Chapter 4 - Income Subject to the Reform Proposals
4.1 Scope of Reform
4.2 Non-Resident Companies
4.3 Non-Resident Trusts
4.4 Bases for Reporting Income
4.1 Scope of Reform
The purpose of these reforms is to tax New Zealand residents on income as it accrues to their benefit through their direct interest in a non-resident company or trust and through their interest held indirectly through that non-resident entity in other non-resident entities. Two requirements must therefore be met before income will be subject to the rules:
a the income must be earned through a company or trust resident outside New Zealand; and
b a New Zealand resident must have an interest in the company or trust.
Once these requirements have been met, a New Zealand resident will be required to include in assessable income his or her percentage interest in the income of the non-resident company or trust. Whether a person is a New Zealand resident for the purposes of these measures will be determined according to the normal tax residence provisions in section 241 of the Income Tax Act. However, there will be one special rule. An individual who has been resident in New Zealand for a cumulative period of less than 24 months in the immediately preceding 15 years will not be a resident for the purposes of these measures. Thus, individuals who work in New Zealand on a temporary basis will not be taxed on their interest in non-resident companies or trusts.
The new regime will apply only to income earned through non-resident companies or trusts. These are separate taxable entities under New Zealand law and may be used to avoid or defer New Zealand tax. Income derived by New Zealand residents through foreign branches or partnerships, which are not separate taxable entities under New Zealand tax law, will not be affected since such income is already subject to current taxation in New Zealand. Income derived directly by New Zealand residents from foreign property, whether tangible (such as land) or intangible (such as debt instruments), is also excluded since it is already subject to taxation in New Zealand as it is earned.
This chapter elaborates on the types of non-resident entities that will be subject to the rules. It deals first with companies and then with trusts.
4.2 Non-Resident Companies
The forthcoming legislation will apply to income earned through the following "non-resident companies":
a a non-resident entity which is comparable to a company under New Zealand law or to an entity which is deemed to be a company under New Zealand tax law (eg a unit trust); and
b a company or deemed company which is a resident of New Zealand and any other country and which is not subject to tax in New Zealand on its foreign income.
The existing residence rules in the Income Tax Act will apply to determine the residence of companies. For the guidance of taxpayers, a list of common non-resident entities that will be treated as companies for the purpose of this legislation will be issued by the Commissioner of Inland Revenue.
4.2.1 Percentage Interest in a Non-Resident Company
This regime will require the measurement of a New Zealand resident's true economic stake in a non-resident company. This is best measured by the ability of a resident to extract income from the company. As proposed in the consultative document on full imputation, the definition of dividends for income tax purposes is to be widened to include all types of distributions, with the exception of certain returns of paid-up share capital. Thus, a New Zealand resident's interest in a non-resident company will be defined in terms of his or her expected return of dividends from the company. It is clearly not feasible to give the Commissioner of Inland Revenue a discretion to decide what is a resident's ability to extract dividends from a non-resident company on a case by case basis. The rule should ideally be clear and objective so that taxpayers know in advance the tax consequences of investing in non-resident companies. Furthermore, it is not sufficient to define an interest in a non-resident company only in terms of current rights, or future entitlements, to dividends. In order to prevent avoidance, it is also necessary to measure a resident's current and future entitlement to voting rights in relation to the distribution policy of the non-resident company.
Therefore, a taxpayer's "percentage interest" in a non-resident company will be defined as the greatest of:
a the proportion of rights to dividends to which the resident is entitled;
b the proportion of rights to dividends which the resident is entitled to acquire;
c the proportion of voting rights, in relation to distributions and changes to the company's constitutional rules, to which the resident is entitled;
d the proportion of voting rights, in relation to distributions and changes to the company's constitutional rules, which the resident is entitled to acquire.
A taxpayer's percentage interest will be determined at the end of the non-resident company's accounting year.
An interest in a non-resident company will include an interest held indirectly through interests in other non-resident companies or trusts. A taxpayer's percentage interest in a lower-tier non-resident company will be determined by multiplying the taxpayer's interest in the first-tier non-resident company by that company's percentage interest in the lower-tier company. This determination must be made for all levels in a chain of ownership of non-resident companies (see sections 5.2.1 and 5.2.2 and Appendices 5.1 and 5.2 for further details).
Many capital structures are designed to take advantage of tax provisions. It is not unreasonable to expect that these structures will be altered to reflect the new tax provisions. However, the adoption of the rule outlined above may cause difficulties for some taxpayers who currently hold certain classes of shares in non-resident companies. A period of adjustment will therefore be provided before the regime comes into effect. In this period, taxpayers may wish to reconsider their interests in companies with complicated capital structures or, if they control the non-resident company, to adjust the way in which they invest in the company so that they obtain the desired level of risk, return and control, taking into account the definition of "percentage interest" in this regime.
