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Last Updated: 26 April 2020
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INTERNATIONAL TAX REFORM
PART 1
___________
REPORT OF THE
CONSULTATIVE COMMITTEE
MARCH 1988
Consultative Committee on
Full Imputation and International Tax
Reform
PO Box 3724
WELLINGTON
23 March
1988
Hon R O Douglas
Minister of Finance
Parliament
Buildings
Wellington.
Dear Mr Douglas,
On behalf of the
Consultative Committee on Full Imputation and International Tax Reform, I
enclose Part 1 of the Committee's report
on the reform proposals outlined in the
Consultative Document on International Tax Reform. The report outlines the
Committee's recommendations
on the main elements of the international tax
regime. We will report separately on further details of our recommended regime
and
on the proposals in the Consultative Document on Full Imputation.
The
Consultative Document proposed that the main taxing regimes, the branch
equivalent and the comparative value regimes, take effect
from 1 April 1988. We
have therefore concentrated in this report on the matters which need to be
decided before 1 April 1988 so that
taxpayers will know with as much certainty
as possible whether they are to be affected after that date. We believe that,
once you
have made your decisions, taxpayers will have a considerable degree of
certainty.
A period of uncertainty is one of the costs of the
consultative process. The trade off is that taxpayers have far more input into
decision making than they had previously. We believe that the benefits of the
consultative process outweigh the costs and that it
would be impossible to
implement tax reforms as complex as these without such a process.
If you
accept our recommendations on transitional provisions, most existing foreign
investments owned by New Zealand residents will
not be affected by the branch
equivalent regime until 1 April 1990. The need for legislative certainty from 1
April 1988 would therefore
be reduced.
This report deals with the major
building blocks of the international regime. Because of the substitutability of
different legal entities,
the building blocks need to be closely integrated. In
addition, the international reforms are intimately linked with the full
imputation
proposals, the reforms to the taxation of superannuation funds and
life insurance and also future tax reforms such as the introduction
of a capital
gains tax. We have considered our recommendations
in this context.
I would add that the recommendations in this report
represent the unanimous views of Committee members .
The Committee has
benefited from the input of officials of the Treasury and the Inland Revenue
Department. In particular, we express
our thanks to Messers Alex Duncan, Ken
Heaton and David White of Treasury and Anthony Grace and Michael Rigby of the
Inland Revenue
Department.
Yours sincerely
Arthur Valabh
Chairman
25 March 1988
PRESS STATEMENT
BY
Minister of Finance, Hon R O Douglas
Minister of
Revenue, Hon T A de Cleene
This document is the first part of the
report on the introduction of international tax measures by the Consultative
Committee on Full
Imputation and International Tax Reform. The report sets out
the major building blocks of the regime recommended by the Committee
following
its review of the regime contained in the Consultative Document and the many
public submissions received. So as to provide
taxpayers with as much information
as possible as soon as possible, this first part of the report is being released
now.
The Committee broadly endorses the Government's objective of
reducing the opportunities for the avoidance and deferral of New Zealand
tax by
residents through the use of offshore entities. It also recommends the
introduction of a domestic capital gains tax as a matter
of priority. It is
partly in light of such future action on capital gains that the Committee has
recommended a number of important
changes to the international tax regime set
out in the Consultative Document.
In brief, the major recommendation is that the branch-equivalent method of
taxation should apply only where there is control and,
where there is not
control, the comparative-value method of taxation should apply but only to a
limited range of investments (foreign
investment funds). To streamline the
operation of the branch-equivalent method and reduce compliance costs, an
exemption is recommended
for taxpayers having interests in entities which are in
designated countries and which do not benefit from significant tax preferences.
Transitional arrangements are also recommended by the Committee together with
more comprehensive disclosure provisions.
The regime recommended by the
Committee, although less comprehensive than that in the Consultative Document,
is one which substantially
meets the objectives of reform which were set by the
Government. The Committee has developed the regime in accordance with clear
principles and at the same time has given due recognition to the real practical
constraints. It has also had regard to the Government's
broader programme of
taxation reform.
Accordingly, we agree with the recommendations in the
Committee's report which constitute the basic framework of the regime. At this
stage there are only three main areas in which the Government reserves its
position. The first concerns the foreign investment fund
provisions
(recommendation (g), page 63). Their effect is to exclude from the regime all
residents with non-controlling interests
in 'active' tax haven entities. The
Committee has suggested that coverage of this area should await the introduction
of a domestic
capital gains tax, or evidence that the regime is not catching the
majority of opportunities for avoidance and deferral, or evidence
that taxpayers
are abusing the exemption. This is an area the Government intends to monitor
closely in the initial stages of the
operation of the regime. If necessary, such
provisions will be reviewed and strengthened prior to the introduction of a
capital gains
tax.
The second area in which the Government reserves its position is the
treatment of capital profits earned by trusts subject to the
settlor regime, and
by testamentary trusts, after 31 March 1989, that is after the end of the
transitional period. The Committee
has recommended that, on distribution,
capital profits be allowed to pass through to beneficiaries tax free
(recommendation (o),
page 65 and recommendation (t)(i), page 66). The Government
wishes to consider these recommendations further in the context of the
imputation and superannuation reforms.
The third area concerns the
taxation of resident trusts as defined under the new regime, settled on or
before 17 December 1987, in
the period from 1 April 1989. The Committee
recommends that the settlor regime apply to any such trusts which are newly
settled or
which have new settlements made to them after 17 December 1987, or
which have elected with the settlor's agreement to come under
that regime; other
trusts could remain outside the settlor regime, but distributions of income
(including accumulated income) and
capital profits to New Zealand resident
beneficiaries would be taxed to the beneficiary with an interest charge
calculated from 1
April 1988 to recoup deferred tax (recommendations (r), page
65 and (s), pages 65-66). At this stage, the Government considers that
from 1
April 1989 resident trusts should be taxed according to the settlor regime,
except where the settlor can demonstrate that
there is manifest good reason for
such an exception and it can be shown that either the trust is subject to tax in
a high tax jurisdiction
or the imposition of the settlor regime would cause
undue hardship to the settlor. For these excepted trusts, as for testamentary
trusts, the beneficiary regime recommended by the Committee would apply
(recommendation (s), pages 65-66 and recommendation (t) (ii),
page
66).
Subject to these reservations it is agreed that work on the further
detailed measures and the draft legislation, to be developed for
the
Government's final approval, proceed on the basis of the Committee's report.
A summary of the changes and the key elements of the new regime are to be set
out in a separate press release. Further information
on the detailed technical
issues relating to the operation of the regime will follow in the second part of
the Committee's report.
The Committee is chaired by Mr Arthur Valabh and
its members comprise Dr Robin Congreve, Mr Stuart Hutchinson, Dr Susan Lojkine,
Professor
John Prebble and Mr Tim Robinson. The Committee has faced a formidable
task. Its professionalism is reflected in the excellence of
the
report.
We thank Mr Valabh and his Committee for their significant
contribution to the reform of taxation in this area. Our appreciation extends
also to those who took the time to make submissions and provide constructive
comment. This has facilitated the Committee's work and
will result in
improvements to the policies finally enacted.
We look forward to the
second part of the Committee's report on the international tax measures and its
report on full imputation;
both will be accompanied by draft legislation. After
the subsequent introduction of the Bill to Parliament, it will be referred to
a
Select Committee. Interested parties will therefore have a further opportunity
to make submissions.
Roger Douglas Trevor de
Cleene
Minister of Finance Minister of Revenue
TABLE OF CONTENTS
Letter to the Minister of Finance
i
Press Statement by the Ministers
of Finance and Revenue iii
Table of Contents vii
CHAPTER 1 – INTRODUCTION 2
1.1 Purpose of This Report 2
1.2 Submissions 3
1.3 Context of the Reforms 3
1.4 Criteria for Evaluation of Proposals
4
1.5 Objectives of
International Tax Reform 5
1.6 Regimes Proposed in the
Consultative Document 10
1.7 Summary: Main
Building Blocks 13
CHAPTER 2 – BRANCH EQUIVALENT
REGIME
FOR CONTROLLED FOREIGN COMPANIES 15
2.1 Control Test 15
2.2 White List 18
2.3 Tax Preferences 20
2.4 Submissions 24
2.5 Dividends Received by a Controlled Company, Losses and Foreign Tax Credits 27
CHAPTER 3 – FOREIGN INVESTMENT
FUNDS 31
3.1 Avoidance Problems: Need for an
Alternative Regime 31
3.2
Coverage of the Regime 32
3.3 Foreign Investment Fund Regime
35
CHAPTER 4 – TREATMENT OF
DIVIDENDS 39
4.1
Corporate Recipient 39
4.2 Non-Corporate Recipient
42
CHAPTER 5 – TRUSTS
43
5.1 Introduction
43
5.2 Trust Income
43
5.3 Distributions From
Resident Trusts 46
5.4
Distributions From Non-resident Trusts 46
CHAPTER 6 – DISCLOSURE REQUIREMENTS AND
PENALTIES 49
6.1
Disclosure Requirements and Penalties 49
CHAPTER 7 – TRANSITIONAL PROVISIONS
50
7.1 BE Regime
50
7.2 Resident Trusts
51
7.3 Non-Resident
Trusts 54
7.4 Foreign
Investment Funds 55
7.5
Recommendations 55
CHAPTER 8 – FURTHER MEASURES
58
8.1 Role of a Capital Gains
Tax 58
8.2
Interjurisdictional Allocation Rules 59
8.3 Recommendation 60
CHAPTER 9 – SUMMARY AND CONCLUSION
61
9.1 Summary of
Recommendations 61
9.2 Conclusion
67
ANNEXES
1 Control Interests of Residents in Controlled Foreign Companies 69
2 Issues Relating to the Determination and Attribution of Branch Equivalent Income 80
5 An Illustrative Transitional List
of Low Tax Jurisdictions
112
Report on
International Tax
Reform
Part
1
______
Consultative
Committee on
Full Imputation and International Tax Reform
CHAPTER 1 – INTRODUCTION
1.1 Purpose of This Report
1.1.1 This
is Part 1 of the Report of the Consultative Committee on Full Imputation and
International Tax Reform. It deals with the
Committee's recommendations on the
main elements of the international tax reforms. Our aim in presenting this
report is to enable
you to give taxpayers as much certainty as possible before 1
April 1988, the implementation date proposed in the Consultative Document
on
International Tax Reform (the "CD") for the regimes to apply to undistributed
income.
1.1.2 To this end, the report concentrates on the Committee's
recommendations on the main building blocks of the international tax
reforms
and, in particular, the boundaries of the regime and the transitional
provisions. In this way, we hope that, once you have
considered our
recommendations, taxpayers will know with as much certainty as is practicable at
this stage whether they are affected
by the regime and, if so, when it will
first affect them and broadly how it will do so. Where we have not finalised our
views, we
say so or refrain from commenting.
1.1.3 A number of details
are still to be considered. We will address these in Part 2 of our report which
will accompany the draft
legislation. A separate report will also be prepared on
full imputation and the corresponding draft legislation.
1.1.4 Given the Committee's reporting deadline of 31 March 1988, we began
meeting on 22 December 1987 in an endeavour to identify
the major issues. We
have met regularly, usually several times a week, since then. Since our brief
includes the preparation of draft
legislation, we have engaged three legal
draftsmen to assist with this task. As a result, the draft legislation is well
advanced,
though considerable detail has still to be decided.
1.2 Submissions
1.2.1 A total of
209 submissions were received by the Committee. Of these, 108 dealt only with
the international tax reforms, 49 dealt
only with imputation and 47 commented on
both. Given our reporting deadline, we have been able to hear only a small
number of oral
submissions. Committee members have, however, discussed the CD
proposals widely with tax practitioners and business people. In addition,
Committee members attended the Institute of Policy Studies seminar on the
reforms, which was held in Wellington on 2 February 1988,
and the annual
conference of the New Zealand branch of the International Fiscal Association,
held at Wairakei on 26-27 February 1988,
which was focussed entirely on the
international reforms and imputation. These were helpful in providing feedback
on the CD proposals
and alternatives advocated by practitioners.
1.3 Context of the Reforms
1.3.1 The
international tax reforms are part of a wider package of reforms which includes
substantial reductions in statutory tax
rates and removal of tax concessions for
superannuation and life insurance. The Committee recognises that
the Government regards an effective international regime as part of the
trade off for lower tax rates and, indeed, a prerequisite
for the latter. In
addition, the reforms should be mutually consistent and should reinforce one
another as far as possible. For example,
the effectiveness of the superannuation
fund tax reforms depends in part on the international tax regime covering
offshore vehicles
which could substitute for domestic superannuation funds. The
Committee has kept these linkages in mind in considering the present
proposals.
1.3.2 The reforms must also be seen in the context of future
tax reforms, particularly the possible introduction of a capital gains
tax and
interjurisdictional allocation rules (such as transfer pricing and expense
allocation provisions). The latter are necessary
to ensure that New Zealand
collects the appropriate amount of revenue from domestic investments owned by
non-residents. This objective
is not addressed in the current international
proposals, which are aimed at taxing New Zealand residents on income diverted
from
New Zealand and foreign-source income derived through offshore companies
and trusts.
1.4 Criteria for Evaluation of Proposals
1.4.1 There are
a number of criteria which are conventionally used to evaluate tax reforms.
These have formed the basis of the Committee's
framework for considering the CD
proposals and possible alternatives. In brief, we believe the reforms should
be:
1.4.2 We would add that taxpayer perceptions of the
reforms will be enhanced if they are consistent with existing income tax
principles
and give adequate recognition to the need for transitional
measures.
1.5 Objectives of International Tax Reform
1.5.1 The CD
has two main objectives: to
"a protect the domestic tax base from arrangements which seek to avoid or defer New Zealand tax by the accumulation of income in offshore entities; and
(CD, page 1)
1.5.2 There is no sharp distinction between tax avoidance and tax
deferral since the latter amounts to a permanent reduction in the
present value
of the tax collected by New Zealand. The avoidance problem which the CD
identifies and which was the target of the
controlled foreign company ("CFC")
measures announced in Annex 4 of the 1987 Budget is essentially the use of
controlled tax haven
vehicles, whether companies or trusts, to avoid New Zealand
tax by the diversion of New Zealand-source income. There is widespread
agreement amongst parties making submissions that the Government is fully
justified in addressing this
problem. The Committee certainly endorses this
view. There is also general, though less solid, support for a regime which taxes
the
accumulation of foreign-source income in tax haven
entities.
