1

Thin Capitalisation Rules and Treaties: Does the Ratio in the New

Zealand Thin Capitalisation Rules Contravene New Zealand’s Tax

Treaty Obligations?

By Craig Elliffe*

1.0 Introduction

The fundamental conflict between thin capitalisation rules targeted at non-resident ownership and

non-discrimination Articles

A company, of course, finances itself by the issuing of shares or by borrowing. When it makes this

choice it does so aware that tax implications arise from that decision on funding. Debt finance

usually has a tax advantage over equity finance.1 It is likely that the company will itself pay

significantly more tax if it is equity financed than if it is debt-financed because the return paid to the

shareholder (equity investor) is ordinarily not deductible to the company.2

This means shareholders based in one country investing in a company based in another country (the

source country) can usually reduce their tax in the source country by choosing to debt rather than

equity finance. The Committee of Fiscal Affairs recognises "that it may sometimes, from the tax

point of view, be more advantageous to a particular combination of company contributor to arrange

the financing of the company by way of loans rather than by way of equity contributions."3

If debt finance trumps equity investment in the game of cross-border investment, investors in the

company may decide to substitute equity with debt (this is referred to in the Report4 as "hidden

capitalisation"). Tax authorities are concerned with this tax driven preference for debt finance and

have devised a number of approaches to deal with what they regard as the problem of hidden

capitalisation. Some of these approaches recognise that the occurrence of hidden capitalisation is

*By Craig Elliffe, Professor of Taxation Law and Policy, University of Auckland and consultant to Chapman Tripp. The writer would like to acknowledge the assistance of Associate Professor Peter Vial and Pam Kam from Auckland University. 1 This is because a return on equity investment (shares) is the payment of a dividend on tax paid profits and

usually non-deductible, whereas a return on a loan is interest and a deductible expense for the company. 2 Of course, the tax consequences for the investor must also be considered and it is common, in an

international context where the investor is based in a different country from the company, for both the return on equity (dividends) and the return on debt (interest) to be subject to withholding tax. 3 OECD Report on "Thin Capitalisation" adopted by the OECD Committee on Fiscal Affairs on 26 November

1986 at paragraph 10. 4 OECD Report on "Thin Capitalisation" adopted by the OECD Committee on Fiscal Affairs on 26 November

1986.

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greater where funding is provided by majority shareholders or associated companies. Other

approaches recognise that there can be some circumstances in which unacceptable tax advantages

are provided when funding is by a loan from an unconnected party.5 These rules are normally known

as thin capitalisation rules because they are designed to prevent the excessive use of debt and the

corresponding lack of equity funding.

According to the OECD domestic thin capitalisation regimes are normally formulated in two broad

ways. First, some countries apply a general anti-abuse approach described as an arm's-length

principle.6 These countries’ rules might be specific anti-avoidance provisions or an application of

more general anti-avoidance rules. This approach looks at the true nature of the funding in the light

of all facts and circumstances to determine whether it is really debt or equity. The problem with this

approach, acknowledged by the OECD7, is that these types of rules suffer from an absence of clarity

and therefore do not create certainty for taxpayers.

Under the second approach countries adopt a "fixed ratio" approach. If a company's total debt

exceeds a proportion of its equity (or total assets) the interest on the loan, in excess of the fixed

ratio, is either disallowed as a deduction, treated as income, or both. Some countries apply these

rules only to loans from associated parties but others apply their regimes to loans from both

associated and non-associated parties.

The potential conflict between these domestic thin capitalisation rules and the non-discrimination

article in double tax agreements arises because the thin capitalisation rules target entities or

companies which are owned by residents of the other Contracting State. The fundamental reason for

this is that hidden capitalisation is usually only a problem cross-border. Where the investor is in the

same jurisdiction and elects to fund the company by way of debt rather than equity the deduction

for interest expense is symmetrical (from the perspective of the country’s revenue base) with the

interest income earned by the investor. The rate of tax for the two taxpayers (the company and the

investor) is the only point of potential difference. Thin capitalisation regimes therefore often apply

to companies that are owned or controlled by non-residents but do not apply if that same company

is owned or controlled by a resident.

5 Ibid, at paragraph 14.

6 Ibid, at paragraph 25.

7 OECD Report on "Thin Capitalisation" adopted by the OECD Committee on Fiscal Affairs on 26 November

1986 at paragraph 25.

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Thin capitalisation regimes are inherently discriminatory to the extent they provide for adverse tax

consequences for non-resident investors but not for resident investors.8

2.0 The OECD’s approach to thin capitalisation and non-discrimination

Article 24 (5) should not be read literally because it is subject to an exception for thin capitalisation

regimes which are designed on an arm's-length basis to prevent the transfer of profits in the guise of

interest

The OECD Report on thin capitalisation9 identified that Article 24 of the OECD Model may prevent

the application of the thin capitalisation rules if those rules apply only in respect of payments to

non-residents (in contrast to residents), or if the rules disallow the deduction of interest in

circumstances where a company is controlled by non-residents but allow the deduction if the

company is controlled by residents. Articles 24 (4) and (5) are relevant in the context of this

discussion.

Article 24 (4) requires that interest paid by an enterprise of a Contracting State to a resident of the

other Contracting State is deductible under the same conditions as if it had been paid to a resident

of the first mentioned State.10 Paragraph (4) examines the residency of the lender and ensures that,

when interest paid to a resident is deductible, interest paid to a non-resident is also deductible.

Article 24 (4) is expressly subject to the provisions of paragraph 1 of Article 9, paragraph 6 of Article

11, and paragraph 4 of Article 12. These overriding paragraphs are all concerned with the

ascertaining of profits on an arm's-length basis. Article 24 (4) was introduced into the OECD Model in

1977. It has remained unchanged since that time as has the key part of the Commentary explaining

its role.11 The Commentary concerns itself simply with confirming what the words of the Model say:

8 In the case of debt actually held by those investors (Article 24(4) of the OECD Model) or in the case of

companies owned and controlled by non-residents (Article 24(5) of the OECD Model). 9 OECD Report on "Thin Capitalisation" adopted by the OECD Committee on Fiscal Affairs on 26 November

1986 at paragraph 66, noting that the reference to paragraphs (5) and (6) of Article 24 in that Report now relate to paragraphs (4) and (5) of Article 24 of the Model Convention (as at 22 July 2010). 10

Article 24 (4) of the OECD Model Tax Convention on Income and Capital, Paris, Eighth Edition, July 2010 reads as follows:

Except where the provisions of paragraph 1 of Article 9, paragraph 6 of Article 11, or paragraph 4 of Article 12, apply, interests, royalties and other disbursements paid by an enterprise of a Contracting State to a resident of the other Contracting State shall, for the purpose of determining the taxable profits such enterprise, be deductible under the same conditions as if it had been paid to a resident of the first-mentioned State. Similarly, any debts of an enterprise of a Contracting State to a resident of the other Contracting State shall, for the purposes of determining the taxable capital of such enterprise, be deductible under the same conditions as if they had been contracted to a resident of the first-mentioned State.

11 Isabel Nepote, "Article 24-Non-Discrimination" in Ecker and Ressler (eds) History of Tax Treaties-The

Relevance of the OECD Documents for the Interpretation of Tax Treaties Linde, Vienna, 2011, 663 at 680. The

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that paragraph (4) will apply when a payment applies only to non-resident creditors and is in breach

of the arm's-length requirements of Article 9 (1) et al. The Commentary on paragraph (4) does not

explain why this arm's-length override exists.12

Article 24 (5) of the OECD Model precludes a Contracting State from imposing less favourable

treatment on an enterprise, when the capital of that enterprise is owned or controlled, wholly or

partly, directly or indirectly, by one or more residents of the other Contracting State. There is no

exception in paragraph (5) of the Model for the arm's-length principles espoused by Article 9 (1) et

al.

The paragraph reads:13

Enterprises of a Contracting State, the capital of which is wholly or partly owned or controlled,

directly or indirectly, by one or more residents of the other Contracting State, shall not be subject in

the first-mentioned State to any taxation or any requirement connected therewith which is other or

more burdensome than the taxation and connected requirements to which other similar enterprises

of the first-mentioned State are or may be subjected. This provision shall, notwithstanding the

provisions of Article 1, also apply to persons who are not residents of one or both of the Contracting

States.

In summary, Article 24 (4) prohibits the disallowance of a deduction for interest paid to a non-

resident creditor when the deduction would be allowed if the interest were paid to a resident

creditor. Paragraph (4) is, however, expressly subject to an exception for any domestic thin

capitalisation regime which meets the arm's-length requirements of Article 9 (1) et al.

Prima facie Article 24 (5) regards as discriminatory the disallowance of an interest deduction in

circumstances in which a company is controlled by non-residents, if the interest deduction would be

allowed if the company was controlled by residents. Unlike Article 24 (4), Article 24 (5) is not

qualified by any arm’s-length exceptions. Many thin capitalisation regimes are structured to apply

only where entities in a state are controlled by non-residents, and the New Zealand regime is no

exception.

Commentary on Article 24 is found in paragraph 74 (current Commentary) which is the same as paragraph 56 of the 1977 Commentary. 12

More information on the role of these arm’s-length provisions and their relationship to Article 24 (5) are contained in the Commentary at paragraph 79, but the most illuminating discussion is contained in the OECD Report on "Thin Capitalisation" adopted by the OECD Committee on Fiscal Affairs on 26 November 1986. 13

Article 24 (5) of the OECD Model Tax Convention on Income and Capital, Paris, Eighth Edition, July 2010. Paragraph 5 is the "base case" for many countries. Some countries go on to significantly modify paragraph 5 provisos limiting the application of the foreign owned capital non-discrimination Article.

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The focus of this article is on Article 24 (5) and its potential conflict with the New Zealand thin

capitalisation rules. To address this topic properly a threshold question must be answered. This

question applies to all countries that have non-discrimination articles and thin capitalisation rules

which operate on the basis of non-resident ownership. The question is whether it is correct to

import a restriction on paragraph 5 or should Article 24 (5) apply to thin capitalisation rules without

limitation?

