Chapter 3 – The current tax regime

3.1 Current tax treatment of foreign-sourced income of New Zealand residents
3.2 Current tax treatment of non-residents - general comments
3.3 Taxation of income to non-residents from "portfolio" investment
3.4 Conclusion

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A description and assessment of the current regime in the light of the general discussion in Chapter 2

3.1 Current tax treatment of foreign-sourced income of New Zealand residents

3.1.1 The general principle - New Zealand residents pay tax on their world wide income

In principle, New Zealand residents are taxed on their world-wide income; that is, the income they derive from all foreign sources as well as the income that they derive from New Zealand. However, as explained below, credits are offered for taxes paid overseas.

New Zealand residents can engage in a wide range of economic activities offshore, directly or indirectly, through various mechanisms such as companies, partnerships and trusts.

3.1.2 Credits for taxes paid overseas

The amount of New Zealand tax collected from the foreign-sourced income of residents can vary greatly depending on the extent to which New Zealand grants the taxpayer a credit for taxes paid overseas to a foreign jurisdiction.

3.1.3 Income from foreign “portfolio” investment and distributions

Resident individuals or companies can receive distributions of income from offshore in a number of different forms, including:

• interest paid by a non-resident borrower;
• dividends paid by a non-resident company;
• royalties paid by a non-resident;
• payments for services performed offshore; and
• business income derived from an offshore branch.

Income earned by a New Zealand resident individual from foreign portfolio investments, such as interest, dividends and royalties, is subject to the resident’s personal New Zealand tax rate, less a credit for foreign taxes paid by the individual (these are usually withholding taxes imposed by foreign governments).

The same types of income, other than dividends, earned by a New Zealand company are also taxed at 33% less a credit for foreign taxes paid by the New Zealand company.

A dividend received by a New Zealand company is subject to FDWP of 33%, less a credit for foreign taxes paid by the New Zealand company.

If the New Zealand company owns at least 10% of the foreign company paying the dividend, the New Zealand company may credit against its FDWP liability a proportionate share of the foreign company taxes borne by the foreign company which pays the dividend.

3.1.4 Income earned from investment in foreign companies

The CFC regime applies to investment in foreign companies controlled by the New Zealand shareholders. Broadly, that is the case where five or fewer residents own more than 50% of the foreign company or, in specified circumstances, where a single person owns 40% or more of the company.

The FIF regime applies when the CFC regime does not apply; that is, it applies to investment in foreign superannuation schemes, foreign life insurance policies and foreign companies that are not controlled by New Zealand shareholders.

Resident shareholders are allowed a credit for foreign withholding taxes paid by them. Additionally, under the CFC regime and in certain circumstances under the FIF regime, the resident shareholders are allowed a credit for the underlying foreign taxes paid by the foreign company that is earning the income on their behalf. In other circumstances, the FIF regime gives only a deduction for the foreign taxes.

The main exception to this treatment is the “grey list” exemption. If the foreign company is resident in a grey list country, neither the CFC nor the FIF regimes apply (unless the foreign company is subject to a low foreign tax rate due to a designated concession listed in the 16th Schedule to the Act).

Since New Zealand offers a credit for taxes paid to overseas countries, it is likely that little revenue, if any, would be collected by New Zealand from businesses operating in countries that apply taxes equal to or greater than those imposed under the CFC regime. Accordingly, to reduce unnecessary compliance costs, companies operating in grey list countries are exempted from the Controlled Foreign Company (CFC) and Foreign Investment Fund (FIF) regimes.

The tax regimes in overseas jurisdictions vary enormously. Certain countries have robust tax rules while others do not. A list of countries that meet certain robustness criteria are listed in the 15th Schedule to the Act and are referred to as the “grey list” countries. The list of countries included on the grey list is reviewed annually. As would be expected, given the benefit that inclusion confers, the criteria for inclusion on the grey list are rigorous.

There are currently six countries on the grey list (Australia, United Kingdom, Canada, United States, Germany and Japan). As a general rule, tax levied in a grey list country should equate to the level of New Zealand tax that would be payable if that income was sourced entirely from New Zealand. The grey list and the availability of tax credits mean that New Zealand residents might pay nil New Zealand tax on profits earned overseas. At most, the payment of New Zealand tax on overseas earnings is no more than the corporate rate; that is, 33%.

The Government announced its policy on the “grey list” in the 1992 Budget. Under that policy, each year the schedule of countries on the “grey list” will be reviewed as part of the Budget consideration process. As other countries meet the criteria for inclusion laid out in the 1992 Budget documentation, they will be added to the “grey list”. Apart from this, the Government considers the current “grey list” criteria as settled.

