Media Release - July 2012

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Mark Loveday and Kim Atwill, EY, Auckland

The IRD encourages voluntary compliance and facilitates a taxpayer friendly APA regime

Although New Zealand’s core transfer pricing legislation has remained unchanged in recent years, recent court decisions and increased activity and focus by the Inland Revenue Department (IRD) certainly means multinational companies in New Zealand should not become complacent in managing their transfer pricing risks.

New Zealand remains a highly sophisticated jurisdiction in terms of transfer pricing enforcement and factors such as the recent global financial crisis have only increased the New Zealand Government’s appetite to ensure companies within New Zealand’s broad tax net continue to pay their fair share of tax in New Zealand.

In this article we broadly outline the current transfer pricing landscape in New Zealand, highlighting areas of interest and recent focus by the IRD.

l. IRD activity and focus

The IRD’s dedicated transfer pricing unit has bolstered its resource and capability over recent years and activity is higher than ever. Generally the IRD does not seek to target specific industries or transaction types, preferring instead to gain the widest coverage possible. Notwithstanding this, there are areas of focus when certain trends or risk factors are identified.

The current focus areas include:
- companies incurring consecutive and/or substantial losses; inter-company financing, particularly in respect of ‘non-vanilla’ arrangements and interest rates applied to large value loans (greater than NZ$10m);
 
- thin capitalisation;
 
- importation of losses into New Zealand, particularly through outbound market support payments to offshore subsidiaries of New Zealand parents;

- excessive royalty payments; and
 
- sale of intellectual property (IP) out of New Zealand, particularly where the IP is licensed back to the original New Zealand IP holder or the New Zealand company is converted to a captive R&D service provider.

The IRD relies mainly on detailed transfer pricing questionnaires to gather targeted information of both inbound and outbound multinational taxpayers, including New Zealand branches. These questionnaires are issued routinely with most IRD general risk reviews or can be specifically targeted to gather information on a company’s transactions. More detailed queries and/or commencement of a formal audit may follow. Broadly, these questionnaires request the following
information from multinational taxpayers:

- financial details of the New Zealand taxpayer and the consolidated group;

- types and value of cross border associated party transactions;

- transfer pricing methodologies applied;
 
- details of any restructures to the New Zealand taxpayer in the last five years;

- transactions with low tax countries;
 
- debt and asset figures for thin capitalisation purposes for the New Zealand taxpayer and consolidated
group;

-whether any associated party transactions have been the subject of an advance pricing agreement in another jurisdiction; and

- whether transfer pricing documentation has been produced to support the taxpayer’s transfer prices.

Based on experience, where a taxpayer indicates that no transfer pricing documentation exists, the IRD is more likely to initiate a transfer pricing audit. Where documentation does exist, the IRD will generally request a copy for review. Given the IRD’s aim to gain widespread coverage of all industries, the key message to New Zealand taxpayers is that sooner or later the IRD is likely to be asking to review the New
Zealand transfer pricing documentation.

The IRD also has a separate financing questionnaire to identify non-commercial intercompany finance structures. In particular hybrid debt structures are presently very much in focus with the IRD and the courts.

New Zealand subsidiaries of multinational groups are sometimes seen by their much larger parents as being immaterial, therefore warranting a low, or even zero, level of attention regarding transfer pricing matters. In many cases there is reliance on global template documentation to support the New Zealand subsidiary’s transfer prices. The IRD is becoming increasingly sceptical of such documentation and has been known to disregard documentation that does not address the specific circumstances and transactions of the New Zealand company. In many cases, we are asked to prepare a New Zealand addendum to the global master file.

ll. APAs

New Zealand remains a very attractive country for multinational taxpayers wishing to enter into an Advance Pricing Agreement (APA), particularly a unilateral APA. The IRD has experienced a significant rise in APA applications, having completed 15 APAs in the 2011 calendar year and approximately 70 APAs across all industry sectors since the APA programme was established.