The following are examples of instruments to which the rights taken into account in determining a taxpayer's percentage interest in a non-resident company may attach:
a shares in a non-resident company;
b units in a non-resident unit trust;
c debentures of a non-resident company without a fixed interest rate and debentures issued in substitution for shares of a non-resident company as defined in sections 192 and 195 of the Income Tax Act;
d options, or other rights to acquire, interests in a non-resident company or a non-resident unit trust that can be exercised directly or indirectly by the holder of the option, and put options which are in substance callable options;
e convertible debt of a non-resident company, including instruments similar in nature to convertible notes defined in section 196 of the Income Tax Act; and
f any interest in non-resident companies owned by a non-resident company or trust in which the taxpayer has an interest as described in (a) to (e) above, including any interest in non-resident companies and trusts held through a chain of ownership.
Convertible debt in a non-resident company is debt which converts automatically, or at the option of the holder or issuer of the debt, into equity in the company. Convertible debt instruments have the characteristics of both equity and debt. Any change in the market value of convertible debt reflects changes in market yields on debt and changes in the market value of the potential equity rights represented by the instrument. The debt portion of such instruments is currently taxable under the provisions of section 64B to 64M of the Income Tax Act. The forthcoming legislation will ensure that a taxpayer is not taxed twice on income derived from convertible debt instruments.
Where a nominee of a resident holds an interest in a non-resident company, the interest shall be deemed to be held by the resident. The existing definitions of "nominee" in the Income Tax Act will be reviewed to ensure that they are satisfactory for the purposes of this regime.
4.2.2 De Minimis Rule
Where the market value of an individual's aggregate direct interests in non-resident companies, at all times in the individual's income year, does not exceed $10,000, the individual will be exempt from reporting his or her income from those non-resident companies under the branch-equivalent or comparative-value basis. Market value will be determined according to the valuation rules set out in section 6.1.2.
4.3 Non-Resident Trusts
The measures will also apply to non-resident trusts. To eliminate any possible ambiguity in the present law, a trust will be deemed to be resident in New Zealand for tax purposes if any trustee of the trust is resident in New Zealand at the end of the accounting year of the trust. The existing residence rules in section 241 of the Income Tax Act will apply to determine the residence of a trustee. A non-resident trust will thus be a trust that does not have any trustee resident in New Zealand at the end of the accounting year of the trust. The measures will apply to inter vivos and testamentary trusts, irrespective of whether they are specified or non-specified trusts pursuant to the Income Tax Act.
4.3.1 Interest in a Non-Resident Trust
Non-resident trusts may be used to avoid New Zealand tax where the non-resident trustee or trustees accumulate trustee income and it is not also derived by New Zealand resident beneficiaries entitled, or deemed to be entitled, in possession to the receipt of it (this is the definition of beneficiaries' income in section 227 of the Income Tax Act). In many cases it will not be possible to ascertain, at the end of a trust's accounting year, whether there are any resident beneficiaries, or, if there are, their respective shares of the trust income. Consequently, it is often not feasible to tax resident beneficiaries on their share of the trust income of non-resident trusts.
In order to achieve the objectives of these reform measures with regard to non-resident trusts, any person resident in New Zealand (referred to as a "resident settlor") who has contributed property by way of gift, including a transfer of property for inadequate consideration, to a non-resident trust will be considered to have an interest in the non-resident trust until such time as:
a a resident settlor who is a natural person dies and his or her estate is wound up; or
b a resident settlor which is a company or another trust is wound up.
The value of a contribution to a non-resident trust will be the difference between the market value of the property transferred to the trust and the market value of any consideration given by the trust. Special rules will be necessary in relation to any financial assistance given to non-resident trusts, whether given directly or indirectly, and whether by means of a loan, guarantee, the provision of security or otherwise. The definition of a "resident settlor" will include residents who make indirect contributions to non-resident trusts through resident or non-resident interposed entities such as trusts, companies or financial institutions, or through non-resident individuals. A resident will also be considered to have an interest in any non-resident trust to which a non-resident trust or a non-resident company in which the taxpayer has an interest contributes property. This determination must be made for all levels of entities in a chain of ownership irrespective of whether the income of the higher-tier entity is being reported on a branch-equivalent or comparative-value basis. A resident settlor with an interest in a non-resident trust will also be deemed to have an interest in any non-resident company in which that trust has an interest.
4.3.2 Percentage Interest in a Non-Resident Trust
The rules for determining a resident settlor's percentage interest in a non-resident trust are set out in section 5.3.2.
4.3.3 De Minimis Rule
An individual will be exempt from the proposed resident settlor rules if the market value of all contributions made by him or her to non-resident trusts at any time is less than $500. For this purpose, the market value of each contribution must be determined at the time of the contribution.
4.3.4 Beneficiaries
New Zealand-resident beneficiaries of non-resident trusts must include in their assessable income trust income distributed to them or which becomes vested indefeasibly in them in accordance with the rules set out in section 7.3.1.
New Zealand residents who purchase a beneficial interest in a discretionary non-resident trust will be taxed on such an interest on the comparative-value basis (see section 6.3).
4.4 Bases for Reporting Income
Once it is determined that a New Zealand resident has an interest in a non-resident company or trust, then the amount of the entity's income that has accrued to the benefit of the New Zealand resident must be calculated in accordance with the "branch-equivalent" basis or the "comparative-value" basis.
The next two chapters explain in more detail the branch-equivalent and the comparative-value bases of determining income to which the reform measures outlined in this document apply.