Taxation (International Investment and Remedial Matters) Bill. Commentary on the Bill

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1 Taxation (International Investment and Remedial Matters) Bill Commentary on the Bill Hon Bill English Minister of Finance Hon Peter Dunne Minister of Revenue

2 First published in October 2010 by the Policy Advice Division of Inland Revenue, PO Box 2198, Wellington Taxation (International Investment and Remedial Matters) Bill; Commentary on the Bill. ISBN

3 CONTENTS Changes to FIF rules 1 Overview of proposed amendments 3 Extending the active income exemption to non-portfolio FIFs 4 Rationalising other FIF calculation methods 12 PIEs with non-portfolio interests in CFCs or FIFs 16 Replacing the grey list exemption with an Australian exemption 18 Branch equivalent tax accounts of companies and conduit tax relief accounts 19 Repeal of branch equivalent tax accounts of companies and conduit tax relief accounts 21 Remedial amendments: branch equivalent tax accounts of companies 28 Changes to the thin capitalisation regime 29 Applying the thin capitalisation rules to active FIFs 31 New thin capitalisation test for low-asset companies 32 State-owned banking groups 38 Application to non-residents with no fixed establishment 41 Exemption from the outbound rules 42 Zero rate of AIL on bonds 43 Zero rate of AIL on qualifying bonds 45 Miscellaneous remedial changes 51 Revaluing inherited former grey-list shares 53 Qualifying companies amendment 55 Amendment to non-resident exclusion from conduit anti-avoidance rule 56 Attributed foreign income liability to tax 58 Active business test clarifications and remedial amendments 62 Ability for Commissioner to impose conditions on an insurance CFC determination 65 Foreign dividend exemption deductible dividends 66 Losses of controlled foreign companies transition 68 Foreign tax credits of controlled foreign companies transition 69 Other remedial changes 70

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5 Changes to FIF rules 1

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7 OVERVIEW OF PROPOSED AMENDMENTS The Taxation (International Investment and Remedial Matters) Bill builds on and extends earlier international tax reforms. The main proposal is to extend the active income exemption that currently applies to offshore subsidiaries so that it also applies to joint ventures and other significant shareholdings in foreign companies. This will remove a barrier to offshore expansion by New Zealand businesses. In 2009 an active income exemption was introduced for foreign companies that are controlled by New Zealand investors (controlled foreign companies (CFCs)). This reform was designed to ensure that New Zealand businesses that expand offshore by operating subsidiaries in foreign countries can compete on an even footing with foreign competitors operating in the same country. This means that a New Zealand-owned manufacturing plant in China would generally face the same tax rate as other manufacturers operating in China. An active business test is used to reduce the tax and compliance costs associated with calculating and attributing small amounts of passive income. The test is passed and no income is attributed, if less than 5% of the gross income of the CFC is passive. If the test is failed, then only the passive income (i.e. highly mobile income such as interest, rent or royalties) is attributed to the shareholder. In 2007 some new methods were introduced for calculating income from less than 10% shareholdings in foreign companies (portfolio foreign investor funds (FIFs)). As a consequence, such investors generally calculate income based on an assumed 5% rate of return (fair dividend rate method), although a natural person and trustees of family trusts can choose to be taxed on the actual returns of all of their foreign portfolio investments (although any losses are reduced to zero). The 2007 and 2009 reforms did not apply to interests of between 10% and 50% in companies that are not controlled by New Zealanders (non-portfolio FIFs). Within this tranche some investors take an active role in managing the foreign company or invest in companies that are strategically aligned with their own business (akin to a CFC), while others will enter an investment based mainly on expected dividends and share gains (akin to a portfolio shareholding). The Taxation (International Investment and Remedial Matters) Bill ( the Bill ) aims to provide consistency of tax treatment between similar types of foreign investment. It achieves this by extending the active income exemption and active business test (with some small modifications) to non-portfolio FIFs. It also extends and rationalises the portfolio FIF reforms so that those investors who are unable to use the active income exemption (due to having an insufficient shareholding or access to information) will generally be taxed on an assumed 5% rate of return (fair dividend rate method). The main exception to these rules is for foreign companies that are located in Australia. The Bill replaces the grey list for non-portfolio FIFs with an exemption for nonportfolio FIFs that are resident and subject to tax in Australia. This is consistent with earlier reforms that replaced the eight-country grey list exemptions with an exemption for CFCs that are resident and subject to tax in Australia and with an exemption for ASX-listed companies. 3

