Chapter 2 – Branch-Equivalent Regime Part 1: Definitions

2.1 Introduction
2.2 Relationship of BE Regime to Existing Act
2.3 Definition of "Company" and "Trustee"
2.4 Residence: Individuals
2.5 Residence: Companies
2.6 Definition of "Nominee"
2.7 Definition of "Associated Persons"

2.1 Introduction

2.1.1 Chapters 2, 3 and 4 outline the Committee's recommendations on the outstanding issues relating to the branch-equivalent ("BE") regime. The main elements of this regime were outlined in Chapter 2 of Part 1 of the Committee's Report on International Tax Reform. For ease of reference to the draft legislation, the issues are discussed in the order that they arise in the legislation. This chapter deals with the definitions which are central to the BE regime.

2.2 Relationship of BE Regime to Existing Act

2.2.1 The BE and the Foreign Investment Fund ("FIF") regimes will represent substantial additions to the existing Income Tax Act 1976 (the "Act") and, as a practical convenience, are best located together in Part IV of the Act. Their particular location is a minor matter - we have proposed that they form new sections 245A, 245B, etc. The regimes do, however, require a number of definitions. Definitions which are intended to apply generally throughout the Act are contained within section 2, while definitions which are specific to particular sections are usually included within those sections. The BE regime will apply when five or fewer New Zealand residents hold interests, either directly or through nominees or associated persons (which include certain relatives and trustees), which in aggregate equal or exceed 50 percent of the shares, voting rights, etc, of a foreign company. Thus, the definitions of residence, nominee, associated person, relative, trustee and company are critical to the effective operation of the scheme.

2.2.2 For this reason, we have reviewed existing definitions in the Act in order to consider their appropriateness for the purposes of the BE regime. We have proposed new definitions of a company, a trustee a resident which we recommend apply generally throughout the Act. Our proposed definitions of a nominee, associated person and relative are, however, intended to apply only to the international regime. The main reason for this limitation is that these definitions are pivotal to the operation of other sections of the Act as well as the sections that will form part of the international regime and should not be amended for the purposes of those other sections without careful consideration of the consequences. In the time available, we have not been able to undertake this task. There are, however, a number of deficiencies in the existing definitions and they should be reviewed at some stage. To this end, we have included in an appendix to the draft legislation new drafts of section 7, the present section defining associated persons, and section 8, the section dealing with control of a company, which could be considered in this review. Special definitions for particular sections may still be required.

2.3 Definition of "Company" and "Trustee"

2.3.1 As noted in the previous section, we recommend that the existing general definition of a "company" in section 2 of the Act be changed. It should be expanded to include any entity with a legal personality or existence separate from those of its members, which is created by way of incorporation or otherwise whether in New Zealand or elsewhere. This change is not fundamental but aims to more clearly include within the definition the variety of legal entities in overseas jurisdictions that are equivalent to companies. We understand that it is the intention of the Inland Revenue Department to publish for the guidance of taxpayers a list of the types of non-resident entities it considers to be the equivalent of companies under New Zealand law.

2.3.2 We also propose a minor amendment to the existing section 2 definition of a trustee to make it clear that a reference to a trustee of a trust means the trustee only in his or her capacity as trustee of that trust and includes all trustees of that trust.

Recommendation

2.3.3 Accordingly, the Committee recommends that:

a the definition of a "company" in section 2 of the Act be amended to include any entity which has a legal personality or existence separate from that of its members, which is created by way of incorporation or otherwise whether or not in New Zealand; and

b the definition of a trustee of a trust in section 2 of the Act be clarified to mean that trustee only in his or her capacity as a trustee of that trust and includes all trustees of that trust.

2.4 Residence: Individuals

2.4.1 The BE regime will apply to residents in respect of interests in foreign companies which are controlled by residents. Similarly, the settlor regime for trusts will apply to trusts which have a New Zealand resident settlor. Thus, the definitions of residence of an individual and of a company for tax purposes are key elements of the regimes. Residents should not be able to cease temporarily or regularly to be resident in order to avoid the control test and income attribution under the BE regime nor the settlor designation under the trust regime. In addition, residents should not be able to lose temporarily their residence status in order to receive a taxable distribution from a trust or company without suffering New Zealand income tax.