As explained above, this exemption is given to save taxpayer compliance costs. It is presumed that companies resident in these countries pay foreign taxes sufficient to generate foreign tax credits that would offset all of the New Zealand tax otherwise due under the CFC or FIF regimes.

If the grey list exemption applies, the income will be taxed upon distribution to the shareholder rather than when it is earned. The grey list exemption applies to 70-80% of New Zealand’s foreign direct investment income.

If a taxpayer is subject to the CFC or FIF regimes on income earned through investment in a foreign entity, mechanisms are used to prevent the double application of New Zealand tax on the income when distributed to the shareholder. This means that income distributed to a shareholder is subject to total New Zealand tax equal to the shareholder’s total tax rate.

However, the mechanism does not apply to foreign taxes and therefore shareholders are effectively given a deduction for foreign taxes. In essence, foreign tax credits given for CFC, FIF or FDWP imposts are ‘clawed back’ at the shareholder level.

3.1.5 Income earned from trusts

Income derived by a trustee of a trust in any income year is either ‘trustee income’ or ‘beneficiary income’.

Beneficiary income is that part of income that vests in or is distributed to a beneficiary in the year that it is derived by a trustee or within six months after the end of the year. A resident beneficiary can be taxed on beneficiary income and certain other distributions from trusts with foreign connections.

Trustee income of a trust that has a resident settlor at any time in an income year is taxable in New Zealand, even where the trustees are non-resident and the income has a foreign source. In the latter case, the resident settlor will be liable for the tax as agent for non-resident trustees.

Taxable distributions can be made by foreign trusts and non-qualifying trusts. A foreign trust is a trust in which no settlor has been a resident of New Zealand from 17 December 1987 (or when the trust was first settled, if later) to the time that the distribution is made. A non-qualifying trust is a trust which, at the time of a distribution, is neither a qualifying nor a foreign trust.[2]

3.1.6 Provision of credits for foreign taxes

New Zealand provides foreign tax credits both unilaterally and through its Double Taxation Agreements (DTAs) with other countries.

The objective of foreign tax credits is to avoid double taxation of the foreign-sourced income of residents. If a resident derives foreign-sourced income and that income is subjected to foreign tax, New Zealand provides the resident with a foreign tax credit.

Calculating the foreign tax credit involves two steps:

1. determining, in accordance with s.293(2) of the Income Tax Act 1976 (the Act)[3], the foreign income tax borne by the New Zealand resident; and
2. determining, in accordance with s.306(2) of the Act, the New Zealand tax that would have been payable on the foreign-sourced income if no foreign tax had been paid. This is the foreign tax credit limit. (The method of calculating the foreign tax limit is shown below.)

The foreign tax credit allowed is the lesser of the foreign tax borne by the New Zealand resident and the foreign tax credit limit.

3.1.7 Foreign tax credit gross-up

If income is received net of foreign tax (for example, interest subject to foreign NRWT), then the income must be grossed-up by adding the amount of the foreign tax before determining the New Zealand tax.

3.1.8 Calculating the foreign tax credit limit

The foreign tax credit limit is calculated by multiplying the amount of New Zealand tax payable on the taxpayer’s world-wide income (determined after the gross-up and before the foreign tax credit) by the ratio of the foreign-sourced income subject to the foreign tax to the total assessable income of the taxpayer.

Foreign Tax Credit Limit = New Zealand Tax X

Foreign Sourced Income ------------------------------------ Total Assessable Income

3.2 Current tax treatment of non-residents - general comments

Non-residents can engage in a wide range of economic activities in New Zealand, directly or indirectly, through various mechanisms including companies, partnerships and trusts.

There are considerable differences - from 1.34% to 53% at the extreme ends of the range- in the rates of New Zealand tax applied to the income derived from these economic activities.

These differences arise not only because of differences in the statutory rates of tax that New Zealand applies to different forms of income (that is, interest or profit), but also from differences in the tax treatment of different entities and in the tax treatment of non-residents in different countries.

3.3 Taxation of income to non-residents from “portfolio” investment

3.3.1 Equity investment

There are two distinct layers of New Zealand tax that can be imposed on the income that non-residents derive from equity invested in a New Zealand company:

• the New Zealand company pays 33% company tax on the profit made in New Zealand; and
• NRWT is applied to any dividends distributed offshore to the non-resident.

Dividends paid by a company, unlike interest, are not deductible in determining its New Zealand tax liability. Therefore, the income that non-residents derive from equity investments in New Zealand can be subject to both the rate of company tax when that income is derived by a New Zealand company in which they have invested and the rate of NRWT when that income is distributed in the form of dividends.

A New Zealand resident shareholder in a New Zealand company receives credit for company tax through the imputation system. For non-resident portfolio shareholders, partial relief for double taxation is provided through the foreign investor tax credit described below.

