Chapter 6 - Alternative methods for holders of FIF interests

Attribution methods when the active income exemption cannot be applied

6.1 A New Zealand investor with an income interest of 20 percent or more in a foreign company would usually be able to apply the active income exemption. Indeed, as discussed in the previous chapter, one of the reasons for requiring an investor to have a 20 percent or greater interest in a FIF to access the active income exemption would be to ensure that investors eligible for the exemption would generally have the ability to perform the necessary calculations.

6.2 However there will be instances when investors with interests of 20 percent or more in a FIF are unable to benefit from the active income exemption either because they cannot apply the active business test itself, or because having failed the test they are unable to make the calculations necessary to apply the exemption on a transactional basis.

6.3 Situations can arise where it is difficult to access financial information. For example, if a business relationship collapsed the majority shareholder might withhold financial information on the company from the minority New Zealand partner. Similarly, if a joint venture was running into financial problems the New Zealand partner might find it difficult to get accurate financial information on its investment.

6.4 Consequently, it is necessary to provide alternative attribution methods that can be operated with less financial information.

6.5 It is important that the “safety net” of alternative methods made available for investors with insufficient information is not too generous. Otherwise there is a risk that some investors who are capable of performing the calculations necessary for the active income exemption will choose the safety net mechanism if it provides a more favourable tax treatment (for example, if the FIF generates a high proportion of passive income).

6.6 The active income exemption will effectively replace the branch equivalent and accounting profits methods for FIF interests of 20 percent or more. It is suggested that investors who cannot use the active income exemption will be able to use one of four alternative attribution methods:

• comparative value;
• deemed rate of return;
• fair dividend rate; or
• cost.

6.7 It could be argued that the fair dividend rate and cost methods are too broad-brush to apply to non-portfolio interests in FIFs. It is certainly not an ideal method for these sorts of interests. In most cases, a company with a 20 percent or greater interest in a FIF engaged in an active business will want to benefit from the active income exemption, and will have access to the information needed to make any active/passive apportionment required. Only in very exceptional circumstances would a company with a large interest in a FIF generating active income have to use the fair dividend rate or cost methods.

6.8 If this approach is taken, rules will be needed to prevent abuse of the fair dividend rate and cost methods. Otherwise an investor with an interest of over 20 percent in a FIF that had mainly passive income could choose these methods if they provide a more beneficial tax treatment than apportionment of active and passive income. The rules for restricting the choice of method would be modelled on those already in place for FIF interests of less than 10 percent. Those rules require taxpayers to use the comparative value method (or the deemed rate of return method if it is not practical to find out the market value of the investment) for shares that are considered equivalent to debt (such as fixed-rate shares). They also prevent an investor from using the fair dividend rate or cost methods if they use the comparative value method for one of their other investments.

Which FIF attribution methods are most appropriate in these circumstances?