Certainly there is no limitation in the language of the Model itself. The OECD Committee of Fiscal

Affairs acknowledged this deficiency in Article 24 (5) in 1986 (… "The Commentary on this paragraph

does not deal with the point").14 This led to changes in the Commentary in 2008.15

Citing Article 31 of the Vienna Convention on the Law of Treaties, “a treaty shall be interpreted in

good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their

context and in the light of its object and purpose”, as authority for its approach the OECD

Commentary has applied a teleological and systematic basis of interpretation16 to import the

restriction included in paragraph 4 of Article 24 (namely an arm's-length transfer pricing type of

exception) into paragraph 5. The 1986 Thin Capitalisation Report indicates this is a pragmatic

solution. Simply put, this is because the wording of paragraph 5 is too broad and would otherwise

not prevent the transfer of profits in the form of interest. Without limitation in this way Article 24 (5)

would render many countries’ domestic thin capitalisation rules ineffective.

The Committee's view is that, where thin capitalisation rules are inconsistent with Article 9 (1) or

Article 11 (6), a residual non-discrimination power exists in Article 24 (5).17 The object of the

14

Paragraph 46 of the OECD "Thin Capitalisation" adopted by the OECD Committee on Fiscal Affairs on 26 November 1986. 15

See paragraph 88 of the Report "Application and Interpretation of Article 24 (Non-Discrimination)" adopted by the OECD Committee on Fiscal Affairs on 20 June 2008 and now paragraph 79 of the Commentary on Article 24, OECD Model Tax Convention on Income and Capital, Paris, Eighth Edition, July 2010. 16

For a discussion on the general principles of the interpretation of the VCLT and public international law generally see Shelton N, Interpretation and Application of Tax Treaties, LexisNexis UK, (2004) at 166, where he traces the three main approaches to treaty interpretation: textual (or the ordinary meaning of the words) which analyses the actual words in the text of the treaty; the intention of the parties’ (or founding fathers) approach which attempts to ascertain the parties' intention and then construes the treaty to give effect to those intentions; and the aims or objects (or teleological) approach which seeks to ascertain the treaty's aims and objects, the treaty being construed to give effect to these aims and objects. Slightly different terminology is used by Pijl H, "The Theory of the Interpretation of Tax Treaties, with Reference to Dutch Practice", (1997) Bulletin, IBFD, 539 at 540, when he describes the instruction for the interpretation of treaties in Article 31 (1): "A treaty shall be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in the context and in the light of its object and purpose" as combining the grammatical ("ordinary meaning"), teleological ("object and purpose") and systematic ("context") methods without giving preference to any one method. 17

OECD "Thin Capitalisation" adopted by the OECD Committee on Fiscal Affairs on 26 November 1986 at paragraph 66.

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paragraph is to prevent the deterrence by tax measures of inbound investment (tax protectionism)

rather than interference with the rules that prevented the transfer of arm’s-length profits in the

guise of interest.18 This view led to the 1992 Commentary reflecting the 1986 Report’s conclusions.

From 1986 onwards countries negotiating Article 24 (5) should have been aware that the non-

discrimination article would not interfere with a thin capitalisation rule which did not offend an

arm's-length principle.

The first question discussed above was "whether it is correct to import a restriction on paragraph

5?" The answer to this question is yes, at least in respect of treaties negotiated from 1986

onwards,19 which means that the non-discrimination article cannot override an arm's-length thin

capitalisation regime.

3.0 The New Zealand thin capitalisation regime

The basis for the New Zealand Thin Capitalisation Regime

The New Zealand rules relating to thin capitalisation are contained in subpart FE of the New Zealand

Income Tax Act 2007. The rules apply to debt on both foreign controlled inbound investment and

outbound investment by New Zealand residents with respect to their controlled foreign companies.

Relevantly, for the purposes of this discussion, these rules apply to apportion interest expenditure

when a company is resident in New Zealand and a non-resident has either an ownership interest in

the company of 50 per cent or more, or control of the company by any other means.20 The definition

of "ownership interest" includes direct and indirect ownership interests and aggregate interests held

18

Paragraph 66 (b) of the OECD "Thin Capitalisation" Report adopted by the OECD Committee on Fiscal Affairs on 26 November 1986. 19

So while it seems clear that for treaties negotiated from 1986 onwards an arm's-length principle is a fetter

on the clear words of Article 24 (5) the position for treaties concluded prior to 1986 is less certain. Certainly

the German and French courts have taken the view that the arm's-length principle is not necessarily a

restriction on the non-discrimination article in an older treaty. As the writer has discussed previously in

another article, ( "Discriminatory Thin Capitalisation Rules: The Relationship between the Non-Discrimination

Article in the OECD Model and Domestic Thin Capitalisation Rules.") the approach of the Bundesfinanzhof in Re

Treaty Discrimination and Fiscal Unity, (2011) 13 ITLR 839 and the Conseil d'Etat, Re Société Andritz Sprout

Bauer, (2003) 6 ITLR 604, in refusing to acknowledge that the arm's-length principle suggested by the

Commentary is appropriate and correct for a treaty concluded in 1964 and 1959 (with the protocol of 30

October 1970) respectively.

20 See section FE 2 (1) (c) of the Income Tax Act 2007 (New Zealand). It also can apply to non-resident

companies in certain circumstances (see paragraph (b)) of the same section.

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by associated persons.21 A key feature of the New Zealand thin capitalisation regime is the fact that

it applies not only to associated person lending but also to arm's-length funding.

The broad effect of these rules is that a foreign controlled New Zealand resident company (or group

of companies) that has a debt percentage of more than 60 per cent, and more than 110 per cent of

the debt percentage of the worldwide group, will be required to adjust its interest expense so that

its deductions are restricted.22

Key questions

In examining the New Zealand thin capitalisation regime and the potential application of the non-

discrimination principle the following key questions arise. First, is the feature of non-resident control

and ownership sufficient to contravene the operation of the non-discrimination Article? This issue is

whether there is sufficient connection or nexus between the requirements of the New Zealand thin

capitalisation regime and discrimination against non-residents proscribed in Article 24 (5) to suggest

that the New Zealand thin capitalisation regime is potentially subject to the non-discrimination

Article.

Secondly, if the non-discrimination article applies because of the requisite non-resident control,

does the New Zealand thin capitalisation operate on an arm's-length basis? As explained, the OECD

Commentary excuses arm's-length compliant thin capitalisation regimes from the non-discrimination

provisions of double tax treaties. Given that the New Zealand regime applies to both associated and

non-associated debt it is necessary, when calculating the ratio of debt to total assets, to include all

debt in the calculation (including arm's-length debt). How does the inclusion of arm's-length debts

relate to the concept of compliance with an arm's-length principle?

This question involves a twofold enquiry. First the question "whether an arbitrary fixed ratio is

consistent with an arm's-length principle?" The New Zealand thin capitalisation rules specify that the

fixed ratio of total New Zealand group debt does not exceed 60 per cent of total New Zealand group

assets. Does this comply with the arm's-length principle required by Article 9? Is this New Zealand

test a valid proxy for an arm's-length test? The OECD believes that the lower the ratio of debt to

equity and the more rigid the practice followed in applying it, the more serious is the risk of

producing a result which is inconsistent with the arm's-length principle and in breach of the non-

21

Section FE 38 of the Income Tax Act 2007 (New Zealand). 22

The adjustment required under section FE 6 requires the entity with excess debt to calculate and include deemed income effectively disallowing the excess interest expense. The debt percentage of a New Zealand group is calculated under sections FE 14 to 16 and the debt percentage of a worldwide group is captured under sections FE 17 and 18.

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discrimination article.23 A low fixed ratio approach may go beyond preventing the transfer of profits

in the guise of interest and encroach into the area of tax protectionism – using tax to deter

investment from outside the country. This point needs to be considered from two perspectives:

whether the statistical evidence would suggest that 60 per cent debt to total assets is a ratio that

represents an arm's-length norm, and subsequently whether the New Zealand fixed ratio is

consistent with other countries’ fixed ratios.

Further, in respect of this proxy for an arm's-length principle, New Zealand has another safe harbour

test and that is whether the indebtedness of the New Zealand entity is greater than 110 per cent of

the debt percentage of the worldwide group. Is this test a valid proxy for the arm's-length principle?

4.0 The context for examining the New Zealand thin capitalisation rules-

an examination in the light of Article 24 (5)

Do the New Zealand thin capitalisation rules apply solely because the enterprise is foreign owned?

As discussed above, Article 24 (5) applies when an enterprise in one Contracting State is owned by a

resident of the other Contracting State. In other words the capital of the domestic enterprise must

be owned by a non-resident of the enterprise’s State. If the non-discrimination article is to override

domestic thin capitalisation rules then the question becomes: is foreign ownership the cause of the

discrimination? A relatively recent case in the United Kingdom24 concerning the application of Article

24 (5) in circumstances involving the group loss offset rules, rather than domestic thin capitalisation

rules, confirms that the non-discrimination article applies when the foreign ownership is the cause of

the denial of relief (or the imposition of an additional burden) under the domestic legislation.

The United Kingdom First-tier Tax Tribunal considered the "ownership" paragraph of the non-

discrimination article25 in its decision FCE Bank plc v Revenue and Customs Commissioners.26 This

decision was appealed to the Upper Tribunal (Tax and Chancery chamber) and affirmed by

Henderson J and Judge Ghosh QC.27 The Upper Tribunal agreed with the "full and cogently reasoned

decision"28 of the First-tier Tax Tribunal, expressly endorsing the principle "that courts give

consistent interpretations of treaty provisions contained in the OECD model that are widely used in

23

Paragraph 79 of the OECD "Thin Capitalisation" Report adopted by the OECD Committee on Fiscal Affairs on 26 November 1986. 24

FCE Bank plc v Revenue and Customs Commissioners 12 ITLR 962. 25

Article 24 (5) of the United States-United Kingdom Double Tax Agreement 1975, scheduled to the Double Taxation Relief (Taxes on Income) (the United States of America) Order 1980, was identical to the OECD Model Article. 26

FCE Bank plc v Revenue and Customs Commissioners 12 ITLR 962. 27

FCE Bank plc v Revenue and Customs Commissioners 14 ITLR 319. 28

Ibid, at 24.

