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12 May 2017
Appeal Status

Entitlement to tax sparing credits under the double tax agreement between New Zealand and China

2017 case note - provides guidance on the interpretation of Article 23 of the China DTA - CFC, tax sparing, tax credits, OECD Model, UN Model.

Patty Tzu Chou Lin v Commissioner of Inland Revenue [2017] NZHC 969


This case concerns an investment held in five companies established in China (“the Chinese Companies”) and the tax consequences to the plaintiff, Ms Lin, of that investment.

Ms Lin was assessed by attribution for New Zealand tax on a 30 per cent share of the income derived by the Chinese Companies.

Ms Lin contends that, in assessing her, the defendant, the Commissioner of Inland Revenue (“the Commissioner”), failed to allow her the full tax credits to which she was entitled under the double tax agreement (“DTA”) between New Zealand and China (“the China DTA”) and under the related New Zealand domestic law.

The Court found that the Commissioner’s assessments and default assessments in respect of Ms Lin’s income tax are incorrect.

This judgment is under appeal.


The judgment provides guidance on the interpretation of Article 23 of the China DTA.


Ms Lin is a New Zealand tax resident and her income is subject to New Zealand tax, regardless of where it is sourced. The present case concerns income attributed to Ms Lin in the 2005 to 2009 tax years (“the tax years in dispute”). During those years, Ms Lin held a 30 per cent stake in two BVI companies.

Because of her shareholdings in these companies, Ms Lin was considered to hold a control interest in the Chinese Companies. Each of the Chinese Companies was accordingly defined as a Controlled Foreign Corporation (“CFC”) for New Zealand purposes. The income derived by the Chinese Companies was therefore attributed to Ms Lin for New Zealand purposes under the regime pertaining to CFCs.

Over the course of the tax years in dispute, Ms Lin was attributed with personal income from the Chinese Companies totalling $4.605 million.

The Commissioner allowed tax credits from China of $926,968 to offset Ms Lin's New Zealand tax liability on her attributed CFC income for Chinese tax paid by the Chinese Companies in relation to that income, leaving some $869,000 due from Ms Lin.

Under Chinese domestic tax law, tax concessions were available to the Chinese Companies, so they were relieved of Chinese tax in the amount of $588,135, which would otherwise have been imposed on their incomes (tax spared).

If credited against her New Zealand liability, as she asserts should be the case, Ms Lin's tax liability would have been reduced to just under $281,000. However, the Commissioner refused to allow any credit in respect of tax spared to the Chinese Companies.



Under a DTA one country gives up some of its income taxation rights over source or residence taxation in return for which the other country gives up some of its own income taxation rights in an effort to ensure that income is taxed only once (and in some cases, to ensure it is taxed at least once).

The differing objectives of countries in entering into DTAs are reflected in the two different Model Conventions upon which most DTAs are based: The OECD Model Convention (“OECD Model”) and the UN Model Convention (“UN Model”). New Zealand is a member of the OECD and generally adopts the OECD Model’s provisions but also adopts aspects of the UN Model.

Many DTAs include "tax sparing" provisions, whereby a contracting country agrees to grant relief from residence tax by way of foreign tax credits with respect to source taxes which have not actually been paid (taxes which have been "spared") because of source taxation concessions provided by the other contracting country. In the absence of tax sparing provisions, an investor who takes advantage of Chinese tax concessions, reduces its tax in China but loses its foreign tax credits (in its New Zealand tax return) and pays more tax in New Zealand. The Chinese tax concessions, instead of encouraging investment in China, effectively transfers tax revenue from China to New Zealand.  A tax sparing provision deems Chinese tax to have been paid as if no Chinese tax concessions existed so the investor and not the New Zealand government, gets the benefit of the Chinese tax concessions and the investment incentive stays in place.  Whilst the Commentary to Article 23 of the UN Model strongly supports the inclusion of such provisions, the OECD Model does not.

The New Zealand Approach

Expert witness Robin Oliver for the Commissioner described New Zealand's underlying policy framework for international tax as a "national welfare maximisation" model meaning that New Zealand's domestic tax rules should apply the same rate of domestic tax regardless of whether the investment is made onshore or offshore. This best ensures investments made make the highest return to New Zealand. However, New Zealand recognises its ability to deny foreign tax credits is severely constrained by DTAs and other international practical and political considerations. The granting of credits for foreign tax is the international norm and a political necessity, rather than a desirable policy outcome as far as New Zealand is concerned. Mr Oliver described each Article of a DTA as being negotiated separately because each deals with a different income stream based on its legal form. Precedents are very important and once a deviation from national policy is agreed to with one country, it is hard to resist providing the same concession to other negotiating partners. A provision might have no practical effect but might be necessary for political or other reasons.

The China DTA

The Court heard that China had a firm policy of requiring tax sparing provisions in DTAs reflecting its position as a developing economy, its adherence to the UN Model, and its global positioning as a "leader of the third world". Evidence was given that New Zealand had a long-standing policy against the inclusion of tax sparing provisions in DTAs. However, by the time the China DTA was being negotiated, New Zealand had already incorporated tax sparing provisions in agreements with six other countries and was, therefore, not in a position to refuse a tax sparing agreement with China. Mr Oliver said that New Zealand would have sought a provision which was as restricted in its application as possible.

