Draft Question We ve Been Asked PUB00296: When is income from a cash dividend paid on ordinary shares derived? 22 December 2017
22 December 2017 Team Manager, Technical Services Office of the Chief Tax Counsel National Office Inland Revenue Department PO Box 2198 Wellington Dear Grant and Lynn PUB00296: When is income from a cash dividend paid on ordinary shares derived? Thank you for the opportunity to comment on this item. Summary Our key submissions are: We do not support the conclusion in the item that cash dividends paid to accrual-basis taxpayers are derived before they are paid or credited to account or dealt with on their behalf. If current practice is not accepted we recommend that the issue be referred to Policy and Strategy to introduce a legislative change. The conclusion gives rise to uncertainty regarding who is considered to be an accrual-basis taxpayer in relation to cash dividend income. We highlight some practical issues with the conclusions drawn in the exposure draft subsequent non-payment, Business Transformation. The Commissioner should issue an operational statement to confirm that resources will not be applied to identify cases before 1 April 2018 where cash dividends have been returned on a cash basis by accrual-basis taxpayers. Accrual-basis taxpayers We do not support the Commissioner s view that accrual-basis taxpayers derive cash dividends on the record date (for a dividend from a listed company), or other date that determines the taxpayer s right to receive the dividend payment (for a dividend from an unlisted company). The Commissioner s approach in the exposure draft gives rise to uncertainty and does not promote voluntary compliance.
In many cases it is uncertain whether a taxpayer is required to return dividend income on a cash basis or an accrual basis. There is no hard and fast rule that a taxpayer in business or undertaking a particular activity is required to return passive investment income on an accrual basis. While the Commissioner has published some guidance in IS 16/06, Income tax Timing When is income from professional serviced derived? on when the cash or accrual basis is appropriate (referred to in paragraph 8), these statements are made in the context of deriving professional services income. If the Commissioner settles on the view expressed in the exposure draft more guidance should be published on when a taxpayer is considered an accrual-basis taxpayer in relation to dividend income. For example, would a family trust that has a managed portfolio be required to return dividend income on an accrual basis? Would it make a difference if the family trust self-managed the portfolio? Would a taxpayer who carried on a retail business who bought a few shares on the stock market with some surplus cash be required to return dividend income on an accrual basis? General principles Paragraphs 1 8 of the exposure draft discuss the derivation of income generally. Paragraph 6 states that whether income is derived on a cash or accrual basis depends on a number of factors. The following statements are then made: However, generally, the cash (or receipts) basis is appropriate for individuals who are salary and wage earners or professionals... However, if the earning of income is not solely related to the personal exertions of the individual in question, such as when they undertake business activities, the accrual (or earnings) method is more appropriate. These statements do not take into account the fundamental principle that the most appropriate income derivation method is the one that provides a substantially correct reflex of income (see Interpretation Statement IS 16/06, Income Tax Timing When is Income from Professional Services Derived?, paragraphs 22 28. In particular, citations of Carden s case [1938] 63 CLR 108 and Farmers Trading case (1982) 5 NZTC 61,200). Applying this principle, depending on the nature of the taxpayer s income earning activity, it may be appropriate for an accrual-basis taxpayer to recognise cash dividends on a cash basis. With respect to the first statement quoted above regarding professionals, the statement is not consistent with the Commissioner s view expressed in IS 16/06. The conclusion in IS 16/06 is that there is no general rule of law requiring any particular profession to account for income using the cash method or accrual method. Identifying the correct method is a question of fact, having regard to the nature of the business or income-earning activity of the professional. Factors to be considered include: the type of activity carried on; the characteristics of the type of income at issue; the scale of the income earning activity; the level of sophistication or complexity of the business. This approach is also appropriate when considering the timing of cash dividends paid to a shareholder. Paragraph 11 expresses the Commissioner s view that the accrual-basis method generally applies to profits from a business activity, including interest or dividends that, as passive income, is usually derived on receipt. Reference is made to Tax Information Bulletin Vol 4, No 6 (January 1993), Non-
