TRANS-TASMAN CONSEQUENCES OF NZs FOREIGN INVESTOR TAX CREDIT REGIME

TRANS-TASMAN CONSEQUENCES OF NZs FOREIGN INVESTOR TAX CREDIT REGIME By Mark Pizzacalla and Paul Whitehead This article considers New Zealand s approach to international taxation and, more specifically, the impact of New Zealand s Foreign Investor Tax Credit ( FITC ) regime on Trans Tasman investments. 1. INTRODUCTION It has long been recognised by the New Zealand government that its approach to the question of international taxation directly affects the country s domestic economy. 1 As such, a key tax policy objective of the government has been to attract foreign investment by remedying the imbalance between the taxation treatment of New Zealand residents and non-residents. It was generally considered that if New Zealand were to tax non-residents New Zealand sourced income twice, 2 it would be to the detriment of the New Zealand economy as this would lead to a reduced level of overseas investment. In recognition of both the economic requirements of New Zealand, and the way in which other foreign jurisdictions were moving in this area, the New Zealand government introduced an integrated package of international tax reforms in February 1995 eventually becoming law in December 1995. 3 This package introduced: a comprehensive transfer pricing regime; a thin capitalisation regime; and various other reform measures aimed at ensuring that non-resident investors were taxed on a basis consistent with New Zealand resident taxpayers, the most notable of which is the extension of the Foreign Investor Tax Credit ( FITC ) regime to all non-resident shareholders. These international tax reforms were aimed at building upon measures introduced over the last ten years to develop a fully integrated package to deal with the taxation of income flows into and out of New Zealand. 4 The purpose of this article is to discuss the application of the New Zealand FITC regime and, in particular, how this regime affects Trans-Tasman investment flows. Certain practical issues concerning the repatriation of profits will also be considered. 2. THE NEED FOR A FITC REGIME Prior to the introduction in 1988 of its imputation system, New Zealand operated a classical company system of taxation. This 1 M Pizzacalla, New Zealand s Thin Capitalisation Regime: Practical Considerations When Crossing the Tasman (1996) 46 CCH Tax Week. 2 That is, once when earned in New Zealand and once when repatriated to the non-resident s home country. See New Zealand Government, International Tax - A Discussion Document, February 1995. 3 By way of background, the Income Tax Act 1994 Amendment Act (No 3) 1995, introduced into Parliament as the Taxation (International Tax) Bill in August 1995, became law when it was assented to on 12 December 1995. 4 See Ministerial Media Release, International Tax Reforms, 13 July 1995. 202 JOURNAL OF AUSTRALIAN TAXATION

NZs FOREIGH INVESTOR TAX CREDIT REGIME resulted in double taxation for both resident and non-resident investors in New Zealand corporates. From a non-resident s perspective, income earned by New Zealand resident companies would, firstly, be subject to tax in New Zealand (at the corporate tax rate) and, secondly, via the imposition of non-resident withholding tax ( NRWT ) when that income was repatriated to non-resident shareholders by way of dividend. Similarly, New Zealand resident shareholders were also double taxed on income earned through a company; once at the company level and then again at the personal level via the imposition of personal income tax on dividends received from New Zealand resident corporates. The dividend imputation regime alleviated the problem of double taxation as it affected New Zealand resident shareholders, by allowing them a credit for tax paid by the New Zealand resident corporate. 5 However, this regime did not assist the position of non-residents who continued to be double taxed on dividends received. This resulted in foreign investors requiring a higher level of return from their New Zealand investment to compensate for the higher (effective) New Zealand tax rate. 6 For non-residents, this resulted in a total New Zealand tax impost of around 43% on pre tax income (that is, 33% company income tax plus 15% NRWT on the net cash dividend paid). This position was further exacerbated with respect to countries with which New Zealand had no Double Taxation Agreement ( DTA ), with the total New Zealand tax impost increasing to 53%. 7 In seeking a method that would reduce the double impost of taxation on income repatriated to non-resident investors, the New Zealand government devised the FITC regime. This regime was seen by the government as a desirable mechanism for reducing double taxation, as its application was limited to the extent that the New Zealand company had actually paid tax in New Zealand. This regime has now been a feature of the New Zealand taxation landscape since September 1993. 8 3. THE ORIGINAL AND EXTENDED FITC REGIMES When originally enacted, the FITC regime operated to remove the double imposition of New Zealand tax on dividends paid to foreign portfolio investors only (that is, non-resident investors with an interest of less than 10% in a New Zealand resident company). The FITC regime was subsequently extended to encompass all non-resident investors in an effort to fully eliminate the New Zealand double taxation of all dividends paid to non-residents, including Trans-Tasman dividend flows. 9 At the time the extension of the FITC regime was being considered, the New Zealand government identified two key aims as part of its programme of international tax reform: 10 A desire to place international and domestic investors on an equal footing by reducing the New Zealand tax impost on non-resident investors to 33%, thereby removing the distortionary effects of taxation and equalising the cost of capital for both foreign and domestic investors alike. It was anticipated that this would, in turn, encourage additional foreign capital investment into New Zealand. 5 The dividend imputation regime was introduced in New Zealand in 1988. 6 For example, there is anecdotal evidence of an increase in the price of listed shares when the FITC regime was first announced. 7 By virtue of an NRWT rate of 30% on the net cash dividend paid. 8 The FITC system of tax relief applies to dividends paid on or after 28 September 1993. 9 The FITC regime was extended to all non-resident shareholders in New Zealand companies by the Taxation (International Tax) Act 1995, with application to dividends paid on or after 12 December 1995. 10 New Zealand Government, above n 2. NOVEMBER/DECEMBER 1998 203

