Chapter 5 – Foreign Investment Funds
5.1 Introduction
5.2 Definitions
5.3 Calculation of FIF Income or Loss
5.4 Treatment of Losses
5.5 Entry and Exit Provisions
5.6 Conflict Provisions
5.1 Introduction
5.1.1 The foreign investment fund regime is to apply to interests in offshore investment vehicles which fall outside the BE regime but nevertheless confer tax advantages on residents because of a favourable tax treatment in the country of residence of the fund. An investment fund in the form of a unit trust domiciled in a tax haven is a typical example of such an entity. By accumulating rather than distributing most of its income, the fund can convert income such as interest and dividends into a capital gain to the investor, which can be realised either by sale through a stock exchange or by repurchase by the fund or its managers.
5.1.2 We defined a foreign investment fund in our previous report as any entity:
a which derives its income or value primarily or substantially from holding or trading portfolio investments in shares, investments in debt instruments, real property, commodities, etc; and where
b the effect of the fiscal residence and the distribution policy of the entity is to reduce the tax payable on the income of the entity below what it would have been had the income been taxed in New Zealand as it was derived.
5.1.3 The taxable income derived by a New Zealand resident from an interest in a foreign investment fund in any income year is to be calculated as the increase in the market value of the interest over the income year, plus any distributions receivable by the resident.
5.1.4 This chapter outlines the Committee's recommendations on the remaining issues which need to be decided in order to implement the foreign investment fund ("FIF") regime. The relevant section in the draft legislation is section 245O.
5.2 Definitions
5.2.1 The definition of a FIF in the draft legislation follows closely the one outlined above with the following changes. Instead of referring to an "entity", the definition lists the types of entities which could be FIFs, namely, a foreign company, a foreign unit trust and a foreign superannuation fund ( which together can be referred to as "foreign entities"). Although a unit trust is deemed to be a company by section 211 of the Income Tax Act, we have expressly referred to unit trusts to emphasise their inclusion in the FIF definition. We propose that the new definition of "superannuation fund" to be added to section 2 as a result of the current review of the tax treatment of superannuation also apply for the purposes of the FIF definition.
5.2.2 The explicit inclusion of unit trusts and superannuation funds in the definition recognises that some countries give favourable tax treatment to such entities. A parallel change is therefore needed to the second leg of the definition, which requires a person to have regard to the jurisdiction in which the entity is resident, requiring a person to also have regard to be concessionary tax regimes applying within that jurisdiction.
5.2.3 An interest in a FIF is defined in the same way as a direct income interest in a foreign company for the purposes of the BE regime. As explained in chapter 3, income interests are defined in terms of the things that a shareholder of a company, or a person entitled to acquire shares, would hold. A person may, however, have rights to the income of a foreign entity by holding a life insurance or superannuation policy issued by that entity. Consequently, life insurance or superannuation policies must be added to the definition of an interest in a foreign entity for the purposes of the FIF regime. Such an interest will, however, be taxable under the regime only if the foreign entity that issued the policy falls within the definition of a FIF.
5.2.4 Constructive ownership rules are not needed in this regime since there is no control test, nor do we propose a minimum interest threshold before the regime applies. Given that the market value of an interest in a FIF will reflect the value of the FIF's direct and indirect interests, it is necessary to focus on direct interests only.
Recommendation
5.2.5 Accordingly, the Committee recommends that the foreign investment fund regime apply to interests in foreign companies, foreign unit trusts and foreign superannuation funds that fall within the definition of a foreign investment fund and that the definition of an interest in a foreign investment fund include policies of life insurance or superannuation issued by a foreign investment fund.
5.3 Calculation of FIF Income or Loss
5.3.1 The income or loss in any income year that a person derives from an interest in a FIF is to be measured by the change in value of the interest over the year. Taking into account purchases and sales within a year, the taxable income or loss of a person holding an interest in a FIF in any income year can be defined as:
(a + b) − (c + d)
where a = the market value of the interest held at the end of the income year;
b = the market value of all distributions and any other consideration receivable by the person in that income year with respect to that FIF, including any consideration resulting from any disposal of an interest during the income year;
c = the market value of the interest held at the end of the previous income year; and
d = the market value of any consideration paid by the person for the acquisition of an interest during the year.
This definition is essentially the same as the one that you approved in response to our recommendation in Part 1 of our Report on International Tax Reform.
5.3.2 The term "b" in the above formula is defined to include within FIF income all distributions of a FIF. All such distributions, whether of income or capital, need to be included within the definition since any distribution will reduce the end of year market value of a FIF interest. Furthermore, distributions should be taxed in the year they become receivable, rather than the year that they are received, since the corresponding reduction in the market value of a FIF interest resulting from a distribution will be taken into account on an accrual basis. Finally, all distributions must be included, whether they are in cash or otherwise and whether or not they are received directly or are credited in account or are otherwise dealt with in the interest or on behalf of the person.
