Chapter 4 – Taxation of residents’ foreign-source income

Taxing income earned through foreign companies
Taxation of foreign-source income
Controlled Foreign Company (CFC) regime
    Purpose and description
    Some options for change
Foreign Investment Fund (FIF) regime
    Purpose and description
    FIF regimes in other countries
    Problems with the current FIF regime
    Some options for change
Foreign Dividend Withholding Payment (FDWP) regime

This chapter reviews the practical implications of taxing residents’ foreign-source income. The particular emphasis is on the taxation of income earned through separate legal entities.

The total foreign-source income of residents, earned both directly and through companies, is about $1 billion. It appears that only a small percentage of this amount is paid in New Zealand tax[5].

Taxing foreign-source income also helps preserve the domestic tax base (the New Zealand-source income earned by New Zealand residents), as discussed above. That is, while taxes on foreign-source income might not raise much revenue, they help ensure that individuals pay other taxes by removing an incentive to earn foreign-source income.

Taxing income earned through foreign companies

There are two important aspects to the taxation of foreign companies owned by residents.

First, taxing domestic and foreign income on the same basis encourages New Zealanders to invest in a manner that produces the greatest benefit for New Zealand as a whole.

Similarly, taxing New Zealanders on income earned on their behalf through companies on the same basis as income they earn themselves directly encourages them to select whichever direct or indirect investment yields the highest return to New Zealand as a whole.

If New Zealanders were not subject to New Zealand tax on income earned on their behalf by non-resident companies, but were subject to company tax on income earned by resident companies, they would be encouraged to invest offshore, even when investment in New Zealand would have a higher yield. In effect, the tax system would be subsidising the export of productive investment and associated employment.

That is, the tax system should, wherever possible, ensure that New Zealanders invest how and where they can earn the highest return, rather than how or where they can pay the lowest tax.

Secondly, New Zealand residents can use companies in low-tax countries (‘tax havens’) or in concessionally taxed investment in otherwise high-tax countries, as a way of escaping tax on their New Zealand-source income. For example, a New Zealander could own a company in a tax haven that owns a factory in New Zealand. In the absence of the CFC regime, there are a number of ways this structure could then be used to avoid New Zealand tax.

Such practices would have little effect on investment and employment in New Zealand, but could seriously erode the tax base.

Taxing foreign-source income of New Zealand residents, including that earned through separate entities, will therefore both encourage investment with a sound economic base and protect the tax base from avoidance.

Taxation of foreign-source income

The Government considers that it should continue to tax New Zealanders on the foreign-source income they earn both directly and through separate legal entities.

This section focuses on the three regimes New Zealand has for taxing income earned through such entities:

the Controlled Foreign Company (CFC) regime
the Foreign Investment Fund (FIF) regime
the Foreign Dividend Withholding Payment (FDWP) regime.

In considering these regimes, the Government must find the best possible compromise between three competing policy objectives:

effective taxation of residents’ foreign-source income
removing barriers to investment
low compliance and administration costs.

Controlled Foreign Company (CFC) regime

Purpose and description

The CFC regime is necessary to ensure that foreign-source income is taxed effectively. Before the CFC regime was introduced, New Zealand residents could and did avoid tax by accumulating income in companies resident offshore, but effectively controlled from New Zealand.

The CFC regime attributes the current income of an offshore company back to the New Zealand owners if:

A group of five or fewer New Zealand residents control 50% or more of an offshore company.
The offshore company is resident outside a ‘grey list’ of seven designated countries - Australia, Canada, France, Germany, Japan, the United Kingdom and the United States.

CFC earnings are subject to New Zealand tax with a credit for foreign income taxes paid. In effect, CFCs are taxed in the same way that the foreign branches of New Zealand companies have been taxed for many years. For this reason, the CFC regime is referred to as a ‘branch-equivalent’ tax.

The seven grey-list countries were selected according to two criteria:

tax rules (including standards of administration) that produce effective company tax rates similar to those in New Zealand
comprehensive international tax rules that reduce international tax planning opportunities and support the New Zealand CFC regime.