M PIZZACALLA & P WHITEHEAD A desire to ensure that New Zealand tax payments had value to foreign investors (that is, that they were able to utilise tax paid in New Zealand to offset foreign tax liabilities). Much debate ensued concerning the most appropriate method of achieving these aims. A number of options were open to the government at this time which included: 1. An extension of the imputation regime to nonresident shareholders which would enable them to satisfy their NRWT liability via imputation credits attached to dividends received by them. 2. The adoption of an exemption regime similar to that utilised by Australia. 3. An extension of the FITC regime to all nonresident investors. Whilst it was generally accepted that options 1 and 2 would achieve the first of the two aims noted above, they would not necessarily achieve the second. With respect to option 1, it was considered that foreign tax jurisdictions may not necessarily recognise NRWT credits paid for by way of the New Zealand imputation system. In terms of option 2, NRWT credits would simply not exist. Accordingly, the New Zealand government chose option 3. The relief afforded by the FITC regime is provided at the New Zealand company level by reducing the effective rate of company tax courtesy of a rather complicated tax credit mechanism. The dividend paying company is then required to pass on this reduction in tax to the foreign investor by paying a higher cash dividend than it would otherwise pay. The complex nature of the FITC regime ensures that the benefit of a lower overall New Zealand tax charge is passed on to the non-resident shareholder instead of foreign revenue authorities (which may occur under an NRWT exemption method). 11 The FITC regime is designed, therefore, to maximise the after tax return to foreign investors by: enabling the New Zealand resident corporate to pay a higher cash dividend than it would otherwise be able to; and enabling non-resident shareholders to claim a credit for New Zealand NRWT in their home country, thus reducing taxes payable at home. The legislative process which ensued culminated in the enactment of the new-look FITC regime in the Income Tax Act 1994 Amendment (No 3) Act 1995 ( ITAAA ). This extended regime is contained in Pt LE of the New Zealand Income Tax Act 1994 ( NZITA ) and replaced the FITC regime which applied to non-resident portfolio investors effective from 12 December 1995. In attempting to remedy the imbalance between the taxation treatment of resident and non-resident investors, the ITAAA also: reduced the non-resident company (branch) tax rate from 38% to 33%; reduced the rate of NRWT payable on fully imputed dividends to 15% (irrespective of the country of residence of the recipient shareholder); and excluded non-cash dividends from the ambit of the FITC regime on the basis that a zero rate of NRWT now applies to these dividends to the extent that they are also fully imputed. 12 11 G Trainer, The Extended Foreign Investor Tax Credit Regime: Some Implications CCH New Zealand Tax Planning Report. 12 New Zealand tax legislation deems a large number of transactions to be dividends where cash does not flow (eg, a nil interest loan advanced to a shareholder, or the transfer of property to a shareholder for less than market value). To the extent that these non-cash dividends are fully imputed, a zero rate of NRWT will apply. 204 JOURNAL OF AUSTRALIAN TAXATION

NZs FOREIGH INVESTOR TAX CREDIT REGIME 4. THE OPERATION OF THE FITC REGIME 4.1 General Pursuant to the FITC regime, a New Zealand dividend paying company pays a supplementary dividend to non-resident shareholders, in addition to an ordinary cash dividend. It is important to note that for the FITC regime to apply, both the ordinary and supplementary dividend must be paid in the same income year. 13 The amount of the supplementary dividend is calculated by reference to the quantum of imputation credits attached to the ordinary dividend. 14 The New Zealand dividend paying company is then entitled to a tax credit equal to the amount of the supplementary dividend paid. This credit supposedly funds the payment of the supplementary dividend, whilst also ensuring that the effective rate of tax paid on both the ordinary and supplementary dividends is equal to 33% (that is, no more than the New Zealand corporate tax rate). Note that all shareholders, whether resident or not, receive the ordinary dividend, whereas only non-resident shareholders receive the supplementary dividend (however, note our comments in part 5.6 below). Appendix 1 illustrates the mechanics of the FITC regime and its interaction with the Australian tax regime upon the repatriation of a dividend to either corporate or individual Australian investors. Note that the FITC is calculated in terms of the quantum of imputation credits attached to the ordinary dividend (that is, the actual amount of corporate tax paid in New Zealand). Two critical factors must be considered before applying the FITC regime: 1. the dividend paying company must have imputation credits, as the supplementary dividend (and, therefore, the FITC) is calculated by reference to the quantum of imputation credits attached to the ordinary dividend; and 2. the dividend paying company must have a tax base (tax paid or payable in any income year from the 1994 income year onwards). There is, however, no restriction on the distribution of retained profits. Any retained profits can be distributed regardless of when they were earned. Similarly, there is no restriction on the use of imputation credits. In other words, all imputation credits, regardless of the year in which they were generated, can be attached to an ordinary dividend and, thereby, give rise to a FITC regime credit. However, only those imputation credits arising from tax paid in the 1994 income year and onwards (such tax comprising a company s tax base ) are able to be refunded under the FITC regime. Further, the FITC regime is optional, not mandatory. However, there would appear to be no good reason not to utilise the FITC regime when paying a dividend offshore, apart from the cash flow disadvantages which may occur (refer below). 15 4.2 Utilisation of the FITC The FITC legislation contains a number of ordering rules which deal with how the FITC, once generated via the payment of an ordinary and supplementary dividend, is to be utilised by the dividend paying company. These are summarised below. 13 The definition of income year for FITC purposes includes a non-standard accounting year. The requirement for both dividends to be paid within the same accounting year, as opposed to the same standard 31 March income year, was clarified through subsequent amendment. 14 See the definition in NZITA, s OB 1. 15 There is no requirement that a New Zealand company pay a supplementary dividend when paying an ordinary dividend to non-resident shareholders. However, should a supplementary dividend not accompany an otherwise fully imputed dividend, Australian shareholders will suffer an effective New Zealand tax rate of 43% through the interaction of New Zealand company tax and NRWT. NOVEMBER/DECEMBER 1998 205

