General comments
Issue: General comments on the changes
Clauses 2(25), 87 to 98 and 123(32)
Submissions
(PricewaterhouseCoopers, KPMG, Ernst & Young, Corporate Taxpayers Group, Deloitte, Staples Rodway, New Zealand Council of Trade Unions)
Several submitters supported the proposed changes to the thin capitalisation rules in principle. They noted there were gaps in the current rules and that it was appropriate for these to be closed.
Some submitters, however, expressed concern with certain elements of the changes, such as a lack of certainty over when the rules will apply. Others did not support all aspects of the proposed changes such as the proposal to disregard certain uplifts in asset values.
One submitter suggested the changes should not proceed: the thin capitalisation rules play a role when non-residents decide to invest in New Zealand. Extending the thin capitalisation rules to cover non-residents that act together may therefore deter investment in New Zealand. Further, the thin capitalisation rules discriminate against non-resident investors since they do not apply to domestic investment. (Staples Rodway)
Another submitter said the proposed changes are too cautious and that more work should be done to prevent tax avoidance by overseas investors. Consideration should be been given to further lowering of the safe harbour level of allowable debt (currently 60 percent of assets). Further, the burden of proof on whether overseas investors are “acting together” should be placed on taxpayers – any company where 50 percent or more of its shares are owned by non-residents should be subject to the thin capitalisation rules unless the shareholders can demonstrate they are not acting together. (New Zealand Council of Trade Unions)
Comment
Officials note the comments supporting the broad direction of reforms and suggest changes recommended in this report will address many submitters’ concerns. These changes should, for example, increase certainty over when and how the rules will apply.
Officials do not agree that the changes should not proceed. Most submitters acknowledged there are weaknesses in the current rules and that these need to be dealt with.
Officials consider it appropriate that the thin capitalisation rules apply only to non-resident-controlled companies. This is the international norm.
Officials also do not agree that the reforms are too cautious. Throughout the policy development process submitters have stressed the importance of certainty when taxpayers are making decisions about large investment projects. Placing a strong burden of proof on taxpayers that they are not acting together would create significant uncertainty. The rules have been designed to be as certain as possible while still providing appropriate base protection.
Changes to the “safe harbour” were not considered as part of the review of the thin capitalisation rules. This was because the safe harbour was only recently lowered (as was recommended by the Victoria University of Wellington Tax Working Group).
Recommendation
That the submissions supporting the reforms be noted and that the other submissions be declined.
Issue: Treatment of look-through entities
Submission
(KPMG)
If an entity is treated as look-through for New Zealand tax purposes, such as a limited partnership, and is used as an investment vehicle in New Zealand, the tested entity for thin capitalisation purposes will be the individual partners, not the partnership.
This is illogical. The tested entity should be the limited partnership, not the partners in the partnership. Were this change made, the partnership itself would be subject to the thin capitalisation rules on the basis that it is owned by non-residents who are acting together.
This has significant implications for large infrastructure projects such as Public-Private Partnerships (PPPs). These projects typically have high levels of third-party gearing, but it is unlikely that such high gearing would be allowed under the current treatment of limited partnerships. If, however, limited partnerships were treated as the tested entity, the modified rules for entities that are controlled by non-residents acting together would apply. This would mean any third-party debt would (in essence) no longer be counted for the thin capitalisation rules.
Comment
Limited partnerships are transparent for New Zealand tax purposes. This means the partnership is disregarded; instead, the partners are treated as carrying on the business of the partnership. A consequence is that each non-resident partner is considered a single non-resident controller of a New Zealand investment.
Officials do not believe changes should be made to the thin capitalisation treatment of limited partnerships without reviewing the rules for those entities more generally. Treating limited partnerships as opaque for thin capitalisation but transparent for other purposes may provide taxpayers with avoidance opportunities.
We also note that changing the tax treatment of limited partnerships, even if such a change were isolated to the thin capitalisation rules, would be a significant shift in policy. It would be important to consult fully on any such change.
Recommendation
That the submission be declined.
