Chapter 3 – Branch-Equivalent Regime Part 2: Determination of Control and Income Interests
3.1.1 The BE regime will apply when five or fewer residents control 50 percent or more of the rights or powers of ownership which when aggregated sufficiently enable those residents to control a company. A person's proportionate share of the total of such rights or powers will be referred to as his or her "control interest" for the purposes of the control test and his or her "income interest" for the purposes of income attribution. Depending on whether interests are held directly or indirectly through companies or associated persons, a person's control interest may be different from his or her income interest.
3.1.2 The objective of this chapter is to set out the Committee's recommendations on the determination of control and income interests. These matters are dealt with in sections 245B to 245G of the accompanying draft legislation.
3.2.1 The attributes of a company which are critical for the purposes of calculating control and income interests are the rights or powers which give the holders the ability to receive or control the disposition of the company's income or capital. In general, these rights or powers attach to shares and are held by the shareholders of the company. Different classes of shares may, however, have a wide variety of rights attached to them so that it is not sufficient to focus on the percentage of the shares held by a person. Thus, control and income interests in a foreign company need to be defined in terms of:
a paid-up capital;
b nominal capital;
c rights to vote or participate in any decision-making concerning distributions, the constitution of the company or variations in its capital (e.g. the issuing, redemption, acquisition or cancellation of any shares);
d income of the company which the person would be beneficially entitled to receive or to have dealt with in his or her interest or behalf if it were distributed; and
e net assets of the company (or the proceeds from the realisation thereof) which the person would be beneficially entitled to receive or to have dealt with in his or her interest or behalf if they were distributed.
3.2.2 The ownership of or an entitlement to acquire any one of these things in relation to a foreign company will be referred to as an "interest" in the company. Thus, the list above specifies five categories of interest. A foreign company should be deemed to be a controlled foreign company (CFC) when five or fewer residents, directly or indirectly, own or are entitled to acquire 50 percent or more of any category of interest. The meaning of "directly or indirectly" is outlined in the next section. For example, if five or fewer residents own 50 percent of the voting rights in relation to the distributions of a foreign company, it should be a CFC.
3.2.3 The income attributed to any resident having an interest in a CFC will, however, depend on that person's income interest in the CFC. The definition of an income interest is explained further in section 3.5.
3.2.4 In determining how voting rights are held, those of directors to decide distributions, such as interim dividends, should be excluded. These are exercised by directors acting in their capacity as directors under an authority delegated by shareholders in terms of the articles of the company.
3.2.5 The calculation of an interest under category d would require taxpayers to decide how the income of a company would be allocated if it were distributed as a dividend on a particular day. Certain shares, such as preference shares, may be entitled only to a fixed rate of dividend payable on specified days during the year. To accommodate these types of share, category d interests need to be measured on the basis that all of the foreign company's income for the accounting year is distributed as a dividend on the last day of the accounting year and all interests held on a measurement day are treated as if they were held on the last day of the accounting year.
3.2.6 In some circumstances, the percentage of the income or the net assets of a company that a person could acquire may differ from the percentage of its paid up capital, nominal capital or votes that he or she may hold. For example, minority shareholders of private companies may have no rights, or the powers given to a majority shareholder, directors or managers may be such that the shareholders who control the company could cause to be distributed to them or for their benefit a disproportionate share of the income or assets of a company. In cases such as this, the income interest of a person or group holding a control interest of more than 50 percent should be taken as 100 percent.
3.2.7 Accordingly, the Committee recommends that residents' control and income interests in foreign companies be defined in terms of:
i paid-up capital;
ii nominal capital;
iii rights to vote or participate in any decision-making concerning distributions, the constitution of the company or variations in its capital (e.g. by the issuing, redemption, acquisition or cancellation of any shares);
iv income of the company which the person would be beneficially entitled to receive or to have dealt with in his or her interest or behalf if it were distributed; and
v net assets of the company (or the proceeds from the realisation thereof) which the person would be beneficially entitled to receive or to have dealt with in his or her interest or behalf if they were distributed.
