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International tax reform Full imputation Part 2 Report of the Consultative Committee Volume 1

Chapter 1 – Introduction

1.1 Purpose of This Report
1.2 Outline of the Report
1.3 "Grey List Exemption"
1.4 Compliance and Administration
1.5 Trust Transition
1.6 Credit Streaming
1.7 Draft Legislation

1.1 Purpose of This Report

1.1.1 The Committee's recommendations on the main features of the international tax reforms and the imputation scheme were outlined in Part 1 of its Report on International Tax Reform and its Report on Imputation. The Government's response to these recommendations was outlined in press statements issued jointly by you and the Minister of Revenue. These were published with the Committee's reports. With three reservations, the Government accepted the Committee's recommendations on the international reforms while those on imputation were accepted in full.

1.1.2 The purpose of this report is to outline the Committee's recommendations on the outstanding issues relating to both sets of reforms and to present the Committee's draft of the legislation. We comment only on those areas where we have found it necessary to modify our original recommendations and on issues which were left undecided in our earlier reports. In all other respects, the draft legislation implements the recommendations of the previous reports.

1.1.3 The aim of this report is therefore to provide interested parties, once you have made your decisions, with an explanation of the policy behind the draft legislation. The report is not intended as an exhaustive guide to the draft legislation. It does not restate all of the arguments or conclusions reached in the Committee's first two reports. This report should therefore be read in conjunction with the earlier reports. We do, however, elaborate our views on a number of the issues which have been raised in response to our previous reports.

1.2 Outline of the Report

1.2.1 The report is contained in two volumes. Our recommendations are presented in this volume. The Committee's draft of the legislation covering the international regimes, the imputation and the withholding payment system and related reforms is contained in a separate volume which forms an annex to this report.

1.2.2 The present chapter includes further comment on a number of issues which are central to the Committee's recommendations. Chapters 2, 3 and 4 outline the Committee's recommendations on the remaining details of the branch-equivalent ("BE") regime to apply to certain controlled foreign companies ("CFCs"). Chapter 5 discusses the outstanding issues relating to the foreign investment fund ("FIF") regime. Trusts are dealt with in chapter 6, while disclosure and default provisions are the subject of chapter 7. Transitional issues relating to the international reforms are considered in chapter 8.

1.2.3 Chapter 9 outlines the Committee's views on the remaining issues concerning the imputation and withholding payment regimes. Consequential and related changes to other aspects of the existing tax law are dealt with in chapter 10. Finally, chapter 11 draws together all of the recommendations of the previous chapters and makes a number of concluding remarks.

1.2.4 Annex 1 of the separate volume consists of the Committee's draft of the legislation on the international tax reforms. Annex 2 in the same volume presents the Committee's draft of the legislation on imputation, the withholding payment system and related matters.

1.3 "Grey List Exemption"

1.3.1 Residents are to be exempt from the BE regime in respect of interests in CFCs resident in certain "grey list" countries unless such a CFC utilises a listed significant tax preference available in a grey list country. These countries are the United States, the United Kingdom, West Germany, Canada, Australia, France and Japan. The list is referred to as "grey" because it may be qualified by the listing of certain significant tax preferences.

1.3.2 Since by far the bulk of existing New Zealand investment overseas is in these countries, it is not surprising that further elaboration of the exact details of the operation of the grey list exemption have been sought by tax practitioners and businesses. In addition, a number of criticisms have been made: that the list should be expanded, perhaps to include all of the countries with which New Zealand has a tax treaty; that it should not be qualified by the listing of preferences; that no criteria have been given for deciding what preferences would be listed; that there should be no "look through" of a CFC resident in a grey list country to CFCs underneath it; and that the compliance costs of the regime would be unmanageable if it frequently applied to CFCs in grey list countries.

1.3.3 These concerns to some extent reflect the uncertainty that arises when tax reforms are developed during a consultative process. Though everyone would wish to see uncertainty minimised to the greatest extent possible, some considerable uncertainty is inevitable if the Government's reform proposals are to be the subject of private sector input and consultation. The trade off is that a better result will usually emerge. It is not possible to have consultation and certainty.

