Tax Tips Alert: December 2017

The impact of the thin capitalisation regime will "bite" harder (again) for almost all businesses subject to the thin capitalisation rules. The Government intends those changes to apply very soon (i.e. for income years starting on/after 1 July 2018).

The way that thin capitalisation ratios will need to be calculated is proposed to change significantly. If you are currently subject to the thin capitalisation regime, or will be in future, you need to check how the new rules will change your position. If the proposals are enacted as drafted:

• You will be required to calculate the value of your assets, net of your non-debt liabilities -there are some exceptions to this for liabilities that are "equity-like", such as interest-free loans from shareholders, some shares that are classified as debt instruments for accounting, and provisions for the payment of dividends.

• Deferred tax liabilities will count as a non-debt liability, unless the crystallisation of the liability would not actually result in a tax cost (e.g. on a notional liquidation).

• If you calculate your thin capitalisation ratio using net current values rather than financial statement values for certain assets, you will need to get a valuation from either an independent expert or a suitably experienced person using a methodology approved by an expert.

• If you enter into transactions that change your thin capitalisation ratio near a measurement date, you need to make sure those transactions are not entered into with the purpose or effect of manipulating the ratio.

• If the New Zealand companies are in the thin capitalisation regime (because of the measures introduced in 2014), where a group of non-resident shareholders who act together and hold more than 50% (under the current test) and/or act in concert with other shareholders (under the new extension), the safe harbour debt-to-net asset thresholds now will be 60% (or 100% for worldwide debt), subject to grandparenting for five years in relation to the existing 110% worldwide debt threshold.

Limited relaxations of the current thin capitalisation regime are also proposed:

• You may be able to take advantage of the extension of a new $1 million interest de minimis threshold if you are subject to the inbound thin capitalisation rules, but only if you have only third party debt.

• If you are engaged in infrastructure projects that meet certain public infrastructure project criteria, you may be able to claim a full interest deduction on third party debt even if your debt to asset ratio exceeds 60% for the relevant project.

Our comment: The proposals, as introduced, are largely what was signalled following targeted consultation over the last six months. We are particularly disappointed with aspects of the proposals. For example, while the exclusion of deferred tax liabilities from being a non-debt liability has been welcomed, the limited nature of the exclusion as proposed will be difficult for taxpayers to apply and should be relaxed. Other aspects of the new rules will need more clarification than currently given. For almost all taxpayer groups subject to thin capitalisation, these rules will likely have a significant negative effect on the thin capitalisation gearing ratios – some industries much more than others. Taxpayer groups need to be modelling the impact of the proposed change as soon as possible as restructuring may be needed if the ratios are expected to exceed the safe harbour ratios.

If you have borrowed funds from an offshore related party, the way those borrowings must be priced for New Zealand tax purposes is changing significantly. The Government intends to proceed with the proposed 'restricted transfer pricing rule' under which, unless borrowings do not exceed $10m, they must be priced by:

• using a credit rating which is one notch below the ultimate parent's credit rating, or if you have no identifiable parent, a credit rating of BBB-, unless you can demonstrate you are not in a BEPS risk category (which is proposed to be based on prescribed criteria, being your interest coverage ratio, your leverage ratio and the tax rate applicable to the recipient of the interest); and 

• ignoring what the Government views to be "exotic" features not typically found in third-party debt e.g. subordination, a loan term of more than five years and convertibility, unless you can demonstrate that your group has a significant amount of third party debt with those features.

Our comment: We strongly recommend taxpayers start considering now the potential size of impact of these proposed rules for related party debt pricing. We anticipate that it will be difficult for many taxpayers to demonstrate that they are not a "BEPS risk" on the restrictive criteria currently proposed, and will therefore be forced to price debt for New Zealand tax purposes effectively on the basis of their parent's credit rating (minus a notch), whether or not this is commercially rational or appropriate. Furthermore, the proposed rule is very complicated and will lead to (a) high compliance costs for taxpayers, the opposite of the Government’s aims, and (b) cross-border interest rate mismatches (and potentially double tax) where the offshore lender is required to price the loan for overseas tax purposes using normal arm’s length principles. Although the proposed rule was expected following the consultation process, it is disappointing that there are not more "exceptions" to the rule to allow for normal transfer pricing principles where taxpayers can prove that the pricing of the loan is consistent with third party borrowing.