3.3.1 The objective of the BE regime is to tax residents on the income of certain CFCs that remains undistributed from one year to the next. Thus, the regime needs to determine which residents hold interests in a CFC from one year to the next. This requires the determination of the interests held by residents at least once a year. There are, however, several problems with a single annual measurement of interests. First, there would obviously be an incentive for residents to avoid holding interests on that particular day. To counter this incentive, rules would be required to catch "bed and breakfast" transactions whereby interests were disposed of prior to the measurement day and reacquired after that day. Where a right of repurchase existed, the disposal would not be effective since the measurement of a control interest will require taxpayers to take into account interests that they are entitled to acquire. In addition, a provision would be needed to counteract temporary changes in the aggregate interests of a CFC in any category of interest (e.g. by the issue and cancellation of shares around the measurement day). Both of these types of rule would be needed if measurement of interests takes place on only a number of specified days during the year. A single measurement day would, however, put more pressure on the rules than more frequent measurement.
3.3.2 Secondly, a single measurement day would enable taxpayers in some cases to avoid the regime by holding companies for the interval between measurement days - that is, up to 364 days but not the measurement day. Income could thus be accumulated in a CFC which might then be sold to a non-resident prior to the measurement day for a gain that reflected the accumulated income. The longer the period between measurement days, the greater the scope for such activity. Thirdly, a single measurement day may be unfair on taxpayers who hold interests for short periods that included the measurement day, since their proportionate share of the income of the CFC for the whole of the year would be attributed to them. In principle, the anticipated tax liability could be taken into account in the purchase price of the interest.
3.3.3 At the other extreme, measurement of interests could be required on each day of the foreign company's accounting year. This was the approach we favoured in our earlier report and is the method adopted in the United States and Canadian CFC regimes for the purposes of determining control. The major disadvantage of this option is the compliance cost involved. In practice, residents would not need to compute interests daily, but they would need to do so for each day on which there was a change in their own interests, those of associated persons or in indirect interests held through CFCs and for each day on which there was a change in the aggregate of any category of interest in the relevant foreign company. The compliance costs could thus be onerous where taxpayers had complex holdings of interests and where the aggregate interests in the foreign company changed relatively frequently, such as may be the case for listed companies (which, for example, may regularly issue shares to finance acquisitions). While the compliance burden of this approach to measuring control interests may be acceptable under the United States and Canadian regimes, which are directed mainly at "passive" investment income, they could be excessive under the New Zealand regime which is targeted more widely.
3.3.4 The choice of the interval between the measurement of interests needs to weigh up the compliance costs of more frequent measurement on the one hand and, on the other hand, the possible reduction in the effectiveness and fairness of the regime if measurement is relatively infrequent. The Committee favours a compromise of requiring measurement four times a year at the end of each calendar quarter. A resident having a control or an income interest on a measurement day would then be deemed to have held the interest on every day of the previous quarter. If no interest were held on a measurement day, the resident would be deemed not to have held a control or income interest at any time during that previous quarter.
3.3.5 As noted above, a trade off for less than daily measurement is the necessity to have provisions to counteract bed and breakfast transactions and temporary changes in the aggregate interests in a foreign company. In essence, the bed and breakfast provision would deem a person who had disposed of an interest in a CFC before a measurement day which had the effect of reducing his or her attributed income not to have disposed of it to the extent that an interest in the CFC was acquired within a certain period, which we propose be 183 days, after the date of the disposal. A parallel rule would apply where a person temporarily increased an interest before a measurement day which had the effect of increasing an attributed loss.
