Restricted transfer pricing and the impact on interest deductibility in New Zealand
Issues and potential pitfalls for taxpayers
In 2018 New Zealand introduced a raft of new measures aimed at neutralising Base Erosion and Profit Shifting (“BEPS”) behaviour. These measures included new legislation (applying to income years commencing on or after 1 July 2018) which can impact interest deductibility on cross-border related borrowing. Under the new provisions (known as restricted transfer pricing) allowable interest deductions may, in certain situations, be less than would be deductible under ordinary OECD transfer pricing principles.
The restricted transfer pricing rules act to determine terms and conditions of the loan/borrower, which may be different to the actual or contractual terms and conditions. Ordinary OECD transfer pricing principles are then applied to these altered terms and conditions.
This article summarises restricted transfer pricing and outlines some of the issues and potential pitfalls that taxpayers should be aware of if they have cross-border related borrowing in place. Issues include the effective double taxation of the interest, requirements to make disclosures to the New Zealand Inland Revenue, the need to continually monitor the potential application of the regime, the impact on withholding taxes, and interaction with the OECD BEPS measures.
Summary of restricted transfer pricing
Restricted transfer pricing broadly requires taxpayers with NZD10 million or more in aggregated cross-border related borrowings to consider their related party financing arrangements and capital structures against the following threshold criteria:
- The New Zealand-based borrower has a debt percentage greater than a 40% ratio, and the debt percentage exceeds 110% of the worldwide debt percentage of the group; or
- The funds come from a jurisdiction where the lender is subject to a lower than 15% tax rate, unless the company’s ultimate parent is resident in that jurisdiction.
Taxpayers that do not breach the threshold criteria, or that have aggregated cross-border related borrowing of less than NZD10 million, may continue to price cross-border related borrowings using a credit rating determined under ordinary OECD transfer pricing principles or, where appropriate, with reference to Inland Revenue’s administrative guidance on small value loans (cross-border associated party loans by groups of companies for up to $10 million principal in total). Please note that taxpayers classified as insuring or lending persons for restricted transfer pricing are treated differently and are discussed separately below.
Credit rating methods
Taxpayers that do breach one or more of these thresholds are obligated to price cross-border related party debt instruments using a specified methodology, which can substantially depart from ordinary OECD transfer pricing principles.
The restricted transfer pricing rules distinguish between taxpayers with or without an “identifiable parent”. An identifiable parent broadly captures taxpayers that have a shareholder with a > 50% ownership interest.
Group credit rating
Taxpayers with an identifiable parent that breach one of the threshold requirements and have NZD10 million or more in cross-border related borrowing are obligated to apply the “Group” credit rating method. The Group credit rating determines the credit rating of the New Zealand based borrower to be the higher of:
- the credit rating of the worldwide group entity with the highest level of debt or the member with the highest credit rating (adjusted downward by one to two notches depending on whether or not the credit rating is less than BBB+ (Moody’s Baa1 equivalent)); and
- the credit rating the borrower would have under ordinary OECD transfer pricing principles.
Alternatively, the taxpayer may be able to apply the Optional credit rating method instead, which is discussed further below.
Restricted credit rating
Taxpayers without an identifiable parent that breach one of the threshold requirements and have NZD10 million or more in cross-border related borrowing are obligated to apply the “Restricted” credit rating method. The Restricted credit rating method determines the credit rating of the New Zealand based borrower to be the higher of:
- a Standard & Poor’s BBB- rating (BBa3 Moody’s equivalent); and
- the credit rating the borrower would have under ordinary OECD transfer pricing principles if their New Zealand group’s debt percentage was equal to the lesser of 40% and the debt percentage of the New Zealand group.
Captured taxpayers must then price cross-border related party financial instruments on the basis of the Group/Restricted credit rating assigned, rather than the credit rating assignable under ordinary OECD transfer pricing principles. This may result in a reduced rate of interest being deductible for the relevant instrument(s).
Alternatively, the taxpayer may be able to apply the Optional credit rating method instead, which is discussed below.
Optional credit rating
Taxpayers with existing external debt (i.e. concurrent or already in place at the time relevant related debt is advanced to the borrower) may make a one-time election in the first year that an instrument is subject to restricted transfer pricing to apply the “Optional” credit rating method. The Optional credit rating method can be used provided that the principal of the related party debt is equal to or less than four times the principal of the external debt.
The Optional credit rating is determined by:
- The borrower’s or a New Zealand group member’s credit rating for third-party long-term senior debt, if the borrower or member has such a credit rating; or
- The credit rating corresponding to the interest incurred on third-party long-term senior debt of the taxpayer or a member of the New Zealand group.
Insuring or lending person credit rating
Taxpayers considered to be “insuring or lending persons” for restricted transfer pricing purposes must determine their credit rating with reference to the insuring or lending person credit rating method. Insuring or lending persons (as defined) are captured by restricted transfer pricing regardless of whether the threshold for the debt percentage or the 15% tax rate criteria have been breached. Insuring or lending persons must determine their creditworthiness with reference to third-party long-term senior unsecured debt for the worldwide group member with the most debt of this kind, or where the group has no such debt, the worldwide group member with the highest credit rating. No notching adjustment is permitted.
Alternatively, the taxpayer may be able to apply the Optional credit rating method, which is discussed above.
Disregarded loan features
Restricted transfer pricing requires taxpayers with NZD10 million or more in cross-border related borrowing to disregard certain loan features for the purpose of pricing the interest rate, regardless of whether the threshold for the debt percentage or the 15% tax rate criteria have been breached. These features include a term in excess of five years, subordination to other debt instruments, and any other “exotic” features (broadly features which would result in increased interest rates due to the ability to defer/cancel interest payments).
