Technical amendments to the offshore portfolio share investment rules

Sections CD 26, CQ 5, DN 6, EX 33, EX 33B, EX 33C, EX 33D, EX 40, EX 40B, EX 41, EX 44, EX 44B to EX 44E, EX 45B, EX 47, EX 50, EX 51, EX 54B, EX 56 and OB 1 of the Income Tax Act 2004; section CG 15 of the Income Tax Act 1994; section 91AAO of the Tax Administration Act 1994; sections EX 31, EX 32, EX 36, EX 37, EX 37B, EX 38, EX 39, EX 46, EX 51, EX 52, EX 53, EX 56, EX 59, EX 62, EX 63, EX 67, EX 68, EZ 32 and YA 1 of the Income Tax Act 2007

A number of remedial amendments have been made to the new tax rules for offshore portfolio investment in shares. These amendments ensure that the new rules achieve their intended policy effect.

Background

New tax rules for offshore portfolio investment in shares were enacted by the Taxation (Savings, Investment, and Miscellaneous Provisions) Act 2006. The new rules apply for income years beginning on or after 1 April 2007.

The new rules generally apply to an investment by a New Zealand resident in a foreign company when the investor owns less than 10 percent of the company. Under the new rules, offshore portfolio investment in shares is taxed consistently, regardless of the country where the investment is located and whether the investment is made by an individual directly or through a collective investment vehicle.

The new tax rules for offshore portfolio investment in shares mainly involve changes to the foreign investment fund rules. The main changes are that the "grey list"exemption in the foreign investment fund rules has been removed and a new fair dividend rate method - which broadly taxes 5 percent of a person's offshore share portfolios' opening value each year - has been introduced.

A number of technical problems have been identified with the new rules. These problems have been addressed by remedial amendments which are consistent with the policy intent of the new rules.

Application dates

The amendments contained in the Income Tax Act 2004 are effective from 1 April 2007. The equivalent amendments to the Income Tax Act 2007 are effective from 1 April 2008. One amendment (section EX 46(10)(c)), concerning restrictions on the use of the fair dividend rate method, is only being included in the Income Tax Act 2007, effective from 1 April 2008. The relevant amendments to the Tax Administration Act 1994 are effective from 1 April 2007.

Detailed analysis

$50,000 minimum threshold for application of foreign investment fund rules

Amendments have been made to the $50,000 minimum threshold rules in sections CQ 5 and DN 6 of the Income Tax Act 2004 and the Income Tax Act 2007 to ensure that the deemed disposition and reacquisition that occurs when there is a change in application of foreign investment fund exemptions, changes between the comparative value method and fair dividend rate method, and entry into the foreign investment fund rules is ignored for the purposes of the $50,000 minimum threshold rules. The $50,000 exemption in section CG 15 of the Income Tax Act 1994 has been similarly amended for changes in application of foreign investment fund exemptions. These amendments ensure that the original cost basis applies for the relevant shares.

Australian-resident listed company exemption

Investments in Australian-resident companies listed on an approved index of the Australian Stock Exchange (ASX), such as the All Ordinaries index, are exempt from the foreign investment fund rules. To assist compliance with this exemption in section EX 33C of the Income Tax Act 2004 and section EX 31 of the Income Tax Act 2007, the previous requirement that the Australian-resident company must be included in an approved ASX index at all times during the income year has been replaced generally by a requirement that the company's shares must be included in an approved ASX index at the beginning of the income year. The amendment ensures that the exemption will apply for an income year if a company's shares are listed on an approved ASX index at the beginning of the year but are omitted from the index during the year.

In the situation where a person acquires shares in an Australian-resident listed company during the income year and did not previously hold any shares in that company in that year, the relevant time for testing whether the company's shares were listed on an approved ASX index is on the day of that acquisition. This different testing time has been provided because the investor would probably have based their decision on the status of the company on the date they acquired shares in it and they should not be expected to ascertain the listing status of the company at the beginning of their income year when they did not hold any shares in the company.

