TOPIC 10 TAXATION OF DIFFERENT BUSINESS STRUCTURES & ENTITIES COMPANY TAXATION LEARNING OBJECTIVES After studying the material for this week you should be able to: Define what a company is for tax purposes and the broad taxation principles applicable to the treatment of net income and losses; Outline the main principles of the qualifying company regime; Describe the meaning of dividends as defined for income tax purposes; Differentiate between the classical system of company taxation and the dividend imputation system, and the reasons why many countries, including New Zealand, have adopted the dividend imputation system; Discuss the NZ Imputation regime summary of principal features. Demonstrate an ability to research and cross reference applicable sections of NZT. Page 1 of Topic 10
Supplementary Readings 1. Supplementary Readings in this Study Guide: (a) Cnossen, S. (1984). Alternative Forms of Corporation Tax. Australian Tax Forum, 1(3) September, pp.253-279. Page: 18 (b) Vann, R. (1986). Eliminating the Double Tax on Dividends - Legal and Practical Issues. Wellington: Victoria University Press. Chaps. 1, 2 and 5. 48 Additional Readings 2. Additional Reading References: Alley, C., Chan, C., et al. (2009). New Zealand Taxation [Chaps 2 (part), 11 (part) and 14]. Wellington: Thomson Brookers. Streaming and Refundability of Imputation Credits A Government Tax Policy Discussion Document. Chapter 4 Rethinking the refund rules pp27-33. Downloadable from: http://www.taxpolicy.ird.govt.nz/publications/files/imputationdd.pdf Page 2 of Topic 10
Topic Ten Outline 1. Introduction. 2. Company Defined. 3. Residency. 4. Income and Expenditure. 5. Special Features. 6. Close Company. 7. Qualifying Companies. 8. The New Zealand Dividend Imputation System. Page 3 of Topic 10
Explanatory Notes Refer to NZT Chap. 14 1. Introduction Refer to NZT 14.1 This week focuses on company taxation. It is a challenging area, but one which draws on and extends many of the principles you have learned to date. The dividend imputation system is a key feature of the company tax regime and, as well as being an interesting policy development, is one which is growing in importance in the Asia-Pacific region. There is not a separate company tax as such - companies, like individuals, are subject to tax on their taxable income under the Income Tax Act. Some sections of the Act (be it 2004 or 2007), however, relate specifically to companies, or have specific implications for companies. So before we actually start considering the income tax law as it relates to companies, we must first clarify what the tax law means by the term company. 2. Company Defined The definition of a company for tax purposes differs to the definition under commercial law. The tax law specifically states in section YA 1 (2007 ITA) that a company is any body corporate which has a legal personality or existence distinct from those of its members. A unit trust, local/public authorities, and Maori authorities are specifically included. 3. Residency Refer to NZT 2.3.4 Like individuals, a company may be a resident or a non-resident of New Zealand. If a company does not fall within the resident company definition then it is obviously a non-resident. The Act has different implications for resident and non-resident companies. Most notably, the difference lies in the determination of the income of the company which is taxable in New Zealand: Resident companies are liable to tax on their world-wide income; Non-residents are liable to tax only on their income derived in New Zealand. Page 4 of Topic 10
4. Income and Expenditure Refer to Topic 4 (Income) 6.3 and Topic 6 (Deductions) 1.2.2. The principles relating to company income and expenditure are broadly the same as those applying to individuals. With respect to income, sections BD 1-4 include in assessable income: All receipts or gains derived from any business [ Sec CB 1 and 2, ITA 2007]; and All receipts or gains derived from the sale or other disposition of any personal property or any interest in personal property (not being property or any interest in property which consists of land), if the business of the taxpayer comprises dealing in such property, or if the property was acquired for the purpose of selling or otherwise disposing of it, and all profits or gains derived from the carrying on or carrying out of any undertaking or scheme entered into or devised for the purpose of making a profit [Sec CB 3-5 of ITA 2007]. Income received by a company, in the form of dividends, from another company is taxable. An exemption still applies to inter-company dividends within a 100 per cent common ownership (Sec CW 10 and refer to NZT 6.2.4 and 14.3.23). With respect to expenditure, Sec DA 1 allows the deduction of any expenditure or loss to the extent that it is: (i) (ii) Incurred in gaining or producing the assessable income - Sec DA 1(1)(b); or Is necessarily incurred in carrying on a business for the purpose of gaining or producing the assessable income - Sec DA 1 (1)(b). 5. Special Features Refer to NZT 14.2 & 14.3, 11.3 and 11.5 5.1 General treatment of Company Losses 5.1.1 Carrying Forward of Company Losses [Part I (Subpart IA)] When deductible expenses exceed assessable income a taxable loss is incurred (Sec BC 4). Losses incurred by a company in any particular year can be carried forward and offset against the profits derived in a later year - subject to the commonality of shareholding rules being met. Page 5 of Topic 10