The IRD’s transfer pricing unit strongly encourages taxpayers to use APAs to manage their transfer pricing risk and considers all types of transaction from very routine import/distributors through to more complex royalty and restructure transactions. The generally open and flexible approach taken by the IRD has resulted in a very efficient APA process, meaning the time and expense to the taxpayer of applying for an (unilateral) APA is one of the lowest in the world.

The IRD aims to complete unilateral APAs within six months from the date of formal application. In cases of relatively simple transactions (e.g. import/ distributors) APAs have been agreed within three months.

As an alternative to an APA, the IRD encourages taxpayers to volunteer transactions for review and are prepared to issue a non-binding letter of comfort following the review.

lll. Recent court decisions

A. Alesco New Zealand

A recent tax avoidance decision in the New Zealand High Court has brought into focus the pricing of financial arrangements between associated parties.

In Alesco New Zealand & Ors v CIR,1 the issue of zero coupon optional convertible notes by Alesco New Zealand to its Australian parent were recently held to be tax avoidance. These notes gave a partial interest deduction in New Zealand (consistent with IRD’s own methodology) but were treated as equity in Australia. The High Court determined that the zero coupon convertible notes were not an arrangement entered into at arm’s length and reconstructed the loan as an interest-free loan.

The Court emphasised the lack of evidence of bargaining between the related parties and that Alesco New Zealand had not considered alternative financing options.

Ironically, the decision suggests that the New Zealand taxpayer should have borrowed via a ‘vanilla loan’ which would have given greater interest deductions in New Zealand. Furthermore, the Court did not find the hybrid was arm’s length yet reconstructed it as an interest-free loan.

Although the case is under appeal by the taxpayer, John Nash (Manager, International Revenue Strategy and New Zealand Competent Authority) of the IRD provided some general comments at the EY Tax Directors Forum held in February 2012. John reminded taxpayers that although an arrangement may pass muster in terms of transfer pricing rules, an arrangement must also satisfy (or not offend) other provisions in the legislation, including the general anti-avoidance provision.

Financing arrangements is an area the IRD is actively reviewing. The IRD expects an appropriate level of transfer pricing documentation for intercompany financing arrangements, particularly for loans over $10m. ‘‘Novel instruments’’ (such as the notes in Alesco) are expected to be supported by documentation analysing the choice of one financing instrument over other realistic options (including vanilla loans).

B. SNF Australia

Early indications suggest that there should not be any significant fallout in New Zealand from the recently decided Australian case of Commissioner of Taxation v SNF (Australia) Pty Ltd2 in which the taxpayer won on final appeal in the Australia Federal Court.

Broadly, SNF Australia purchased chemical-based products from various SNF Group affiliates and had incurred consecutive losses for 13 years. Not surprisingly, the ATO attacked the arm’s length nature of the transactions on the basis that SNF Australia had not derived adequate net profit margins as benchmarked against independent comparable distributors. SNF Australia successfully argued that Group internal CUPs were sufficiently comparable and should be more reliable than the more subjective profit based methods. The court agreed – in this case.

The ATO is now seeking to push through retrospective legislation to effectively place more emphasis on multinational taxpayers to derive a ‘commercially reasonable’ level of profit. In New Zealand, the IRD has reaffirmed its position that the CUP (or other transactional method) will always trump a profit margin method. The IRD has re-emphasised that companies should not automatically jump to profit based methods. The first step should always be to ask the question as to whether any internal comparables exist.

That said, the IRD is likely to look closely at a company which has sustained losses over a longer period of time, particularly more than three years. For a distributor to incur sustained losses, the IRD could possibly assert that the New Zealand subsidiary should have received some form of market assistance from another group affiliate. New Zealand companies in such positions are strongly encouraged to document the underlying cause of the ongoing losses.