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tax treaties".29 In the First-tier Tax Tribunal, Avery Jones and Sadler JJ had defined the approach in

the FCE Bank case as a twofold exercise:

Does the UK company with a US parent suffer a greater tax burden than a UK company with

a UK parent? If the answer to that question is yes, then;

Is that difference in taxation based solely on the ground that its capital is "wholly or partly

owned or controlled, directly or indirectly" by the US parent company?

Although the decisions in FCE Bank is from a court of first instance, it is an authoritative case. The

judges had to deal with, and distinguish, an important House of Lords decision in Boake Allen.30 In

doing so they carefully evaluated and reconciled not only the House of Lords decision but also

reviewed comparable jurisprudence emanating from the Dutch Supreme Court,31 the Finnish

Supreme Administrative Court,32 and the Swedish Supreme Administrative Court,33 all of which

supported the approach taken in FCE Bank.34 Applying the jurisprudence from the FCE Bank case to

the New Zealand thin capitalisation rules leads to the following propositions;

1. is the alleged discrimination against a New Zealand company which is not entitled to full

interest deductions (and hence is subjected to taxation which is more burdensome) in

circumstances where it has a debt percentage greater than 60 per cent, because the shares

of the company are wholly or partly owned, directly or indirectly by residents of another

contracting state?;

2. if a New Zealand company owned by New Zealand resident shareholders had the same level

of debt (and hence was a similar enterprise) would the New Zealand company be entitled to

a full interest deduction;

3. the question is “whether the thin capitalisation rules create an extra burden on the New

Zealand enterprise solely because the capital of that New Zealand enterprise is owned

overseas?”

29

Ibid, at 24. 30

NEC Semi-Conductors Limited v Revenue and Customs Commissioners [2007] UKHL 25, 9 ITLR 995,[2007] STC 1265, sub nom Boake Allen Ltd v Revenue and Customs Commissioners [2007] 1 WLR 1386 at [16]. 31

23 December 1992, BNB 1993/71c. 32

Decision KHO 10.05.2000/864. 33

RÅ 1996 ref. 69 and 1998 ref. 49. 34 Further, judges such as John Avery Jones have a long and distinguished career and acknowledged expertise

in the area of international tax.

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Type of ownership Residence of

Shareholder

Interest apportionment

rules apply if the NZ

enterprise has excess debt

Direct, company Overseas Yes

Direct, company NZ No

Indirect, non-resident

company

Overseas

(ultimately) NZ

(the intermediate

holding

company)

Yes

Direct, individual NZ No

Direct, individual Overseas Yes

Direct, incorporated charity NZ No

Similar to the analysis in the FCE Bank case, there is no reason other than foreign ownership to

explain for the difference in treatment between New Zealand enterprises with excess debt and New

Zealand resident shareholders and New Zealand enterprises with overseas shareholders. To

paraphrase Lord Hoffmann in Boake Allen, the question is whether the New Zealand thin

capitalisation rules discriminate against a New Zealand company on the ground that its capital is

"wholly or partly owned or controlled, directly or indirectly" by residents of some other foreign

state.35 His analysis was;36

In relation to article 24 (1) of the OECD model convention, which prohibits discrimination between

residents on the grounds of nationality, the commentary says that the "underlying question" is

whether residents are being treated differently "solely by reason of having a different nationality". It

does not repeat this observation in relation to article 24 (5), the principle must be the same...

Applying this analysis to a heavily indebted New Zealand enterprise, which is owned by foreign

rather than New Zealand owners, one is forced to the conclusion that the New Zealand thin

capitalisation rules are prima facie in breach of Article 24 (5) of the OECD Model because foreign

ownership is the cause of the application of the New Zealand thin capitalisation rules.

35

NEC Semi-Conductors Limited v Revenue and Customs Commissioners [2007] UKHL 25, 9 ITLR 995,[2007] STC 1265, sub nom Boake Allen Ltd v Revenue and Customs Commissioners [2007] 1 WLR 1386 at [16]. 36

Ibid.

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Do the New Zealand thin capitalisation rules depart from an arm's-length principle?

When New Zealand introduced its thin capitalisation regime in 199537 it was the first country to

extend non-deductibility to the arm's-length debt of a foreign-controlled resident corporation.38

Since then other countries39 have followed suit. This has lead Tim Edgar to comment that the

"extension of the rule of non-deductibility to both arm's-length and related party debt is the most

significant recent trend in country legislative practice."40 There does not appear to have been any

discussion in the New Zealand Government's proposal41 on the relationship between New Zealand's

double tax agreements and the new thin capitalisation regime when that regime was first

introduced.42 With the benefit of hindsight and for the reasons which are now canvassed,

consideration of compliance with an arm's-length principle in order to allay fears of discrimination

against foreign investors would have been highly desirable.43

On first blush the inclusion of arm's-length debt in the calculations for the New Zealand thin

capitalisation regime seems to contravene the principles in Article 9 (1) of the OECD Model

Convention. Article 9 (1) concerns itself with the ascertaining of profits in two associated enterprises

whose commercial or financial relations were conducted as independent enterprises. Put simply,

arm's-length debt ought not to be subject to any adjustment under transfer pricing rules or Article 9

because it is inherently calculated and formulated on an independent basis.44 This leads to the

37

For a background on the introduction to New Zealand's thin capitalisation rules, an excellent explanation on how they work, and a critical analysis see A Smith, "New Zealand's Thin Capitalisation Rules" Canadian Tax Journal, (1996), Vol 44, No 6, 1525. 38

Tim Edgar "Interest Deductibility Restrictions and Inbound Direct Investment", a Research Report prepared for the Advisory Panel on Canada's System of International Taxation (October 2008) available at http://www.apcsit-gcrcfi.ca/06/index-eng.html. 39

Ibid, Appendix 1 lists the following countries thin capitalisation or earnings-stripping rules as including arm's-length debt: Australia, Belgium, Denmark, Germany, Italy. 40

Ibid, at 3. 41

Contained in the Report, "International Tax-A Discussion Document", Rt Hon W Birch, Minister of Finance and Hon W Creech, Minister of Revenue, Government Print, Wellington, March 1995. 42

This point was noted by Andrew Smith and Paul Dunmore in "Double Tax Agreements and the Arm's-Length Principle: The Safe Harbour Ratio in New Zealand's Thin Capitalisation Rules", Working Paper Series number 14, 2005. 43

In his article, Andrew Smith speculates that the omission of any discussion of the interaction between thin capitalisation rules in New Zealand double taxation agreements possibly indicated that officials were nervous of the issue and aware of potential problems, see A Smith, "New Zealand's Thin Capitalisation Rules" Canadian Tax Journal, (1996), Vol 44, No 6, 1525 at 1549. 44

There may also be an argument based on the Commentary that thin capitalisation regimes when discussed by the OECD in the Commentary and the OECD "Thin Capitalisation" Report adopted by the OECD Committee on Fiscal Affairs on 26 November 1986 were only ever envisaged as applying to related party debt. See for example paragraphs [72]-[74] where arm's-length debt seems largely to fall outside the contemplation of the Committee. At [73], “Article 9 may not however be strictly applicable. If the loan which is being treated as an equity contribution is a loan between ostensibly independent persons, and Article 9 therefore does not apply…

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logical conclusion that Article 9 applies only to the portion of funding that relates to loans with

associated parties leaving the thin capitalisation rules to operate on the residual indebtedness45and

to the further conclusion that is highly arguable that the New Zealand rules are inconsistent with the

arm's-length principle.46

Is the New Zealand fixed ratio approach compatible with the arm's-length principle?

A fixed ratio (debt to equity, or debt to total assets) is an arbitrary tool designed to be a proxy for an

arm’s-length measure. The OECD considers that such a fixed ratio could be compatible with the

arm's-length principle but only in certain circumstances. These circumstances are those in which the

ratio is employed as a kind of "safe haven" rule, and where the "safe haven" is breached, the

taxpayer has the option of showing that the actual ratio of the company's debt to equity is an arm's-

length ratio (by demonstrating that independent companies would be leveraged to that level on an

arm's-length basis). The OECD states that, although the onus would be on the taxpayer to discharge

the burden of proof, the thin capitalisation regime could be compatible provided the taxpayer can

demonstrate "that it corresponds to the ratio which is characteristic of independent companies in

the same kind of business in the same country".47

The OECD highlights that allowing the taxpayer to demonstrate that its actual ratio is an arm's-length

one in thin capitalisation rules is very important to this analysis. It asserts: "where, on the other

hand, a fixed debt/equity ratio is employed by the tax authorities without allowing such an option,

the majority of countries consider that the results would undoubtedly be inconsistent with the

At [74], “Where Article 9 is, in terms, applicable, ie broadly, where the relevant transaction is one between associated persons…” 45

See for example the approach of the Australian Taxation Office in their Taxation Ruling TR 2010/7, "Income tax: the interaction of Division 820 of the Income Tax Assessment Act 1997 and the transfer pricing provisions", where they state at paragraph 4, "The transfer pricing provisions are applied before the thin capitalisation provisions in determining the deduction allowable for the pricing of debt", and at paragraph 65 "It follows that Division 820 can operate to reduce the amount otherwise deductible as the arm's-length consideration after the application of Division 13 if, and to the extent that, the actual amount of debt exceeds the ‘maximum allowable debt’". 46

Andrew Smith and Paul Dunmore in "Double Tax Agreements and the Arm's-Length Principle: The Safe Harbour Ratio in New Zealand's Thin Capitalisation Rules", Working Paper Series number 14, 2005, at 11, and see the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, July 2010, OECD, Paris at paragraph 4.96 which states: “The provision of safe harbours raises significant questions about the degree of arbitrariness that would be created in determining transfer prices by eligible taxpayers, tax planning opportunities, and the potential for double taxation resulting from the possible incompatibility of the safe harbours with the arm’s length principle.” 47

Paragraph 79 of the OECD "Thin Capitalisation" Report adopted by the OECD Committee on Fiscal Affairs on 26 November 1986.

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arm's-length principle."48 The requirements in the New Zealand thin capitalisation rules do not

include an option to demonstrate that the taxpayer’s actual debt to asset ratio is consistent with

independent companies in the same kind of business.