3.3.6 A person's attributed income will depend, first, on whether a foreign company in which he or she holds an interest is a CFC and, secondly, on his or her income interests in the foreign company if it is a CFC. As discussed further below, whether a foreign company is a CFC will depend on the interests held by residents, their associated persons and CFCs in which they have a direct or indirect interest. Thus, a disposal and acquisition around a measurement day by any of these parties will affect the control interest of the person. This means that it is necessary to draw the bed and breakfast provision widely, so that it applies not just where one person reduces and subsequently increases an interest in a foreign company, but also where such a reduction occurs and any other party connected with the person whose interests affect that person's control interest subsequently acquires an interest. The provision should not, however, apply where a disposal or acquisition is made by one person and an opposite transaction is made by another person whose control interests do not affect the other's control interests.
3.3.7 The rule to reverse the effect of temporary changes in the aggregate interests in a CFC would deem the change not to have occurred to the extent to which it is reversed within a certain period, which we propose be 365 days. Where the provision applies, it would require residents to determine their interests on each measurement day in the period on the basis of the deemed aggregate interests.
3.3.8 The effect of these rules is to ignore for interest measurement purposes changes in interests in foreign companies which have the effect of defeating the intent and application of the BE regime. A remaining problem is the acquisition and disposal of interests within a period between successive measurement days. This would have the effect of converting what would be income under the BE regime to a gain. The principal provision dealing with the taxation of such gains is section 65(2)(e). This taxes gains on the disposal of personal property (which includes shares):
"if the business of the taxpayer comprises dealing in such property, or if the property was acquired for the purposes of selling or otherwise disposing of it, and all profits or gains derived from the carrying on or carrying out of any undertaking or scheme entered into or devised for the purpose of making a profit".
3.3.9 In practice, this section has proved difficult to administer because, for example, of the need for the Department to establish the taxpayer's purpose of acquiring property at the time of its acquisition. In addition, the section cannot be successfully administered without sufficient disclosure by taxpayers. With adequate disclosure, however, we consider that this provision will be more effective in taxing gains on the disposal of interests in foreign companies in the circumstances outlined in the previous paragraph since, in many instances, the substantive purpose of the acquisition of such interests will be to dispose of them at a gain.
3.3.10 To reinforce the need for disclosure, we propose that residents who have a control interest in a foreign company at any time during its accounting year equal to or higher than 10 percent should be required to disclose the interests they hold in the company on its balance date and any disposals of interests in the company made during its accounting year. Similarly, where a resident has a control interest of 10 percent or more in a CFC at any time during its accounting year and that CFC has a control interest of 10 percent or more in another foreign company, the resident should be required to disclose the interests in that foreign company held by the CFC on its balance date and any disposals of such interests the CFC has made during its accounting year.
3.3.11 The circumvention of the BE regime by the disposal of shares for a capital gain can be addressed comprehensively only by the general inclusion of capital gains within the income tax system. The income tax system will always be vulnerable if taxable income can be converted, in one way or another, into an exempt capital gain. Accordingly, we commented on the need for the inclusion of capital gains within the income tax base in our two previous reports.
3.3.12 The Committee therefore recommends that:
a for the purposes of determining control and income interests in a foreign company, residents be required to measure their interests in the company in each category of interest listed in paragraph 3.2.7 on the last day of each calendar quarter;
b an interest held on a measurement day be deemed to have been held on every day of the previous quarter;
c provisions be included to reverse the effect of short term transactions and changes in the aggregate interests in foreign companies which have the effect of reducing the income attributed to residents or increasing an attributed loss; and
d residents who have a control interest in a foreign company at any time during its accounting year equal to or higher than 10 percent be required to disclose the interests they hold in the company on its balance date and any disposals of such interests made during its accounting year and where a resident has a control interest of 10 percent or more in a CFC at any time during its accounting year, the taxpayer be required to disclose the equivalent information in respect of the CFC.
3.4.1 We referred in chapter 2 to the need to aggregate interests held by residents through nominees, associated persons and other controlled companies in order to counteract the incentive for the dispersion of interests aimed at avoiding the control test. Interests held by a person directly will be referred to as "direct control interests". Those held indirectly through CFCs will be referred to as "indirect control interests".
