A trifecta of BEPS reforms
Tax Alert - March 2017
By Emma Marr
On Friday 3 March 2017 the Government released three discussion documents proposing wide-ranging changes to our tax rules to address concerns that multinationals operating in New Zealand are not paying their fair share of New Zealand tax. The proposals should have such multinationals sitting up straight and paying close attention, as the suggested reforms are significant and likely to have a meaningful impact.
Broadly, the three discussion documents cover the following:
- Interest deductions: interest deductions on cross-border loans will be further limited by capping interest rates, changing the asset measurement rules, and implementing a range of other smaller reforms to the thin capitalisation rules.
- Transfer pricing and permanent establishment avoidance: Substantial changes to source, permanent establishment (PE) and transfer pricing rules, including a suite of rule changes to enhance Inland Revenue’s ability to enforce the rules.
- International convention: New Zealand’s intention to sign the OECD’s Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS (the multilateral instrument or MLI).
The application date for most of the proposals would be the first day of the first income year after the rules are enacted. Some of the administrative transfer pricing and PE rules would apply from enactment.
At this stage officials are seeking submissions on the proposals, which are due in April (7 April in relation to proposals on implementing the MLI, 18 April in relation to limiting interest deductions, and transfer pricing and permanent establishment avoidance).
Further detail on each of the discussion documents is covered below. Please get in touch with your Deloitte advisor to discuss how these proposals could apply to you. Given the typical rush of a 31 March tax return filing season, the 6 week period for consultation will be tight. Given the significance of some of the proposed changes it is important that people make time to understand the impacts the proposals will have on their current arrangements.
Limitations to Interest deductions
The first discussion document, BEPS – Strengthening our interest limitation rules, proposes tightening our thin capitalisation rules in two significant ways: interest rates will be limited, and the measurement calculation for assets will be amended to reduce assets by the value of any non-debt liabilities. There are a number of other amendments proposed including: a de-minimis exemption, concessions for specific circumstances, and eliminating all interest deductions for groups of non-residents acting together when the 60% safe harbour is breached.
It is interesting to note that the EBITDA approach, limiting interest deductions by reference to the profits of the company, while not the preferred course of action, has not been definitively rejected at this stage. Rather, the document’s focus is considering whether the current thin capitalisation regime, based on debt to asset ratios, can be adapted to address some of the disadvantages of this type of thin capitalisation regime, as identified by the OECD in the BEPS Action 4 Final Report. If the changes proposed in the discussion document are not effective, the EBITDA approach could well be re-considered.
Capping interest rates
Although the current transfer pricing regime does limit permissible interest rates, Inland Revenue's concern is that this is not “wholly effective”, as no matter how the related party debt is structured, some comparable arms-length debt can always be found to justify the structure and terms adopted. Assessing compliance is also complex and resource intensive.
The proposed solution is to cap interest rates on related party debt, with the cap set at the company’s ultimate parent’s interest cost on senior unsecured debt, plus a margin. Inland Revenue consider this to be a reasonable approximation of the multinational’s cost of debt. If the New Zealand company has a credit rating itself, the rate would be capped at the higher of the parent’s credit rating for senior unsecured debt plus a margin, and the New Zealand group’s credit rating for senior unsecured bonds.
If there is no ultimate parent, the cap will be the interest rate that would apply for the New Zealand group when raising senior unsecured debt.
In addition, to prevent the parent loading the subsidiary with debt to depress their credit rating and justify higher interest rates, the discussion document proposes two further options (inviting submissions without stating a preference):
- Determining credit-worthiness based on an arms-length amount of debt; or
- Deeming all related party debt to be equity for the purposes of determining the borrower’s credit rating.
The document offers examples of how both a fixed and floating rate would be calculated, and suggests that guarantee fees would be limited to the margin allowable under the interest rate cap.
Other suggestions include:
- A de minimis rule for groups with debt principal of less than $10m, to which ordinary transfer pricing rules would apply.
- The proposals would apply to banks.
- The rules would apply to all inbound debt, whether it is from a foreign parent to a New Zealand subsidiary, or a foreign subsidiary to a New Zealand parent, and would not apply to outbound debt.
- If the rules are applied the normal transfer pricing rules wouldn’t apply.
- Even if the interest cap rules are applied, the anti-avoidance rules in the tax legislation would still apply. As an example, the discussion document states that, in a market with rising interest rates, a company that chooses to break a loan early and re-sets at a higher interest rate would defeat the intention of the rules and could be subject to the anti-avoidance rule.
- Any loan with a period of longer than five years would be treated as having a term of five years, on the basis that a longer term is an “unusual” commercial arrangement.
- There would be no transitional rules. The rules would apply to existing arrangements as soon as they are enacted.
Changing asset measurement
Currently, when measuring the debt to asset ratio, a taxpayer will include their gross assets (i.e., all assets on their balance sheet) and their interest bearing debt. Officials are concerned that taking into account gross assets rather than net assets is a non-commercial approach and a lender would be more concerned with a company’s net assets, as non-debt liabilities also reduce the assets a company will have available to pay its debt. The discussion document notes that New Zealand is unique in the world in using gross assets when calculating debt to asset ratios.
