Chapter 5 - Rules for applying the active income exemption to FIF interests
Summary of suggested changes
- The active business test and the definition of “passive income” for interests of 20 percent or more in a FIF should follow the rules developed for the CFC active income exemption.
- Consistent with the CFC changes, the grey list exemption for non-portfolio FIFs will be replaced with an exemption for shareholders with a 20 percent or more interest in a FIF that is resident in Australia.
- Interest, royalties or rents received from a related foreign company in the FIF’s jurisdiction will be disregarded under the new rules.
- The interest allocation rules that apply in relation to CFCs should also apply to FIF interests benefiting from the active income exemption.
5.1 As noted in chapter 3, having similar rules for CFC and FIF interests should make the active income exemption easier to operate. Many companies have interests in CFCs as well as non-portfolio interests in FIFs, and some FIFs may subsequently become CFCs or vice versa. On the other hand, an investor in a company that is controlled by non-residents may find it more difficult to access detailed financial information, and the potential revenue risks associated with FIF investments can be different from those that can arise from CFC investments. This chapter takes the new CFC rules as a starting point and then sets out some of the potential issues that could arise from applying these rules to investors with income interests of 20 percent or more in FIFs. We invite comments on these and any other practical concerns that might arise for investors.
Active business test
5.2 Under the new rules, a CFC is not required to attribute income if its passive income is less than 5 percent of its total gross income. It is anticipated that most CFCs will pass this active business test. Investors are able to calculate the percentage of passive income based on information from audited accounts that comply with IRFS or NZ GAAP (for smaller entities that are not required to use IFRS), or based on New Zealand tax concepts of passive and total income.
5.3 It is suggested that the same active business test would be available to investors with interests of 20 percent or more in a FIF. In most circumstances, a FIF should be able to pass the active business test based on data from audited accounts. This has the advantage of requiring less information than the test based on tax concepts and the branch equivalent calculation that will be used to attribute passive income (if a FIF fails the test). Chapter 6 discusses the attribution methods that will be available to investors with insufficient information to apply the active income exemption.
5.4 Under the new CFC rules, New Zealand companies that have more than one majority-owned CFC in a jurisdiction are allowed to use consolidated accounts for all their majority-owned CFCs in that jurisdiction for the purposes of the active business test. The purpose of this measure is to simplify the application of the test when accounting information is available at a consolidated level, such as when a group produces segmental reporting by country.
5.5 In cases where the CFCs or FIFs are not majority owned, the benefits from allowing consolidation are more questionable, as it would be unusual for line-by-line consolidated accounts to have been prepared in those circumstances. Allowing consolidation of non-majority-owned interests could lead to increased risk or more complex rules, as such interests are not subject to the same accounting treatment as majority-owned interests. There could also be complex interactions if more than one owner seeks to consolidate the same FIF.
Replacement of the grey list exemption
5.6 To limit the risk to the New Zealand tax base, it is essential that FIFs with significant amounts of passive income are subject to tax on this income. For this reason the remaining eight-country grey list exemption for greater than 10 percent interests in FIFs should be replaced with:
- the active business test; and
- an exemption for FIFs that are resident and subject to tax in Australia (if a 20 percent or greater interest) or that are listed on the Australian stock exchange (if a less than 20 percent interest). These Australian exemptions are consistent with the Australian exemptions that currently apply to CFC and portfolio FIF investments.
Passive income definition
5.7 It is suggested that the definition of “passive income” that currently applies for CFCs will also generally apply to interests of 20 percent or more in FIFs. The types of income that come under the passive income definition for CFCs include interest, royalties and rents, being income that is highly mobile and not location-specific. However, exceptions apply when the income is associated with an active business and there is limited risk to the New Zealand tax base.
5.8 The broad categories of passive CFC income are:
- certain types of dividend;
- rents earned outside the jurisdiction of the CFC;
- income from services performed in New Zealand;
- personal services income;
- income from offshore insurance businesses;
- income from life insurance policies;
- income from the disposal of revenue account property; and
- certain income related to telecommunications services.