The reach of the transfer pricing regime is being extended - New Zealand companies owned by investors in the same "control group" (which is a new BEPS-related concept and includes acting together/acting in concert to effectively control a taxpayer) will become subject to the regime following enactment.

If you are currently subject to the transfer pricing regime, or will be in the future, you need to check that your current arrangements will comply with the new transfer pricing rules. If the transfer pricing proposals are enacted:

• your legal arrangements will be required to be commercially rational and consistent with their economic substance, otherwise Inland Revenue will be able to disregard or replace them for transfer pricing purposes

• the onus of proof will shift so that you (the taxpayer) will have to prove that your arrangements are on arm's length terms (rather than Inland Revenue having to disprove it) 

• the time bar for making transfer pricing adjustments will be extended from 4 years to 7 years.

Our comment: The proposed transfer pricing changes have been foreshadowed for some time. Taken together, the changes will enable Inland Revenue to adopt a more stringent approach to transfer pricing compliance, in line with the approach currently adopted by the Australian Tax Office. Taxpayers will need to meet a much higher standard to be eligible for penalty protection if they are audited. Detailed and contemporaneous New Zealand-specific transfer pricing documentation in line with the new legislation and following closely the analysis as set out in the new OECD guidelines will be critical moving forward.

If you benefit in any way from a tax advantage that arises due to an entity or arrangement being treated differently for tax purposes by different countries, whether in New Zealand or elsewhere, this benefit is likely to be counteracted under the proposed (and very complicated) “hybrid mismatch” New Zealand tax rules. If enacted as expected, the rules may apply to deny deductions or tax income that is not currently taxed, with limited exceptions to the proposed application date of income years starting on or after 1 July 2018. It is important for any business with related party cross border transactions or an offshore presence to consider as soon as possible the potential impact of these proposals and to engage quickly if restructuring might need to be considered.

Common examples of hybrid mismatches include (see our September 2016 and August 2017 Tax Tips Alert for more detail):

• a payment that is interest in one jurisdiction (therefore deductible) but the receipt is a dividend in another (potentially exempt)

• a limited partnership that is treated as transparent in its country of formation but not in a partner’s country (or vice versa)

• a trust that is not taxed on income anywhere due to how the trust is treated in the country of the settlor, trustee, and beneficiary respectively 

• a branch or a dual resident company that is currently allowed deductions for expenditure in two countries.

The proposals largely follow the OECD recommendations in relation to hybrid and branch mismatches, with some modifications for the New Zealand context. One such modification is that some taxpayers may be required to use the comparative value method to calculate FIF income if the FIF pays distributions that are deductible to the FIF entity.

Proposals to simplify the impact of the anti-hybrid/branch proposals

Following extensive consultation, some measures have been proposed to help taxpayers deal with the potential application of the rules. The key ones are summarised below: 

• Dividend election – a person who pays interest which is non-deductible as a result of the hybrid rules can elect to treat the hybrid instrument on which the interest is paid as a share for New Zealand tax and the payment as a dividend (non-deductible). This could eliminate any potential double taxation arising as the payment may be able to be made without non-resident withholding tax if imputation credits are attached etc.

• Opaque election – a New Zealand resident may elect to treat a wholly-owned foreign hybrid entity (e.g. a foreign partnership) as a company for New Zealand tax purposes, so that there is no hybrid mismatch and the hybrid rules do not apply. 

• Foreign branches – the rules applying to branches have been limited in scope to try to ensure that they do not apply to New Zealand companies with simple branch structures (which are not viewed as a BEPS hybrid risk).

Our comment: These rules are by far the most complex of the proposed measures. They are very difficult to navigate and will apply in many unexpected circumstances. We expect that in many cases it will be hard to ascertain with certainty whether the rules apply. Whilst these rules have been foreshadowed for some time, and are being proposed as a result of the OECD’s recommendations, New Zealand would be only second globally after the United Kingdom to adopt them. The Australian Government has recently released similar proposals, which are likely to take effect after New Zealand’s rules are expected to apply. Given the nature of the rules, our view is that the implementation date should be delayed until more countries where hybrid mismatches are prevalent adopt the OECD recommendations. If enacted as expected, there will be many difficult transitional cases where the New Zealand rules only apply until the other country has enacted rules. It may also be difficult in some cases to determine whether the other country’s rules are “hybrid rules” – for example, there are some aspects to the current United States tax reforms that could be viewed as hybrid rules but will these rules qualify to mean the New Zealand rules do not? 

