The views reflected in this document are the views of the authors and do not necessarily reflect the views of the global EY organisation or its member firms. Tax watch: Edition 2 March 2017 Transfer Pricing, Permanent Establishment and Interest Limitation Changes Announced Finance Minister Steven Joyce and Revenue Minister Judith Collins have called for feedback on three consultation papers proposing new measures to strengthen New Zealand s rules for taxing large multinationals. The proposals are far reaching. We expect increased disputes between taxpayers and Inland Revenue. All multinationals with crossborder transactions, especially related party finance and/or global turnover in excess of 750 million need to work through the implications for their structure. BEPS Transfer pricing and permanent establishment avoidance proposes rules to bring more entities into the New Zealand tax base, increase emphasis on
transfer pricing documentation and give Inland Revenue greater powers to re-characterise transactions and to raise assessments. BEPS Strengthening our interest limitation rules will reduce the amount of interest payments deductible on related party finance and also on non-related party funding given the proposed changes to the thin capitalisation rules. New Zealand s implementation of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS confirms that New Zealand will modify our existing double tax agreements in line with OECD recommendations. These changes would put New Zealand at the forefront of countries implementing the G20/ ECD Base Erosion and Profit Shifting (BEPS) recommendations. Collins sees the changes as a considered, balanced approach. We welcome her statement that most firms are not gaming the system. That s consistent with EY s research on corporate debt levels which showed overall corporate debt levels are relatively modest and multinationals are not significantly indebted when compared to New Zealand-based companies. The proposed changes to the thin capitalisation rules will impact some corporates currently well within the safe harbour. While we have not seen evidence sufficient to justify complex new rules, Government action is inevitable, given its support for the OECD s work. Submissions on the major changes are due by 18 April 2017 immediately after Easter. All multinationals with cross-border transactions, especially related party finance and/or global turnover in excess of 750 million need to work through the implications for their structure. Talk to us today Geoff Blaikie Head of Tax + 64 272 930 787 Aaron Quintal Partner Tax + 64 274 899 029 David Snell Tax Watch Editor Executive Director Tax + 64 21 845 361 2 Tax Watch: Edition 2, March 2017
Transfer pricing and permanent establishment avoidance New Zealand copies Australia s multi-national anti-avoidance rule Collins proposes to strengthen transfer pricing rules to align with OECD guidelines, Base Erosion and Profit Shifting (BEPS) recommendations and Australia s new multi-national anti-avoidance rule (MAAL). A new anti-avoidance rule will apply to multinationals with over 750 million global turnover. It will target multinationals structuring their sales to avoid a taxable presence in New Zealand. The central theme of these changes is the Government s intention to align tax outcomes with the economic substance of a transaction. Recharacterising a transaction according to a subjective view of economic substance can lead to uncertainty. We anticipate a rise in the level and complexity of crossborder tax disputes. Inland Revenue will also get tough new powers of assessment to bring uncooperative multinationals to account. Recharacterising a transaction according to a subjective view of economic substance can lead to uncertainty. We anticipate a rise in the level and complexity of cross-border tax disputes. 3 Tax Watch: Edition 2, March 2017
Transfer pricing rules to be reconstructed in Inland Revenue s favour Transfer pricing at its simplest refers to the determination of prices charged in cross-border transactions between related parties. Transactions include the purchase of goods, services, provision of funds, and use or transfer of intangibles. Inland Revenue s concern is that some related parties will pay an artificially high or low price compared to the arm s length price or conditions that an unrelated third party would accept. Profits could then be shifted out of New Zealand and into a lower tax jurisdiction. While New Zealand already has transfer pricing rules which aim to stop such tax planning, Inland Revenue finds it difficult to enforce existing law. Changes are therefore proposed to: Allow the Commissioner to disregard the legal form of a transaction if it does not align with her view of its economic substance Reconstruct transactions where, in the Commissioner s view, the transaction would not be agreed by independent businesses operating at arm s length Require all conditions of a crossborder related party loan (not just the consideration) to be at arm s length Shift the burden of proof to show that conditions are arm s length onto the taxpayer rather than the Commissioner Apply transfer pricing rules to investors that act together even though they are not related, such as private equity investors, and Extend the time-bar for transfer pricing to seven years, up from the current four years We are concerned the Commissioner is not necessarily well placed to judge all the factors which would be involved in an arm s length commercial negotiation. We are concerned the Commissioner is not necessarily well placed to judge all the factors which would be involved in an arm s length commercial negotiation Many of these proposals are copied from Australia which has aligned its transfer pricing rules to the OECD standard. The Australian Tax Office (the ATO) has had the power to reconstruct transactions since 2012. Our experience in Australia is that uncertainty and disputes have increased. The ATO interprets arm s length conditions broadly, and has the ability to reconstruct transactions where independent parties would, in its view, have agreed to transact under different conditions. 4 Tax Watch: Edition 2, March 2017
