Active business test – clarifications and remedial amendments
(Clauses 20, 22(2) and 22(3))
Summary of proposed amendment
The Bill proposes changes to the definitions of passive and total income used in the active business test for controlled foreign companies. These will make it easier to pass the active business test that is based on accounting data. The Bill also clarifies that when the active business test is applied to a group of CFCs, a CFC may not be included in more than one group.
Income years beginning on or after 1 July 2009.
This amendment is retrospective so that affected taxpayers can benefit from the policy from the inception of the international tax rules, consistent with the original intent.
The Bill proposes changes to ensure that:
- Rental income may be included in the measure of reported income in section EX 21E (which contains the active business test using accounting data).
- Income from financial arrangements that is received from a non-attributing active CFC may be excluded from the measure of passive income in section EX 21E.
- Income from some financial assets that are in the nature of accounts receivable may be excluded from the measure of passive income in section EX 21E.
- A CFC that is part of a “test group” for the purposes of the active business test under sections EX 21D or EX 21E cannot be part of another test group and cannot apply the test as an individual CFC.
The first three proposed changes fix unintended omissions. The final change is for clarification only, and does not – in our view – result in the effect of the law changing.
All references are to the Income Tax Act 2007 unless stated.
The active business test is used when a New Zealand resident has an income interest in a foreign company. If the foreign company passes the active business test, the New Zealander may ignore the current income of the foreign company for tax purposes.
There are two forms of the test, one using accounting data and one using the usual provisions of the Income Tax Act for calculating income. In concept, both are similar – they measure the amount of passive income of the foreign company as a proportion of total (gross) income, and deem the company to be an active business if the proportion is less than 5%.
Passive income is exhaustively defined. For example, it explicitly includes rental income and interest income. However, there are numerous exceptions which allow a person to remove items if they wish. Total income is also defined.
It is possible for companies in the same country (in the case of some interests in foreign investment funds, companies in any country) to undertake the test as a group, using consolidated accounts. This may reduce compliance costs and also simplifies the treatment of holding companies or other companies with non-operational functions within the group.
Paragraph EX 21E(10)(ab)
Reported revenue in section EX 21E(10) is the measure of total income for the purposes of the active business test using accounting concepts. Reported revenue includes “revenue” if IFRS is used, a term which is defined by International Accounting Standard 18. Lease income is generally excluded from the definition of “revenue” under that standard. Lease income is brought in under another item that is part of reported revenue, but only if it is income other than rent from finance or operating leases.
This means that rental income may not be able to be included in the measure of total income. This is not intended, and this Bill proposes an amendment to the definition of reported revenue so that rent may be included.
Paragraph EX 21E(9)(cb)
Reported passive in section EX 21E(7) is the measure of passive income that is used in the active business test using accounting concepts. One component of reported passive is income or loss from a financial asset, other than a derivative or a share on capital account. Accounts receivable can be financial assets. This means that gains or losses on accounts receivable – for example, due to exchange rate fluctuations – may be included in the measure of passive income. However, active businesses will have accounts receivable, so including them is not necessarily appropriate.
Reported passive also includes interest received from associated non-attributing CFCs. Such interest may not be ignored even though other forms of passive income from such CFCs can be (see paragraphs EX 21E(9)(a) to (c)).
The Bill makes a change to the measure of passive income to address these problems.
The change allows gains or losses on financial assets (including interest income) to be excluded from the measure of passive income if:
- they are included in the measure to begin with (see the existing provision at the beginning of subsection EX 21E(9)); and
- they could be excluded under the active business test that uses tax rules (see subsection EX 20B(12), but subject to the modification described below).
This allows the exclusion of amounts that are, broadly speaking, payments from related active entities and gains or losses relating to accounts receivable.
The exclusions in subsection EX 20B(12) are exclusions from financial arrangement income. The subsection does not apply to financial arrangement expenditure. However, in the context of section EX 21E, it would be inappropriate not to exclude expenditure if income was being excluded; section EX 21E refers to gains or losses from financial assets. Therefore, paragraph EX 21E(9)(cb) refers to any gain or loss on a financial asset that is a financial arrangement or agreement that subsection EX 20B(12) refers to (whether or not the arrangement or agreement actually generates income under that subsection). That is, a person may exclude gains under the exclusion, but only if they also exclude similar losses.
Clarification – test groups
Subsection EX 21B(4)
Subsections EX 21D(1) and EX 21E(2) each define a “test group” for the purposes of the active business test.
The Bill proposes a clarification to make it clear that a CFC may not be part of more than one test group, and may not apply the test on an individual basis if it is part of a test group.