“You Do The Math” – 10 Simple Ways to Keep Inland Revenue Away
Tax Alert - December 2019
By Bart de Gouw & Eleanor Yew
Last month, amongst other significant developments in the International Tax space, Inland Revenue released its latest Multinational Enterprises Compliance Focus 2019 document (the Compliance Focus document). The aim of this document is to make tax compliance more transparent for businesses and give them certainty.
One thing is for sure, with Inland Revenue’s Basic Compliance Package, International Questionnaire and account management processes already in place, combined with greater international transparency (i.e. Country-by-Country reports and information exchanges), Inland Revenue can tailor interventions to facilitate compliance with tax law. The Compliance Focus document states, “In the coming year we will be asking for more information and clarification of changes in MNEs tax affairs to give us a clearer view of the impact of the new anti-BEPS measures”. The recent Transfer Pricing questionnaire for wholesalers and distributors as well as the new BEPS disclosure requirements are evidence of this new approach. Next year, further targeted questionnaires will be sent covering the topics of losses, intellectual property and royalties, debt and thin capitalisation.
The Compliance Focus document also includes a simple transfer pricing checklist. If taxpayers identify that one (or more) of the risk indicators apply, they are on notice that Inland Revenue may request more information. We have expanded on the checklist below to provide further insights and examples.
2 consecutive years of tax losses
A company reporting two years of consecutive losses may trigger Inland Revenue’s curiosity on the viability of the company. Inland Revenue’s concerns are that if there are constant periods of losses for either foreign-owned multinationals operating in New Zealand, or New Zealand owned multinationals with loss making associates abroad, this may suggest commercially unrealistic transfer pricing transactions and policies. For example, an associated enterprise making losses may remain in business if the business is beneficial to the MNE group as a whole, but this not the case for an independent company, which will not be prepared to tolerate losses for a continuous period or indefinitely.
This could affect Small and Medium-sized Enterprises (SMEs) and start-ups, especially in their early years of incorporation. It is not uncommon for SMEs to incur significant expenses, i.e., research and development expenses during their infancy which can often result in losses being reported over a period of time.
Prevention is better than cure, thus we recommend that documentation is in place to support and provide explanation of the losses. Additionally, forecasts of the next couple of years’ financials to support the strategies to be taken towards making profits in the medium term are helpful.
Negative Earnings Before Interest and Tax (EBIT)
A negative EBIT (which would indicate a company is failing to turn a profit), is another cause for suspicion in the eyes of Inland Revenue. EBIT basically focuses on a company’s ability to generate earnings from its operations and it does not take into account interest, taxes and capital structure. Therefore, a negative EBIT gives Inland Revenue indicators that the company is purchasing goods from related parties at a high price (Cost of Goods Sold), or is paying high management service recharges from associated parties, and royalty payments.
>5% cost plus margin on service charges
Consistent with OECD’s simplification measure for qualifying low value-adding intra-group services (LVAIGS) charged to a New Zealand taxpayer with a total value below NZ$1m per annum, ‘qualifying services’ may be priced at cost plus a 5% mark up without having to provide benchmarking support. Entities that are pricing their services at more than 5% for qualifying services, without benchmarking support, may hear from Inland Revenue, as Inland Revenue will want to understand the basis for the level of pricing.
You need to be aware of what a “qualifying service” is. For example, management fees that include the services of the senior management will fall outside of this category. For more information about LVIAGS, refer to our recent Tax Alert Article.
<3% Distributor EBITE
For foreign-owned wholesale distributors with an annual turnover of less than NZ$30m, Inland Revenue currently maintains that a weighted average earnings before interest, tax and exceptional items (EBITE) margin of 3% of sales or greater is broadly indicative of an arm’s length rate. Foreign-owned wholesale distributors that fall within this threshold will not be required to be provide benchmarking support to Inland Revenue. However, distributors that do not fall within the annual turnover threshold should consider revising their positions by having adequate benchmarking support on hand. For more information refer to our recent Tax Alert Article.
<5% Retailer EBITE
In respect of retailers, Inland Revenue is likely to maintain that a weighted average EBITE ratio of 5% or greater is broadly indicative of an arm’s length outcome. However, Inland Revenue does not have published guidance on whether businesses will not be required to provide benchmarking support below a level of turnover. If retailers are below 5% EBITE, we recommend explanations of the reasons for the results be documented.
<7% Manufacturer EBITE
For foreign-owned manufacturers, Inland Revenue is likely to maintain that a weighted average EBITE ratio of 7% or greater is broadly indicative of an arm’s length outcome. There is no indication of size limits or benchmarking requirements. Manufacturers that do not fall within this threshold should consider their positions and have benchmarking support and explanation of the results ready to support the positions taken.
Royalties >33% EBITE
Inbound licensing of intangibles, trademarks, patents as well as other intellectual property are a current focus for Inland Revenue. Inland Revenue has recently updated its risk assessment threshold for royalties. Royalty payments exceeding 33% of EBITE are assigned a high risk rating pending further review. We therefore recommend that taxpayers consider applying this as a cross-check if they have licenced intangibles from foreign related parties. Taxpayers should be on notice that an upcoming Inland Revenue questionnaire will focus on royalties.
Debt >40% (Assets – Non-debt Liabilities)
New Zealand based borrowers need to ensure they are not at risk of ‘excessive debt gearing’ in relation to their capital structures. For the purposes of the restricted transfer pricing rules, a New Zealand borrower will be considered a “high BEPS risk” if it has a New Zealand Group debt percentage (as measured for thin capitalisation purposes) that is greater than 40%, unless its ratio is within 110% of its world-wide group (where relevant).
Interest >20% EBITDA
Inland Revenue also has concerns where a taxpayer’s interest expense is more than 20% of EBITDA. A high ratio can be due to a commercial or industry issue, as well as a bad year for a company, for example, where there is a decrease in revenue or increase in one-off expenses. In such circumstances, the company may wish to re-look at what caused the high ratio and have supporting documents readily available.
Purchases + other operating expenses > $20m (involving low/no tax jurisdictions)
If taxpayers have been purchasing goods or services from non-resident associated persons located in certain jurisdictions, Inland Revenue will likely raise their eyebrows. Inland Revenue has identified Hong Kong, Ireland, Luxembourg, Netherlands, Singapore or Switzerland in their recent transfer pricing survey as higher risk jurisdictions.
Our advice is to be prepared, start early, be generous with your supporting documentation, and abide by the New Zealand Transfer Pricing legislation. Talk to your usual Deloitte advisors or the authors if any of these items raise red flags in your company.
December 2019 Tax Alert contents
- Inland Revenue: “No place to hide overseas income”
- “You Do The Math” – 10 Simple Ways to Keep Inland Revenue Away
- Corporate Tax Governance – From the Top Down…
- Tax Policy: What to expect in the twenties
- Don’t hold back; investment income reporting is almost
- OECD consults on “GloBE” global minimum corporate tax rate
- Snapshot of Recent Developments