8 EXTENDING THE ACTIVE INCOME EXEMPTION TO NON- PORTFOLIO FIFS (Clauses 7(2), 7(3), 8(2), 13, 14, 15(2), 16, 19(2), 25(3), 26(2), 29, 33, 35(2), 35(8), 35(9), 36 to 40, 42, 43, 69 70(3), 70(4), 72, 73, 97, subclauses 126(4), (9), (18), (20), (25), (27) and (30)) Summary of proposed amendments In 2009 an active income exemption was introduced for foreign companies that are controlled by New Zealand investors (CFCs). The Bill extends the active income exemption to interests of between 10% and 50% in companies that are not controlled by New Zealanders (non-portfolio FIFs). Application date The changes apply to income years beginning on or after 1 July Key features Under the existing rules investors in FIFs are able to calculate their income based on how the income would be calculated if the FIF were a branch of a New Zealand company (the branch equivalent method). The branch equivalent method will be replaced by the attributable FIF income method. Investors will only be able to use the attributable FIF income method in respect of FIFs in which they have a 10% or greater interest. Such investors will generally calculate their FIF income as though the FIF were a CFC using the active income exemption, although two modifications are made to make the CFC rules more accommodating to FIF investors. Firstly, the active business test is relaxed to enable FIF investors to use consolidated accounting information to apply the test to chains of FIFs (including FIFs that are in different jurisdictions). Secondly, the exemption that applies to payments of interest, rent and royalties from an active CFC to an associated CFC (e.g. 50% common ownership) is modified so that a similar exemption applies when a FIF holding company controls an active FIF. These modifications are explained in the detailed analysis below. Background New Zealand s international tax rules can impose higher tax or compliance costs on offshore operations than those faced by competing businesses operating in the same country. In many cases a New Zealand business which invests into a foreign country needs to not only comply with the tax rules of that country, but also attribute income (and potentially pay further tax in New Zealand) using New Zealand tax concepts. In contrast, many other countries reduce or eliminate the additional tax or compliance burden created by a second layer of tax by exempting offshore income that is earned by active businesses (e.g. manufacturing, services and sales income). This may create an incentive for New Zealand companies undertaking or considering active business ventures outside New Zealand to relocate their headquarters to countries with more favourable tax rules. 4

9 In 2009 an active income exemption was introduced for foreign companies that are controlled by New Zealand investors (CFCs). The reform was intended to ensure that New Zealand businesses that expand offshore by operating subsidiaries in foreign countries could compete on an even footing with foreign competitors operating in the same country. This means that a New Zealand-owned manufacturing plant in China would generally face the same tax rate as other manufacturers operating in China. CFCs are a key vehicle for expanding New Zealand businesses beyond the domestic market. However, firms expand beyond New Zealand through a variety of structures, and New Zealand companies wanting to expand overseas may have good commercial reasons for not operating through a wholly or majority-owned subsidiary. For this reason the proposed Bill will allow investors with interests of between 10% and 50% in foreign companies that are not controlled by New Zealanders to apply the active income exemption to these FIF interests. Detailed analysis Attributable FIF income method (section EX 50) The branch equivalent method is replaced with an attributable FIF income method. Under this method investors in the FIF generally calculate their FIF income as though the FIF were a CFC using the active income exemption. No income is attributed from FIFs that satisfy the active business test, either independently or as part of a consolidated group of FIFs. Investors that do not satisfy the active business test attribute the portion of attributable income that corresponds with their income interest in the FIF (the investor s income interest is also worked out by applying the CFC rules). The attributable FIF income method differs from the CFC rules in two key respects. Firstly, the active business test is relaxed to enable investors to use consolidated accounting information to apply the test to chains of FIFs (including FIFs that are in different jurisdictions). Secondly, the exemption that applies to payments of interest, rent and royalties from an active CFC to an associated CFC (e.g. 50% common ownership) is modified so that a similar exemption applies when a FIF holding company controls an active FIF. The remainder of this commentary focuses on these differences. A detailed description on how the CFC rules operate can be found in the October/November 2009 Tax Information Bulletin (Part II, Vol. 21, No. 8). Active business test (sections EX 21D, EX 21E and EX 50) An active business test is used to reduce compliance costs in cases where there is a low risk to the tax base. The test is passed and no income is attributed, if less than 5% of the gross income of the foreign company is passive. If the test is failed, then only the passive income (i.e. highly mobile income such as interest, rent or royalties) is attributed to the shareholder. 5

10 Under the CFC rules, New Zealand investors that have more than one majority-owned CFC in a jurisdiction are allowed to use consolidated accounts for all their majorityowned CFCs in that jurisdiction for the purposes of the active business test. The purpose of this measure is to simplify the application of the test when accounting information is available at a consolidated level, such as when a group produces segmental reporting by country. The Bill proposes a similar consolidation rule for investors in non-portfolio FIFs. This should enable more investors to use the active business test as it can be easier to access consolidated accounting information for an entire group of FIFs than to access information for each separate company. The requirements for being able to apply the active business test to a group of foreign companies under the attributable FIF income method are more relaxed than those that apply to a group of CFCs: The CFC rules require the investor to have a more than 50% income interest in each CFC. Under the attributable FIF income method it is the FIF for which that method is used which must have a more than 50% voting interest in the lower-tier foreign companies. Voting interests include interests that are held directly or indirectly. The CFC rules also require all the CFCs to be in the same jurisdiction in order to apply the active business test on a consolidated basis to a group of CFCs. Under the attributable FIF income method the foreign companies can be in different jurisdictions (so long as none of those companies is a CFC). Finally, the CFC rules require the investor to remove amounts corresponding to income interests not held by the investor (i.e. minority interests). The attributable FIF income method omits this requirement so amounts belonging to other investors are included in the calculations. This concession is made purely because of concerns about the practical difficulties for a non-controlling shareholder of identifying amounts attributable to other shareholders. The above modifications to the CFC rules occur through new section EX 50(4B). Requirement to apply FIF calculation methods to lower-tier foreign companies (sections EX 50(6), EX 50(7) and EX 50(7B)) In many cases a New Zealand investor will own shares in a foreign company which itself owns shares in a second foreign company. If the investor chooses to use the attributable FIF income method in respect of the first foreign company, they will generally be required to look-through and to apply a FIF calculation method with respect to their indirect interest in the second foreign company. This is achieved by the formula in sections EX 50(6) and (7) and is consistent with the existing practice under the branch equivalent method. 6