M PIZZACALLA & P WHITEHEAD 1. The overriding criteria is that the FITC be first applied against the dividend paying company s income tax payable for the income year in which the supplementary dividend is paid. Thus, the FITC is utilised by the company in: reducing (or eliminating, depending on the quantum of the FITC) its end of year tax liability; or reducing (or eliminating) its provisional tax liability. If the use of money interest provisions of the NZITA apply, the FITC regime may be used to generate an interest credit (where provisional tax has been paid during an income year) or, alternatively, to mitigate or eliminate an interest debit (where provisional tax has not been paid). 2. If surplus FITCs exist after satisfying 1 above (that is, the tax credit exceeds income tax payable in respect of the year in which the dividend is paid), they are to be applied against the dividend paying company s income tax payable for the previous four income years, or the income tax payable by another company in the same wholly owned group 16 for the income year in which the supplementary dividend is paid or the four previous income years. There is a proviso to this treatment, however, which is that only income tax paid in the 1994 income year and onwards may be refunded. 17 It is important to note that if refunds of tax are obtained by carrying FITC credits back, a use of money interest credit will not result. 3. If surplus FITCs still remain after satisfying both 1 and 2 above, they may be carried forward to a future income year and offset against the dividend paying company s (or another company in the same wholly owned group) income tax liability for that year. The ability to carry forward FITCs is dependent on certain shareholder continuity criteria being satisfied. 18 The critical issue to note from the above discussion is the time at which a FITC will mitigate income tax payable (be it the dividend paying company s end of year tax liability or provisional tax payments), or generate tax refunds (in the case of provisional tax actually paid or FITC credits carried back to earlier years). This is elaborated on below. 4.3 Cash Flow Implications In terms of the ordering rules detailed above, the FITC must first be utilised against tax payable in the year the supplementary dividend is paid. Only then may any remaining tax credits be applied to earlier income years in order to generate tax refunds. Given that, in practical terms, the FITC is used to fund the New Zealand dividend paying company s NRWT liability which is payable on the 20th day of the month following the month in which the dividend is paid, it is important to obtain the FITC refund as soon as possible to avoid potentially serious cash flow problems arising. This point is illustrated numerically in Appendix 2. The potential cashflow problems inherent in the FITC regime currently in force appear to be inconsistent with the purpose statement contained within the legislation itself: Subject always to its express provisions, the purpose of this Subpart is to allow a company, which pays to a non-resident investor a dividend with an imputation credit attached, and a supplementary dividend to the same investor, to claim an income tax 16 For these purposes, New Zealand resident companies are considered to be part of a wholly owned group provided there is at least a 66% commonality of shareholding. 17 The significance of the 1994 income year is that this is the year in which the FITC regime, as originally enacted, came into effect. 18 Shareholder continuity will be satisfied if there is at least a 49% continuity of shareholding in the New Zealand company from the beginning of the income year in which the FITC is generated to the end of the year in which it is offset. 206 JOURNAL OF AUSTRALIAN TAXATION

