New Zealand’s BEPS proposals go beyond OECD’s recommendations
With a general election looming, the New Zealand government has unveiled a raft of measures intended to counter base erosion and profit shifting (BEPS) that, in some respects, go further than any of the OECD’s BEPS recommendations. Brendan Brown and Tim Stewart of Russell McVeagh in New Zealand explain the recent announcements, which include measures to address permanent establishment avoidance, significant changes to the transfer pricing and thin capitalisation rules, measures to address hybrid mismatch arrangements, and various measures (going beyond the OECD’s BEPS recommendations) to increase Inland Revenue’s enforcement powers.
Parliament could be discussing the proposals within a few months
On August 3 2017, the New Zealand government announced its final policy decisions on proposals to address BEPS. The announcements follow public consultation on discussion documents released on September 6 2016 (concerning hybrid mismatch arrangements) and on March 3 2017 (concerning measures to address arrangements that avoid creating a permanent establishment, to further limit related party interest deductions, and to further strengthen the transfer pricing rules and Inland Revenue's enforcement powers more generally).
The final policy decisions are wide-ranging. In some respects, the measures go further than any of the OECD's BEPS recommendations, such as by further strengthening Inland Revenue's information-gathering and other enforcement powers.
The government proposes an aggressive timetable for implementation. It is proposed that legislation be introduced to Parliament before the end of the year, and enacted in the first half of 2018. This could see most of the measures applying from as soon as July 1 2018.
In this article, we summarise the government's final policy decisions and the likely next steps.
Permanent establishment and transfer pricing proposals
The government had proposed a number of measures relating to the definition of permanent establishment (PE) and the transfer pricing (TP) rules. The measures included a proposed anti-avoidance rule in respect of structures that avoid creating a PE, extending the circumstances in which income will be deemed to be New Zealand sourced, strengthening the TP rules, and increased enforcement powers. Some measures would apply only to groups with a turnover of at least €750 million ($885 million) (large multinationals), while other measures potentially apply to all taxpayers. The government has announced that it will proceed with all but one of its proposals.
The government is not proceeding with the proposal to require large multinationals to pay disputed tax earlier. This recognises that the interest regime applicable to underpaid tax already creates a strong incentive for taxpayers to pay tax in dispute. In addition, Inland Revenue already has the power to require payment of disputed tax in advance of the dispute being determined in cases where there is a risk of non-payment of tax subsequently found to be owing.
The PE avoidance rule (applicable to large multinationals only)
The PE avoidance rule, as initially proposed, would deem a non-resident entity to have a PE in New Zealand if there is an arrangement under which:
A non-resident supplies goods or services to a person in New Zealand;
An entity either associated with or commercially dependent on the non-resident carries out an activity in New Zealand in connection with that particular sale for the purposes of bringing it about (the required link to a particular sale is intended to exclude from the rule preparatory work of a general nature, such as marketing);
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 double tax treaty's (DTA's) PE provision.
Consultation on the proposals released in March highlighted concerns that the proposed PE avoidance rule could apply too broadly, in two main respects. One concern was that the PE avoidance rule was unnecessary in light of the measures included in the Multilateral Instrument (MLI) to address arrangements that artificially avoid the PE status. A second concern was that the rule, as proposed, was not sufficiently targeted to avoidance transactions and so could apply to commercially driven non-abusive transactions.
The PE avoidance rule will proceed, although the government has recognised that the proposal consulted on requires refinement to be more workable in practice. The new rule will therefore not apply in cases to which the MLI measures to address PE avoidance (or, potentially, equivalent changes in a later bilateral DTA or protocol) apply. In addition, officials are further considering options that would see the PE avoidance rule expressly target cases of avoidance:
The first option is to replace the proposed requirement that the arrangement defeats the purpose of the PE provision with a test that requires a more than merely incidental purpose of tax avoidance; and
The second option is to replace the proposed PE avoidance rule with the OECD's widened PE definition, which would be incorporated in New Zealand's domestic law on a standalone basis.