11 Example If the NZ investor chooses to use the attributable FIF income method for FIF 1, it would generally have to apply a FIF calculation method to FIF 2 and FIF 4. If the investor then chooses to apply the attributable FIF income method to FIF 2, it would then generally have to apply a FIF calculation method to FIF 3. NZ investor 20% FIF 1 20% 100% FIF 2 FIF 4 60% FIF 3 If the investor had instead decided to apply a different FIF calculation method (such as the fair dividend rate or cost methods) to FIF 1, then they would not be required to look-through and apply a FIF calculation method to FIFs 2, 3 or 4, as they only have an indirect interest in these FIFs. The Bill proposes several exceptions to the look-through rule in section EX 50(6). The purpose of these exclusions is to enable investors to apply the active business test using consolidated accounting information in situations where they have a direct interest in a FIF that holds shares in other foreign companies. In such cases it may be easier to access consolidated accounting information, than it would be to access separate accounting information for each company. Consider a New Zealand investor with an interest in a FIF that owns a second foreign company. The investor will have no additional FIF income from the second foreign company if: The second foreign company is able to apply and pass the active business test on its own terms, independent from the upper-tier FIF. Note that the New Zealand investor would have to have an indirect interest of 10% or more in the second foreign company for that company to be able to apply the active business test in the first place; or 7

12 The FIF and the second foreign company are able to apply and pass the active business test as part of the same test group. To be part of the same test group the FIF must hold a 50% or greater voting interest in the second foreign company, and the second foreign company must not be a CFC; or The FIF is able to apply and pass the accounting-based active business test in section EX 21E even after some relevant amounts from the second foreign company are included in the added passive item. The relevant amounts will differ depending on the level of shareholding that the FIF has in the second foreign company. If the FIF holds a joint venture interest in the foreign company the amounts which would be recorded in that FIF s accounts under New Zealand Equivalent to International Accounting Standard 31 (NZIAS 31) would need to be included. If the FIF holds 20% or more, but less than 50% of the foreign company, then amounts recorded under the equity method in that FIF s accounts under NZIAS 28 would need to be included. If the FIF holds less than 20% of the foreign company then any dividends and holding gains recorded under NZIAS 39 for that company would need to be included. Note that including such amounts in the added passive item is optional, but the look-through rule will continue to apply to indirect FIF interests that do not qualify for one of the above exclusions. Example Consider the following group structure. NZ investor 30% FIF 1 (UK) 20% 100% FIF 2 (UK) FIF 4 (Germany) 60% FIF 3 (France) If the New Zealand investor chooses to apply the attributable FIF income method to FIF 1 it can apply the active business test using information from the consolidated accounts of FIF 1. Each line item in these accounts will include amounts from FIF 2 and FIF 3. These amounts will be included in the reported passive item for the purposes of the test. 8

13 Amounts from FIF 4 will be included as a separate line item (income from equity in associates) in the consolidated accounts of FIF 1. If the investor chooses to add this line item to the added passive item for applying the active business test to the test group and that test group still passes the active business test with these amounts included then the investor would not apply a FIF calculation method to FIF 4. Now assume that FIF 1 receives $400,000 of interest payments from FIF 2, $240,000 of royalty payments from FIF 3 and $100,000 in dividends from FIF 4. FIF 1 earns $5m of sales income and $200,000 in interest from unrelated entities. FIF 2 earns $2m of sales income, FIF 3 earns $3m of sales income and FIF 1 is entitled to 20% of the $1m earned by FIF 4. Because FIF 2 and FIF 3 are controlled by FIF 1 their earnings appear in full in the consolidated accounts. The intra-group royalty and interest payments are disregarded in the consolidated accounts. Income from FIF 4 comprises $200,000 of income from associates under the equity method (the dividend is not recognised in income and instead reduces the carrying value of the investment). The New Zealand investor chooses to apply the active business test using the consolidated accounts of FIF 1, FIF 2 and FIF 3 and by adding amounts from FIF 4 to the added passive item. Reported passive is $200,000 (third-party interest), added passive is $200,000 (from FIF 4) and total revenue is $10.4m, so the percentage of total passive to total revenue is 3.85%. Because this is less than 5% the New Zealand investor does not attribute any income from FIF 1, FIF 2, FIF 3, or FIF 4. All figures in $000s Consolidated accounts of FIF 1, FIF 2 and FIF 3 FIF 1 FIF 2 FIF 3 FIF 4 Income Sales 10,000 5,000 2,000 3,000 Less cost of goods sold 3,400 1, ,500 Gross profit 6,600 4,000 1,100 1,500 Other income Interest (400 from FIF 2) Royalty (from FIF 3) Income from equity in associates (FIF 4) Operating expenses Interest Royalty payment Net profit before tax 7,000 5, ,260 Active business test Reported Passive 200 Added Passive (from FIF 4) 200 Total Passive 400 Total Revenue 10,400 % Total Passive to Total Revenue 3.85% 1,000 (of which 200 belongs to FIF 1) 9

