Branches

The great majority of branches of multinational enterprises ("MNEs") operating in New Zealand are permanent establishments ("PEs") of enterprises headquartered in treaty partner countries, especially Australia. Our double taxation agreements ("DTAs") are based on the OECD's Model Tax Convention ("the MTC"). The relevant article of the MTC is Article 7 which addresses the treatment of business profits of PEs. Section BH 1(4) of the Income Tax Act 2007 provides for the overriding effect of DTAs in the approval of a person’s tax obligations.

Article 7 of the MTC

A new Article 7, along with new commentary, has been included in the 2010 update of the OECD MTC. The changes result from the OECD’s “Report on the Attribution of Profits to Permanent Establishments” which has attracted considerable academic and practitioner interest.

At paragraph 39 of our October 2000 Transfer Pricing Guidelines, it was stated that we were likely to endorse any position established by the OECD in the area of branch taxation. We have not done so, and we have made an explicit reservation on the new article 7 of the MTC.

The new Article 7 will only apply if and when it is adopted in New Zealand’s DTAs. This is unlikely to occur in the near future, and the recently renegotiated DTAs with Australia and the United States, do not include the new Article 7.

Legal position of PEs

A PE is not legally distinct from the rest of the enterprise the same way a separate legal entity is legally distinct from other enterprises within the same MNE group.

For transactions between separate legal entities, the determination of which enterprise owns assets, which bears risks and which possesses capital is determined by legally binding contracts or other confirmed legal arrangements. The legal position in a PE context is quite different - there is no single part of an enterprise which legally owns the assets, assumes risks, possesses the capital or enters into contracts with separate legal entities. There are no legal transactions between different parts of a single entity - the now familiar limited risk structuring between separate legal entities has no legal meaning within a single legal entity.

General principles of attribution

The starting point in any attribution exercise is the financial statements of the New Zealand PE determined by the ordinary processes of good business accountancy. They should be a fair reflection of the real economic functions performed and the assets utilised by the PE. A cross-check should be carried out by examining any internal documentation relating to the functional operation of the PE. Such documentation should describe the key functions performed and assets used in the PE’s business operations.

The internal transfer of goods and/or services may be recognised at full market prices provided the goods and/or services are of the same kind as those which the enterprise would normally sell to third parties. Trading stock may be transferred by a head office to its PE at cost plus a normal mark-up. An appropriate profit element is acceptable, measured by reference to the arm’s-length standard.

For other expenditure, the amount to be taken into account as incurred for the purposes of the PE’s taxation position is limited to the actual costs with no profit element added - notional sums are not deductible. The following issues commonly arise:

• General management/administration/support services - these should be allocated on an actual cost basis only (no mark-ups).
• Guarantee fees - a deduction is not available as no credit risk happens within a single enterprise (you cannot guarantee yourself).
• Research and development - part of an actual cost basis may be appropriate where the PE is a direct beneficiary of the R&D and makes use of the intangible created.
• Royalties - as there is only one legal entity, it is not possible to allocate legal ownership of intangible rights to any particular part of the single enterprise. However, if a third party charges a royalty for the specific use of intellectual property by the PE, then this cost may be allocated accordingly.

The transfer of capital against the payment of interest and an undertaking to repay in full at a future date does not fit with the true legal nature of a PE. Where no business of banking is involved, internally-charged interest is non-deductible to a PE apart from the cost of funds incurred when borrowed from third parties and used in the PE’s business (non-resident withholding tax or approved issuer levy would also apply in these circumstances).

Special considerations apply to payments of interest made by different parts of a financial enterprise to each other on advances. Making and receiving advances are closely related to the ordinary business of such enterprises so market interest rates are acceptable.

Finally, a general reasonableness check is required to ensure the profit calculated as being linked to the PE is in line with that which would be expected from a comparable business operating entirely at arm’s-length. This is subject to the particular deductibility restrictions outlined above. The OECD Transfer Pricing Guidelines, while not directly applicable, are of general assistance in this regard.

Domestic rules for branches

In the absence of a DTA, section YD 5 of the Income Tax Act 2007 applies to branches. The basic approach of section YD 5 is to identify and apportion income and expenditure to the New Zealand branch, ensuring the result of the exercise is an arm’s-length outcome. In doing so, expenditure must be incurred, ruling out any deductions for internal mark-ups (even for trading stock) and notional payments.

 

Date published: 01 Dec 2010

Back to top