Chapter 2 - Background

2.1 New Zealand has a policy of taxing non-residents on income that has a New Zealand source. When a non-resident has a branch or subsidiary in New Zealand, tax can be imposed on the income of that branch or subsidiary in the same way as it would be on New Zealanders. When the non-resident does not have a New Zealand presence, it is substantially more difficult for New Zealand to collect normal net income tax from the non-resident. Instead, a gross withholding tax is imposed on the payer of certain types of income, typically being a resident that New Zealand can enforce tax obligations upon (though the non-resident payee also has a liability to pay this tax if it is not withheld). This withholding tax is called NRWT. For interest payments, the rate of NRWT is usually 10%[1] of the interest paid.

2.2 New Zealand’s policy on taxing non-residents and the use of withholding taxes for income when the non-resident does not have a presence in New Zealand is intended to ensure that an appropriate level of tax is paid and is broadly consistent with the OECD norm.

Policy framework

2.3 From an economic perspective there is little difference between debt and equity. However, interest payments on debt are deductible whereas dividends are not. Tax therefore can create a cross-border bias in favour of debt over equity.

2.4 In the case of cross-border related-party investment, NRWT reduces this bias by subjecting related-party interest payments to some amount of tax (usually 10%).

2.5 New Zealand is often characterised as a small, capital importing country. It is sometimes suggested it is not in the best interests of such countries to impose any tax (corporate tax on profits or NRWT on related-party interest payments) on non-resident direct investment. It is argued that the tax will reduce investment in New Zealand and therefore its capital stock. New Zealand would have fewer machines such as tractors, buildings and computers, making labour less productive and resulting in lower wages. Based on some strong assumptions, it is claimed that a tax on non-resident investment is borne entirely by New Zealanders.

2.6 Nevertheless, New Zealand has decided to tax non-resident direct investment. This decision has been frequently tested, most recently by the Savings and Investment Review conducted by the Treasury and Inland Revenue in 2012. That review concluded it is in New Zealand’s best interests to tax direct investment by non-residents. If New Zealand reduced the tax on non-residents it would lose more from giving up tax revenue from non-residents than it would gain from increased investment by non-residents.

2.7 This conclusion applies to related-party debt, which can be seen as a substitute for equity. However, it is unlikely that it would be in New Zealand’s best interest to impose NRWT on third-party debt. Third-party debt is unlikely to be a close substitute for equity. At the same time, imposing NRWT on third-party borrowing would be likely to increase the cost of debt for New Zealanders.

2.8 In 1991 the effect of NRWT on the cost of capital for New Zealand borrowers was recognised and AIL was introduced to lower that cost. Lending by non-residents to unassociated New Zealand residents is subject to AIL rather than NRWT.

2.9 While the imposition of AIL may still result in a small increase in the cost of borrowing from offshore, the economic distortion this creates is likely to be minimal. It also may reduce the general tax bias favouring non-resident debt investment over non-resident equity investment.

2.10 We continue to be relatively comfortable with the AIL, imposed at an effective rate of 1.44%[2], applying to interest on third-party borrowing.

2.11 Paragraphs 6.26 to 6.35 of this paper explore special rules for when New Zealand-registered banks borrow from related banks offshore. In the case of banks, it is suggested that AIL will be available even for related-party borrowing. The basis for this is that, as banks are margin lenders (i.e. they are largely debt financed) and conduits for ultimately unrelated non-resident lenders and domestic borrowers, there is less risk that the related-party debt will actually be in-substance equity. Rather, it is more likely to be on-lent debt sourced by the related non-resident bank. In that case, the arguments for a lower rate of tax are similar to those for third-party debt generally.

Link with the thin capitalisation rules

2.12 There is an interface between the thin capitalisation rules and NRWT because they both have an impact on the effective taxation of inbound investment income. Thin capitalisation rules restrict the amount of interest deductions that can be claimed by a New Zealand subsidiary of a non-resident owned group. NRWT imposes a tax on interest payments from a New Zealand subsidiary to its non-resident owner and associates.

2.13 New Zealand has a worldwide group debt test in the thin capitalisation rules which is designed, in part, to prevent debt being used as a substitute for equity. A New Zealand subsidiary of a multinational group is only able to deduct the interest on a related-party loan under the worldwide group debt test if the amount of that loan can be viewed as having been borrowed from a third party by a group member and on-lent to the subsidiary.

2.14 As things stand, however, the worldwide group test is rarely applied because firms stay within a “safe harbour” which allows them to claim deductions on all debt up to a threshold of 60% of assets without reference to their worldwide gearing position.

2.15 The OECD is currently examining rules similar to ours in the context of the BEPS Action Plan. It is possible that, as a result of this work, countries could substantially tighten their thin capitalisation rules well beyond our existing rules and the current international norm. At one end of the range, new rules could require New Zealand subsidiaries to use the worldwide group debt test as a matter of course to determine interest deductibility. In that event we would need to consider the overall picture in relation to the taxation of inbound direct investment and the extent to which it is necessary to continue to impose NRWT on interest.

Avoidance concerns

2.16 Interest, dividends and royalties sourced in New Zealand and paid to non-residents are known as NRPI and are subject to non-resident withholding tax. Through Inland Revenue compliance activity, officials have become aware that the NRWT rules have limited application in relation to interest, due to the wide variety of transactions available to prevent, or delay, the payment of interest with a New Zealand source. This is explored in Chapter 3.

2.17 This ability to circumvent the NRWT rules contrasts with New Zealand’s comprehensive financial arrangement rules that ensure financing income is taxable to New Zealand residents over the term of an arrangement on some form of economic accrual basis.

2.18 Officials believe that the combined effect of the transactions outlined below is that NRWT has largely been regarded as a voluntary tax for those with sufficient resources to avoid it. Transactions to avoid the imposition of NRWT are not economically efficient. They would not make good business sense in the absence of tax as a factor. Their tax consequences are often uncertain because of the general anti-avoidance provision. Removing the tax incentive to structure into these transactions will level the playing field for other businesses who are unwilling or unable to undertake such transactions. Such transactions also risk bringing the tax system into disrepute.

2.19 Due to the large number of potential ways to avoid NRWT it is not considered efficient or effective to introduce specific rules to deal with each specific type of transaction. This is because each transaction would require detailed provisions and in many cases the introduction of these provisions would create the incentive for these transactions to be subtly modified so they did not fall within the new provisions.

2.20 Instead this issues paper sets out suggestions intended to cover a wide range of transactions which currently avoid, or significantly defer, the imposition of NRWT.

2.21 The suggested changes in this issues paper are aimed at helping ensure a more appropriate amount of tax is paid by non-residents on their New Zealand-sourced income, thus better aligning taxation with real economic activity and reducing current asymmetries.

2.22 This paper does not deal with all tax issues arising from related-party debt. In particular, it does not deal with cross-border hybrid issues. The timetable for dealing with those issues is linked to the OECD’s timetable. Consultation is likely to commence on them by early 2016.

2.23 This paper does not consider the potential application of section BG 1, the general anti-avoidance provision in the Income Tax Act 2007, to any of the examples discussed.


1 The domestic law rate of NRWT on interest is 15%; this is usually reduced to 10% under a double tax agreement.

2 The rate of AIL is 2%; however, this is deductible for income tax. At a 28% company tax rate the effective rate is 1.44%.