14 Exemption for intra-group payments (sections EX 50(4B)(a), (b) and (c) and EX 50(4C)) In the event that the active business test is not satisfied for a particular FIF, and the holder of the FIF interest uses the attributed FIF income method to calculate attributed income, the method treats the FIF in many ways as a CFC. However, there are some key differences. Under the existing CFC rules there is an exemption for interest, rent and royalty payments between commonly-controlled CFCs, so long as both CFCs are in the same jurisdiction and the CFC that makes the payment is a non-attributing active CFC (i.e. passes the active business test). The Bill modifies the requirement for foreign companies that are not CFCs, so that a similar exemption applies when the recipient foreign company has more than 50% of the voting interests in the foreign company that makes the payment. For payments between CFCs, the requirement that the CFCs be associated companies is unchanged, but some changes have been made to same jurisdiction test (see commentary on attributed foreign income liability to tax). Payments between FIFs will have to pass a similar same jurisdiction test in order for the exemption to apply. Example Interest, royalty and rent payments from FIF 2 to FIF 1 would normally be attributable income of FIF 1. However because FIF 1 and FIF 2 are in the same jurisdiction (the UK) and FIF 1 holds more than 50% of the voting interests in FIF 2, the payments would be excluded from the definition of attributable income. NZ investor 30% FIF 1 (UK) 100% Interest, royalty or rent payment FIF 2 (UK) 10

15 Amendment to definition of passive Telecommunications income Subsection EX 20B(3)(m)(ii) of the Income Tax Act 2007 deems certain telecommunications services income to be attributable income to the extent to which the equipment is owned by the CFC or by another CFC that is associated with the CFC. This subsection is amended so it also covers situations where a CFC (or a FIF using the attributable FIF income method) is associated with a (second) FIF or CFC. In the absence of this change it would be possible to reduce a foreign company s attributable income by dealing with an associated foreign company that is not a CFC. 11

16 RATIONALISING OTHER FIF CALCULATION METHODS (Clauses 8(2), 15(2), 25(1), 25(2), 26(1), 26(3) to (7), 27, 28, 30, 33, 35(1), 35(3), 35(4), 35(5), 35(6), 36(7), 35(8), 35(10), 36 to 40, 42, 62, subclauses 126(2), (6)and (7), and clause 131) Summary of proposed amendments Investors who are unable to use the active income exemption (due to having a less than 10% shareholding or insufficient access to information) will use the rules that were developed for portfolio FIFs. To achieve this, the fair dividend rate and cost methods will be available to most FIF interests and not just those that are a less than 10% interest. Investors will only be able to choose to use the comparative value method if they are a natural person or a trustee of a family trust. In addition, the accounting profits and branch equivalent methods will be repealed. Investors with non-ordinary shares (i.e. shares that are economically equivalent to debt) will apply the comparative value method in cases where an end of year market value is available and the deemed rate of return method in cases where it is not. Application date The changes apply to income years beginning on or after 1 July Key features Under the existing FIF rules sections EX 46 and EX 62 limit an investor s choice of calculation method and their ability to change from a method they are currently using. The Bill reforms these rules so that the fair dividend rate and cost methods will be available to most FIF interests and not just those that are a less than 10% interest. Investors will only be able to choose to use the comparative value method if they are a natural person or a trustee of a family trust. Non-portfolio investors will generally be able to change to the fair dividend rate or cost method in respect of their first income year beginning on or after 1 July Background In 2007 some new methods were introduced for calculating income from less than 10% shareholdings in foreign companies (portfolio FIFs). As a consequence, such investors calculate income based on an assumed 5% rate of return (fair dividend rate method), although natural persons and trustees of family trusts can choose to be taxed on the actual returns of all of their foreign portfolio investments (although any losses are reduced to zero). 12

17 These new methods were limited to FIF interests of less than 10%. In cases where the investor cannot use the active income exemption, it makes sense to tax foreign investments consistently. Accordingly, it is proposed that all investors who are unable to use the active income exemption for FIFs (due to having a less than 10% shareholding or insufficient access to information) will use the rules that were introduced in 2007 for portfolio FIFs. Detailed analysis Fair dividend rate and cost methods The fair dividend rate and cost methods will no longer be limited to FIF interests of less than 10%. The Bill aims to achieve this by removing subsection EX 46(7)(a) and subsection EX 46(9)(a). If a person does not choose a calculation method (and is not required to use a certain method), they are deemed to have chosen to use the fair dividend rate method, or the cost method if it is not practical to use the fair dividend rate method. This is achieved by changes to the default calculation methods in section EX 48. Proposed repeal of accounting profits method The Bill proposes that the accounting profits method be repealed with application from an investor s first income year beginning on or after 1 July Persons who used the accounting profits method in the year preceding the repeal of this method would be able to change to any other method (see new subsection EX 62(2)(a)), subject to the limits on the choice of method in section EX 46. Comparative value method Investors will only be able to choose the comparative value method if: a) the interest is a non-ordinary share under subsection EX 46(10); or b) if they are a natural person or a trustee of a family trust and do not use the fair dividend rate or cost method for any of their other interests. This simply reflects the existing limitations on choosing the comparative value method under the portfolio FIF rules. The Bill aims to achieve this by removing subsection EX 46(6)(c) (which prevented the above limitations from applying to FIF interests of 10% or more). Where a person chooses to use the comparative value method for one FIF interest they will not be able to use the fair dividend rate method or cost method for their other FIF interests. This result is achieved by existing section EX 46(8)(b). Note that an investor would be required to use the comparative value method if they have a non-ordinary share (share that is equivalent to debt) as defined in section EX 46(10) and it is practical to get an end of year market value for that share. Subsection EX 46(6)(d) already achieves this. 13

