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New Zealands International Tax Review extending the active income exemption to nonportfolio FIFs

Chapter 1 - Introduction

1.1 New Zealand firms are increasingly looking for opportunities to expand into new and emerging markets. The Government recognises that the tax system should not hinder this expansion overseas and that it is important that New Zealand businesses can compete on an even footing with other foreign competitors in the same country.

1.2 New Zealand-based businesses have previously raised concerns that New Zealand’s international tax rules could impose higher tax or compliance costs on offshore operations than those faced by competing businesses operating in the same country. This was because a New Zealand business that operated in a foreign country had to comply with the tax rules of that country and also attribute income (and potentially pay further tax in New Zealand).

1.3 To address these concerns the Government began a review of the international tax rules in 2006. A series of consultation documents were published (December 2006, October 2007 and December 2007) to consult on a new approach to the taxation of foreign companies that are controlled by New Zealand investors. The main feature of this new approach was the introduction of an active income exemption – an exemption from New Zealand tax on income earned through controlled foreign companies (CFCs) that carry on an active business (for example, manufacturing, distribution or sales activity). Legislation giving effect to these changes was introduced in the Taxation (International Tax, Life Insurance, and Remedial Matters) Bill in July 2008 and enacted in October 2009, with application for all income years from 1 July 2009.

1.4 However, the tax system also needs to reflect the commercial reality that direct investment overseas by New Zealand companies is not always channelled through controlled subsidiaries. When entering new markets, New Zealand firms frequently opt to establish links with a partner in the host country and set up a jointly owned entity. Although the New Zealand firm may not control the entity, it will generally have significant input in areas such as management, technical or marketing expertise. There are clear benefits to New Zealand from this kind of outbound foreign direct investment. These include access to new markets, the further development of New Zealand’s skill base and the development of effective and profitable synergies (for example, when New Zealand’s design or technological expertise is complemented by efficient and low-cost production facilities overseas).

1.5 This issues paper sets out a suggested approach to the taxation of non-controlling interests in foreign companies. It considers how the active income exemption might be extended to some interests in foreign companies that are not controlled by New Zealand residents, referred to as foreign investment funds (FIFs), and whether any rationalisation of the various methods for calculating FIF income is appropriate. One of the main objectives of the reform is that the FIF rules should be easy for taxpayers and advisors to understand and operate.

1.6 We are seeking the views of companies that have offshore operations or are contemplating offshore expansion on how these proposals may affect their business. The next step will be to analyse submissions on the suggestions presented here and make formal recommendations to the Government on changes to the FIF rules. The aim is to introduce a bill in August that gives effect to the reform.

1.7 The changes suggested in this issues paper should play a significant part in facilitating the expansion of New Zealand companies and ensuring the overall coherence of the tax rules for New Zealand investment in foreign companies.

SUMMARY OF SUGGESTED CHANGES

Active income exemption for interests of 20 percent or more in foreign companies

  • No income will be taxable from income interests of more than 20 percent in FIFs that have passive income of less than 5 percent of their total gross income. This is the active business test and is the same test that applies to CFCs.
  • If a person who has an interest of 20 percent or more in a FIF fails the active business test, only passive income will be taxable using branch equivalent calculations.
  • To reflect the extension of the active income exemption to interests in FIFs, the remaining exemption for non-portfolio investments in grey list jurisdictions will be repealed. However, in line with the treatment proposed for CFCs, an exemption for greater than 20 percent interests in FIFs resident in Australia will be introduced.
  • It is anticipated that most New Zealand investors with interests of 20 percent or more in a FIF should be able to perform the active business test and, if this test is failed, be able to accurately attribute the passive income arising from the FIF. In rare cases when investors cannot do the necessary calculations, they will be able, subject to certain restrictions on the choice of method, to use one of the attribution methods available for FIF interests of less than 20 percent to work out their tax liability.
  • Portfolio investment entities (PIEs) will be prevented from holding income interests of 10 percent or more in a CFC (except if the CFC is a foreign PIE equivalent).

Investors with a less than 20 percent interest in a foreign company

  • The active income exemption will not be available to investors with interests of less than 20 percent in a FIF (although investors with a 10 percent or greater interest in a CFC will still be able to access the active income exemption). Instead, a single harmonised regime will apply to all FIF interests of less than 20 percent.
  • The methods available for attribution of interests of less than 20 percent will be:
    • fair dividend rate;
    • cost;
    • comparative value; and
    • deemed rate of return.
  • There will be some restrictions on the choice of method, similar to those currently in force for FIF interests of less than 10 percent, to prevent manipulation of the attribution methods.
  • The accounting profits method will be repealed completely and the branch equivalent method will not be available for FIF interests of less than 20 percent.
  • The existing exemptions from the FIF rules for Australian companies listed on the ASX and certain venture capital investments made through grey list companies will be modified to apply to less than 20 percent interests in FIFs. Dividends paid from such FIFs will be subject to income tax.
  • Portfolio shares that escape attribution under the $50,000 minimum threshold because they were inherited at nil value, will be subject to a deemed sale and reacquisition at market value.

How to make a submission

1.8 Submissions should be made by Friday, 30 April 2010 and be addressed to:

International Tax Review
C/- Deputy Commissioner, Policy
Policy Advice Division
Inland Revenue Department
PO Box 2198
Wellington 6140

1.9 Or e-mail: [email protected] with “International Tax Review” in the subject line.

1.10 Submissions should include a brief summary of their major points and recommendations. They should also indicate whether it would be acceptable for Inland Revenue and Treasury officials to contact those making the submission to discuss the points raised, if required.

1.11 Submissions may be the source of a request under the Official Information Act 1982, which may result in their publication. The withholding of particular submissions on the grounds of privacy, or for any other reason, will be determined in accordance with that Act. Those making a submission who feel there is any part of it that should properly be withheld under the Act should indicate this clearly.