Although there is no option in the New Zealand rules which allows a taxpayer to demonstrate that

their gearing is on an arm's-length basis, it is sometimes argued that the safe harbour rules equate

to an arm's-length test. The two safe harbours in the New Zealand legislation are for entities which

have a debt percentage of more than 60 per cent and/or the debt percentage of the New Zealand

group is more than 110 per cent of the debt percentage of the worldwide group. These two safe

harbours are now examined to identify whether they could constitute a proxy for an arm's-length

test.

The fixed ratio of 60 per cent debt to total assets

When the New Zealand thin capitalisation rules were introduced in 1995, they had a 75 per cent

debt percentage to total assets. This ratio was re-evaluated as part of a major review of New

Zealand's international tax policy in the discussion document "New Zealand’s International Tax

Review: a direction for change".49 The key factors in the assessment of the appropriateness of the 75

per cent safe harbour ratio were expressed as:50

A safe harbour ratio that is too high would allow New Zealand entities to restructure their affairs to

achieve a tax advantage and result in under-taxation of these entities. Conversely, a safe harbour

ratio that is too restrictive might impose unnecessary compliance and administrative costs.

The December 2006 discussion document proposed lowering the safe harbour rate noting:51

The safe harbour ratio of 75 per cent under the current interest allocation rules is relatively high

compared with debt limitations that are commonly found in commercial debt contracts. Empirical

evidence from commercial public debt contracts, such as debentures, tends to require New Zealand

borrowers to maintain a maximum 60 per cent debt-to-tangible-asset ratio.

48

Ibid, at paragraph 79. 49

"New Zealand’s International Tax Review: a direction for change": a government discussion document prepared by the Policy Advice Division of Inland Revenue, Wellington, December 2006. 50

Ibid, at 6.28. 51

Ibid, at 6.30.

14

The 60 per cent figure seems to originate from a maximum debt-to-tangible-asset ratio found in a

study of the expectation in commercial public debt contracts, such as debentures issued in the New

Zealand market.52 The proposal to reduce the safe harbour rate met significant opposition in 2006

and it was left at the 75 per cent level.

In a document prepared for the Victoria University of Wellington Tax Working Group in October

2009 53 the Policy Advice Division of the Inland Revenue Department and the New Zealand Treasury

re-evaluated the proposition of a reduction to 60 per cent. It is clear from the discussion in this

document that the key factors influencing the setting of the rate for the thin capitalisation regime

were simply the possibility of increased tax revenue and the efficiency of raising it versus the

potential discouragement of marginal foreign investment. The discussion paper quite openly admits

that "the 75 per cent safe harbour is arbitrary".54

As announced in the May 2010 New Zealand Budget and subsequently enacted in the Taxation

(Budget Measures) Act 2010 the thin capitalisation ratio changed to 60 per cent debt to total assets.

The change came into effect for the 2011/12 income tax year. The reason for the change given was

simply:55

Changing the thin cap rule limits the extent to which foreign multinationals can allocate debt to their

New Zealand subsidiaries, claim tax deductions for the interest they pay on this debt, and therefore

reduce the amount of tax they have to pay here.

In the 2010 Budget and subsequent legislative documents there is no discussion as to whether 60

per cent constitutes an arm's-length rate. Instead the documents implementing the change focus on

the fact that non-resident multinationals will be bearing the anticipated $200 million per year cost of

52

Law S, "The choice of fixed accounting ratios as safe harbours in thin capitalisation rules-some guidance from commercial debt contracts", Australian Tax Forum, 21 (2006), 363. 53

"Debt and equity finance and interest allocation rules", a background paper prepared by the Policy Advice Division of Inland Revenue and the New Zealand Treasury for session 4 of the Victoria University of Wellington Tax Working Group, October 2009. 54

Ibid, at page 3. 55

Fact sheet-Thin capitalisation rules (20 May 2010) of the New Zealand Inland Revenue found at http://taxpolicy.ird.govt.nz/sites/default/files/news/2010-05-20-budget2010-thin-capitalisation-fact-sheet.pdf.

15

the change.56 There is, however, a reference back to the Victoria University Tax Working Group

report57 and to the Capital Markets Development Taskforce report.58

In summary it appears that the evidence relied on to support a 60 per cent ratio comes from the

government discussion document published in February 1995,59 which stated that the top 40 NZSX

companies (the New Zealand 40 largest listed stock exchange companies) had a debt to asset ratio of

50%, and with the study of commercial debt contracts prepared by Shee Boon Law in 2006 (which

illustrated that such debt offerings as debentures tended to impose a maximum 60 per cent debt-to-

tangible-asset ratios).60

So can 60 per cent be a proxy for an arm’s-length rate? As discussed above there appears to be a

lack of information and evidence upon which the decision to use 60 per cent is based. Arguably the

1995 information is outdated.61 The more serious concern is that a small sample of large listed

companies does not reflect the majority of entities to which the rules apply. Large listed companies

have access to equity markets whereas many foreign controlled New Zealand companies do not

have access to equity markets.

The evidence on public debt contracts filed with the Registrar of Companies considered in the Law

article is suspect for the same reasons. This article was based on information presented62 in respect

of 74 publicly listed firms in the New Zealand stock exchange in the period 1962 to 1992.63 This

means that some of the information used to establish the basis for change was up to 50 years old.

The conclusion reached in the Law article was that New Zealand borrowers in the survey had

covenants to maintain the debt capacity at between 60 to 100 per cent of the total tangible assets.

The most common requirement was for a borrower to limit its total debt to 60 per cent but the

56

Although in the Fact sheet referred to ibid there is a statement that the United States also has a 60 per cent safe harbour in its interest allocation rules. 57

"Debt and equity finance and interest allocation rules", a background paper prepared by the Policy Advice Division of Inland Revenue and the New Zealand Treasury for session 4 of the Victoria University of Wellington Tax Working Group, October 2009. 58

Capital Markets Matter, a report of the Capital Markets Development Taskforce, December 2009 http://www.med.govt.nz/business/economic-development/pdf-docs-library/cmd-capital-markets-matter-full-report.pdf. 59

Contained in the Report, "International Tax-A Discussion Document", Rt Hon W Birch, Minister of Finance and Hon W Creech, Minister of Revenue, Government Print, Wellington, March 1995. 60

Law S, "The choice of fixed accounting ratios as safe harbours in thin capitalisation rules-some guidance from commercial debt contracts", Australian Tax Forum, 21 (2006), 363. 61

Contained in the Report, "International Tax-A Discussion Document", Rt Hon W Birch, Minister of Finance and Hon W Creech, Minister of Revenue, Government Print, Wellington, March 1995. 62

This was reported in the article Law, Waldron and McGregor "And Examination of the Debt/Equity Proxy for Probability of Default on Loan Covenants", Pacific Accounting Review, 10, No.2, December 1998, 33-52. 63

Law S, "The choice of fixed accounting ratios as safe harbours in thin capitalisation rules-some guidance from commercial debt contracts", Australian Tax Forum, 21 (2006), 363, at 381.

16

article is certainly not suggesting that 60 per cent was some sort of magic arm's-length ratio. At the

time it was written in 2006 the current New Zealand thin capitalisation ratio was 75 per cent and the

article suggests that this safe harbour appeared too generous compared to the usual commercial

limits on public debt capacity (60 per cent). Law, however, expressly acknowledges that there are

significant variations in the level of maximum allowable debt (both in New Zealand, Australia and the

United States):64

This systematic variation means that one simple safe harbour ratio is unlikely to achieve all the

objectives of the policymakers (e.g. in reducing administrative and compliance costs and producing an

outcome that is consistent with the arm's-length principle).

The article rather tellingly concludes:65

This evidence suggests that even a carefully selected safe harbour thin capitalisation ratio cannot

guarantee arm's-length results under all circumstances. To ensure that the thin capitalisation rules

will produce arm's-length results, safe harbour ratios could be used with an option for the borrowers

to show that the debt level is consistent with the arm's-length principle. (Emphasis added)

Given that the information upon which the 60 per cent ratio was based was first, dated, with some

of it being 50 years old, and secondly, limited to a small sample of large publicly listed companies,

and thirdly, heavily caveated that it was not necessarily consistent with an arm's-length principle,

the writer suggests there is a problem in relying upon the 60 per cent ratio as a proxy for an arm's-

length rate.

What current information is available and what does that suggest?

More recent statistical information highlights the problem in using a simple safe harbour ratio. The

2010 Annual Enterprise Survey66 published by Statistics New Zealand provides information on a wide

variety of New Zealand businesses. The industries covered in the survey represent approximately 90

per cent of New Zealand's GDP and so represent a much broader cross-section of the various types

of companies and businesses (including both domestic and foreign owned).

Unfortunately the information relating to equity and liabilities is not presented in terms of interest-

bearing debt but rather only in three categories, being shareholders’ funds, current liabilities, and

64

Law S, "The choice of fixed accounting ratios as safe harbours in thin capitalisation rules-some guidance from commercial debt contracts", Australian Tax Forum, 21 (2006), 363, at 380. 65

Ibid, at 385. 66

This is found on these statistics New Zealand website as follows: http://www.stats.govt.nz/browse_for_stats/businesses/business_finance/Annual-Enterprise-Survey_HOTP10/Definitions.aspx.

17

other liabilities. Let us assume that all other liabilities are interest-bearing and that no current

liabilities are interest-bearing. These assumptions are likely to be incorrect but it is the principle

which the writer wishes to highlight. Statistics New Zealand information across all industries

confirms that the ratio of other liabilities to total assets is 33 per cent for 2010.67 In contrast to the

average across all industries, the ratio of other liabilities to total assets for agriculture, forestry, and

fishing sector is 39 per cent. Information, media and telecommunications is also 39 per cent, whilst

the education and training sector is 8 per cent. In other words the ratio of other liabilities to total

assets varies widely in different industry categories.

The Inland Revenue website68 contains information on benchmarking across various industry types.

Included in this information is a statistic on liability structure which is a summarised form of

information contained in the Statistics New Zealand Annual Enterprise Survey for the 2009/2010

financial year. The liabilities structure ratio is the shareholders’ funds divided by the total

shareholders’ funds and liabilities. This survey not only benchmarks different industries but also

categorises businesses into different sizes based on turnover. The liability structure ratio for these

different sized businesses in different industry categorisations varies significantly. For example, in

supermarket and grocery stores, the small business size ($60,000-$300,000 annual turnover) has a

liability structure ratio of 74 per cent, the medium business size ($300,000 to $800,000 annual

turnover) is 62 per cent, and the large business size ($800,000 plus annual turnover) is 38 per cent.