Limited risk distributor model under threat Multinationals often operate under a customary limited risk or routine distributor structure to distribute goods in New Zealand. A limited risk distributor typically undertakes sales and marketing activities and logistics. Its offshore principal (or other affiliates) perform more of the strategic and value-creating activities. Typically, a limited risk distributor buys products on its own account from its overseas principal for sale to local customers on the basis that the principal is well placed to control and manage various business risks and will underwrite the financial performance of the distributor. The routine type activities often mean the distributor returns a modest, but guaranteed, profit margin in New Zealand: the economic substance is that little value is added here compared to the various value-add activities occurring offshore in other group companies. The proposal suggests that such structures may be To suggest that such structures may be considered unrealistic and not meet the arm s length standard is concerning. The example given is too simplistic to draw such conclusions. commercially unrealistic and not how a third party distributor would necessarily be engaged to sell products. The document has an example of a regional procurement hub sourcing products and on-selling to a New Zealand related distributor entity. To suggest that such structures may be considered unrealistic and not meet the arm s length standard is concerning. The example given is too simplistic to draw such conclusions. 5 Tax Watch: Edition 2, March 2017
Permanent Establishment Avoidance A permanent establishment is a fixed place of business of a nonresident, such an administrative offices, factory, or workshop. It can also include activities where a dependent agent is concluding contracts in New Zealand on behalf of the non-resident person. New Zealand, like most countries, taxes non-resident business income earned through a permanent establishment here. The Government is concerned that some multinationals are avoiding permanent establishment status by using a related party to carry on sales activities here, and paying tax on only a small profit made by that related party. As an indication of a possible target, the paper gives an example of a non-resident located in a low-tax jurisdiction selling computer equipment to New Zealand customers, with its wholly owned subsidiary undertaking sales activity. Arguably, the non-resident currently has no permanent establishment here, but the proposal would take a substance-driven approach looking at the activities of the subsidiary and non-resident as a package. The non-resident s low-tax location will be taken as a strong indication of permanent establishment avoidance. The Government proposes to copy the UK s diverted profits tax and Australia s MAAL. The proposal would deem a non-resident entity to have a taxable permanent establishment in New Zealand where a related entity carries out sales related activities here: The rule would apply to large multi-nationals with global turnover of 750 million Avoidance would be considered where a multinational structures their affairs so as to avoid having a taxable presence (permanent establishment) in New Zealand The test focuses only on salesrelated activity by related parties. General preparatory or auxiliary activities, such as advertising and marketing, should not by themselves trigger a deemed permanent establishment, nor will activities of an unrelated independent agent Once a permanent establishment is deemed to exist, Inland Revenue expects a fairly significant amount of the sales income to be taxable here through the deemed permanent establishment. Inland Revenue The Government is concerned that some multinationals are avoiding permanent establishment status by using a related party to carry on sales activities here, and paying tax on only a small profit made by that related party. has also indicated they will apply a 100% shortfall penalty As we are seeing for Australia s MAAL, the deemed permanent establishment proposal will create considerable uncertainty. Potentially affected multinationals will need to examine their supply chains, contractual arrangements and group structures to assess the possible impact on their business. We would like to see improved guidance from Inland Revenue on how the proposals will work in practice. Profit attribution for permanent establishments will be more important than ever. 6 Tax Watch: Edition 2, March 2017