A person's total or aggregate control interest in each category of interest listed in paragraph 3.2.1 should be calculated by aggregating the person's direct and indirect control interests in that category and those of associated persons. Any person's interest in any category should include interests held by nominees.
3.4.2 The calculation of indirect interests requires the attribution to New Zealand residents of the direct control interests of CFCs and their associated persons (hereafter together referred to as "qualified control interests"). We propose that, where one CFC is controlled by a second CFC, the qualified control interests of the first CFC be attributed to the second CFC. The resulting qualified control interests deemed to be held by the second CFC should then be deemed to be held by the persons who control that CFC. This tier by tier or step by step attribution process means that the interests being attributed at each stage are direct control interests only.
3.4.3 As a general principle, we propose that such interests be attributed to the smallest group of residents who have a control interest of 50 percent or greater and, where there is more than one such group, to the group with the highest aggregate control interest. In particular, we propose that:
a qualified control interests held by a CFC in another foreign company be attributed to the group of residents who control the CFC (i.e. who together have control interests totalling 50 percent or more);
b if there is more than one such group, the qualified control interests held by the CFC be attributed to the smallest group;
c if there is more than one such smallest group, the qualified control interests held by the CFC be attributed to the group with the highest aggregate control interest in the CFC;
d if there is more than one group which satisfies rule c, the qualified control interests held by the CFC be divided equally among them; and
e if there is more than one person in any group selected by rules a to d, the qualified control interests held by the CFC be apportioned among them according to their income interests in the CFC.
3.4.4 In summary, a resident's control interest in any category of interest would be the sum of the direct and indirect interests of the person and associated persons. A foreign company would be deemed to be a CFC if there is any category of interest in which the aggregate control interests of five or fewer residents equals or exceeds 50 percent.
3.4.5 The control interests of two persons who are associated would each be included in the control interest of the other so that, when interests are aggregated for the purposes of determining whether a foreign company is a CFC, multiple counting of control interests may arise. It is therefore necessary to have a general proviso to the effect that any person's (including a CFC's) direct control interests shall be counted only once for the purpose of determining whether a foreign company is a CFC.
3.4.6 Another source of potential double counting is the inclusion, for the purposes of determining control interests, of interests which a person holds and those which another person is entitled to acquire. Where one person holds an interest in a foreign company and another person is entitled to acquire that interest and both are in the same group of 5 or fewer persons for the purposes of determining whether the foreign company is a CFC, the interest would be double counted. We have therefore included in the draft legislation a provision which would avoid this type of double counting.
3.4.7 It is necessary to base the control test on the aggregate interests of a small number of persons, though the particular number is arbitrary, because the larger the group, the smaller each person's respective interest will be and the less likely it is that they will have sufficient incentive or opportunity to concert their actions in order to control a company. Where, however, the directors of a company control it, the size of the group is irrelevant. We therefore propose that a foreign company in which the New Zealand resident directors (or their nominees) have an aggregate control interest of 50 percent or more be included in the definition of a CFC, irrespective of the number of such directors.
3.4.8 It is important to note that the calculation of a person's control interest in a foreign company requires the person to include interests which he or she is contingently or absolutely entitled to acquire in the future. Thus, interests which a person could acquire under an option to buy shares or an option to acquire such an option must be taken into account. Similarly, interests which a person would acquire if another person exercised an option to sell such interests to them need to be taken into account where the terms of the agreement are such that the exercise of the option is a matter of course. Hence, so-called "shot-gun provisions" in a buy-sell agreement requiring a purchaser to buy shares in certain circumstances must be taken into account. In addition, a right or entitlement to acquire shares or voting rights given to a creditor in terms of a debt instrument needs to be taken into account.
