New Zealand versus the world: The battle for international tax revenues reaches our shores
The amount of tax paid by multinationals in New Zealand continues to be a sore point between taxpayers and Inland Revenue.
Since the sharp fall in profits, and corresponding reduction in tax revenue, paid by companies following the GFC, coupled with an increasing realisation that archaic international tax rules are inadequate to cope with modern commerce, governments around the world have actively taken steps to coordinate and cooperate in order to ensure taxpayers “pay their fair share of tax” in each jurisdiction. The Base Erosion Profit Shifting (BEPS) initiative led by the OECD countries has promoted 15 action points for countries to implement to counter measures by taxpayers to divert profits away from the countries in which they are earned into low-tax or no-tax jurisdictions.
New Zealand Inland Revenue has been an active and eager participant in developing those action points and is now in the process of domestic implementation. The IRD has recently published three separate policy papers regarding measures to counter BEPS. These cover: implementation of the new multi-lateral convention implementing the BEPS action points; strengthening our rules that limit the quantum of interest that can be deducted by non-residents; and expanded transfer pricing and anti-avoidance rules.
Inland Revenue has sought feedback from taxpayers and their advisers on the scope and application of the proposed rules. It is presently considering submissions received and will next publish draft legislation for further consultation.
While many of the proposals are wide-ranging and heavy-handed, the most contentious and complex of the proposals relates to transfer pricing. In particular, the proposals will make significant changes to the long-standing law dealing with cross-border transactions entered into by related parties.
The current transfer pricing rules are found in Part GC Income Tax Act 2007. Those rules, and the OECD transfer pricing guidelines, were designed to ensure related parties deal with each other on an arm’s length basis. It requires multinationals to equalise the terms and prices on which they purchase or sell goods and services, or lend funds, to their New Zealand corporate group members with what non-related parties would transact.
Our domestic law, with very limited exceptions, does not currently restrict what transactions could be entered into or upon what terms, provided the price reflects what an unrelated party would have paid for the same arrangement. Under the current rules, so long as the taxpayer is able to support their pricing structure and co-operates with Inland Revenue, the onus of proof lies on Inland Revenue to demonstrate the taxpayer was not transacting at a fair price by identifying a more accurate arm’s length price.
This reverse onus of proof for transfer pricing is unusual in tax matters, with the onus of proof in almost all other respects falling on the taxpayer.
Given that sophisticated multinationals generally have better information and know their business much better than the IRD, this onus has proved extremely difficult for it to discharge in practice. Accordingly, while transfer pricing has been a regular area of audit by Inland Revenue for many decades, not a single case has ever been brought against a taxpayer in a New Zealand Court.
Nevertheless, the widespread perception within Inland Revenue has been that this failing is largely due to weaknesses in the current transfer pricing provisions and not because most multinational taxpayers actually complied with their obligations to adopt arm’s length pricing. This, coupled with growing political pressure around the world to update international tax rules to cater for the digital economy, is what has given rise to this fundamental change in approach in New Zealand.
The focus in transfer pricing cases has always been whether the transaction takes place at arm’s length – not necessarily where the profit from that transaction arises. Although this is invariably a factor to consider in transfer pricing audits, from Inland Revenue’s perspective, their toolbox is limited to proving that there was a more reliable arm’s length measure than the ones used by the taxpayer to price its arrangements.
Where the value was created
Generally the profit from a transaction should arise where the value was created (ie, where the goods are produced, where the services are performed, where the relevant intellectual property is located, or where the funds are sourced). Just looking at the sales made to New Zealand consumers is not helpful because it all depends on who is making the sale and who has added the value such that the sale itself can be fairly attributed to recompense that value adding party for their efforts.
Unfortunately for New Zealand, beyond the agricultural sector, we produce few raw materials, have a small manufacturing base, rely heavily on services provided from overseas, hold little intellectual property and are a net importer of capital. Accordingly, New Zealand adds little value to most transactions – in many instances we are merely a comparatively small customer base for the wares provided by overseas suppliers. And that is just as true for the New Zealand arm of a multinational group as for those transacting with unrelated parties.
This problem has been recognised by some within the tax department. The officer within Inland Revenue responsible for administering New Zealand’s international tax obligations, the Competent Authority, John Nash, has previously admitted that:
“In terms of the way we tax, you tax the value-add. I wish it wasn’t like this. But you can only tax what gets added in New Zealand and we’re right at the end of the value chain. Unfortunately, that’s the state of the industry in New Zealand; it’s not necessarily a reflection of profit-shifting”.
Mr Nash referred to the pharmaceutical sector as an example of a corporate sector that, while profitable internationally, only used the local industry as a “distribution agent”.
Those comments reflect the reality of New Zealand’s trading position – but seem lost on policy-makers within Inland Revenue, who continue to view the low profits returned by the New Zealand arms of multinationals as suspicion of BEPS.
Due to New Zealand’s small size and relative unimportance within most multinational groups, it is common place for services and often intellectual property to simply be provided to New Zealand entities free of charge or on a simple cost-recovery basis. Up until now, to accurately price those transactions has not been worthwhile as the amounts are not material to the group. However, that pricing may not reflect the true arm’s length price of the benefit enjoyed by New Zealand.
Greater costs passed into NZ?
When more comprehensive and aggressive transfer pricing rules come into effect around the world, all groups will be required to accurately establish the proper price for such group-services provided, including into New Zealand. The likely result is greater costs being passed into New Zealand which will only reduce the profit and therefore tax payable by multinationals in this country.
It is unclear the degree to which this, combined with where New Zealand generally sits in the value chain of multinationals, has been factored into the anticipated additional revenue that the policy makers have said they are expecting as a result of the proposed law changes. The Minister, Judith Collins, claimed recently that up to $300 million of additional revenue may be gathered when all proposals are fully implemented.
The experience of most tax practitioners advising taxpayers targeted by these proposals is that, while the compliance costs of demonstrating they have paid the correct amount of tax will significantly increase, the amount of additional revenue collected for New Zealand may be less clear. Nevertheless, it may well be that New Zealand policy-makers feel compelled to have enough legislative tools at their disposal to protect the tax base from erosion, not just by taxpayers, but potentially by other revenue authorities driven to retrieve profits perceived as leaking from their own jurisdictions.
Kirsty Keating email@example.com is a partner and New Zealand Law Leader with EY Law Ltd. She is a member of the NZLS Tax Law committee.
Last updated on the 30th June 2017