This may mean that no tax is payable despite a company having a successful year. If losses are big enough, there may be no tax to pay for several years. These losses therefore have a value. In order to carry forward a company loss, a continuity percentage is required throughout the period from the time the loss is incurred to the time it is offset, based on ultimate shareholders voting interest. The make-up of a person s voting interest in a company. In certain circumstances where the voting interests do not reflect the true economic interests held in the company the shareholder s economic interests will also be determined by the market value of interests in the company [NZT 11.6.4]. The continuity percentage is set at a minimum of 49% of the relevant interests [Sec IA 5(2) and refer to NZT 11.5.4]. When calculating voting interests held in a company it is required [SecYC 7-19] to look through all interposed corporate shareholders to ascertain the ultimate owners of the company [NZT 11.6.1-2]. When tracing the ultimate shareholders, [s YC 10] treats all persons (except associated companies) having a less than 10% direct interest in a company as notional single person. The effect of this aggregation is that share transfers between less than 10% direct holders have no effect on continuity. For dividend imputation purposes the shareholder continuity must be 66 per cent [Refer to point 8.5(a) on page 14 below and NZT 14.4.7]. Refer to NZT 11.6.2 Example 11.10 p 437 Note: Watch for anti-avoidance provision in Subpart YC Application of Minimum Voting/Market Value Interest Rule. Refer to NZT 11.5.1, Example 11.2 p 431 Where there has been a breach of shareholder continuity part way through a company s current income year, a loss incurred by the company which is attributable to the part period of the income year after the change in shareholding may be carried forward by the company. This relief only applies to the relevant current part year loss period and does not extend to later periods (i.e. subsequent carry forward years). Page 6 of Topic 10
Adequate accounts must be furnished to the Commissioner showing the amount of loss reasonably and fairly attributable to that part year. Refer to NZT 11.5.2, Example 11.3 p 432 Where shareholder continuity is breached during an income year, previous year losses can be carried forward to that income year and set off against any current part year profit that is attributable to the period before the change in shareholding. 5.1.2 Grouping of Companies [s IC 3] Refer to NZT 11.5.3 Companies with substantially the same shareholders can be treated as a group of companies for tax purposes. This grouping permits the transferring of losses between companies within the group - thus reducing tax payable by the group as a whole, in the year the loss was incurred. Section IC 1 provides the legislative machinery whereby companies within a group can offset losses amongst themselves. 5.2 Group Consolidation: Refer to NZT 14.7.1 This applies to wholly owned groups of companies and has been in place since 1/4/93. In essence, consolidation treats a group of eligible companies owned by the same shareholders as one economic entity. Eligible companies are companies that are taxed under consistent rules for any particular activity, i.e. companies, which pursuant to Sec FM 8 are: - resident in New Zealand; - not treated as non-resident under a Double Taxation Treaty Agreement; - not exempt from income tax; - not a loss attributing qualifying company under the qualifying company regime. Unlike grouping of companies in the situations mentioned in previous Page 7 of Topic 10
paragraph, a consolidated group files one tax return, receives one tax assessment, and consequently has one tax liability for any income year. The group will file the tax return under an IRD number that is separate from the individual company s IRD number. The group members are not required to file separate returns unless these are needed due to part year consolidations. For this course, students are required to be aware of this new regime and not the mechanics of it. 5.3 Definition of Dividends Refer to NZT 14.3 5.3.1 In general, dividends are distributions made by a company from tax-paid profits. Unlike capital distributions (made by companies) dividends are taxable in the hands of shareholders [Sec CD 1]. The characteristics relating to the transfer of value are explained in NZT 14.3.2. Dividends include [Sec CD 3-21]: (a) All sums distributed in any manner (cash or otherwise) and under any name among all or any of the shareholders of the company including: o Excess remuneration paid to a relative of a shareholder or director of a company other than a close company; and o Any amount paid or credited by a close company as remuneration for services rendered to a director or shareholder of the company (or a relative of such director or shareholder) in excess of the sum which in the opinion of the Commissioner is reasonable [NZT 14.3.7 & 14.3.8]. (b) Forgiveness of debt [NZT 14.3.4]; (c) Property acquired from shareholder for consideration greater than market value; and property made available to shareholder for consideration less than value of benefit enjoyed [NZT 14.3.3]; (d) Taxable or bonus issue in lieu [NZT 14.3.5]; (e) Income of a unit trust distributed to a unit holder [NZT 14.3.6]; Page 8 of Topic 10
