Indirect income interests in FIFs

2012 amendments clarify how some exemptions apply to foreign investment funds that are held indirectly through other FIFs or controlled foreign companies.

Sections EX 50(7B) and EX 58(5) of the Income Tax Act 2007

Several amendments have been made to the rules enacted in the Taxation (International Investment and Remedial Matters) Act 2012, to clarify how some exemptions apply to FIFs that are held indirectly through other FIFs or CFCs.

Background

In many cases, a person will own shares in a foreign company which itself owns shares in a second foreign company.

If the shares represent an interest in a CFC, the person is always required to "look through" that CFC to determine if the second foreign company is a CFC (in which case
the investor would apply the CFC rules), or an attributing interest in a FIF (for which the investor would apply a FIF calculation method).

However if the first company is not a CFC, the requirement to "look through" to the second foreign company depends on whether the person uses the attributable FIF income method for that company and whether an exception to the "look through" rule applies.

If the fair dividend rate, cost, comparative value or deemed rate of return method is used for a FIF, any foreign shares held by that FIF are not subject to the FIF rules (as in most cases the FIF rules only apply to direct interests in foreign companies. (See section EX 29(2).)

If the attributable FIF income method is used for a foreign company, the default position is to "look through" this foreign company and apply the FIF rules to any shares that the company holds in other foreign companies. This is achieved by the formula in sections EX 50(6) and (7).

However, there are several important exceptions to the "look-through" rule in section EX 50(6). These are listed in section EX 50(7B).

Key features

Several remedial amendments have been made to the "look-through" rule in section EX 50(7B) for calculating additional FIF income from indirect interests in FIFs.

Some amendments have been made to clarify how taxpayers should measure indirect income interests for the purpose of applying the Australian or active income exemptions to such interests.

Other amendments have been made to clarify how taxpayers should apply a modified version of the active business test to a FIF which has non-controlling shareholdings in other foreign companies.

Detailed analysis

Measuring indirect income interests

Section EX 35(a) allows the exemption for certain FIF interests in Australian companies to be applied in cases when a person holds an indirect income interest of 10% or more in an Australian company. If the requirements of section EX 35 are met for the person and their indirect interest in the FIF, the person does not have any attributable FIF income or loss from that FIF.

Section EX 46(3)(a)(ii) allows the attributable FIF income method to be applied in cases when a person holds an indirect income interest of 10% or more in a foreign company.

Sections EX 50(7B)(a)(i), EX 50(7B)(c) and EX 58(5)(b) have been removed. These sections were intended to duplicate the requirements in sections EX 35(a) and EX 46(3)(a)(ii), and highlight that the Australian and active income exemptions could still apply when a person held an indirect income interest of 10% or more.

However, they could have been interpreted more broadly so as to deem the person to directly hold another foreign company's income interest. This meant that a person with a less than 10% indirect income interest could in certain circumstances, be deemed to hold an income interest of 10% or more (for example a person who owns 50% of a company which owns 10% of another company).

This was contrary to the policy intention which was that a person would work out their indirect income interest by multiplying their direct income interest in a foreign company by that foreign company's direct income interest in other foreign companies (this approach is provided by section EX 50(4)).

Examples

A person has a direct income interest of 10% in a FIF which holds a 100% direct income interest in a second foreign company. The person would have a 10% indirect income interest in the second foreign company.

A person has a direct income interest of 50% in a FIF which holds a 10% direct income interest in a second foreign company. The person would have a 5% indirect income interest in the second foreign company so the person would not meet the requirements in sections EX 35(a) or EX 46(3)(a)(ii).

A person with an income interest of less than 10% is not generally able to apply the attributable FIF income method.

There is one exception to this. A person may be able to apply the attributable FIF income method to less than a 10% interest in a CFC if the person and the CFC meet the conditions in section EX 46(3)(b).5 The main requirement is that a market value for shares in the CFC is not available except by independent valuation (for example, if the CFC is not listed on a stock exchange). In addition there are some restrictions on the types of investors in the CFC.

