Chapter 5 - Tooling costs

5.1 In the manufacturing sector, we understand that there is a specific pricing model that is used to quote for, and undertake, work of a tailor-made nature. This system involves quoting for the production of a certain quantity of goods (either in bulk or on a per unit basis) and quoting separately for the “tooling costs” associated with completing the order to the specific requirements of the customer. As the name suggests, these tooling costs are designed to cover expenses associated with creating or adapting tools that can only be used in fulfilling the particular order.

5.2 We understand the major reason for this separation of costs is driven by the customer’s desire to be the “owner” of the specific tools, even though they have no intention of ever taking delivery of them. This is important for the customer because it prevents the manufacturer from using the tools in a future product, thereby reducing the possibility of copy products appearing on the market.

5.3 However, this pricing structure creates a problem from a GST perspective when the manufacturer is resident in New Zealand and the customer is non-resident. The actual goods being produced will be exported and therefore generally able to be zero-rated under section 11. By contrast, the tools will be used exclusively in New Zealand and will not be physically exported. Because the tools are not exported, none of the existing zero-rating rules apply and the tooling costs will be subject to GST at the standard rate.

5.4 The imposition of GST would not occur if the tooling costs were bundled into the cost of the completed product. For example, instead of charging $100 for the products and $10 for the tooling costs, the New Zealand manufacturer could charge $110 for the products. Because the products would ultimately be exported, the full amount could be zero-rated. However, this alternative, as we understand it, would not be acceptable to international consumers, who operate in a set quoting/invoicing environment and insist on this model being followed to assert their proprietary rights over the tools used.

5.5 This is not a problem unique to New Zealand. Australia recognises this problem specifically in legislation. Section 38−188 of the A New Tax System (Goods and Services Tax) Act 1999, provides:

A supply of goods is GST free [zero-rated] if:

(a) the recipient of the supply is a non resident, and is not registered or required to be registered; and

(b) the goods are jigs, patterns, templates, dies, punches and similar machine tools to be used in Australia solely to manufacture goods that will be for export from Australia.

5.6 The UK has a provision in its Value Added Tax Act 1994 that is very similar in its application.[20]

5.7 New Zealand manufacturers are of the view that the lack of a corresponding provision in our GST legislation forces them to charge any tooling costs on a “plus GST” basis. As the non-resident customer is usually unable to reclaim this GST as input tax, New Zealand manufacturers are arguably at a competitive disadvantage to other potential suppliers.

Options

5.8 It is arguable that imposing GST on tooling costs is justifiable because the tools are used and consumed entirely within New Zealand. There will always be occasions when businesses are forced to absorb costs in order to win substantial contracts. These costs include the price of premises, plant, labour and raw materials – all of which naturally fluctuate between various jurisdictions. Tax, it can be argued, is a similar variable. For a New Zealand business, absorbing the GST on a small fraction of the overall income derived from a contract (i.e., the tooling costs) could be a price worth paying for the overall revenue stream that a contract would generate.

5.9 Despite this, we consider this issue should be considered further. There are two main options for addressing the concerns of manufacturers in these circumstances:

• relying on the enhanced registration system; or
• introducing a special zero-rating rule.

Registration system for tooling

5.10 Under the enhanced registration system we have outlined, a non-resident business incurring GST as a real cost would effectively become optional. If a non-resident business was engaging a New Zealand manufacturer, it would, in most cases, be able to register for GST and claim input tax for any GST imposed on the tooling costs. Assuming it had no other connection with New Zealand, the non-resident business would be eligible to have this input tax refunded. The same economic result as zero-rating would be achieved without the need for a special legislative provision.

Special zero-rating rule

5.11 For GST purposes, it is important to focus on who the consumer actually is and where the benefit from the consumption of the goods and services is enjoyed.

5.12 In the case of tooling costs, the customer is the non-resident business and the enjoyment of that contract is also wholly offshore. Unlike, for example, tourists that consume goods and services in New Zealand, the manufacturing customer may not visit New Zealand. The ultimate product of the manufacturing process is exported and the tools, although not physically exported, are owned by the non-resident for the purpose of their offshore business. The fact that the tools remain here can be said to be of little consequence, because they are no longer owned by the New Zealand resident and the value of them is never realised in the domestic market. The customer could, as owner, insist on their exportation at any time.

5.13 If the tooling costs are in effect an export, it is arguable that their supply should be zero-rated in the same manner as other exports. Of relevance to this view is the treatment of services that are performed for a non-resident directly in connection with goods that are then exported. Section 11A(1)(m) allows such services to be zero-rated. It is difficult to argue that the tooling costs are conceptually different to services provided in relation to exported goods.

5.14 Given the similarities between tooling costs and services provided directly in connection with exported goods – both are provided to a non-resident as an inherent part of goods that are ultimately exported – we consider that this could be a situation where a specific zero-rating rule may be justified.

5.15 However, if a zero-rating rule was introduced, it would only apply to tools that are exclusively used on exported goods and where title of those tools passes to a non-resident. If these tools or resulting goods were later on-supplied by the non-resident owner back into the New Zealand domestic market (or allowed by the non-resident to be used for manufacturing for the domestic market), supporting rules may be needed to ensure that the tools would then be treated as imports and GST paid at an appropriate level at that time.

5.16 This exclusivity requirement would add some complexity to a zero-rating system, in that it would still require an enhanced registration system to provide the right result in certain instances. For example, if the goods were used both for domestic and foreign markets, or the tools or goods were on-supplied into New Zealand, GST would be payable. The non-resident would have to use the enhanced registration system to claim any available input tax.

5.17 A further disadvantage of zero-rating (as mentioned previously in relation to zero-rating more generally) is the definitional concern. Although both Australia and the UK use very similar wording for their zero-rating provision, it seems likely that there could be some debate around what constitutes a “similar machine tool”, for example.

Conclusion

5.18 We can see merit in both options and welcome submissions on which is preferable. We are particularly interested in the definitional issues surrounding a zero-rating rule and the extent to which a zero-rating rule for tooling costs would be necessary if an enhanced registration system were introduced.

20 See Value Added Tax Act 1994, Schedule 8, group 13, section 3.