NZs FOREIGH INVESTOR TAX CREDIT REGIME credit calculated by reference to the imputation credit which is equal to and sufficient to fund the supplementary dividend. 19 (emphasis added) Given that it is the payment of a supplementary dividend which generates the tax credit, one would expect the words sufficient to fund the supplementary dividend to be stated in the present tense. This would imply that the tax credit should flow at the same time as the supplementary dividend is paid, and thereby physically fund the supplementary dividend. However, as illustrated in Appendix 2, there may be a significant time lag between the time the supplementary dividend is paid and when the FITC actually comes home. The writers are not aware of any intention on the part of the New Zealand government to alter this state of affairs. Tax practitioners must, therefore, be aware of the potential cash flow problems inherent in the FITC regime and manage these as best they can. One possibility is for the dividend paying company to time the payment of ordinary and supplementary dividends to the end of its income year, or to around the time provisional tax payments would otherwise be made. 20 5. TRANS-TASMAN INVESTMENT FLOWS: PRACTICAL FITC CONSIDERATIONS 5.1 Double Taxation of Income Flows Subsequent to the new DTA being entered into between Australia and New Zealand, the then Australian Treasurer indicated that the new DTA would ensure that income flows between the countries would be taxed only once. 21 However, it is generally accepted that this is not the case due to the failure of both countries to address the issue of the mutual recognition of imputation credits. 22 Accordingly, until this issue is resolved, dividend flows between Australia and New Zealand will continue to be taxed twice; once (at least) in each country. As demonstrated in Appendix 1, the FITC regime goes some way towards relieving the double taxation of Australian investors in New Zealand companies. 5.2 New Zealand Perspective From a New Zealand perspective, the taxation treatment of dividends received by New Zealand resident investors from Australian corporates will vary depending on the nature of the New Zealand investor (that is, individual versus corporate investors). 5.2.1 Dividends Received by New Zealand Corporate Investors From Australia Dividends received from Australia by New Zealand corporate investors are exempt from corporate income tax in New Zealand, 23 but are subject to a foreign dividend withholding payment ( FDWP ) tax at the rate of 33%. 24 As the dividend received from Australia is exempt from New Zealand corporate tax, NRWT deducted by the Australian corporate (on any unfranked portion of the dividend) is unable to be utilised by New Zealand corporate investors against their company income tax liability. 19 NZITA, s LE 1. 20 On the seventh day of each of the fourth, eighth and twelfth months of a taxpayer s income year. 21 Refer Press Release dated 27 January 1995. 22 DG Gunbar, The New Double Taxation Agreement - Implications for Australian Portfolio Investors Asia Pacific Tax Bulletin. 23 NZITA, s CB10. 24 The FDWP regime applies to dividends received by a New Zealand tax resident company from a non-resident company on or after 1 April 1988 (see Pt NH of the NZITA). Accordingly, it may be more desirable to re-invest an Australian subsidiary s profits in Australia, as compared to the repatriation of such profits to New Zealand (depending on whether foreign taxes paid can be taken into account to reduce the FDWP tax liability). NOVEMBER/DECEMBER 1998 207

M PIZZACALLA & P WHITEHEAD A credit for the Australian NRWT will, however, be allowable against the FDWP payable by the New Zealand company. Further, where a New Zealand corporate owns at least 10% of an Australian corporate, the New Zealand corporate may be able to claim a credit for tax paid by the Australian corporate via the underlying foreign tax credit ( UFTC ) regime. 25 This credit is then applied against the FDWP payable by the New Zealand company. It is important to note that the UFTC regime is not available to individual investors. No further income tax liability arises until such time as the dividends are distributed by the New Zealand corporate to its shareholders. At this time, the New Zealand corporate may attach imputation or FDWP credits to the dividend. These can then be used by the individual to offset against his/her personal income tax liability. 26 5.2.2 Dividends Received by New Zealand Individual Investors Where dividends are received by a New Zealand resident individual (directly) from an Australian resident company, the mechanics are slightly different, but the end result is similar. In both cases, individual New Zealand investors who pay tax at the top New Zealand marginal tax rate of 33% bear an effective tax rate of around 57% (that is, 36% at the Australian company level and a further 21% via personal income tax). A numerical example is given in Appendix 3. This can be compared to the FITC regime where individual Australian shareholders receive not only a greater cash dividend, but also a credit for NRWT paid in New Zealand. Therefore, as a result of the operation of the FITC regime, Australian investors into New Zealand are at a distinct advantage over their New Zealand counterparts, at least from a tax perspective. 5.3 Australian Perspective 5.3.1 Direct Versus Indirect Shareholdings in New Zealand Corporates by Australian Investors The position for corporate Australian shareholders is somewhat different to that experienced by New Zealand corporates. Pursuant to s 23AJ of the Income Tax Assessment Act 1936 ( ITAA36 ), non-portfolio dividends (that is, a dividend paid to a company that holds at least 10% of the voting power in the dividend paying company) repatriated to Australian resident companies are exempt from Australian corporate tax. 27 This effectively means that NRWT deducted in New Zealand is unable to be utilised by such Australian corporate investors, whereas a credit for New Zealand NRWT would be available to an Australian individual investing directly into a New Zealand company. The effective tax rate on dividends received by Australian individuals via Australian corporate shareholders of a New Zealand company is, therefore, higher than that for individual Australians investing directly into New Zealand corporates. The reason for this is that whilst a credit for NRWT paid in New Zealand will be allowed to an individual shareholder, it will not be allowed to a corporate shareholder. This results in a 6% tax advantage to the individual shareholder. This is the case even when the FITC regime is used by the New Zealand dividend paying company, as is illustrated in Appendix 1. 25 Where the dividend is sourced from a grey list country (such as Australia), the foreign company is deemed (subject to certain conditions) to have paid tax equal to the New Zealand tax liability on the dividend. If the dividend is not received from a company resident in a grey list country, the amount of the credit will depend on foreign tax actually paid and earnings distributed by the overseas company. 26 The principal difference between imputation and FDWP credits is that the latter can be refunded in cash (eg, where the individual shareholder is in a net tax loss position). 27 Such dividends are exempt from corporate tax to the extent that they constitute an exempting receipt as defined in s 280 of the ITAA36. 208 JOURNAL OF AUSTRALIAN TAXATION