The grey list is an example of the compromise between the competing objectives of:

effective taxation of residents’ foreign-source income
minimising compliance and administration costs.

Each of these countries have tax rates similar to New Zealand’s and the decision was made to allow New Zealand residents a credit for foreign taxes paid by the company. Therefore, applying New Zealand’s CFC regime to companies in these countries was judged to produce insufficient gain in investment allocation or revenue to justify the costs. New Zealand residents’ interests in foreign companies located in grey-list countries were exempted from the CFC regime.

Implicitly, the regime makes the judgement that where avoidance through the use of interposed entities is not a significant problem, and where revenue gains would be small or nil, the compliance cost savings from not requiring the calculation of income are greater than the disadvantages of encouraging investment and associated employment to move offshore and of higher tax rates on other New Zealanders.

It thus means that the bulk of foreign-source income earned on behalf of New Zealanders through CFCs is exempt from tax on an accruals basis. Over the most recent four years for which statistics are available, 80% of New Zealand Direct Investment Overseas was in the seven grey-list countries.

However, in the jurisdictions where it does apply, the regime does tax foreign-source income of all kinds earned by controlled foreign companies.

In short, the operation of the ‘grey list’ means that most offshore income earned by controlled foreign companies is exempt from the CFC regime.

The CFC regime will continue to tax foreign-source income except where the compliance and administrative costs of doing so outweigh the revenue gain and where there is no significant risk of tax avoidance.

Some options for change

The Government is investigating ways of modifying the current CFC rules to improve the balance between:

encouraging New Zealanders to invest where the returns to all New Zealanders are highest
raising revenue and protecting the tax base
compliance and administrative costs.

In considering options for change, the Government will have regard to:

the compliance costs of the current regime, and any changed regime, for different classes of taxpayers
the revenue effects of any changes, including any tax avoidance possibilities such changes might create
the effect of any change on the location and quality of New Zealanders’ investment
the Government’s view that foreign-source income as a general rule should be taxed.

The Government will look to the experiences of other countries when considering the available options.

Calculation of CFC income

A principal source of CFC compliance costs is the need to convert CFC income, calculated in accordance with the tax laws of the country in which the CFC is resident, to the income definitions in force in New Zealand.

More flexible methods of calculating CFC income are being considered.

The Consultative Committee on Tax Simplification suggested that CFC calculations could be simplified by providing the Commissioner of Inland Revenue with the authority to accept some countries’ tax treatment of some assets and transactions. The Government is considering this approach.

One option is for a list of the countries and/or acceptable tax provisions to be published. Under this approach, there would be three classes of CFC income:

exempt income, which is earned in a company resident in a ‘grey list’ country
income earned in ‘second list’ countries, with simplified calculation provisions
income earned outside either list, where the current ‘branch-equivalent’ regime would apply.

Another approach would recognise that smaller taxpayers tend to have the most compliance problems by targeting the regime more towards large companies.

A black list

In its election manifesto, the Government said that it would consider applying the international tax regime to a restricted list of countries.

During a transitional period from 1 April 1988 to 31 March 1991, in broad terms the CFC regime applied only to companies resident in a ‘black list’ of some 61 countries with very low effective tax rates and to specified corporate entities granted tax preferences in 10 other countries.

The current regime exempts virtually all income earned by CFCs resident in seven listed countries, but applies to companies resident in all other countries.

The Government will be considering whether the current ‘grey list’ should be modified. In particular, it will be considering whether the ‘grey list’ should be replaced with a ‘black list’ of low tax countries, with all income earned by companies resident outside listed countries being exempt from the CFC regime.

Passive income

The Government’s election manifesto also said that the Government would consider only applying the CFC regime to passive income.

Australia, Canada and the United States restrict their CFC regimes to ‘passive’ or ‘tainted’ investment income and exempt earnings of ‘active’ business operations.

‘Passive’ income is often regarded as income that is most likely to involve tax avoidance. That is, it is income that is either:

really New Zealand-source income that has been disguised as foreign-source income by interposing a foreign entity between its true New Zealand source and its ultimate New Zealand owner
a close substitute for New Zealand-source income, which may be chosen because of tax advantages rather than any innate superiority.