If you (or your group) have a physical presence in New Zealand but are not currently subject to New Zealand tax on New Zealand sales revenue, or if you pay royalties attributable to New Zealand sales that are not currently subject to New Zealand withholding tax, this may change if the deemed PE proposals are enacted. You should review your business processes and contractual arrangements to confirm whether the new rules apply to you. Similar rules are being adopted in other countries, so if you are New Zealand-based and operating overseas you need to consider whether foreign equivalent rules apply to you.

The new measures proposed to address the Government’s concerns around the avoidance of permanent establishments (PEs) include both domestic measures and changes to New Zealand’s double tax treaties, to be incorporated by the OECD’s multilateral instrument (MLI) (see August 2017 Tax Tips Alert). Each new measure is broadly intended to have a similar scope. However, there are subtle differences between them.

One of the domestic tax law measures, the deemed PE anti-avoidance rule, is intended to override New Zealand’s double tax treaties, although it will not apply where a non-resident benefits from a double tax treaty that incorporates the OECD’s new PE definition under the MLI. New Zealand will also have a new domestic law definition of a PE if the proposals are enacted which will apply if there is not an applicable double tax treaty or at least a relevant double tax treaty PE definition (the new PE definition reflects the OECD’s revised definition of PEs). Which new PE measure applies will therefore be determined by the jurisdiction of residence of the non-resident concerned. Once the existence of a PE is established in New Zealand, income attributed to the PE will be automatically deemed to have a New Zealand source (including royalties paid between non-residents that relate to that New Zealand deemed PE).

The deemed PE anti-avoidance rule is targeted at large multinationals (with consolidated global turnover of more than EUR 750 million), where a related or commercially dependent entity carries out activities for the purpose of bringing about a supply by the non-resident and there is a tax avoidance purpose that is more than incidental. An exception will apply if the activities are preparatory or auxiliary in nature (e.g. general marketing and advertising of a non-resident’s products).   

Our comment: The proposals as introduced are broadly as previously discussed with Policy Officials, with some helpful clarifications in relation to issues we raised during the targeted consultation process. We welcome that the Bill Commentary gives useful guidance as to the scope of activities that the proposed deemed PE anti-avoidance rule is intended to capture. However, in our view, the proposed statutory language itself is far from clear and needs to be more targeted. We expect that there will be confusion for a long time around which new rule could apply, and there will be situations where a domestic rule could seem to apply for a transitional period until a relevant double tax treaty changes due to the MLI or bilateral negotiations.  

If a non-resident has a deemed PE in New Zealand, the next important question is: what profits should be attributed to it? The calculation of the resulting tax outcome for New Zealand is a contentious issue globally (see our March 2017 Tax Tips). Detailed guidance from Inland Revenue is urgently needed to help taxpayers assess tax outcomes if they would be affected by the rules.

If you are a member of a large multinational group (with consolidated turnover in excess of EUR750m), Inland Revenue will have greater powers to investigate your group’s tax affairs and collect New Zealand tax payments if the proposals are enacted. Under the new measures, intended to be mostly focussed on matters around transfer pricing and deemed New Zealand permanent establishments:

• a local subsidiary can be required to provide information held by any member of the group

• a local subsidiary may not be able to use information that it failed to produce when formally requested by Inland Revenue in dispute resolution or challenge proceedings

• the Commissioner may impose a civil penalty of up to $100,000 for the failure to produce information when formally requested

• criminal penalties may apply in situations where information held by other members of a multinational group is not provided when formally requested 

• the Commissioner may collect unpaid tax from any local subsidiary of a multinational group.

Our comment: These proposals were foreshadowed in previous policy announcements, but the scope of the proposals as introduced is much clearer than the original announcements. 

The cumulative effect of the changes will, in many cases, be significant and with short lead times to effective dates, the potential impact of these proposals need to be considered now (especially given we now have draft legislation). Our team are keen to help you assess the impact of the proposed new rules on your business. Please contact your PwC team to discuss the new measures further.