1.5.3 The anti-deferral objective is much more contentious and
there is considerable opposition in submissions to a comprehensive
anti-deferral
regime. The CD regards the deferral problem broadly as the absence of taxation
on an accrual basis of residents on
income they earn through non-resident
companies and trusts. At present, New Zealand tax is collected on income derived
by foreign
companies owned by New Zealand residents only when it is distributed
to non-corporate resident taxpayers. In the case of trusts,
New Zealand tax is
collected, if at all, only when distributions are made to resident
beneficiaries.
1.5.4 The CD proposals pursue the anti-deferral objective
primarily by aiming to tax residents on the undistributed income of non-resident
companies and trusts in which they have an interest or a connection as a
settlor. This objective is also behind the introduction
of a withholding payment
to apply to foreign-source non-portfolio dividends received by resident
companies, as announced in the Government
Economic Statement of 17 December
1987.
1.5.5 Thus, the thrust of the reforms is to tax all residents, including
companies, on the income that they actually receive from
foreign entities (i.e.
non-resident companies and trusts) and on certain undistributed income. The
taxation of income on receipt
is well within the current concepts of the income
tax system (though other considerations may suggest that dividends received by
companies should be taxed differently from dividends received by individuals).
As commercial transactions have become more sophisticated,
both the accounting
and the income tax concepts of income have of necessity been extended in many
areas to include not only income
received but income which can be said with
reasonable certainty to have accrued. It is fully consistent with this extended
definition
of income to tax residents on the undistributed income of
non-resident entities that can reasonably be assumed to have accrued to
them.
This does not require that they have legal title to the income. It is sufficient
that they possess the power to give themselves
legal title. We therefore do not
regard it as offensive to income tax principles that residents are taxed on
income over which they
have power of disposition, even if they have not received
it. We would, however, go no further than this. It is not reasonable to
tax
residents on income that they may never receive.
1.5.6 One of the
Committee's main reservations about the CD proposals is that they pursue the
anti-deferral objective to its extreme
limits without giving enough attention to
conventional income tax principles or to the administration and compliance
problems which
arise. In some cases, taxation would be levied on amounts that
were well beyond the income to which a taxpayer had any reasonable
chance of
access. Moreover, at some point, the administration and compliance costs would
be excessive relative to the revenue that
could be expected.
1.5.7 The CD supports the anti-deferral objective on the basis that "a
broadening of the tax base with respect to foreign income is
required to permit
cuts in the rates of income tax applicable to both individuals and companies"
(CD, page 15). This is seen as the
primary justification for the comparative
value ("CV") regime (under which residents would be taxed on the annual change
in the market
value of their interests in foreign companies), though it has also
been advanced on other grounds which will be discussed below.
The Committee
strongly supports the objective of broadening the tax base and lowering income
tax rates. We believe that this objective
also has widespread support amongst
the business community. There is, however, strenuous opposition to pursuing it
through what is
in effect an accrual nominal capital gains tax, i.e. the CV
method. The CV method is not defended in the CD as a capital gains tax.
There is
no discussion of the fundamental design issues associated with such a tax, such
as whether it should tax only real or nominal
gains and whether it should apply
on an accrual or realisation basis. Given the complete novelty of the CV
proposal, its lack of
any international precedent, its valuation problems, its
cash-flow consequences and the absence of a convincing justification for
it in
the CD, it is not surprising that the proposal found no support amongst those
who made submissions.
1.5.8 This raises the Committee's other main
concern. The CD gives too little weight to the importance, in a tax system based
on voluntary
compliance, of acknowledging taxpayer perceptions of "fairness". If
the CV regime were implemented as proposed, it would encourage
evasion and
stretch the limits of avoidance because taxpayers would regard it as very
unfair. The objective of retaining taxpayer
goodwill should be kept in mind.
1.5.9 The second objective referred to in paragraph 1.5.1, of reducing
the extent to which the tax system encourages offshore investment,
is intimately
linked with the first objective. To the extent that tax payable on foreign
investment is avoided or deferred relative
to the tax that would be payable in
New Zealand, the tax system will influence decisions to invest in New Zealand or
overseas. Most
decisions to invest offshore are not tax driven though, as an
important business cost, taxes must obviously be taken into account
and will
influence decisions to repatriate or reinvest income. The CD objective refers to
the impact of taxes on the marginal investment decision, that is, where
other factors are in balance, tax considerations might tip the scales in favour
of investing
offshore rather than in New Zealand.
1.5.10 This objective
can be addressed in terms of the criteria of "capital export neutrality" (which
holds when foreign- and domestic-source
income are taxed in the same way so that
residents are indifferent on tax considerations between investing offshore or
domestically)
and "capital import neutrality" (which holds when the tax
treatment of foreign investments is determined solely by the rules applying
in
the country in which the investment is located). Many submissions explicitly or
implicitly advocated the latter approach in order
that New Zealand firms could
compete with foreign firms. It was pointed out that no other country has a
regime comparable to that
proposed in the CD.
1.5.11 To a large extent,
the international competitiveness argument advanced in submissions reflects the
immediate and potentially
adverse impact the CD proposals would have on existing
investment. The Committee considers that these concerns can be addressed by
providing adequate transitional arrangements. As to the future, we recognise
that tax is only one factor
affecting competitiveness. In the long run, New Zealand as a whole is
best served by an efficient tax system: that is, one which is
neutral between
domestic and foreign investment. The Committee therefore supports the second
objective of the CD, though there are
major constraints on the extent to which
it can be achieved. We comment further on this issue in section
2.3.
1.5.12 Wherever there is cross-border investment, there are at least
two tax jurisdictions involved: the country in which the investment
is sourced
and the country in which the investors are resident. The interests of the
respective revenue authorities are to some extent
in conflict because the
residence country typically allows a tax credit, within limits, for the tax
levied by the source country.
Tax treaties resolve the conflicting interests to
some extent but unilateral tax changes can affect the balance. For example,
Australian
companies have an incentive to minimise the New Zealand tax they pay,
even if this means increasing their Australian tax, since the
Australian
imputation scheme allows credits for Australian but not foreign company tax.
Thus, another general objective of reform
of New Zealand's international tax
regime should be to ensure that New Zealand collects its share of tax,
especially on income that
has a New Zealand source. This is the objective of
allocation rules which we referred to in section 1.5.
1.6 Regimes Proposed in the Consultative Document
1.6.1 The
scope and nature of the international tax regime should be determined in the
light of the above objectives and the criteria
for evaluation outlined in
section 1.4. The CD proposes two broad options for taxing on an accrual basis
income derived by residents
through offshore entities. The first is to tax
residents each year on "their share" of the underlying income of
the offshore entity. This is the approach taken under the
branch-equivalent ("BE") method. The second approach is to tax residents
on the
distributions they receive from the offshore entity and the capital gain or loss
that accrues to them each year. This is the
all-embracing approach of the CV
method.
1.6.2 These two approaches differ because taxable income may be
less than comprehensive but, given a reasonably broad tax base, the
primary
difference is that the BE method taxes what may be termed systematic gains
(which are due primarily to the accumulation of
assets within companies as a
result of retained earnings), whereas the CV method taxes both systematic and
non-systematic or unanticipated
gains. From the point of view of the efficiency
of the tax system, it is not necessary to tax unanticipated or windfall gains
and
losses. Because such gains cannot be anticipated, they cannot influence
investment decisions. Thus, the case for taxing them must
rest on some notion of
fairness.
1.6.3 Another way of viewing the difference between the two
methods is that BE income is taxable income as currently defined whereas
CV
income is the much less conventional economic concept of income. The Committee
prefers the approach, wherever feasible, of taxing
residents on the underlying
income of foreign entities since this focuses on systematic or planned gains and
is consistent with the
principles of the current tax system.
1.6.4 Where
this approach (i.e. the BE method) is not feasible, the CD falls back on the CV
method. Some of the Committee's concerns
about the CV approach were referred to
above. An accrual alternative to the CV method would be to tax residents each
year on their
share of the reported income of foreign companies based on the
companies' audited accounts. In
order to avoid taxing residents on the undistributed income of foreign
companies which they never receive, it would be desirable to
have a post facto
wash up on disposal of shares. This post facto adjustment would determine the
actual gain or loss derived by a
taxpayer on a foreign investment by calculating
the distributions received and the capital gain or loss. Thus, a
realisation-based
capital gains tax is an inherent part of this
approach.
1.6.5 The Committee do not advocate the adoption of this
approach now. We mention it mainly to suggest that there are alternatives
to the
CV method that would meet the Government's objectives and in some respects are
preferable to the CV method. The option outlined
would be best examined in the
context of the current investigation of capital gains taxes and should be
introduced only as part of
a general capital gains tax.
1.6.6 The CV
method does, however, have a role as part of the current reforms where there are
systematic or expected gains resulting
from the accumulation of income in an
offshore entity, such as may be the case for some unit trusts and mutual funds.
We comment
further on this in chapter 3.
1.7 Summary: Main Building Blocks
1.7.1 The
Committee's proposals are developed in the following chapters. The main elements
are:
CHAPTER 2 – BRANCH EQUIVALENT REGIME FOR CONTROLLED FOREIGN COMPANIES
2.1 Control Test
2.1.1 The
BE method would tax New Zealand shareholders on their proportionate shares of
the undistributed income of foreign companies
measured according to New Zealand
tax rules. Thus, the method requires taxpayers to have all of the information
necessary to recompute
the taxable income of offshore companies. In practice,
this information will generally not be available unless the resident(s) control
the offshore company. In addition, as we have argued in section 1.5, it is
unreasonable to tax residents on the undistributed income
of offshore companies
which they may never receive, unless they at least have access to it, that is,
they have the power to require
distribution if they wish. For these two reasons,
the Committee recommends that the BE regime apply only where residents control
an offshore company.
2.1.2 This would be in line with practice overseas,
where BE-type regimes apply only where there is a controlled foreign company.
Submissions were strongly in favour of a control test. This would not be a
significant departure from the CD proposals since, in
practice, the BE regime
could be applied only where there is control.
2.1.3 A number of companies
making submissions noted that their ability to repatriate profits from
non-resident subsidiaries may be
restricted because of exchange controls,
governmental foreign investment requirements, or agreements made with
co-venturers. Since
businesses do not consciously make bad investment decisions,
we would expect that the return generated
from foreign subsidiaries in these circumstances will be higher than
otherwise to reflect the constraints imposed. Thus, the New Zealand
parent will
generally expect to be able to gain access to the foreign subsidiary profits at
some stage, though not necessarily to
repatriate them, and be compensated for
any impediments and time delays. Even if this were not the case, it would be
impracticable
to give relief from the BE regime merely because profit access
restrictions exist because taxpayers could voluntarily enter into
such
arrangements to suspend the effect of the regime. It might also encourage
foreign governments to impose repatriation controls
on New Zealand investment.
Where such restrictions currently apply to foreign subsidiaries, some relief
will be provided by the transitional
provisions recommended by the
Committee.
2.1.4 The Committee has considered the appropriate control
test after looking at several overseas models. Any test must of necessity
be
somewhat arbitrary since, in practice, there are no clearly defined criteria for
control. We recommend defining control as the
ownership of 50 percent or more of
the shares (or rights to income, distributions on wind up, votes, etc) of a
company by 5 or fewer
residents. This is similar to the Canadian test and that
proposed in Annex 4 of the 1987 Budget. It would be necessary to have a
constructive ownership rule so that interests held in nominees and associated
parties would be aggregated. In addition, we propose
an anti-avoidance provision
aimed at arrangements, such as voting trusts and understandings, which have the
effect of defeating the
intent and application of the control test. We would
also add a de facto control test to cover situations such as where a shareholder
has a right to require a distribution or the wind up of a company.
2.1.5 Where a non-resident company falls within the control test, all of its
New Zealand shareholders or only the controlling ones
could be subject to the
regime. The Committee favour the latter approach because only controlling
shareholders have access to the
necessary information and the undistributed
income of the company. Since there may be more than one group of 5 residents
which satisfies
the control test, we recommend that all resident shareholders of
controlled companies with interests of 10 percent or more (hereafter
referred to
as "non-minor" shareholders) be subject to the BE regime. An exception should
apply where control exists by virtue of
the proposed anti-avoidance or de facto
control provisions. In those cases, the residents deemed to have control should
be subject
to the regime in accordance with their proportionate
interests.
2.1.6 Further details of the control provisions proposed by
the Committee are contained in Annex 1.
Recommendation
2.1.7 The Committee therefore recommends
that, in relation to foreign companies:
2.2. White List
2.2.1 One of the
criticisms of the BE regime is that it would involve heavy compliance costs for
possibly little revenue when it applied
to companies in "high tax" countries,
such as the United States and the United Kingdom. The compliance costs would be
most acute
for New Zealand's large internationally diversified companies, some
of which have hundreds of offshore subsidiaries. In addition,
the administrative
costs of the regime would be high.
2.2.2 The United Kingdom, West Germany and France address this problem by
having a so-called "white list" of countries. If a company
is resident in a
white list country and the large bulk of its income is sourced and subject to
tax in such countries, it is exempt
from the CFC regime.
2.2.3 In
principle, it is desirable to minimise compliance costs where the revenue at
stake is not material. The practical difficulty
in this case is that the revenue
loss relative to the compliance cost savings resulting from some form of list
cannot readily be
quantified. Nevertheless, the Committee recommends the
adoption of a restricted list as a reasonable pragmatic compromise. We recognise
that no list can be watertight and that there will be costs in compiling and
updating it. These problems must be weighed against
the need to reduce the
compliance costs of the regime where it is unlikely that revenue would be
collected.
2.2.4 Accordingly, the Committee favours a list, qualified by
tax preferences as set out below, of countries which have comprehensive
international tax rules including CFC regimes. At present, there are six - the
United Kingdom, the United States, West Germany, France,
Canada and Japan. We
understand that Australia is currently considering the introduction of a CFC
regime and, given our proposed
transitional provisions (discussed in chapter 7),
we recommend that Australia be included on the list. The existence or otherwise
of a CFC regime gives the list an objective basis.
