Foreign branch ring-fencing
Clause 71
Submissions
(5 – Lindsay McKay for Greymouth Petroleum, 16 – Petroleum Exploration and Production Association of NZ, 21 – New Zealand Oil and Gas, 32 – KPMG, 68A – Corporate Taxpayers Group)
The proposed rule ring-fencing deductions for petroleum mining expenditure incurred through a foreign branch should apply only to foreign branches of New Zealand-incorporated petroleum miners controlled by non-residents, or to those where the majority of their petroleum mining operations are done outside New Zealand.
The provisions that ring-fence foreign branch losses discriminate against the petroleum industry because all other industries can offset foreign branch losses against New Zealand-sourced income.
Comment
The current petroleum mining rules allow an up-front deduction for exploration expenditure that is of a capital nature to encourage petroleum exploration and development in New Zealand.
The primary reason why we do not support limiting the scope of the proposed amendment is to ensure that New Zealand receives its proper share of benefit from New Zealand petroleum resources. Given the substantial increase in oil production in recent times, the government considers it is critical to protect the New Zealand petroleum mining tax base.
Petroleum mining generally involves large amounts of expenditure incurred by companies that operate in a number of countries. The reality is that these companies, by their very nature, have considerable flexibility over what jurisdiction they structure expenditure through. The costs of a significant foreign exploration or development project could eliminate a New Zealand petroleum miner’s tax liability on its New Zealand operations. This concern applies whether the company is owned by residents or non-residents.
The submission that the scope of the current provision in the bill be limited to off-shore branches of New Zealand incorporated petroleum explorers controlled by non-residents is also problematic because it may run foul of the non-discrimination clauses in New Zealand’s double tax agreements. These generally prevent New Zealand applying more restrictive tax treatments to non-residents than to New Zealand residents.
The current provision in the bill is in line with the practice in a number of other countries, such as the United Kingdom, which do not allow foreign petroleum mining expenditure to be offset against domestic petroleum mining income.
The current tax treatment of petroleum mining expenditure is arguably concessionary. The concern is that the concession is not working as intended because some New Zealand-resident companies are, in effect, gaining a significant subsidy from the New Zealand tax base for overseas petroleum exploration. Officials were alerted to taxpayers using foreign branches to shelter significant amounts of New Zealand petroleum mining income in late 2007. The proposed legislation merely ensures that the concession is available only for the exploration and development of New Zealand’s petroleum resources. Should similar concerns arise in other areas of offshore activity, officials would provide advice on ways of addressing these concerns.
Recommendation
That the submissions be declined.
Submission
(5 – Lindsay McKay for Greymouth Petroleum)
There should be no change to the law for off-shore branch operations of petroleum mining companies, especially when such a change compromises existing petroleum mining off-shore branch operations.
Comment
Legislative changes often preserve the existing tax treatment for expenditure already incurred. The proposal to ring-fence foreign branch expenditure applies only to expenditure incurred on or after 4 March 2008, therefore preserving the tax treatment for expenditure incurred before that date.
However, while the law changes are technically prospective, they do affect the future tax position of petroleum miners who have entered into arrangements involving future expenditure. In this case, the changes defer deductions for the costs of future foreign petroleum mining exploration and development until foreign petroleum income is returned. This treatment may be mitigated by grandparenting provisions, so the law does not apply to transactions already entered into before the proposed change to the law was announced/enacted.
Businesses constantly have to deal with change, such as new competitors, products and services.
Similarly, changes in tax law occur for many reasons, reflecting society’s changing view of equity, to counter the erosion of the tax base by aggressive tax behaviour, or to correct mistakes that are harmful to taxpayers. Officials recognise that changing the tax law is not a costless exercise and that costs must be justified.
For this reason, “grandparenting” is sometimes used to introduce changes to the tax system. Grandparenting is generally limited to transactions of a specific nature that are expected to be completed in a relatively short time after enactment. This is because there is a close similarity between the transaction completed just before enactment and one entered into but not completed until just after enactment. Giving the contracting parties certainty in allowing arrangements to be completed as contemplated by the parties helps to outweigh the costs (mainly fiscal) of not allowing these arrangements to be completed as contemplated.
However, longer term arrangements, like obligations given under an exploration permit, tend to involve less certainty across a whole range of factors, including tax rules, than short-term transactions. For example, petroleum exploration tends to involve open-ended arrangements, where decisions about incurring exploration costs can occur many years after the date the arrangement was first entered and these costs may be very large. In such instances grandparenting is not appropriate because the costs (mainly fiscal) outweigh the objective of providing certainty.
For these reasons we do not support grandparenting arrangements beyond expenditure incurred before 4 March 2008.
Recommendation
That the submission be declined.