CFCs and attribution

New Zealand's statutory CFC regime came into effect from 1 April 1988, with the objective of reducing opportunities for New Zealand residents to avoid or defer New Zealand tax through the accumulation of income in foreign non-resident companies. The OECD Commentary states that CFC rules which tax "residents on income attributable to their participation in certain foreign entities" are “internationally recognised as a legitimate instrument to protect the domestic tax base”.

There is no dispute that the CFC regime applied to Ms Lin. She had the necessary control and income interests. The Court noted that none of the Chinese Companies ever distributed dividends to Ms Lin.

The principles governing treaty interpretation

The Vienna Convention on the Law of Treaties 1969 (“Vienna Convention”) applies to DTAs. While the ordinary meaning of the terms of a DTA is the starting point, it is also mandatory to consider the context, object and purpose of the DTA.

Where the treaty in question is a DTA based wholly or in part upon the OECD or UN Models, the Commentaries will be highly relevant in determining the correct interpretation of the treaty. Although the Commentaries are not legally binding, they are regarded as “a source from which courts of different states can seek a common interpretation”.

Chinese tax paid in respect of [CFC] income derived by a resident of New Zealand

The outcome of this issue turns almost exclusively upon the meaning of the phrase “in respect of”.  Ms Lin contends that tax which is paid by a CFC is “Chinese tax paid…in respect of [CFC] income derived by a resident of New Zealand”. The Commissioner submits that this must mean tax which has been paid by the New Zealand resident herself, therefore excluding tax paid by the CFC. The Commissioner submitted that the CFC regime has created a different income stream which is not business income but is an income stream derived by the New Zealand owner in respect of which the New Zealand owner has not paid in China. Ms Lin submitted that the proper construction of Article 23(2)(a) is to focus on the tax not the payer and the proper construction is much wider than the approach taken by the Commissioner.

Under the CFC regime the profits of the CFC are subject to corporate tax in the home jurisdiction of the CFC whilst the same or derivative income is taxed in the hands of investors in the resident state. Two separate legal persons are taxed on the same income - one directly, the company in China, and one by attribution, the investor in New Zealand. In this way, it can be said that the CFC regime results in economic double taxation.

Paragraph 3 of the OECD Commentary on Articles 23A and 23B describes international juridical double taxation as arising in three cases. This expanded definition of juridical double taxation is helpful to the CFC analysis because CFC attributed income can be considered as income derived from, in this case, China and both China and New Zealand impose tax on that income. Taxation of CFC attributed income can be considered to fall within the definition of or be deemed to be juridical double taxation and covered by Article 23. Further support for this interpretation is found in the discussion in the OECD Commentary on Articles 23A and 23B regarding the tax treatment of partnerships. The interpretation of the partnerships discussion is critical to the interpretation of Article 23 generally. In the view of the Court, the OECD Commentary extends Article 23 to partnerships and entities which, like partnerships, are treated in different ways by contracting states and this can properly include CFCs.

The Court concluded that “Chinese tax paid ... in respect of income derived by a resident of New Zealand from sources in the People's Republic of China” includes Chinese tax paid by the CFC itself. The effect of Article 23(2)(a) of the China DTA is therefore that Chinese tax paid by a CFC must be allowed as a credit against New Zealand tax payable by Ms Lin on her CFC income.

The application of tax sparing provisions to CFC income

Unlike Article 23(2)(a), Article 23(3) refers specifically to “tax payable ... by a resident of New Zealand”. The question is whether Article 23(3) therefore precludes a New Zealand resident from obtaining any tax credit in respect of tax spared to a CFC.

The Court concluded that Article 23(3) must be read in light of Article 23(2)(a). That under the CFC rules, the income of the CFC is deemed to have been earned by the owner, and so the tax paid by the CFC is deemed to have been paid by the owner (the New Zealand resident). When this analysis is extended to Article 23(3), the only logical conclusion is that tax paid or payable by a New Zealand resident includes tax which is deemed to have been paid or to be payable by the New Zealand resident for the purpose of Article 23(2)(a).

The Court concluded that a New Zealand resident is entitled to a credit for tax spared in China to the CFC. This enables Article 23 to be read in a principled way, giving effect to its purpose of relieving double taxation.

The effect of Article 23 on New Zealand’s domestic income tax legislation

The China DTA has direct effect in New Zealand and therefore pursuant to the China DTA, Ms Lin is entitled to credits for tax paid by and tax spared to the CFCs. New Zealand's domestic legislation must be interpreted consistently with and give effect to New Zealand's obligations under the China DTA.

Shortfall penalty

Given the decision, the question of shortfall penalties does not arise.


The Court gave judgment for Ms Lin.


Article 23 New Zealand/China DTA, s 138P of the TAA 1994, ss LC 4(1) of the Income Tax Act 1994, LC4(1) of the Income Tax Act 2004 and LK 1 of the Income Tax Act 2007