1.3.4 In Part 1 of our Report on International Tax Reform, we said the list should include countries "which have comprehensive international tax rules including CFC regimes" (page 19 of our report). The governing principle for listing a country is that, if the BE regime were applied in respect of CFCs resident in that country, it would be probable that the tax credit allowed for tax paid by a CFC resident there would be sufficient to offset the New Zealand tax liability on that income. In other words, the compliance costs of the regime would be excessive in relation to any revenue likely to be raised.

1.3.5 Whether or not the income tax paid by a CFC is likely to be comparable to the tax that would be levied on its income under the BE regime will depend on the definition of taxable income in its country of residence (such as whether there are significant tax preferences), income tax rates, the efficiency of the tax administration and the extent to which the domestic tax base is protected from avoidance. The existence of comprehensive international tax rules is relevant to the last factor, in particular. The tax legislation by itself may suggest that nominally high rates of tax will be payable, but if there are international planning opportunities effective rates may be very different.

1.3.6 We consider that the existence of a CFC regime is indicative of an income tax system and administration in respect of which it can reasonably be assumed that the effective tax rates on business income in those countries do not depart substantially from the statutory rates. In addition, the CFC regime of the grey list country tends to support the New Zealand BE regime where residents hold interests in CFCs resident outside a grey list country through intermediate companies resident in such a country.

1.3.7 We do not consider that the list should be extended to include all of New Zealand's tax treaty partners. The treaties are entered into to relieve double taxation, promote trade and advance our relationships with other countries. They say nothing about the robustness of the tax system of the treaty partner nor its comparability with New Zealand's. That is not relevant to the decision to establish a treaty. Indeed, we have suggested that a number of our treaty partners should be listed on the transitional list of low tax jurisdictions.

1.3.8 If the grey list is to serve its purpose, provision must be included for its qualification by the listing of preferences. Until recently, countries such as the United States and the United Kingdom gave substantial tax preferences to a broad range of businesses. If the list were being considered, say, four years ago, it would have been necessary to either exclude these two countries or to designate the preferences that would trigger the application of the BE regime. Because so much of New Zealand's investment is in these countries, the compliance costs of the BE regime will depend importantly on whether a country is listed with preferences or the country is excluded from the list altogether. Listing with a qualification for certain preferences is the more flexible approach and the one which will have lower compliance costs.

1.3.9 The general arguments for not preserving the effect of tax preferences under the BE regime were set out in section 2.3 of our previous report. The main counter argument is that the claw-back of tax preferences will make foreign subsidiaries of New Zealand companies uncompetitive. In our view, this argument exaggerates the importance of tax considerations in investment decisions. Factors such as relative labour costs and inflation rates, access to capital and raw materials and proximity to markets will generally be far more important determinants of international competitiveness than relative tax burdens.

1.3.10 Nevertheless, one of the objectives of the BE regime is to minimise the extent to which tax influences the location of investment. Over time, the regime will tend to equalise the effective tax rates on the income of foreign and domestic companies owned by New Zealand residents. The potential effect of a tax preference on investment decisions should be the principal criterion for determining whether the preference should be listed. Developments in the tax systems of the grey list countries will need to be monitored by the Government. If a country introduces a tax preference that is significant enough to attract New Zealand investment, the preference should be listed. A number of generous preferences are to be or are currently being phased out in grey list countries but, because of their limited future, they are unlikely to influence investment decisions.

1.3.11 Even if no preferences are listed, the possibility of one being listed does introduce uncertainty. To minimise this, we recommend that the listing of a preference should have prospective application. Since an existing or a newly established CFC in a grey list country could take advantage of a preference, it is not sufficient to restrict the effect of the listing of a preference to CFCs established after its introduction. Thus, we propose that, if a preference is listed, the listing should not take effect until the beginning of the next income year.

1.3.12 We commented in our previous report on the need for the New Zealand regime to "look through" CFCs resident in grey list countries to CFCs owned by them. If this were not done, New Zealand would not have one CFC regime, but eight - those of the seven grey list countries as well. Residents could choose which of the eight was most favourable to them and establish an intermediate CFC in the relevant country which would own the underlying CFC. It would be pointless to have such a system. As noted above, the existence of a CFC regime in the grey list countries is indicative only. The complete exemption of a grey list CFC and all of its underlying interests should not turn on this factor.