Administrative measures to make it easier for Inland Revenue to assess large multinationals Inland Revenue claims that it needs additional powers to deal with uncooperative multinationals that refuse to provide relevant information. The rules will apply to multinationals with over 750 million global turnover: Non-cooperation will include failure to provide information within a statutory timeframe, failure to respond to Inland Revenue correspondence and provision of materially misleading information Inland Revenue will then be able to issue a Notice of Proposed Adjustment or assessment based on the information it does hold Tax at stake will also be payable early in the disputes process Inland Revenue will be given additional powers to request information from group members outside New Zealand, and Fines of up to $100,000 are proposed for information offences committed by multinational groups. These rules are intended to apply only rarely and it is good to see that sanctions will not be applied without warning. Nevertheless, we are concerned that Inland Revenue will move too quickly towards default assessments based on arbitrary profit splits. This would depart from the standard OECD approach and lead to disputes and potentially double taxation. 7 Tax Watch: Edition 2, March 2017
Could documentation provide protection? Shifting the burden of proof onto taxpayers, along with tougher administrative sanctions, places more weight on having high quality transfer pricing documentation. A statutory requirement to prepare documentation is not proposed, even though 79 per cent of large multinationals operating here already prepare some form of documentation. However, by incorporating the OECD transfer pricing standards into domestic law, Inland Revenue is expecting multinationals to meet the master file/local file requirements as a minimum. Contemporaneous documentation will become increasingly important to ensure the onus of proof can be discharged and penalties mitigated. Inland Revenue enforcing documentation rules, and providing guidance on the standard expected, could be a good step towards managing taxpayer risk. It would allow the Commissioner to concentrate her resources on issues which really matter. Smaller businesses within a de minimis level of cross cross-border activity could be exempt from any documentation requirement. Contemporaneous documentation will become increasingly important to ensure the onus of proof can be discharged and penalties mitigated. Plan for change from 2019 The Government wants submissions by 18 April 2017. We would not expect any final decisions until closer to the election, with nothing enacted before 2018. Changes to the permanent establishment and transfer pricing rules would apply to income years beginning on or after the date of enactment. Mark Loveday Partner International Tax Services + 64 274 899 336 Andy Archer Partner International Tax Services + 64 274 899 052 8 Tax Watch: Edition 2, March 2017
Interest limitation rules New Zealand to reduce interest deductions on debt New Zealand has thin capitalisation rules to limit interest deductions for many foreign owned businesses. Overall the current rules work well. The Government proposes to tighten the thin capitalisation rules by limiting the interest rate that can be applied to related party loans from a non-resident New Zealand borrower. It also proposes to exclude non-debt liabilities such as trade credits, employee provisions, tax liabilities, impairment and other provisions and industry specific liabilities like policyholder liabilities and outstanding claims reserves from the thin capitalisation asset base. Its concern is a minority of firms are borrowing from foreign affiliates at very high interest rates, leading to excessive interest deductions. The proposed changes will also limit deductions for New Zealand originated and other nonrelated party debt. Most multinational firms take conservative debt positions, with moderate gearing levels. Even so, they will need to work through these changes. All companies with debt will need to review their position These changes will mean: Debt to asset ratios will need to be recalculated with a reduced gearing level allowed Existing loans will need to be repriced, increasing compliance costs for many companies Likely disputes with foreign lenders unwilling to accept lower interest rates, and Risk of double taxation with overseas tax administrations demanding a higher return Most multinational firms take conservative debt positions, with moderate gearing levels. Even so, they will need to work through these changes. 9 Tax Watch: Edition 2, March 2017
Interest rate cap to be based on parent credit rating The Government intends to cap the deductible interest rate on related party loans, based on the interest rate of the ultimate parent. The cap will take account of the yield derived from so-called appropriate senior unsecured corporate bonds at the parent level, plus a margin. The suggestion is that an appropriate margin would usually be one credit notch. For example, an AA- rated multinational group could base its deductible interest rate on an A+ corporate yield for senior unsecured debt. The term of the loan will be restricted to 5 years. A de minimis rule will apply for groups where the principal of all cross-border related-party loans is less than NZ$10 million. In these cases, Inland Revenue s current approach will continue. This change underplays commercial reality. In our experience, businesses do not base their financing decisions on interest rate alone. Most will look at a range of factors such as term, security, funding source, relationship with bank, banking covenants and ability to control an asset unfettered before arriving at their preferred funding mix. We also have concerns that the New Zealand subsidiary s cost of borrowing may differ markedly from that of its parent. Many subsidiaries will have a low standalone credit risk, by virtue of profitability, industry, country specific or local market factors. Of concern is Inland Revenue s assertion that this interest rate cap should generally produce a similar level of interest expense as would arise in arm s length situations. Our experience suggests otherwise. The change is likely to increase the level of disputes with lender countries. 10 Tax Watch: Edition 2, March 2017
