Thin Capitalisation Rules and Treaties: Does the Ratio in the New Zealand Thin Capitalisation Rules Contravene New Zealand’s Tax Treaty Obligations?

Abstract

This article examines the potential conflict between thin capitalization rules and the OECD Model article on non-discrimination using the New Zealand regime exempli gratia. It is discriminatory to impose a higher tax burden on an enterprise funded with foreign capital. Yet that is the basis for the New Zealand - and many other countries' - thin capitalization regimes. The OECD rationalize this conflict by agreeing that thin capitalization rules are effective against non-discrimination provisions in a treaty when they operate on an arm's-length basis.A thin capitalization regime can therefore successfully prevent the transfer of profits in the guise of interest up to an arm's-length level. Beyond this arm's-length amount the thin capitalization rule is providing tax protectionism which is discriminatory. The application of the non-discrimination principles to the New Zealand thin capitalization rules will be of interest to other jurisdictions in the design of their thin capitalization regimes because they may be contemplating a similar approach. New Zealand makes use of two safe harbor fixed ratio formula in its thin capitalization rules: a 60 percent total debt to total assets calculation, and a ratio of 110 percent of worldwide debt to worldwide assets. Debt includes both related party and non-related party borrowing. After revisiting the basis upon which these tests were formulated, and categorizing the various types of non-discrimination approach, this article concludes that: these fixed ratios offend the arm's-length principle in some circumstances, because of their low rates and application to total debt; and New Zealand entities which are controlled by shareholders resident in certain jurisdictions will be protected under the applicable double tax treaty from the application of the New Zealand thin capitalization rules.The conclusion that the New Zealand thin capitalization rules do not work for entities with arm's length debt applies to three important trading nations (China, India and the United Kingdom) and leads inevitably to the suggestion that New Zealand should, for example, follow the Australian approach of allowing a taxpayer to show it is compliant with thin capitalization rules when its funding is on an arm's-length basis.