There are two other circumstances when a person does not strictly apply the attributable FIF income method to indirect income interests in FIFs, but is instead able to include relevant amounts from these indirect interests in FIFs when applying the active business test to a FIF through which they hold these indirect interests. If the test is still passed with these additional amounts included, the person does not attribute income from any FIFs that were included in the test.

Applying the active business test to a consolidated test group

The first case is when a FIF owns more than 50% of another foreign company (that is not a CFC). In this case, the parent FIF and its subsidiaries can be included in the same test group for the purposes of applying the active business test. The test is then applied on a consolidated basis to the test group. If the test group has less than 5% passive income, then no FIF income or loss is attributed to the New Zealand shareholder from any member of that test group.

Applying the active business test when a FIF has non-controlling shareholdings in other foreign companies

The second case is when a FIF owns non-controlling interests, such as shares, in other foreign companies. In these cases, the person can choose to apply a modified version of the active business test that includes some additional amounts in the "added passive" and "reported revenue" terms of the calculation. The additional amounts correspond to the amounts that are reported in the FIF's accounts as being derived from shares in the non-controlling interests.

This rule is set out in sections EX 50(7B) and EX 50(7C).

Section EX 50(7B)(b) has been modified to explicitly allow a person to choose to include none, some, or all the FIF's non-controlling interests in foreign companies when applying the modified active business test in section EX 50(7B). Note however, that if a person chooses to exclude an indirect interest from the modified test, they will usually be required to "look through" and apply a FIF calculation method to that indirect interest in a FIF in accordance with section EX 50(6).

New section EX (7C)(b) prevents a person from using the result of the test for a FIF and a group of foreign companies, if the person has used the result of a different test for that FIF and a different grouping of foreign companies. The purpose of this condition is to prevent a taxpayer from manipulating their test results by applying multiple tests to smaller groups consisting of the same parent FIF and only some of that FIF's shares in other companies. Such manipulation could ensure that each test resulted in less than 5% passive income when there would have been more than 5% passive income had the test been applied to a larger group that included all of the foreign shares in the same test.

Both of these changes are illustrated in the following example.

Example

A person uses the attributable FIF income method for a FIF that has non-controlling shareholdings in two other companies, company A and company B.

The FIF has $9.3 million of total revenue and no passive income. This means the person does not attribute income from the FIF as the FIF passes the active business test.

The FIF's accounts include profits of $0.3 million from company A and $0.4 million from company B.

The person can apply the modified test in section EX 50(7B) to determine if they need to attribute FIF income from company A or company B.

The person can only include the FIF and each company in one test for the purpose of section EX 50(7B)(b). This means they can apply the test to one of three possible groups. A group comprising the FIF and company A, a group comprising the FIF and company B or a group comprising the FIF and companies A and B.

If the person applies the test to a group comprising the FIF and company A, the result is 3.1% (= 0.3 ÷ 9.6). This is less than 5% so they do not attribute FIF income from company A. However they would still have FIF income from company B as the profit from company B was not included in the test.

If the person applies the test to a group comprising the FIF and company B, the result is 4.1% (= 0.4 ÷ 9.7). This is less than 5% so they do not attribute FIF income from company B. However they would still have FIF income from company A as the profit from company A was not included in the test.

If the person applies the test to the FIF and both companies A and B the result would be 7% (= 0.7 ÷ 1) so they would have FIF income from companies A and B.

Further explanation and examples on how to apply the attributable FIF income method can be found in the Tax Information Bulletin, Vol 24, No 6, July 2012.

Application date

The amendments to sections EX 50(7B), EX 58(5) apply from income years beginning on or after 1 July 2011. This is consistent with the application dates of the international tax reforms in the Taxation (International Investment and Remedial Matters) Act 2012.


5 Even though the company is a CFC, a person with less than a 10% interest in the CFC (including interests of associated persons) will use the FIF rules rather than the CFC rules to attribute income from the CFC.