Non-debt liabilities to be excluded from thin capitalisation asset base Current thin capitalisation rules give foreign-owned companies a safe harbour allowing tax deductions for interest payments on debt up to 60 per cent of their New Zealand asset value. The Government proposes to restrict allowable assets by excluding non-debt liabilities such as trade credits, employee provisions, tax liabilities, impairment and other provisions and industry specific liabilities like policyholder liabilities and outstanding claims reserves and certain interest-free loans. This change is based on Australian rules. It will mean that New Zealand s safe harbour will be considerably less. The impact will be uneven across industries. Those with high provisions and liabilities such as insurers, mining companies and distributorships will be the most affected. Industry specific concessions should be considered to minimise anomalies. Measurement to be quarterly or daily Businesses will no longer be able to calculate their thin capitalisation position at year-end. Instead either quarterly or daily calculations will be required. This will increase compliance costs. Removal of ability to use net current asset values Businesses will no longer be able to use net current asset values as an alternative to financial statement assets values which is an unnecessary change. The ability to use net current asset values existed to allow businesses to use a better proxy for the market value of assets if such market values are not reflected in financial statements. The rationale for removing this is not compelling. 11 Tax Watch: Edition 2, March 2017
Government does not favour OECD style EBITDA limit The OECD recommends an interest limitation rule based on the level of interest relative to earnings typically based on earnings before interest, tax, depreciation and amortisation (EBITDA). We are pleased that the Government does not favour this approach, given the volatility of interest rates, earnings and difficulties associated with loss making companies. EBITDA-style interest limitation rules do not work well for commodity based economies. Joyce and Collins should be applauded for rejecting them in New Zealand. EBITDA-style interest limitation rules do not work well for commodity based economies. Joyce and Collins should be applauded for rejecting them in New Zealand. Plan for change from 2019 The Government wants submissions by 18 April 2017. We would not expect any final decisions until closer to the election, with nothing enacted before 2018. Changes would apply to income years beginning on or after the date of enactment. Most existing related party loans will be subject to the new interest rate cap from the date of enactment. Matthew Hanley Partner Tax + 64 274 899279 Mark Loveday Partner International Tax Services + 64 274 899 336 Andy Archer Partner International Tax Services + 64 274 899 052 12 Tax Watch: Edition 2, March 2017
Implementation of the multilateral convention to implement tax treaty related measures to prevent BEPS New Zealand s network of double tax agreements to change The Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS (the MLI) introduces a process to modify many existing double tax agreements globally at once. New Zealand expects to be in a position to sign the MLI in mid- 2017. It intends the MLI to cover the majority of our DTA network and to adopt all applicable minimum standards and optional provisions. Call for feedback on practical issues The MLI represents a new approach to international tax law. An officials issues paper requests feedback on how best to implement the MLI and on practical issues associated with its implementation. Likely changes to double tax agreements The articles in the MLI would bring a number of BEPS changes into DTAs including articles: Preventing the grant of treaty benefits in inappropriate circumstances via a principal purpose test (similar to New Zealand s general antiavoidance rule) Preventing the artificial avoidance of permanent establishment status by strengthening the definition of a permanent establishment Neutralising the effect of hybrid mismatch entities, and Providing improved mechanisms for cross-border dispute resolution For a DTA to be modified: Both contracting states need to agree that the treaty will be modified A mirroring process takes place: where each country subscribes to certain articles, and the only articles that apply to modify a double tax agreement are those where both states have consented to the article, and There are a limited number of exceptions which allows reservations in respect of specific articles Once a double tax agreement has been modified, it will also need to be ratified by the parties domestically. In New Zealand, ratification requires parliamentary treaty consideration by select committee. Submissions close on 7 April 2017. Andy Archer Partner International Tax Services + 64 274 899 052 David Snell Executive Director Tax + 64 274 845 361 13 Tax Watch: Edition 2, March 2017
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