NZs FOREIGH INVESTOR TAX CREDIT REGIME It should be noted that the 59% effective tax rate for an Australian individual investing directly into a New Zealand company, is further reduced to 48% (assuming the individual pays tax in Australia at the top marginal tax rate), if the individual conducts business operations in New Zealand as a sole trader or via a partnership. However, there are obvious commercial reasons as to why this option would not be practical in a large number of cases. These results clearly indicate that Australian individuals should consider investing into New Zealand directly wherever possible. Clearly, this is not an option in the case of multinationals. However, direct investment should not be ruled out altogether, particularly in the case of small to medium sized investors. 5.3.2 Branch Versus Subsidiary There are a number of options which may be considered by an Australian company when structuring its investment into New Zealand. These include: a branch or permanent establishment ( PE ); a New Zealand subsidiary; or a New Zealand group (including a holding company and a number of subsidiaries to accommodate various forms of proposed investments). There are a number of permutations and combinations available to Australian investors in terms of the options outlined above, as well as alternative forms of investment into New Zealand (eg, via trusts and special partnerships). In light of the introduction of the extended FITC regime, and the reduction of the New Zealand branch tax rate from 38% to 33%, there are now no significant differences in the taxation treatment of a branch and a subsidiary as far as the repatriation of profits to Australia is concerned. This is illustrated in Appendix 4. Accordingly, the decision as to which structure is the most appropriate method of conducting business operations in New Zealand will largely depend on the commercial objectives of the Australian investor and proposed strategic plans with respect to New Zealand. 5.4 Tax Planning Techniques Given that the interaction between the Australian and New Zealand tax regimes do not prevent Trans-Tasman income flows from being taxed twice, a number of methods aimed at reducing the tax cost of investment have been implemented by ensuring that profits are taxed in Australia rather than New Zealand. This has generally been achieved by: the charging of management fees; the charging of interest; taking advantage of the change in the force of attraction rule in the new Australia/New Zealand DTA. Consideration of these techniques in detail is outside the scope of this article. 28 5.5 Interaction Between the Thin Capitalisation Regime and FITC New Zealand s thin capitalisation regime applies to resident New Zealand taxpayers from the 1997 income year onwards. 29 This regime is designed to limit the extent to which non-resident investors fund their New Zealand operations with interest bearing debt so as to reduce their New Zealand tax liability. This is achieved by denying interest deductions in relation to debt which breaches both of the following ratios: 28 Gunbar, above n 22. 29 Pizzacalla, above n 1. NOVEMBER/DECEMBER 1998 209

M PIZZACALLA & P WHITEHEAD 75% of the total assets of the New Zealand company; and 110% of the controlling non-resident group s world wide interest bearing debt percentage. Generally, no adverse thin capitalisation issues should arise if a dividend paid within the ambit of the FITC regime is funded entirely out of available cash reserves. However, should funds be borrowed to pay the dividend, care must be taken to ensure that the safe harbour ratios stated above are not breached. 5.6 Holding Company Issues 5.6.1 The Original FITC Regime The ordering rules contained within the FITC legislation (and discussed above) allow excess FITCs to be transferred from one New Zealand resident company to another provided certain criteria are met. Whilst this would appear to be beneficial, a potential problem existed in terms of the original FITC regime as it impacted on corporate group structures. Consider A Co which wishes to pay a dividend to its overseas shareholders. Being a non-operating holding company, it receives only fully imputed dividends from B Co, a wholly owned operating subsidiary. Under New Zealand tax law, the dividend received from B Co will be exempt from tax in A Co s hands. In this scenario, A Co will be able to pay an ordinary dividend to overseas shareholders by passing on the dividends received from B Co. However, it will not necessarily have the cash resources to pay a supplementary dividend and may have to borrow in order to pay this dividend. In this case, it is crucial that the benefit of the FITC which flows from the payment of the supplementary dividend be available as soon as possible so as to fund the payment of the supplementary dividend. The problem here is that A Co does not pay tax and does not have a tax base against which the FITC may be offset. In other words, it will never be able to utilise the FITC, but it will still have to fund the payment of a supplementary dividend. This situation can be managed if, in addition to the dividend paid to A Co, B Co also lends sufficient funds to A Co to enable it to pay the supplementary dividend offshore. As A Co and B Co form a wholly owned group, A Co can sell the FITC it generates to B Co, which then uses the credit against its income tax liability. In this way, the loan from B Co to A Co is then satisfied. Consider now the same facts as above, except that B Co is only 30% owned by A Co. The fully imputed dividend received from B Co will not be exempt from tax and A Co will have to include it in its annual tax return. However, because the dividend from B Co carries full imputation credits, A Co will pay no further tax on the dividend and still have no tax base against which the FITC generated by payment of a supplementary dividend may be offset. As A Co has only a 30% holding in B Co, the two companies do not form a wholly owned group and any FITC generated by A Co will not be able to be passed down to B Co. Furthermore, it is highly unlikely that B Co would loan moneys to A Co as A Co does not have a controlling interest in B Co. If A Co wishes to pay a supplementary dividend to offshore investors in respect of the dividend received from B Co, it will have to borrow money. It would then generate a FITC which would be unable to be utilised until such time as it pays tax. This situation meant that companies not forming a wholly owned group were effectively unable to utilise the FITC regime. 210 JOURNAL OF AUSTRALIAN TAXATION