‘Active’ income is foreign-source income that is earned by a business largely for commercial reasons, rather than being tax driven.

Foreign Investment Fund (FIF) regime

Purpose and description

As outlined in Chapter 2, New Zealand’s domestic income tax system ensures that residents cannot defer tax by investing through separate entities.

Company tax and the taxation of trusts (including superannuation and life insurance funds) ensure that New Zealand-source income earned on behalf of residents is taxed as it is earned.

By reducing tax deferral opportunities and incorporating more income into the tax base, New Zealand has been able to reduce marginal tax rates.

The measures that eliminate tax deferral on domestic-source income would be undermined if New Zealand residents could avoid or defer tax by accumulating income in offshore funds in which they do not have a controlling interest. In the absence of a FIF regime, New Zealanders would have an incentive to shift their investments offshore to get around the accruals regime for financial arrangements and the taxation of superannuation and life insurance funds.

The objective of the FIF regime, where it applies, is to levy the same tax on the income earned by the FIF on behalf of the resident as would be levied if the fund were a New Zealand company. Because the FIF is resident offshore with no effective connection with New Zealand, the only way of levying the tax is on the New Zealand holder.

Furthermore, because FIF investors do not exercise control over the fund, they do not normally have access to the detailed records of underlying activities needed for the branch-equivalent calculation of CFC income. Therefore, a proxy for this calculation is required.

Annual FIF income is currently calculated according to the comparative-value method, which measures the change in the market value of a FIF interest during the taxation year plus any cash distributions.

The comparative-value method seeks to tax foreign-source income that would be taxable if it were domestic-source income on the same basis that that domestic-source income is taxed. However, because details of the actual income earned by the FIF are often not available, the comparative-value method must approximate domestic taxation.

The Government will consider alternative methods of calculating FIF income. The final choice of method will, however, depend on the method’s ability to meet the goal of effectively measuring the income earned by the taxpayer through a FIF.

The FIF regime also complements the CFC regime. If the FIF regime did not exist, the CFC provisions might be avoided by structuring offshore investments to fall below the ownership levels that define a CFC interest (five or fewer New Zealand residents own 50% or more of a foreign company outside the seven grey-list countries). Even if not deliberately structured to avoid the CFC regime, FIF investments could also be easily substituted for domestic investments.

The FIF regime or an equivalent regime will remain in place to support the CFC regime and protect the tax base.

However, the Government recognises that the current FIF regime does pose compliance problems, sometimes insurmountable problems, for taxpayers. Modifications to reduce compliance costs are being reviewed.

As in other areas of international tax, the Government has to weigh the need to minimise compliance costs against the objectives of taxing income that should be taxed, removing barriers to productive investment and protecting the tax base.

In practice, the FIF regime should be targeted on the areas which pose the greatest risk to the New Zealand tax base.

The current FIF regime covers investments that provide the greatest scope for diverting New Zealand-source income or which are regarded by investors as being close substitutes for alternative New Zealand investments.

The definition of a FIF is based on criteria that assess whether the offshore entity is structured to defer tax. An offshore entity is not a FIF if it meets one of these tests:

It is resident in one of the seven ‘grey-list’ countries.
It distributes at least 60% of its aggregate annual income, profits and capital gains.
No more than 40% of its total assets consist of listed assets that could be broadly described as ‘portfolio investments’.
It pays total (foreign plus New Zealand) tax at an effective rate of at least 20%.

However, investors often cannot obtain the information needed to determine whether an entity is or is not a FIF.

FIF regimes in other countries

The Government has reviewed FIF-type regimes in other countries to see whether another country has found a simpler and less costly way to prevent tax avoidance and deferral in offshore investment funds.

Canada, the United Kingdom and the United States have provisions similar to the FIF regime.[6]

The review showed that, in all these countries, provisions to tax FIF income are both more complicated and more severe on the taxpayer owning the interest than equivalent provisions to tax domestic-source income. Complexity and severe treatment appear to be necessary costs of protecting the tax base from offshore funds that provide tax avoidance or deferral benefits.