The other requirements in the Australian-resident listed company exemption, such as the requirement that the company be resident in Australia, have been amended so that they only need to be satisfied at all times in the income year when the New Zealand investor holds a right in the company rather than necessarily at all times in the income year.

A further amendment to the exemption for shares in Australian-resident listed companies provides that the exemption does not apply to stapled securities. This means that a share in an Australian-resident listed company which would otherwise qualify for the exemption does not qualify if it is stapled to another security. Stapled securities are two or more securities that are contractually bound together so they can only be sold together and not separately. The effect of this amendment is that the foreign investment fund rules (and most likely the fair dividend rate method) apply to investments in Australian stapled securities.

Australian unit trusts exemption

Section EX 33D of the Income Tax Act 2004 and section EX 32 of the Income Tax Act 2007 provide that investments in certain types of Australian unit trusts are exempt from the foreign investment fund rules. The minimum investment turnover requirements in these provisions have been amended to provide that they apply only to shares held by the unit trust and not to all assets as previously provided. A clarifying amendment also ensures that the turnover requirement relates to the unit trust's accounting year which ends in the investor's income year.

The RWT proxy requirement has been amended so that it must be satisfied when the Australian unit trust makes a distribution to investors.

The exemption has also been expanded to include investments in Australian unit trusts that distribute at least 70 percent of their income and use an RWT proxy. This minimum distribution requirement addresses the policy concern that these investment vehicles could be used to defer New Zealand tax.

Venture capital exemption

The exemption in section EX 33(3) and (4) of the Income Tax Act 2004 and sections EX 36 and EX 37 of the Income Tax Act 2007 for certain venture capital investments has been expanded and clarified.

One of the criteria that must be satisfied for the venture capital exemption is that the relevant grey list company has a fixed establishment in New Zealand, or owns a company in New Zealand, that conducts a minimum level of activity. Previously, this minimum level of activity in New Zealand included only incurring expenditure (other than interest) of at least $1 million or engaging 10 or more full-time employees or contractors. This minimum level of activity has now been expanded to include the situation where the relevant company through its fixed establishment in New Zealand incurs at least 25 percent of its expenditure or has at least 25 percent of its employees in New Zealand. This change is designed to benefit smaller venture capital start-ups.

One of the criteria that previously had to be satisfied for the venture capital exemption was that the relevant company has to be resident in New Zealand for a minimum of 12 months. This criterion has been changed to require the relevant company to carry on a business in New Zealand for a minimum of 12 months. This change should accommodate situations where venture capital start-ups have been operating for 12 months or more, but have not been incorporated for that long or were restructured shortly before the company migrated to a grey list country or became owned by a grey list company.

The venture capital exemption has also been amended to ensure that the exemption continues to apply if an original investor acquires more shares after the relevant company is listed.

The reference to a grey list company directly or indirectly owning a New Zealand-resident company has been clarified to refer to the grey list company holding more than 50 percent of the voting interests in the New Zealand-resident company.

A separate venture capital exemption has been enacted for persons who co-invest with New Zealand Venture Investment Fund Limited under a venture investment agreement. A "venture investment agreement"is defined in section CW 11C(6) of the Income Tax Act 2004 and section CW 13(6) of the Income Tax Act 2007 and ensures that a substantial level of activity in New Zealand is maintained.

Finally, a clarifying amendment has been made to ensure that the references to $1 million of expenditure include expenditure over $1 million.

Employee share purchase scheme exemption

The exemption for certain employee share purchase schemes in section EX 33(5) of the Income Tax Act 2004 and section EX 38 of the Income Tax Act 2007 has been amended to remove the requirement that the relevant share purchase agreement must include a restriction on disposal of the shares that affects the value under section CE 3 of the benefit to the person under the agreement. The relevant criterion now requires only that the share purchase agreement includes a restriction on the disposal of the relevant shares.