Similar sized categories in takeaway food services have liability structure ratios of small (85 per

cent), medium (59 per cent), and large (17 per cent). It is clear from this survey that the liability

structure ratio, which reflects the debt to total assets ratio, varies widely between different sized

businesses.

Andrew Smith and Paul Dunmore undertook an empirical study,69 which examined publicly available

information filed by New Zealand public companies and New Zealand non-resident controlled

companies with the New Zealand Companies Office. Although the authors acknowledge there were

major limitations in identifying the amount of interest-bearing debt borne by companies (there

being no disclosure requirement either under New Zealand accounting standards for the period in

question70 or under the Companies Act 1955), they come to some interesting conclusions. First, they

suggest that at 75 per cent debt to total assets (the survey was written prior to the 2010 Budget

67

This is calculated from the 2010 Annual Enterprise Survey and is the figure of other liabilities ($585,733, 000) divided by total assets ($1,775,929,000). 68

This is found on the Inland Revenue industry benchmark website as follows: http://www.ird.govt.nz/industry-benchmarks/. 69

Andrew Smith and Paul Dunmore in "Double Tax Agreements and the Arm's-Length Principle: The Safe Harbour Ratio in New Zealand's Thin Capitalisation Rules", Working Paper Series number 14, 2005. 70

1983 to 1992.

18

change reducing the rate to 60 per cent) only 5 per cent of non-resident controlled companies would

be affected by the New Zealand thin capitalisation rules. Obviously the new 60 per cent ratio would

affect a higher number of non-resident controlled companies prior to any thin capitalisation self-

correcting behaviour (such as capitalising foreign owner inter-company debt).

Secondly, for non-resident controlled New Zealand companies, 16.1 per cent of their interest would

have been non-deductible under the old thin capitalisation rules whereas, for domestically owned

New Zealand companies, the corresponding figure was 19.2 per cent. This led to the conclusion that

non-resident controlled companies finance themselves with levels of interest-bearing debt that are

no greater than those used by resident companies leading Smith and Dunmore to the view that "the

entire thin capitalisation regime may be incompatible with the arm's-length principle". The paper

concludes:71

whether the safe harbour debt-percentage has been set at a too high level so that insufficient

protection is afforded to the New Zealand revenue is an issue to be considered given the results

obtained here, however, the arm's-length principle could place a major constraint on lowering that

safe harbour percentage.

In summary, previous studies and current publicly available information suggest there is concern

that the fixed ratio of 60 per cent chosen was arbitrary and was based upon outdated statistical

information from a small sample. The Law article, which, according to government discussion

documents, supports the fixed rate of 60 per cent, cautions that a fixed ratio does not comply with

the arm's-length principles in all circumstances. Other information from Statistics New Zealand

referred to in above suggests that there is an enormous discrepancy between different businesses

with respect to various debt ratios depending, first, upon the category of business and industry

group, and secondly, upon the size of the business. A single 60 per cent fixed debts to total asset

ratio will almost certainly offend an arm's-length level of borrowing for some individual businesses,

and therefore offend the non-discrimination article of the relevant treaty.

Reference to other countries’ fixed ratios

The New Zealand approach to selecting an appropriate level for a fixed ratio has been justified

somewhat by the ratio employed in other countries. When the 2010 Budget changes were

71

Andrew Smith and Paul Dunmore in "Double Tax Agreements and the Arm's-Length Principle: The Safe Harbour Ratio in New Zealand's Thin Capitalisation Rules", Working Paper Series number 14, 2005, at 18.

19

announced the Fact sheet72 described the following fact: "The United States also has a 60 per cent

safe harbour in its interest allocation rules." The discussion document in December 200673 states

"the United States adopts a 60 per cent debt-to-asset safe harbour ratio under its earnings stripping

rules".74 The accuracy of this comparison and hence its helpfulness is dubious. The United States

operates earnings-stripping legislation rather than thin capitalisation legislation.75 This legislation

specifies an interest-coverage ratio limiting the taxpayer’s deductible interest expense in

circumstances where their "net interest expense" exceeds 50 per cent of their "adjusted taxable

income" for the year. The focus of the legislation is on the relationship between interest expense

and earnings.76

The fact that the debt which forms part of this ratio relates to debt owed to, or guaranteed by,

certain non-US related parties makes the comparison meaningless.77 As the New Zealand thin

capitalisation rules include both related and unrelated debt, the expression "comparing apples to

oranges" comes quickly to mind. To make the comparison to the New Zealand ratio meaningful the

comparable country’s thin capitalisation regime should at least include non-associated debt and not

be based on an earnings-stripping regime. The reference to the United States regime in the New

Zealand Fact sheet78 and the implication that New Zealand should align itself to the 60 per cent ratio

in order to be consistent with a worldwide trend is misleading as, in general, other countries have

72

Fact sheet-Thin capitalisation rules (20 May 2010) of the New Zealand Inland Revenue found at http://taxpolicy.ird.govt.nz/sites/default/files/news/2010-05-20-budget2010-thin-capitalisation-fact-sheet.pdf. 73

"New Zealand’s International Tax Review: a direction for change": a government discussion document prepared by the Policy Advice Division of Inland Revenue, Wellington, December 2006 at paragraph 6.29. 74

Ibid. at paragraph 6.29, it goes on to discuss the German safe harbour debt-to-asset ratio thin capitalisation rules being reduced from 75% to 60% in 2001 although it has kept the 75 per cent ratio for holding companies and the fact that Australia uses a 75 per cent safe harbour ratio. 75

For a discussion on how earnings-stripping legislation differs from thin capitalisation legislation refer to page 27 of the article by Tim Edgar "Interest Deductibility Restrictions and Inbound Direct Investment", a Research Report prepared for the Advisory Panel on Canada's System of International Taxation (October 2008) available at http://www.apcsit-gcrcfi.ca/06/index-eng.html. 76

To the extent that the US operates thin capitalisation principles Ernst & Young suggest that the US has no fixed rules for determining whether a thin capitalisation situation exists however they state that a debt to equity ratio of 3 to 1 (75% debt to total assets) is usually acceptable to the tax authorities. See Ernst & Young 2011, The Worldwide Corporate Tax Guide, at page 1231, found at http://www.ey.com/Publication/vwLUAssets/Worldwide_corporate_tax_guide_2011/$FILE/Worldwide_corporate_tax_guide_2011.pdf. 77

Ernst & Young 2011, The Worldwide Corporate Tax Guide found at http://www.ey.com/Publication/vwLUAssets/Worldwide_corporate_tax_guide_2011/$FILE/Worldwide_corporate_tax_guide_2011.pdf. and Deloitte 2011, International Tax and Business Guide, United States. http://www.deloitte.com/assets/DcomGlobal/Local%20Assets/Documents/Tax/Taxation%20and%20Investment%20Guides/2011/dttl_tax_guide_2011_United_States.pdf. 78

Fact sheet-Thin capitalisation rules (20 May 2010) of the New Zealand Inland Revenue found at http://taxpolicy.ird.govt.nz/sites/default/files/news/2010-05-20-budget2010-thin-capitalisation-fact-sheet.pdf.

20

ratios of 75 per cent or higher79 and those countries that have a lower debt ratio only count the

related party debt in the debt part of the formula. This makes the Australian regime, which has a 75

per cent debt to total assets ratio, the nearest comparison.

The 110% worldwide debt to total assets ratio

The second safe harbour test applies if the debt percentage of the New Zealand group is less than

110 per cent of the debt percentage of the worldwide group. This worldwide debt percentage allows

some highly geared multinationals to defeat the application of the thin capitalisation regime to New

Zealand companies that have been asked to assume responsibility for their share of indebtedness.

The worldwide ratio is sometimes explained as "a proxy for an arm's-length capital structure of a

foreign-controlled resident corporation".80 The logic inherent in the worldwide ratio approach is that

the New Zealand company’s appropriate share of the arm's-length debt of its multinational parent is

its relative proportion of the arm's-length debt and equity for the whole group. The question is "how

good a proxy is this?"

Tim Edgar explains that the use of the consolidated leverage ratio of a worldwide group as the

"singular expression of the arm's-length standard is tantamount, however, to asset apportionment

and suffers from the kinds of problems noted in Part 6".81 These problems discussed in Part 6 include

the issue that such restrictions on interest deductibility relating to arm's-length debt were "difficult

to justify in terms of an expression of the arm's-length principle in executing a transfer-pricing

response".82 His view is that using thin capitalisation regimes so that they disallow deductions for

arm's-length debt in the context of inbound direct investment performs quite a different function

from the transfer pricing reaction to the use of related party debt. The reason for this is quite

fundamental. Revenue and expenses are recognised on the basis of individual transactions carried

out by separate corporate resident members with an underlying acceptance of the private law

integrity of those transactions. When you overlay the acceptance of individual companies validly

79

From the author's brief review only the United States (60 per cent), France (60 per cent) and Canada (66 per cent) are at this lower end of the ratio and in each of these countries the rules applied to interest paid to related parties and not to both related and non-related parties. On a straight ratio comparison without considering the fundamental underlying nature of the regime (thin capitalisation versus earnings-stripping) or related/unrelated party debt the following countries have an 80 per cent debt to equity ratio: Albania, Croatia, Czech Republic, Denmark, Lithuania, Serbia, Slovenia, certain companies in Jordan, Sri Lanka and Fiji. Countries that have a 75 per cent debt to equity ratio include Bulgaria, Greece, Hungary, the Netherlands, Poland, Romania, Spain, Turkey, Ecuador, Mexico, Georgia, Japan, Mongolia, Pakistan, Kenya and South Africa. Some South American countries have 66 per cent debt to equity such as: Argentina and Brazil. 80

Tim Edgar "Interest Deductibility Restrictions and Inbound Direct Investment", a Research Report prepared for the Advisory Panel on Canada's System of International Taxation (October 2008) at 35, available at http://www.apcsit-gcrcfi.ca/06/index-eng.html. 81

Ibid, at 40. 82

Ibid, at 32.

