Chapter 3 - Eligibility requirements

3.1 There are several criteria that companies must satisfy to become qualifying companies. In particular, a company must be tax-resident for all of the income year, must be closely held (five or fewer shareholders) unless it is a flat-owning company, must meet certain shareholding criteria (a shareholder must be a natural person, another qualifying company, or an eligible trustee), may not be a unit trust, and may not earn more than $10,000 foreign non-dividend income in an income year.

3.2 Because of the potential for abuse of the LAQC rules due to the streaming of losses to shareholders best able to use them, LAQCs must meet additional requirements. First, there must be only one type of share (section HA 10 of the Income Tax Act). All shares must have the same rights concerning, for example, receiving distributions and the appointment of directors. LAQCs must also meet an additional anti-avoidance requirement in section HA 12.

Eligibility for new rules

3.3 It is proposed to maintain the current general qualifying company eligibility requirements for the new regime, with some modifications. This recognises that the new qualifying company rules, like the old rules, are designed for closely held New Zealand-resident entities. Keeping mostly the same rules will also minimise compliance costs for businesses.

3.4 Officials propose to remove the requirement in section HA 8B of the Income Tax Act that a qualifying company must not have income interests in a CFC or attributing interests in a FIF that are a direct income interest of 10 percent or more. Similarly, we propose removing section HA 9 which prescribes that a qualifying company may not have more than $10,000 of foreign non-dividend income in any particular income year. Such investment and income restrictions mainly apply because unimputed dividends paid out by qualifying companies are currently exempt in a shareholder’s hands. These restrictions are unnecessary with flow-through tax treatment because qualifying company shareholders will be directly allocated their share of any foreign-sourced income.

Elections

3.5 Shareholders and directors are required to elect into the qualifying company regime, as set out in sections HA 5 and HA 28 to HA 37 of the Income Tax Act. Shareholders must also elect to take personal liability, according to their share in the company, for the company’s income tax liability that is not met.

3.6 Submissions are sought on whether the current election (and revocation of election) provisions should be retained or amended for the new qualifying company rules, subject to the entry and exit rules; in particular, whether the elections in and out of the rules should operate prospectively only, that is, from the start of the following income year.

3.7 As income will automatically flow through to shareholders, the shareholder election to be personally liable for the company’s income tax, in section HA 8, is redundant and will therefore be removed.

One class of share requirement

3.8 The Valabh Committee in its final report considered that, if the flow-through of losses was extended to income as well, the one share requirement would be necessary. Officials propose that the current one share requirement for LAQCs should be included as a general requirement for qualifying companies under the new rules.

3.9 The one share requirement would help ensure that the allocation of income and losses to shareholders is as simple as possible. This is necessary to avoid complex allocation rules for income and losses under different classes of shares. However, it would increase the number of requirements that companies would need to meet to become qualifying companies. By comparison, limited partnerships do not have a similar eligibility requirement. This requirement may have implications for existing qualifying companies (not also being LAQCs) which currently have more than one class of share. In order to transition into the new qualifying company rules, such qualifying companies would need to have only one class of share – for example, by amending the company’s constitution – before 1 April 2011.

3.10 Maintaining this requirement would reduce the ability for income and losses to be streamed to particular shareholders, as each share must have the same allocation of income and losses as every other share. The proposed anti-streaming rule would provide similar protection against streaming.