The proposal is that assets should be measured on a net basis – i.e., net of non-debt liabilities, such as trade debts andprovisions.
Non-debt liabilities would include:
- All liabilities that are not included in the thin capitalisation calculation (i.e., that are not interest bearing debt); less
- Any interest free shareholder loans, or loans from a person associated with a shareholder, as such loans are equivalent to equity.
Similar definitions are provided when calculating the debt/asset ratio of the worldwide group.
There is no proposal to grandparent existing arrangements, and the new rules would apply from the first income year beginning after their enactment. Officials consider this delay would be sufficient to enable companies to re-arrange their affairs.
The discussion document has some other suggestions for modifying the interest deductibility rules:
- Assets will have to be valued for the thin capitalisation rules using the values reported in a taxpayer’s financial accounts – alternative valuations will no longer be available.
- Assets and debts will have to be measured for thin capitalisation purposes using average values during the year (either quarterly or daily), removing the ability to measure values on the final day of a taxpayer’s income year.
- A de-minimis level for the inbound thin capitalisation rules, so long as that debt is not owner-linked debt (i.e., is third party debt).
- Concessions for infrastructure projects that are controlled by a single non-resident, if the project has been established at the request of the Government or another public body. The concession would exempt the New Zealand company from applying the thin capitalisation rules to third party debt. Any interest on related party debt would not be deductible.
- The “acting together” rule, that has only just been introduced, would be significantly strengthened. Where a New Zealand entity controlled by a group of non-residents acting together exceeds the 60% safe harbour debt/asset ratio, any interest on owner-linked debt will be non-deductible. This is much stricter than the current rules which in effect deny interest deductions to the extent that the 60% ratio is exceeded. This rule would apply on a prospective basis – i.e., not to arrangements in force before the enactment date of these proposals.
These proposals are likely to have a material impact on some New Zealand entities. Companies that are already complying with transfer pricing rules in relation to setting interest levels may find that the first proposal, capping interest rates, does not have a significant impact. However there are arm’s length scenarios where a subsidiary’s costs are materially above the parent’s such that these proposals may not result in an arm’s length outcome. The second proposal, to change the way assets are calculated for the thin cap calculation, could tip companies that are close to the 60% debt/asset ratio over the edge and result in interest deductions being denied to those companies. Issues such as the derivative valuation, non-equity funding, deferred tax liabilities, creditors, accruals and provisions will under the proposals all impact a company’s debt to asset ratio. Companies who are still sitting on large deferred tax liabilities due to the removal of depreciation on buildings may once again be rueing those changes!
The proposal to require daily or quarterly valuations will add a compliance cost to taxpayers. We’ve been moving towards a system where many companies do not need to comply with IFRS or even prepare financial statements, so this approach is out of step and an excessive reaction to a minor issue with the existing valuation rule.
Transfer pricing and PE avoidance
The second of the three discussion documents, BEPS –Transfer pricing and permanent establishment avoidance focuses on strengthening existing rules on transfer pricing and PE avoidance. The Government is concerned that our transfer pricing and PE rules are too easily worked around, and although New Zealand proposes to adopt a number of changes recommended by the OECD to address this issue, the Government is concerned these changes won’t go far enough.
Rather than adopt the diverted profits tax (DPT) that is being considered by Australia and France, and adopted by the UK, the Government proposes a package of measures that, combined with steps already taken in recent years, plus the OECD recommendations, would in many ways replicate the effect of a DPT.
Source and PE avoidance
- A new PE anti-avoidance rule will be introduced to prevent large multinationals (more than EUR 750m global turnover) structuring to avoid having a PE in New Zealand. A non-resident entity will be deemed to have a PE in New Zealand if a related entity carries out sales-related activities for it here, some or all of the sales income is not attributed to a New Zealand PE of the non-resident, and the arrangement defeats the purpose of the relevant double tax agreement’s (DTA) PE rule. A related entity would be either associated or commercially dependent. The rule would also apply where an unrelated third party entity is interposed between the non-resident and the New Zealand customer, if all the other attributes outlined above are present.
The PE will be deemed to exist for the purpose of any applicable DTA and the non-resident’s supplies in New Zealand will be deemed to be made through that PE. New Zealand will tax sales income that is attributable to the PE.
- Income will be deemed to have a source in New Zealand if it is attributable to a New Zealand PE, either under a DTA, or, if no DTA applies, under New Zealand’s model treaty PE article, which will be incorporated into domestic law to apply as an additional source rule. This would include circumstances where a non-resident is deemed to have a PE under the previously discussed proposal that a non-resident may in some circumstances be deemed to have a New Zealand PE.
- A non-resident’s income will have a source in New Zealand if the income would have a source if one treated the non-resident’s wholly owned group as a single entity. This would prevent groups dividing up activities between group members to prevent New Zealand source income arising.
The life insurance source rules will be amended to remove a preference currently available to insurers based in Canada, Russia and Singapore. No deductions will be available for the reinsurance of life policies if the premium income on that policy is not taxable in New Zealand. Further, any life insurance policies that are not subject to New Zealand tax under the life insurance rules will be subject to the FIF rules.
