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In this issue:

• Controlled foreign company (CFC) regime or confused foreign company regime?
• Payroll giving
• Elections to change balance date
• Mutual recognition of tax credits on the agenda
• Company income tax return under review
• STOP PRESS Streaming and refundability of imputation credits

Controlled foreign company (CFC) regime or confused foreign company regime?

By Robyn Walker and Bruce Wallace

Investors with controlling interests in foreign companies have every right to be feeling a bit confused right now.

First, in Budget 2007 the Government announced it will replace the existing 20 year old CFC regime, which comprehensively taxes New Zealand shareholders on attributed CFC income, with a compliance cost friendly regime that exempts “active” income. To supplement this exemption, dividends received from CFCs will also be exempt.

Second, the rules are to apply from the 2009-10 income year, which starts on 1 April 2009 for most taxpayers and from late 2008 for those taxpayers with early balance dates.

The introduction of the active business income and foreign dividend exemptions is extremely positive. Unfortunately however, the recently introduced Tax Bill is highly complex and is far from being compliance cost friendly. It will hopefully undergo amendments through the select committee process but this means additional compliance costs for taxpayers trying to come to grips with the draft rules and their likely impact. In addition, it is probable that the Tax Bill will not be enacted until May 2009 (at the earliest!).

The Tax Bill largely reflects the proposals that were outlined in the discussion documents released by officials. The core features of the proposals are:

• An exemption from attributing “active” CFC income, (effectively only taxing certain passive income);
• An exemption for dividends received from CFCs (other than those dividends that are deductible for the CFC or paid in relation to fixed rate shares);
• The removal of the “grey list exemption” other than Australia;
• The repeal of the conduit regime; and
• The introduction of “interest allocation” or outbound thin capitalisation rules.

These proposals have been discussed in prior Alert articles, however once again the devil is in the detail.

The theory behind the active business exemption is quite simple – if a CFC earns mainly “active” income, there will be no attribution of any of the CFC’s income back to the New Zealand shareholder(s). If a CFC earns more than 5% “passive” income then the passive income (less attributable expenses) is attributed back to the New Zealand shareholder(s) who pay New Zealand tax on that passive income. The New Zealand shareholder(s) can claim a foreign tax credit for any foreign tax paid on that passive income. Conceptually, the end result should simply be to pick up the difference, if any, between the New Zealand tax payable on the net passive income and the tax paid in the foreign jurisdiction.

Simple right?

Far from it! In fact, it seems there is a new twist on the old adage that the only things certain in life are death and taxes, being death, taxes and now compliance costs. In the case of the latter, it is certain the tax legislation will be fiendishly complicated despite New Zealand having just completed a long process of rewriting its income tax legislation to make it clear, plainly expressed and easy to understand.

Under the Tax Bill, the first step is to work out whether the CFC’s passive income is less than 5% of its total income. This requires the identification of the CFC’s passive income. Typical sources of passive income (with various exemptions) are interest, dividends, royalties and rent and it was proposed that the test would be based on the financial statements of the CFC. Unfortunately however, the definition of “passive” income is a classic example of the complexity of the legislation.

Passive income is not called passive income; it is now to be known as “attributable CFC amount”. The definition of “attributable CFC amount” contains an extensive list of items including not only the items noted above but a range of other items including income from an insurance business (unless an exemption is granted), associated person personal services income, income from the disposal of revenue account property which consists of shares and certain other items, services performed wholly or partly in New Zealand, and income from certain types of telecommunications services. It is noted that dividends (other than dividends that are deductible for the CFC or paid in relation to fixed rate shares) are excluded, as is rental income other than cross border rental income.

The definition gets even more complex when considering the rules around interest income and foreign exchange gains and losses. Foreign exchange gains on financial arrangements are required to be separated from foreign exchange losses with only the gains being taken into account in determining whether the 5% threshold is exceeded. Gains arising from financial assets (other than derivatives) are included whether reported in the profit and loss account or in equity, again without losses being netted off. Income from derivatives that hedge active income is generally not included in passive income. However, income from derivatives that are not hedging instruments or that hedge passive income is included together with income from the ineffective portion of active income hedges.