3.3.1.1 NRWT on dividends

The rate of NRWT applying to dividend income is 30%, except where the non-resident resides in a country with which New Zealand has negotiated a DTA.

The usual rate of NRWT on dividends set by DTAs is 15%.[4] This means that, except where the foreign investor tax credit (FITC) applies, the overall combined statutory tax rate on non-resident equity investment in New Zealand is 53% in cases where the 30% NRWT rate applies and 43% in cases where the 15% DTA NRWT rate applies.[5]

The amount of NRWT on dividends is reduced, however, by credits for foreign dividend withholding payments levied on foreign-sourced dividends derived by New Zealand resident companies.

3.3.1.2 Foreign investor tax credit

The FITC regime, enacted in September 1993 (s.308A), provides a credit of company tax to non-resident portfolio investors. The FITC is calculated as 0.5583 of the imputation credits attached to the dividends paid to non-resident portfolio investors (defined as non-resident shareholders owning a voting interest of less than 10% in the company). The credit is paid to companies, which are required to pass it on to eligible non-resident shareholders through the payment of a supplementary dividend.

With the FITC, the total New Zealand tax on non-resident portfolio investment in New Zealand is the standard New Zealand company tax rate of 33% when the DTA 15% NRWT on dividends applies and 45% when the dividend is paid to an investor from a country which does not benefit from a DTA and the statutory 30% NRWT on dividends applies.

3.3.1.3 Taxation of income from “direct” investment

Non-residents can engage in direct investment in New Zealand either through a branch (that is, an unincorporated “fixed establishment”), or a subsidiary (that is, an incorporated “fixed establishment”).

3.3.1.3.1 Branch investment

One common investment option for non-residents is to establish a branch of their business operations in New Zealand. For example, a non-resident individual can operate a branch factory in New Zealand. Similarly, a non-resident company can establish an office in New Zealand to administer its operations here.

Distributions from a branch to its head office are not separately taxed because no payment to another separate legal entity is made. For this reason, branches are subject to a 38% company tax rate instead of 33%.

3.3.1.3.2 Subsidiary investment

Another common form of non-resident investment is the establishment by the foreign company of a subsidiary in New Zealand.

New Zealand tax law does not “look through” a company to its shareholders to determine where a company is resident. A subsidiary of a non-resident company is treated as a New Zealand resident and taxed by New Zealand on its world-wide income if:

• the subsidiary company is incorporated in New Zealand; or
• it has its head office in New Zealand; or
• it has its centre of management in New Zealand; or
• control of the company by its directors is exercised in New Zealand.

In addition, interest or dividends paid from a New Zealand-resident subsidiary to its offshore parent would generally be New Zealand-sourced income derived by the parent and subject to the tax treatment discussed in this Chapter.

3.3.1.3.3 Summary

Currently, the FITC does not apply to direct investment, although this document proposes that it should apply in future. Company tax is only one of the levels of tax imposed on the income that non-residents derive from direct investment in New Zealand. As distributions are also often taxed, the tax on the distribution must be considered as well. The combined effects of the company tax and tax on distributions of interest and dividends are summarised in the following table.

Table 1

TAXATION OF COMPANY DISTRIBUTIONS FOR A TREATY INVESTOR

CASH FLOW	DEBT		EQUITY
	Portfolio	Direct	Portfolio	Direct
Income	100	100	100	100
Company Tax	0[6]	0[6]	-21[7]	-33
Distribution	100	100	79	67
AIL / NRWT	-1[8]	-10[9]	-12[10]	-10[11]
Net Received	99	90	67	57
Eff. Tax Rate	1%	10%	33%	43%

3.3.2 Debt investment

Generally, interest income derived by a non-resident from debt investment in New Zealand will be deemed to have a New Zealand source and therefore be subject to NRWT in cases where a non-resident[12]:

• lends money in New Zealand (s.243(2)(l) of the Act;
• lends money outside of New Zealand to a resident, except where the resident uses the money for the purposes of a business carried on outside New Zealand through a fixed establishment outside New Zealand (s.243(2)(m)(i)); or
• lends money outside of New Zealand to a non-resident, if the money is used for the purposes of a business carried on in New Zealand through a fixed establishment in New Zealand (s.243(2)(m)(ii)).

The rate of NRWT applying to such interest income is 15%,[13] except:

• where the non-resident resides in a country with which New Zealand has negotiated a DTA. Most of New Zealand’s DTAs restrict, to 10% of the gross amount of the interest,[14] the rate of NRWT that New Zealand can apply to the interest income earned by a non-resident; or
• where the borrower is an “approved issuer” for the purposes of the Approved Issuer Levy (AIL) under Part VIB of the Stamp and Cheque Duties Act 1971. If the borrower is an approved issuer and is not associated with the lender, the rate of NRWT is reduced to zero.

