TalkTax

The Approved Issuer Levy (AIL) rules were introduced in the early 1990s.  The rules were designed to reduce the cost suffered by borrowers as a consequence of New Zealand’s non-resident withholding tax (NRWT) regime.

Absent the AIL regime, a New Zealand borrower is generally required to withhold NRWT from New Zealand sourced interest payments made to a non-resident lender unless that lender has a fixed establishment in New Zealand. NRWT must be deducted by the borrower from the interest payment and generally represents the lender’s final New Zealand tax liability in respect of that interest.

The default withholding rate for NRWT on interest is 15 per cent, with a reduced 10 per cent rate under most of New Zealand’s double tax agreements (DTAs).  However, because most independent lending institutions are lending money they have borrowed from someone else, a 15 per cent (or even 10 per cent) withholding tax can, in many cases, represent more than the lender’s entire profit from entering into the loan. Accordingly, it is standard commercial practice for lending institutions to require the borrower to gross up the interest payment for any withholding taxes so that the lender receives the same amount of money they would have been paid had the withholding tax not been imposed.  At the same time New Zealand’s rules for identifying and taxing New Zealand-sourced interest income meant that lenders operating their own cross-border financing arrangements were not subject to the same constraints.

If a non-resident lender has a New Zealand fixed establishment (ie a branch), the NRWT rules will not apply even where lending does not emanate from that branch. Instead the lender is effectively required to treat the interest income as part of the New Zealand branch: the interest income (net of available deductions including financing costs) will be taxed as if it forms part of the net income of the branch capped at the maximum rate under any applicable DTA.

Because NRWT is not imposed in relation to interest payments a resident borrower makes to a non-resident branch lender it has historically served no purpose for AIL to be paid in this situation.   However, this is no longer the case in all situations – access to some treaty relief under certain New Zealand DTAs will now depend on AIL having been paid.

Some of New Zealand’s recently revised DTAs (notably the treaties with Australia and the US) contain articles that (where applicable) prevent New Zealand tax from being charged in respect of non-New Zealand lending (which consequently means that such amounts would no longer be included in the fixed establishment’s income tax return).  For such treatment to apply the non-resident must be a financial institution and AIL must be paid.

Somewhat paradoxically these new treaty provisions appear to have resulted in a step backwards both for the New Zealand borrower and the New Zealand Treasury.  The New Zealand borrower is paying AIL, not to reduce the rate of NRWT payable on the loan (because a borrower with a New Zealand branch is not subject to NRWT), but to ensure that the lender is not subject to net income taxation on the interest.

Policy makers are presumably confident that AIL payable by the borrower will compensate for the tax lost through the DTA exemption conferred upon the borrower.  But something interesting has happened in this exchange.  The New Zealand tax imposed on this arrangement (AIL) has now been explicitly added to the borrower’s cost of capital while part of the tax base has been shifted offshore into the lender’s jurisdiction.  This is an perfectly sensible thing to do if you are an Australian owned bank with a NZ branch which (in the absence of trans-Tasman recognition of imputation credits) has considerably more incentives to pay tax in Australia than they do in New Zealand – but it might appear to be a something of an own goal for a country where our access to capital is so dependent on foreign owned banks.

New Zealand’s treaty policy on interest withholding cannot be viewed in isolation from the broader global economic context. In a world with unconstrained capital flows, countries such as New Zealand with limited amounts of domestic saving are simply finding it impossible to make non-residents bear the cost of taxation on the fixed return they demand for lending money to New Zealand businesses.  The need to exempt non-residents does not explain, however, why it was necessary to add an additional 200 bps to the New Zealand borrower’s interest costs by imposing AIL on the NZ resident borrower.