Once the passive income items have been identified, one of two formulae must be applied in order to determine whether the 5% threshold is exceeded and attribution of passive income is required. The formulae are:

or alternatively:

Each of the above items has its own definition and supporting calculation. We won’t get into the detail behind these items but it is notable that certain income items are removed from both the numerator and the denominator under both formulae. The original proposals were that the attribution threshold would be 5% passive income compared to total income. This does not in fact seem to be the case as the effect of the reduction in both the numerator and the denominator is to reduce the level of passive income that can be earned before attribution is required.

With the removal of the grey list other than Australia, taxpayers with CFCs in those countries now need to apply the new rules in order to work out whether any passive income needs to be attributed. This will be a significant increase in compliance costs for these taxpayers compared with the current rules.

The above calculations to determine whether attribution is required can be performed on a consolidated basis for all CFCs in a particular jurisdiction if the CFCs are consolidated for accounting purposes. If the 5% threshold is exceeded however, the attribution calculation needs to be undertaken separately for each CFC in that jurisdiction.

The level of deductible expenditure (if any) which can be offset against the attributable passive income then needs to be determined. The general proposition is that expenditure needs to meet the general deductibility tests and have nexus to the passive income.

The apportionment of interest expense is especially problematic as it is not possible to directly trace the use of the funds to determine what interest expense can be deducted. Apportionment is generally required based on the proportion of passive assets to total assets (which will require inclusion of equity investments in other CFCs). To add further complexity, there are additional rules if the CFC has a debt to asset ratio greater than 75% (referred to as “excessively debt funded”). Regardless of the method of calculating deductible interest, the level of interest available to deduct against passive income will likely be significantly limited. Careful planning will therefore be required in order to ensure the best possible outcomes are achieved.

If the attributing CFC has existing tax losses or excess foreign tax credits to carry forward, the task at hand becomes even more difficult as there are a number of complex provisions that need to be navigated to determine the amount of the losses or tax credits that can be utilised.

Again the theory is quite simple, carry forward losses or tax credits that relate to active income in prior years cannot be offset against passive income once the active business exemption is introduced. In reality however, the legislation to achieve this outcome is extremely complicated with a multitude of defined terms and amounts that need to be calculated. The outcome is essentially that the level of carry forward losses and excess tax credits is first reduced by the active income that is not required to be attributed, with only any residual losses or tax credits being available to offset against passive income.

In order to buttress the new active income exemption, the existing thin capitalisation rules are also being expanded to apply to most companies (including New Zealand owned) with outbound CFC investments. This is to ensure that taxpayers are not tempted to place debt in New Zealand to fund active offshore businesses which will now be exempt from New Zealand tax (albeit they may be subject to tax in the foreign jurisdiction). Unfortunately, these rules fail to recognise the reality for many growing New Zealand businesses that it is only the New Zealand operations that can obtain debt funding and it can be difficult to push debt down into the foreign operations. As such, these rules have the potential to significantly increase the cost of foreign investment and in some cases will result in further disincentives for investment overseas.

All in all, the reality is that what is proposed is an incredibly complex regime. The morale of the story is to not be lulled into thinking the new regime will be simple. It is certainly not a simple regime and there will be major compliance costs in coming to grips with it.

We note that we fully support the general direction of the new regime and officials should be congratulated for this. It does however need to be simplified. In addition, key issues such as the removal of the grey list and the introduction of the interest allocation rules should be reconsidered.

Payroll giving

If you are an employer you might take one of two views on this one. One view is that it is yet another compliance burden being foisted upon employers who in recent times have had to deal with KiwiSaver and very shortly the impact on payroll of upcoming personal tax cuts. The other view is that this may be an opportunity to introduce a point of difference for some employers wishing to encourage a philanthropic community spirit. It may be that the compliance implications can be managed if a policy is developed and or a PAYE intermediary is used. In this article we explore the Government’s proposals and raise some issues for consideration.

Do employers have to offer payroll giving to employees?