2.2.5 The United Kingdom white list is qualified by an income source rule to
the effect that, to be exempt from the CFC regime under
the white list
provisions, controlled companies must derive at least 90 percent of their income
in the (white list) country in which
they are resident. This rule aims to ensure
that, to qualify for exemption, the large bulk of the income of a controlled
company
must be subject to tax in a white list country. An alternative approach
is to "look through" companies resident in white list countries
to controlled
companies beneath them. These lower tier controlled companies would be exempt
only if they also satisfied the qualified
white list test. The Committee favours
this approach rather than an income source test, In addition, it would be
necessary to list
as a significant preference the exemption of foreign-source
income where a listed country excluded it from its tax base. This is
presently
the case with France. We discuss the issue of foreign tax preferences in the
next subsection.
2.3 Tax Preferences
2.3.1 In
addition to having a white list, the United Kingdom has a qualified (or "grey")
list which provides for exemption from the
CFC regime only if the foreign
company does not benefit from certain listed tax preferences. Many submissions
argued that foreign
tax preferences should be recognised under the BE regime to
preserve the competitiveness of foreign subsidiaries of New Zealand companies.
We commented briefly on the international competitiveness argument in section
1.5. The arguments against recognising foreign preferences
are that:
were recognised under the BE regime since it would merely encourage New Zealand residents to invest offshore. If tax incentives were to be allowed as a matter of tax policy, it would be better to provide them domestically;
2.3.2 In addition, the trend amongst OECD countries
is to phase out or remove tax preferences. This is certainly the case in the
United
States, the United Kingdom and Canada. As tax preferences are removed,
effective tax rates in other countries will rise so that,
since New Zealand's
statutory tax rates will be amongst the lowest, if not the lowest, in the OECD,
our
effective tax rates should be comparable to those in the countries where most
of New Zealand's offshore investment is located. The
impact of the BE regime on
the competitiveness of New Zealand-owned foreign companies will therefore
diminish as the trend away from
preferences continues.
2.3.3 In the
Committee's view, the arguments against recognising foreign tax preferences
under the BE regime outweigh the counter
arguments. We therefore favour the
qualification of the proposed white list by the identification of significant
tax preferences
in each country. As noted above, this qualified list is referred
to as a grey list. Taxpayers would be required to adjust the taxable
income of a
CFC resident in a listed country, measured according to that country's tax
rules, for any identified significant preferences
that the CFC has utilised. If
the foreign tax paid as a proportion of the adjusted taxable income equals or
exceeds the New Zealand
company tax rate, the taxpayer would be exempt from the
regime in respect of that CFC. In our view, the reduction in the New Zealand
statutory company tax rate removes the need to base this effective tax rate
comparison on two-thirds of the statutory rate, as proposed
in Annex 4 of the
1987 Budget.
2.3.4 The comprehensiveness of the list of preferences is
largely a matter of tax policy. New Zealand tax policy has been to eliminate
explicit preferences. This may suggest a relatively extensive list, though
materiality and compliance costs must be taken into account.
2.3.5 A
number of submissions argue that the claw back of foreign tax preferences would
be inconsistent with a number of New Zealand's
tax treaties which include tax
sparing provisions. These provisions generally apply only to branches of New
Zealand
companies in the tax treaty country and, since foreign branches are not
affected by the present reforms, tax sparing would not be
withdrawn or
diminished. We are satisfied that the BE regime does not breach a tax treaty
obligation. The tax sparing provisions
were, however, entered into before the
introduction of the present proposals and may now appear to be inconsistent with
the thrust
of the reforms.
Recommendation
2.3.6 The Committee therefore recommends
that:
2.4 Submissions
2.4.1 Most
submissions were in favour of a CFC regime along the lines of those applying in
other countries. The two main differences
between the regime proposed by the
Committee and CFC regimes elsewhere are that:
2.4.2 The artificiality of the distinction between active
and passive income is best illustrated in the case of shares. A share portfolio
of, say, one percent stakes in 100 companies is regarded as a passive investment
even though each company may itself be an active
business. Conversely, a 100
percent holding
in a single company is regarded as a direct or active investment. In the
first case, an interest is held in 100 active businesses.
In the second case, an
interest is held in one active business. In both cases, the income of the
shareholder consists of dividends
and capital gain on the shares. Though these
investments may differ in other respects, both are ultimately investments in
active
businesses. Thus, there are boundary problems in distinguishing between
active and passive investments.
2.4.3 Another problem with the
active/passive income distinction arises with certain classes of income. For
example, interest income
is regarded as active business income when it is earned
by a financial institution but passive income when derived by other businesses.
If the regime employed this distinction, banks could shelter interest income
while other businesses would reorganise themselves in
an attempt to resemble
banks or they would establish finance subsidiaries which were difficult to
distinguish from banks. This problem
has forced the United States to include
within its definition of CFC (i.e, subpart F) income dividends, interest and
realised gains
from the disposition of shares and other securities, regardless
of the nature of the business deriving them. For similar reasons,
subpart F
income now includes income from the insurance of risks outside the insurer's
country of incorporation.
2.4.4 Finally, the advantages of low tax rates
and tax preferences are the same whether they apply to active or to passive
income.
In view of these considerations, the Committee considers that there is
no merit in distinguishing between different classes of income.
2.4.5 The argument for targeting the BE regime on tax haven CFCs is that
these are the major avoidance vehicles. There are, however,
several problems
with this approach. The first is that there are definitional problems. A country
which is normally regarded as a
high tax country may in practice be a tax haven
for certain types of investment. An example was the United Kingdom in respect of
manufacturing activity before it commenced to phase out immediate capital
write-offs in 1984. The effect of the capital write-offs
was generally to
eliminate the tax liabilities of manufacturing businesses in the United Kingdom.
If this had been achieved by abolishing
income tax on manufacturing, the United
Kingdom would have been regarded as a tax haven for this type of business. Thus,
the existence
of tax preferences removes any clear distinction between a tax
haven and a non-tax haven.
2.4.6 The more general argument is that, from
an anti-deferral perspective, there is no difference between these two types of
jurisdiction.
Offshore income derived by resident companies that is ultimately
taxable in New Zealand is foreign income net of foreign taxes. (Where
foreign income is earned directly by an individual, a credit is given for
foreign taxes). It does not matter
whether the income is sourced in a low- or
high-tax jurisdiction, the deferral benefit is the same. The CD does not,
however, propose
the complete elimination of tax deferral by permitting
companies only a deduction for foreign tax in the calculation of a their tax
liability on BE regime. Instead, a credit will be given, though this is clawed
back when the income is distributed. Thus, in the
context of the CD proposals,
New Zealand tax liabilities under the BE regime will depend on whether the
foreign company is resident
in a high- or low-tax jurisdiction. For this reason,
the Committee advocates the adoption of a grey list as outlined in section
2.3.
2.4.7 On a practical level, there would be obvious difficulties with the
alternative approach of targeting the regime on companies
resident in listed tax
havens. The list would never be up to date and would probably exclude apparently
high tax countries which
nevertheless had significant tax preferences. For this
reason, no country except Japan bases its CFC regime on a formerly published
tax
haven list. (The Committee does propose a distinction between tax havens and
other countries as part of its recommended transitional
provisions but in this
case, a need for exhaustive coverage and updating does not arise.)
2.5 Dividends Received by a Controlled Company, Losses and Foreign Tax Credits
2.5.1 BE
income will be calculated according to New Zealand tax law. A number of special
rules will, however, be required in respect
of dividends received by a
controlled company, BE losses and the calculation of the amount of foreign tax
to be credited against
the New Zealand tax liability on BE income. The Committee
has had time to give only preliminary consideration to these issues but
we set
out below our current thinking.
2.5.2 The tax treatment of dividends
received by a controlled foreign company needs to mirror their treatment in the
hands of its
resident shareholders. If this were not the case, it would be easy
to avoid the domestic rules by trapping dividends in a non-resident
vehicle.
There would then be little point in changing the domestic rules. Thus, portfolio
dividends received by a controlled non-resident
company should be assessable to
both corporate and non-corporate resident non-minor shareholders.
Non-portfolio dividends received by the controlled company should also be
assessable to a non-corporate non-minor shareholder but a
corporate non-minor shareholder would be subject to the proposed
withholding payment system if the proposed domestic tax rules applied to the
calculation of the BE income. In order to avoid the multiple levying of tax on
dividends, it would be necessary in the case of both
corporate and non-corporate
non-minor shareholders to exclude dividends received by a controlled
company from another company in relation to which the taxpayer is also a
non-minor shareholder.
2.5.3 This treatment would, however, be simplified
if all dividends received by a controlled company, other than those received
from
another company in respect of which the taxpayer is a non-minor
shareholder, were made assessable. It would then not be necessary
for a
corporate shareholder to keep separate account of portfolio and non-portfolio
dividends.
2.5.4 The BE regime itself and the proposed changes to the
treatment of dividends received by companies have implications for the
deductibility of interest on money borrowed by a company to acquire shares in
non-resident companies. The deductibility of interest
expense relating to
foreign investments would also be affected by interjurisdictional allocation
rules. It would therefore be desirable
to review the current provisions relating
to interest deductibility in the context of the consideration of allocation
rules.
2.5.6 The treatment of BE losses was one of the most contentious
issues raised in submissions. The CD proposed that BE losses (which
would be
computed according to New Zealand tax rules) be "ring-fenced" to the BE regime.
That is, losses would be able to be offset
against any BE income of a taxpayer,
but not
against non-BE taxable income (i.e New Zealand- and foreign-source income
taxable under current law). Any excess BE loss not able
to be offset against BE
income in the current year would be carried forward for offset against BE income
in future income years.
2.5.7 Submissions were opposed to any
ring-fencing of BE losses and generally called for unrestricted pooling of
losses with a taxpayer's
other taxable income. The unrestricted offset of BE
losses would, however, lead to a decidedly asymmetric result as far as the New
Zealand tax base was concerned. When a taxpayer derived a BE profit but the
foreign tax paid by the controlled company was at least
equal to the New Zealand
tax liability on the BE income, no New Zealand tax would be collected. If, once
the controlled company made
a loss, the loss could be offset against other New
Zealand taxable income, the overall result would be to diminish the New Zealand
tax base. Similar problems arise now with actual branches. There is no point in
implementing a regime which would further erode the
present tax
base.
2.5.8 Another problem would arise if taxpayers could acquire BE tax
losses (by obtaining an interest in non-resident companies which
were in tax
loss under New Zealand rules) to shelter BE income in low tax jurisdictions.
Anti-avoidance rules could cope with this
to some extent but such rules have
their own deficencies.
2.5.9 Considerations such as these suggest that
the CD proposals will need to be tightened rather than relaxed. At one extreme,
BE
losses could be ring-fenced to the offshore entity for each taxpayer. This
may, however, be impracticable since, where control exists,
taxpayers will
generally have some
discretion to shift taxable income between different controlled companies,
particularly where they are resident in the same country.
Thus, a further
possibility would be to allow the grouping of profits and losses among entities
within the same tax jurisdiction.
The Committee will report further on this
issue.
2.5.10 The rules for crediting foreign taxes need to be integrated
with those applying to losses. The CD proposed that credits be
limited on an
entity by entity and a source of income basis. We have yet to discuss the
appropriate rules for foreign tax credits.
2.5.11 Some further discussion
of various aspects of the BE regime is contained in Annex 2.
CHAPTER 3 – FOREIGN INVESTMENT FUNDS
3.1. Avoidance Problems: Need for an Alternative Regime
3.1.1 If,
as recommended by the Committee, the BE regime applied only to the non-minor
shareholders of controlled foreign companies,
the types of offshore investment
outside the regime would be:
3.1.2 The CD
proposes that the CV regime should apply to all of these types of investment. In
the light of the concerns about the
CV regime outlined in chapter 1, the
Committee considers that it could be justified now only where there is a serious
avoidance problem
that exists or can reasonably be expected to develop. Outside
that area and CFCs, the taxation of the gains, other than dividends,
that
residents derive from offshore investments should await the introduction of a
general capital gains tax.
3.1.3 In the Committee's view, minor or
non-controlling shareholdings in companies resident outside tax havens clearly
fall in the
category of investments that are best taxed under a capital gains
tax. These companies cannot be used by the investor to erode the
New Zealand tax
base and the most important
of them, publicly listed companies, generally distribute a substantial
proportion of their income as dividends which are already taxed
or will suffer a
similar impost under the Government's new proposals.
3.1.4 Minor or
non-controlling shareholdings in tax haven companies are a possible source of
concern. The majority of problem cases
will, however, be passive investment
vehicles which would fall into the foreign investment fund regime discussed in
section 3.3.
3.1.5 Offshore funds, especially those located in tax
havens, are clearly the biggest avoidance problem. The Committee therefore
favours
the introduction of a foreign investment fund regime targeted at
investment vehicles which confer significant tax benefits, such
as unit trusts
based in tax havens.
3.2 Coverage of the Regime
3.2.1 In summary,
the two building blocks of the Committee's proposals for companies would
be:
3.2.2 Between these two types of investment, no regime
would apply. Three arguments have been advanced for a regime which applies
to
all foreign investments. The first is that complete coverage is needed to catch
taxpayers who have control of an
foreign company but manage to avoid the control test. The response in other
countries to vehicles which side step the control test
has been to introduce an
offshore fund regime. We would similarly expect that many of these
non-controlled vehicles would fall into
the foreign investment fund regime
proposed by the Committee. With a comprehensive definition of control and a wide
foreign investment
fund definition, the remainder of the problem does not
justify the administration and compliance costs of a fully comprehensive regime.
We would also note that most companies find real minority interests
disadvantagous. Minority interests will be all the more unattractive
as a result
of these reforms since a substantial though minority shareholder in a
non-resident company could be tipped into the BE
regime by the purchase of a
possibly small interest in the company by another New Zealand
resident.
3.2.3 The second argument for comprehensive coverage is that a
CV or comparable regime is needed to discourage resident companies
from "going
offshore", by penalising their New Zealand resident shareholders. By going
offshore it is meant that a New Zealand company
would establish a non-resident
holding company which would own its New Zealand and foreign subsidiaries. No New
Zealand company would
then own foreign assets. Thus, the corporate group would
avoid the international regime. Under the CD proposals, however, the resident
shareholders in the foreign company would fall into the relatively draconian CV
regime, thereby discouraging such restucturing.
