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Chapter 2 - Introduction

2.1 The government has extensively modernised New Zealand’s international tax rules in recent years.

2.2 In 2007, the tax treatment of offshore portfolio investment by New Zealanders was overhauled. The fair dividend rate method of taxing portfolio investors replaced an inefficient system which favoured investment in certain countries and discouraged investment through mutual funds.

2.3 Then in 2009, the tax treatment of offshore direct investment was reformed. Following the reform, New Zealand multinationals with foreign subsidiaries were no longer taxed on the active foreign income of those subsidiaries, such as income from manufacturing or retail sales. This reduced barriers to global expansion from a New Zealand base. In 2011 this “active income exemption” was extended to direct (more than 10%) but non-controlling interests in foreign companies.

2.4 In tandem with the changes to domestic tax law, the government has also begun a programme of updating our double tax agreements. New Zealand has already obtained substantially lower withholding tax rates for dividends and royalties with Australia and the United States, and is likely to obtain those lower rates with other countries in future.

2.5 The treaty reform provides another reason for multinational enterprises to keep their New Zealand base. However, treaty reform entails reciprocal obligations: the same concessions that have been made to New Zealand investors abroad must also be made to foreign investors here. In some cases this removes an element of protection for the New Zealand tax base.

2.6 This puts the spotlight on the effectiveness of other base-protection measures aimed at non-residents such as thin capitalisation, transfer pricing and non-resident withholding tax. More generally, it has been some time since these sorts of measures were introduced or reviewed, and there are concerns that they are not working as well as they could.

2.7 This issues paper proposes changes to the thin capitalisation rules to ensure New Zealand collects its fair share of tax from inbound foreign investment.

The thin capitalisation rules

2.8 In 1997 thin capitalisation rules were introduced to prevent non-residents from allocating an excessive proportion of their world-wide interest expenses against their New Zealand sourced income. The need for such rules arose because interest is deductible at the company tax rate but withholding tax of only 10% or 2% was payable on the corresponding interest income. Equity investment, however faces the full company tax rate. Thus there are inherent incentives for taxpayers to capitalise companies with debt instead of equity. The rules are briefly summarised in the Appendix.