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New Zealand: What Transfer Pricing in the Recession Means for New Zealand Business
The following discussion examines what transfer pricing in the recession means for New Zealand businesses with an international footprint as well foreign multinationals operating in the New Zealand market or looking to set up new business in New Zealand.
The discussion also looks at some of the transfer pricing issues that businesses will face on the road to recovery.
The current environment creates two significant transfer pricing challenges for taxpayers:
- If a business is to be restructured, what is the optimum pricing structure for the future
- Demonstrating that the results of the local operation are appropriate under the existing transfer pricing regime
Business restructuring is a difficult area, with the potential for significant transaction costs (e.g., exit charges and compensating payments). Supporting poor financial results, as arm’s length, may also require significant care. Inland Revenue may question whether losses are consistent with the local operations’ transfer pricing risk profile and contractual arrangements. The future transfer pricing profile will also need to be considered, particularly if functions, assets, and risk change as a result of a restructure.
Some key transfer pricing issues to consider are as follows.
Business Restructuring
Some multinationals may be driven to rationalise their supply chain in response to the economic downturn (e.g., closing down a plant, moving functions to lower cost jurisdictions, or centralisation of certain functions). Others may find this an ideal opportunity to streamline processes and functions.
In either case, such transfers of functions, assets, and risks may entail exit charges in some jurisdictions, including New Zealand. Particular care is required to consider, and document:
- The commercial rationale for the change in business—this needs to be from the point of view of the local operations (i.e., as if it was a stand-alone operation) and not just the group’s perspective. Stemming ongoing local losses are a very strong commercial rationale. So is a more efficient supply chain option.
- The economic substance of the transfer—for example, does the acquiring company have the staff and infrastructure to support the business it is taking on, and the ability to manage and control the risks it is adopting?
- Contractual arrangements—are any ongoing contractual rights to the business being sold or transferred, and what are the termination provisions of any existing contracts?
- Intangibles transfers with the business (e.g., marketing intangibles, customer lists, brands or know how)—if there are such transfers, are these at market value?
- The structure of the continuing business, and the transfer pricing policies that will apply to future transactions—is the restructuring recession driven or part of a wider realignment of the business model?
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Loss Making Entities
It is not uncommon for enterprises to incur losses during a recession. These losses may arise from a multitude of factors, such as depressed margins, increased bad debt costs or restructuring costs.
At the same time, losses could be made independently of the economic cycle—for example, new businesses may still incur start-up losses due to significant setup costs, or losses may be made due to inefficient business practices.
The different loss drivers need to be considered and documented. The key is to be prepared; document the reasons for losses contemporaneously, while staff members still remember the background for the financial results. Observers anticipate, and indeed are already seeing, an increase in Inland Revenue audit activity in relation to losses in all jurisdictions.
Market Support Payments
When a business is set up in a new market, the parent may consider supporting the business activities of the new enterprise by way of market support payments for a period of time. Ultimately, this will be a business decision of the parent company—and Inland Revenue would expect to see a business plan that demonstrates that the parent company ultimately expects to generate greater returns through its new subsidiary, thereby warranting the temporary support.
A market support approach would normally only be adopted for two to three years (varying by industry). However consideration may need to be given to extending this in the current market—in a recession, it may take longer than usual to establish a foothold in a new market.
Market support payments are a complex area of the transfer pricing rules even in the best of times. Businesses making such payments during a recession need to be mindful so that the funding is not used to prop up poor trading results as a result of the recession, and are genuinely to assist market penetration.
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Funding
The tightening of credit has seen volatility in spreads and a lack of financial market data in the last 12 months. In recognition of this, the Inland Revenue has indicated that it will accept a margin of 300 basis points over the risk-free rate, i.e., the NZ Bank Bill rate, as broadly representative of an arm’s length interest rate for small value loans (i.e., loans of less than NZ$1 million). The margin previously accepted was 150 basis points.
For higher value loans (up to NZ$10 million), interest rates based on independent bank quotes may be acceptable.
However, a stronger alternative, and particularly necessary for high value loans, is an interest rate benchmarking study tailored to the specific funding situation to support the rate applied, prior to the funding being drawn-down.
This will provide greater certainty (and at a minimum must demonstrate reasonable care to Inland Revenue), than an ex post justification.
It is also worth bearing in mind that interest rates are not “set and forget.” As capital markets realign, funding costs will change. This in turn will affect the appropriate arm’s length interest rate on related-party funding.
Comparable Data
Publicly available financial information for independent companies is typically used to develop an arm’s length range for comparison purposes. The difficulty in the current recession is that the most recently available “historical” financial data will typically encompass a different economic cycle (i.e., the 2003 to 2007 period of economic growth), creating challenges in identifying an appropriate set of comparable companies and/or comparison period. Different approaches may be warranted here.
For example, it may be possible to identify the factors which have contributed to poor profitability, in which case a counter-factual (or “but for the recession”) analysis may be useful in demonstrating that the arm’s length return would have been achieved but for prevailing economic conditions. Also, the full range of comparable results—not just the interquartile range—is accepted by the Inland Revenue. This may provide greater flexibility in determining the appropriate arm’s length range. Notwithstanding the approach, it always important to consider the core functions, assets, and risks of the potential comparable companies as part of any benchmarking exercise.
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For more information, contact a tax professional with KPMG’s Global Transfer Pricing Services group in New Zealand:
Kim Jarrett, +64 9 363 3532, kmjarrett@kpmg.co.nz
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