3.2.4 It is obvious that
this restructuring does not result in a shift of physical assets out of New
Zealand. In addition, the resident
shareholders end up in no better position
than residents who own shares in what are now non-resident companies.
Furthermore, the
tax advantages are not one-sided since the restructured company
would lose the ability to pass imputation
credits for New Zealand tax paid through to its resident shareholders. In
addition, non-resident dividend withholding tax on dividends
paid out of New
Zealand and dividend withholding payment on incoming dividends might also be
incurred. Moreover, there are commercial
constraints on this process since, at
the end of the day, New Zealand companies are dependent on New Zealand
shareholders for their
equity base and need to maintain good relationships with
them. The Committee therefore considers that the second argument is not
sufficient to warrant a fully comprehensive regime at this
stage.
3.2.5 The third argument is that a comprehensive regime would
extend the tax base and permit a further reduction in tax rates. If
revenue were
the objective, however, it would be necessary to evaluate alternative sources
which might better meet the efficiency,
equity and simplicity objectives of tax
reform. As argued elsewhere, the Committee considers that the taxation of
foreign equity
investments outside tax havens is best left to a capital gains
tax regime and could not be advanced now without a real cost in taxpayer
attitudes towards voluntary compliance.
3.2.6 The Committee therefore
concludes that there is insufficient justification for a fully comprehensive
regime at this stage. If
a problem emerges, additional measures could be
considered. In order to monitor developments and encourage compliance, it is
desirable
to have comprehensive disclosure requirements. For example, all
taxpayers could be required to disclose offshore interests that fall
outside the
BE and foreign fund investment regimes. This would enable the Inland Revenue
Department to request further information
where necessary and hence keep abreast
of responses to the new measures. We consider that the approach of aiming to
define the extent
of the problem, if any, resulting from incomplete coverage is
preferable to implementing an across-the-board regime now.
Recommendation
3.2.7 The Committee therefore recommends that
the CV regime apply only to interests in foreign investment funds, as discussed
in section
3.3.
3.3 Foreign Investment Fund Regime
3.3.1 The
definition of a foreign investment fund can potentially be very wide. The regime
should be targeted at non-resident entities
which provide significant tax
advantages compared with comparable entities in New Zealand. This is the case
when the income of the
entity is untaxed or only lightly taxed compared with the
tax that would be levied on such income in New Zealand. For example, a
unit
trust based in a tax haven which invests in debt securities would offer
significant tax advantages to New Zealand investors
compared with an identical
unit trust in New Zealand. A unit trust investing exclusively in shares,
however, offers tax advantages
only to the extent that it permits dividend
income to be converted into capital gain. A diversified foreign investment fund
will,
however, typically own non-controlling interests in companies, debt
instruments and other investments.
3.3.2 The other targets of the foreign
fund regime are entities which slip outside the BE regime because they provide
tax benefits
which do not depend on control. This will generally be feasible
among non-associated persons only when there are well-defined means
of
purchasing and disposing of interests and regularly quoted prices for them so
that members can monitor fund performance. Thus,
such funds will typically be
listed on a stock exchange or have redemption arrangements under which
investors can sell their interests to the fund manager at a price based on
the net assets of the fund.
3.3.3 In order to address the tax advantages
offered by these types of fund, the Committee favours a regime based on the
Canadian
one. According to Canadian tax practitioners, this has largely
eliminated the marketing of tax haven funds in Canada. The key criteria
for the
application of the regime would be that:
3.3.4 We would define a "portfolio investment" as a
non-controlling interest where the investor has no significant influence over
the investee. The term is incorporated in the foreign investment fund definition
not because we believe that there are particular
tax advantages in holding
shares in foreign funds (apart from the deferral or avoidance of tax on
dividends) but because such investments
are characteristic of the type of fund
we have in mind.
3.3.5 An effect test such as that outlined in (b) is to
some extent subjective but it is necessary to target the regime on entities
in
low tax countries. Taxpayer compliance would be encouraged by comprehensive
disclosure requirements.
3.3.6 Canada taxes residents on the basis of a prescribed rate of interest
applied to the amount of their investment in such funds.
Because there will
usually be a quoted price for interests in such funds which reflects the
underlying income they accumulate, the
Committee considers that the CV regime
could apply to such investments. Thus, the investor would be taxed on the
difference between
the market price of the interest at the end of the income
year and the equivalent value at the beginning of the year, plus any
distributions
received during the year. Where a taxpayer was subject to both the
BE and offshore fund regimes, the former should apply.
3.3.7 It may be
necessary to include an anti-avoidance rule aimed at entities which are in
substance foreign investment funds but
which are structured to avoid the regime.
Further comment on the Committee's recommended regime for foreign investment
funds is provided
in Annex 3.
Recommendation
3.3.8 The Committee therefore recommends
that:
CHAPTER 4 – TREATMENT OF DIVIDENDS
4.1 Corporate Recipient
4.1.1 The
CD distinguishes between "portfolio" and "non-portfolio" dividends received by a
resident company from a non-resident company.
Portfolio dividends are defined to
be dividends received by a resident company from a non-resident company in which
the resident
owns less than 10 percent of the paid-up share capital. All other
foreign dividends received by a resident company are defined to
be non-portfolio
dividends.
4.1.2 The CD proposes that portfolio dividends be assessable
to companies in accordance with general international practice. Non-portfolio
dividends are to be subject to a withholding payment system, as outlined in the
Government Economic Statement of 17 December 1987.
The withholding payment
system does not come directly within the Committee's terms of reference but it
is necessary to consider it
in order to integrate the taxation of dividends with
the taxation of undistributed income under the BE regime. The treatment of
dividends
received by a controlled company for the purposes of calculating BE
income was discussed in section 2.5.
4.1.3 A number of submissions called
for the retention of the existing dividend exemption for companies. Other
submissions took the
view that dividends should be assessable to a company only
if credit were given for both foreign withholding tax and the underlying
foreign
company tax. A number of other countries have such a system in respect of
non-portfolio dividends, including the United States,
the United Kingdom and
Australia.
While credit for foreign taxes may be allowed at the corporate level, no
country passes credits for foreign taxes through to non-corporate
or individual
shareholders. In this respect, the proposal to allow credits for non-resident
dividend withholding tax to pass through
to individuals under the New Zealand
imputation system goes further, as far as we are aware, than any other country.
Thus, all countries
ultimately claw back credits given to companies for
underlying foreign company tax. This is not surprising since the revenue
consequences
of permitting credits to flow through to individual shareholders
could be substantial.
4.1.4 If credits for foreign taxes do not pass
through to individual shareholders, they are allowed to them in effect as a
deduction
from assessable income. Under the proposed withholding payment system,
the conversion to a deduction system will be advanced from
the ultimate
individual recipient to the first corporate recipient of a foreign dividend.
This is very much the objective of the
withholding payment system and it would
be incompatible with it to allow the corporate dividend recipient a credit for
underlying
foreign company tax. Foreign tax credit systems are also extremely
complex, as the United States and Canadian systems illustrate,
and inherently
arbitrary because of the practical difficulty of tracing foreign dividends
through time and among different companies.
The Committee therefore considers
that it would not be feasible from a compliance or administrative point of view
to introduce a
foreign tax credit system for intercorporate dividends, at least
in the current context.
4.1.5 Submissions also questioned the need for a
separate withholding payment system for non-portfolio dividends. It would
undoubtedly
be simpler to make all foreign dividends assessable
to a corporate recipient but this would not be consistent with a number of
New Zealand's tax treaty obligations.
4.1.6 One of the differences
between taxing such dividends and the proposed withholding payment system is
that a company in tax loss
receiving foreign dividends would not incur any tax
liability if the dividends were assessable but would incur the withholding
payment.
This problem could be overcome by allowing a company in tax loss to
offset the dividend against its loss. Thus, the loss would reduce
by the amount
of the gross dividend (i.e. the dividend received plus any foreign withholding
tax), thereby extinguishing the withholding
payment liability.
4.1.7 In
order to avoid taxing foreign-source income twice, once as BE income and again
on receipt, the CD proposes that, in calculating
BE income, taxpayers be able to
deduct any dividends received from the foreign company concerned. We consider
that there are serious
problems with this deduction system. For example, a
company which had a BE loss in the year it received a dividend would obtain no
relief from double taxation. There are potentially many timing differences
between New Zealand's and other countries' tax rules which
could lead to this
result.
4.1.8 In order to avoid these problems, in principle a separate
account needs to be kept of tax paid on BE income. When a resident
receives a
dividend from a controlled company, the tax (or withholding payment) liability
on the dividend would be offset in whole
or in part according to the balance of
the tax paid in the special account. In practice, for resident companies, the
Imputation Credit
Account ("ICA") proposed for the imputation system can perform
just this function so that a separate account is not necessary.
4.1.9 The Committee propose to detail its recommendations on the integration
of the international, imputation and withholding payment
regimes in Part 2 of
this report and in our report on the imputation proposals.
4.2 Non-Corporate Recipient
4.2.1 For
the same purpose of avoiding the double taxation of offshore income, it would be
necessary to require individual and other
non-corporate non-minor shareholders
to keep the equivalent of an ICA. We will also report further on this aspect in
Part 2 of this
report and our report on full imputation.
CHAPTER 5 – TRUSTS
5.1 Introduction
5.1.1 In
this chapter we comment on the future regime for trusts (which also has
implications for existing trusts). By existing trusts, we mean
settlements made before 17 December 1987. The treatment of these trusts, and the
transition to the proposed new regime,
is dealt with in chapter 7.
5.2. Trust Income
5.2.1 The
international tax reforms cannot be fully effective unless there is a regime to
apply to trusts since, in many cases, a
trust can substitute for a company. The
CD treats "foreign trusts" (i.e. those with non-resident trustees) in a similar
manner to
foreign companies. Since there is no resident trustee and the
beneficiaries may not be identified, the CD proposes that resident
settlors be
liable for tax on trustee's income. This approach ignores the legal
relationships between a settlor and a trustee since
the former has no right to
the income of the trust. Indeed, the whole point of a trust is to ensure that
property and the income
it produces is legally divested by a settlor. In
reality, however, a settlor often has substantial influence over the trustee,
usually
on an informal basis though there may be specific provision in the trust
deed and, in practice if not in law, may be able to wind
up the trust and take
back the property. Thus, the economic substance of a trust may differ from its
legal appearance.
5.2.2 In order to meet the objectives of the international reforms, trust
income derived by non-resident trustees of trusts settled
by New Zealand
residents must be taxed each year as it is earned. Ignoring enforcement
problems, the best course would be to tax
the income in the hands of the trustee
as if he or she were a resident. Where the trustee did not comply, there would
be little alternative
but to tax the resident settlor since there may be no
identifiable resident beneficiaries. In the first instance, however, the legal
liability for the tax should be placed on the trustee. This could be achieved by
defining trusts with resident settlors to be New
Zealand residents for tax
purposes. The trust would then be liable for New Zealand tax on its foreign- and
New Zealand- source income
in the same way as other residents. Where a
non-resident trustee defaulted on the liability, the resident settlor would be
liable
as the agent of the trustee. It would be necessary to define a trust
settlement widely to include settlements made indirectly through
nominees or
associates and all dispositions of property to a trust made for less than full
consideration.
5.2.3 The Committee therefore supports the basic approach
of the CD. This closely follows the grantor trust provisions in the United
States. This regime would, however, be unjustifiably severe if it applied to all
existing trusts since settlors will usually be unable
to alter their settlor
status and, furthermore, distribution requirements and trustees' powers are
comparatively inflexible. Hence,
we recommend more generous transitional
provisions for trusts than for companies.
5.2.4 The concept of the
residence of a trust could also apply to existing trusts. As with future trusts,
residence would be determined
by the residence of the settlor. Where there
was:
5.2.5 One
consequence of this approach would be that New Zealand would not tax the
foreign-source trust income of a resident who was the trustee of a trust
with a non-resident settlor. In our view, this is the appropriate treatment
since such income has no definite connection with New Zealand apart from the
existence here of the trust administrator (who will,
however, have no beneficial
interest in the income). Beneficiaries may be resident here, but their interests
do not materialise until
there is a distribution or vesting. This makes it
infeasible to tax beneficiaries on trust income. Resident beneficiaries should,
however, be taxed on any trust income which is distributed to or vested in them,
as discussed in the next subsection. This leaves
only the resident trustee to
tax but, if that were done, he or she would of course resign in favour of a
non-resident trustee. Thus,
we believe there is little to be gained from
attempting to tax foreign-source income derived by resident trustees of
non-resident
trusts.
5.2.6 The adoption of this trust residence rule would remove some ambiguities
in the taxation of existing trusts. There may be other
consequential changes to
the current treatment of trusts that will need to be addressed when the
Committee considers the draft legislation
dealing with trusts.
5.3 Distributions From Resident Trusts
5.3.1 Distributions
to beneficiaries from resident trusts (as defined in the previous section) made
out of trust income (i.e. income which has been taxed as assessable
income in the hands of the trustee or the resident settlor) should be exempt
from tax since they will have already borne the appropriate amount of New
Zealand tax.
5.3.2 Where a distribution from a resident trust is not made
out of trust income, it should continue to be assessable or exempt to
the
beneficiary as under the present rules, except in the situation dealt with in
paragraph 7.2.4.
5.4 Distributions From Non-Resident Trusts
5.4.1 There
are deficiencies in the present tax treatment of trust distributions received by
resident beneficiaries from non-resident
trusts (i.e those with no resident
settlor). Case law supports the view that if trust income has been taxed in the
hands of the non-resident
trustee, it is not assessable a second time in the
hands of the beneficiary. If, however, the trustee has not paid tax on that
income,
the treatment of the distribution in the hands of the beneficiary is
unclear.
5.4.2 This unsatisfactory ambiguity should be resolved by amending the law to
make it clear that resident beneficiaries will be assessable
on all income
distributions received from non-resident trusts. A credit should be given for
any foreign or New Zealand tax paid by
the trustee on the income out of which
the distribution is made. This would necessitate the trustee keeping records of
the income
of the trust and the tax paid, but the onus for establishing that a
credit should be given can be placed on the beneficiary.
5.4.3 The trust
regime should mirror the taxation of individuals since individuals are
ultimately the beneficiaries of trust income.
