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- Some basic principles
- Stand alone entity approach usually applied
- Is the entity too important to be allowed to fail?
- Compliance costs
- Bank quotes
- Major current tax risks
- Emerging tax risks
- Some errors to avoid
- Documentation of intragroup lending
- Non-commercial borrowing
- Other related tax issues
Cross-border financings form a substantial part of total associated party dealings by New Zealand members of multinational groups. Key issues arising include the pricing of interest and guarantee fees at market rates and capital structuring within New Zealand’s thin capitalisation rules. New Zealand-owned multinationals also need to account for the very same issues in their outbound financing activities.
Most interest rate analyses begin with an appropriate reference rate or base indicator. For variable rate loans, this is typically the bank bill rate; for fixed rate loans, usually swap rates are applicable.
Financing is mostly about margins. The key factor in determining interest rate margins is credit risk or the probability of default (which includes term to maturity). Factors such as liquidity, ranking (senior or subordinated) and early repayment have only limited impact compared with credit risk. Thus the margin added to the base indicator in order to arrive at an interest rate is almost entirely compensation for credit risk.
The margin over the base indicator is best determined by reference to credit ratings. In our experience, by far the most common credit rating for foreign-owned subsidiaries in New Zealand is the Standard & Poor’s rating of "BBB". However, with credit spreads being repriced over the last three years and the current trend to de-leverage balance sheets, the optimal capital structure today may well be somewhat higher than a "BBB" rating.
In determining an appropriate interest rate, we generally evaluate the credit risk of the company in question on the basis that it is a stand-alone entity, rather than an inseparable part of a single unified business. Well-performing subsidiaries may be more robust financially than their wider multinational groups, therefore notching down subsidiary credit ratings should be done with some care.
Some subsidiaries in a multinational are so central (or core) that, even absent any formal financial guarantees, if the subsidiary should be unable to repay its debt, the parent will intervene with the necessary financial support. This parental intervention will occur either due to reputation concerns or in order for the parent to ensure that its own credit rating is not jeopardised by the rumour mill.
The following factors need to be weighed up:
- relative size and profitability of the New Zealand operation compared with the global group,
- whether the New Zealand operation is strategic to the global group,
- whether the New Zealand operation is part of a wider integrated supply chain,
- whether valuable name and/or brand flows through the group, and
- level of visibility and awareness that the New Zealand operation is likely to attract internationally.
The arm’s length principle which underpins international transfer pricing practice does not operate in a vacuum. Would bank credit approvals of a subsidiary in the local New Zealand market take into account the wider multinational group’s creditworthiness? If so, then this market condition must be factored into the transfer pricing analysis, in just the same way as third party banks and rating agencies do currently in their decision-making.
From their inception, in enforcing New Zealand’s transfer pricing rules, we have endeavoured to strike a balance between protecting the tax base and containing compliance costs. Our approach to financing costs is no different. For small value loans (ie, for cross-border associated party loans by groups of companies for up to $10m principal in total per year), we currently consider 250 basis points (2.5%) over the relevant base indicator is broadly indicative of an arm’s length rate, in the absence of a readily available market rate for a debt instrument with similar terms and risk characteristics.
Our next review of interest rates for small value loans is scheduled for 30 June 2018.
For all loans in excess of the $10m guideline above, we expect far more science and benchmarking to support interest rates applied. For previous years, indicative rates for small value loans have been as follows:
- 1 July 2006 to 30 September 2009 – 1.5% on a maximum principal of $1m
- 1 October 2009 to 30 June 2013 – 3% on a maximum principal of $2m (reflecting the GFC)
- 1 July 2013 to 30 June 2014 – 2.75% on a maximum principal of $2m
- 1 July 2014 to 30 June 2015 – 2% on a maximum principal of $10m
- 1 July 2015 to 30 June 2017 – 2.5% on a maximum principal of $10m
In general, we do not accept bank quotes for transfer pricing purposes. Bank quotes are typically indicative only and are often not derived from an actual credit analysis or do not reflect the actual terms and conditions under which a bank would be willing to lend.
Accordingly, there is a potential to bias quotes away from an arm's length interest rate. More fundamentally, bank quotes are not necessarily reflective of market trades or prices on which banks stand willing to trade and thus are not transactions for comparability purposes.
Consequently, we do not consider indicative bank quotes are able to satisfy the requirement that the method used to price an associated party transaction falls under one of the five methods set out in section GC 13 of the Income Tax Act 2007.