21

transacting on their own behalf with the application of the arm's-length principle (the origin of which

can be traced to the League of Nations 1935 Model Convention on Income Allocation) the idea of

imposing worldwide interest deductibility allocation rules is a totally different concept.

The use of a worldwide debt ratio respects the private law integrity of transactions only to the

extent of the leverage ratio of the worldwide group. To the extent that a New Zealand company

validly incurs interest expense on an arm's-length basis beyond this worldwide ratio the arm's-length

principle is ignored. This is the major issue with using such an asset apportionment basis as a

sourcing rule.

The second problem is revenue adverse. This is that such an asset apportionment basis allows a

multinational group to move a portion of its debt to the New Zealand operations entirely for tax

reasons (beyond the debt it would incur on an arm's-length basis). These features are clearly noted

in the Inland Revenue and Treasury Report to the Victoria University of Wellington Tax Working

Group:83

The use of a worldwide debt percentage makes some sense if the business carried on in New Zealand

is similar to that carried on by the rest of the worldwide group. It has less validity for multinationals

operating across a range of industries or if the business carried on in New Zealand is materially

different from the wider business of the worldwide group. This could result in either an over-

allocation or an under-allocation of interest deductions.

A simple example illustrates this point. A large multinational company operates as a listed property

trust in Australia. It has arm's-length debt to total asset ratio of 50 per cent. The New Zealand

subsidiary has won a major contract to provide for a new private/public infrastructure development.

If the arm's-length debt that a smaller infrastructure company is 75 per cent, the worldwide 110 per

cent debt ratio will provide no relief to an arm's-length interest expense (the maximum ratio

permitted would be 60 per cent under the first safe harbour and the worldwide debt ratio would be

110 per cent of 50 per cent, namely 55 per cent).

The 110 per cent worldwide debt ratio offends an arm's-length principle for similar reasons to those

referred to above with respect to the 60 per cent debt to total assets ratio safe harbour. The New

Zealand business may operate in an industry or business category which is fundamentally different

from that of its multinational parent and to which the different arm's-length level of gearing would

83

"Debt and equity finance and interest allocation rules", a background paper prepared by the Policy Advice Division of Inland Revenue and the New Zealand Treasury for session 4 of the Victoria University of Wellington Tax Working Group, October 2009.

22

apply. Further, it may because of its size or its stage of development have quite a different profile

with respect to an appropriate arm's-length level of indebtedness.

For the reasons given above the writer concludes that the application of the New Zealand thin

capitalisation regime may, in some circumstances, be in breach of some of New Zealand's double tax

treaty obligations under the non-discrimination article. We now turn to examine to which of these

treaties this potential breach may apply.

5.0 New Zealand's Treaty Network

Application to the various categories of New Zealand treaties

New Zealand‘s current treaty policy is not to include a non-discrimination article in its double tax

conventions.84 New Zealand lodged a Reservation to the Model convention in 1977. Despite this

New Zealand has agreed to various forms of non-discrimination articles in 20 of its 37 full double tax

agreements including some recently negotiated agreements.85 Of course, many of New Zealand's tax

treaties were concluded prior to the design, and introduction, of the country’s thin capitalisation

regime. A recent trend in New Zealand's treaty network is to carve out and protect New Zealand's

domestic anti-avoidance rules and specifically the thin capitalisation regime. That said, some recent

treaties have been negotiated without such carve-outs.86

The group referred to above can be categorised into four further groups of treaties;

The group for which the foreign control non-discrimination article is consistent with the

OECD Model Article 24 (5) and therefore is not subject to any of the limitations referred to in

the subsequent three groups.87

A group for which the foreign control non-discrimination article has a clause which compares

the enterprise which is foreign owned by a resident of the contracting state, not to an

enterprise which is owned domestically, but to residents of a third state.88

84

International Fiscal Association's Cahier De Droit Fiscal International (volume 93a, The Hague, the Netherlands 2008) at page 427 (New Zealand Reporters: Denham Martin and Carmel Peters). 85

These countries are: Australia, Austria, Belgium, Chile, China, Denmark, Finland, Hong Kong, India, Ireland, Mexico, Netherlands, Poland, the Russian Federation, South Africa, Spain, Thailand, Turkey, the United Kingdom, United States. 86

See Article 23 of the New Zealand/Turkey treaty gazetted in 2010. Double Tax Agreements (Turkey) Order 2010, SR 2010/311. 87

The countries that New Zealand has treaties of this form include: China, India and the United Kingdom. 88

The article reads; Enterprises of one of the Contracting States, the capital of which is wholly or partly owned or controlled, directly or indirectly, by one or more residents of the other Contracting State, shall not be subjected in the first-mentioned State to any taxation or other requirement connected therewith which is other or more burdensome than the taxation and connected requirements to which other similar enterprises of the first-mentioned State, the capital of which is wholly or partly owned or controlled, directly or indirectly,

23

A group for which the foreign control non-discrimination article is expressed to be subject to

a general proviso which has an anti-avoidance override. These treaties have another

paragraph which may be paraphrased as follows:89

o This article shall not apply to any provisions of the taxation laws of a Contracting

State which are reasonably designed to prevent or defeat the avoidance or evasion

of taxes (or a substantially similar general purpose or intent but are enacted after

the date of signature of the treaty).

A group where the foreign control non-discrimination article is expressly subject to various

forms of domestic anti-avoidance including the thin capitalisation rules.90

New Zealand treaties that use the OECD Model Article 24 (5)

Enterprises controlled by residents of these three countries, where the New Zealand treaty is exactly

based on the OECD Model Article 24 (5) (China, India and the United Kingdom), have the strongest

argument that the thin capitalisation rules do not apply to them other than to the extent that

interest payments are made on a non arm's-length basis.

Each of China91, India and the United Kingdom are significant current, historic, and future trading

partners of New Zealand. In the application of the non-discrimination article to a United Kingdom

controlled New Zealand enterprise, a New Zealand court will have the benefit, on a reciprocal basis,

of seeing how the United Kingdom’s judiciary interprets the article (see the House of Lords decision

in Boake Allen92 and the United Kingdom courts in FCE Bank93).

A New Zealand court will need to be persuaded that it is correct for the treaty to override New

Zealand domestic law. This ought not to be that difficult, as section BH 1 (4) provides that a double

tax agreement has effect "despite anything in this Act".94 This was interpreted by Richardson J in the

by one or more residents of a third State, are or may be subjected. The countries that New Zealand has treaties of this form include: Austria, Belgium, Chile, Mexico, Netherlands, Poland, the Russian Federation, South Africa, Spain, Thailand, Turkey. 89

The countries that New Zealand has treaties of this form include: Austria, Denmark, Finland, Ireland, the Russian Federation, South Africa, Thailand, United States. 90

An example of which is found in Article 25 (6) of the New Zealand/Australian Double Taxation Relief (Australia) Order 2010 or in Article 22 (6) the New Zealand/Hong Kong Double Tax Agreements (Hong Kong) Order 2011. 91

In 2011 China was New Zealand's second largest trading partner see statistics New Zealand: http://www.stats.govt.nz/browse_for_stats/snapshots-of-nz/nz-in-profile-2012/imports.aspx. 92

NEC Semi-Conductors Limited v Revenue and Customs Commissioners [2007] UKHL 25, 9 ITLR 995,[2007] STC 1265, sub nom Boake Allen Ltd v Revenue and Customs Commissioners [2007] 1 WLR 1386 at [16]. 93

FCE Bank plc v Revenue and Customs Commissioners 12 ITLR 962 and FCE Bank plc v Revenue and Customs Commissioners 14 ITLR 319. 94

Income Tax Act 2007 (New Zealand).

24

New Zealand Court of Appeal decision of Commissioner of Inland Revenue v E R Squibb & Sons (New

Zealand) Ltd to mean:95

In short, wherever and to the extent that there is any difference between the domestic legislation and

the double tax agreement provision, the agreement has overriding effect.

The requirements of Article 24 (5) are that the capital is "wholly or partly owned or controlled,

directly or indirectly". A point worth considering is the consequence for Chinese, Indian or United

Kingdom parent companies owning their investment in a New Zealand subsidiary indirectly through

an interposed company based in another jurisdiction. Another question is whether indirect

ownership applies when a minority interest shareholder from one of the three jurisdictions above

co-invests with other shareholders from another jurisdiction.

Let us consider the first of these issues by way of example. A United Kingdom company public

company owns all the shares of a Hong Kong subsidiary which in turn owns all the shares of a New

Zealand subsidiary. New Zealand has a tax treaty with both the United Kingdom (which has, as

discussed above,96 an unmodified Model Article 24 (5)) and Hong Kong.97 The Hong Kong treaty has a

non-discrimination article which contains a paragraph identical to paragraph (5) of the Model,

although it is subject to the following express carve out for the operation of thin capitalisation

rules:98

In this Article, provisions of the laws of a Contracting Party which are designed to prevent

avoidance or evasion of taxes include:

(a) measures designed to address thin capitalisation, dividend stripping and transfer pricing;

(b) controlled foreign company and similar rules; and

(c) measures designed to ensure that taxes can be effectively collected and recovered, including

conservancy measures

There seems to be no reason why the UK/New Zealand treaty could not be invoked notwithstanding

the direct ownership by the Hong Kong interposed regional company. The New Zealand/UK treaty

applies to indirect ownership. There is authority for this approach. The Supreme Court of Finland99

95

Commissioner of Inland Revenue v E R Squibb & Sons (New Zealand) Ltd (1992) 14 NZTC 9,146; (1992) 17

TRNZ 97; (1992) 6 PRNZ 601.

96 New Zealand/United Kingdom Double Taxation Relief (United Kingdom) Order 1984, Article 23 (3).

97 New Zealand/Hong Kong Double Tax Agreements (Hong Kong) Order 2011.

98 Ibid, at Article 22 (6).

99 SCA 2004:65 (Supreme Administrative Court).

25

held that the US/Finland treaty applied for a subsidiary held through an interposed Bermudan

company even though there was no double tax agreement between Finland and Bermuda.