Restrictions on using the fair dividend rate method

It is the policy intent that the fair dividend rate method for calculating foreign investment fund income cannot be used for investments that are akin to New Zealand dollar denominated debt investments. Several amendments have been made to sections EX 40 of the Income Tax Act 2004, section EX 46 of the Income Tax Act 2007 and section 91AAO of the Tax Administration Act 1994 to better effect this policy intent.

A more effective test for excluding certain types of investments from the fair dividend rate method has been inserted as new section EX 46(10)(c) of the Income Tax Act 2007. This test is effective from 1 April 2008 and provides that the fair dividend rate method cannot be used for an interest in a non-resident entity holding directly or indirectly assets of which 80 percent or more by value consist of financial arrangements providing funds to a person or fixed rate shares. These financial arrangements or fixed rate shares must be denominated in New Zealand dollars or if they are denominated in foreign currency they must be hedged back to New Zealand currency with that hedging at least 80 percent effective. Whether such hedging arrangements are at least 80 percent effective is determined under New Zealand Equivalent to International Accounting Standard 39.

The Commissioner's power to make a determination under section 91AAO of the Tax Administration Act 1994 has been widened to allow the Commissioner to determine that the fair dividend rate method may be used for an investment even though the specific requirements of the legislation may not otherwise allow it to be used. This is designed to allow the fair dividend rate method to be used for investments which are not, in substance, debt in nature.

The criteria in section 91AAO(2) of the Tax Admin-istration Act 1994 for when the Commissioner may make a determination that the fair dividend rate method may or may not be used for a type of investment, have been amended to better reflect the factors that should be taken into account when a determination is made. The criteria that the Commissioner may take into account include:

• the principle that the fair dividend rate method should not be used for an investment that is economically equivalent to New Zealand denominated debt, taking into account the whole arrangement, including any interposed entities or financial arrangements;
• the extent to which the assets of a foreign entity are loans, fixed rate shares or arrangements with a fixed economic return;
• the extent to which the assets of a foreign entity are denominated in New Zealand dollars or are hedged to achieve the effect of New Zealand dollars; and
• compliance costs.

These criteria are inclusive only and therefore do not restrict the flexibility of the determination-making process to deal with cases close to the boundary.

The amendments effectively widen the Commissioner's power to determine when the fair dividend rate method can or cannot be used for a certain type of investment. For example, if the Commissioner considers that the compliance cost of applying the fair dividend rate method to an investment would be higher than is appropriate and that not applying the method would not pose a revenue risk, the Commissioner can make a determination that the fair dividend rate method may not be used for that investment.

The application date provisions for fair dividend rate method determinations have also been amended. Determinations may be made for the income years specified by the Commissioner in the determination. However, a determination does not apply for a person and an income year beginning before the date of the determination unless the person chooses that the determination apply for the income year. This election would typically be evidenced by the investor completing their income tax return for the relevant year in accordance with the determination.

The Commissioner's general policy for specifying the income years for which a determination applies is that a determination would normally apply to income years starting after the date of the determination. However, the Commissioner may also specify the income year in which the determination is made if this would be consistent with the general policy of the fair dividend rate method (that the method should not be used for investments akin to a New Zealand dollar denominated debt investment) and would reduce compliance costs.

Another amendment to the Commissioner's determin-ation-making power provides that the Commissioner must notify the making of a determination in the Gazette within 30 days of the date of determination. The determination itself will be published in the Tax Information Bulletin as soon as possible. A copy will also be available on the Inland Revenue Department's website.

Fair dividend rate method amendments

Several amendments have been made to the fair dividend rate method provisions in sections EX 44B to EX 44E of the Income Tax Act 2004 and sections EX 52 and EX 53 of the Income Tax Act 2007.

