Chapter 11 - Design principles, including introduction and transitional rules

11.1 Final Report Recommendation 9 contains recommendations for:

  • the design of the hybrid rules, including their interaction with other parts of the legislation, and
  • introduction and transitional issues, and how countries should implement the hybrid rules.

Design and interaction


11.2 Most of the design principles in Recommendation 9 are uncontroversial, and it is proposed that they would be utilised if the OECD recommendations were adopted in New Zealand. Adhering as closely as possible to the OECD recommendations is more likely to create rules that are:

  • Comprehensive. This is important so that the rules do not leave open or create hybrid planning opportunities, while imposing unnecessary compliance costs.
  • Consistent with those adopted by other countries. This will go some way to creating a single set of rules, so that the rules do not give rise to unintended gaps or overlaps, and anyone who is familiar with hybrid rules in one country will have a good idea of how they work in another. Nevertheless, some variations between countries are inevitable.

Ordering of hybrid rules

11.3 As recommended in the Final Report (paragraph 286), it is proposed that the OECD recommendations would apply in the following order if implemented in New Zealand:

  • hybrid financial instrument rule (Recommendation 1)
  • reverse hybrid rule (Recommendation 4) and the disregarded hybrid payment rule (Recommendation 3)
  • imported mismatch rule (Recommendation 8)
  • deductible hybrid payment rule (Recommendation 6) and the dual resident entity rule (Recommendation 7).

Interaction of hybrid rules and withholding tax

11.4 In accordance with the OECD recommendations, we propose that denial of a deduction for a payment under any of the hybrid rules would not affect its withholding tax treatment.

Interaction of hybrid rules and transfer pricing

11.5 It is proposed that taxpayers are able to apply the hybrid rules in priority to the transfer pricing rules. This will ensure that to the extent a payment is disregarded under the former, there is no need to undertake a transfer pricing analysis.

11.6 When a New Zealand taxpayer is required to include an amount in income under Recommendations 1, 3 or 4, the amount included would be net of (reduced by) any transfer pricing adjustment in the payer country.

Interaction of hybrid rules and thin capitalisation

11.7 Where a deduction is disallowed for an amount of interest under the primary rule in Recommendation 1, or under Recommendations 4 or 8, it is proposed that the thin capitalisation rules be applied on the basis that the disallowed interest and the debt relating to that interest are both disregarded. This will produce the same result as if the interest was a dividend and the debt was equity. It will prevent any double deduction denial of the same payment.

11.8 The interaction with thin capitalisation rules and Recommendations 3, 6 and 7 is more complex due to the carry-forward rule which has no equivalent in New Zealand’s thin capitalisation regime. Due to the carry-forward rule, if the disregarded hybrid payments rule applies before thin capitalisation, a permanent deduction denial under thin capitalisation could be replaced by a deduction denial under anti-hybrid rules which may be reversed by the carry-forward rule in a later year (due to excess dual inclusion income).

11.9 To address this problem without giving rise to double denial of interest expense, it is proposed that the carry-forward rule is limited such that the amount of denied deductions able to be carried forward is reduced by the amount of adjustment that would have occurred under thin capitalisation rules if there was no hybrid counteraction. With this limitation, the hybrid rules can apply before thin capitalisation and the intended result of New Zealand’s thin capitalisation rules will be preserved in the event of a carry-forward deduction being allowed in a future year.

11.10 In applying the defensive rule in Recommendation 1 or 3, or Recommendation 2, a New Zealand payee should not consider the thin capitalisation adjustments made by a payer jurisdiction. This is the same approach that is applied to a straightforward interest payment received by a New Zealand payee from a foreign payer. The amount of taxable income is not reduced on account of any interest denial in the payer jurisdiction.

