Chapter 4 - Eligible FIFs

Which FIF interests should be eligible for the active income exemption?

4.1 In policy terms, the active income exemption should only apply to interests where the investor is directly involved in the operations of the foreign company. Portfolio shareholders should not have access to the active income exemption. They typically focus on investment returns rather than seeking to directly influence management decisions or exchange knowledge and skills that may help grow a New Zealand business.

4.2 Also, if the active income exemption were to apply to portfolio FIFs, it could create a bias toward investing in offshore stock markets as opposed to domestic investments. Exempting such interests would increase the revenue cost of the active income exemption for little additional economic benefit. Excluding portfolio investors from the scope of the exemption would be consistent with international norms. Other countries do not generally exempt active income from portfolio FIFs.

4.3 Another factor in determining the availability of the active income exemption is the ability for investors to comply with the terms of the exemption. Obviously, an investor who has insufficient information to apply the active business test would need to attribute their income under an alternative method (see chapter 6). But other investors in FIFs fall into two categories.

4.4 In the first category, there are investors who have access to sufficient information to comply with all elements of the rules. They have sufficient information to determine whether or not the FIF has passed the active business test. They also have information to enable them to calculate the amount of income that is required to be attributed if the FIF fails the test.

4.5 In the second category are investors who, like those in the first category, have sufficient information to determine whether the FIF has passed the active business test. However, they do not have the information needed to calculate the amount to be attributed if the FIF fails the test. This category may include investors with access to audited account data but without the detailed information that would allow them to apply the branch equivalent method on a transactional basis.

4.6 Ideally, the active income exemption would be available only to investors in the first category described earlier. This is because an investor’s access to the information needed to comply with all the requirements of the exemption is a strong indication that the person has an appropriate level of involvement in the management of the company. In other words, it demonstrates that they are the type of investor that the active income exemption is aimed at in a policy sense. It also makes more sense from a tax administration perspective that the taxpayer can consistently use the active income exemption from year to year. Investors in the second category only have sufficient information to rely on the exemption in years when the entity passes the active business test.

4.7 It would be difficult to devise and enforce a rule that expressly limited the availability of the active income exemption to the first category of investors. It is therefore suggested that the exemption be limited to investors with a minimum level of income interest in a FIF.

4.8 In determining what level of income interest is most appropriate as a threshold, two factors must be considered.

• Proxy for effective control. The level of interest must be set at a point at which there is a reasonable presumption that the investor has influence on the management of the foreign company. It needs to reflect the point at which a shareholding could generally be expected to give the investor an active and direct involvement in the running of the company.
• Proxy for ability to access information. The level of interest must be set at a point where there is a reasonable presumption that the investor has sufficient information in respect of the foreign entity to comply with the elements of the active income exemption, including both the active business test and, if the test is failed, the calculation of attributable income. Any extension of the active income exemption needs to be workable in practice, and take account of the level of information that is likely to be available to shareholders with various levels of holdings.

4.9 In this context, it is instructive to look at some of the thresholds used for tax and company law purposes in New Zealand that try to capture the point at which an investment becomes “significant” or “substantial”.

4.10 Under the current New Zealand regime, 10 percent is the dividing line between portfolio and non-portfolio interests in FIFs in terms of the application of the fair dividend rate method. Also, investors with a 10 percent income interest in a CFC are able to access the active income exemption for CFCs – although the context is different for CFCs because the 10 percent threshold only applies when the entity is controlled by a single or small group of New Zealand residents.

4.11 Under the entity shareholding investment requirements in the portfolio investment entity (PIE) rules, a PIE must hold less than 20 percent ownership interests (denoted by voting interests) in companies (including unit trusts) that it invests into (other than other PIEs or foreign entities that would be PIEs if they were resident in New Zealand). This means that if the threshold for using the active income exemption was set at 10 percent, a PIE could hold an interest of between 10 to 20 percent in an active FIF or CFC and not be taxed on the foreign income at all, including on distribution to individuals with an interest in the PIE. This is not an appropriate outcome. (PIEs, as their name suggests, are not supposed to have an active role in the management of the companies they invest in, and should not be able to benefit from the tax treatment extended to non-portfolio foreign investments.)

4.12 This difficulty could be resolved for FIF interests by limiting access to the active income exemption to investors with at least a 20 percent FIF interest. In relation to CFCs, it is suggested that PIEs would be prohibited from holding a 10 percent or greater interest in a CFC. PIE holdings of more than 10 percent in a CFC are expected to be rare, and in any case an exception will be made to allow greater than 10 percent holdings in any CFCs that would be PIEs if they were resident in New Zealand.

4.13 Twenty percent is also the threshold for the “fundamental rule” in the New Zealand Takeovers Code – signalling effective control of an entity. Over this threshold additional voting securities can only be acquired in accordance with the rules set out in the Code.

4.14 Finally, the 2001 Tax Review suggested a 30 percent ownership threshold as the appropriate point for an active income exemption to apply.

4.15 Since a threshold based on the level of interest held in a company can only be a proxy measurement for management influence and ability to comply with an active income exemption, there is no threshold that will give the “right” answer in every case. A 10 percent threshold seems too low in this respect. On the other hand, pushing the threshold up to 30 percent seems too strict. On balance, it seems appropriate to extend the active income exemption to income interests of 20 percent or more in a FIF.

4.16 A threshold of 20 percent should ensure that:

• most investors who have an influence on the management decisions of a foreign company have access to the active income exemption;
• any additional revenue cost associated with the active income exemption applying to investors without management influence is minimised; and
• there is generally sufficient access to detailed financial information for the eligible investors to be able to perform both the active business test and, if the test is failed, the relevant transactional calculations.

4.17 The remainder of this issues paper is premised on the active income exemption being limited to income interests of 20 percent or more in a FIF (or income interests of 10 percent or more in a CFC).