Since capital gains will normally
be exempt in the hands of resident individuals, capital profits, as defined in
New Zealand tax
terms, distributed to beneficiaries should also be exempt in
their hands. Similarly, a distribution of the corpus (i.e. the original
capital
settled plus all additional settlements) of the trust should not be assessable
to a beneficiary.
5.4.4 Further elaboration of the Committee's views on
trusts is contained in Annex 4. Our recommendations on transitional provisions
relating to existing trusts are outlined in chapter 7.
Recommendation
5.4.5 The Committee recommends that, in
respect of future trust settlements:
CHAPTER 6 – DISCLOSURE REQUIREMENTS AND PENALTIES
6.1 Disclosure Requirements and Penalties
6.1.1 The
objective of information disclosure is twofold. First, it provides the Inland
Revenue Department with the base data necessary
to administer the tax system.
Secondly, it encourages taxpayers to comply with the law since they commit an
offence if they fail
to provide the information requested. New Zealand requires
a much lower level of disclosure than countries such as Australia, the
United
States and the United Kingdom. Furthermore, our penalties for non-compliance are
generally lighter than those applying in
these countries. A combination of
minimal disclosure and low penalties reduces compliance and makes enforcement
more difficult.
6.1.2 Both of these matters need to be addressed in the
context of the international tax reforms. The Department will be dependent
in
the first instance on the information provided by taxpayers. The objective of
disclosure is not to obtain exhaustive information
from every taxpayer. That
would merely swamp the Department and impose unnecessary compliance costs on
taxpayers. Rather, at the
first level of disclosure, a small number of key
questions should be asked of all taxpayers. This enables the Department to
identify
those taxpayers who should then be required to provide fuller
disclosure.
6.1.3 The Committee will comment further on disclosure
requirements and penalties in the context of the present reforms in Part 2
of
its report.
CHAPTER 7 – TRANSITIONAL PROVISIONS
7.1 Branch Equivalent Regime
7.1.1 The
CD proposes no transitional arrangements apart from the deferral of the
implementation date of the BE and CV regimes until
1 April 1988. A number of
submissions argue for complete exemption of investments entered into before the
announcement of the regime
and you will be aware of the general arguments made
against retrospective tax changes. The Committee considers that complete
"grandfathering"
can seldom be justified since commercial decisions do not
assume that the tax system applying when they are made will continue
indefinitely.
Nevertheless, we consider that a reasonable period of adjustment
is necessary in order to give taxpayers time to restructure their
affairs and
gear up to comply with the regime. There has, however, been fair warning of the
Government's intention to address tax
haven avoidance.
7.1.2 To this end,
we recommend that residents be exempt from the BE regime until 1 April 1990 in
respect of interests acquired on or before 17 December 1987 in companies
that are not resident in low tax jurisdictions specified in a
transitional list. An illustrative transitional list is shown in Annex 5.
Shareholders
with controlling interests in tax haven companies will generally
have known since at least the date of the 1987 Budget that they
were to be
subject to a CFC regime. We therefore consider that a 1 April 1988
implementation date is appropriate in these cases.
7.1.3 We also
recommend that residents be exempt from the BE regime until 1 April 1989 in
respect of interests acquired after 17 December 1987 in companies which
are resident in the listed
countries (though the exemption of any underlying controlled companies would
depend on whether they also were resident in a listed
country). After that date,
a continued exemption would apply only if the company met the grey list test
outlined in section 2.3.
Taxpayers in this position would therefore not have to
adjust the taxable income of the controlled company for significant preferences
in the first year. It would in any case be difficult to compile lists of
significant preferences in time for a 1 April 1988 start
date.
7.1.4 For
the purposes of determining whether a non-resident company is controlled, a
resident's total interest in the company, whether
acquired before or after 17
December 1987, would be considered. Similarly, a resident's total shareholding
would be considered for
the purposes of determining whether the 10 percent
interest threshold for attribution of income was triggered. Attribution of
income
during the transitional period would, however, be based on that part of a
resident's total interest that was acquired after 17 December 1987. An
example illustrating these transitional provisions is shown in Annex 2.
7.2 Resident Trusts
7.2.1 As
mentioned above, we consider that a more generous transition is justified for
existing resident trusts (as defined in chapter 5) with non-resident
trustees. In some cases, settlors will be able to wind up a trust and remove
themselves
from the new regime but this will often not be possible. Thus, some
settlors of such resident trusts would be unable to alter their
settlor status
and could suffer a considerable additional tax liability that could not have
been anticipated. The regime
should not, however, protect existing settlors forever where they are able,
through their influence over the trustee, to effect a
wind up of a trust since a
decision not to do so represents in effect a new settlement. Where a wind up is
not feasible, the settlor
should not be subject to the new regime. Since the
trustee is offshore, the only other party, if any, with a connection with New
Zealand will be resident beneficiaries. We do not consider that it is feasible
to tax beneficiaries on undistributed trust income
each year, but the benefit of
deferral of tax that they enjoy can to some extent be addressed once a
distribution (or vesting) is
made.
7.2.2 The Committee therefore favours
a trust transition which encourages settlors and trustees to wind up existing
resident trusts
with non-resident trustees if they can. If they are not able to,
an interest element should be incorporated into the determination
of the
assessable income of a beneficiary resulting from a trust distribution. The
latter approach is adopted in the United States
in respect of distributions to
United States beneficiaries from trusts settled by
non-residents.
7.2.3 In order to encourage dissolution of a trust where
it is feasible, we propose that distributions of income made on or before
31 March 1989 from existing trusts with non-resident trustees be subject to a
final tax levied at a rate of 10
percent, provided that either the trust
is wound up before 1 April 1989 or the settlor elects to be subject to the new
settlor regime from that date.
Distributions of capital profits and the
corpus of such a trust made on or before 31 March 1989 should be exempt from tax
in beneficiaries' hands. Our proposed
rate of 10 percent reflects a compromise
between the rate of tax which would have been payable had the distribution been
unambiguously
taxable under current law and the rate needed to encourage
dissolution.
7.2.4 Where these alternatives are not availed of, we recommend that the
non-resident trustee and the resident settlor not be subject
to the settlor
regime, but that all distributions, whether of income or capital (other than of
the corpus of the trust), should be
assessable in the hands of a resident
beneficiary with an interest charge to reduce the advantage of deferral. The
interest should
be calculated from 1 April 1988, the implementation date of the
settlor regime. A credit should be given for any foreign tax paid
by the
trustee. In addition, where a settlor has a loan, guarantee or other form of
financial assistance outstanding to the trustee,
he or she should be assessed on
imputed interest at a prescribed rate (less any interest actually received by
the settlor or paid
by the trustee, as the case may be) computed on the amount
of the loan, guarantee or other assistance.
7.2.5 A less stringent
transition is justified for resident testamentary trusts with
non-resident trustees since these are not used for avoidance purposes. Where
such trusts are wound up on or before 31
March 1989, the provisions outlined in
paragraph 7.2.3 should apply. We propose that distributions of capital profits
from this category
of testamentary trusts made after 31 March 1989 be exempt in
the hands of beneficiaries. Distributions of income should, however,
be
assessable with the interest charge since the beneficiaries of testamentary
trusts may enjoy the advantages of tax deferral to
the same extent as
beneficiaries of other trusts.
7.2.6 Where a settlement is made after 17
December 1987 to an existing resident trust, the whole of the trust income could
be subject
to the new regime or only that part attributable to post-17 December
1987 settlements. It would, however, be difficult to arrive
at workable
apportionment rules because of the need to
trace and compare settlements made at different times in the past and in
various forms. We therefore favour the approach of bringing
all trust income
within the regime where a new settlement is made to an existing trust. This
would have little practical impact,
since future settlements could be made to a
new trust on the same terms as an existing trust, but would avoid the need for
apportionment
rules.
7.2.7 In order to implement this transition,
resident settlors should be required to disclose all settlements, as widely
defined,
on non-resident trustees existing on 1 April 1988. Settlors should also
notify the Inland Revenue Department of the transition they
have
elected.
7.2.8 Settlements of trusts made by residents after 17 December
1987 and distributions of income or capital from such trusts would
be subject to
the new regime proposed in chapter 5.
7.3 Non-Resident Trusts
7.3.1 Non-resident
trusts (i.e those which are not settled by a New Zealand resident) are not
affected by the settlor regime, irrespective
of when they were settled. The
treatment of distributions from such trusts to resident beneficiaries is,
however, to be clarified
as part of the present reforms. The Committee's
recommended treatment was outlined in chapter 5. The Government's intention to
clarify
the law in this area was included in the CD. We therefore propose that
our recommended regime apply to distributions from non-resident
trusts made
after 17 December 1987.
7.4 Foreign Investment Funds
7.4.1 The
foreign investment fund regime is targeted at tax haven entities. The Government
signalled its concern about the use of
tax havens in 1986 and again in the 1987
Budget. In addition, taxpayers will usually be readily able to dispose of the
interests
that would be affected by the regime. Thus, the Committee supports the
implementation of the foreign investment fund regime from
1 April 1988.
7.5 Recommendations
7.5.1 The
Committee recommends that:
and the corpus of the trust made on or before 31 March 1989 should be exempt from tax in beneficiaries' hands;
exempt in the hands of beneficiaries; and
CHAPTER 8 – FURTHER MEASURES
8.1 Role of a Capital Gains Tax
8.1.1 We
have commented already on the possible role of a capital gains tax in the
context of the present reforms. In many cases,
the income that residents derive
through offshore investments (apart from distributions) is best characterised as
capital gain and,
short of violating accepted income tax principles, is most
appropriately taxed under a capital gains tax.
8.1.2 The lack of the
comprehensive taxation of capital gains in New Zealand is the last outstanding
gap in our tax system. The reforms
that the Government has implemented over the
last few years have gone a long way to broadening the tax base and addressing
sources
of avoidance. The first major base broadening measure was the
introduction of GST. Within the income tax system, the next step was
the removal
of explicit tax concessions such as export incentives and accelerated
depreciation provisions. The removal of such incentives
in return for a
reduction in tax rates is very much the central theme of current tax reform
programmes in OECD countries.
8.1.3 The third set of reforms was the
adoption of comprehensive accrual rules. These were aimed at countering tax
planning based
on the deferral of financial arrangement income or the advancing
of tax deductions. The fourth and present set of reforms address
the avoidance
and deferral opportunities which
arise in the international context. The Government has also moved
simultaneously to reduce the avoidance problems which arise with
the exemption
of the superannuation funds and other entities.
8.1.4 The last major tax
base problem is the general exclusion of capital gains from the definition of
assessable income. There is
widespread support amongst tax practitioners for the
taxation of capital gains. The Committee endorses this view. Many of the
remaining
deficiencies in the tax system have their origin in or are compounded
by the lack of a capital gains tax. The next step in the Government's
tax reform
programme should be to extend the tax base to include capital gains as soon as
it is feasible to do so with the objective
of facilitating a further reduction
in tax rates.
8.1.5 New Zealand is the only country in the OECD which
still has no general capital gains tax. Countries such as the United States,
the
United Kingdom, West Germany, France and Japan have all taxed capital gains for
some time, while Australia introduced a capital
gains tax in 1985.
8.2 Interjurisdictional Allocation Rules
8.2.1 In
addition, we reaffirm our view that priority should also be given to the
introduction of interjurisdictional allocation rules
to ensure that New Zealand
collects its share of tax. Along with the taxation of capital gains, such rules
form one of the basic
building blocks of the tax systems of countries such as
the United States and the United Kingdom.
8.3 Recommendation
8.3.1 The
Committee therefore recommends that, in addition to giving priority to the
extension of the income tax base to include capital
gains, the Government give
priority to the introduction of interjurisdictional allocation rules, such as
expense allocation rules
and more effective transfer pricing provisions.
CHAPTER 9 – SUMMARY AND CONCLUSION
9.1 Summary of Recommendations
9.1.1 In
summary, the Committee's recommendations are that:
BE Method
companies be subject to the regime unless the controlled company satisfies the exemption outlined in recommendation (d);
CV Method
Foreign Fund Regime
Trusts
Transition
Other Reforms
9.2 Conclusion
9.2.1 We believe
that the regime we have outlined goes as far as is practicable towards achieving
the Government's objectives within
the boundaries of existing income tax
principles, given the constraints imposed by compliance and administrative
costs. It differs
from the CD proposals primarily by introducing a control test
and a grey list exemption to the BE regime,
curtailing the scope of the CV regime and giving more transitional relief.
While our regime is more limited in scope than that in
the CD, we have sought to
make it effective in its area of application.
9.2.2 Once we have your
response to our recommendations, we will consider the more detailed design
issues and advance the draft legislation.
There are many subsidiary issues to
consider. We will report further on these, along with our proposed draft
legislation.
ANNEX 1 – CONTROL INTERESTS OF RESIDENTS IN CONTROLLED FOREIGN COMPANIES.
1 Introduction
1.1 Under
the branch equivalent ("BE") regime, the income of controlled foreign companies
would be assessed to their New Zealand resident
shareholders in proportion to
the interest held by each shareholder.
1.2 In order to determine whether
income will be assessed in New Zealand on the basis of an interest held in a
foreign company, a
taxpayer will be required to establish:
2 Interests to which the Regime Applies
2.1 As outlined in the Consultative Document
("CD"), the regime will apply to interests in companies that are not resident in
New
Zealand or that are resident in New Zealand but, by virtue of the provisions
of a double tax agreement, are not subject to tax in
respect of foreign source
income. The definition of a company will include entities that have a legal
personality and existence distinct
from that of their members.
2.2 The BE
regime should apply to residents in respect of their interests in foreign
companies. The control test advocated by the
Committee would determine that a
foreign company would be a controlled foreign company if five or fewer New
Zealand residents owned
50 percent or more of its equity. This test requires
taxpayers to determine their respective proportions of the equity of a foreign
company.
2.4 The proportion so calculated for each resident is termed the
resident's control interest. For this purpose, the Committee
favours no minimum shareholding threshold for a resident's control interest to
be taken into account
when determining whether a company is a controlled foreign
company. However, as explained in Chapter 2, taxpayers with interests
in a
controlled foreign company below a minimum threshold would not be required to
include any part of that controlled foreign company's
income in their assessable
income.