Submissions
(16 – Petroleum Exploration and Production Association of NZ, 32 – KPMG, 67 – New Zealand Institute of Chartered Accountants)
The submissions suggest a number of alternative proposals to address the government’s base maintenance concerns while being less problematic for taxpayers. They include:
- denying deductions for foreign branch losses and expenditure with no tax on foreign branch income; or
- limiting the application of the foreign branch ring-fencing rule to those companies where the majority of their petroleum mining operations (say 75 percent) are done outside of New Zealand, or limiting the rules to companies that are controlled by foreigners.
Comment
Given the immediacy of the risk to the petroleum mining revenue base and the expected timeframe for the review of the tax treatment of foreign branch active income, we consider that ring-fencing petroleum mining expenditure incurred outside New Zealand’s territorial waters is a discrete approach that targets the concern.
Provisions within the bill introduce changes to the tax treatment of controlled foreign companies. Under the current proposal, active foreign income will be exempt, and deductions will be excluded from the New Zealand base. Consideration is being given to apply a similar treatment to foreign branch active income. While this reform would in theory protect the New Zealand petroleum mining income base, it is not scheduled to apply until the 2010–11 income year at the earliest. A key concern to be resolved in the review of foreign branch active income relates to the allocation of income and expenditure to branches.
We have previously discussed the problems with applying more restrictive tax rules on non-residents.
Recommendation
That the submissions be declined.
Submission
(16 – Petroleum Exploration and Production Association of NZ, 21 – New Zealand Oil and Gas, 32 – KPMG)
Allow an automatic entitlement to carry forward and reinstate any unallocated foreign branch deductions regardless of the normal shareholder continuity rules. One way to achieve this result would be to apply the amortisation rules that apply to research and development expenditure.
Comment
The government is concerned to ensure that tax losses of one person cannot be acquired by another person who happens to have taxable income. To prevent taxpayers trading losses, the current tax rules only allow deductions for expenditure and losses that are incurred by the taxpayer. The shareholder continuity rules set the bounds for determining changes in shareholder interests.
An exception to the general loss trading policy was implemented for research and development expenditure, because the policy was problematic for the growth cycle of high technology companies. These companies typically have a long lead-in period where significant expenditure is incurred before any income is realised. It is part of the normal financing process for such companies for additional equity investors to come in after the initial development work has been successful. If tax deductions for this development work cannot be used because of shareholding changes, this can effectively result in technology companies being taxed on their gross income.
The government previously decided to defer extending the current tax treatment of research and development expenditure to petroleum mining. As such, any project on this matter needs to be considered in the context of the government’s tax policy work programme.
Recommendation
That the submission be declined.
Submission
(68A – Corporate Taxpayers Group)
Under the foreign branch ring-fence proposal, there is a risk that the investment will not produce sufficient petroleum mining income and give rise to a loss which will never be tax deductible.
Comment
The concern the submission raises can occur with rules designed to prevent the trading of losses. For example, a taxpayer goes out of business and has significant tax losses.
While we share the concern that some losses may be stranded, the provisions in the bill try to minimise the risk of this occurring. Allowing foreign branch petroleum mining expenditure to be offset against any foreign petroleum mining income reduces the risk of stranded losses.
Recommendation
That the submission be noted.
Submission
(67 – New Zealand Institute of Chartered Accountants)
The reference to section IF 1 in new section DT 1A(4) is a 2004 Act reference and should be in the 2007 Act.
Comment
The reference to section IF 1 is correct. There are two versions of section DT 1A(4), one for the Income Tax Act 2004 and one for the Income Tax Act 2007. Both versions have the correct references.
Recommendation
That the submission be declined.
Submission
(16 – Petroleum Exploration and Production Association of NZ, 35B – PricewaterhouseCoopers, 62 – Minter Ellison Rudd Watts)
Section DT 1A(2) should be amended by replacing “those operations” with the phrase “petroleum mining operation undertaken outside New Zealand”. This would clarify the basis of deductibility for petroleum mining expenditure incurred through a foreign branch.
Comment
The policy is to allow foreign branch petroleum mining losses to be offset against petroleum mining income from any country other than New Zealand. The provisions in the bill ring-fence foreign branch petroleum mining losses on this basis. The reference to “on a country by country basis” in the commentary does not reflect the government’s final policy.
There is a discrepancy between section DT 1A(2) and the commentary on that section. Section DT 1A(2) would be clearer if the words “those operations” were replaced with the words “petroleum mining operation undertaken outside New Zealand”.
Recommendation
That the submission be accepted, subject to officials’ comments.
Submission
(16 – Petroleum Exploration and Production Association of NZ)
It is not appropriate to ring-fence deductions for development expenditure and residual expenditure.
Comment
The government is keen to ensure that New Zealand receives its fair share of the benefits from petroleum mining operations in New Zealand. This is fully achieved under the current amendments. Excluding other types of petroleum mining expenditure makes no sense given the policy objective.
Once the petroleum miner returns foreign petroleum mining income, the foreign petroleum mining deductions can be used.
Recommendation
That the submission be declined.