2.4.2 The present definitions are contained in section 241 of the Act. A natural person is deemed to be resident in New Zealand if he or she:

a has a permanent place of abode in New Zealand; or

b is personally present in New Zealand for a continuous period of not less than 365 days except that, where the person has a permanent place of abode outside New Zealand, he or she may request to be treated as a non-resident.

2.4.3 Where a person is absent from New Zealand for a continuous period of not less than 365 days, the person is deemed not to be resident in New Zealand during that period except that, where a person has a permanent place of abode in New Zealand at all times during the period, he or she may request to be treated as a resident.

2.4.4 For the purposes of both 365 day tests, two or more periods are defined to be continuous if there are not more than 28 days between them and the intervening days do not exceed 56 days in that 365. In order to cease to be a New Zealand resident, a natural person must therefore be absent from New Zealand for at least 309 (i.e 365 less 56) days of a 365 day period and not be present here for any period exceeding 28 days. An absence of only 29 days is sufficient under the definition to break the residence link where the person in question does not have a permanent place of abode in New Zealand.

2.4.5 A person who is not a New Zealand resident can remain a non-resident by having a permanent place of abode outside of New Zealand and no permanent place of abode in New Zealand, irrespective of the time they are in New Zealand. Thus, a New Zealand resident can cease to be resident here by disposing of any permanent place of abode in New Zealand and acquiring a permanent place of abode outside New Zealand.

2.4.6 In our view, the permanent place of abode test needs to supplemented by a strengthened personal presence test. As noted above, the present test can be avoided by disposing of one's permanent place of abode in New Zealand and spending 29 continuous days out of New Zealand or by maintaining a permanent place of abode outside New Zealand. The continuous period concept in the existing personal presence tests adds little. We propose that they be simplified by determining residence according to whether a person is present or absent from New Zealand for a certain number of days. Thus, we propose that a natural person be deemed to be a New Zealand resident if:

a his or her permanent place of abode is in New Zealand; or

b he or she is personally present in New Zealand for not less than 183 days of any 12 month period.

2.4.7 In addition, we propose that a natural person who is a New Zealand resident may cease to be a resident only if:

a he or she is absent from New Zealand for not less than 325 days in any 12 month period; and

b he or she has, at no time during that period, a permanent place of abode in New Zealand.

2.4.8 The effect of these changes would be to make it easier for a person to become a New Zealand resident and harder to cease to be one. We propose that the amendment come into effect from the commencement of the 1989 income year.

Recommendations

2.4.9 Accordingly, the Committee recommends that the residence tests applying to natural persons be amended with effect from the income year commencing on 1 April 1988 so that:

a a person is deemed to be resident in New Zealand if he or she:

i has a permanent place of abode in New Zealand; or

ii is personally present in New Zealand for at least 183 days of any 12 month period; and

b a person ceases to be resident in New Zealand only if he or she:

i is absent from New Zealand for 325 days of any 12 month period; and

ii has at no time during that period a permanent place of abode in New Zealand.

2.5 Residence: Companies

2.5.1 Temporary changes of residence by companies do not present the same problems under the international regime as do those by individuals. A company controlled by residents which became a non-resident to avoid the control and income attribution rules under the BE regime would itself fall within the regime. The present definition of the residence of a company is contained in section 241(2). A company is deemed to be resident in New Zealand if it:

a is incorporated in New Zealand; or

b has its "centre of administrative management" in New Zealand.

An exception applies to a "banking company" which is deemed to be resident only if its centre of administrative management is in New Zealand.