Canada

Canadian residents with interests in Offshore Investment Fund Property are subject to an annual imputation of income. Canada avoids any difficulties in obtaining information on the annual return of the fund by deeming the investment to earn a prescribed rate of return equal to the interest rate levied on unpaid taxes.

Offshore investment funds are subject to this treatment if tax deferral is a primary motivation for holding the interest. Canada decides to accord this special tax treatment by looking at such factors as the foreign tax paid by the fund and the extent of fund distributions.

The calculation of income from Offshore Investment Fund Property for Canadian residents is simpler than the FIF calculation for New Zealand residents. However, under the Canadian approach, taxpayers are levied on the basis of an assumed return, which may bear no relation to actual earnings.

United Kingdom

The United Kingdom does not tax income from non-qualifying offshore funds (non-resident companies, unit trusts or similar entities that distribute less than 85% of income) until distribution or realisation.

British investors must report net gains from sales of non-qualifying offshore funds as ordinary income, rather than capital gains. Thus, investors in offshore funds cannot take advantage of the annual capital gains exemption and indexation allowance for capital gains. Investors cannot offset any losses on offshore funds against other income.

By delaying tax until realisation, the British approach can induce a ‘lock in’ effect, discouraging the sale of offshore investments. Realisation taxes also require records of the purchase price of assets to be kept until disposal. Special ordering rules are also required to deal with disposal of part of a holding.

United States

American shareholders of Passive Foreign Investment Companies (PFICs) are not taxed until they receive distributions or sell their shares. A PFIC is any foreign corporation or fund that earns 75% or more of gross income from ‘passive investments’ or holds 50% or more of total assets in the form of ‘passive investments’.

Unlike tax on other income, the tax calculation for PFICs includes an interest charge to offset the benefits of tax deferral. The calculation of this interest charge can be very complicated and can require extensive record keeping.

Problems with the current FIF regime

The definition of what constitutes a FIF is based on a set of qualifying tests of whether the offshore entity is structured to avoid or defer tax. However, individual investors often cannot obtain the information needed to determine whether an entity is or is not a FIF.

Taxpayers have been dependent on determinations by the Commissioner of Inland Revenue on whether particular entities are FIFs. The determination process has itself been lengthy because of the difficulty of obtaining information on foreign entities.

Whether there are any significant compliance problems apart from the determination that the entity is a FIF depends on the nature of the entity.

If the market value of the interest is readily available, for example traded shares, then compliance with the current FIF regime is reasonably easy. The calculation of taxable income is very simple.

For some offshore funds, however, the market value required for the annual calculation of FIF income cannot be easily established because the funds are not traded. For example, in most cases, New Zealand residents with interests in foreign superannuation and life insurance funds will not be able to obtain a current market value of their interests.

Some options for change

The Government believes that New Zealand’s FIF regime can and must be improved to ease taxpayer compliance. The Government is particularly concerned about the compliance problems facing small investors with minimal FIF interests.

In considering changes to the FIF regime, the Government will have regard to:

compliance costs
the role of the FIF regime in backing up any modified CFC regime
the revenue effects of any changes, including tax avoidance possibilities created by any changed regime
the interaction of the FIF regime with other parts of the tax system, especially the taxation of domestic superannuation and life insurance
the desirability of taxing foreign-source income.

Definition of a FIF

As noted above, the greatest difficulty in the FIF regime is determining what is a FIF. Taxpayers and administrators often do not have and cannot easily obtain the necessary information to determine whether an entity meets the tests listed above.

The Government will consider whether the definition of what constitutes a FIF can be changed to make the regime easier to comply with.

One option is to class as FIFs all entities that are resident outside an expanded list of countries and are not CFCs.

This would reduce the costs of determining whether an entity is a FIF, but would expand the scope of the regime.

The Government has not made any decision on whether it will pursue this option.

Small FIF holdings

The Government is exploring the possibility of providing a simpler method of taxation for taxpayers with FIF investments below a minimum threshold.

One option is an outright exemption if a taxpayer’s total FIF interests or FIF income were below a specified threshold. However, as the Consultative Committee on Tax Simplification pointed out, such an exemption would lead to a variety of problems.