An amendment allows any person to choose to use the fair dividend rate method in section EX 44D of the Income Tax Act 2004 and section EX 53 of the Income Tax Act 2007 if they determine the market value of their foreign shares on a daily basis.

For the purposes of applying the fair dividend rate method, an original share in a foreign company that is subject to a returning share transfer is treated as being held by the share supplier and not the share user. Therefore, it is the share supplier rather than the share user that is subject to the fair dividend rate method in respect of an original share which is acquired under a returning share transfer. Although the share supplier is treated as holding the original share for the purposes of the fair dividend rate method, the share user will still derive a dividend paid on the original share (with any replacement payment for the dividend being deductible to the share user and taxable to the share supplier).

A clarifying amendment confirms that the average cost basis is used for both the peak holding adjustment and quick sale gains components of the quick sale adjustment in the fair dividend rate method.

The deemed sale and reacquisitions that occur under sections EX 51(5) or EX 54B of the Income Tax Act 2004 and sections EX 63(5) or EX 67 of the Income Tax Act 2007 are ignored for the purposes of the quick sale adjustment in the fair dividend rate method.

Cost method

Several amendments have been made to the cost method in section EX 45B of the Income Tax Act 2004 and section EX 56 of the Income Tax Act 2007.

An investor with publicly available audited accounts may choose to use as its opening value under the cost method the net asset value of its shares in foreign companies if the foreign company also has publicly available audited accounts.

Another amendment allows investors to use their actual cost for their opening value under the cost method, instead of obtaining an independent valuation, for interests acquired in the 2005-06 or 2006-07 income year. This amendment is designed to reduce compliance costs for persons using the cost method for the 2007-08 income year instead of requiring such persons to obtain an independent valuation.

The definition of "opening value"in the cost method has also been amended to require an independent valuation on entry into the cost method when a person has an attributing interest for which no foreign investment fund or loss arose because the interest was previously covered by the $50,000 minimum threshold. This amendment is necessary because it would not be appropriate to allow what could be a very old historical cost to be used as the opening value.

It has also been clarified which of the paragraphs in the definition of "opening value"has priority in a particular case.

Average cost definition in fair dividend rate and cost methods

The definitions of "average cost"in the fair dividend rate and cost methods have been amended to refer to expenditure incurred in acquiring or increasing the attributing interest during the relevant period instead of referring to expenditure incurred in a particular period. This amendment is designed to cater for deferred purchase situations.

Currency conversion rules

The foreign currency conversion provisions in sections EX 44C and EX 44D of the Income Tax Act 2004 have been amended to include references to amounts derived. The currency conversion provision in section EX 57 of the Income Tax Act 2007 already caters for this situation and therefore does not need to be amended.

Imputation credit under the trans-Tasman imputation rules

Section LB 2 of the Income Tax Act 2004 and section LE 1 of the Income Tax Act 2007 have been amended to ensure that an investor is entitled to an imputation credit under the trans-Tasman imputation rules when they receive a dividend from an investment in an Australian-resident company which is subject to the distribution exclusion in section EX 47 of the Income Tax Act 2004 and section EX 59 of the Income Tax Act 2007. Also, the amount of "gains"under the comparative value method in section EX 44 of the Income Tax Act 2004 and section EX 51 of the Income Tax Act 2007 is grossed up by the amount of this imputation credit.

Consequences of changes in method

Section EX 51 of the Income Tax Act 2004 and section EX 63 of the Income Tax Act 2007 have been amended to include a rule for changing between the fair dividend rate and comparative value methods. The rule provides that there is a deemed disposal and reacquisition of the interest at its market value at the start of the income year to which the new method applies. This deemed disposition is ignored for the purposes of the quick sale rules in the fair dividend rate method and is also ignored for the purposes of the $50,000 minimum threshold rules.