(f) Income of investment fund distributed to investor [NZT 14.3.19]. 5.3.2 When are Dividends Derived? Under Sec BD 3(3), dividends are deemed to be derived (and are therefore assessable as income) if for a person they have been: (a) (b) Credited in their account, or In some other way, dealt with in their interest or on their behalf. 6. A Close company Refer to NZT 14.1. A close company is defined in section YA 1 as being one where there are five or fewer ultimate natural persons (with associated persons being counted as one) who hold a total of: More than 50 per cent of the voting interests; or More than 50 per cent of the market value of the company. If a company is not a close (closely-held) company, then it is a widely-held company (previously referred to as a public company). The relevance of close corporations lies in the extent to which certain deductions are permitted. In particular this relates to the deductibility of employee remuneration and donations. While salaries paid to employees would generally be deductible, in the case of a close company the Commissioner has the power to limit the deduction to a reasonable limit where the remuneration is paid to a shareholder or a director, or to a relative of a shareholder or director. Close corporations are not entitled to a deduction for any donations made to charitable organisations. This is in contrast to widely-held corporations who can claim such deductions, within stated limits. Page 9 of Topic 10
7. Qualifying companies Refer to NZT 14.5 A closely-held company can elect to become a qualifying company, but it does not have to do so. The qualifying companies regime was introduced from the 1992-93 income year with the purpose of treating small companies in the same way as partnerships for the purposes of taxation. A company may become a qualifying company if it meets the following conditions: It is not a unit trust. It is not a foreign company. It has five or fewer shareholders. Each shareholder is: - a natural person - another qualifying company; or - a trustee of a trust where all dividend income and all taxable bonus issues are distributed to beneficiaries. The company does not derive foreign non-dividend income of greater than $10,000. All directors and shareholders must elect that the company becomes a qualifying company. Shareholders must also elect to become personally liable for their share of any income tax not met by the company. The principal advantage of becoming a qualifying company is that it can pay tax exempt dividends. The company pays tax in the same way as any other company, and distributes dividends accordingly with imputation credits attached. Dividends with imputation credits attached are taxable to the shareholder. However, the company can distribute additional dividends without imputation credits attached and these dividends are non-taxable. Thus, a qualifying company can distribute tax free capital gains to its shareholders. The main disadvantage is that shareholders become personally liable for their share of tax not paid by the company (their liability in respect of the IRD is no longer limited). Page 10 of Topic 10
Loss attributing qualifying company (LAQC) Refer to NZT 14.6. Where all shareholders and directors elect to do so, a qualifying company may become a loss attributing qualifying company (or LAQC). This enables the company to pass through (attribute) losses to its shareholders which they are able to deduct against their own income or carry forward. 8. The NZ Dividend Imputation System Refer to NZT 14.4 8.1 Overview: NZT 14.4.1 Prior to 1989 New Zealand had a classical company tax system. From 1989 onwards, a dividend imputation system has been in place. The purpose of dividend imputation is to integrate the company and personal tax systems. New Zealand is not alone in adopting integration - many countries in the Asia-Pacific region have adopted similar schemes. In this section, we need to consider why New Zealand adopted integration, how the integration system actually works, and what its impact is on both resident and non-resident shareholders. 8.2 Classical and integrated tax systems Refer to Supplementary Reading, pp. 18 33. In a legal sense, a company and the shareholders who own it are separate and distinct entities. The classical company tax system adheres to this separation of company and shareholders; integrated tax systems break down this legal separation. Classical system Under a classical system of company taxation, tax is paid at the company level (on profits), and then again at the shareholder level when the company pays out its profits as dividends. Refer to NZT 14.4.1, example 14.6 p 615 The problem with this system is that it violates the principles of equity and efficiency. Often, it is said that there is a problem because the same income is double-taxed. This is not the problem. It doesn t matter how many times the same income is taxed - what matters is the overall rate of tax applied to the income. Page 11 of Topic 10
