Chapter 3 - Extending the active income exemption to FIFs
Summary of suggested changes
- The active income exemption for FIFs, like that applying to CFCs, would use an active business test as a gateway.
- If a FIF passes the active business test, no income will be taxable, if a FIF fails, only passive income will be taxable.
Existing rules for taxing FIF interests
3.1 As described in chapter 2, a “full accrual” approach still applies to most investments in foreign companies not controlled by New Zealand residents (FIFs). The main exceptions are an exemption for 10 percent or greater interests in FIFs located in one of eight grey list countries and an exemption for less than 10 percent interests in Australian companies listed on the Australian stock exchange.
3.2 The methods used for calculating FIF income differ depending on whether the investor has a portfolio (less than 10 percent) or non-portfolio (10 percent or greater) shareholding in the foreign company.
3.3 Subject to certain restrictions, non-portfolio investors have a choice of four possible attribution methods.
- The branch equivalent method: This involves the taxpayer doing a full calculation of FIF income using New Zealand tax rules as though the FIF were a New Zealand company. It requires access to very detailed financial information, so is usually only suitable for larger shareholders. The current branch equivalent method for FIFs is identical to the old rules for calculating CFC income.
- The accounting profits method: This method is essentially the same as the branch equivalent method but is easier to apply as it is based on accounting information. FIF income is the investor’s share of the foreign company’s accounting profit less credits for foreign tax paid.
- The comparative value method: Under this method, FIF income is the difference between the value of the investment at the end of the year (plus any gains during the year) and the value at the beginning of the year (less costs during the year).
- The deemed rate of return method: This method calculates FIF income as a percentage of the book value of the investment at the end of the previous year. Each year the Government sets what percentage is to be used, and investors are required to make adjustments to update the book value of their investment.
3.4 Portfolio investors can also choose from the four attribution methods described above. However, the main attribution method for portfolio investors is the fair dividend rate method. Under this method the investor’s FIF income is 5 percent of the market value of their investment at the start of the income year (with an adjustment if the investment is bought and sold in the same year). If a market value is not available, the cost method can be used, under which the 5 percent return is based on either the net asset value, the cost of the investment or an independent valuation.
3.5 For shares that are equivalent to debt the only methods that can be used are the comparative value or deemed rate of return methods (this restriction applies to portfolio as well as non-portfolio investors).
Should the active income exemption for CFCs also apply to FIFs?
3.6 The 2006 Government discussion document, New Zealand’s International Tax Review: a direction for change, considered three broad options for applying an active income exemption to CFC interests. In theory, the same three options should also be available for implementing an active exemption for FIF interests. They are:
- An entity approach: an assessment is made of a foreign company’s business activities or assets as a whole. If the entity is predominantly “active” no income is attributed. If not, the shareholder is taxed on its share of the foreign company’s income (regardless of whether the underlying income is active or passive).
- A transactional approach: shareholders in the foreign company calculate their attributable income and pay tax based on their share of the foreign company’s income, and the proportion of that income that is passive.
- A hybrid approach: an entity test is first applied to the foreign company’s activities. For example, using financial accounts, the active business test looks at whether less than 5 percent of the gross income of the foreign company is passive. If the test is passed, the New Zealand-resident shareholder is not taxed on any income from the shareholding. If the test is failed, only passive income is attributed to the shareholder on a transactional basis, so active income continues to be exempt from attribution.
3.7 A concern with the entity approach in the context of the CFC rules is that it can lead to significant amounts of passive income being exempted. The entity approaches used in other countries generally have a high tolerance (up to 50 percent) for passive income or assets. This implies that a pure entity approach could lead to considerable amounts of passive income escaping New Zealand tax. This is problematic given that passive income can be shifted offshore to avoid or defer New Zealand tax. At the same time, for those entities that fail the test all income, including active income, is taxed on accrual.
3.8 A pure transactional approach would avoid these problems, but would involve significant compliance costs for investors in entities with mainly active income.
3.9 For CFCs, the hybrid approach offered a sensible compromise between the various concerns associated with the entity and transactional approaches. Similar considerations seem to arise in relation to FIF interests. A further consideration is that adopting either a pure entity approach or a pure transactional approach for FIF interests would create boundary concerns between the CFC and FIF rules. These could result in tax considerations driving commercial decisions. Taxpayers who preferred the CFC hybrid approach would be motivated to hold a level of offshore interest that brought them within CFC rules. By the same token, taxpayers who preferred the entity approach could structure their investment so that they stayed outside the CFC rules.
3.10 It is therefore suggested that the hybrid approach adopted in the new CFC rules should also form the basis on which the active income exemption is applied to interests in FIFs.
3.11 Having the same design for CFCs and FIF interests would reduce the potential complexity of the international tax rules and make the exemption easier for companies and advisors to understand and operate.
3.12 In particular, some New Zealand companies will have CFCs as well as non-portfolio interests in FIFs, so it could be efficient for these companies to have only one set of active income exemption rules to operate. Changes in the level of stake held, or even changes in the composition of shareholders can result in a CFC interest becoming a FIF interest and vice versa. It would be simpler if these kinds of changes could be dealt with under a common exemption framework.
The Australian experience
3.13 The broad design of New Zealand’s new CFC rules (particularly the hybrid approach) is similar to the design of the current Australian CFC rules.
3.14 To date, Australia has had an entity approach for calculating income from FIF interests, using two possible methods. Under the stock exchange listing method, a company passes the active income test if it is listed in a class of companies designated by an approved stock exchange as engaged in active business activities, or the company is included in an approved industry classification system as engaged in such activities. Under the balance sheet method, a company passes the active income test if the gross value of the company’s assets for use in active business exceeds 50 percent of the gross value of all its assets.
3.15 The Australian Government has recently announced the repeal of its FIF rules and the reform of its CFC rules.