2.5.2 There are two problems with this definition. The first is the ambiguity of the term "centre of administrative management". The Inland Revenue Department interprets this to mean the place where the day to day administration of a company is carried out. By contrast, a number of tax practitioners consider that it means the place where the highest (i.e board of director) level of decision-making takes place. Many other countries use the term "place of central management and control" to designate the place where the board of directors meets.

2.5.3 The second problem with the definition is the administrative difficulty of applying a place of management test (whether central or day to day). To a large extent, the need for a CFC regime arises because of this difficulty. The place of management test has, however, much more economic substance than the place of incorporation test. In addition, most of New Zealand's double tax agreements employ a management and control test to settle the residence of a company resident within the jurisdiction of both treaty partners. Thus, a management and control test is an integral part of our tax law since the treaty tests override the Income Tax Act provisions where the two are in conflict. For these reasons, we favour retaining a place of management test of corporate residence.

2.5.4 To clarify the present definition, the level of management on which it is intended that residence depend should be spelt out more precisely. To avoid altering substantively the present test, we propose that the place of both the board and executive levels of management be included and that the term "head office" (where both levels of management would normally be located) be retained. Thus, a company would be resident in New Zealand if it:

a is incorporated in New Zealand; or

b has its centre of director control in New Zealand; or

c has the centre of its executive management in New Zealand; or

d has its head office in New Zealand.

For the purposes of the second test, the substantive issue is whether control by directors is exercised in New Zealand, irrespective of whether board meetings are also occasionally held outside New Zealand. We propose that the new residence definition apply with effect from the present (i.e. 1989) income year.

2.5.5 We have asked the Inland Revenue Department to investigate the origin of the special residence rule applying to banking companies. It dates from 1941 and was apparently intended to permit banks incorporated in New Zealand for the purposes of issuing banknotes here to do so without being subject to tax on their worldwide income, as would be the case if the place of incorporation test applied to them. Since this consideration is no longer relevant, we propose that the residence of a banking company be determined under the normal rules.

Recommendation

2.5.6 Accordingly, the Committee recommends that the residence test for companies be amended with effect from the income year commencing on 1 April 1988 so that a company, including a banking company, is resident in New Zealand if it:

a is incorporated in New Zealand; or

b has its centre of director control in New Zealand; or

c has the centre of its executive management in New Zealand; or

d has its head office in New Zealand.

2.6 Definition of "Nominee"

2.6.1 Since the BE regime will apply whenever residents hold a certain threshold percentage of the "control interests" (meaning generally the various rights or powers of ownership which when aggregated sufficiently enable a person to control a company) in a foreign company, there is an obvious incentive for a person to disperse interests among nominees or associated persons. To counteract this, interests held by a nominee of a person must be deemed to be held by that person. The treatment of interests held by associated persons is referred to in the next section.

2.6.2 The scope of the definition of nominee will depend to some extent on its application. There are at present two definitions of nominee in the Act but they are both framed in relation to the sections to which they apply. For example, they differ according to the way in which relatives are brought within the definition. In principle, it is not necessary to deem relatives to be nominees of a person but, in practice, where it is likely certain relatives will be acting as nominees, it is reasonable to shift the burden of proof on to the taxpayer to establish that this is not so.

2.6.3 For the purposes of the BE regime, the definition of nominee needs to be framed in terms of the rights and powers which, if a person held them directly, would be taken into account in determining his or her control interest. With respect to relatives, given that the tax consequences for a person of having someone else deemed to be his or her nominee may be substantial, we propose that only children under 18 years of age be deemed to be nominees of a person unless the person can establish otherwise. In addition, we propose that a bare trustee (i.e. a trustee who holds property to the order of a beneficiary) be included in the definition. (A broader inclusion of relatives and trustees is proposed for the definition of associated persons.)

2.6.4 To support the definition, we propose that the definition of a nominee include a person who has entered into an arrangement or understanding with another person with respect to the holding or exercising of rights or powers in relation to foreign companies.

Recommendation

2.6.5 The Committee therefore recommends that, for the purposes of the BE regime, a nominee of a person be defined to include:

a a child of the person under 18 years of age, unless the person can establish otherwise;

b a bare trustee; and

c a person who has entered into an arrangement or understanding with that person with respect to the holding or exercising of rights or powers.