5.4 Treatment of Losses
5.4.1 FIFs have been defined so that it can be reasonably assumed that the change in the market value of an interest in a FIF over an income year will reflect the change in the market value of its net assets over the year. The growth in a FIF's net assets over a year will in turn depend on its income for that year, reduced by any tax paid and by any amount distributed to interest holders during the year. Thus, FIF income or losses will be measured net of any income tax paid by the fund. This means that it is not appropriate to allow interest holders a credit, or a deduction, for any income tax paid by a FIF.
5.4.2 By contrast, a tax credit is to be allowed under the BE regime. We recommended in respect of the BE regime that attributed income and losses of a person under the regime should not be amalgamated except where they are derived in respect of interests in CFCs resident in the same jurisdiction. Residents would otherwise be able to use credits for tax paid by a CFC in a high tax jurisdiction to offset a New Zealand tax liability in respect of an interest in a CFC resident in a low tax jurisdiction. This consideration is not relevant under the FIF regime since credits will not be given. We therefore propose that residents should be able to aggregate their FIF income and losses derived in any income year, irrespective of the residence of the FIF.
5.4.3 In order to ensure that residents are not double taxed on FIF income, once as it is reflected in an increase in the market value of an interest and again on distribution, it is necessary to allow FIF losses to be deductible. The regime should not, however, permit residents to claim a deduction for a FIF loss of income and/or capital accumulated or contributed prior to the introduction of the regime. It is therefore necessary to limit the FIF loss that can be deducted by a resident in any income year to the amount of the FIF income, if any, derived by the resident in that year or an earlier income year with respect to any FIF. Thus, where a FIF loss derived by a resident in any income year exceeds his or her FIF income for that year, the excess loss should be able to be deducted from other income of the resident derived in that year to the extent that the excess loss was less than the cumulative FIF income of the resident derived in earlier income years, less the amount of any such excess losses set off against other income in those earlier years. The effect of this rule is that a FIF loss could be deducted only to the extent to which a person has previously or will currently be taxed on FIF income.
5.4.4 To the extent that a FIF loss cannot be deducted in the year that it is derived, it should be carried forward for offset against FIF income derived in subsequent years. Where the taxpayer is a company, such a loss carry forward should be subject to a 40 percent shareholding continuity test, as we have recommended in the case of BE losses. Similarly, FIF income and losses should be able to be amalgamated within a specified group of companies resident in New Zealand, subject to provisions comparable to those applying to the grouping of losses under section 191.
Recommendations
5.4.5 Accordingly, the Committee recommends that:
a residents be able to aggregate their FIF income and losses derived in any income year from all FIFs in which they have an interest;
b where a FIF loss derived by a resident in any income year exceeds his or her FIF income for that year, the excess loss be able to be deducted from other income of the resident derived in that year to the extent that the excess loss is less than an amount equal to the cumulative FIF income of the resident derived in earlier income years, less the sum of any excess losses set off against other income in those earlier years pursuant to this provision;
c to the extent that a FIF loss cannot be set off against FIF or other income derived in the same income year, it be carried forward for offset against FIF income derived in future income years;
d the carry forward of a FIF loss by a company be subject to a 40 percent shareholding continuity test similar to that in section 188; and
e a FIF loss incurred by one company in a specified group of companies be able to be offset against FIF income derived by another company in the specified group subject to provisions equivalent to those in section 191.
5.5 Entry and Exit Provisions
5.5.1 Occasions will arise when an interest in a FIF will fall within or cease to be within the regime without an acquisition or disposal at market value occurring at the same time. This will happen when:
a a person becomes or ceases to be a resident;
b a person disposes of an interest by way of gift or for a consideration which is less than its market value;
c a person dies; or
d an interest in a FIF becomes an income interest in a CFC of not less than 10 percent, or vice versa.
In such cases, the interest should be deemed to be acquired or disposed of, as the case may be, for its market value on the relevant day.
Recommendations
5.5.2 Accordingly, the Committee recommends that a deemed acquisition or disposal at market value occur when:
a a person becomes or ceases to be a resident;
b a person disposes of an interest by way of gift or for a consideration which is less than its market value;
c a person dies;
d an interest in a FIF becomes an income interest in a CFC of not less than 10 percent; or
e an income interest in a CFC of not less than 10 percent ceases to be such an interest but is an interest in a FIF.
5.6 Conflict Provisions
5.6.1 As decided previously, where an interest in a foreign company would give rise to attributed income under both the BE and FIF regimes, the BE regime will apply. This is provided for in section 245P of the draft legislation. The exemption from the BE regime for income interests of less than 10 percent does not, however, apply to the FIF regime. Thus, persons holding income interests in a CFC of less than 10 percent may fall within the FIF regime if the CFC is a FIF.