2.5 A foreign company would be a controlled foreign company if,
at any time in the foreign company's accounting year, the sum of the
control
interests held by five or fewer New Zealand residents is greater than or equal
to 50 percent. The Committee favours applying
the test to determine control at
any time in
the year to prevent taxpayers 'de-controlling' by disposing of interests in
controlled foreign companies through permanent sale to
non-residents before the
end of each accounting year of a foreign company. By disposing of interests in
this manner taxpayers could
accumulate income in the non-resident company and
sell their interest for a tax free capital gain. Other countries with CFC
regimes
tend to apply the control test to interests held at the end of a foreign
company's accounting year. However, this test does not provide
an avoidance
opportunity because, unlike the position in New Zealand, capital gains taxes in
these countries ensure that a taxpayer
is taxed on any gains realised on the
disposal of interests in foreign companies during an accounting year.
3 Measurement of a Control Interest
3.1 A control interest measures the proportion
of a foreign company's equity or profits over which a resident is considered to
have
control. This includes control interests held through nominees of
the taxpayer and control interests held indirectly by the resident
through other controlled foreign companies. Taxpayers could avoid the 50 percent
control by five or fewer residents
test by fragmenting shareholding or by
exercising de facto control of a foreign company. The control test would
therefore need to
be supported by constructive ownership rules to
include, in the control interest of a resident, control interests held by
persons associated with the resident. In addition, de facto control rules
will be needed to deal with situations where taxpayers can exercise control over
the distribution of a foreign company's income or
capital but do not fall within
the formal control tests.
3.2 To prevent avoidance of the control test, determination of a control
interest in a foreign company needs to take account of interests
held by a
taxpayer in a number of ways. For the purpose of determining whether a company
is a controlled foreign company, the Committee
considers that the control
interest attributable to a taxpayer should include:
3.3 The Committee favours an approach
for measuring a control interest based on that set out in section 191 of the
Income Tax Act
1976 for measuring a "prescribed proportion" of the equity of two
or more companies. We propose that the control interest in a company
held by a
resident be the proportion of:
3.4 The taxpayer would be required to take into account
all classes of shares held when determining a control interest as well as
rights
to acquire equity in the foreign company whether in the form of options,
convertible debt or other contingent interests.
4 Nominees and Trustees
4.1 Interests in companies in the names of
trustees and nominees are a particular form of beneficial ownership. Interests
held by
nominees or by bare trustees would therefore be attributable to their
beneficial owners. Nominee rules would also attribute a control
interest to a
shareholder who has an arrangement with another person to resume ownership of
shares at a subsequent date (through
so called "warehousing" of
shares).
4.2 The Committee's general approach to the taxation of trusts
is that their tax treatment should be determined by reference to the
residence
of settlors (see Annex 4). In accordance with this preferred approach, the
Committee considers that a control interest
in a controlled foreign company held
by trustees of discretionary trusts should be attributed to any New Zealand
resident who has
settled property on the trust. In this context, the trustees of
the discretionary trust settled by the resident would be considered
to be
nominees of the resident. A settlement of a trust is defined in Annex 4.
5 Indirect Control Rules
5.1 To determine accurately the level of a
taxpayer's control interest in a foreign company, control interests held in the
foreign
company indirectly by a taxpayer through another controlled foreign
company would need to be combined with control interests held
directly by the
taxpayer.
5.2 Indirect control interests held through a chain of
controlled foreign companies would be determined by multiplying the taxpayer's
control interest in the top tier controlled foreign company by the top tier
company's control interest in the second tier controlled
foreign company and so
on. The indirect control test would 'look through' each controlled foreign
company in a corporate tier in
this manner until the combined control interest
of the taxpayer and four other residents in the foreign company is less than 50
percent
(i.e. the lowest tier foreign company is not a controlled foreign
company).
5.3 For the purposes of tracing control down a corporate tier,
a resident with a direct control interest in a first tier controlled
foreign
company of more than 50 percent would be deemed to hold a 100 percent control
interest in the foreign company. Similarly,
where a higher tier controlled
foreign company in which a taxpayer has an interest controls a lower tier
foreign company (i.e. its
control interest is 50% or more) the higher tier
company would be deemed to hold a 100 percent control interest in the lower tier
company. This rule is necessary to prevent taxpayers avoiding the 50 percent
control threshold in respect of an interest in a particular
foreign company by
interposing between themselves and the company in question a series of
controlled foreign companies in which the
control interest held by the taxpayers
is less than 100 percent.
5.4 The effect of the procedure for tracing control down a corporate tier
described in paragraph 5.3 is that, where a controlled foreign
company holds a
control interest of less than 50 percent in a foreign company, the control
interest held by the controlled foreign
company would be considered to be held
by its New Zealand resident shareholders.
5.5 The following example
illustrates the operation of the indirect control rules.
NZCO, a company resident in New Zealand has a 40 percent control interest in
SUBCO1, a non-resident company in which another resident
holds a control
interest of 30 percent, making SUBCO1 a controlled foreign company. NZCO also
holds a direct control interest of
40 percent in CFC, another non-resident
company. SUBCO1 holds a 60 percent control interest in SUBCO2, which in turn
holds a 25 percent
control interest in CFC. NZCO would determine its indirect
control interest in CFC by multiplying its control interest in SUBCO1
by
SUBCO1's control interest in SUBCO2, and SUBCO2's control interest in CFC. As
SUBCO1's control interest in SUBCO2 is 60 percent,
SUBCO1 would be deemed to
hold a 100 percent control interest in SUBCO2 for the purposes of computing
NZCO's indirect control interest
in CFC. NZCO's control interest in CFC held
indirectly would therefore be 10 percent (i.e. 40% x 100% x 25%). NZCO's
aggregate control
interest in CFC would be 50 percent, being the sum of its
direct control interest (40 percent) and its indirect control interest
(10
percent).
5.6 In the example set out in paragraph 5.5, if SUBCO1 was not
a CFC, NZCO would not be required to multiply its control interest
in SUBCO1 by
any of SUBCO1's control interests. Similarly, if SUBCO2 was not a controlled
foreign company, NZCO would not be required
to multiply its control interest in
SUBCO2 by any of SUBCO2's control interests. However, where five or fewer New
Zealand residents
have an indirect income interest in a foreign company of 50
percent or more, a rule described in paragraph 2.13 of Annex 2 will apply
to
make the company a controlled foreign company.
6 Constructive Ownership Rules
6.1 The Committee considers that constructive
ownership and control rules are necessary in order to prevent avoidance of the
regime
by spreading ownership of foreign companies among a number of associated
persons. For the purpose of determining the control interest
in a foreign
company held by a New Zealand resident, constructive ownership rules would
attribute to the resident ownership and control
rights that in fact or in law
belong to his or her associates or relatives.
6.2 Constructive ownership
rules should only apply for the purposes of the control test and to determine
the minimum level of interest
before income is attributed to a taxpayer
(described in Annex 2). Constructive ownership rules would not apply for the
purpose of
determining the basis on which income would be
attributed.
6.3 Persons considered to be associated for the purposes of
the controlled foreign company rules would include, as a minimum:
6.4 The associated persons rule in conjunction with
the constructive ownership rule may be illustrated by way of example. Suppose
four New Zealand residents together own 40 percent of Nonresco, a non-resident
company. A fifth New Zealand resident owns a further
2 percent. However, the
fifth resident has four children, each of whom also owns 2 percent. In these
circumstances, the shareholding
of the children will be attributed to the fifth
resident whether the children are resident in New Zealand or abroad. Nonresco
would
thereby be considered to be a controlled foreign company.
6.5 A
further example of the operation of the associated persons rule in the context
of constructive ownership provisions is a large
New Zealand company with many
shareholders that establishes a foreign associated company, with the same
shareholders as the New Zealand
company, holding interests in the same
proportion. If the shares of the two companies are 'stapled' (that is, they may
be transferred
only if kept together) the companies have a relationship that is
somewhat similar to a holding company and subsidiary. The subsidiary
would be a
controlled foreign company, but, in the absence of special rules, the stapled
associated company would not, unless by
chance it was controlled by five or
fewer New Zealand residents. However, the associated persons rule treat the two
companies as
one person as they have shared interests.
6.6 The Committee is reviewing the definitions of associated persons and
nominees in the Income Tax Act to make the definitions more
consistent and
effective, where necessary.
7 De-facto Control and Anti-avoidance Rules
7.1 The Committee favours an anti-avoidance rule
as part of the control test that would apply to taxpayers who exercise de
facto control of a foreign company. Residents who are entitled to call for
or prevent the distribution of the profits of a foreign company,
or who have the
power to call for the wind-up of a foreign company would be deemed to have a 50
percent control interest and the
company would therefore be a controlled foreign
company, irrespective of the proportion of the equity of the company held by New
Zealand residents. The anti-avoidance rule would also be aimed at arrangements,
such as voting trusts and understandings, which have
the effect of defeating the
intent and application of the control test. The Committee considers that these
anti-avoidance rules will
support the nominee rules.
7.2 Taxpayers will
include all the interests they hold in a foreign company to compute a control
interest, irrespective of whether
these were acquired before or after 17
December 1987. However, in respect of investments in countries that are not on
the transitional
list of specified low tax jurisdictions, income would be
attributed during the transitional period only in respect of interests acquired
after 17 December (see Annex 2) .
ANNEX 2 – ISSUES RELATING TO THE DETERMINATION AND ATTRIBUTION OF BRANCH-EQUIVALENT INCOME
1 Introduction
1.1 As
noted in the Committee's report, we favour a taxation regime that only requires
taxpayers with interests in excess of a minimum
level in controlled foreign
companies to report income on a branch-equivalent basis. The amount of income to
be reported would be
determined by applying the attribution rules to the total
annual income of the company, computed on the basis of New Zealand tax
rules.
1.2 Income attributed under this regime would be included in a
taxpayer's assessable income and taxed at personal or corporate rates
applicable
to income derived by the taxpayer. The Committee is still considering
appropriate rules for the treatment of losses.
1.3 The two aspects of the
international tax regime addressed in this annex will be details of the
attribution rules and guidance
for taxpayers on procedures for computing the
income of a controlled foreign company on a branch-equivalent basis.
2 Attribution of Branch-equivalent Income
Determination of an Annual Income Interest.
2.1 The annual
branch-equivalent income of a controlled foreign company would be attributed to
a taxpayer on the basis of the income interest held by the
taxpayer. A taxpayer's income interest in a controlled foreign company is the
basis upon which income is attributed under
the proposed regime. It is computed
by reference to the control interest held by the taxpayer and the nominee of the
taxpayer as
described in Annex 1.
2.2 The Committee considers that a
taxpayer should be required to include in assessable income only income to which
he or she can
reasonably be considered to have access. Consistent with this
view, control interests in a foreign company held by associated persons
of the
taxpayer and attributed to the taxpayer for the purpose of determining his or
her control interest should be excluded when
determining the income interest
held by the taxpayer.
2.3 As would be the case in determining a control
interest, indirect interests held by a taxpayer would be taken into account when
determining an income interest held by a taxpayer. However, an income interest
would be computed by reference to the actual interests
held at each tier in a
chain of controlled foreign companies rather than deemed interests as would be
the case when determining a
control interest. The calculation of an income
interest held indirectly is explained below in paragraphs 2.11 to 2.14.
2.4 In addition to the important differences between an income interest and a
control interest described above an income interest
differs from a control
interest in the following respects:
2.5 To avoid attribution of the undistributed income of a
controlled foreign company, taxpayers may hold rights to acquire interests
in a
foreign company in the form of options or other contingent interests. Rights
held by a taxpayer that entitle the taxpayer to
acquire a future interest in the
company are taken into account when determining a control interest (as explained
in Annex 1). It
is the Committee's view that such rights are also to be taken
into account when determining an income interest in relation to any
accounting
year of a foreign company in which the company derives a taxable profit. For
this purpose, however, a taxpayer may exclude
any rights to acquire interests in
the company pursuant to normal commercial transactions where the rights, such as
options or convertible
debt, are acquired or are exerciseable by the taxpayer at
fair market value.
2.6 Taking account of the varying levels of interest
held during the accounting year of a controlled foreign company is considered
to
be more equitable than attributing income on the basis of the income interest
held at the end of its accounting
year. The former approach will reflect more accurately an interest built up
by a taxpayer during the course of a controlled foreign
company's accounting
year.
2.7 The first step in establishing the level of a taxpayer's income
interest would be to calculate the interest in the company for
each period
during its accounting year in which the control interest remained unchanged. The
income interest in each period would
be determined according to the rules for
determining an ownership interest set out in Annex 1 subject to the
modifications set out
in paragraphs 2.1 to 2.5 above.
2.8 The next step
would be to pro-rate the income interest determined for each period by the
proportion of the year (or part-year
where the non-resident entity has an
accounting period of less than a year) the interest remained unchanged. A
taxpayer's overall
income interest will be the sum of the pro-rated interests
computed for each period in the non-resident entity's accounting year.
In
respect of any accounting year of a controlled foreign company, income
attributable to a resident is derived by multiplying the
income interest
computed for that year by the annual branch-equivalent income for that
accounting year (or part-year as appropriate).
2.9 The pro-rating of
interests for any relevant period during the accounting year of the controlled
foreign company would be on the
basis of the number of days in that period as a
proportion of 365, or the number of days in the controlled foreign company's
accounting
period if this is less than a year.
2.10 The method for determining the level of a taxpayer's interest in a
non-resident entity for the purpose of attributing income
is illustrated in the
example set out below:
Example
Taxpayer X holds an interest in Nonresco, a controlled foreign company. A summary of X's control interest during Nonresco's accounting year, modified to conform with the adjustments set out in paragraphs 2.1 to 2.5 above, is:
– 33 percent for the first three months;
– 50 percent for the next six months;
– 66 percent for the last three months.
X's interest is
computed as follows:
Pro-rated interest for the first 3 months
= 33% x 25% = 8.3%
Pro-rated interest for next 6
months = 50% x 50% = 25.0%
Pro-rated interest for last 3
months = 66% x 25% = 16.5%
Total Income Interest = 49.8%
If
Nonresco's branch-equivalent income for its relevant accounting year was (say)
$100, $49.80 would be attributed to X on the basis
of X's interest.
Income Interests where there is Indirect Ownership.