5.9 A more detailed description of the composition of passive income can be found in the report on the earlier CFC and foreign dividend reforms published in the October/November 2009 Tax Information Bulletin (Part II, Vol. 21, No. 8).
Payments from related CFCs or FIFs
5.10 Under the new CFC rules, interest, rent and royalties received by a CFC (CFC A) from an associated CFC (CFC B) are not treated as passive income if CFC B passes the active business test and both CFC A and CFC B are resident in the same jurisdiction. To be associated the CFCs are required to have at least 50 percent common ownership. The objective of these concessions is to ensure that taxpayers are not penalised when a holding company is used to control an active business in the same jurisdiction (relative to holding the active business directly). The concession is not intended to apply to companies that operate independently from each other.
5.11 There does not appear to be a strong case for reducing the required common ownership threshold below 50 percent. There are risks from exempting passive income and it seems less appropriate to disregard intra-group payments when there is not a control relationship.
Treatment of indirect income interests in other foreign companies
5.12 A New Zealand shareholder that uses the branch equivalent method to calculate FIF income will have an indirect income interest in a second FIF if the first FIF has an income interest in another foreign company. The indirect interest is calculated by multiplying the New Zealand shareholder’s direct income interest in the first FIF by the first FIF’s direct income interest in the second FIF.
5.13 If an indirect interest arises, the New Zealand resident needs to make two separate FIF income or loss calculations: one for the direct income interest held in the first FIF, and one for the indirect income interest in the second FIF. The investor can use a different method to calculate the income or loss from the indirect FIF interest from the branch equivalent method used for the direct FIF interest. If the branch equivalent method is used for that second FIF, the indirect interest rules apply in the same manner so that any direct interest held by that FIF in another entity may also be a FIF.
5.14 It would be sensible to keep broadly the same approach under any new regime for FIFs. This would be consistent with the rules for CFCs, under which income from foreign shares owned by CFCs is attributed back to the New Zealand shareholder. Under the suggested approach the active income test would be applied to the FIF. If the FIF has an interest in another company, the shareholder would need to calculate any income to be attributed in respect of that indirect FIF interest. Under the suggested approach, it would be possible, if the indirect interest were 20 percent or over, for the shareholder to apply the active income exemption to the indirect interest.
Interest allocation rules
5.15 The interest allocation rules for CFCs place an upper limit on the level of New Zealand debt that a company can use to finance its CFCs. This limit is necessary as New Zealand loses tax revenue when interest costs are taken against New Zealand income to finance a CFC which earns exempt income. The interest allocation rules for investors with CFCs are designed to prevent a New Zealand company allocating a disproportionate amount of interest deductions to New Zealand, with its foreign subsidiary being disproportionately funded through equity.
5.16 The principle underlying the extension of the active income exemption to FIFs is that it should apply to investments where there is a substantial stake in an active foreign company. If there is a substantial stake, there will sometimes be scope to manipulate how a FIF is funded. For example, in the case of a joint venture or a closely held FIF, the New Zealand shareholder could easily have tax incentives that are aligned with those of foreign shareholders, in which case they could negotiate financing arrangements which produce a mutual tax benefit.
5.17 Accordingly, it is suggested that the interest allocation rules should apply to New Zealand residents with FIF interests of 20 percent or more in the same way that they apply to New Zealand residents with CFC interests.
5.18 This should ensure that tax considerations do not drive the decision of whether to hold a CFC or FIF interest. It would also eliminate some potential complications (such as a FIF interest becoming a CFC interest) and inconsistencies (such as a taxpayer with a 10 percent interest in a CFC being subject to the interest allocation rules and a taxpayer with a FIF joint venture being outside the rules).
Questions for submitters
How important is it for the active income exemption for FIF interests to be consistent with the rules for CFCs?
Are there any areas where there is a strong case for deviation?
Are there any practical issues with applying the active business test developed for CFCs to a greater than 20 percent interest in a FIF?