While the commentary accompanying the bill states that it is intended that payroll giving be voluntary for employers, in our view the first drafting of the legislation does not actually achieve this intention and will need to be addressed before enactment. The intention is that only employers filing employer monthly schedules electronically will be able to offer payroll giving. Employers whose annual PAYE deductions are $100,000 or more are required to file their employer monthly schedules electronically, although those under this threshold have the option of e-filing.

How does it work?

Where an employee chooses to make a payroll donation, the employee is entitled to a tax credit of 331/3 of the total donations for that pay period. The employer must then subtract the amount of the tax credit from the employee’s PAYE and record the information in the relevant employer monthly schedule. The employer must transfer the donation to the charitable organisation within a three month period. The tax credit is limited to the employee’s PAYE for that pay period. The employer is required to keep sufficient records to enable Inland Revenue to determine that the payroll donation has been transferred to the correct recipient.

The advantage for the employee is that he or she will receive the immediate benefit of the tax credit at the point of payment instead of having to file a rebate form with the IRD after the end of the income year as is currently the case. The end of year rebate claim will still be available for those that cannot or choose not to donate via payroll.

Who can employees donate to?

As well as the list of charitable organisations set out in schedule 32 of the Income Tax Act 2007, this list also includes any society, institution, association, organisation, or trust that is not carried on for the private pecuniary profit of an individual and whose funds are applied wholly or mainly to charitable, benevolent, philanthropic or cultural purposes within New Zealand. A charitable purpose includes, but is not limited to, the relief of poverty, advancement of education or religion or any other matter beneficial to the community.

This is an extremely wide list of potential charities to choose from. Take the example of a company that has several employees within the one company that tithe to different churches in the community who would prefer to use the payroll giving mechanism. This imposes compliance costs on employers who under the draft proposals have an obligation to ensure that the organisation qualifies before transferring the donation. Contrast the design of this system to overseas schemes where the list of charities to which employees can contribute under a payroll scheme is limited. In our view this is the most problematic area of these rules.

If the donation is paid to an ineligible recipient, the tax credit for the employee is extinguished. Clearly if a tax credit is extinguished because it has been transferred to an ineligible organisation, a further payment of PAYE will need to be made to Inland Revenue, but it is not clear practically how the employer recovers this amount from the employee and what the penalty implications may be.

These additional compliance and risk issues will deter some employers from offering the scheme, however we think these can be managed if an internal policy is developed.

The “glass half full” view

These problems could be minimised if the employer develops a policy and limits the choice of charities. One option may be for the employer to sponsor a charity of choice for a specific time period and all employees who wish to can donate to that particular charity. Charitable organisations may look to work with employers and allow their logos to be used on company letterheads, and in return the company can promote that it supports a community cause to employees and to those that deal with the company.

With the lifting of the donations rebate threshold there will be more incentive for individuals to donate and they may feel more comfortable contributing via their employer than the normal unsolicited door to door or telephone approach.

Some employers will see this scheme as an opportunity to be an employer of choice and to be a point of difference when competing for staff. If you would like further information on payroll giving or wish to provide input into the submission process, please contact your usual Deloitte Tax advisor for more information.

Elections to change balance date

Inland Revenue has released a draft standard practice statement which sets out Inland Revenue’s practice for considering applications to change a balance date for income tax purposes.

The standard tax year is 31 March, but taxpayers can apply for consent to change this date where a March balance date is impracticable due to the nature of their business or circumstances. Typical examples include subsidiaries that wish to align with parent companies for reporting purposes, a franchise owner who has to adopt a non-standard balance date as a condition of the franchise agreement or taxpayers such as farmers or growers that have a natural end of year due to their business cycle. Consent will generally be provided taking into account each set of circumstances where the Commissioner agrees that a 31 March balance date would place an unfair burden or be impracticable. Consent will not be given where tax is deferred or avoided, so as to take advantage of any tax incentive or concession, or where it is simply made for administrative convenience. Of note is that the Commissioner will only agree to a balance date that is the last calendar day of a month. This could impact companies that currently have a varying balance date for financial reporting and tax purposes.