NZs FOREIGH INVESTOR TAX CREDIT REGIME 5.6.2 The Extended FITC Regime and Holding Companies The problems discussed above have been eliminated by s LE 3 of the NZITA (passed into legislation at the same time as the extended FITC regime) which essentially provides for the following: a trading company may pay both an ordinary and supplementary dividend to a New Zealand corporate shareholder (an LE 3 holding company ) as if that company were not resident in New Zealand; and the LE 3 holding company may then on-pay the ordinary and supplementary dividend either to a further LE 3 holding company (and so up the holding company chain) or to the ultimate non-resident shareholders. Section LE 3 provides a mechanism for allowing holding companies which do not generate a sufficient New Zealand tax liability to use the FITC regime. This is achieved by allowing lower tier New Zealand companies to generate a FITC when paying dividends up the chain of companies to the ultimate New Zealand holding company. The key element here is that for the purposes of s LE 3, companies need not be members of a wholly owned group. Generally speaking, the holding company rules contained in s LE 3 do not generate adverse cash flow difficulties for the LE 3 holding company other than those already discussed in part 4.3 above and in Appendix 2. Details of the LE 3 holding company mechanism are beyond the scope of this article. However, the point to note is that s LE 3 has made the payment of a dividend by a New Zealand holding company, which is owned partially or fully by Australian shareholders, more attractive to those shareholders. 5.6.3 Should Dividends be Imputed? Should the ordinary dividend paid by the trading subsidiary carry full 30 imputation credits or not? Generally speaking the answer to this question is yes. The ramifications of not fully imputing the ordinary dividend will depend on whether the trading subsidiary is wholly or only partially owned by the holding company. Where the trading subsidiary is wholly owned by the LE 3 holding company, the only adverse effect of paying a partially imputed dividend (apart from the potential cash flow effects discussed above and in Appendix 2) is that the dividend paying company is not availing itself of the full benefits available under the FITC regime. This is because the supplementary dividend and, therefore, the FITC, is calculated with respect to the quantum of imputation credits attached to the ordinary dividend. The lesser the level of imputation credits attached, the lesser the FITC and the higher the effective rate of tax suffered by the Australian shareholder. The LE 3 holding company remains in a neutral net cash position where an ordinary dividend is only partially imputed. The adverse effect of partial imputation is borne by the Australian shareholder by receiving a lower supplementary dividend and, therefore, suffering a higher effective rate of tax. Where the trading subsidiary is only partially owned by the LE 3 holding company, two elements can conspire to make life extremely difficult: 30 A dividend which is fully imputed in the traditional sense (that is, ignoring the FITC regime), means a dividend which carries imputation credits in the amount of 33/67 of the cash dividend paid. This is not true of a fully imputed dividend paid within the ambit of the FITC regime. Such a dividend will carry fewer imputation credits than its traditional counterpart, yet will, nevertheless, be considered to be fully imputed for the purposes of the imputation credit and NRWT regimes. It is the FITC concept of full imputation that is referred to by the use of the word full in inverted commas. NOVEMBER/DECEMBER 1998 211

M PIZZACALLA & P WHITEHEAD Dividends received by an LE 3 holding company from a partially owned subsidiary are fully taxable. If the ownership of the trading subsidiary by the LE 3 holding company is 66% or below, resident withholding tax ( RWT ) on dividends is payable to the extent that a dividend is not fully imputed. Problems which could be encountered if a partially imputed dividend is paid to an LE 3 holding company by a partially owned subsidiary, and either or both of the above elements are present, include: cash flow difficulties additional to those already discussed; and/or an overdrawn imputation credit account ( ICA ). If, at 31 March each year, a company s ICA is less than zero, the shortfall must be paid along with penalty taxes. The longer the debit balance remains outstanding, the higher the penalties that accrue. Care should, therefore, be taken when consideration is being given to paying partially imputed dividends to an LE 3 holding company. This is particularly important when the dividend paying company is only partially owned by the LE 3 holding company. 6. CONCLUSION Some would argue that the mere complexity of the FITC regime negates any benefits it may have. There is no doubt that it is difficult to grasp some of the concepts quickly and that some degree of mathematical literacy is required. Nevertheless, the FITC regime does provide more cash in hand to non-resident investors. In addition, it provides non-resident investors with the further possibility of utilising NRWT in their home jurisdiction, which would not otherwise have been available, for eg, if an exemption regime had been adopted. The extent to which the FITC regime has been successful in the first of its stated objectives, that is, to encourage additional foreign capital investment into New Zealand, is far from clear. Statistics recently issued by Statistics New Zealand indicate that foreign direct equity investment into New Zealand has risen over past years. However, there is insufficient information to be able to conclusively state the reason(s) behind this increase. Furthermore, we are not aware of any studies being conducted in this area and are hesitant to speculate on the effect the FITC regime has had on foreign direct equity investment into this country in isolation. Clearer, perhaps, is the reason behind the huge increase in the payment of dividends to overseas direct investors in recent years. Prior to the introduction of the FITC regime, it was relatively costly for foreign investors of a New Zealand corporate to repatriate retained earnings. With the advent of the FITC regime, and its subsequent extension to all non-resident investors, significant retained earnings have been repatriated from New Zealand offshore. Perhaps this will be the legacy of the FITC regime? 212 JOURNAL OF AUSTRALIAN TAXATION