Equity violation - in terms of equity, the classical system has a number of problems. Primarily, the problem lies in the fact that the level of taxation an individual bears depends on the extent to which profits are paid out as dividends. This means that income earners who have marginal tax rates above the company tax rate can benefit from profits being retained by the company (ie. their profits bear only the company tax rate). However, low income earners with marginal tax rates below the company rate still suffer since the higher company tax rate is applied. Basically, the system is able to be used by high income earners to reduce their effective tax rates, but low income earners cannot. Efficiency violation - in terms of efficiency (or neutrality) issues, there are several problems. These include: The classical system favours the use of debt rather than equity. This is because debt financing results in tax-deductible interest payments but equity results in dividend payments which are subject to a further layer of tax. The classical system biases against the use of companies for the conduct of business. Other structures such as trusts can be used to minimise tax. There is a strong disincentive for shareholders on marginal tax rates lower than the company tax rate to invest in shares. There is an incentive to retain profits (reinvest them in the business) rather than pay them out. From an efficiency point of view, the better outcome is for investment to go to the area of highest return. Despite its problems, the classical system remains in use in a number of countries, including the United States, China, Malaysia, the Philippines and Taiwan. Integration of the personal income and company tax systems According to the Collins Concise dictionary, to integrate is to make or be made into a whole. This is precisely what we mean when we talk about integrating the company and personal tax regimes. The theoretically ideal system would involve assigning (or attributing) a company s income to each of its individual shareholders and then taxing the individual shareholders on their total income. This would apply even if the company did not actually pay out the income to shareholders. However, this ideal system is not feasible and in practice some modified system must be used. Page 12 of Topic 10
Dividend imputation Dividend imputation is one form of partial integration of the individual and company tax systems. It operates by imputing to the shareholder the tax which is actually paid by the company. When a dividend is paid, the shareholder may also receive an imputation credit which can then be used to offset the shareholder s liability to personal income tax. For example: Company level Taxable income 100 Co. tax 30 After tax income 70 Shareholder level Dividends received 70 Imputation credits 30 Grossed-up dividend 100 Tax payable (assume 33%) 30 less imputation credit 30 Final tax payable 0 Note that if the shareholder s marginal tax rate was less than 30%, then the surplus imputation credit could be offset against any income the taxpayer receives (eg. income from employment). The credit is not cash refundable so if the shareholder has no other income, surplus credits can be converted to a loss (based on the extra emolument rate of tax) and carried forward. Imputation systems have become popular in the Asia-Pacific region. In addition to New Zealand, other countries in the region with imputation systems include Australia, Singapore and Canada. 8.3 Non-resident shareholders Refer to NZT 14.4.10 Non-resident shareholders cannot make use of the imputation system in the same way as residents. Foreign governments will not recognise the underlying company tax paid to the New Zealand government when assessing individuals for personal tax liability on dividends received. However, foreign shareholders do get some limited benefits from the imputation system by virtue of the foreign investor tax credit regime Page 13 of Topic 10
(FITC). Under this regime, a credit is given (which is determined by reference to the level of imputation of the dividend) which offsets against the non-resident withholding tax (NRWT) applicable on dividends paid to foreigners. Basically, on a fully imputed dividend, the NRWT is eliminated. [Optional: See NZT 17.11.2, Example 17.17 p 786]. Although this benefit of imputation is less than that which applies to resident shareholders, it is at least some return to the non-resident. 8.4 Tax incentives and imputation Earlier in this paper we considered the issue of tax incentives. Dividend imputation has particular implications for tax incentives. Tax incentives reduce the amount of tax a company must pay. However, if the company pays less tax, it will not be able to provide as high a level of imputation credits. This means that the shareholders will receive less imputation credits and thus have to pay more tax themselves. So, although the amount of tax paid by the company has declined, the amount paid by the individual has risen. In reality, there are still some benefits of tax preferences. These benefits arise because of the timing effect (the company pays less tax now but the individual will not have to pay the higher tax until later); because not all company profits are paid out as dividends; and because foreign shareholders cannot benefit from the imputation system. 