1.3.13 Chapter 4 outlines the Committee's views on how the BE regime should apply in respect of a CFC resident in a grey list country which does utilise a listed preference. We propose that the computation of the BE income of the CFC for any accounting year should be simplified by taking it as the taxable income of the CFC for that year, measured according to the tax laws of its country of residence, adjusted for the effect of the preference. This approach should significantly reduce compliance costs. The major avenue for minimising the compliance costs of the regime in respect of grey list CFCs should be the listing of significant preferences only. It may well be that the best approach initially is to refrain from listing preferences until the regime has been introduced and some experience with its operation has been gained.

1.4 Compliance and Administration

1.4.1 The grey list exemption will remove most of New Zealand's offshore investment from the regime. This will substantially reduce the compliance and administrative costs of the BE regime to the extent that it will affect relatively few taxpayers. The Committee has, however, been concerned to reduce as far as possible the compliance costs of the regime where it will apply. In our previous report, we recommended that the BE regime should apply to a foreign company that is controlled at any time during its accounting year. In principle, this would require taxpayers to compute their interests daily though, in practice, this computation would obviously be necessary only when a taxpayer's interest changed. Nevertheless, the compliance and administrative costs of the scheme will be raised the more frequent the measurement of interests is required.

1.4.2 For this reason, we recommend in chapter 3 that interests in foreign companies for both control and income attribution purposes be measured on four days during the year -on the last day of each calendar quarter. A consequence of this decision is the need to have rules to deal with disposals and related acquisitions straddling a measurement day but, for taxpayers who do not engage in such activity, the reduction to four measurement days should considerably simplify compliance.

1.4.3 The definition of an interest for control and income attribution purposes is, of necessity, broad - we have defined five categories of interest in a company. For most normal share structures, the five categories will, however, reduce to only one or two. Where complicated share structures and rights exist, greater computational requirements will arise. Similarly, greater compliance costs will arise where there are relationships between companies which complicate the calculation of indirect interests. These can be reduced by simplifying corporate group structures.

1.4.4 We mentioned in the previous section the Committee's recommendation for a simplified basis of computing the BE income of a CFC resident in a grey list country. This should considerably reduce the compliance costs of the regime to the extent that it applies to such companies.

1.5 Trust Transition

1.5.1 A further issue which has attracted comment is the transition to apply to trusts with non-resident trustees settled on or before 17 December 1987. Once again, the concern is in part due to uncertainty since your earlier decision on the transition was only provisional. We discuss this matter further in chapter 8.

1.6 Credit Streaming

1.6.1 The Committee proposed a number of provisions to reduce the streaming of imputation and withholding credits. By streaming, we mean the allocation of credits disproportionately to taxpayers able to use them rather than to those, like non-residents, who will be unable to. Streaming would not be a concern if tax revenue were not an issue, but since it is, rules are needed to minimise its impact.

1.6.2 A related matter is whether New Zealand shareholders in non-resident companies with New Zealand subsidiaries should be able to receive credits for any New Zealand tax paid by the subsidiaries. One mechanism to achieve this would be to issue "stapled" shares in the subsidiaries to the resident shareholders.

1.6.3 The Committee considered this issue in its report on imputation. Imputation cannot be considered in isolation from the international reforms. If non-resident companies could direct credits to their resident shareholders through stapled stock and similar arrangements, a constraint on the adoption of a non-resident corporate structure in order to avoid the international reforms would be removed. Hence, we see the disallowance of stapled stock arrangements as a quid pro quo for non-resident status and relief from the international reforms. We consider that this argument also applies to companies which are already non-resident.

1.6.4 It has also been suggested that, if stapled stock type arrangements were to be disallowed in general, an exception should apply for Australian companies, in particular, and perhaps others. It is for the Government to consider whether a special arrangement is warranted with Australia. We would note, however, that a number of New Zealand's tax treaties have non-discrimination articles and most favoured nation provisions which might mean that a special arrangement could not be confined to only one of our treaty partners.

1.7 Draft Legislation

1.7.1 The Committee's draft of the legislation is contained in the annex to this report which is presented in a separate volume. The legislation has not been fully considered by officials nor parliamentary counsel, but we consider that it is sufficiently well-developed to provide a considerable degree of certainty to tax practitioners and businesses. Refinements to the legislation will, however, be needed. We understand that it will be considered by the Finance and Expenditure Select Committee so that interested parties will have an opportunity to comment on it.