Default calculation method

The default calculation method in section EX 41 of the Income Tax Act 2004 has been amended to cater for the situation where the accounting profits method is allowed but it is not practical to use it. This situation was covered previously but was inadvertently omitted when the current section EX 41(2) was enacted in 2006. The default calculation method in section EX 48 of the Income Tax Act 2007 covers this situation and therefore does not need to be amended.

Family trust definition

Certain family trusts, along with natural persons, are allowed to use the comparative value method for their offshore portfolio share investments in years in which the foreign investment fund income would be lower under that method than under the fair dividend rate method. A number of remedial amendments have been made to the definition of "family trust"that is used for this purpose in sections EX 40(6) and EX 50(8) of the Income Tax Act 2004 and sections EX 46(6) and EX 62(8) of the Income Tax Act 2007. The remedial amendments, which ensure that this safety net option is available to family trusts as intended, are that:

"The ordinary definition of the term "settlor"- which is limited to dispositions of property at less than market value - is used. The reference to "settlor "also includes a deceased person, to ensure that a testamentary trust qualifies for this purpose.

"The person who requests another person to make a settlement of a nominal amount is treated as the settlor rather than the other person.

• Family trusts that have been resettled can still qualify as a family trust for the purposes of this provision if the trust and the settlors of the trust from which the resettlement is made satisfy the primary family trust definition requirements.
• The "natural love and affection"requirement must be satisfied at all times in the income year rather than only at the time of a trust's establishment.
• The qualifying trust (Income Tax Act 2004) or complying trust (Income Tax Act 2007) criterion is now expressed by reference to distributions because the qualifying trust or complying trust terms are defined in relation to distributions.

Interest in grey list company falling below 10 percent during an income year

The fair dividend rate method in the Income Tax Act 2004 and the Income Tax Act 2007 has been amended to ensure that there is no foreign investment fund income under that method in the situation when a 10 percent or more holding in a grey list company at the start of an income year falls below 10 percent during the year. This is consistent with the general fair dividend rate treatment, which ignores purchases of shares during a year (other than quick sales). For example, in the case of a person with a 30 percent interest in a grey list company at the start of an income year who reduces their interest to 8 percent during the year, they should be treated as having acquired an 8 percent interest during the year the opening value for which would be zero.

However, when a person's interest in a grey list company falls below 10 percent during an income year, and the fair dividend rate method can be applied to the interest (resulting in nil foreign investment fund income for that year), the interest holder remains liable to income tax or dividend withholding payments on any dividends received in that year. This continued taxation of dividends is achieved by amendments to sections EX 47 and CD 26 of the Income Tax Act 2004 and sections EX 59 and CD 36 of the Income Tax Act 2007.

Transitional rules

Offshore investments which become subject for the first time to the foreign investment fund rules enter those rules at their market value. This is achieved by a deemed disposition and reacquisition under section EX 54B of the Income Tax Act 2004 and section EX 67 of the Income Tax Act 2007. These transitional provisions have been amended to ensure that they apply as intended to persons that intended to become portfolio investment entities and who elected to defer the start date of the foreign investment fund rules to the same date that they became subject to the portfolio investment entity rules.

The deemed disposition and reacquisition under the transitional rules also applies to any shares for which a person is a share supplier in a returning share transfer. This ensures that a tax liability may still arise for a person who holds their offshore shares on revenue account before those shares enter the foreign investment fund rules and who lends their shares under the share lending rules at the time the person becomes subject to the foreign investment fund rules. The treatment of any dividend paid on the lent shares will continue unchanged - that is, the dividend is taxable to the share user under ordinary rules, with the replacement payment for the dividend being deductible to the share user and taxable to the share supplier.

Measurement of cost

Section EX 56 of the Income Tax Act 2004 and section EX 68 of the Income Tax Act 2007 have been amended to replace the cost flow using an average cost approach with a FIFO (first-in-first-out) cost flow identification approach. These provisions are subject to the LIFO (last-in-first-out) approach used for the purposes of calculating quick sale gains under the fair dividend rate method.