The second issue is also best explained by way of example. A UK company holds 45 per cent of a

New Zealand company; another unrelated Hong Kong company holds 25 per cent and the remaining

30 per cent is owned by New Zealand residents. The class of shares that the UK shareholder owns

have voting rights sufficient to give the UK company "control of the New Zealand company by any

other means".100 The question is whether a minority shareholding would enable the UK shareholder

to invoke the non-discrimination article. The general reporters to the 2008 International Fiscal

Association conference in Brussels seemed to think so:101

The precise scope of the second "indirect" ND provision in article 24 MC is not totally clear.

First of all, it can be derived from the wording above that it is not necessary that the

domestic enterprise in the source state is controlled by one or more residents of the other

contracting state. It appears to be sufficient that part of its capital is owned by a resident of

the other contracting state so that even minority shareholders could invoke this provision.

The New Zealand thin capitalisation rules only apply when a non-resident has an ownership interest

of 50 per cent or more or control of the company by any other means. It would therefore seem to

the writer that in New Zealand the only form of minority interest that could be subject to the thin

capitalisation rules (and hence the non-discrimination article) is that minority interest that itself is

causing the non-discrimination to apply. The reason for this is because the Commentary generally

requires the discrimination to be "solely" on specific grounds set out in the treaty.102 A non-resident

shareholder owning less than 50 per cent and not controlling the company by any other means will

not be solely responsible for the New Zealand thin capitalisation rules applying.

New Zealand treaties in which the non-discrimination article compares the enterprise owned by

foreign contracting state residents to an enterprise owned by residents of a third state

100

This is the requirement under section FE 2 of the Income Tax Act 2007. 101

Cahier De Droit Fiscal International (volume 93a, The Hague, the Netherlands 2010) Subject 1 of the 62nd Congress of the International Fiscal Association discussing "Non-discrimination at the crossroads of international taxation" (Luc Hinnekens and Philippe Hinnekens) at 34. 102

See paragraph 3 of the Commentary on Article 24, OECD Model Tax Convention on Income and Capital, Paris, Eighth Edition, July 2010.

26

This second group of New Zealand's double tax treaties compares the position of an enterprise with

foreign ownership of the treaty partner to that of an enterprise owned by shareholders in a third

state. It reads:103

Enterprises of one of the Contracting States, the capital of which is wholly or partly owned or

controlled, directly or indirectly, by one or more residents of the other Contracting State, shall not be

subjected in the first-mentioned State to any taxation or other requirement connected therewith

which is other or more burdensome than the taxation and connected requirements to which other

similar enterprises of the first-mentioned State, the capital of which is wholly or partly owned or

controlled, directly or indirectly, by one or more residents of a third State, are or may be subjected.

(Emphasis added)

This requirement, that the comparison be made with a third country owner, is different from the

OECD Model paragraph 5 which does not make it clear whether the comparison is between a

domestic enterprise owned by residents of the same State as the enterprise, or whether the owners

might be residents of a third country. For the OECD Model (the first category of treaties above) it

seems clear that the comparison should be made to a domestic entity owned by domestic State

owners. In its 2008 discussion document,104 the Committee on Fiscal Affairs expressly considered

these two alternatives and concluded that the comparison should be made with resident State

owners and that there was no need to clarify this issue in the Commentary. Courts in the United

Kingdom and France have also considered this point and come to the view that the comparator

enterprise is one controlled in the State which is alleged to have applied other or more burdensome

taxation.105

With this second group of New Zealand's treaties the comparator is clearly an enterprise owned by

residents of a third state so the puzzle is which state does a treaty resident owner use for the

comparison? Can a Mexican resident owner of a New Zealand company which has an arm's-length

level of debt but is still in breach of the thin capitalisation rules compare the application to their New

Zealand subsidiary with a company which is owned by a Chinese resident owner? In other words

does the most-favoured-nation principle apply in circumstances where the comparison is made to

103

Using as an example Article 22(3) of the New Zealand/Mexico Double Tax Agreements (Mexico) Order 2007. 104

OECD "Application and Interpretation of Article 24 (Non-Discrimination)", adopted by the OECD Committee on Fiscal Affairs on 20 June 2008 at 92. 105

NEC Semi-Conductors Limited v Revenue and Customs Commissioners, High Court (Ch), 6 ITLR 416 at 433

and [29], the High Court decision which went on to the House of Lords in NEC Semi-Conductors Limited v

Revenue and Customs Commissioners [2007] UKHL 25, 9 ITLR 995,[2007] STC 1265, sub nom Boake Allen Ltd v

Revenue and Customs Commissioners [2007] 1 WLR 1386 at [16] and Re Société Andritz Sprout Bauer, 6 ITLR

604 a decision of the Conseil d'Etat.

27

residents of a third state? Or must they use a non-treaty resident comparator, or a comparator

based in a country which has the same or less favoured tax outcome?

The OECD Commentary is less helpful than one would expect. A general remark establishes the

proposition that "the provisions of the Article cannot be interpreted as to require most-favoured-

nation treatment".106 This is based on the principle of reciprocity, that a tax treatment is negotiated

and agreed between two Contracting States and should not be extended to a resident or national of

another Contracting State.

It seems that the most-favoured-nation treatment is not to be accorded to the second group of

treaties. This Commentary, however, applies to Article 24 (5) in the form it takes in the OECD Model,

which is distinctly different. One assumes that the Contracting parties in using the comparator of

"residents of a third state" have deliberately chosen not to follow the Model. The Commentary is

making it clear that when the ordinary words of Article 24 (5) are used (and no comparator is

specified) the comparator is a domestic State owner for the reasons set out above and based on the

principle of reciprocity.

Where the negotiators of the treaty deliberately choose to use the term "residents of a third state"

it is less clear whether the Contracting States are intending to apply the most-favoured-nation

treatment. There is a suggestion in the 2008 Report of the OECD Committee on Fiscal Affairs that if

they use the term "residents of a third state" they are intending a most-favoured-nation clause: 107

Two different interpretations appear possible: to compare it with a domestic enterprise owned by

residents or to compare with the domestic enterprise owned by third country residents, which would

be tantamount to making paragraph 5 a most-favoured-nation clause. (Emphasis added)

There is a need for further guidance from the OECD. It is clear from the Commentary that the

principle of reciprocity normally does not support a most-favoured-nation interpretation.108 Even if

both States negotiate for a most-favoured-nation interpretation intending that they will give the

most concessionary non-discrimination result (within the treaty network) to the other contracting

party it will not necessarily have a reciprocal result. Going back to the Mexico/New Zealand example,

106

Paragraph 2 of the Commentary on Article 24, OECD Model Tax Convention on Income and Capital, Paris, Eighth Edition, July 2010. 107

OECD "Application and Interpretation of Article 24 (Non-Discrimination)", adopted by the OECD Committee on Fiscal Affairs on 20 June 2008 at 92. 108

From paragraph 2 of the of the Commentary on Article 24, OECD Model Tax Convention on Income and Capital, Paris, Eighth Edition, July 2010 and paragraph 55 of the 1992 Model Commentary (replaced by paragraph 73 of the current Commentary) which read: "Nor could such an enterprise invoke for this purpose a most-favoured-nation clause, however general its terms, included in a treaty or agreement concluded between States A and B. In fact, it has always been accepted that such a clause did not apply in the case of double taxation conventions because these are essentially based on the principle of reciprocity."

28

New Zealand may have some treaties in which the thin capitalisation rules are overridden by the

non-discrimination article, but Mexico may have none.

On balance, because the outcome in terms of the non-discrimination result may be different for the

two Contracting States and hence offensive to the principle of reciprocity, the better view is that the

term "residents of a third state" does not have to be given most-favoured-nation status.109

New Zealand treaties in which the non-discrimination article provide that the article does not apply

to taxation laws of a Contracting State reasonably designed to prevent or defeat the avoidance or

evasion of taxes

A good example of this category of treaty is the New Zealand/United States treaty which has a

foreign controlled ownership non-discrimination paragraph in Article 23 (5) which is exactly the

same as the OECD Model paragraph 5.110 Article 23 (7) then goes on to state:

This Article shall not apply to any provision of the taxation laws of a Contracting State which is

reasonably designed to prevent or defeat the avoidance or evasion of taxes.

Has the New Zealand thin capitalisation regime been "reasonably designed to prevent or defeat the

avoidance of taxes"? The purpose of the New Zealand thin capitalisation regime is expressed to

be:111

... to protect the New Zealand tax base against excessive interest deductions. This is achieved by

requiring certain multinational groups to allocate their global interest costs in accordance with their

worldwide gearing ratio. Thus, the rules are intended to ensure that New Zealand does not bear a

disproportionate share of the global interest costs of multinational groups.

The New Zealand thin capitalisation rules primarily focus on ensuring that excessive interest

expenses are not allocated to foreign controlled New Zealand taxpaying entities or, as the Inland

Revenue’s Fact sheet describes it, "New Zealand has rules to limit the scope for excessive amounts

of debt to be loaded against the domestic tax base".112 Despite the fact that the thin capitalisation

regime is contained in Part F of the Income Tax Act113 which is the part of the legislation which deals

109

This issues needs clarification. 110

New Zealand/United States of America Double Taxation Relief (United States of America) Order 1983 which was amended by a protocol which came into force on 15 November 2010. 111

"New Zealand’s International Tax Review: a direction for change": a government discussion document prepared by the Policy Advice Division of Inland Revenue, Wellington, December 2006 at paragraph 6.2. 112

Fact sheet-Thin capitalisation rules (20 May 2010) of the New Zealand Inland Revenue found at http://taxpolicy.ird.govt.nz/sites/default/files/news/2010-05-20-budget2010-thin-capitalisation-fact-sheet.pdf. 113

Income Tax Act 2007 (New Zealand).

