Tax and Exporters – Important changes

During August, tax legislation will pass through the final stages of the Parliamentary process. With amendments under titles such as “controlled foreign companies”, “thin capitalisation”, “deductible foreign equity” – it would seem at face value to be something that most New Zealand exporters and SME’s could ignore as applying only to the corporates. That would be a mistake. A privately owned New Zealand business that might have a subsidiary in - say, the Pacific Islands – is now subject to the full might of New Zealand’s international tax regime and might not get a tax deduction for all of its funding costs.

The legislation affects any New Zealand tax payer that carries on business offshore through a company that it controls. The new rules govern:

• the extent to which New Zealand tax must be paid on offshore profits;
• when that tax must be paid;
• the extent to which New Zealand funding costs are tax deductible; and
• the reporting obligations of New Zealand taxpayers.

In very broad terms, any New Zealand business that controls an overseas subsidiary that has a “active” business will now be subject to tax on the distribution of those profits to its owners. This is good news - previously profits earned in countries other than Australia, UK, US, Canada, Germany, Spain, Japan and Norway were probably taxed as they were earned. The new regime defers the payment of tax until the relevant profits are paid out to the ultimate NZ shareholders. Determining what is an “active” business is complex and requires information beyond the financial statements of the overseas company. Reporting obligations exist even though income may not be taxable in New Zealand. The conventional wisdom that operating offshore through a branch of the New Zealand company or an overseas subsidiary is tax neutral no longer applies. Consideration needs to be given to the profile of losses and earnings of the overseas operation, the extent to which profits will be reinvested or returned to New Zealand and the structure of the balance sheet of the New Zealand company.

A New Zealand company with an investment in an overseas subsidiary may no longer be entitled to a deduction for all of its funding costs – even where it borrows money to expand its operations in New Zealand.

New Zealand has always had rules – so called Thin Capitalisation rules – that govern the extent to which funding costs paid by New Zealand companies are deductible for tax purposes. Until now those rules were aimed mainly at New Zealand subsidiaries of multinationals. Under amendments to these rules, New Zealand companies that control subsidiaries offshore may no longer be entitled to a tax deduction for all of their funding cost. Worse still, this situation will arise even where the relevant borrowings do not relate in any way to providing funds to the overseas company.
The new rules require careful consideration of how overseas operations are established. The new rules potentially impact on the deductibility of existing and future funding costs. Some concessions apply for predominantly New Zealand based businesses or those with minimal funding costs.

Disappointingly, the new rules for taxing overseas subsidiaries do not contain any real concessionary provisions for small businesses. IRD rejected submissions for such provisions at the consultation phase. Where the subsidiary is engaged in “active” business then the new rules are good news – the payment of NZ tax on these profits should be deferred. However, the lack of concessions for small and medium sized business means these changes come with heavy compliance costs - life may just have got a lot more complicated for many New Zealand businesses expanding their operations offshore.

The new rules apply either to the 2009 or 2010 tax year depending on your tax balance date