Expanded definition of source (applicable to all taxpayers)
New Zealand has detailed definitions for determining when income will be sourced in New Zealand. The government proposes extensions to this definition.
The government had originally proposed that income will be deemed to be sourced in New Zealand if New Zealand has a right to tax that income under the PE article of an applicable DTA. For non-residents in respect of whom no DTA applies, New Zealand's model treaty PE article will be incorporated into domestic law to apply as an additional source rule. The government has announced that it intends to extend this proposal to all types of income covered by a DTA (not just income covered by the PE article). The government will undertake further consultation on this proposal.
Another aspect of the proposed extensions to the definition of source will be modified to be more targeted. The proposal that income should be deemed to have a New Zealand source if the multinational group were a single entity will be modified. The rule as modified will (broadly) provide that where another group member carries on a non-resident's business in New Zealand, the non-resident will be deemed to carry on that business itself for the purposes of determining whether its income from New Zealand customers has a New Zealand source.
Strengthening the TP rules (applicable to all taxpayers)
The government had proposed numerous substantive and procedural changes to the TP rules. The government has announced that these proposals will be implemented (other than, as noted above, the proposal to require large multinationals to pay disputed tax in advance).
The substantive changes to the TP rules would largely follow amendments that Australia made to its TP provisions in 2013. The changes would expressly incorporate the OECD TP guidelines into domestic law, endorse a substance-over-form approach, and provide Inland Revenue the power to reconstruct an arrangement when applying the TP rules if the arrangement would not be commercially rational if entered into between unrelated parties. In addition, the scope of the TP rules would be extended to arrangements under which groups of persons (typically a consortium of investors) act together in relation to an entity, even if each individual investor is not associated with the entity. These changes will generally proceed as proposed although the test for reconstruction is to be based on the OECD TP guidelines rather than on Australia's reconstruction provision.
The government also intends to reverse the onus of proof in transfer pricing matters, so that taxpayers will bear the burden. Presently, the onus is (with some exceptions) on Inland Revenue to demonstrate that an amount it determines as the arm's-length amount is "more reliable" than the arm's-length amount determined by the taxpayer.
Finally, the government has announced that the limitation period will be increased from four years (after the end of the year in which the return is filed) to seven years. This is especially controversial because, in combination with the other proposed changes to the TP rules, it could herald more prolonged and aggressive TP audits than is already the case.
Increased enforcement powers (applicable to large multinationals only)
Certain changes to tax payment obligations will also proceed. The government intends to give Inland Revenue the power (in cases where Inland Revenue considers the large multinational to have been uncooperative) to accelerate the making of an amended assessment. In addition, a new collection power would provide that New Zealand tax payable by a non-resident member of a large multinational group could be collected from any wholly-owned subsidiary of the multinational that is resident in New Zealand if the non-resident member fails to pay the tax itself.
Inland Revenue will be given the power to require a New Zealand entity within a multinational group to provide information held by a member of that group outside New Zealand. A related proposal is to extend the scope of a provision under which a deduction is denied for cross-border payments in respect of which a person fails to provide requested information. These measures could be especially onerous in the case of large multinational groups. A broadly worded information request could in theory require the review of information and records held by the group in multiple countries in circumstances where the New Zealand subsidiary and its management have no practical ability to know what records are held in which locations, let alone the power to access those records.
A civil penalty of up to NZ$100,000 ($70,000) is proposed if a large multinational fails to comply with an information request. Existing law provides criminal law sanctions for failure to comply with an information request, but the advantage of a civil penalty (for Inland Revenue) is that it can be imposed without bringing a prosecution before the courts.
The upcoming New Zealand elections could change the course of proposed tax changes
Interest limitation proposals
Restricted TP methodology
New Zealand has thin capitalisation rules based on debt to total asset ratios (with a safe harbour of 60% for inbound and 75% for outbound investment) or (in the case of banks) the required equity for tax purposes. The government proposes to maintain that basic framework and does not at this stage plan to implement an earnings-based limitation on deductible interest expenses, as recommended the OECD's BEPS Action 4 Final Report.