18 Investors will only be able to get a loss for an entire portfolio under the comparative value method if they have a non-ordinary share. Other losses for an entire portfolio using the CV method will be treated as zero income. The removal of subsection EX 51(7)(a) achieves this result. Deemed rate of return method Under the proposed rules investors will only use the deemed rate of return method when they have a non-ordinary share and it is not practical to get an end of year market value for that share. This is achieved through the repeal of section EX 46(4) and amendments to section EX 46(5). Now that non-portfolio investors can use the fair dividend rate and cost methods (which apply tax to an assumed 5% return), it is no longer necessary to allow taxpayers to choose to use the deemed rate of return method as this applies tax at a higher than 5% return. Limits on choice of calculation method (section EX 46) The following diagram summarises the main limitations that would apply to an investor s choice of calculation method under the proposed amendments. Note the diagram does not include the rules in section EX 62 which limit an investor s ability to change from a method that they are currently using to a different method. Changes to section EX 62 are described below. Start Interest in a CFC? (section EX 1) Interest is 10% or more and investor is not a PIE? (section EX 14) Use CFC attribution method Use CV method Non-ordinary share? (section EX 46(10)) Know market value? (section EX 47) Use DRR method Interest is 10% or more and investor is not a PIE? (section EX 46(3)) Want attributable FIF income method and have data? Use attributable FIF income method Know market value? (section EX 46(i)(b)) Investor is a natural person or trustee of family trust? (section EX 46(6)) Want FDR? Have chosen CV for other FIF interests? (section EX 46(8)) Use cost method Use CV method Yes No Use FDR method 14

19 Limits on changes of method (section EX 62) In general, once investors start to use a calculation method for a FIF interest they are required to continue using the same calculation method. Section EX 62 supports this approach by providing a set of rules that limit an investor s ability to change from a FIF calculation method that they are currently using to a different FIF calculation method. The Bill proposes several changes to this section to reflect the changes to the available calculation methods. The limits on the choice of method under section EX 46 also apply when changing a method. A proposed amendment to section EX 62(2)(a) would allow investors who used the accounting profits method in the year preceding the repeal of this method to change to any other method (see new subsection EX 62(2)(a)). A proposed amendment to section EX 62(2)(c) would allow investors to switch from the comparative value method when it is impossible to find out the end of year market value of the interest or if they are prevented from using it because they are not a natural person or a trustee of a family trust or using it in respect of a non-ordinary share (i.e. section EX 46(6) prevents them from using it). A new provision is proposed after section EX 62(9) that would allow investors to change to the fair dividend rate method (and by implication also the cost method) from the accounting profits method, the branch equivalent method or deemed rate of return method in respect of their first income year beginning on or after 1 July This reflects the fact that the accounting profits and branch equivalent methods have been repealed and the deemed rate of return method will only be used in the case of nonordinary shares where it is not practical to get an end of year market value for the share. A proposed amendment to section EX 62(6) would allow investors to change from the branch equivalent method to the attributable FIF income method. It would also allow investors to change to or from the attributable FIF income method on one occasion (not counting the initial change from branch equivalent method to attributable FIF income method). An investor will only be able to change to or from the attributable FIF income method a second time if there has been a change in circumstances that significantly changes their ability to obtain enough information to use the attributable FIF income method and if altering their income tax liability is not the principal purpose or effect of the change (section EX 62(7)). This is consistent with the existing restriction on changing to or from the branch equivalent method. 15

20 PIES WITH NON-PORTFOLIO INTERESTS IN CFCS OR FIFS (Clauses 7(1), 9(2), 12, 18, 23 and 26(2)) Summary of proposed amendments Proposed amendments will deem all CFC interests held by a portfolio investment entity (PIE) to not be CFC interests. Note this will not mean that the foreign company would stop being a CFC, it just means the PIE will use the FIF rules as opposed to the CFC rules. A similar amendment will prevent PIEs from using the attributable FIF income method. Application date The changes would apply to income years beginning on or after 1 July Key features Under proposed amendments to sections EX 14 and EX 34 an investor would only have a CFC interest if they have a 10% or more interest in the controlled company and if they are not a PIE. If they are a PIE they will have an ordinary (non-cfc) FIF interest in the company. Proposed amendments to section EX 46 would prevent a PIE from using the attributable FIF income calculation method. A proposed amendment to section CW 9 will prevent all PIEs from accessing the foreign dividend exemption (currently only multi-rate PIEs are excluded from this exemption). Note that PIEs will not actually be taxed on foreign dividends as they will be treated as only having FIF income from their FIFs (see section EX 59(2)). Background The interaction of the PIE rules and the active income exemption rules can lead to individuals who invest through a PIE being treated differently to other individual investors. If PIEs were able to access the active income and foreign dividend exemptions they would be able to pass foreign income through to their members with no New Zealand tax. In contrast, New Zealand tax would be payable in cases where a non-pie company distributed untaxed foreign income. Under the existing rules, PIEs can hold a 10-20% interest in a CFC (that is not a foreign PIE equivalent). In such cases they are required to apply the active income exemption to such interests. However, if the investors in the PIE held their share of the CFC directly, they would usually be required to use a FIF calculation method (as an interest of less than 10% in a CFC is not a CFC interest). 16

