Are my debt levels subject to the Arm’s Length Test?
Tax Alert - November 2021
By William Dawson, Bart de Gouw & Chanelle Stoyanov
Cross-border financing continues to remain a key focus of the Inland Revenue, as it maintains a close watch on all cross-border financing arrangements between associated parties, especially inbound loans in excess of NZD10 million in principal, due to the application of the restricted transfer pricing regime to these loans.
Transfer pricing of financing arrangements has historically focused on determining the arm’s length nature of the interest rate applicable to intercompany loans. However, recently there has been a global shift to scrutinise whether the amount of intercompany debt advanced is comparable to what third party borrowers would borrow in a commercial arrangement.
In a third-party context, companies are incentivised to maintain a certain level of equity to keep the cost of borrowing down and maintain the lowest possible weighted average cost of capital. However, where the shareholder is lending to its subsidiary, this commercial tension is absent. Since the shareholder will receive funds either as interest or dividend, groups may be incentivised to gear as highly as possible (maximising interest expense) if the lender’s jurisdiction has a lower tax rate than the borrower’s jurisdiction.
Earlier this year, several changes were proposed by the Organisation for Economic Co-operation and Development (“OECD”) to the commentary on Article 9 (Associated Enterprises) of the Model Tax Convention. The draft commentary clarifies that an arm’s length debt quantum is within the ambit of Article 9. Once the draft commentary is finalised, Inland Revenue will have enhanced ability to challenge the arm’s length nature of debt quantum, and we could well see Inland Revenue begin to challenge interest deductions on the basis that the taxpayer has a debt levels in excess of an arm’s length amount.
New Zealand’s thin capitalisation restrictions will typically kick-in to deny interest expenditure where the 60% interest bearing debt-to-net asset threshold has been breached. On this basis many groups will debt fund NZ subsidiaries to be within the thin capitalisation limits. We have not yet seen incidences of Inland Revenue challenging interest deductions of taxpayers that are within thin capitalisation limits on the basis that the taxpayer is excessively geared, however the revised commentary may see this change.
The restricted transfer pricing rules are trigged when a New Zealand borrower with inbound debt in excess of NZD10m has a debt percentage that is greater than 40%. The fact that a 40% threshold was set (i.e. well below the thin capitalisation threshold of 60%) is a key indicator that Inland Revenue does consider debt capacity to be a continuing issue and are concerned with debt capacity in the matter of cross-border financing.
Where taxpayers have some level of related party debt financing, we recommend the level of debt-to-equity is assessed against comparable independent companies to sense check the level of debt is not excessive for the taxpayers particular circumstances (for example the specific industry, business cycle and cashflow projections).
If you would like to discuss any of the above in more detail, please contact your usual Deloitte advisor or Deloitte’s specialist transfer pricing team.
November 2021 Tax Alert contents
- Significant reporting and disclosure changes looming for New Zealand trusts
- Income tax implications for capital gains distributed to New Zealand beneficiaries through Australian discretionary trusts
- The property parent trap
- PAYE and NRCT simplification coming for cross-border workers
- Are my debt levels subject to the Arm’s Length Test?
- Updated political agreement on global tax reform
- Operational Taxes update: New W-8 series forms – are you ready?
- Snapshot of recent developments