In our current programme of work, we are paying close attention to the following:
- all inbound loans over $10m
- outbound loans of all sizes - we still see such oversights as low or no interest loans from New Zealand corporates to their foreign associates and no fees charged for guarantees
- appropriateness of non-investment grade credit ratings (i.e. Standard & Poor’s "BB" or lower) - interest rates move exponentially higher once the "investment grade divide" is crossed, so companies must be prepared to substantiate these ratings.
- cash pooling arrangements.
The great majority of multinational financings in New Zealand are plain vanilla loans. In general, they are current account recallable at two days’ notice or term loans with provisions to alter rates during the course of the loan (for example, annual interest rate reviews). Consequently, we pay special attention to more exotic financings, such as hybrid instruments and long-term subordinated debt facilities.
We will certainly examine closely any capital restructurings which result in major reductions in New Zealand tax paid. Depending on the facts and circumstances of the case, it may be appropriate to consider an upward movement in operating margins to account for the increased risk brought about by greater gearing.
The following errors have been identified in the course of our examinations of associated party financings:
- Internal comparables readily available but ignored
- Wrong geographic market data applied
- Selection of base indicators and/or credit spreads that do not match the terms and conditions or the timing of the loans in question
- Inappropriate use of the Reserve Bank “base lending rate” (i.e. weighted average of rates for banks lending to small-sized businesses without too much credit standing) in preference to the bank bill rate as a base indicator
- No regard paid to early repayment clauses when an arm’s length party would exercise such a clause at a time of declining interest rates
- Not all financing costs captured (arrangement/commitment/facility fees, etc) in the pricing analysis
- Additional cost of non-resident withholding tax gross up clause not captured in the pricing analysis, and
- Failure to use the credit rating of a lesser developed country for outbound loans where the country credit rating is lower than that of the stand-alone borrower entity.
Too often we see minimal or even non-existent documentation in respect of loans between associated parties. In particular, this can be problematic when reviewing the interest rates on cross-border loans if the terms and conditions of such loans are uncertain.
Our expectation is that the following fundamentals are documented clearly:
- purpose or intention - should be unambiguous e.g working capital, term finance
- parties - all lenders and borrowers named in full
- amount and currency - this includes the total amount available to be borrowed under a loan facility, not just the initial sum advanced
- interest rates - an absolute rate or an external benchmark rate plus a margin, whether the interest rate is fixed or floating and how it was determined as being reasonable
- interest payment dates - specific dates or periodic e.g every 3 months
- term and repayment - start date and maturity or a specific period e.g on demand, 5 years
- fees - specify any and all fees e.g guarantee fee, facility commitment fee
- security - whether repayment obligations are secured or unsecured. If secured, the form of the security e.g the borrower's assets
- guarantees - whether repayment obligations are guaranteed or indemnified. If so, the relevant names of the party or parties
- amendments - note any changes to the above that arise over the loan’s life.
In common with generally accepted international practice, we require an explicit written guarantee in the form of a letter of guarantee or irrevocable letter of credit before a guarantee fee will be recognised. We do not accept that any financial service has been received merely because the credit rating of a subsidiary is higher by reason of affiliation alone. Letters of comfort are also not sufficient to create legal obligations.
We will as a matter of course check the financial capacity of the offshore guarantor to meet its obligations in the event of a default. We will verify that there is sufficient capital available to support the risk guaranteed.
Our preferred approach to pricing guarantee fees is based on interest rate savings, with the interest spread (pre-guarantee less post-guarantee) quantifying the total benefit from the financial service provided. In theory, arm’s length parties would look to share the economic benefit of this interest rate reduction according to their relative contributions. In practice, we have seen non-bank guarantors generally sharing such savings on a 50/50 basis, which is also consistent with economic game theory.
As a matter of routine, we don't deny interest deductions to taxpayers carrying high debt levels that satisfy the thin capitalisation rules. However, where a loan transaction would not have taken place in the open market, then the commerciality of the financing arrangement between the associated parties may be called into question. In such extreme circumstances, serious consideration would be given to call upon the general anti-avoidance provision.
It pays to double check thin capitalisation calculations, especially if the group’s gearing ratio is nudging the 60% mark. Note that non-resident withholding tax still applies to interest paid, even if a deduction is not available under the thin capitalisation rules.
Where interest has been paid to a branch without any non-resident withholding tax impost, we will check the bona fides of the branch to ensure the substance truly matches the form.
The 2% approved issuer levy is not available to associated parties, and failure to deduct non-resident withholding tax instead can result in penalties.