21 PIEs that have a 10% or greater interest in a CFC or FIF should not be considered to have a CFC interest, should not be able to use the attributable FIF income method to access the active income exemption, and should not be able to use the dividend exemption in section CW 9. 17

22 REPLACING THE GREY LIST EXEMPTION WITH AN AUSTRALIAN EXEMPTION (Clauses 5, 8(1), 9(1), 15(1), 19(1), 24, 31, 32 and 34) Summary of proposed amendments The exemption for rights of 10% or more in FIFs that are resident in one of eight grey list countries is replaced with an exemption for rights of 10% or more in FIFs that are resident and subject to tax in Australia and that do not receive certain Australian tax concessions. Application date The proposed changes would apply to income years beginning on or after 1 July Key features Under the changes proposed in the Bill, the section EX 35 exemption will require an investor to have a direct income interest of 10% or more in a FIF that is resident and subject to tax in Australia. The FIF must not have had its liability for Australian tax reduced by an exemption related to income earned outside of Australia or from the concession for offshore banking units. The new provision is designed to accommodate cases where the FIF is not technically subject to tax in Australia because it is taxed as part of an Australian consolidated group in such a way that the head company pays tax on behalf of the FIF. The exemption in section EX 35 does not apply to investments held by portfolio investment entities, superannuation schemes, unit trusts, life insurers or group investment funds. This is consistent with the exclusions from the existing grey list exemption. Background As part of last year s CFC reforms the exemption for CFCs located in eight grey list countries was replaced with an exemption for CFCs that are resident and subject to tax in Australia. (Section EX 22) Consistent with this change, the Bill replaces the remaining grey list exemption for FIFs with an exemption for FIFs that are resident and subject to tax in Australia. 18

23 Branch equivalent tax accounts of companies and conduit tax relief accounts 19

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25 REPEAL OF BRANCH EQUIVALENT TAX ACCOUNTS OF COMPANIES AND CONDUIT TAX RELIEF ACCOUNTS (Clauses 4, 6, 10, 11, 52, 59 to 61, 63, 65, 67, 68, 75 to 96, 98, 100 to 102, 104 to 111, 113 to 115, 117 to 125, subclauses 126(5), (8), (10), (12) to (15), (17), (19), (22), (23), (26), (28) and (31) to (33), and clauses 127, 128, 130, 133 to 135 and 137 to 139) Summary of proposed amendment The Taxation (International Taxation, Life Insurance, and Remedial Matters) Act 2009 made major changes to the tax treatment of foreign investments. Those changes made branch equivalent tax accounts of companies (BETAs) and conduit tax relief accounts (CTRAs) obsolete. However, the government at the time announced that these memorandum accounts would be retained for a transitional period of two years, to allow the use of remaining BETA debits (to prevent double-taxation of foreign income) and the distribution of conduit-relieved income (to prevent the dilution of foreign dividend payment credits). This Bill proposes provisions to remove the BETAs and CTRAs at the end of the relevant period, and to repeal associated provisions and references. Application date The proposed repeal of BETAs and related provisions applies, for most provisions, from the beginning of the fourth income year the taxpayer is under the new international tax rules (that is, the first income year beginning on or after 1 July 2012). A restriction on elections to use BETA debit balances, limiting the use to relieving tax on attributed foreign income that is allocated to the second year under the international tax rules or to an earlier year, would apply from the first income year beginning on or after 1 July The proposed repeal of CTRAs and related provisions would apply from the beginning of the first income year beginning on or after 1 July Key features BETAs will be repealed after three years under the new international tax rules passed in 2009, but debit balances will be able to be used to relieve tax on attributed foreign income only where that income is allocated to the second year under the new rules or to an earlier year. BETAs remain for the third year only to allow determination of income and filing of returns for the second year. CTRAs will be repealed after two years under the new international tax rules. Dividends not paid before that date will not be able to have conduit tax credits attached to them. 21