In limited circumstances restricted transfer pricing does permit such features to be priced in. This is where the relevant feature is present in the external debt of the group. However, this concession is governed by specific and complex rules. We recommend advice is obtained before seeking to rely on this concession.
Issues and considerations
Relief under the double tax treaties
As restricted transfer pricing can limit interest deductions to below an arm’s length amount as determined under ordinary OECD transfer pricing principles there is potential for double taxation to occur i.e. taxpayers are denied interest deductions in New Zealand while returning interest income at an ordinary arm’s length level in the counterparty jurisdiction.
Under New Zealand tax law, double tax agreements override the domestic position. Despite this, Inland Revenue has made its intention clear to apply restricted transfer pricing to transactions covered by double tax treaties, advising taxpayers to make use of the Mutual Agreement Procedure (“MAP”) to resolve any disputes/uncertainty in this regard. Alternatively, taxpayers may consider making an application for a bilateral advance pricing agreement (“APA”).
Under MAP or bilateral APA negotiations Inland Revenue will be obligated to apply ordinary OECD transfer pricing principles as the basis for determining and agreeing an arm’s length interest, meaning the restricted transfer pricing outcome can be overridden and double taxation relieved.
Unilateral APAs are also possible but taxpayers should be aware that a unilateral APA will be negotiated in the context of restricted transfer pricing being applicable to the relevant financial arrangement and would accordingly not resolve the issue of double taxation.
Taxpayers with cross-border related borrowing in excess of NZD10 million are required to complete a contemporaneous BEPS disclosure (filed annually online with Inland Revenue), including the quantum (if any) of interest expense that a taxpayer has denied due to the application of restricted transfer pricing. The BEPS disclosure also requires taxpayers to disclose whether their debt percentage is in excess of 40% (together with other hybrid regime disclosures), noting that the debt percentage disclosure does not necessarily align with the debt percentage calculation required for the restricted transfer pricing rules. It would be prudent for taxpayers disclosing cross-border related borrowing in excess of NZD10 million and debt percentages in excess of 40% to conduct at least a high-level analysis of the application of restricted transfer pricing and prepare for further attention from Inland Revenue.
Taxpayers should be aware when contemplating changes to a financial arrangement (i.e. where the financial arrangement is renewed, renegotiated or extended) that these changes may have the effect of triggering a reset of both the calculation date of the threshold criteria and the pricing date of the instrument itself. In light of materially reduced interest rates in the current environment, this could have the impact of significantly reducing the level of deductible interest.
The triggering of a new testing date by making amendments to intercompany debt arrangements may mean that a taxpayer becomes subject to the restricted transfer pricing where they previously were not. Upfront discussions with your tax adviser, where possible, can assist with mitigating adverse and/or unexpected outcomes in this regard.
Withholding taxes & deemed dividends
Taxpayers may prefer to price interest rates applicable to their cross-border related borrowings in line with the arm’s length principle in order to meet the arm’s length standard obligations of the lender. Where a restricted transfer pricing analysis calculates an interest rate that is less than an arm’s length rate calculated under ordinary OECD transfer pricing principles, taxpayers will be required to deny a deduction for the difference. However, New Zealand’s non-resident withholding tax (“NRWT”) rules require that NRWT be withheld on all payments in the nature of interest regardless of whether the interest payments are deductible for tax or not.
On a related but separate note, Inland Revenue has released commentary suggesting that the denied interest deduction (due to the application of restricted transfer pricing rules on existing arrangements) may give rise to a deemed dividend for tax purposes. This is a complex area and can create issues from a technical and practical perspective that need to be considered and managed.
OECD Guidance on financial transactions and the implication for financial services structures
In February 2020 the OECD released guidance in respect of the transfer pricing for financial transactions (the “OECD FT Guidance”). The OECD FT Guidance made clear that the Chapter 1 principles aimed at aligning profits with value creation are also applicable to financial transactions, stating at paragraph 10.25 that:
“When, under accurate delineation, the lender is not exercising control over the risks associated to an advance of funds, or does not have the financial capacity to assume the risks, such risks should be allocated to the enterprise exercising control and having the financial capacity to assume the risk.”
Due to its prescriptive nature restricted transfer pricing does not contemplate or make allowance for a holistic analysis of the transfer pricing arrangement. This can result in outcomes under the restricted transfer pricing regime that differ materially from a position when the financial arrangement is considered in light of the functions, assets and risks that are associated with it. In this regard outcomes under restricted transfer pricing may not align with Section GC 13 of the Income Tax Act 2007, which requires transactions to be priced in accordance with the accurately delineated form as set out in the OECD FT Guidance.
This issue is particularly prevalent in the financing/lending sector. Please reach out to us if you would like to discuss the application of restricted transfer pricing in the financing/lending sector.
In adopting restricted transfer pricing New Zealand has stepped away from the BEPS Action 4 unilateral measures such as limits on interest deductibility based on a net interest/EBITDA ratio. The overlay of a unique and prescriptive approach to the OECD arm’s length principle has resulted in a number of novel considerations and interplay with other tax considerations. Taxpayers that have or are considering new cross-border related borrowing into New Zealand should proactively consider the implications of the restricted transfer pricing and seek advice where appropriate, as the outcomes are often not aligned with an outcome under the OECD Transfer Pricing Guidelines.