2.11 If a controlled foreign company is a second
or lower tier company, its income will be attributed directly to New Zealand
residents
in accordance with their direct and indirect interest in the
controlled foreign company. For this purpose, an income interest is
determined
by multiplying the taxpayer's income interest in the top tier controlled foreign
company by the top tier company's income
interest in the second tier
controlled
foreign company company and so on. A taxpayer would multiply income interests
in controlled foreign companies at each tier until the
lower tier company either
was not a controlled company, or the taxpayer's income interest fell below the
minimum level of interest
for income attribution.
2.12 The procedure for
determining an indirect income interest in a controlled foreign company held
through a series of higher tier
controlled foreign companies contrasts with that
for determining a control interest down a corporate tier described in Annex 1.
Under
the latter approach, a higher tier controlled foreign company is
considered to hold a 100 percent control interest in any lower tier
foreign
companies it controls.
2.13 Ordinarily, a taxpayer should not be required
to multiply an income interest held in a company that is not a controlled
foreign
company by income interests that the foreign company has in other
foreign companies. This is because it is impossible, in normal
commercial
circumstances, for a taxpayer to 'look through' a company that is not a
controlled foreign company to trace indirect interests.
However, the Committee
is considering a rule aimed at situations where five or fewer taxpayers
structure their indirect interests
in order to collectively hold more than 50
percent of an income interest in a foreign company but hold a control interest
of less
than 50 percent. Such a rule might require a taxpayer to multiply an
interest in a top tier foreign company that is not a controlled
foreign company
by an income interest the top tier company holds in a lower tier foreign company
where there was such an arrangement
and its application resulted in the lower
tier entity becoming a controlled foreign company.
2.14 The following example illustrates the operation of these rules:
X, a resident company, holds a 60 percent income interest in Nonresco1, a
controlled foreign company. Nonresco1 has a 60 percent income
interest in
Nonresco2 which in turn, has an income interest of 25 percent in CFC. X also
holds directly an income interest of 35
percent in CFC. X's income interest in
CFC held indirectly through Nonresco1 and Nonresco2 would be 9 percent (i.e. 60%
x 60% x 25%)
which, when combined with X's direct interest of 35 percent, gives
an overall income interest held by X of 44 percent.
Minimum Interest for the Attribution of Income
2.15 The Committee considers that where an
income interest of a taxpayer in a controlled foreign company is below 10
percent, branch-equivalent
income of the company should not be attributed to the
taxpayer.
2.16 To prevent fragmentation of shareholding in order to fall
below this threshold, constructive ownership rules that combine the
interests of
associated persons of any taxpayer with those of the taxpayer, will be used to
determine whether a taxpayer's interest
is above the minimum threshold. This
means, for example, that if a taxpayer held a five percent income interest in a
controlled foreign
company and associated persons of the taxpayer held income
interests of another five percent, the income interest of the taxpayer
for the
purpose of applying this test will be ten percent. As the interest of the
taxpayer is above the minimum threshold, branch-equivalent
income of the
controlled foreign company would be attributed to the taxpayer and persons
associated with the taxpayer.
2.17 While the interest held by a taxpayer
and associated persons of the taxpayer would be combined when applying the
minimum interest
test, income would be attributed to the taxpayer, and persons
associated with the taxpayer, on the basis of the interests held by
each
individually.
Transition Rule
2.18 Whether an income interest is above the
minimum threshold for attribution needs to be determined having regard to the
proposed
transitional measures. To determine whether income interests are above
the minimum threshold, a taxpayer would
take into account all income interests held irrespective of whether they were
acquired before or after 17 December 1987. However,
during the transitional
period, should it apply, income would be attributed to the taxpayer only on the
basis of income interests
acquired after 17 December 1987.
2.19 For
example, a taxpayer may have an income interest of 15 percent in a controlled
company resident in a country that is not on
the transitional list of designated
low tax jurisdictions. The transitional provisions would therefore apply. The
taxpayer's income
interest in the company as at 17 December was 8 percent and
the taxpayer acquired a 7 percent income interest in the company after
17
December. Income of the controlled foreign company would be attributed to the
taxpayer on the basis of the 7 percent income interest
acquired after 17
December during the transitional period.
Changes of Residence
2.20 The CD proposed on page 20 that a person
would not be a resident of New Zealand for the purposes of income attribution
where
the person had been a resident of New Zealand for a cumulative period of
less than 24 months in the immediately preceding 15 years.
2.21 The
Committee will review this proposal together with the appropriate treatment
under the regime of persons who become, or cease
to be New Zealand residents.
The rules for determining residence in the Income Tax Act, particularly as they
relate to individuals,
will also be reviewed to ensure that they do not provide
scope for unacceptable avoidance of the regime by taxpayers.
3 Calculation of the Income of a Controlled Foreign Company on a Branch-equivalent Basis.
3.1 Opening Balance Sheets
3.1.1 In order for
taxpayers to compute the income of controlled foreign companies on a
branch-equivalent basis, some of the opening
balance sheet items will need to be
restated, in the foreign currency, but as if New Zealand tax rules applied. The
proposals set
out below are designed to reduce compliance costs where there is
little, if any, revenue consequence.
3.1.2 The rules which follow in
relation to the opening values of fixed assets and trading stock give the
taxpayer the option of choosing
opening values in accordance with either New
Zealand tax rules or the tax rules of the country of residence or income source
of the
foreign company. Whichever option a taxpayer elects to use, he or she
would be required to use the same basis for determining the
opening values of
both fixed assets and trading stock to ensure the consistent application of
whichever option is chosen.
Fixed Assets
3.1.3 The opening tax value of fixed assets for
the year in which the taxpayer commences reporting on a branch-equivalent basis
should
be, at the taxpayer's option either:
Trading Stock, including Livestock
3.1.4 The opening tax value of trading stock
should be, at the taxpayer's option either:
This opening value of trading stock should be deemed to
be cost for the purpose of subsequent value for branch-equivalent income
determination.
Financial Arrangements
3.1.5 The opening tax value of financial
arrangements should be, at the taxpayer's option either:
Prepayments
3.1.6 If under New Zealand income tax rules a
resident incurs a deductible expense in the accounting year of the foreign
controlled
company preceding the accounting year in which income is assessed to
the resident on a branch-equivalent basis, the taxpayer should
not be permitted
to include an adjustment for prepayments in respect of the expense in the
opening balance sheet. However, if a deduction
would not have been permitted in
respect of the previous accounting year under New Zealand tax rules, an opening
adjustment to the
balance sheet for prepayments in respect of the deduction
should be permitted.
Specified Leases
3.1.7 Specified leases entered into by a
controlled foreign company after 1 April 1988 would be brought into the balance
sheet for
the purpose of computing branch-equivalent income as if New Zealand
tax rules had applied from the commencement of the lease. Specified
leases
entered into before that date should be disregarded.
3.2 Calculation of Annual Income
3.2.1 There are two basic approaches to the
calculation of annual income on a branch-equivalent basis. One is to apply New
Zealand
tax rules and conversion to New Zealand currency on a
transaction-by-transaction basis. The other is to apply New Zealand tax rules
to
items in the profit and loss account in the foreign currency, and convert the
net annual income to New
Zealand currency as a second step. The latter method is implicit in the CD,
and the Committee considers that it is preferable on the
grounds of minimising
compliance costs.
3.2.2 In general, the application of New Zealand tax
rules within the branch-equivalent regime as recommended should not impose undue
compliance costs on New Zealand taxpayers. There are at least two types of
provision, however, which may need amendment.
3.2.3 Specific references
to "New Zealand" in the Income Tax Act will need to be reviewed to determine
whether the relevant provision:
offers a benefit or concession intended to be
confined to New Zealand; contains a definition of New Zealand source income; or
limits
the scope of the tax net. Such provisions may need to be modified in the
context of the branch-equivalent regime. As a general rule,
provisions of the
Income Tax Act that provide a specific tax concession for income sourced in New
Zealand should not be taken into
account when computing income on a
branch-equivalent basis.
3.2.4 A review will also be undertaken by the
Committee of the application of the associated persons provisions of the Income
Tax
Act. There does not, for example, seem to be any justification for
determining the assessability of the income of controlled foreign
companies to
residents by reference to the activities of associated persons who are
non-resident shareholders.
3.3 Conversion Rules
3.3.1 It is proposed that branch-equivalent
income, expressed as a single figure in foreign currency, be converted into New
Zealand
currency at the average of the mid-monthly exchange rates for the
relevant year. Exchange rate movements in respect of balance sheet
items would
not be taken into account in determining annual branch-equivalent
income.
3.4 Differing Balance Dates
3.4.1 A taxpayer's share of the income of
controlled foreign companies should be assessable in his or her income year in
accordance
with section 15(1) of the Income Tax Act. That is, a taxpayer would
include the branch-equivalent income of a controlled foreign
company in income
for the income year ending with the 31st day of March nearest to the end of the
foreign company's accounting year.
3.4.2 For interests in controlled
foreign companies taxable from April 1 1988, or from the date when the regime
may otherwise apply
pursuant to the transitional provisions set out in the
Committee's report, annual branch-equivalent income would be pro-rated to
apply
to that proportion of the foreign company's accounting year subsequent to the
commencement date of the regime.
3.4.3 This means that a taxpayer would
be required to compute income according to New Zealand income tax rules
(including adjustments
to the opening balance sheet set out in paragraphs 3.1.2
to 3.1.7) for the accounting year of the foreign company that straddles
the date
from which the regime applies.
3.5 Losses
3.5.1 Just as past profits would not be subject
to the new regime, the Committee considers that there should also be no relief
for
past losses, except to the extent that the transitional measures recommended
by the Committee will provide a period of adjustment
and potential loss
recoupment for taxpayers covered by them. With this limited exception, past
losses should not be able to be brought
forward into the first year of the
branch-equivalent regime.
3.5.2 Quite apart from maintaining parity of
treatment with past profits, another reason for not permitting past losses to be
brought
forward is that they will not have been computed according to New
Zealand tax rules, and may well be the result of tax preferences
in the foreign
country which should not be brought through into the New Zealand tax
base.
3.5.3 There should, however, be a limited amount of relief for
current year losses. The CD (page 7) proposed that losses from interests
in
non-resident companies could be carried forward or offset against other
branch-equivalent income, but not against other assessable
income, while losses
from interests in trusts could only be carried forward. As noted in our report,
the Committee considers that
these proposals could lead to a significant erosion
of New Zealand tax revenue. Taxpayers could defer New Zealand tax by, for
example,
offsetting losses in high tax jurisdictions against profits in low tax
jurisdictions, while at the same time carrying forward the
losses to be offset
against subsequent years' profits in the high tax jurisdictions.
3.5.4 One possibility being considered by the Committee would be to allow
losses in respect of a taxpayer's income interest in a controlled
foreign
company to be either carried forward, or offset against the income in respect of
income interests held by the taxpayer in
a group of controlled foreign companies
resident in the same jurisdiction, under the grouping provisions of sections 188
and 191.
The Committee will report further on this issue.
3.6 Dividends Received by a Controlled Foreign Company
3.6.1 As noted in our report, it is necessary
for non-portfolio dividends received by controlled foreign companies to be
either subject
to the withholding payment system or to be made assessable. This
is necessary to prevent controlled foreign companies being used
as dividend
traps to avoid the domestic rules that apply to non-portfolio dividends. The
Committee has yet to consider this issue
in detail but considers that the
treatment of dividends received by controlled foreign companies would be
simplified if they were
made assessable. However, to avoid the multiple levying
of New Zealand tax on dividends, taxpayers would exclude dividends
received by a controlled foreign company from another controlled foreign company
in relation to which the taxpayer reports
income on a branch-equivalent
basis.
3.7 Foreign Tax Credits
3.7.1 The CD proposed that foreign tax credits
be limited on an entity by entity and a source of income basis and be attributed
on
the same basis as the branch-equivalent income of a foreign company. It is
immediately apparent that foreign tax should be creditable
to a taxpayer on the
same basis that the
income of a controlled foreign company is attributed (i.e. on the basis of
income interests held by taxpayers in controlled foreign
companies). However,
issues that the Committee has yet to discuss include:
The Committee will report on these issues in its next
report.
3.8 Treatment of Dividends from Tax Paid Income
3.8.1 The Committee outlines in its report
problems that may result from the adoption of the proposal in the CD that
taxpayers should
be able to deduct dividends they receive from accumulated
income of a foreign company for the purposes of computing branch-equivalent
income. We consider that the proposed imputation system may provide an
appropriate means of affording relief for dividends received
by taxpayers from
the accumulated income of a foreign company that has been subject to New Zealand
income tax. The Imputation Credit
Account (ICA) records amounts of New Zealand
tax paid by resident companies including that on the attributed income of
controlled
foreign companies. Appropriate balances in the ICA could, for
example, be used to reduce or offset New Zealand tax at the shareholder
level on
dividends received by resident companies from controlled foreign companies in
which they have income interests.
3.8.2 As an alternative to meeting a withholding payment liability in cash,
consideration is being given to allowing resident companies
the option of
meeting withholding payment requirements in respect of dividends received from
controlled foreign companies by:
In either case the reduction in tax benefit arising
from the reduction in carried forward loss or the ICA balance will match the
withholding
payment liability.
3.8.3 In order to avoid multiple levying
of New Zealand tax on income derived by an individual through a controlled
foreign company,
it would be necessary to require the individual to keep the
equivalent of an ICA in respect of income attributed directly to him
or her
under this regime.
3.8.4 The Committee will report further on this aspect
of the regime in Part 2 of its report.
ANNEX 3 – FOREIGN INVESTMENT FUNDS
1 Characteristics of Foreign Investment Funds
1.1 Foreign
investment funds are usually entities resident in tax havens which hold
portfolio interests in shares, or which invest
in financial arrangements, real
estate, commodities, currencies or a range of such investments. The funds often
re-invest their income
to increase their value, or they may distribute the
income to investors in non-taxable forms.
1.2 A typical foreign
investment fund is one which invests the savings of its members in order to
provide them with retirement benefits,
such as pension or lump sum
superannuation. Its constitution is often not a material consideration. It may
be organised in a form
that has a fiscal personality apart from its members,
such as a company or unit trust. Such a fund is 'foreign' if it is not a New
Zealand resident for tax purposes.
1.3 The shares or units of some funds
are listed on public stock exchanges. Other funds are not listed but offer to
re-purchase the
shares of members, usually at a price that is published from
time to time. Sometimes the price is guaranteed not to fall below a
certain
minimum, perhaps related to the value of the investments of the fund verified by
an independent valuer.
