How do you tax Apple? Very carefully
Parliament is considering new tax rules to stop the likes of Apple, Google and Facebook shifting profits made here to low tax countries, but other companies argue the Government is taking a sledgehammer approach.
The Taxation (Neutralising Base Erosion and Profit Shifting) Bill heard a second day of oral submissions this week. The bill was drafted under the previous Government and announced in August, but only introduced after the election by new Revenue Minister Stuart Nash.
The proposed legislation aims to stop large multinationals shifting profits offshore to jurisdictions where they are taxed at a lower rate than in New Zealand, which has a relatively high corporate tax rate of 28 percent. Large technology companies in particular have come under fire for paying little or no tax on large revenues. An investigation by the New Zealand Herald last year found that Apple had paid no income tax in New Zealand over the previous decade in spite of sales of more than $4.2 billion.
One of the most common ways companies shift earnings offshore is by artificially inflating their lending costs. This minimises the amount of profit that can be taxed in New Zealand. The international parent company will lend to its New Zealand subsidiary at an artificially inflated rate, increasing the New Zealand subsidiary’s costs and reducing taxable profits.
The parent will often be based in a jurisdiction with a low corporate tax rate where the loan can be booked as profit and incur much less tax. This is called Base Erosion and Profit Shifting, often simplified to BEPS.
It’s a complex problem and the bill to tackle it is complex too. The first day of oral submissions drew laconic comments from accountants who accused it of being long and occasionally confusing.
So how does it work?
Currently, lending between two companies with the same economic owner is undertaken on the “arm’s length” principle. This means that the international parent and its New Zealand subsidiary must lend on the same conditions as if they were owned by different people.
This part of the law isn’t new. What is new is that the burden of proof will shift from the IRD Commissioner to the company itself. Under the current law the IRD has to prove that the arm’s length principle hasn’t been applied. If the Commissioner decides a company has been lending to itself at artificially inflated rates they can apply hefty penalties.
Deloitte Tax Partner Patrick McCalman said the changes would give the IRD the power to ignore “non-commercial features” that might contribute to a company lending to itself at a different rate to the commercially arm’s length rate. The current rule means the Commissioner is not allowed to ignore non-commercial features and the burden of proof rests upon her to prove a company is engaging in BEPS.
A non-commercial feature may sound outlandish, but it could be as simple as a condition which would defer the interest until the end of the term or a loan that had a term of more than five years.
The bill also attempts to regulate transfer pricing, which is the price of transactions between the parent and its subsidiary.
The new rules go much further by restricting the pricing of transfers. Now, lending between associates must be done on the basis that the New Zealand company uses the credit rating one notch below that of its overseas parent, unless they’re a bank, in which case they must use the same rating as their parent. This is called the “one notch” rule.
“It’s a one size fits all rule. In some cases it will be entirely appropriate and in some cases it won't be,” McCalman said.
He offered an example.
“Say you have a situation where Australia is charging New Zealand 6 percent on an interest rate and when we apply this one notch down rule that means New Zealand will only give a deduction for five percent,” he said.
“Australia will still demand six percent, still be paid six percent and still tax six percent, but New Zealand will only give a deduction for five percent, and as a result you end up with double tax.”
The complicated stuff
The "one notch" transfer pricing rule will be mandatory to apply if a business meets one of three criteria. The Government thinks that if a company meets one of these criteria, there is a good chance it is using BEPS so the “one notch” rule should be applied to make sure it isn’t lending to itself at artificially inflated rates.
The first criteria for the "one notch" rule applies if the person or company from which the New Zealand company is lending has a tax rate of lower than 15 percent. This rule is relatively straightforward. If the lender is based in a jurisdiction with a tax haven rate of less than 15 percent there’s a good change they’re based there for primarily tax reasons.
“That will stop an Australian company lending to New Zealand, but interposing a low tax jurisdiction in between and booking the profits in that low tax jurisdiction,” said McCalman.
“That’s absolutely appropriate as a gateway. You shouldn’t be able to go and shop for jurisdictions,” he said.
The second criteria is that if a company has an EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortisation) of more than 3.3 percent, the rule must be applied. An EBITDA threshold 'is used is a good measurement of a company’s earnings and earning potential.
This is where the rules get difficult and potentially unfair to certain industries. EBITDAs vary from industry to industry, from capital intensive to non-capital intensive industries. This could mean some industries are left unfairly burdened by the legislation.
“If you’re in an expansion and you’re incurring lots of financing you will have a high interest rate,” said McCalman.
The third criteria for applying the rule is if the company’s debt to asset ratio is greater than 40 percent. A large debt to asset ratio could indicate that a company is piling on debt from its parent to minimise profits. But its argued that this provision is inconsistent with the rest of our tax legislation, where the rule has been 60 percent.
“Elsewhere in our act we have rules that says non-residents are allowed ratios of 60 percent,” said
“Why are we now saying those who have 60 percent debt are bad and they need these steps and a special rule,” he said.
A sledgehammer when an icepick will do
A common theme of submissions was the bill was too broad, forcing a large compliance burden on businesses for the purpose of catching out a small number of offenders.
“We’ve ended up with legislation that could be a sledgehammer for something that you could use an ice pick for,” said Westpac's head of tax, Jo Sawden.
McCalman pointed to an IRD survey that found that one in four companies would be caught by the new rules. This survey used different measurements to the legislation so the actual number of companies forced to comply may be much higher, he said.
The legislation could have unintended consequences. Submissions from the banks pointed out that it was unfair they should be forced to lend based on the same credit rating as their parents.
BNZ's head of tax Campbell Rapley told the select committee BNZ had a robust discussion with its parent National Australia Bank on the interest rate.
“The banking market is really competitive. When we raise funds we try and raise them at as low a cost as possible so that we can be competitive in the mortgage and lending markets. The higher our costs, the harder it is for us to be competitive in a really competitive market," he said.
A safe harbour
A potential compromise is the so-called ‘safe harbour’ rule. This means that companies that companies can opt-in to complying with the new rules. Those that opt-out will have do so in the knowledge that they will be given extra scrutiny by the IRD to determine whether they are shifting profits. Companies that opt-in will be given ‘safe harbour’ from this extra scrutiny.
Companies will be able to make the choice about which option suits them best based on which model suits their business and which places fewer costs of compliance on them.
The stakes are high. The Government has made ambitious spending promises and it will need every dollar it can get. There’s a political cost as well. If the Tax Working Group announces new taxes, workers and businesses will want to know that the burden is shared equally and that the biggest international firms aren’t getting a free ride.
There’s an incentive for big business to play ball too. The BEPS bill may seem onerous to businesses, but it could be worse. The European Union has decided to introduce a tax so simple it may be nearly impossible to evade. Big firms operating in Europe could be forced to pay a 3 percent tax on their revenue, not just their profits. It comes after years of tech companies shifting European earnings to low-tax jurisdictions like Ireland.