Issue: Allowable debt test for single non-resident controllers
Submission
(KPMG)
The current thin capitalisation rules, where all debt is counted when determining if a company has too much debt, will continue to apply where a single non-resident investor holds a 50 percent or greater interest in a New Zealand investment. For companies controlled by non-residents acting together, however, only related-party debt will be counted.
This puts single non-resident investors at a disadvantage. The proposed rules for non-residents acting together should be extended to single non-resident controllers.
This issue is particularly pertinent for Public-Private Partnerships (PPP) projects. It puts a potential investor in a PPP who is a non-resident acting alone at a disadvantage compared with a group of non-residents acting together.
The submitter did note that the change could potentially allow non-residents to allocate debt that truly belongs elsewhere to New Zealand but contended that other changes to the rules, such as the exclusion of shareholder guaranteed debt from the worldwide group debt test, will limit this ability.
Comment
The proposed changes will deem the worldwide group of a New Zealand company owned by non-resident shareholders who are “acting together” to be just its New Zealand group. In effect, this means these companies will be unrestricted in how much they can borrow from genuine third-parties. This was done for practical reasons. Applying the standard worldwide group test to shareholders acting together is not feasible. It would be extremely difficult to meaningfully consolidate the debts and assets of the company’s shareholders (who are presumably unrelated parties) to construct a worldwide group as it relates to their New Zealand investments.
Companies controlled by single non-residents do not face this problem. They can use the worldwide group debt test as it currently stands. This means if the parent company’s worldwide operations are highly geared, the New Zealand operation can use the worldwide group debt test to justify a high level of gearing in New Zealand.
The suggested change would also provide companies controlled by a single non-resident with two methods for applying the worldwide group debt test: the existing test (based on the debt-to-asset ratio of the worldwide debt), and the new modified test for those “acting together” (that allows unlimited borrowing from third-parties). The companies could pick and choose the method that would best suit them.
Officials therefore do not support changing the worldwide group debt test for companies controlled by single non-residents at this time.
Recommendation
That the submission be declined.
Issue: Complexity of the proposed amendments
Submissions
(Ernst & Young, New Zealand Institute of Chartered Accountants)
The amendments to the thin capitalisation rules are complex. Given this, the amendments to the thin capitalisation rules should be separated from the rest of the bill and progressed at a slower pace. This would allow sufficient time to ensure all of the amendments are appropriately drafted. (Ernst & Young, New Zealand Institute of Chartered Accountants)
The amendments are complex and will impose additional compliance costs on taxpayers, yet the expected fiscal gain, as reported in the regulatory impact statement, is only $20 million over three years. It is not clear the appropriate balance between complexity and revenue protection has been achieved. (New Zealand Institute of Chartered Accountants)
Given the complexity of the rules, a mechanism should be introduced that allows taxpayers to apply to the Commissioner of Inland Revenue for a thin capitalisation determination. This would cover whether, and how, the rules apply to the taxpayer – for example, what its New Zealand and worldwide groups are, and its relevant debt-to-asset ratios. (Ernst & Young)
Comment
The changes being recommended in this report should address many of submitters’ concerns about the complexity and uncertainty in the rules.
Officials do not consider the changes should be broken out from the bill as the next available omnibus tax bill is unlikely to have passed before the beginning of the 2015–16 income year for many taxpayers. Delaying enactment of these provisions could create uncertainty.
We also do not agree than the changes are too complex given the forecast revenue impact. The thin capitalisation rules are an important part of New Zealand’s international tax rules, helping ensure non-resident investors pay an appropriate amount of tax in New Zealand. It is important that the rules work effectively. Without the proposed changes the revenue lost could grow over time as the global economy recovers, increasing non-residents’ demand for investment opportunities.
In terms of providing a determination mechanism, we note that taxpayers can request binding rulings on elements of the thin capitalisation rules. While binding rulings are restricted to questions of law, such a ruling could cover questions such as whether the rules apply to an entity based on the facts described. There are also numerous complex regimes in the Income Tax Act yet almost all of these do not feature a special determination mechanism. We do not recommend a determination mechanism for thin capitalisation be inserted through this bill.