An approved issuer must pay a levy of 2% of any interest that is paid to unassociated persons. This levy can be deducted when calculating the borrower’s New Zealand taxable income, so that the effective cost of the levy to a taxable borrower is 1.34% of the interest paid.

When a non-resident lends money to a New Zealand company engaging in a business activity that generates assessable income, interest paid on that debt can generally be deducted by the borrower in determining a New Zealand income tax liability.

Deductibility means that the interest income of the non-resident investor making a loan to a New Zealand company is not subject to the company tax as well as NRWT. Rather, the total New Zealand impost applying to such interest income is the rate of AIL payable by borrower, or the rate of NRWT imposed on that interest income.

3.4 Conclusion

Statutory imposts of New Zealand tax on cross-border income flows are quite disparate, ranging from very high to very low.

Residents are generally taxed on foreign-sourced income at the time when it is received by them. They are sometimes taxed on foreign-sourced income on a current basis as it is earned; for example, when the CFC or FIF regimes apply. In some cases, the grey list exemption and foreign tax credits reduce the effective New Zealand tax rate on foreign-sourced income to nil. As a result, the rate of New Zealand tax payable on offshore income can range from 0% to 33%.

For non-resident investors, combined statutory imposts range from 1.34% to 43% where a DTA applies and up to 53% otherwise. For treaty investors, some examples of imposts on non-resident investment in New Zealand are:

• portfolio debt investment is subject to an effective impost of approximately 1% when AIL applies;
• portfolio equity investment is taxed at approximately 33%;
• direct debt investment is taxed at approximately 10%; and
• direct equity investment is taxed at approximately 43%.

Given the wide range of tax rates applying to both arms of international tax policy, significant changes in either area need to be considered in conjunction with the other; for example, significant reductions in the high tax rates on non-residents would have to be considered together with measures to increase uniformity in tax rates and the level of New Zealand tax applied to offshore income of residents.

In practice, there are difficulties applying even rates and timing rules for New Zealand tax to cross-border income flows. In each case, the underlying logic of the particular regime covering a particular income flow drives the applicable New Zealand rate. For example, residents who own offshore entities that are not CFCs or FIFs are generally taxed on foreign-sourced income when it is received by them in New Zealand. For CFC and FIF income, the tax is applied to the income as it is earned. Foreign tax credits and the “grey list” can see the New Zealand impost reduced to zero, although those taxpayers will normally be meeting their tax impost in the overseas jurisdiction from which the income comes.

Any changes in these areas were it contemplated would have to be fully integrated taking into account all factors including the final determination as to the extent to which the theoretical considerations outlined in Chapter 2 should be drivers of policy in this area. Submissions are invited on that and other relevant issues raised in this chapter.

2 A qualifying trust is generally a trust that has always been subject to New Zealand tax from the time it has been settled.

3 This document refers to the provisions of the Income Tax Act 1976, rather than to the recently passed Income Tax Act 1994, which will come into force on 1 April 1995.

4 The exceptions are the Indian DTA that reduces NRWT on dividends to 20% and the Philippines DTA that reduces it to 15% if the shareholder is a company or 25% if the shareholder is not a company.

5 In the remainder of this Chapter, tax rates refer to combined statutory (rather than effective) tax rates unless otherwise indicated.

6 Because interest is deductible in determining company tax, there is no net company tax imposed on profits distributed as interest.

7 33% company tax less FITC credit which amounts to approximately 12% of distributed profits.

8 2% AIL less the effect from 0.66% company tax deduction for net 1.34% effective cost of AIL.

9 Presumes 10% NRWT rate on interest applies under a DTA as a final tax. AIL not available on distribution to direct investor (associated person). When the 10% NRWT is not a final tax, the effective tax rate on debt supplied by direct investors will exceed 10%.

10 15% NRWT on the dividend and supplementary dividend which together amount to $79 in this example. 15% DTA NRWT rate presumed to apply, otherwise 30% statutory NRWT rate may apply (or alternative DTA rate).

11 15% of $67 distribution. 15% DTA NRWT rate presumed to apply, otherwise 30% statutory NRWT rate may apply (or alternative DTA rate).

12 NRWT does not apply to interest derived by a non-resident who is engaged in business in New Zealand through a fixed establishment. Such interest income is subject to ordinary income tax.

13 However, NRWT is a final tax only when the borrower and the issuer are not associated. If they are associated, NRWT represents a minimum tax, subject to DTA restrictions. The remainder of the discussion assumes that the borrower and the lender are not associated.

14 Most DTAs provide for 10% NRWT on interest, except those with India, Canada, Malaysia, the Philippines and Singapore, which provide for 15% NRWT on interest and the Japanese DTA, which does not cover interest, so the statutory 15% rate applies.