Parliament reports back on BEPS changes
Tax Alert - June 2018
Changes to debt pricing, thin capitalisation calculations and permanent establishment rules, among other things, are now almost law, following the report back of the BEPS legislation by the Finance and Expenditure Select Committee on 15 May 2018. The Taxation (Neutralising Base Erosion and Profit Shifting) Bill (the Bill) will generally apply to income years starting on or after 1 July 2018.
We have outlined the key proposals below, highlighting the changes made by the Select Committee. You can read our December Tax Alert for more detail on the changes as originally proposed, and you can see further detail on the final Bill in the Officials' report. We recommend, if you are looking after tax for a company owned by non-residents or that might have a permanent establishment or a hybrid arrangement in New Zealand, that you contact your usual Deloitte tax advisor to discuss the impact these changes will have on your company.
Main changes made at Select Committee:
If you’re already familiar with the proposals in the Bill, the below is a quick snapshot of the main changes to the Bill since it went to Select Committee.
- Removing the EBITDA test from the list of “high risk” criteria for identifying BEPS behaviour for the restricted transfer pricing rule.
- Extending the allowable difference between a New Zealand borrowers’ credit rating and the worldwide group to two notches instead of one, if the resulting credit rating for the New Zealand borrower will be BBB- or higher.
- Allowing credit ratings to, in certain circumstances, be implied from significant long term third party senior unsecured debt, including for those at high risk of BEPS.
- Changing the reference group credit rating so that the credit rating for the borrower must be compared to the group company with the highest level of unsecured third party debt (rather than the highest credit rating in the group).
- Extending the $10m de minimis rule to insurers and lenders.
- More extensive grandfathering of advanced pricing agreements.
- Some amendments have been made to the thin capitalisation proposals to clarify which deferred tax liabilities are deducted from gross assets to measure net assets, however these changes do not extend the liabilities that may be deducted.
- Amendments have been made to the new thin capitalisation rule for infrastructure projects to ensure they operate as intended.
- The time bar is still being extended from four years to seven, but only in cases where Inland Revenue has begun a transfer pricing investigation within four years of the relevant tax return being filed, and has notified the taxpayer within that period that a seven year time bar will apply.
Summary of the Bill
Interest Limitation Rules
Related party debt pricing will be subject to greater restrictions than it has been in the past. A “restricted transfer pricing” rule will apply to related-party debt between a non-resident lender and a New Zealand-resident borrower although a de minimis rule applies to exempt taxpayers from these rules if related-party cross-border borrowings are less than $10million.
Generally this means that debt will have to be priced based on the assumption that the borrower’s credit rating is one notch below the credit rating of the member of the group with the highest unsecured third party debt (or two notches where the resulting credit rating for the New Zealand-resident borrower will be BBB- or higher), regardless of that borrower’s actual credit rating. This will be a significant change for some New Zealand companies.
Whether or not this “deemed” credit rating must be used depends on whether the borrower is considered to be at a high risk of BEPS behaviour, having failed one or more of the following tests:
- The borrower has a greater than 40% thin capitalisation ratio, or they exceed the 110% worldwide debt test; or
- Borrowing comes from a jurisdiction, that is not the ultimate parent jurisdiction, where the lender is subject to a lower than 15% tax rate.
As noted earlier, the Government has abandoned a third test known as the EBITDA test, which calculated the income to interest ratio of the borrower. Previously, this test had meant that where that ratio was less than 3.3 the borrower was considered to be high BEPS risk and subject to the restricted transfer pricing rule. Inland Revenue recommended that this test be removed as it would result in the rules targeting taxpayers who were not intended to be targeted.
A credit rating will now also be able to be implied from third party debt even if the borrower fails the above tests, but only if:
- The related party debt is no more than four times the amount of the relevant third party debt;
- The third party debt is unsubordinated; and
- The third party debt is unsecured.
In practice, we do not anticipate that this new carve out will attract many users as it will only really provide a benefit where no explicit guarantee has been provided by the Parent to the third party lender.
Once a credit rating is established, some features of the debt may have to be disregarded when pricing the debt. These features include (among other things) the term of the loan, whether the payment of interest can be deferred for more than 12 months, changes to interest rates that are controlled by the borrower or lender, and whether the debt is subordinated. Minor changes have been made to the features listed in the Bill since it was introduced.
Thin capitalisation rules
The thin capitalisation (thin cap) rules stop foreign-owned New Zealand companies overloading on debt, and moving profits offshore by way of interest payments. The new rules impose even greater restrictions on the amount of debt the New Zealand company can have, primarily by changing the way the assets of the company are measured. We will move from a “gross asset” to a “net asset” test, which means that assets will be reduced by the value of any non-debt liabilities on the company’s balance sheet similar to the approach in Australia.
This change is likely to mean that many companies currently complying with the thin cap rules will fall foul of them under the new test, and will have to either restructure their debt or accept that some interest deductions will be denied for tax purposes.