NZs FOREIGH INVESTOR TAX CREDIT REGIME APPENDIX 1 - AUSTRALIAN INVESTMENT INTO NEW ZEALAND MECHANICS OF THE FITC REGIME 1. New Zealand Company Level Direct Shareholding $ Indirect Shareholding $ Pre-tax earnings 100.00 100.00 Less income tax (@ 33%) 33.00 33.00 Net profit after tax ( ordinary dividend) 67.00 67.00 Supplementary dividend/fitc 11.82 11.82 ($33 @.358288 - see below) Total dividends paid 78.82 78.82 Less: NRWT 11.82 11.82 Total dividend repatriated to Australian investor 67.00 67.00 2. Australian Company Level Cash dividends received NA 67.00 Australian tax payable NA 0.00 Total dividend paid to Australian shareholders NA 67.00 3. Australian Individual Shareholder Level Taxable ordinary dividend 67.00 67.00 Taxable supplementary dividend 11.82 0.00 Total taxable dividends 78.82 67.00 Personal tax @ 48% 37.83 32.16 After tax cash available 40.99 34.84 Effective tax rate 59.01% 65.16% 1.1 Calculation of Supplementary Dividend and FITC As this example illustrates, the Australian investor s New Zealand NRWT liability of $11.82 is funded by the supplementary dividend. The supplementary dividend is, in turn, funded by the FITC credit which also amounts to $11.82. Whilst this may seem a straight forward calculation, a problem lies in the obtuse manner in which the FITC legislation determines the amount of the tax credit. The formula contained in s LE 2 of the NZITA is: NOVEMBER/DECEMBER 1998 213

M PIZZACALLA & P WHITEHEAD Formula 1: FITC = IC x (67/120) where IC is the imputation credit (if any) actually attached to the ordinary dividend. This illustrates that the FITC is a function of the imputation credit actually attached to a dividend. However, the imputation credit actually attached to a dividend (the actual imputation credit) is not the same as the imputation credit which would normally be attached to a dividend if the FITC regime did not exist (we will call the latter the ostensible imputation credit). New Zealand tax law imposes a limit on the quantum of imputation credits that can ostensibly (that is, ignoring the FITC regime) be attached to a dividend. This maximum is expressed as a function of the cash dividend paid by the dividend paying company and is currently the fraction 33/67. Any dividend which carries imputation credits of exactly this ratio is called fully imputed. Any dividend carrying less than this amount of imputation credits is termed partially imputed. Thus, in the example above, the maximum ostensible imputation credit which may be carried by the ordinary dividend is: $67 x 33/67 = $33. The relationship between the actual and ostensible imputation credits is as follows: Formula 2: ICa = ICo - FITC where ICa is the actual imputation credit and ICo is the ostensible imputation credit. The FITC regime essentially splits the ostensible imputation credit into two components: the imputation credit which is actually attached to the dividend paid to the non-resident investor (ICa); and the tax credit itself (FITC). Herein lies the difficulty with formula 1 given above. The term IC given in the formula is not the ostensible imputation credit, but the actual imputation credit. Given that the determination of the actual imputation credit is dependent on knowing the quantum of the FITC, it can be seen that the formula above does not actually tell us much about how to calculate the FITC. What is really required is a formula such as that given below: Formula 3: FITC = ICo x C where ICo is the ostensible imputation credit and C is a constant to be applied to ICo to determine the quantum of the FITC. As it turns out, constant C is equal to 0.358288. These relationships can be illustrated by proving the amount of the FITC in the example above. $ Ostensible imputation credits (ICo) 33.00 Less: FITC (ICo x 0.358288) 11.82 Actual imputation credits attached to the dividend (ICa) 21.18 A check of these figures will show that formula 1 above is satisfied (that is, 67/120 x ICa = $11.82, the amount of the FITC). 214 JOURNAL OF AUSTRALIAN TAXATION

NZs FOREIGH INVESTOR TAX CREDIT REGIME 1.2 Other Considerations The above example illustrates the position applying to the ordinary dividend paid to nonresident shareholders only. The ordinary dividend paid to resident shareholders will, of course, still carry the full imputation credit of $33. For the purposes of the imputation credit and NRWT regimes, the ordinary dividend paid to non-resident shareholders is considered to be fully imputed, even though it carries only $21.18 of imputation credits. Thus, NRWT of only 15% would need to be withheld, regardless of the country of residence of the non-resident investor. In order to obtain the full relief available under the FITC regime, the ordinary dividend should be fully imputed ( fully meaning to the extent of $21.18 as explained above and not fully in the classical sense of $33). This is because the FITC is calculated in terms of the quantum of imputation credits attached to the ordinary dividend, that is, the lesser the level of imputation credits attached, the lesser the FITC and the higher the effective rate of tax suffered by the non-resident investor. By contrast, the supplementary dividend need not be imputed at all. Moreover, the supplementary dividend is only paid to nonresident shareholders. Payment of the supplementary dividend to only non-resident shareholders where a company also has resident shareholders will not contravene: the benchmark dividend or streaming rules (essentially anti-avoidance rules) contained within the NZITA; New Zealand company law; any provision of the paying company s articles of association or constitution (except one explicitly referring to the FITC regime); and any rule of law, which might otherwise prohibit such a distribution. APPENDIX 2 - CASH FLOW IMPLICATIONS OF THE FITC REGIME This example illustrates the potential cash flow problems associated with the FITC regime. Consider a company with a 31 December 1997 balance date which is not part of a New Zealand resident company group. This company is required to pay provisional tax on the 7th day of April, August and December 1997. Any shortfall between the company s actual tax liability, and provisional tax paid by it, is due for payment on 7 November 1998. Assume that the company has estimated its end of year income tax liability as $600,000 (meaning that on each provisional tax date it must pay provisional tax of $200,000). Assume further that provisional tax was paid on 7 April and the company subsequently pays an ordinary and supplementary dividend on 1 May which will generate a $900,000 FITC. NRWT of $900,000 must, therefore, be paid to the Inland Revenue Department on 20 June. The company s actual tax payable for the year is $650,000, as determined in its tax return filed on 1 July 1998. An assessment is received from the Inland Revenue Department on 1 August 1998. In this example, the FITC of $900,000 will be utilised in the following manner: applied against provisional tax actually paid on 7 April 1997: $200,000; applied against remainder of provisional tax payable on 7 August and 7 December 1997: $400,000; applied against remainder of income tax payable for year: $50,000; tax refund of prior years income tax payable (to the extent possible) or carried forward to future income years: $250,000. Consideration of the following time line will illustrate the cash flow problem: NOVEMBER/DECEMBER 1998 215