8.5 Some technical aspects of imputation Refer to NZT 14.4.7 17 (a) New Zealand resident companies must maintain an imputation credit account (ICA) for each imputation year (which is always 1 April to 31 March) [NZT 14.4.3]. The account is credited for: New Zealand income tax paid by the company during the imputation year; Any imputation credits on dividends the company receives from other companies during the year; Any resident withholding tax deduction a company makes during the year. The account is debited for: Page 14 of Topic 10
Any imputation credits attached to dividends paid during the year. Any credits in the account must be extinguished where shareholder continuity requirements cannot be met. That is, after a credit arises there must continue to be a group of shareholders whose total voting interest in the company is equal to or greater than 66 per cent, or whose minimum market value interest in the company 66 per cent [NZT 14.4.7]. (b) (c) (d) (e) A company is not required to pay any imputation credits on dividends it pays. Where it chooses to do so, a maximum limit of 30 per cent applies. The ratio of imputation credit to dividend paid cannot exceed 30:70 [NZT 14.4.8]. A company that does not fully impute a dividend must pay RWT on the dividend [NZT 14.4.9]. The dividend and the imputation credit becomes the gross dividend to the shareholder [NZT 14.4.10]. Every dividend paid during the year must have the same ratio of imputation credits attached. The first dividend that a company pays during the year is called the benchmark dividend - it establishes the imputation ratio for the year. A change to this ratio can only be made where a company completes a statutory declaration that the change is not being made to gain a tax advantage [NZT 14.4.8]. If a company s ICA is in debit at the end of the year (ie. the company has paid out imputation credits above the level of company tax it has actually paid), then the company must pay further tax to clear the debit. It will also have to pay an imputation penalty tax of 10 per cent, and this amount cannot be credited to the ICA [NZT 14.4.15]. Every company which operates an imputation credit account must file an annual imputation return. This return shows movements within the imputation credit account over the year, and the opening and closing balance. [NZT 14.4.12]. 8.6 Anti-avoidance issues There are three particular areas to note with regard to anti-avoidance. These are: (a) (b) The requirement for common share ownership (discussed earlier); The stapled stock arrangements [section GB 23, LE 1]; and Page 15 of Topic 10
(c) Arrangements to obtain a tax advantage (Sec GB 35-38 and LE 1). Stapled stock arrangements involve the payment of a dividend to shareholders of a company by a subsidiary of that company. This would enable imputation credits to be streamed to shareholders who are able to utilise them rather than going to all shareholders generally. Section GB 37 circumvents such behaviour by deeming the dividend to have been paid by the company (rather than the subsidiary) and ensuring that imputation credits are not able to be utilised. Arrangements to obtain a tax advantage are specifically denied under section GB35. Page 16 of Topic 10
Work Preparation Read and study the material required for this week. Review the following questions. 1. How does the definition of a company differ between company and tax laws? 2. Discuss: (a) What is full integration? What are the costs and benefits of achieving full integration? (b) To what extent does the NZ imputation system achieve in eliminating double taxation of income from companies? 3. Discuss the way the imputation system treats foreign shareholders. Are there any problems with this treatment? Do you think this treatment can be sustained over the long term - why /why not? 4. What is a dividend? What are the dividend implications of the following? (a) (b) (c) (d) A company sells to a shareholder a car (market value of $18,000) for $9,000. A shareholder sells a small property to the company at its market value of $75,000. A shareholder is unable to repay a loan of $40,000 to the company. The company forgives the loan. A year later the shareholder receives a large windfall gain and repays the loan. A company hires out luxury cruising boats for $15,000 per week. This week the company hires the boat to a major shareholder for $10,000. 5. Sands Ltd entered the qualifying company regime on 1 April 2009. As at 1 April 2009 it had the following reserves: Unrealised capital reserves $140,000 Undistributed realised revenue reserves $35,000 The balance in the Imputation Credit Account was $10,000 credit as at 1 April 2009. Is qualifying company election tax payable by Sands Ltd, and if so, how much? Page 17 of Topic 10
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