One of the more problematic parts of this rule is that deferred tax liabilities are prima facie included in these non-debt liabilities. The rules in the Bill, as introduced, that sought to exclude certain deferred tax liabilities where an actual tax liability would not arise on the ultimate disposal of the asset (e.g. non-depreciable buildings and intangible assets) were complex and hard to understand. These have been slightly amended in the reported back Bill, but have not been extended to exclude all deferred tax liabilities as many submitters suggested and are still likely to be difficult to apply in practice. Volatile deferred tax liabilities could have a material impact on thin cap calculations.
Positively, Inland Revenue has accepted a number of submissions made in respect of the new thin capitalisation rule for certain infrastructure projects. While these rules do not go as far as some submitters had wanted, the changes should at least ensure that projects within scope are able to use the new rules.
Permanent Establishment Rules
Large multinationals that currently conduct sales activity in New Zealand but don’t think they have a permanent establishment (PE) in New Zealand for the non-resident entity making the sale to a New Zealand customer might find they do under the new rules. A multinational will be deemed to have a New Zealand PE for the non-resident company if they are carrying out sales activity that is structured in such a way as to avoid tax in New Zealand or overseas.
The rules, which only apply to multinationals with at least €750million consolidated global turnover, could be considered to contravene some of New Zealand’s Double Tax Agreements (DTAs). It will be interesting to see how the rule and the DTAs interact in practice although most multinationals in this situation will likely amend their arrangements.
Transfer Pricing Rules
Changes to the transfer pricing rules give Inland Revenue more power: the burden of proof is reversed and now sits with the taxpayer, and Inland Revenue can both give priority to the economic substance and conduct of parties over the terms of a legal contract, and disregard or replace transfer pricing arrangements which are not commercially rational. The time bar has also been extended from four years to seven, but this is now only in cases where Inland Revenue has begun a transfer pricing investigation within four years of the relevant tax return being filed, and has notified the taxpayer within this period that a seven time bar will apply.
Other than the change to the application of the time bar, few changes have been made to the proposed transfer pricing rules at the Select Committee stage. A test designed to apply the transfer pricing rules to shareholders who are “acting together” to control a New Zealand resident company has been amended to restrict it to a group of non-residents acting together, rather than potentially applying to a group made up of both New Zealand resident and non-resident shareholders.
The Bill now allows greater grandfathering of advanced pricing agreements (APAs), which are entered into with Inland Revenue to agree the transfer pricing of transactions. Previously only APA’s relating to establishing arm’s length amounts would be grandfathered. Now APAs relating to related party debt which would otherwise be subject to the new restricted transfer pricing rules and APAs relating to the source rules will be grandfathered. APAs relating to permanent establishments will not be grandfathered.
The requirement for New Zealand headquartered multinational groups with annual consolidated group revenue of €750million or more to prepare and file a country-by-country report will be codified in legislation. This will apply from the date the Bill is enacted.
Hybrid and Branch Mismatch Rules
The Bill includes a comprehensive adoption of the OECD hybrid recommendations with modification for the New Zealand context. The proposed rules are complex and are designed to address mismatches in the tax outcomes between New Zealand and other countries as a result of the different treatment of financial instruments or entities that result in double deductions in New Zealand and overseas, or a deduction in one country without a corresponding amount of income being recognised in the other country.
Some examples of common situations that can be impacted by the rules include:
- Financial instruments (e.g. loans) that are treated as debt in one country but equity in the other;
- Financial instruments that have (or may have) a term of more than 3 years where the interest income is not recognised on a reasonable accrual basis or otherwise in an accounting period beginning within 24 months of the period in which a deduction is allowed for the interest expense;
- Branch operations in New Zealand or overseas;
- Limited partnerships, unlimited liability companies, and other entities that are treated differently for tax purposes in different jurisdictions;
- Dual resident entities; and
- Interest paid on an ordinary cross border loan which is funding a hybrid arrangement entered into between two non-resident members of a multinational group where the rules of those countries do not negate the hybrid outcome.
New Zealand companies owned by non-residents could justifiably feel exhausted by the relentless program of change to our international tax rules in recent years. We hope that, with this Bill, the Government and Inland Revenue feel they have inserted every possible belt and brace into the rules so that we can let the rules bed in without any more tinkering in the near future.
It is disappointing that the rules will still, despite vigorous submissions requesting change, override existing OECD arm’s length concepts for the pricing of debt as well as existing DTAs. In our view a small, capital importing nation should not deliberately go against existing international norms in pricing related party debt and introduce rules that will inevitably result in double taxation.
The majority of the new rules will become law for income years beginning on or after 1 July 2018. For companies with June balance dates, this means they effectively apply from 1 July 2018. This will mean that such entities will urgently need to consider and address the issues these new rules present.
We expect the Bill will be passed before 30 June 2018.
For more information please contact your usual Deloitte advisor.