M PIZZACALLA & P WHITEHEAD 1 May 1997: Dividend paid; 1 May 1997: Provisional tax refund of $200,000 technically available (although in practice the refund will not be paid for some time, due to the time taken for the Inland Revenue Department to process the refund request); 20 June 1997: NRWT payment of $900,000 due; 7 August 1997: Provisional tax saving of $200,000; 7 December 1997: Provisional tax saving of $200,000; 1 August 1998: Tax return assessed and balance of FITC available of $250,000; 7 November 1998: End of year income tax liability saving of $50,000. Only at such time as the dividend paying company s annual tax return is processed by the Inland Revenue Department will the balance of the FITC ($250,000) be able to be carried back to earlier income years to generate tax refunds. Of course, this will be limited to the extent of income tax paid in these earlier years. In the absence of prior year income tax having been paid, the balance of the FITC must be carried forward. In this case, assuming the balance of the FITC of $250,000 generates tax refunds in earlier income years, it has taken over 16 months from the time at which NRWT was paid (20 June 1997) to the time at which the FITC has been fully recovered (7 November 1998). This position is exacerbated in the case where the FITC must be carried forward to future income years. APPENDIX 3 - NEW ZEALAND INVESTMENT INTO AUSTRALIA The position for both New Zealand corporate and individual investors receiving a dividend from Australia (ignoring the UFTC regime) is summarised below. 1. Australian Company Direct Shareholding $ Indirect Shareholding $ Pre tax earnings 100.00 100.00 Less corporate tax @ 36% 36.00 36.00 Net profit/dividend declared (fully franked) 64.00 64.00 Less Australian NRWT 0.00 0.00 Net dividend paid to New Zealand corporate shareholder 64.00 64.00 2. New Zealand Corporate Shareholder Cash dividend received from Australia NA 64.00 Less: FDWP @ 33% NA 21.12 Net dividend paid to New Zealand individual shareholder NA 42.88 216 JOURNAL OF AUSTRALIAN TAXATION

NZs FOREIGH INVESTOR TAX CREDIT REGIME 3. New Zealand Individual Shareholder Cash dividend received 64.00 42.88 Add: FDWP credit attached to dividend 0.00 21.12 Total taxable dividend 64.00 64.00 Less: income tax @ 33% 21.12 21.12 After tax cash available 42.88 42.88 Effective tax rate 57.12% 57.12% APPENDIX 4 - AUSTRALIAN INVESTMENT INTO NEW ZEALAND 1. New Zealand Branch $ Subsidiary $ Pre-tax earnings 100.00 100.00 Less income tax (33%) 33.00 33.00 Net profit after tax 67.00 67.00 Supplementary dividend 0.00 11.82 Total 67.00 78.82 Less non-resident withholding tax 0.00 11.82 Total repatriated 67.00 67.00 2. Australian Company Total repatriated from New Zealand 67.00 67.00 Tax payable 0.00 0.00 Total dividend paid to Australian shareholders 67.00 67.00 3. Australian Individual Shareholder Taxable Dividend 67.00 67.00 Personal tax @ 48% 32.16 32.16 After tax cash available 34.84 34.84 Effective tax rate 65.16% 65.16% NOVEMBER/DECEMBER 1998 217

M PIZZACALLA & P WHITEHEAD Mark Pizzacalla is a Senior Manager in Corporate Tax and GST at KPMG Melbourne Office. Mark holds BBus and M Tax degrees and is an Associate at the Tax Institute of Australia as well as the Institute of Chartered Accountants. Mark has recently returned from an 18 month secondment in New Zealand where he spent time analysing New Zealand s GST systems in an Australian context. Mark s income tax experience has been in relation to international tax issues includinmg multi-national corporate advice and inbound/outbound investments. He is also a regular speaker in taxation issues and contributes to various newspapers and journals including the Fianancial Review and CCH Tax Week. Paul Whitehead is a Tax Manager at KPMG Wellington Office, New Zealand. 218 JOURNAL OF AUSTRALIAN TAXATION