3.4.9 Instances have arisen in other jurisdictions where a parent company has tried to avoid having direct control of a foreign subsidiary by issuing shares in the subsidiary to the parent's own shareholders. In order that the subsidiary's shares are not traded separately from those of the parent, they are "stapled" to the former. To accommodate this possibility, we propose that, where shares in a foreign company (the "stapled" company) can ordinarily be transferred only in conjunction with the shares of a New Zealand resident company or a controlled foreign company, shares in the stapled company should be deemed to be held by the New Zealand resident company or the controlled foreign company. This is simpler than the alternative provision, discussed in our previous report, of treating the stapled company as an associated person of the parent company.
3.4.10 Accordingly the Committee recommends that:
a the control interest of a resident in a foreign company in any category of interest be defined as the aggregate of the person's direct and indirect control interests in that category and those of associated persons;
b as a general principle, interests in a foreign company held by a CFC or associated persons of the CFC be attributed to the group of residents with the highest aggregate control interest in the CFC and, where there is more than one such group, to the smallest one and, where there is more than one person in any such group, the interests of the CFC be apportioned among them according to their income interests in the CFC;
c any interests held by a nominee of a person be deemed to be held by that person;
d a foreign company be defined as a CFC in respect of any accounting year of the company if, on any of the measurement days that fall within that accounting year, there are five or fewer residents whose aggregate control interest in the company in any category of interest is 50 percent or more;
e where residents are directors of a foreign company and in aggregate have a control interest in the company in any category of interest of 50 percent or more, the company be deemed to be a CFC irrespective of the number of such directors; and
f where shares in a foreign company (the "stapled" company) can be transferred only in conjunction with the shares of a New Zealand resident company or a controlled foreign company, shares in the stapled company be deemed to be held by the New Zealand resident company or the controlled foreign company.
3.5.1 As noted above, the interests in a foreign company to be taken into account in determining the income to be attributed to a person under the BE regime can be referred to as his or her "income interest" in the foreign company. We propose three differences between the determination of control and income interests.
3.5.2 First, while it is necessary for the purposes of the control test to take into account interests held by associated persons, this should not be the case for income attribution purposes. The income interest of a resident should depend only on his or her direct and indirect interests, including those of nominees, and not those of associated persons. Where both parties are residents, income attributable to any interests they hold will be taxable in their hands. Thus, there is an important distinction between nominees and associated persons.
3.5.3 Secondly, we propose that the circumstances in which an entitlement to acquire an interest in a foreign company gives rise to an income interest be more circumscribed than we propose for control purposes. A person who is entitled to acquire an interest in a foreign company will have a control interest in that company, but it will not always be appropriate to attribute income to that person. For example, the interest to be acquired may be held by another resident and income would be attributed to that resident. In addition, entitlements may not be exercised. This will generally be the case if the consideration payable to exercise the entitlement exceeds the market value of the interest to be acquired. Conversely, where a resident is entitled to acquire an interest in a foreign company at less than its market value, it is reasonable to assume that the entitlement will be exercised. The resident should then have an income interest in that company. Similarly, an income interest should arise if a resident is entitled to acquire an interest held by another person who has received financial assistance from the resident to acquire that interest.
3.5.4 In view of these considerations, we propose that an entitlement to acquire an interest in a foreign company give rise to an income interest whenever the consideration payable to exercise the entitlement is less than the market value of the interest to be acquired or when a person who is entitled to acquire an interest has given any form of financial assistance, such as a loan, cancellation or reduction of a debt, guarantee or other form of indemnity, to the person who holds the interest for the purposes of acquiring or holding that interest.
3.5.5 In addition, it is necessary to support these provisions by a general anti-avoidance measure the effect of which would be to deem a person to hold an interest which he or she is entitled to acquire if the holding of that entitlement has the effect of defeating the intent and application of these provisions. Such a provision clearly needs to be supported by full disclosure. Entitlements to acquire interests in foreign companies are to be taken into account for control purposes and therefore must be disclosed. Where a person's income interest in a foreign company is significantly less than his or her control interest, the Commissioner should require a reconciliation of the two.
