There are two important principles in taxing non-residents on New Zealand-sourced interest income which the proposals have to deal with, while seeking to address problems of aggressive tax planning.
Firstly, interest is normally deductible to the New Zealand business paying it, and gives rise to a saving in New Zealand tax equal to the business tax rate, which for a company is 28 per cent.
When payments are made from a Kiwi-based business to an associated company (most likely a multinational parent), it is possible to transfer profits out of New Zealand for little, or in some cases no, New Zealand tax.
This is quite different from a situation where a New Zealand business borrows from another New Zealand-based taxpayer because in that situation the interest income is subject to New Zealand tax.
Secondly, New Zealand is a capital importer and relies on foreign capital. Non-residents lending to New Zealand residents usually expect a certain return and if their return is taxed they normally seek to pass the cost of that tax on to the borrower by increasing the rate of interest payable.
A common example is a so-called "gross up" clause in a banking facility where the borrower has to effectively pay the cost of any tax so that the non-resident lender receives the desired return after any applicable withholding tax.
Because borrowers actually have to fund the cost of this cross-border tax (and a higher cost of funds is normally undesirable in an economy) genuine non-associated funding is internationally very lightly taxed.
For this reason we have a special regime called the Approved Issuer Levy rules, which are designed to reduce the cost by imposing a lower rate of tax (2 per cent) on non-associated cross border interest.
Obviously trying to transfer deductible interest out of New Zealand whilst paying very little, if any, withholding tax is one of the more common multinational tax planning techniques.
It's understandable that New Zealand revenue authorities have a problem with some of the transactions currently being undertaken.
The proposals are therefore designed to:
• Stop the mismatch between deductions and the payment of non-resident withholding tax. Changes are proposed to the rules that currently allow taxpayers to claim a deduction on an accrual basis under the financial arrangement rules when the non-resident withholding tax is only payable when the interest is actually physically paid or credited.
• Prevent associated persons from using the special rules around the Approved Issuer Levy. This will be done by making sure that the rules cannot be used when a non-resident parent funds its subsidiary by lending to an independent financial institution which in turn lends to the subsidiary (called a back-to-back loan).
Similarly, sometimes groups of foreign entities operate together (acting in concert together) to provide funding to a New Zealand entity which under the current rules are regarded as non-associated.
The rules will prohibit the use of the Approved Issuer Levy where such groups are acting in concert together.
• Tighten eligibility to use these Approved Issuer Levy rules so that only loans to, or from, non-associated financial institutions, or a group of 10 or more non-associated persons, will qualify.
Consequently some of these proposals will affect the cost of funds to ordinary individual New Zealand borrowers.
New Zealand financial institutions have been able to legitimately take advantage of some quite significant loopholes in the non-resident withholding tax rules.
These loopholes provide for an exemption from non-resident withholding tax in circumstances where New Zealand-sourced interest income is paid by an offshore branch of a New Zealand resident and, also, an exemption where a non-resident is receiving interest but who operates a New Zealand branch - irrespective of whether the New Zealand interest income was connected with the New Zealand branch.
As a result, it is a common structure for financial institutions to use either of the above two exemptions to eliminate non-resident withholding tax.
The proposals will see an end to the offshore and onshore branch exemptions, making such income subject to New Zealand tax.
The problem with imposing tax on these funding structures is that the cost of borrowing is likely to increase for New Zealand resident borrowers as the financial institution seeks to pass on the withholding tax cost.
This issue is recognised in the proposals and the intention is to allow New Zealand banking groups to use the special Approved Issuer Levy provisions, so that they can pay a reduced rate of tax (the 2 per cent) and not, hopefully, increase our mortgage rates.
These are bold changes but they do much to create a fairer and more principled tax system. They will also address some particularly aggressive multinational tax planning issues.
My advice? Keep watching ... there is no doubt that this is the first of many new international tax changes that are likely to arise in the coming months.
• Craig Elliffe is professor of taxation law and policy at the University of Auckland Business School.
