Inland Revenues warn on new international tax rules

In the international tax arena, transfer pricing continues to dominate the news particularly the banks tax cases and the new international tax rules for companies.

Bill English is expected to confirm in the Budget the impact of the international tax changes that will take effect from the 2010-2011 financial year. These changes are fundamental and will bring New Zealand in line with major trading partners including Australia, Britain and the United States.

Importantly, if the government is struggling to fund personal tax cuts, or government spending in general, targeting the collection of additional tax through Inland Revenue audit activity in the international and transfer pricing areas seems a sure bet.

The new international tax rules for Controlled Foreign Companies means that New Zealand controlled companies with foreign active businesses will no longer be immediately taxed in New Zealand on the income from those subsidiaries under new foreign tax rules.

The exemption of active offshore income of these companies replaces the old system of taxing income as it is earned on an unrealised basis. Further important features of the changes are an exemption from tax for most foreign dividends paid to companies and measures to protect the tax base as a result of adopting an active income exemption.

The purpose of these reforms is to assist New Zealand based businesses to compete effectively in foreign markets by freeing them from a tax cost that similar companies in other countries do not face. The changes will improve the competitiveness of New Zealand’s tax system and encourage businesses with international operations to remain in New Zealand, whilst establishing and expanding overseas.

Inland Revenue is keen to ensure that there is no artificial erosion of the New Zealand tax base. In addition to specific anti avoidance measures introduced, a weapon that the Inland Revenue has in their arsenal to control offshore activities is to strictly enforce New Zealand’s transfer pricing rules.

For example a New Zealand company might consider charging less for New Zealand manufactured goods or not charging at all for services provided to offshore related companies thereby deferring indefinitely the New Zealand tax take of the “international tax pie”.

Under the previous rules, income made by such a foreign subsidiary was taxed at the company tax rate of 30 per cent less the amount of tax paid in the other country. This was irrespective of whether the profits were brought back to New Zealand. But under the new rules the income is not taxed in New Zealand till the proceeds are distributed to shareholders.

The new rules may encourage companies to shift as much of their taxable incomes to offshore entities for example including production companies in low or no tax jurisdictions. This could allow the company to defer New Zealand tax indefinitely.

However, the Inland Revenue has sent a clear signal that companies will have to keep a clear record of foreign transactions to ensure they can show any transfer pricing with a foreign subsidiary was done at arms length.

IRD international audit chief advisor John Nash said recently: “A failure to prepare adequate transfer pricing documentation, or acceptance of pricing that is clearly inappropriate could result in a 40 per cent shortfall penalty for gross carelessness.”

A number of New Zealand’s biggest exporters stand to benefit from these changes, including Fonterra, Zespri, Fisher & Paykel and Fletcher Building.

Transfer pricing is the international requirement that ensures related party cross border transactions are carried out at arms length pricing. A global tax management issue, transfer pricing is a priority for tax authorities worldwide.

It is rated as the number one tax issue facing multinational businesses, both from company and revenue Authority perspectives. And it’s easy to see why.

Recall the GlaxoSmithKline transfer pricing case, which resulted in a settlement in 2006 of approximately US$3.4 billion. This is the largest recorded settlement in a tax dispute in IRS history.

The GlaxoSmithKine case has wide reaching implications all companies transacting with foreign affiliates not only pharmaceutical companies. While little comment is available in New Zealand on the case, the issues raised should be reviewed and considered by all companies doing business with foreign affiliates.