26 Detailed analysis All references in this part of the Commentary are to the Income Tax Act 2007, unless noted. Branch equivalent tax accounts (BETAs) of companies Branch equivalent tax accounts of companies are being phased out. Branch equivalent tax accounts of individuals (non-companies) are unaffected. Paragraph FM 6(3)(d) Proposed repeal of this paragraph along with BETA accounts of companies. Dividends between companies in a consolidated group are normally ignored, but are still taken into account for the purposes of the rules relating to BETAs. Once BETAs of companies cease to exist, this paragraph will become redundant. Section GB 40 Proposed repeal of this section. Arrangements to avoid continuity restrictions on BETA account balances will cease to be relevant when BETA account balances are repealed. Arrangements affecting balances prior to repeal will still be caught, since the section applied at the time. Paragraphs OA 2(1)(d), 5(5)(a), 5(5)(c), 6(5)(a), 6(5)(c), sub-paragraphs OA 7(2)(d)(i) and (ii), paragraphs OA 8(6)(c) and (g) Proposed repeal or alteration of these provisions. With the repeal of BETAs of companies from the first income year beginning on or after 1 July 2012, no further credits or debits will arise in the accounts and there will not be any balances in the accounts. No further BETA debits will be used by companies to meet tax liabilities. Section OA 9, paragraphs OA 10(1)(d) and 10(3)(c), subsection OA 14(6), and paragraphs OA 15(1)(c) and 15(3)(c) Proposed repeal or alteration of these provisions. If an amalgamating company has a BETA, BETA debits and credits have to be transferred across to the BETA of the amalgamated company. The requirement to transfer the credits will no longer be necessary if either the amalgamating or amalgamated company has no BETA account. Paragraph OB 4(3)(h) Proposed repeal of this provision. From the beginning of the first income year beginning on or after 1 July 2012, a company will not be able to make an election to use a BETA debit balance to meet an income tax liability. In addition, even if it makes an election prior to that date, it will not be able to make the election in respect of a tax liability for income relating to an income year beginning on or after 1 July Paragraph (h) will therefore be redundant. 22

27 Subsections OE 7(3) and OP 101(2) When the repeal of BETAs of companies was announced, the government said that there would be a two-year transitional period during which existing debit balances could continue to be used. That is, companies will still be able to reduce their tax liability for attributed foreign income earned in the first two income years following application of the new income tax rules. Because the amount of income for the second year will not be known immediately, it will be impractical to make elections to use BETA debit balances before the end of the second year. For that reason, BETAs will remain for a third year. New requirements have been introduced in sections OE 7 and OP 101 to prevent elections to use BETA debits unless: the election is made before the end of the third income year; and the election relates to a tax liability for attributed foreign income that has been allocated to the second year or to an earlier year. These requirements apply retrospectively from the date of application of the new international tax rules. Subsections OE 1(1) and (3), sections OE 2 to OE 4, OE 6 to OB 16B, OP 97 to OP 98, OP 100 to OP 104B and OP 108B It is proposed to repeal these provisions, which impose requirements on BETA companies to keep BETAs and make appropriate entries in them, with effect from the first income year beginning on or after July The BETA regime for companies and requirements to keep such accounts will be no longer required from that date. Accounts must still be kept for the final year of the BETAs, even if only a part tax year because of the repeal (BETAs always have a 31 March balance date, which may not correspond to the end of an income year). Relevant information must also be provided in an imputation credit account (ICA) return for the final year, and records must continue to be kept for the normal record-keeping period (see commentary on changes to the Tax Administration Act 1994, below). Subsection OE 5 This provision is modified to apply only to BETA accounts of individuals, following the repeal of the rules for companies. Section OZ 16 It is proposed to repeal this provision at the same time as BETAs of companies. This was a transitional provision to reduce remaining balances in BETAs following changes to the corporate tax rate in Budget

28 Sub-paragraph YC 17(12)(b)(iii) and subsection YC 18B(3) It is proposed to repeal or modify these provisions to remove redundant references to BETAs. Paragraph 22(2)(f) and subsection 22(7) of the Tax Administration Act 1994 References to BETA accounts will be redundant from the time those accounts are repealed, so are being removed. Records for periods when BETA accounts were in existence are still required to be kept that requirement arose before repeal. Paragraph 69(1)(e) of the Tax Administration Act 1994 It is proposed to repeal this paragraph. BETA information of companies will no longer have to be included in the annual ICA return under this section, once returns have been completed for the tax years up and including the year during which BETAs were repealed. It is possible that the BETA will not exist for the entire tax year in the year BETAs are repealed. Nevertheless, under the existing provision, it is still required to include relevant BETA information in the ICA return (the person was a BETA company during the tax year). Section 77 of the Tax Administration Act 1994 It is proposed to repeal this provision. The provision previously required an amended annual ICA return if a retrospective election to be a BETA company was made, to ensure a complete record of BETA transactions would be returned. It will not be possible to make elections to become a BETA company from the beginning of the income year beginning on or after 1 July 2012, retrospective or not. Since an ICA return must already (under paragraph 69) be provided for any tax year falling wholly or partly within the last income year for which a BETA exists, section 77 is now redundant. Conduit tax relief accounts Sections CW 11 and HA 17 It is proposed to repeal section CW 11. Dividends that are fully credited for conduit tax relief will no longer be exempt income of conduit tax relief holding companies if they are paid later than the beginning of the first income year of the recipient beginning on or after 1 July There are a number of consequential amendments to remove references to section CW 11 in other provisions. Section FE 21(12)(a)(iii) It is proposed to repeal this section. It will neither be possible for companies to attach conduit tax relief credits to dividends, nor to be conduit tax relief holding companies, from income years beginning on or after 1 July This makes section FE(12)(a)(iii) redundant from the beginning of that income year. 24

