OECD’s recently released “Transfer Pricing Guidance on Financial Transactions” (OECD Report) is a welcome addition to the OECD Transfer Pricing Guidelines. See our summary of the report (TPTS summary).
The lack of any definitive guidance on pricing related party loans and guarantees has long been frustrating for many taxpayers with investigations and disputes occurring in a vacuum of accepted rules.
New Zealand has already codified an approach for pricing inbound related-party loans of $10m or more that seeks to restrict the interest rates by requiring interest rates nearer the group’s credit rating (rather than borrower’s own implied rating) for highly leveraged companies. Certain features of a loan are also ignored in the pricing.
New Zealand’s restricted transfer pricing rules will now be seen, in some respects, as a departure from OECD guidance and contrary to the legislated purpose of New Zealand’s transfer pricing rules- “to apply consistently with the OECD transfer pricing guidelines”. This is likely to highlight mismatches in the methods of pricing between a New Zealand borrower and its related offshore lender.
To recap, New Zealand’s ‘restricted transfer pricing rule’ applies to ‘high risk’ inbound loans of at least $10m, defined as:
- the borrower has a thin capitalisation debt percentage at least 40%, or
- the lender’s jurisdiction has a corporate tax rate of less than 15%.
The same rules do not, however, apply to outbound loans, where a New Zealand entity is the lender.
For such loans within a multinational group, the borrower must use the credit rating (less one or two notches, depending on circumstances) of a company belonging to the same group that has the most long-term debt. Invariably that will be the ultimate parent whose rating reflects the group’s diversified global portfolio of businesses.
In the absence of real evidence that the New Zealand subsidiary is so important to the group to conclude the wider group would clearly support the New Zealand subsidiary in the absence of an explicit guarantee, the application of the group’s credit rating is contrary to the new OECD guidance. In our experience, New Zealand subsidiaries are rarely of any high strategic importance to a multinational group.
The OECD guidelines acknowledge that countries are free to determine their own rules to determine an arm’s length capital structure. New Zealand already does this through its thin capitalisation rules, which generally deny interest deductions for foreign-owned companies where the debt is more than 60% of its gross assets.
New Zealand’s transfer pricing rules already permit non-recognition or recharacterisation for pricing purposes, of a transaction which is inconsistent with independent parties behaving in a commercially rational manner. This measure is consistent with OECD guidelines. So, if the borrowing is at a level that could not possibly be serviced, the borrower does risk some or all the loan being recharacterised as equity (i.e. no tax deduction).
New Zealand’s restricted transfer pricing approach also requires ignoring or modifying certain features of an inbound intercompany loan of $10m or more that would have an effect of increasing the interest rate. Two of these such features are:
- the interest rate cannot take into effect where the intercompany loan is subordinated to existing senior debt (it must be treated as if senior debt); and
- the loan will be treated as having a maximum five-year term.
Having a blanket rule that overrides certain loan features is directly inconsistent with the new OECD guidance. A lender making a loan to a borrower that already has senior debt obligations is taking a greater risk and at arm’s length, that risk needs to be reflected in the interest rate. Certainly, the lending company’s jurisdiction will require a premium in the interest rate for the added risk.
The new OECD guidance is certainly a welcome, and long overdue, overlay for New Zealand’s transfer pricing rules. However, as New Zealand has already deviated from this standard, pricing determined under New Zealand’s rules may result in different pricing than in the lender’s jurisdiction for some financial transactions.
Notwithstanding that the New Zealand transfer pricing rules do not fit well with the OECD guidance for some financial transactions, there is little chance that Inland Revenue will review the restricted transfer pricing rule. There are some options available to multinational groups with loans caught under the restricted rule. One option is to ask the tax authorities to resolve any double tax issue through the mutual agreement procedure. Given the time and cost, others will prefer to simply bear any double tax cost or take on a tax risk in one of the jurisdictions.