29

with recharacterisation of certain transactions, rather than Part G, dealing with avoidance and non-

market transactions, the New Zealand rules are designed to counter tax advantages. These tax

advantages are those a taxpayer would derive from thin or hidden capitalisation and to protect the

revenue against tax loss from these phenomena. For this reason, on first principle, the writer

believes they must be viewed as rules which are reasonably designed to prevent the avoidance of

tax.114

Treaties in which the non-discrimination article is expressly subject to the thin capitalisation rules

Clearly this is an obvious situation where the non-discrimination article does not apply. The

approach used by New Zealand in recent treaties115 is to provide that the non-discrimination does

not apply to a provision where the law of a Contracting State is designed to prevent the avoidance or

evasion of taxes. Laws of a contracting state which are designed to prevent the avoidance or evasion

of taxes are defined to include measures designed to address thin capitalisation.116

Although the non-discrimination article does not apply to the application of the New Zealand thin

capitalisation rules to an Australian parent company investing in a New Zealand subsidiary the

variation in New Zealand's treaty network may generate legal argument.117

114

This conclusion is reached based on observation on the purpose and effect of the rules. There is an absence of guidance on this particular issue in the OECD Commentary on Article 24 (OECD Model Tax Convention, Commentary on Article 24, paragraph 6, OECD, Paris, 2010), the OECD Committee Report on non-discrimination in 2008 (Report "Application and Interpretation of Article 24 (Non-Discrimination)" adopted by the OECD Committee on Fiscal Affairs on 20 June 2008 ) and the OECD Committee Report on thin capitalisation in 1986 (OECD Report on "Thin Capitalisation" adopted by the OECD Committee on Fiscal Affairs on 26 November 1986). 115

New Zealand/ Australia Double Taxation Relief (Australia) Order 2010, and New Zealand/Hong Kong Double Tax Agreements (Hong Kong) Order 2011. 116

See Article 24 (6) of the New Zealand/ Australia Double Taxation Relief (Australia) Order 2010. 117

What conclusions are to be drawn from the fact that the New Zealand/ Turkey double tax agreement (Double Tax Agreements (Turkey) Order 2010, SR 2010/311) which came into force in 2010 does not, in respect of the non-discrimination article, have any provisos or exclusions to anti-avoidance rules or thin capitalisation regimes. In contrast contemporaneous agreements that New Zealand negotiated with Australia and Hong Kong expressly carve-out the thin capitalisation rules from the non-discrimination article. An argument on the inference arising from the lack of an insurance clause was successfully run in the Tax Court of Canada in Knights of Columbus v R 10 ITLR 827 where the Canadian/US treaty negotiators were aware that US-resident insurance companies could conduct insurance businesses in Canada without constituting a permanent establishment. The question is whether the express carve-out for the thin capitalisation rules implies anything in treaties where it does not occur: expressa nocent, non expressa non nocent (things expressed may be prejudicial; things not expressed are not). On the other hand, the variation may be simply due to the different treaty negotiating stance of the other Contracting State.

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6.0 Specific versus general anti-avoidance rules

The relationship between thin capitalisation specific anti-avoidance rules and treaties is different to

the general anti-avoidance rule relationship

Is there any support for the argument that the non-discrimination article is subject to the general

anti-avoidance rule (GAAR)? Should a New Zealand court apply the specific anti-avoidance rules of

the thin capitalisation regime in the same way as it might the GAAR?

The 2010 Rome Congress of the International Fiscal Association provided a forum to analyse the

relationship between treaties and the general anti-avoidance rules (GAARs) in a number of different

tax jurisdictions. As a result of the Congress forty four country reporters considered their own

country’s response to the issue.118 The General Reporter, Stef van Weeghel,119 concluded in his

summary of these reports that the majority of these forty four country reporters determined that

their GAARs can be reconciled with their treaty obligations.120 By this he meant that, while most

countries have statutory or judge made anti-avoidance rules (although there are a considerable

number of differences in the way in which these rules are applied),121 these GAARs can, and do, apply

to cross-border transactions. Van Weeghel concluded:122

"Without exception the GAARs can have international effect and there is no distinction in

their application depending on the national or international effect."

If the position is that treaties concluded after 2003123 are subject to domestic GAARs, and this seems

to be the majority consensus of the Rome Congress,124 this is consistent with the Commentary which

incorporated the January 28, 2003 changes.125

118

This was Subject 1 of the 64th Congress of the International Fiscal Association discussing "Tax treaties and tax avoidance: application of anti-avoidance provisions". The General and Branch reports are contained in the International Fiscal Association's Cahier De Droit Fiscal International (Vol. 95a 2010 Rome (Italy) “Tax treaties and tax avoidance: application of anti-avoidance provisions”), (IFA Cahier Vol.95a) (The Hague: IFA, 2010). 119

Partner, PricewaterhouseCoopers and Professor of international tax law, University of Amsterdam. 120

IFA Cahier Vol.95a, above fn. 16, at 21. From the 44 countries’ reports 42 countries’ reporters concluded

this outcome and only two notable exceptions arose. These were the positions reported from the Netherlands

and Portugal.

121 IFA Cahier Vol.95a , above fn 16, at 22.

122 IFA Cahier Vol.95a , above fn 16, at 22,

123 In an earlier article the author argues that the 2003 Commentary clarified changes made to the

Commentary on Article 1 in 1992 and that the 2003 Commentary can be read into treaties concluded prior to 2003, possibly from 1992 or even 1996 when the earlier "Double Taxation Conventions and the Use of Base Companies" report by the Committee of Fiscal Affairs was released. This point is discussed in the article by Elliffe, C, “Applying the GAAR to pre-2003 Treaties” (2012) BTR no 3, 307.

31

The position for specific anti-avoidance rules such as thin capitalisation rules is quite different. The

OECD Thin Capitalisation Report126 has formed the basis for the recognition of how treaties and thin

capitalisation regimes interrelate and there is no general override for thin capitalisation regimes in

the same way as there is for GAARs. The Commentary127 refers to thin capitalisation regimes in a

variety of specific instances, reinforcing their validity in the context of the arm's-length principle, and

ensuring that excessive interest deductions do not transfer arm's-length profits from one jurisdiction

to another.

In the writer's view it is very clear that the OECD agrees that the thin capitalisation rules apply to

treaties but only to the extent that they respect an arm's-length principle. If the thin capitalisation

rules have the same overriding relationship with treaties as GAARs do, the OECD should amend the

Commentary to Article 1 to make this clear. Furthermore, the references to the arm's-length

principle in the rest of the Commentary should be deleted.

7.0 Conclusion

Conclusion and a suggestion for reform

This article began with the possibility of a potential conflict between thin capitalisation rules and the

OECD Model article on non-discrimination. The crux of this problem is that it is discriminatory to

impose a higher tax burden on an enterprise funded with foreign capital and yet thin capitalisation

regimes target foreign controlled companies. The OECD has agreed that thin capitalisation rules will

be effective against the non-discrimination article provided they operate on an arm's-length basis.

The logic of this is that a thin capitalisation regime can prevent transfer of profits in the guise of

interest up to an arm's-length level. Beyond the arm's-length amount the thin capitalisation rule is

providing tax protectionism which is discriminatory.

124

See the summary of the congress in the article by Elliffe, C., ‘International Tax Avoidance: The Tension between Protecting the Tax Base and Certainty of Law‘, Journal of Business Law, no 7, 647-665. 125

OECD Commentary (introduced in January 2003), fn. 2, [7.1] reads: "Taxpayers may be tempted to abuse the tax laws of a State by exploiting the differences between various countries' laws. Such attempts may be countered by provisions or jurisprudential rules of that part of the domestic law of the State concerned. Such a State is then unlikely to agree to provisions of bilateral double taxation conventions that would have the effect of allowing abusive transactions that would otherwise be prevented by the provisions and rules of this kind contained in its domestic law. Also, it will not wish to apply its bilateral conventions in a way that would have that effect." 126

OECD Report on "Thin Capitalisation" adopted by the OECD Committee on Fiscal Affairs on 26 November 1986 at 79. 127

The Commentary discusses the relationship of thin capitalisation to treaties in Articles 7, 9, 10, 11, 23, 24, and 25, but the discussion focuses on the arm's-length principle particularly in the associated enterprises article (Article 9), and in the non-discrimination article (Article 24).

32

The application of the non-discrimination article to the New Zealand thin capitalisation rules should

be of interest to other jurisdictions in the design of their thin capitalisation regimes. The New

Zealand approach to the problem of hidden or thin capitalisation has been to adopt a regime that

utilises a "fixed ratio" approach. It uses a 60 per cent total debt to total assets ratio and a second

safe harbour test of 110 per cent worldwide debt to total worldwide assets. For anti-avoidance

reasons it calculates the debt ratio using related party and non-related party debt so that effectively

the rule becomes based on asset apportionment. The writer argues that these fixed ratios may, in

some circumstances, offend the arm's-length principle because of their low rate and the application

to total debt.

New Zealand policy makers have relied upon previous studies128 on the use of fixed ratios in

justifying their approach. These studies however caution against setting the safe harbour debt

percentage at too low a level in the absence of an option for the borrowers to show that the debt

level is consistent with the arm's-length principle.

This means that, without legislative amendment, a taxpayer controlled by shareholders resident,

indirectly or directly, in China, India and the United Kingdom could use the non-discrimination article

to defeat the application of the thin capitalisation rules in circumstances in which they can

demonstrate their level of funding is arm's-length. The article evaluates the other 17 treaties with

non-discrimination provisions that New Zealand has. In the view of the writer, however, the same

deficiency, or, in some eyes, opportunity, does not exist.

The solution to the problem is a simple change to the New Zealand thin capitalisation rules adding a

third safe harbour. If the taxpayer can show, with the onus upon them to do so, that their funding is

on an arm's-length basis, they should be permitted the deduction for the arm's-length interest

expense. This legislative amendment would accord with the approach in Australia129 and would

accord with the original Report on thin capitalisation adopted by the OECD Council back in 1986.130

128

Law S, "The choice of fixed accounting ratios as safe harbours in thin capitalisation rules-some guidance from commercial debt contracts", Australian Tax Forum, 21 (2006), 363, and also the discussion contained in the Report, "International Tax-A Discussion Document", Rt Hon W Birch, Minister of Finance and Hon W Creech, Minister of Revenue, Government Print, Wellington, March 1995. 129

A new thin capitalisation regime was introduced into the Income Tax Assessment Act 1997 (Australia) by the New Business Tax System (Thin Capitalisation) Act 2001 (Australia). 130

OECD Report on "Thin Capitalisation" adopted by the OECD Committee on Fiscal Affairs on 26 November 1986 at 79.