The Risk - Multilateral Treaty and BEPS
The recently announced proposals to address base erosion and profit shifting (BEPS) activities together with New Zealand signing of the OECD Multilateral Convention on BEPS (referred to as the Multilateral Instrument or MLI) has raised the noise level in New Zealand in relation to transfer pricing and other BEPS activities.
It is clear the Government (irrespective of the outcome of the forthcoming general election) and the Inland Revenue expect to raise significantly more revenue as a result of the proposed measures.
New Zealand is not alone in adopting the MLI or introducing new legislative provisions to counter BEPS activities. Whether you are a New Zealand subsidiary of a Multinational Corporation (MNC) or an entrepreneurial New Zealand company of whatever size or scale doing business overseas, you need to be BEPS compliant.
This means you need to be sure that:
- the price for which you are charging related parties for goods or services meets the arm’s length principle under each country’s respective transfer pricing legislation;
- your business is appropriately structured and your legal structure aligns with the commercial reality and economic substance of your business; and
- your measures are well documented and the respective reporting requirements in each jurisdiction fully met.
What You Need to Know about BEPs
The Specifics
New Zealand has a very well designed tax system based on the “broad-based law rate” mantra which as a general observation has produced a tax system which is less complex than most countries. This should make it easier for companies to comply with their tax obligations and allow the cost of collecting the tax take to remain low. Many of the BEPS activities mentioned by the OECD/G20 recommendations were already adequately dealt with under our existing legislation. As a consequence the BEPS proposals recently announced represent more of a tweak to the New Zealand tax system than a complete overhaul.
While it is generally recognised that many MNCs are compliant, there are areas which require strengthening under New Zealand domestic law. Consequently, additional measures are proposed to:
- prevent multinationals from using artificially high interest rates on loans from related parties (interest limitation);
- prevent MNCs from using artificial arrangements to avoid having a taxable presence (a permanent establishment (PE)) in New Zealand;
- prevent MNCs from using transfer pricing payments to shift profits to their offshore group members in a manner that does not reflect the actual economic activities undertaken in New Zealand and offshore; and
- remove tax advantages of exploiting hybrid mismatches between different countries’ tax rules.
Interest Limitation
Interest rate pricing and allowable debt levels
Charging interest on funds lent to a New Zealand company by a foreign parent has been an effective means of reducing taxable income in New Zealand and allowing funds to be repatriated overseas through the repayment of debt.
Debt is often preferred to capital when establishing a legal entity in New Zealand, not only because of the ease with which the company can be set up, but also because of the ease with which funds can repatriated (and re-advanced) when required.
New Zealand has recognised this and has had a well-established thin capitalisation regime designed to prevent excessive debt levels being allocated to New Zealand. The existing thin capitalisation formula which allows a deduction where the interest-bearing debt does not exceed 60% of the New Zealand Assets is to be tweaked. The 60% test (and extended 110% of worldwide group debt percentage) is to be retained, but the measure of the New Zealand Assets will be reduced by non-debt liabilities.
In addition to this change on allowable debt levels, new measures are proposed to restrict the interest rate which can be charged on related party debt. The approach is termed a “restricted transfer pricing approach” for debt. It will require the interest rate to be in line with the interest rate facing the foreign parent. It is based on a rebuttable presumption that the subsidiary company could be expected to be supported by its foreign parent and that any commercially unattractive terms used to justify an excessive interest rate can be disregarded.
Permanent establishments
New PE avoidance rule
In addition to New Zealand signing the OECD MLI which allows New Zealand to adopt the new definition of a PE into its tax treaty network. New Zealand propose to introduce a specific PE avoidance rule into the New Zealand domestic legislation. The exact wording of this avoidance rule remains a work in progress with further consultation being requested but it will apply to to MNCs who structure their business to avoid having a PE (taxable presence) in New Zealand.
The OECD MLI contains provisions which are aimed at preventing taxpayers from structuring their affairs to avoid a taxable presence in New Zealand where one exists in substance. The most obvious example being where an employee or dependent agent is present in New Zealand but has historically not habitually authorised sales contracts. The MLI contains provisions which deem a PE to exist when the contracts have been substantially negotiated in New Zealand even if the contracts were sent overseas to be concluded. The MLI effectively lowers the threshold for determining when a PE exists.
Transfer pricing
Time Bar Extended
One of the measures proposed to be introduced is an extension of the time bar from four years to seven years. The general statute bar period expires four years after the end of the year in which a tax return has been filed. In the absence of income being deliberately omitted from a tax return the Commissioner is prevented from reassessing an income year once this statute bar period has expired. A longer time bar for transfer pricing cases is considered necessary to reflect the complexity of transfer pricing cases and the difficulty in obtaining information especially where that information is held overseas.
This extension of time will create potential problems when buying and selling companies with respect to tax warranties and indemnities where there is any risk of a transfer pricing adjustment being imposed.
Hybrid Mismatches
Comprehensive adoption but with local modification
A hybrid mismatch arrangement arises when countries classify transactions and entities differently from each other under their domestic tax laws. A simple example would be a fixed-rate share which is treated as debt in one country but as a share in another, thus allowing the payment of an amount that is deductible in one country but non-assessable as an exempt dividend in the other country.
The OECD/G20 recommendations on BEPS provided a comprehensive suite of recommendations which includes structures that have not been widely used in New Zealand. However, rather than limiting rules regarding hybrid mismatches to the known New Zealand hybrids, the government propose comprehensive adoption on hybrid mismatch arrangements with suitable local modifications for New Zealand.
The impact of the proposed rules on the hybrid mismatch arrangements needs to be fully assessed not only in relation to specific instruments but also on fiscally transparent entities such as foreign trusts or limited partnerships.
How BDO Can Help
Now and in the future
Inland Revenue and the government clearly have a renewed focus in ensuring MNCs pay their fair share of tax relative to the New Zealand business. The challenge is determining what that fair share of tax should be. Transfer pricing and the importance of the arm’s length principle remains central to any defence against a proposed adjustment under BEPS.
This is true for MNCs doing business in New Zealand and New Zealand entrepreneurial businesses doing business overseas. Most markets in which New Zealand companies operate will have similar transfer pricing rules and regulations and if they do not have them at present, you can guarantee they are likely to be coming.
At BDO we can assist you with a review of your transfer pricing policies, the application of the arm’s length principle, and the documentation required.
For any MNC concerned about whether they have a PE in New Zealand or a New Zealand company concerned as to whether they have created a PE in an overseas jurisdiction, BDO can review the extent of your presence and help evaluate your risks and recommend any measures that may need to be adopted to address those risks.