standard balance dates and business income, page 11 12. We do not agree that this item supports the Commissioner s view. The TIB item relates to the period in which business income must be returned for taxpayers with a non-standard balance date. It does not relate to the timing of derivation of interest or dividends. Case law A number of cases are cited in the exposure draft to support the Commissioner s view that accrualbasis taxpayers derive cash dividends on an accrual basis. The authorities relied on can be distinguished on their facts: two of them did not involve the derivation of dividend income, the other involved the payment of an intra-group dividend. The National Bank of New Zealand case discussed in paragraphs 12 14 involved a taxpayer in the business of lending money and the nature of the income being considered was interest, not dividends. Given the nature of the taxpayer s business it was appropriate that interest income was derived on an accrual basis. The ABB Australia case discussed in paragraphs 15 17 involved a dividend paid within a group of companies. As stated in paragraph 17, in that case the court held that the accrual basis was appropriate for determining the dividend was derived when declared because of the control the shareholder had over the declaration of the dividend and because declaring the dividend formed part of its business. This reasoning was not a statement of general principle, rather, it was applied to the particular facts of the case. At paragraph 150, Lindgren J states: Generally speaking dividend income is derived when it is received. But generally speaking the shareholder is passive, does not control the declaration of the dividend, and is not carrying on a business of which the very act of declaring the dividend forms part. Therefore it is reasonable for a passive shareholder to derive dividend income on a cash basis, and business or personal services income on an accrual basis. This conclusion is also supported by Bowaters Sales Co Ltd v C of IR (1958) 38 TC 593. In Bowaters, the High Court of Justice (Chancery Division) held that a dividend from the taxpayer s Australian subsidiary declared on 16 December 1953, but not paid until 28 January 1954, was not required to be recognised on an accrual basis. In the court s view, there was no need to treat a debt which is a pure income profit when received as being bound to be brought in as if it were a receipt of a trade. For a passive shareholder, a dividend is a receipt of pure income profit ; therefore, it should not be derived on an accrual basis. We consider this to be the better view. The News Australia Holdings case cited in paragraph 18 was not about the derivation of dividend income. As discussed in paragraphs 18 and 19 the issue involved interest income received by an Australian company for a loan made to an overseas company in the context of the controlled foreign corporation provisions of the Australian income tax legislation. While the taxpayer in this case was not in the business of lending money to third parties, the taxpayer, as part of its income earning activities, lent money to its parent on commercial terms for reward. In these circumstances the court held that it was appropriate that the interest was derived on an accrual basis. The decision should be confined to the particular facts of the case and not applied more broadly to other passive income such as a dividend.
Derivation determined by when a debt arises In the Commissioner s view, accrual-basis taxpayers derive dividend income when a debt is created in favour of the shareholder. This is the date the dividend is declared. Paragraph 21 states that the solvency test requirements in section 52 of the Companies Act 1993 do not affect this conclusion because the solvency test goes to enforceability of the debt to pay the dividend not the creation of the debt. The key criteria underlying the Commissioner s view is the company law definition of distribution. Section 2 of the Companies Act 1993 defines distribution in relation to a distribution by a company to a shareholder as: (a) the direct or indirect transfer of money or property, other than the company s own shares, to or for the benefit of the shareholder; or (b) the incurring of a debt to or for the benefit of the shareholder in relation to shares held by that shareholder, The key part of the definition is paragraph (b). The inclusion of incurring a debt to the shareholder creates tension when applied in a tax context. In relation to a cash dividend, most taxpayers understand a distribution to be a payment or receipt rather than the incurring of a debt. The conclusions reached in the exposure draft for accrual-basis taxpayers will be a surprise to most affected taxpayers. Notwithstanding the legal analysis, the Commissioner s view introduces increased complexity as to the derivation of dividend income. The Commissioner s view creates a need to distinguish between cash-basis and accrual-basis taxpayers and listed and unlisted companies. In relation to an unlisted company, there is a further need to review whether the correct date is the dividend resolution date or some other date that determines the shareholder s right to receive payment. It would be simpler if the Commissioner accepted that all taxpayers derive dividend income on a cash basis or when the dividend is credited to or otherwise dealt with by the shareholder. If this is not possible, the issue should be referred to Policy and Strategy to introduce a legislative change. Tax credits Paragraph 1 of the exposure draft states: Section CD 15 increases the amount of a dividend by any imputation credit attached to, or any resident withholding tax (RWT) deducted from the dividend. Therefore, a reference to a dividend in this QWBA includes any RWT or imputation credit related to the dividend. This statement is incorrect. Section CD 15 does not mention RWT credits.