29 Section GZ 2 It is proposed to repeal section GZ 2 of the Income Tax Act 2007, which is an antiavoidance rule, on the same date as CTRAs. After the repeal of CTRAs, this section becomes redundant and its removal from the Act therefore aids clarity. The rule in section GZ 2 was enacted to prevent people running up CTRA credit balances in anticipation of them being cancelled under the new international tax rules, and then effectively directing tax-relieved income to residents. The rules apply to an arrangement involving transactions that occurred between the date on which repeal of conduit accounts was announced and the enactment of the international tax rules, after which further conduit tax relief was prevented. The anti-avoidance rule will still apply to such arrangements even after repeal of section GZ 2. The rule still applies because the arrangement was entered into before the repeal and the rule would have applied at that time, triggering the imposition of additional income tax. Section HG 2(4)(c) It is proposed to repeal this section. This provision states that partnerships are not subject to the no streaming rules in subsection HG 2(2) in respect of CTR additional dividends. However, there will be no such dividends paid in any income year beginning on or after 1 July Section LQ 5 It is proposed to repeal this section. Since conduit tax credits will no longer be attached to dividends by a company in any income year beginning on or after 1 July 2011, CTR additional dividends will not be payable by the company from that time either. Paragraph OA 2(1)(c), subsections 5(4) and 6(4), paragraph OA 7(2)(c), and subsections OA 8(5) and 18(1) It is proposed to repeal these paragraphs and subsections. With the repeal of CTRAs from the first income year beginning on or after 1 July 2011, no further credits or debits will arise in the accounts and there will not be any balances in the accounts. No further CTR credits will be attached to dividends. Paragraphs OA 10(1)(c), 10(3)(b), subsection OA 10(4) and paragraphs OA 15(3)(b), OB 24(3)(c) and OB 53(3)(c) It is proposed to repeal or alter these paragraphs. At one time, if an amalgamating company had a CTRA but the amalgamated company did not, CTR credits were to be converted to imputation credits and FDP was to be paid. The requirement to transfer the credits ceased when the new international tax rules came into force. 25

30 Sections OC 19 and OP 70 These sections are being repealed at the same time as CTRAs cease. They allow for a transfer from a CTRA to a foreign dividend payment memorandum account in certain circumstances. With no CTRA, such transfers will no longer be possible. Subpart OD and sections OP 78 to 80, OP 83 to 87, OP 89 to 94 and OP 96 The subpart and sections, which impose requirements on CTR companies to keep CTRAs and make appropriate entries in them, are being repealed with effect from first income year beginning on or after July From that time, there will be no CTRAs to meet requirements for. Accounts must still be kept for the final year of the CTRAs, even if only a part tax year because of the repeal (CTRAs always have a 31 March balance date, which may not correspond to the end of an income year). Relevant information must also be provided in an ICA return for the final year, and records must continue to be kept for the normal record-keeping period (see commentary on changes to the Tax Administration Act 1994, below). Section OZ 17 It is proposed to repeal this provision at the same time as CTRAs. This was a transitional provision to reduce remaining credit balances in CTRAs following changes to the corporate tax rate in Budget Paragraphs RF 8(1)(c) and (f), subsections RF (9)(1), 9(6) and (7), paragraph RF 10(3)(a), subsection RF 10(4), paragraph RF 10(5)(e) and subsection RF 10(7) It is proposed to repeal these paragraphs at the same time as CTRAs, since it will no longer be possible to attach CTR credits to dividends or to pay a CTR additional dividend. Sections YD 9 to YD 11 It is proposed to repeal these sections at the same time as CTRAs. A CTRA holding company must be a CTR company, so these provisions will become redundant once CTRAs are repealed. Paragraph 22(2)(k) and sections 29, 30A and 68A of the Tax Administration Act 1994 References to CTR accounts or to CTR credits will be redundant from the time those accounts are repealed and CTR credits can no longer be attached to dividends, so it is proposed to remove these references. 26

31 Paragraph 69(1)(f) of the Tax Administration Act 1994 It is proposed to repeal this paragraph. CTRA information will no longer have to be included in the annual ICA return under this section, once returns have been completed for the tax years up and including the year during which CTRAs were repealed. It is possible that the CTRA will not exist for the entire tax year in the year CTRAs are repealed. Nevertheless, under the existing provision, it is still required to include relevant CTRA information in the ICA return (the person was a CTR company during the tax year). 27

32 REMEDIAL AMENDMENTS: BRANCH EQUIVALENT TAX ACCOUNTS OF COMPANIES (Clauses 99, 103, 112 and 116) Summary of proposed amendment Minor changes to the Income Tax Act 2007 are included in this Bill to ensure that branch equivalent tax accounts (BETAs) cannot go into credit. Application date Income years beginning on or after 1 July Key features Following the changes in the Taxation (International Taxation, Life Insurance, and Remedial Matters) Act 2009, all credit balances in branch equivalent tax accounts of companies (BETAs) were cancelled. However, debit balances remained for a transitional period of two years. As these debit balances are used, credits are put into the account to cancel them out. Minor changes to the rules are included in this Bill to ensure that BETAs cannot go back into an overall credit balance as a result of these credits. Credits arising under sections OE 6, OE 9, OP 100 and OP 103 are now limited to the amount of an overall debit balance in the account at the time. 28