The government is, however, concerned about high-priced related party debt. The proposals released for consultation in March included a proposed cap on the interest rate on such debt for the purposes of determining the amount of deductible interest expense. The cap would have been based on an actual or assumed credit rating of the New Zealand borrower, depending on the circumstances.
Following consultation, the government has decided not to proceed with the interest rate cap but instead to introduce a "restricted transfer pricing" methodology. Under this proposal, the interest rate on inbound related-party loans would be set using transfer pricing methodologies but on the basis that all surrounding circumstances, terms and conditions that could result in an excessive interest rate would be ignored unless similar terms apply to significant amounts of third-party debt, and with the rebuttable presumption that the borrower would be supported by its foreign parent in the event of default.
The government concluded that adjustments would have been required to the original interest rate cap proposal that would have made it more complex. However, the interest rate cap as originally proposed may be implemented as a safe harbour by way of an administrative practice.
The proposed "restricted transfer pricing" methodology, while it should be less arbitrary than the cap originally proposed, nonetheless raises difficult questions. For example, it is unclear whether the rebuttable presumption that the borrower would be supported by its parent in the event of default is intended to confirm that pricing should take into account implicit support, or whether it is intended to require the borrower's debt to be priced as if the parent had given a legally binding guarantee of the borrower's obligations. If the latter approach is intended, then a further question arises as to how to quantify the value of the guarantee and the expense that the borrower should recognise for its provision.
Amendments to thin capitalisation rules for non-banks
The government is proceeding with various amendments to the thin capitalisation rules for non-banks, although the government has decided on modifications to some aspects of the proposals and will undertake further consultation regarding certain technical issues. One proposal that could have a significant impact for some groups is that in calculating the debt to total assets ratio, assets would be measured net of most liabilities that are not treated as debt for thin capitalisation purposes. A common example is trade creditors that (because they are not interest-bearing) are not debt for thin capitalisation purposes.
Other proposed changes include an exemption from the thin capitalisation rules for foreign-controlled special purpose vehicles (SPVs) entering into public private partnerships. Entities using this exemption would be able to deduct their full interest expenditure on third party debt that is limited recourse to the SPV, even if the entity's debt to total assets percentage would exceed the thin capitalisation thresholds.
Anti-hybrid mismatch proposals
The government has also announced that it will proceed with comprehensive implementation of the OECD's recommendations to address hybrid mismatch arrangements, subject to three specific modifications to address the New Zealand context:
New Zealand will modify the OECD's recommendations to clarify that a New Zealand taxpayer that operates a simple offshore branch does not present a hybrid mismatch problem and will be able to offset losses from a foreign branch against its New Zealand income;
The government has recognised a concern that measures to address imported mismatches are highly complex, and may be impractical and result in over-reach. To address these concerns, the government intends to delay the effective date of the imported mismatch rule for "non-structured imported mismatch arrangements" until January 1 2020. The imported mismatch rule will apply to "structured arrangements", which are designed to obtain a hybrid mismatch, from the same time that the rest of the anti-hybrid rules are implemented (proposed to be from July 1 2018); and
To allow the foreign trust and limited partnership industries more time to understand the implications of the proposed rules, the government intends to delay the effective date of the rules for New Zealand reverse hybrids until April 1 2019.
New Zealand is due to hold a general election on September 23 2017. The government proposes that if it is re-elected, legislation implementing its decisions would be introduced to Parliament before the end of the year, and enacted in the first half of 2018. This could see most of the measures applying from as soon as July 1 2018.
The government's proposed timetable for implementation is ambitious considering the complexity of many aspects of the proposals. In addition, there remain questions about the compatibility of certain measures with New Zealand's DTA obligations. Inland Revenue officials announced on August 14 that they would be undertaking targeted consultation on matters of legislative design and technical detail during September. Given the complexity of some of the proposals, businesses will be hoping that there is a meaningful opportunity for consultation on the draft legislation before the bill containing the amendments is introduced to Parliament later this year.