With respect to RWT credits grossing up the dividend, the relevant authority is paragraph (b) of the definition of resident passive income in section YA 1 of the Income Tax Act 2007. This reference should be included in paragraph 1. Paragraph 37 of the exposure draft states that it is the Commissioner s view that sections LE 1(1) and LB 3(1) of the Income Tax Act 2007 intend for the relevant tax credits (i.e. imputation credits and RWT credits) to be available in the same year the related income is returned. Based on the Commissioner s view, an accrual-basis taxpayer can claim imputation credits and RWT tax credits in the income year that the dividends are returned, provided that the imputation credits are attached and the RWT is paid prior to the relevant tax return being filed. In the majority of cases, this will be satisfied. While the provisions relied on by the Commissioner may support her view, there is a clear timing tension with the relevant imputation credit and RWT provisions which apply when the dividend is paid. Imputation credits Section LE 1(1) provides that a person whose assessable income for an income year includes an imputation credit has a tax credit for the tax year corresponding to the income year of an amount equal to the sum of the amount of the imputation credit and any credit carried forward from an earlier tax year. This provision allows a taxpayer to claim the tax credit; however, it does not determine when the credit arises. The attaching of imputation credits is governed by section OB 60(1) which states that when an ICA company pays a dividend, it may attach an imputation credit to the dividend. The credit therefore arises when the dividend is paid, not when a debt for payment of the dividend arises. The corresponding debit in the paying company s imputation credit account is also determined by the date the dividend is paid see section OB 30. RWT credits Section LB 3(1) provides that a person has a tax credit for a tax year equal to the amount of tax withheld and paid in relation to their resident passive income for the tax year (assuming the evidential requirements of section 78D of the Tax Administration Act 1994 are met). Again, the point in time when the tax credit arises is when the tax has been withheld and paid, not when a debt for payment of the resident passive income arises. Credits not paid Paragraph 37 of the exposure draft also states that if credits have not been attached or paid by the time the accrual-basis shareholder files a return of income, the shareholder will need to return the net dividend without claims for credits. When the credits are subsequently paid or attached the taxpayer should submit an application for reassessment under section 113 of the Tax Administration Act 1994. We acknowledge that this situation would likely arise for a limited number of taxpayers only. Nevertheless, for this group the process suggested would result in increased compliance costs.
Practical issues Cash dividend unpaid The Commissioner s view that a cash dividend derived by an accrual-basis taxpayer is recognised on an accrual basis will cause difficulties if the dividend is not subsequently paid because the solvency test cannot be satisfied at the relevant time. Recognition on an accrual basis results in the creation of a receivable amount; however, it is not a debt in the nature of a trade debt or financial arrangement debt. Therefore it is uncertain whether the accrued dividend amount returned can subsequently be reversed in a later income year. The bad debt deduction provision, section DB 31, would not allow a deduction. If, contrary to our view, the accrued dividend is considered to be a debt the criteria for a bad debt deduction would not be satisfied. The shareholder would not be aware before the end of their income year that the dividend will not be paid and so will not have written it off as bad in the income year. The situation is further complicated if imputation and RWT credits have been claimed. The statement should discuss the implications for accrual-basis taxpayers if a cash dividend that has been returned on an accrual basis is subsequently unpaid. For example, will the Commissioner accept a reversal/adjustment in the return for the following income year or will the taxpayer be required to request an adjustment under section 113 of the Tax Administration Act 1994? Business Transformation Under Inland Revenue s Business Transformation project it is proposed that dividend information will be required to be furnished more frequently on a real-time basis. It is intended that the information will be used to pre-populate individuals tax returns and to check/adjust their tax rates and social policy payments. In order for this process to be efficient and accurate Inland Revenue will need to have each taxpayers derivation method correctly recorded and available imputation and RWT credits correctly reflected. This may prove to be challenging and confusing for taxpayers. Furthermore, requiring taxpayers to undertake the level of analysis suggested in the exposure draft is inconsistent with the Business Transformation project objectives of simplicity and real time interactions between taxpayers and IR. It is also unclear how the Commissioner s view will be incorporated in the transformed tax administration system. As you are aware, some accrual-basis taxpayers currently account for cash dividends on a cash basis. In order to comply with the Commissioner s view these taxpayers will be required to incur additional compliance costs to change their systems and processes. Undoubtedly changes will again be required as Business Transformation progresses. Application It is proposed that the QWBA will apply from the income year commencing 1 April 2018 (or, for nonstandard balance date taxpayers, the first day of any income year starting after this date). We support the prospective application date. Given that the Commissioner s view in the item may be unexpected by some accrual-basis taxpayers,
the Commissioner should issue an operational statement at the same time the finalised QWBA is released. The operational statement should assure taxpayers that the Commissioner will not apply resources to identify cases before 1 April 2018 where cash dividends have been returned on a cash basis by accrual-basis taxpayers. We are happy to discuss our submission. Please contact Lindsay Ng or John Cuthbertson. Yours sincerely Paul Dunne FCA Chair, New Zealand Tax Advisory Group John Cuthbertson CA New Zealand Tax Leader