Elections will generally be made in writing, although some elections may be made by telephone. The statement sets out what details must be provided. On a positive note, it is proposed that the rules concerning retrospective elections have been relaxed a little. Ideally elections and consent should be made prior to the commencement of the new income year, however past practice has been modified to provide consent for late applications if made before the earlier of the return filing date under section 37(1) of the Tax Administration Act 1994 for the current balance date and that for the proposed balance date. Consent will be provided where the taxpayer can show that it is possible to file returns for all income years, the application was not made for purposes of a tax deferral or tax avoidance and that any incidental tax deferral as a consequence of the new balance date is insignificant when compared with the tax liability under their current balance date.

The statement also provides guidance on income tax returns in the transitional year following approval for a change.

Overall the draft statement reads positively, however the list of 10 scenarios under which consent will be given is quite prescriptive and there is the concern that if a particular set of circumstances does not fit within these, that consent might not be given. The deadline for submissions is 31 October 2008.

Mutual recognition of tax credits on the agenda

Finance Minister Michael Cullen and Australian Treasurer Wayne Swan have agreed to investigate mutual recognition of imputation and franking credits during talks to progress bilateral economic interests held in July. Currently Australia does not recognise imputation credits received by Australian shareholders in New Zealand companies and New Zealand does not recognise franking credits attached to dividends received by New Zealand shareholders in Australian companies. This can lead to double taxation and stands in the way of the goal to create a single economic market.

Mutual recognition might involve either providing imputation credits for company taxes paid in Australia or extending the full benefit of imputation to Australian shareholders and vice versa with respect to franking credits. Complex issues arise with respect to the impact on each country’s tax revenue, avoidance and the impact on tax treaty obligations. Initial work on the mutual recognition of tax credits will include feasibility and cost benefit analysis.

We do not expect this reform any time soon, but at least this topic is back on the agenda which is hugely positive. We wait with interest to see what solutions are proposed in light of Dr Cullen’s comment that “any solution must be a win-win for both economies”.

Company income tax return under review

Inland Revenue has issued a consultation document seeking feedback on proposals to rationalise and redesign the company income tax return. Also under review is whether the information requested from companies can be tailored depending on the size of a company. This document is mainly aimed at the micro, small and medium businesses as consultation with large companies is being undertaken separately. A medium business in this document is defined as one with a total group turnover of less than $20m and total group assets of less than $10m.

The main proposal is to rationalise company tax forms by incorporating them into one new income tax return to include the company income tax return (IR 4), the annual imputation return (IR 4J) accounts information (IR 10) and other forms including the controlled foreign company and foreign investment fund disclosures and the statement in support of a tax interpretation (IR 282). The aim is to remove some of the duplication of information requested. Technology will be used to tailor the return so as to remove some of the areas that are not relevant for some companies.

The document proposes a different reporting approach which is tailored to the size of the company. This will help reduce compliance costs for the smaller companies. The document outlines the majority of information that Inland Revenue believes it need to collects as well as acknowledging that some of the information currently requested in the IR 10 is not necessary and that it is a problematic form. The information demands are greater depending on the size of the company. A new requirement for businesses will be to report a reconciliation of the difference (if any) between financial and taxable income. Only larger companies will be required to complete a detailed reconciliation; with limited requirements for micro and small companies. Of note is that the draft information request has been developed with Statistics New Zealand and so will include a small number of additional data elements specifically for them. However Statistics New Zealand would continue to require more detailed information for large and complex businesses.

Finally the document proposes to mandate electronic filing from the 2011 tax year. Currently about 25% of companies manually file returns for various reasons.

Submissions close on 30 September 2008. The document can be obtained from the Inland Revenue’s website at http://www.ird.govt.nz/news-updates/like-to-know-future-company-income-tax-returns.html

STOP PRESS: Streaming and refundability of imputation credits

As we went to press, the government issued a tax policy discussion document seeking views on issues relating to the streaming of imputation credits (i.e. directing imputation credits to shareholders that can use them) and the refundability of imputation credits which is an issue of particular importance to charities. This document is the first step in a process of consultation on possible improvements to the imputation system and so, rather than suggest concrete proposals at this stage, the government wishes to understand the current problems first. Submissions can be made until 10 October 2008. Look out for more on this policy development in future issues of Tax Alert. In the meantime please contact us for more information on this document