously raised a concern with Inland Revenue regarding the attribution of profits to the deemed PE, and have called for urgent guidance on this matter. The Bill Commentary is helpful in confirming that the attribution of profits to a deemed PE will follow the earlier version of the OECD s PE profit attribution rules and therefore will align to Article 7 of our existing DTAs. This is because New Zealand has made an explicit reservation against the Authorised OECD Approach to profit attribution. New Zealand s current profit attribution approach only permits actual costs incurred by the nonresident to be attributed to a New Zealand PE. Therefore, the amount of profit subject to New Zealand tax can be disproportionate to the economic activity of the PE because, for example, value attributed to intellectual property generated offshore may be taxed in New Zealand. This is the wrong result and is not in accordance with our understanding of the desired policy outcome. Furthermore, this outcome does not align with the proposed changes to the transfer pricing rules which are intended to base New Zealand s tax rules on economic substance rather than legal form. We acknowledge that this issue with profit attribution already exists. However, it will become increasingly relevant if the PE Avoidance Rule is enacted as it is likely that there will be an increased number of PEs in New Zealand. It is essential that the Government reconsiders its approach to profit attribution to better reflect the economic substance of activity carried on in New Zealand. Alternatively, Inland Revenue needs to assist taxpayers by releasing more detailed guidance in this area as to how the appropriate economic outcome can be achieved within the existing framework. There needs to be more clarity around the other requirements of the proposed PE Avoidance Rule We had raised a number of elements of the proposed PE Avoidance Rule during the consultation period with Inland Revenue which required clarification. The Bill Commentary has been helpful in clarifying a number of these points. However, there are still matters requiring further explanation. For instance: Is the facilitator (proposed section GB 54(1)(b)) intended to capture employees of the nonresident acting in New Zealand? If a non-resident has an employee that visits New Zealand on one occasion to visit a customer to convince them to make an order for a product, that employee could fall within proposed section GB 54 and give rise to a PE for the non-resident. Is this intended? We assume not, as in most cases the non-resident would not have a PE if the OECD s expanded PE definition was applied instead. Would the non-resident would have 2 PEs in New Zealand if it has an existing PE in New Zealand but also falls within the scope of the proposed PE Avoidance Rule (we expect not, but further guidance would need to be provided on profit attribution to the deemed PEs if the nonresident would have 2 PEs). Page 15

16 It would be helpful to establish the scope of the new rule if Inland Revenue guidance included features of arrangements that the Government considers to be indicators of PE avoidance. The application date should be clarified. We understand the policy intention is for proposed section GB 54 to take effect for income years from 1 July 2018 but this is not currently reflected in the Bill. Significant risk that multinationals may exit New Zealand Uncertainties around the scope of the proposed PE Avoidance Rule and profit attribution are likely to lead to multinationals restructuring their affairs so the proposed rule does not apply (as has been the experience in Australia following the enactment of their Multinational Anti Avoidance Rule). There are fundamentally two ways in which a restructure can occur: the non-resident and its New Zealand subsidiary could enter into a buy/sell structure, where the New Zealand subsidiary buys product or services, and / or licenses IP, from the nonresident on arm s length terms and sells directly to New Zealand customers; or the non-resident could wind up its New Zealand subsidiary and either: - not sell product in New Zealand; or - sell product in New Zealand directly from overseas with no group employees in New Zealand. The Bill Commentary is helpful in confirming that Inland Revenue anticipates (and is happy for) multinationals to restructure their New Zealand operations in line with the first scenario. However, we consider the second scenario to be likely in many cases, in light of the relative size of the New Zealand market compared to global operations of affected multinationals, and time and cost involved in restructuring. The Government needs to consider whether it is an acceptable risk that foreign investment into New Zealand will be reduced. There should be a post-implementation review within 3 years of enactment We submit that there should be a post-implementation review of the proposed PE Avoidance Rule within 3 years of enactment. Given the OECD work programme and similar domestic law changes being made in other countries, any new legislation should be measured against necessity and inconsistencies with other jurisdictions. At that time, the Government should consider whether the proposed rule has resulted in unintended consequences for business and Inland Revenue, such as multinationals exiting their investment into New Zealand. The Government should provide guidance as to which PE rule applies in which circumstances Taken together, the new PE rules (including the new domestic source rule) are complex and it may be unclear to taxpayers which PE rule applies in what circumstances to their business activities. This is further complicated by the interaction of the proposed PE changes with New Zealand s double tax agreements, and New Zealand s pending commitments under the Multilateral Instrument. Inland Revenue should provide guidance as to which PE rule applies in which circumstances to assist taxpayers in correctly implementing the various proposed changes. Page 16

17 Royalties attributed to a deemed PE will have a New Zealand source and may be subject to double withholding tax The proposed PE Avoidance rule may result in royalties paid by non-residents being attributed to a New Zealand PE, and therefore deemed to have a New Zealand source. A royalty paid by a non-resident to another non-resident may be subject to foreign withholding tax in the country of residence of the payer. If all or part of a royalty is deemed to have a New Zealand source, and is therefore subject to New Zealand withholding tax, that royalty will be subject to withholding tax twice. In those circumstances, relief would not be available under a double tax agreement. We submit that the Government should consider whether this is acceptable tax policy. Amendments to the source rules Proposed source rule is unnecessary and fundamentally changes New Zealand s approach to interpreting double tax agreements Proposed section YD 4(17D) of the Bill implies that a DTA, once assigning a taxing right to New Zealand, imposes a New Zealand source on this income. This represents a fundamental change in accepted approach to treaty interpretation in New Zealand, where the domestic law position should be established before a double tax agreement is applied. It is unclear what income is captured through this provision which is not already covered as part of the source rules (including the new PE source rule). Given the potential confusion this provision could lead to if enacted, it should be deleted. Page 17