2 Need to Counter Taxation Advantages of Foreign Funds
2.1 Where a foreign investment fund is based in
a jurisdiction that levies little or no income tax, or where the investments of
the
fund are taxed at a lower rate than comparable investments in New Zealand,
residents who invest in the fund enjoy a fiscal advantage
over other New
Zealanders who invest domestically. Some funds distribute dividends to their
members. Others, however, may 'roll up'
their profits each year into more
investments so that members must sell their shares or units in order to realise
a return. Where
a fund rolls up its income, the fiscal advantage may be enhanced
since the investor's proceeds on realisation are generally treated
as a capital
receipt not subject to income tax.
2.2 If the international tax regime
did not embrace foreign investment funds, they would provide residents with an
easy opportunity
to shelter income from New Zealand taxation and thus defeat the
intent of the regime. Other countries have found it necessary to
deal with such
funds, which were being used to circumvent their own international tax regimes.
New Zealand must also address foreign
investments funds, especially in the light
of current proposals to reform the tax treatment of life insurance and
superannuation.
Domestic superannuation funds are to lose their tax exempt
status whereas many foreign investment funds, which provide superannuation
benefits, may enjoy significant tax advantages. If, for tax reasons, residents
were induced to invest in these foreign funds, a considerable
switching of
investment would occur to the detriment of both the New Zealand tax base and
domestic savings institutions.
3 Basis for Taxing Funds
3.1 Investors may obtain tax benefits through
foreign investment funds without controlling them. They will therefore slip
outside
the controlled foreign company regime. Residents should nonetheless be
taxed on fund income accruing to their benefit. However, since
they do not have
control and are unlikely to be able to report income measured according to New
Zealand rules, an alternative basis
of taxation is necessary. It is considered
that, as a proxy or surrogate measure for the direct taxation of income as
conventionally
defined, the comparative-value basis of taxation (see section 5
below) is appropriate in the following circumstances:
– where an investor has straightforward access to the underlying income of the fund. This will be the case where there are well-defined means of buying and selling interests;
– where the value of the interest is likely to reasonably reflect the underlying income. This will be the case where the investments are essentially of a passive nature and producing systematic gains;
– where it is apparent that the investor is obtaining a tax advantage. This will be the case where the foreign tax levied is lower than the comparable tax in New Zealand.
3.2 It is considered that the regime
should apply to any interest held by a New Zealand resident in a foreign
investment fund (as
defined in section 4 below) where the effect of making the
investment is to reduce the tax that is levied on the income earned through
the
fund to a level below that which would be paid had the income been taxed in New
Zealand as it accrued. However,
as those subject to the regime will generally have non-controlling interests,
and therefore limited access to information, the effect
test will often involve
an element of subjectivity. Comprehensive disclosure is therefore essential to
ensure its effectiveness.
Moreover, other factors such as the domicile or
residence of the fund and its distribution policy should be taken into
account.
4 Definition of Foreign Investment Fund
4.1 A foreign investment fund will be defined
by reference to its investments. A fund is any legal entity which derives its
income
or value primarily or substantially from portfolio (or non-controlling)
investments in shares, or from investments of a passive nature.
4.2 Thus,
investments characterising an entity as a foreign investment fund include
non-controlling investments in companies, trusts,
partnerships and other
business and investment entities, and investments in land held for rent or other
investment return, financial
arrangements, annuities, bullion, commodities,
foreign currency, rights to royalties, and rights or options to acquire any of
these.
Fund investments would generally not include controlling interests in
active businesses or in companies that carry on active
businesses.
4.3 Funds subject to the regime include entities whose
primary investments are in other foreign funds, even where those investments
represent controlling interests. Hence, a non-resident holding company that
controlled a number of trading subsidiaries would not
be a fund for purposes of
the regime, but it would be if it controlled several investment funds.
4.4 The characterisation of investments is critical because an entity earning
mainly active rather than passive income would not be
a fund and would fall
outside the regime. The distinction between active and passive income is hot
precise, so at the margin there
will be pressure on the definition of a fund. In
order to prevent passive income being disguised as active income, the need for a
special anti-avoidance rule is being considered.
5 Measurement of Assessable Income
5.1 A New Zealand resident subject to tax on an
interest in a foreign investment fund will be taxed on distributions received
plus
or minus the change in value of the interest from the beginning to the end
of the taxpayer's income year. If there is a market for
interests in the fund,
eg by way of stock exchange listing, market prices will be employed. Otherwise
quoted redemption prices offered
by fund organisers will be used.
5.2 In
the absence of such data, taxpayers will be required to value their interests in
offshore funds by some commercially acceptable
means. For example, a fund may
provide members with market valuations of investments from time to
time.
5.3 Where reliable valuation is unavailable, it will be necessary
to impute a rate of return on the taxpayer's original investment
in the fund and
tax the notional income derived.
6 Overlap with Controlled Foreign Company Regime
6.1 The definitions of 'controlled foreign
company' and 'foreign investment fund' may overlap. Consider a holding company
controlled
by five or fewer New Zealand residents that invests primarily in
portfolio shares. It would be a controlled foreign company as well
as an
offshore fund. Residents holding more than a 10 percent interest could be
subject to tax twice. Hence, a resident in this position
will be required to
report on a branch-equivalent basis.
ANNEX 4 – TRUST REGIME
1 Introduction
1.1 A
trust is created whenever a settlor transfers property to trustees to be held
for the benefit of beneficiaries. Strictly speaking,
a further settlement on the
same trustees for the same beneficiaries upon the same trust provisions creates
a new trust. For the
sake of clarity, however, the individual transfers will be
referred to in this annex as "settlements" and the collection of settlements
made on the same terms as a "trust".
1.2 Trust income which vests in or
is distributed to beneficiaries is termed "beneficiaries' income". By "trust
income" we mean income
which is not vested or distributed and therefore belongs
to beneficiaries, defined or undefined, whose interests will crystallise
only in
the future.
1.3 Though there is no present beneficiary in whose hands
trust income can feasibly be taxed, the objective of the international tax
reforms require that the income be taxed on an annual basis. The issues are
therefore:
2 Residence and Taxpayer
2.1 For individuals and companies, the first
question is answered in terms of residence and source. The international regime
extends
this basic structure by attributing to New Zealand resident shareholders
a share of the taxable income (including non-New Zealand
source income) derived
by non-resident companies.
2.2 In the Committee's view, the taxation of
trusts should follow that of individuals and companies by developing rules for
the residence
of trusts.
2.3 Determination of residence defines the
income to be taxed (worldwide income or source income). A closely related but
separate
issue is the identification of the taxpayer. It is desirable for
practical and philosophical reasons that, wherever possible, the
recipient of
the income should be the taxpayer. If this is not possible, the residence of the
taxpayer and the income recipient should
be the same, since residence is a key
criterion for determining the amount of income which is taxable. Failing that,
for enforcement
reasons, the taxpayer must be a person who is
resident.
2.4 The only candidates for payers of tax on trust income are
the trustees and the settlor. There is a good case for levying tax on
the
trustees: they are the legal owners of the income, they have the power of
disposition over it and therefore the ability to pay
tax from trust funds. The
settlor has none of these and ordinarily could not oblige the trustees to meet
what would be his or her
own tax liability. In fact, the trustees would be in
breach of trust if they did so. The best source of tax on trust income is
therefore
the trustees.
2.5 There are obvious difficulties in determining the residence of trusts by
reference to the residence of the trustees. Individual
trustees may be resident
in a number of countries and it is easy to change the trustees of a trust. This
would make residence ephemeral.
2.6 It would be possible, by analogy with
companies, to determine residence by a concept such as "centre of administration
and control".
Where more than one such centre existed, a tie-breaker test or
dual/multiple residence rules would be required. Such provisions would,
however,
be difficult for New Zealand to implement unilaterally in respect of trusts with
centres of administration and control outside
New Zealand. In addition, this
approach would not satisfy the requirement of the international regime to tax
foreign-source trust
income where the origin of the trust and/or its corpus goes
back to New Zealand.
2.7 An alternative approach would be to look for an
ownership analogy with companies. Corporate structures provide a nexus of
ownership
between the offshore corporate income and New Zealand resident
shareholders sufficient to justify taxing those shareholders on such
income,
provided that they have a power of disposition over the income or over
systematic gains which are a reasonable surrogate
for it.
2.8 The point
of trusts, however, is that the ownership nexus is severed, except to the
extent that the settlor retains a claim over the settled property in the form of
outstanding debt.
A nexus does, however, exist in the form of the influence or
control which the settlor exercises through the establishment of the
trust terms
and, in some cases, through the power of the settlor to appoint or replace
trustees. In the context of anti-
avoidance legislation, this more tenuous nexus could be regarded as
sufficient to justify determining the residence of a trust by
the residence of
the settlor.
2.9 Since no other definition of residence is feasible as a
basis for taxing trust income, including foreign-source income, we propose
that
trustees should be liable for tax on trust income on the basis of residence as
determined by the residence of the settlor.
3 Future Settlements
3.1 There are considerable legal difficulties
in applying new rules to existing settlements. These are dealt with in section 4
below.
New rules can, however, be applied immediately to settlements made on or
after 17 December 1987, the date of release of the CD.
3.2 Trustees in a
foreign jurisdiction may or may not accept that their trust is a New Zealand
resident. It is expected that the majority
will do so, and will therefore pay
tax on trust income at the greater of the foreign or the New Zealand rate.
Should any default
occur, it is necessary to provide that any New Zealand
settlor will be deemed to be the agent of the trustees and be assessable and
liable for tax accordingly. This is not unduly harsh given the fact that the
settlor will know the rules at the time of making the
settlement and could
require an indemnity from the trustees for tax liabilities.
3.3 For these
purposes, "settlor" will need to be widely defined as any person who has,
directly or indirectly, caused an increment
in wealth of the trust by the
transfer to it of money,
goods, services of other benefits at less than arms-length prices. Where
there is more than one resident settlor, the settlors should
be jointly and
severally liable. Where residents and non-residents make settlements on the same
trust, residents will be treated
as having made all settlements on the trust.
This rule is necessary to avoid the need for complicated apportionment rules. It
is
not disadvantageous because residents and non-residents can make settlements
on separate trusts.
3.4 In summary, we propose that the rules for future
settlements be as follows:
entitled to tax rebates or income support measures;
4 Existing Settlements
4.1 If the above rules were applied to existing
settlements, they could be unduly harsh because in many jurisdictions a settlor
has
no way of changing his or her status as a settlor and has no legal access to
trust funds from which to pay the tax. Resident shareholders
disadvantaged by
the new international regime for companies at least have the option of selling
their shares. The only way out for
a disadvantaged settlor would be to emigrate
from New Zealand. The Committee has therefore proposed a transition for trusts
which
recognises these legal constraints.
5 Distributions
5.1 Under the proposed rules for future
settlements, trustees and settlors will taxed on income which will eventually
accrue to beneficiaries.
At present, individuals who derive foreign income are
entitled to credits for foreign tax paid on the income and, in the absence
of
the general taxation of capital gains in New Zealand, they are not taxed on
capital gains. It is proposed to carry these principles
through to the tax
treatment of distributions from trusts settled after 17 December 1987.
5.2 Distributions to New Zealand resident beneficiaries, excluding capital,
capital gains, and distributions from assessable income
which has already borne
New Zealand income tax would be taxed in the hands of those beneficiaries, with
a credit for foreign tax
paid on the income. For tax purposes, such
distributions should be deemed to be made pro-rata from all sources within each
income
year, and on a last in first out ("LIFO") basis from year to
year.
6 Extinguishment of a Settlor
6.1 As the trust regime proposed by the
Committee has as its basis the residence of the settlor, it is necessary to have
rules to
determine the residence of the trust on the extinguishment of the
settlor. The Committee proposes that, on the death of an individual
settlor of a
trust, whether inter vivos or testamentary, the future residence of the trust
should be determined by the residence
of the settlor at death.
6.2 Where
a trust is a sub-trust that has itself been settled by a trust, or where a trust
has been settled by a company, the settlor
of the trust which settled the
sub-trust, or the shareholders of the company, as the case may be, will be
deemed to be settlors of
the first-mentioned trust. Thus, in the Committee's
view: :
6.3 These rules
follow the principle that the residence of a trust should be traced back to the
residence of the original settlor.
With respect to rules (a) and (b) above, the
settling of a trust through another trust or through a company should be treated
as
being equivalent to an indirect settlement by the settlor of the first trust
or by the shareholders of the company.
6.4 The Committee are considering
whether, for these purposes, the best test of the residence of a trust is the
domicile rather than the residence of the extinguished
settlor.
7. Relationship Between Proposed Regime and Existing Law
7.1 The Committee intends to review the
relationship between this proposed trust regime and the present law governing
existing trusts
and will comment further in its next report.
ANNEX 5 : AN ILLUSTRATIVE TRANSITIONAL LIST OF LOW TAX JURISDICTIONS
ANDORRA MACAU
ANGUILLA MALAYSIA
ANTIGUA
AND BARBUDA MARSHALL
ISLANDS
BAHAMAS MONACO
BAHRAIN MONTSERRAT
BARBADOS NAURU
BERMUDA NETHERLANDS
ANTILLES
BRITISH CHANNEL ISLANDS NETHERLANDS
BRITISH VIRGIN
ISLANDS NEVIS
BRUNEI NEW CALEDONIA
CAMPIONE NORFOLK ISLAND
CAYMAN
ISLANDS OMAN
COOK ISLANDS PANAMA
COSTA RICA PHILIPPINES
CYPRUS SAINT
HELENA
DJIBOUTI SAINT KITTS
DOMINICA SAINT LUCIA
FRENCH POLYNESIA SAINT
VINCENT
GIBRALTAR SEYCHELLES
GRENADA SINGAPORE
HONG KONG SRI
LANKA
ISLE OF MAN SWITZERLAND
JAMAICA TONGA
JORDAN TURKS AND CAICOS
ISLANDS
KUWAIT UNITED ARAB
EMIRATES
LIBERIA URUGUAY
LIECHTENSTEIN VANUATU
LUXEMBOURG VENEZUELA
(Some
of the above jurisdictions are listed as they tax on a territorial
basis.)
V. R. WARD, GOVERNMENT PRINTER, WELLINGTON, NEW ZEALAND—1988 83136D-88PTK
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