2.7 Definition of "Associated Persons"

2.7.1 A nominee of a person is in effect that person's agent. The definition of associated persons aims to embrace persons who are not related as principal and agent but who, because of their personal or economic relationship, can reasonably be assumed to have similar economic interests. For example, two companies owned by the same shareholders may not be related as principal and nominee but will nevertheless have substantially similar if not identical economic interests. They should therefore be treated as associated persons.

2.7.2 In the context of the BE regime, we propose that interests in foreign companies held by associated persons be aggregated for the purposes of the control test, but not for the purposes of income attribution. The income attributed to any person would depend only on the interests that the person holds directly, through nominees, or through other controlled foreign companies. (Interests held by the nominees of a person should be aggregated with that person's own direct and indirect interests for the purposes of determining both the control and income interests of the person.)

2.7.3 The present Act contains a general definition of associated persons in section 8. In brief, this section defines associated persons as any two companies which consist of substantially the same shareholders or that are under the control of the same persons; a person and a company where that person owns 25 percent or more of the shares in the company; two persons who are relatives; and a person and a partnership where that person is associated with a partner. This definition is not appropriate for the purposes of the BE regime. First, the relationship between two companies or another person and a company needs to be extended and defined in terms of the rights and powers to be taken into account in determining control and income interests under the BE regime. Secondly, the 25 percent ownership threshold should be raised to 50 percent for consistency with the control threshold under the BE regime. Thirdly, the term relative means persons connected within the fourth degree of relationship (such as first cousins). This is too broad for the purposes of the BE regime. Fourthly, the present definition does not include trust relationships.

2.7.4 Accordingly, we propose that, in relation to the BE regime only, the term associated persons mean:

a any 2 companies:

i which consist substantially of the same shareholders, as presently defined in section 7; or

ii which are under the control of the same person or persons, as presently defined in section 7; or

iii where any group of persons holds income interests in each company totalling in aggregate 50 percent or more;

b any person and a company if that person holds an income interest of 50 percent or more in that company;

c two persons who are relatives if they are connected within the second degree of relationship;

d a partnership and any person, where that person is a partner of the partnership;

e a partnership and any person, where that person and any partner are associated persons;

f a trustee of a trust and any person where that person (or any person associated with that person) has derived a benefit from that trust or, being a person associated with the settlor of the trust, could derive a benefit from it (except where the trust is for the benefit of employees only and the person, or an associated person, does not manage or control the affairs of the trust); and

g a trustee of a trust and any person where that person (or a person associated with that person is a settlor of that trust (except where such an association exists as a result of an employer settling a trust, such as a superannuation fund, for the benefit of employees only and the employer or any associated person does not manage or control the affairs of the trust).

2.7.5 In addition, two persons who habitually act in concert with respect to the holding or exercising of interests in foreign companies should be deemed to be associated persons with respect to those interests.

Recommendations

2.7.6 Accordingly, the Committee recommends that, in relation to the BE regime only, the term associated persons mean:

a any 2 companies:

i which consist substantially of the same shareholders, as presently defined in section 7; or

ii which are under the control of the same person or persons, as defined in section 7; or

iii where any group of persons holds income interests in each company totalling in aggregate 50 percent or more;

b any person and a company if that person holds an income interest of 50 percent or more in that company;

c two persons who are relatives if they are connected within the second degree of relationship;

d a partnership and any person, where that person is a partner of the partnership;

e a partnership and any person, where that person and any partner are associated persons;

g a trustee of a trust and any person where that person (or a person associated with that person) is a settlor of that trust (except where such an association exists as a result of an employer settling a trust, such as a superannuation fund, for the benefit of employees only and the employer or any associated person does not manage or control the affairs of the trust); and

i two persons who habitually act in concert with respect to the holding or exercising of interests in foreign companies, with respect to those interests.