Transfer pricing rules
The transfer pricing rules will be aligned with OECD’s guidelines and Australia’s new transfer pricing rules, including amendments to:
- Focus on the economic substance of a transaction and disregard the legal form if the two do not align;
- Allow transactions to be reconstructed or disregarded where they are considered by the IR to be non arm’s-length, to align with a “commercially rational arrangement that would be agreed by independent businesses operating at arm’s length”;
- Specifically refer in transfer pricing legislation to arm’s length conditions and the latest OECD Transfer Pricing guidelines (which incorporate the BEPS actions 8–10 revisions);
- Reverse the burden of proof for demonstrating that the conditions of an arrangement are arm’s length conditions so that it sits with the taxpayer, rather than the Commissioner of Inland Revenue. Master and local file transfer pricing documentation would be required on request by Inland Revenue;
- Increase the “time bar” for transfer pricing issues from four to seven years;
- Extend the ambit of the transfer pricing rules so that, in addition to applying to transactions between associated parties, they will apply to investors that “act together”, in the same way that the newly amended thin capitalisation rules now apply to such groups of investors.
To beef up their ability to enforce the transfer pricing and PE avoidance rules on uncooperative multinationals, the Government propose additional “administrative” rules that would generally apply from enactment of the relevant legislation. These rules would generally only apply to large multinationals (over EUR 750m worldwide revenue):
- If a large multinational does not cooperate with Inland Revenue (for example, by not providing information within statutory timeframes, failing to respond to Inland Revenue correspondence, or providing misleading information), then it would be categorised as non-cooperative. Inland Revenue would at that point be able to commence the disputes process by issuing a notice of proposed adjustment (NOPA) based on the information available at the time.
- Tax in dispute would have to be paid earlier in the disputes process than it is currently, where the tax in dispute relates to transfer pricing, the amount of New Zealand sourced income, and the application of a DTA.
- Inland Revenue will be able to collect tax payable by a large multinational from any wholly owned group member in New Zealand, or the related New Zealand entity in the case of the new PE avoidance rule.
- Inland Revenue will have enhanced information-collecting powers, enabling it to request information from large multinationals relating to non-resident group members. Failure to comply with such requests could lead to conviction for an offence, fines of up to $100,000, and/or denial of deductions.
The proposed changes to the transfer pricing rules are extensive and wide ranging. Inland Revenue is seeking far more power and discretion in applying the transfer pricing regime and many of the changes will impose significant additional compliance costs on taxpayers.
Changes to deemed PEs, reconstruction powers and the increased focus on economic substance will impact many commercial arrangements and impose compliance costs on multi-nationals operating in New Zealand.
The changes in administrative rules would give Inland Revenue significantly greater powers. In particular the new penalty provisions, greater information gathering powers and the requirement for earlier payment of disputed taxes may embolden Inland Revenue to more aggressively audit transfer pricing positions. The extended time bar will result in taxpayers having the increased uncertainty of transfer pricing positions open for a period of seven years.
Implementing the Multilateral Instrument
The third document, an Officials’ issues paper rather than a discussion document, has the rather self-explanatory title New Zealand’s implementation of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS. The multilateral convention (referred to as either the multilateral instrument or MLI) will modify some of New Zealand’s existing DTAs to align them with OECD recommendations.
The OECD BEPS Action Plan included recommendations to amend DTAs. As there are many thousands of DTAs currently in force around the world, the only rational way to align all the DTAs within a reasonable period of time was for the OECD to present a multilateral instrument that all countries could adopt, thereby aligning the DTAs of all participating countries at the same time. The resulting MLI was published in November 2016, and the discussion document states that New Zealand expects to sign the MLI in mid-2017, after which a domestic ratification process would be followed.
Adopting the MLI in relation to any particular DTA will require the cooperation of both signatories to the DTA. That DTA will then be a Covered Tax Agreement (CTA). The process by which a particular CTA will enter into force takes some time, and the discussion document notes it is likely that the earliest modifications to current DTAs could apply is from 2019.
Four key areas will be addressed by the adoption of the MLI:
- Anti-abuse rule: A principal purpose test (PPT) will be inserted into CTAs. A PPT is equivalent to an anti-avoidance rule.
- PE anti-avoidance rule: The definition of a PE will be strengthened to prevent multinationals structuring their affairs deliberately to fall outside the definition.
- Hybrid mismatches: Hybrids allow entities operating in more than one jurisdiction to exploit differences in the tax laws between those jurisdictions, and avoiding paying tax in either. Changes to the CTA will neutralise any advantage obtained by use of hybrids.
- Effective dispute resolution: A taxpayer will be able to seek binding arbitration when the revenue authorities of two jurisdictions disagree on the correct interpretation and application of a particular DTA.
Unlike some other countries, New Zealand’s commitment to signing up to the MLI has already been signalled and is reiterated in the issues paper. If New Zealand continues down this path, it will be key for New Zealand taxpayers that the Inland Revenue provides adequate resources to help taxpayers when other jurisdictions try to stake a claim over income New Zealand has already taxed.
March 2017 Tax Alert contents