Taxation of foreign hybrids and foreign tax credit rules

Sections CD 10C, EX 24, EX 33, EX 42, EX 44, EX 45, LC 4, LF 1, LF 5, LF 6 and OB 1 of the Income Tax Act 2004

The law has been clarified to allow people who invest in "foreign hybrids" to receive "grey list" treatment and foreign tax credits for tax they pay overseas on income earned by a foreign hybrid. The changes apply to foreign hybrids that are either a controlled foreign company (CFC) or a branch-equivalent foreign investment fund (FIF).

A foreign hybrid is an entity that has the characteristics of both a company and a partnership. It is treated as a company for New Zealand tax purposes, but is treated like a partnership (with "flow-through" tax treatment) or a branch of the parent company under another country’s tax system.

Background

The rules have been introduced to ensure that the tax treatment is consistent when investing into different types of entities.

Under New Zealand domestic tax legislation, an interest in a foreign hybrid entity which has a separate legal personality is treated as an interest in a "company" and taxed as such. An investment by a New Zealandresident in a foreign company will usually be treated as an investment in a CFC or a FIF. An investor in a CFC (or FIF) can usually claim a foreign tax credit for tax paid on its foreign income.

However, there was uncertainty in the rules about whether New Zealand members of a foreign hybrid entity could claim a foreign tax credit against their New Zealand income tax liabilities under the previous tax credit provisions in the Income Tax Act 2004. That uncertainty arose because, under the CFC credit provision in section LB 4, a credit was given only for foreign tax paid by the CFC. Yet a foreign hybrid, that is a CFC, does not actually pay the foreign tax because the tax is imposed on its members.

A further technical problem arose concerning whether a foreign hybrid could qualify for the grey list exemption from the CFC or FIF rules.

Application date

The amendments apply from 1 April 2006 for the 2006-07 tax year and subsequent tax years.

Key features

The Income Tax Act 2004 has been amended as follows:

• Sections EX 24 and EX 33 enables taxpayers to receive a grey list exemption from the CFC and FIF rules for investments in foreign hybrids.
• Section LC 4 enables shareholders with investments in foreign hybrids that are CFCs or branchequivalent FIFs to receive tax credits for the foreign tax paid by the shareholder.
• Subpart LF allows corporate shareholders to receive underlying foreign tax credits and deemed underlying foreign tax credits to offset their foreign dividend withholding payment for tax paid in respect of the foreign hybrid.
• Section CD 10C allows the amount of a dividend received from a foreign hybrid to be reduced by the amount of foreign tax paid by the New Zealand shareholder on income earned by the hybrid.
• When attributing income under the accounting profits method in relation to a FIF, section EX 42 allows foreign tax paid by the New Zealand shareholder on income earned by the foreign hybrid to be taken into account. This effectively reduces the amount of attributed income.
• When attributing income under the comparative value method in relation to a FIF, section EX 44 allows foreign tax paid by the New Zealand shareholder on income earned by the foreign hybrid to be included in the definition of costs. This effectively reduces the amount of attributed income.
• When attributing income under the deemed rate of return method in relation to a FIF, section EX 45 allows foreign tax paid by the New Zealand shareholder on income earned by the foreign hybrid to be included in the definition of costs. This effectively reduces the amount of attributed income.

Detailed analysis

Why is section CD 10C required?

Section CD 10C is required to reflect the fact that the shareholder has directly paid the foreign tax of the hybrid that, in the normal course, would have been paid by the company itself, reducing the amount available for distribution as a dividend.

Without this provision, there would be over-taxation of foreign-sourced income. The following examples illustrate the reason for section CD 10C.

Meaning of the term "organised" in sections EX 24 (1)(b), EX 33(1C)(a), and LF 5(1)(b)(ii)

Sections EX 24(1)(b), EX 33(1C)(a) and LF 5(1)(b) refer to the term "organised". The term "organised" is used because in some countries foreign hybrids are not incorporated nor are they a resident for tax purposes - for example, certain limited partnerships. Therefore, the scope of the term "organised" is wider that scope of the terms "incorporated" and "resident".

80% threshold

One of the conditions for a CFC or FIF, that is a foreign hybrid to receive grey list treatment, is that the CFC or FIF must source at least 80% of its income from the grey list country (sections EX 24(1)(b)(ii) and EX 33(1C)(c)).

The 80% rule is necessary to ensure that grey list treatment is given to a hybrid entity only if the grey list country taxes most of the income earned by (or through) the hybrid entity. The threshold of 80%, as opposed to 100%, is intended to provide some flexibility when an insignificant amount of income is earned outside the jurisdiction.

Similarly, for a corporate investor to receive deemed underlying foreign tax credits, the foreign hybrid must source at lease 80% of its income from the grey list country (section LF 5(1)(b)(ii)). A grey list country would generally not impose tax on income sourced from another country which is attributable to an investor resident in another country. So, without this restriction, a deemed underlying foreign tax credit could be granted for income on which no grey list country taxation is payable by either the foreign hybrid or its investors.