3.5.6 Thirdly, indirect income interests (i.e. those held through CFCs) need to be calculated differently from indirect control interests. As explained in the previous section, for control purposes it is necessary to deem all of the interests held by a CFC in a foreign company to be interests of the controlling shareholders of the CFC. The income of the underlying company would, however, normally be distributed to its shareholders in proportion to their interests in it. Thus, a 51 percent shareholder, even though controlling a company, would normally expect to receive only 51 percent of the income of the company, not 100 percent (although, as noted in section 3.2.6, in some circumstances, shareholders should have 100 percent of the income attributed to them). It is therefore necessary to compute a person's income interest in a CFC held through another CFC by multiplying the person's direct income interest (and that of any nominees) in the first CFC by that CFC's direct income interest in the second CFC, and so on.
3.5.7 The direct and indirect interests of a person in a CFC will be measured on each of the measurement days falling within the accounting year of the CFC. It will be necessary for the person to determine, for each of those measurement days, his or her direct and indirect income interests in each category of interest. The person's income interest for any quarter should then be taken as the highest of the five categories of income interest of the person on the last day of the quarter. In other words, the person would be deemed to have held that highest interest on each day of the preceding quarter.
3.5.8 The calculation of income interests will in most cases be a good deal simpler than the previous paragraph might suggest. In most companies, the rights of members by virtue of share ownership to vote, to share in dividends, to participate in winding up and so on do not vary from share to share, except where there are shares carrying a fixed dividend entitlement only. Thus, generally speaking, a shareholder will not need to examine his or her shares category by category to determine what percentage of rights he or she has in each case. In closely held companies, on the other hand, where a variety of share categories is more common, there is relatively little change in shareholding from year to year. Moreover, where a company is closely held, a New Zealand shareholder should not find the task of checking his or her income interest excessively onerous.
3.5.9 In order to determine a person's income interest with respect to a CFC and an accounting year, his or her income interests in each quarter, calculated as outlined in the previous paragraphs, should be averaged over the year. The resulting income interest represents an average interest of the person in the CFC for that year. This interest would be the basis of calculating the income to be attributed to the person in respect of that CFC and that accounting year. An equivalent rule is needed for short or long accounting periods arising from changes in balance dates or residence.
3.5.10 On page 85 of out first report, we indicated that we were considering an anti-avoidance rule aimed at situations where five or fewer taxpayers structured their affairs to achieve an income interest in a foreign company of more than 50 percent but a control interest of less than a 50 percent. On further examination, we consider that such an arrangement is possible only where the taxpayers hold interests in the company through a non-controlled company. This would mean that the group may not exercise control over the disposition of the underlying company's income and assets. We therefore consider that special provision for this situation is not needed. The definition of associated persons and of a nominee should be sufficient to deal with circumstances where there is any understanding or arrangement between the group and the non-controlled foreign company to act in concert.
3.5.11 Accordingly, the Committee recommends that:
a the income interest of a resident in a CFC for any calendar quarter be the highest of the sum of the resident's direct and indirect income interests in the CFC on the last day of that quarter in the five categories of interest defined in paragraph 3.2.7;
b an entitlement to acquire an interest in a foreign company give rise to an income interest where:
i the consideration payable to exercise the entitlement is less than the market value of the interest to be acquired; or
ii the person holding the entitlement has given any form of financial assistance to the person holding the interest for the purpose of acquiring or holding that interest; or
iii the holding of the entitlement has the effect of defeating the intent and application of the BE regime;
c the income interest of a resident in a foreign company held through a CFC be calculated by multiplying the resident's direct income interest in the CFC by the CFC's direct income interest in the other company, and so on where the interest is held through more than one CFC; and
d the income interest of a person in a CFC for any accounting period of the CFC be calculated as the average of the person's income interests for the quarters which fall in that accounting period.