Recommendation
That the submissions be declined.
Issue: Introduction of a de minimis threshold
Submission
(PricewaterhouseCoopers)
Consideration should be given to the introduction of a de minimis threshold for the inbound thin capitalisation rules. The rules are complex and these changes make them even more so. A de minimis threshold would reduce compliance requirements for smaller non-resident owned companies.
Comment
A de minimis of $1 million of interest deductions would generally allow each company under that threshold to have an additional $400,000 of interest deductions taken in New Zealand compared with if the thin capitalisation rules applied. This could have a moderate fiscal cost.
The question of a de minimis was not raised during the two rounds of consultation while the changes were being developed. Little is known about the type and number of firms that would be covered by a de minimis, their difficulties in complying with the legislation, or whether a de minimis would be the best response.
Given these factors, officials do not recommend a de minimis threshold for the inbound thin capitalisation rules at this time.
The submitter raised the fact that the outbound thin capitalisation rules have a de minimis of $1 million of interest deductions. The rules do not apply below this threshold. Australia similarly has a de minimis, applying to both its outbound and inbound thin capitalisation rules. This will be increasing to $2 million of interest deductions from 1 July 2014.
In terms of providing a de minimis, officials note there are different considerations that need to be borne in mind when comparing the inbound and outbound rules. Given New Zealand’s imputation system, New Zealand-owned companies have a natural incentive to pay tax in New Zealand and therefore place their debt offshore. The New Zealand tax base is therefore protected somewhat even for companies that fall below the de minimis threshold of the outbound rules. The same considerations do not apply for non-resident owned companies, who normally do not face the same incentives to pay tax in New Zealand.
Recommendation
That the submission be declined.
Issue: Revised guidance on the rules
Submission
(PricewaterhouseCoopers)
A comprehensive Tax Information Bulletin article explaining the thin capitalisation rules was released when they were first introduced. Given the significant changes to the rules in this bill, together with other changes to the rules (such as the introduction of the outbound and banking thin capitalisation regimes), it is timely that Inland Revenue issue revised guidance on the rules in their entirety.
Comment
Officials will prepare a Tax Information Bulletin once the bill is enacted, setting out how the new rules are intended to operate.
Officials will pass the request for guidance on the rules in their entirety to the relevant areas of Inland Revenue for consideration alongside their other priorities.
Recommendation
That the submission be noted.
Issue: Grandparenting
Submission
(Staples Rodway)
Grandparenting provisions should be provided so existing investments are not affected by these proposals. Without grandparenting, some existing investments will likely breach their thin capitalisation limits. They will start having interest deductions denied unless they restructure their debt – this restructuring may be costly.
Comment
The application date for these changes is the beginning of the 2015–16 income year (for most taxpayers this will be 1 April 2015). This is a long lead time given the changes were first announced in January 2013. Officials believe this gives taxpayers sufficient time to change their financing arrangements if that is necessary.
Grandparenting would favour existing investments over new investments. It would also create boundary issues in distinguishing whether some funding was the continuation of an existing investment or a new investment. This would require complex or potentially arbitrary rules.
Recommendation
That the submission be declined.
Issue: Changes to the introductory section
Clause 87
Submission
(Ernst & Young, New Zealand Institute of Chartered Accountants)
The proposed changes to section FE 1 refer to adjustments of interest deductions if the level of interest expenditure incurred in New Zealand is too high. This wording is inappropriate as the thin capitalisation rules look only at the amount of debt in New Zealand, not the amount of interest expenditure in New Zealand.
Comment
Officials agree. The introduction to the rules should reflect that they operate based on levels of debt, not levels of interest deductions.
Recommendation
That the submission be accepted.
Issue: Application date
Clause 2(25)
Submission
(Ernst & Young, New Zealand Institute of Chartered Accountants)
The application date of the 2015–16 year is appropriate.
Comment
Officials agree. This application date will ensure taxpayers have the opportunity to consider how the new rules will affect them before they take effect.
Recommendation
That the submission be noted.