In particular, an outright exemption based on the level of FIF income earned will still require taxpayers to determine whether they earned FIF income and how much. Thus taxpayers would still incur significant compliance costs, but would pay no tax.

An outright exemption would also undermine the objective of protecting the tax base. All taxpayers would have an incentive to avoid or defer tax by investing in FIFs up to the minimum threshold. This means that the threshold would have to be so small as to be of little practical value if significant fiscal costs and flight of funds for investment offshore were to be avoided.

Choice of taxation methods for small FIF investors

A further option is to offer those with total FIF interests below a specified threshold a choice between:

the current system of calculating and taxing FIF income annually; or
taxation on distribution or realisation of FIF returns.

To offset the benefits of deferring tax, a higher rate might be applied for small FIF investors opting for the realisation basis.

Alternatively, a deemed earnings rate, along the lines of the Canadian approach, might apply during the time the individual holds an interest in a FIF.

Foreign superannuation and life insurance funds

Foreign superannuation and life insurance funds pose a particular problem.

Earnings of offshore funds cannot be taxed directly on the same current basis as domestic superannuation and life insurance funds. However, if offshore funds were not subject to similar tax treatment as domestic funds, New Zealand superannuation funds and life offices would face a severe competitive disadvantage.

Foreign superannuation and life insurance funds are included in the FIF regime to place the tax treatment of foreign and domestic funds on a comparable basis. However, it is often very difficult to obtain an annual market valuation of an investor’s interest in a foreign superannuation or life insurance fund.

One possible solution to this problem would be to develop a separate tax treatment for investments in foreign superannuation and life insurance funds.

One option might be to require New Zealand residents to pay a withholding tax of 33% of gross contributions. This would effectively act as a withholding of tax on future fund earnings. At the end of the term of the investment, contributors could have the option of reconciling on a Yield to Maturity basis or of paying tax on the withdrawals.

Foreign Dividend Withholding Payment (FDWP) regime

FDWP is a withholding payment on income earned offshore on behalf of shareholders of New Zealand companies.

Operation of the regime

FDWP applies when offshore income is repatriated to New Zealand in the form of dividends. Companies receiving such dividends are required to withhold 33% of the dividend against the future taxation liability of their shareholders.

When a New Zealand company which has paid FDWP distributes dividends to its shareholders, it attaches a FDWP credit which the shareholders can apply against their own tax liability. FDWP credits in excess of any tax liability are refunded in cash. However, to the extent the New Zealand company receiving the foreign-source dividend (and therefore paying FDWP) does not distribute its profits to its shareholders, FDWP constitutes a final tax.

FDWP applies to dividends received by a company from foreign companies in all countries.

For reasons outlined in Chapter 2, it is generally desirable that offshore income earned on behalf of New Zealand residents should be subject to tax.

FDWP acts as a complement to the CFC and FIF regimes by ensuring that income earned on behalf of New Zealand residents in foreign entities is taxed when it is received by a New Zealand entity.

The FDWP regime has been criticised for discouraging repatriation of dividends to New Zealand. This would occur when the New Zealand parent was not immediately passing all FDWP credits on to individual shareholders.

In contrast, the CFC and FIF regimes, by taxing on an accruals basis, avoid this ‘lock-in’ effect, but do so at the expense of higher compliance costs.

In reviewing the place of the FDWP within the tax system, the Government will have regard to:

the effect FDWP has on companies’ decisions to repatriate profits to New Zealand
the role FDWP has in supporting the CFC and FIF regimes
the compliance costs of the FDWP regime
the general desire to tax foreign-source income
the role of the FDWP regime in the context of the repeal of the inter-corporate dividend exemption.[7]

5 The low rate of taxation on foreign-source income is mainly due to the fact that the vast bulk of this income is earned in companies that are located in the seven ‘grey list’ countries that are excluded from New Zealand’s CFC regime.

6 In addition, these and many other countries tax other offshore income earned on behalf of individuals through provisions of their domestic law, like their capital gains taxes.

7 The Government has announced that in future resident companies will be taxed on the dividends they receive from other resident companies. Previously, such dividends were exempt from tax