C. IRD unlikely to litigate transfer pricing disputes

It is interesting to note that neither the IRD nor a taxpayer has, to date, ever pursued a transfer pricing dispute through to litigation in New Zealand. This should not be construed as New Zealand having no entrenched transfer pricing disputes, but rather it reflects the IRD transfer pricing unit’s preference to resolve transfer pricing issues out of court and their generally pragmatic approach towards identifying risk areas before they have a chance to escalate to a point where litigation is required. As illustrated in the Alesco case, the IRD is certainly willing to invoke and litigate via the general anti-avoidance provisions, with considerable recent success.

lV. Captive R&D providers

In recent years, New Zealand has experienced a growing number of instances where intangible property, particularly in relation to software, has been migrated offshore. In many cases, the R&D personnel remain with a New Zealand company that subsequently performs R&D services for the foreign IP holder on a contract basis.

Although the IRD generally recognises the commercial nature of such arrangements, closer attention is being paid to the remuneration mechanisms in place, particularly the margin earned under the typically employed cost-plus methodology. As a general guideline, there is a growing expectation that New Zealand-based captive R&D providers should earn a mark-up on total costs of anywhere between 12 percent to 25 percent. Obviously, the mark-up should be based on the specific facts applying to the taxpayer, particularly the level of skilled personnel employed and risks assumed by the captive R&D provider.

As with most related party transactions, a well considered intercompany agreement for services is vitally important to reflect the R&D decision making process and how the risks are to be allocated.

V. New Customs penalty regime

All goods, with few exceptions, are subject to at least 15 percent goods and services tax (GST) on importation and in some cases, also duty. Customs Service collects GST in the same manner as duty without regard to whether a GST registered importer can claim back the GST.

The need to consider both transfer pricing and customs implications of pricing related-party product transfers has been further reinforced through recent changes to the New Zealand customs penalty regime. These changes are particularly relevant for multinational taxpayers making periodic (or sometimes annual) transfer pricing adjustments to the cost of imported goods in order to provide the New Zealand-based operation with an arm’s length profit (most common with limited risk distributors).

The new penalties apply to goods imported into New Zealand that are only subject to GST in addition to those goods that are also subject to duty. The changes are summarised in Table 1:

Table1

Category of goods Previous maximum penalty New maximum penalty*
Subject to GST only on importation Maximum of $50 per entry Maximum of 20% or 40% or 100% of the error per entry
Subject to duty and GST on importation Maximum of $10,000 per entry Maximum of 20% or 40% or 100% of the error per entry

* The new penalties will be capped at $50,000 per import entry.

Key areas that New Zealand Customs are anticipated to target for additional revenue through the new penalty regime include the following:

- imports from related parties;

- transfer pricing adjustments;

- consignment stock arrangements;

- movements of stock (e.g. from an overseas head
office to a New Zealand branch); and

- royalties (and other adjustments) required to be included in the transaction value of the goods.
Given the prevalence of limited risk distributors in New Zealand, these changes could have costly ramifications for those New Zealand based multinationals that take an ad-hoc approach to transfer pricing implementation and monitoring.

Vl. Conclusion

Transfer pricing review and audit activity remains high in New Zealand. As demonstrated recently in the Alesco case, the IRD is readily prepared to use and litigate anti-avoidance provisions to attack domestic as well as cross border arrangements which are not considered to be constructed on arm’s length terms. It is fair to say that transfer pricing and anti-avoidance rules are increasingly converging.

A range of effective options are available to taxpayers to manage their New Zealand transfer pricing risks. The IRD continues to encourage voluntary compliance in transfer pricing and facilitates a taxpayer friendly APA regime.

In New Zealand multinational companies should be actively reviewing their transfer pricing position on an ongoing basis and considering the most appropriate risk mitigation for their activity. Mark Loveday is a partner and Kim Atwill is a senior manager in the EY, Auckland, transfer pricing group. They can be contacted at: mark.loveday@nz.ey.com kim.atwill@nz.ey.com www.ey.com/nz

The views expressed in this article are the views of the authors, not EY. This article provides general information, does not constitute advice and should not be relied on as such. Professional advice should be sought prior to any action being taken in reliance on any of the information.


1 HC Auckland CIV 2009-404-2145, December 2011
2 [2011] FCAFC 74

07/12 Copyright 2012 by The Bureau of National Affairs, Ine. TPIJ ISSN 2042-8154
Article reproduced with permission of Bloomberg BNA