11.11 Table A sets out the interaction between the hybrid rules and the thin capitalisation and transfer pricing rules.

Table A: Interaction of recommendations with other deduction denial rules

   Recommendation Transfer pricing Thin capitalisation
1 Recommendation 1
1.1 Primary rule – deny deduction in payer jurisdiction. Primary rule first, and then transfer pricing. Saves having to do a transfer pricing analysis in cases where the deduction will be denied in any case. Primary rule first, then thin capitalisation rules. When applying thin capitalisation, ignore disallowed interest, and treat hybrid debt as equity. Ensures no double disallowance.
1.2 Secondary rule – income inclusion in payee jurisdiction. Do not apply hybrid rules to the extent a deduction is disallowed by transfer pricing in payer jurisdiction. Apply secondary rule regardless of any thin capitalisation disallowance in payer jurisdiction – it is issuer-specific. Result is the same as if the payment were interest under a simple debt. Same applies to non-deductibility due to direct use of borrowed funds – see Final Report, paragraph 28.
2 Recommendation 2
2.1 Dividend inclusion in payee jurisdiction. As for Recommendation 1 secondary rule. As for Recommendation 1 secondary rule.
3 Recommendation 3
3.1 Primary rule – deduction denial in payer jurisdiction. Transfer pricing first, then primary rule. Because primary rule allows carry-forward, transfer pricing has to be done anyway. Primary rule first. However, carry forward reduced to the extent that thin capitalisation would have disallowed a deduction if hybrid rules had not applied. Because primary rule allows carry-forward and thin capitalisation does not, if carry forward is not reduced, deductions will avoid thin capitalisation scrutiny, or have the wrong ratio applied.
3.2 Secondary rule – income inclusion in payee jurisdiction. Do not apply hybrid rule to the extent a deduction is disallowed by transfer pricing in payer jurisdiction. As for Recommendation 1 secondary rule.
4 Recommendation 4
4.1 Primary rule – deduction denial in payer jurisdiction. Primary rule first, and then transfer pricing. As for Recommendation 1. Primary rule first, then thin capitalisation. As for Recommendation 1.
5 Recommendation 5
5.1 5.1 – improvements to CFC regimes. Not a linking rule – transfer pricing treatment in payer jurisdiction not relevant – only tax treatment in establishment jurisdiction. But if an interest payment is subject to a transfer pricing adjustment in the payer jurisdiction and we have a treaty with them, the payee could ask for a correlative adjustment. Not a linking rule – thin capitalisation treatment in payer jurisdiction not relevant – only tax treatment in establishment and owner jurisdictions.
5.2 5.2 – limiting tax transparency for non-resident investors. As for Recommendation 5.1, except right to a correlative adjustment clearer. As for Recommendation 5.1.
6 Recommendation 6
6.1 Primary rule – deny deduction in parent jurisdiction. As for Recommendation 3 primary rule. As for Recommendation 3 primary rule.
6.2 Secondary rule – deny deduction in payer jurisdiction. As for Recommendation 3 primary rule. As for Recommendation 3 primary rule.
7 Recommendation 7
7.1 Deny deduction in both jurisdictions. As for Recommendation 3 primary rule. As for Recommendation 3 primary rule.
8 Recommendation 8
8.1 Deny deduction in payer jurisdiction. As for Recommendation 1 primary rule. As for Recommendation 1 primary rule.

Submission point 11A

Submissions are sought on the intended approach to manage the interaction of the OECD’s recommendations and New Zealand’s withholding tax, transfer pricing and thin capitalisation rules.

Interaction of hybrid rules and the CFC regime

11.12 Recommendation 5.1 as it relates to payments to a reverse hybrid is considered in Chapter 7. Recommendation 5.1 also suggests that countries consider introducing or making changes to their offshore investment regimes in relation to imported mismatches.

11.13 One such change, labelled a “modified hybrid mismatch rule”, is set out in paragraphs 29 to 33 of the OECD’s Final Report on Action 3: Designing Effective Controlled Foreign Company Rules.[62] The change suggested is that a payment from one CFC to another should be included in CFC income if it is:

  • not included in CFC income of the payee; and
  • would have been included in CFC income if the parent jurisdiction (the jurisdiction applying its CFC rules) had classified the entities and the arrangement the same way as the payer or payee jurisdiction.

11.14 A more general issue is the extent to which a New Zealand company applying the CFC rules has to determine attributable foreign income when taking into account the application of the hybrid rules.

Submission points 11B

Submissions are sought on:

  • the desirability or otherwise of this modified hybrid mismatch rule; and
  • the interaction more generally between the CFC rules and the hybrid rules.

Hybrid rules and anti-avoidance

11.15 We propose that the rules would apply before (and therefore would be subject to) the general anti-avoidance provision. This will ensure that the hybrid rules, which generally apply automatically and do not have a purpose requirement, cannot be used for a tax avoidance purpose. It is consistent with the way section BG 1 applies to any other tax provision.

11.16 If New Zealand implements the OECD recommendations, the UK approach[63] of having a specific anti-avoidance provision for its hybrid rules should be adopted. This provision would apply to an arrangement which has a more than merely incidental purpose of reducing taxable income by avoiding the application of either the New Zealand hybrid rules or the equivalent rules in a foreign jurisdiction. Taxable income for this purpose would include income taxable in a foreign jurisdiction as well as New Zealand. This reflects the general purpose and approach of the hybrid rules, which is to counteract the double non-taxation of income without any need to determine which country’s revenue has been affected. It may be useful to explicitly state, as the UK does, that in determining whether an arrangement does avoid the application of the rules, reference should be made to the Final Report and any document which replaces or supplements it.

Submission point 11C

Submissions are sought on the proposal to include a hybrid rules-specific anti-avoidance rule.

Legislative design

11.17 The Final Report clearly expects countries to draft domestic legislation implementing the rules, rather than simply incorporating all or some of the Final Report directly into domestic law. Nevertheless, the Report will continue to be an important document in interpreting the legislation, to the extent that interpretation requires an understanding of the purpose of the rules.

