Fri, Dec 13, 2013

Transfer Pricing Times: Volume X, Issue 12

Inside this Edition: New Zealand’s Inland Revenue takes Action following BEPS initiative.

Just as a small splinter in one’s finger can cause a disproportionate amount of pain, it appears that the New Zealand Inland Revenue (“IRD”) is taking significant action in response to the OECD’s work on Base Erosion and Profit Shifting (“BEPS”), as well as its recognition of the changing nature of the international taxation of multinationals.

In our experience, most multinational enterprises (“MNEs”) simply wish to comply with transfer pricing requirements in each jurisdiction in which they operate. Nevertheless, in a cost-constrained environment, a risk-based approach is also necessary, in order to allocate scant resources to the highest-risk transactions and jurisdictions. As New Zealand operations for these MNEs are often a small or de minimis part of the global business, New Zealand transfer pricing risk has historically been perceived as limited, and the resultant focus of many MNEs with regards to this area may well have been to simply minimize compliance costs. Furthermore, the IRD has historically been perceived as one of the more pragmatic revenue authorities, cognizant of the limited materiality of local operations in the context of a global group. However, in the new environment, this approach should be reconsidered. While the time and cost of defending against a New Zealand transfer pricing audit can be disproportionate to potential risk, well-prepared New Zealand-specific transfer pricing documentation may provide relief from an extended audit by the IRD.

Reconsideration of New Zealand transfer pricing analyses and documentation is especially important in light of the recent publications by the IRD, which clearly indicate a hardening approach. In particular, the IRD’s Tax Policy Report1 outlines a number of focus projects, including preventing MNEs from shifting profits out of New Zealand using related-party debt. This issue is again highlighted in the IRD’s tax policy work program 2013-14.2 Other issues highlighted in the work program include (i) the alignment of the treatment of offshore branches with the existing Controlled Foreign Corporation (“CFC”) regime; (ii) addressing current problems with the application of non-resident withholding taxes to interest on related party debts; (iii) examining foreign hybrid instruments and entities; and, (iv) examining options for collecting goods & services tax (“GST”) on online trading.

Through its Significant Enterprises Initiative, the IRD intends to review the transfer pricing of all MNEs with annual turnover greater than NZD 30 million, with a key focus on international financing arrangements. Furthermore, the IRD intends to scrutinize all “inbound” loans of more than NZD 10 million, and all “outbound” loans and financial transactions that report no or low interest, or do not charge fees for guarantees. The IRD also continues to focus on ensuring technical compliance with the active / passive division for CFCs.

The take-away from these initiatives is that the IRD, like any tax authority around the world, wants to maintain its fair share of the multinational tax pie. Whilst one may question whether the IRD currently has sufficient resources to deliver on the published targets, it is clear that MNEs should expect increased scrutiny of their New Zealand transfer pricing and prepare accordingly. More generally, the IRD’s response to the BEPs project, which is attracting considerable attention around the tax world, may function as something of a guide to other tax authorities, including those in previously “low-risk” jurisdictions.

Proposed Changes to Lease Accounting
In May 2013, the .U.S. Financial Accounting Standards Board (“FASB” or “the Board”) issued its latest proposal for new lease accounting rules. Since 2005, the Securities Exchange Commission (“SEC”) has been increasingly pushing for reform of the rules for the accounting of leases. At issue is the classification of lease obligations as “operating leases,” through which firms take on long-term commitments to pay for the use of assets (e.g., equipment or buildings), without reflecting an asset or liability on the balance sheet. The current US GAAP rules allow companies to record lease commitments as operating leases, provided certain criteria are met. However, the latest FASB proposal would require companies to record any lease beyond a period of 12-months on the balance sheet, and includes other criteria concerning how the depreciation of the leased asset, based on its characteristics, must be expensed.

These rules matter for transfer pricing purposes because they affect the financial statement ratios that are often employed to test intercompany transactions. The use of operating leases, a type of “off balance sheet financing,” affects both balance sheet ratios (such as return on assets) and income statement ratios (such as the operating margin). The balance sheet is made smaller, as the cost of the leased item is expensed rather than recorded as an asset and depreciated. Meanwhile, the income statement is affected because the implied interest component of the lease payment is recorded as an operating expense, not as interest expense, which decreases operating profit but leaves net income more or less the same. Since operating profit (rather than net income) is used in most transfer pricing ratios, off balance sheet financing can skew comparability analyses of profitability. Specifically, compared with capital leases, operating leases tend to decrease income statement ratios, by increasing operating expenses, but increase return on assets ratios, by reducing the asset base used in the denominator.3

Not surprisingly, the latest proposed lease accounting rules, like previous proposals, were met with significant resistance. This is particularly true for retailers, who often lease a significant number of properties. At a November 2013 meeting, the Board announced that it expects to continue considering responses to their draft proposal through the first half of 2014. In the meantime, transfer pricing practitioners should be aware of the effect lease accounting has on profit-based analyses. Until these draft rules become final, a number of adjustments can be made to correct inconsistencies in lease accounting that will effectively normalize results between comparable companies and tested parties. These adjustments should be considered in analyses concerning companies that have a significant amount of operating leases.

Changes to Presentation of Unrecognized Tax Benefits
In July 2013, FASB issued Accounting Standards Update (“ASU”) No. 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists.4 This new rule relates to the presentation of unrecognized tax benefits (“UTB”) calculated for uncertain tax positions under the framework of ASC 740 (previously known as FIN48). Prior to the issuance of ASU No. 2011-13, U.S. GAAP did not provide explicit guidance on the financial statement presentation of a UTB when a deferred tax asset (“DTA”) also existed that could be utilized in the settlement of the underlying uncertain tax position. As a result, many companies were presenting UTBs on a gross basis, which in most cases is now disallowed by the new rules.

ASU No. 2011-13 requires entities to present UTBs net of same-jurisdiction DTAs to the extent the DTAs (i.e., net operating loss carryforwards, similar tax losses, or tax credit carryforwards) would be used to settle additional income taxes resulting from settlement of the underlying uncertain tax position with a tax authority.5 Such netting will not be required when, under the laws of the applicable jurisdiction, the DTA cannot be utilized as of the reporting date to settle additional income taxes that would arise from a settlement, or when the entity is not required and does not intend to use the DTA for such purposes.

ASU No. 2013-11 applies to public entities for fiscal years, and interim periods within those years, beginning after December 15, 2013, and to nonpublic entities for fiscal years, and interim periods within those years, after December 15, 2014. Both early adoption and retrospective adoption of the standard are permitted. While the FASB expects the new standard to reduce diverging practices in the presentation of UTBs and more consistency with the manner in which an entity would settle its uncertain tax positions, the new requirement also adds complexity to financial reporting for income taxes. This added complexity may require greater coordination between transfer pricing practitioners and tax personnel within companies in determining the final presentation of UTBs arising from uncertain tax positions related to transfer pricing in order to ensure compliance with ASU No. 2013-11.


1.Inland Revenue Tax policy report: Taxation of Multinationals, Report no: T2013/2059 PAS2013/152, 15 August 2013
2.Government tax policy work programme 2013-14, announced 8 November 2013
3.For balance sheet ratios, use of operating lease accounting methods decreases both the numerator (operating profit) and the denominator (e.g., operating assets), but the denominator is typically decreased more, increasing the ratio.
4.Accounting Standards Update No. 2013-11 can be referenced on the FASB’s website:
5.The UTB is the portion of the unrecognized tax benefit (which arises from the uncertain tax position) that is not recognized for financial statement purposes.

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