11.18 It may be possible or desirable in some areas to legislate broad principles, which could be fleshed out by regulations of some kind. Regulations, or some other form of subsidiary legislation, would have the benefit of being:

  • more easily able to be changed than primary legislation;
  • more flexible in their form. For example, it would be easier to include detailed examples, and to have extended discussion of the examples, in subsidiary legislation.

11.19 Examples of where some form of subsidiary regulation might be appropriate are:

  • fleshing out the imported mismatch rules;
  • providing detail on the definition and calculation of dual inclusion income;
  • determination of the extent to which CFC taxation can be treated as preventing a D/NI outcome;
  • resolution of double taxation outcomes resulting from introduction of the rules in New Zealand or a counterparty country – in this case the Commissioner might be given the power to override the rules where they would otherwise give a double taxation result.

Submission point 11D

Submissions are sought on the legislative design proposals set out above.

General rule for introduction

11.20 The hybrid rules are intended to apply to all payments made after the effective date of the implementing law. This effective date should be far enough in advance to give taxpayers sufficient time to determine the likely impact of the rules and to restructure existing arrangements to avoid any adverse consequences (Final Report, paragraph 311). Since the rules generally apply to arrangements between related parties or within a control group, restructuring arrangements should not be as difficult as it might otherwise be. Furthermore, the result achieved by the rules should not generally be a punitive one, rather it involves the loss of an unintended tax benefit. The Final Report also suggests that the rules should generally take effect from the beginning of a taxpayer’s accounting period.

11.21 The Board of Taxation recommended that the Australian rules come into force with respect to payments made on or after the later of 1 January 2018 or six months after enactment. The UK rules come into force for payments made on or after 1 January 2017, which is approximately eight months after the introduction of the Finance Bill which contained the rules.

11.22 The impact of the proposals will in most cases be able to be established now, by reference to the Final Report. We consider that the period from introduction of the relevant legislation to its enactment should give taxpayers sufficient time to determine the likely impact and accordingly the effective date of the legislation should be its enactment date. In accordance with the OECD recommendation, the provisions would then apply to payments made after a taxpayer’s first tax balance date following enactment. This is a similar approach to that taken to the implementation of the NRWT anti-deferral rules,[64] except that in this case there would be no early implementation for post-enactment transactions.

11.23 An alternative approach would be the Australian one (application to all payments made or received a fixed period after enactment), which would have the benefit of giving all taxpayers an identical start date for applying the rules.

Submission points 11E

Submissions are sought on whether there are any special circumstances that would warrant departing from the general proposition of no grandparenting, and whether the proposed effective date is appropriate.

Co-ordination with other countries

11.24 Rules will also be needed to deal with different implementation dates by different countries. Issues are raised in particular if one country applies an accrual basis of income or expense recognition while the other applies a cash basis.

11.25 For example, suppose a hybrid payment in respect of a hybrid financial instrument is made by A Co to B Co, and Country A does not have the hybrid rules but Country B does. B Co will be taxable on the payment. If Country A then introduces the rules, then A Co will be denied a deduction for its payment under the primary rule and B Co will no longer be taxable on that payment. If both companies are on a cash basis and have the same tax accounting period, there is no issue. However, suppose that the two companies have different tax years. Consider B Co’s tax year during which the Country A hybrid rules take effect. Country B will need to tax payments received by B Co during the part of its tax year before the start of A Co’s tax year, and not tax those received afterwards.

11.26 Example 2.3 in the Final Report concerns a transitional situation where a payer of a deductible/exempt dividend is subject to the primary rule in year two, but in year three the payee country introduces a domestic dividend exemption denial rule, in accordance with Recommendation 2.1. The payer is claiming a deduction on an accrual basis, but the payee is recognising income on a payments basis. The effect of the introduction of the exemption denial rule in the payee country is that the payer is entitled to a full deduction in year 3, and the payee is taxable on the portion of the payment for which a deduction has been claimed. That is less than the entire payment, since a portion of the payment was accrued by the payer in year 2, and was non-deductible due to the primary rule.[65]

Submission point 11F

Submissions are sought on any particular situations that might require particular care to avoid double taxation, beyond those set out here and in the Final Report. It may be desirable to provide some flexibility for the Commissioner to make discretionary adjustments where co-ordination issues mean that the application of the rules in two countries gives rise to double taxation.


62 OECD (2015), Designing Effective Controlled Foreign Company Rules, Action 3 – 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris.

63 See proposed section 259M of TIOPA 2010 (United Kingdom).

64 In the Taxation (Annual Rates for 2016–17, Closely Held Companies and Remedial Matters) Bill.

65 Note that there is an error in the example. B Co’s year 4 interest deduction for tax purposes should be 75 and its year 4 taxable income should be 25.