Attributed foreign income - liability to tax

2012 legislation extends income that can be excluded from attributed foreign income, by permitting certain companies to be treated as resident in that country.

Sections EX 20B(7)(a), EX 20B(11)(a), EX 21D(1)(a) and EX 21E(2)(b), subsections EX 20B(16), EX 21D(10), EX 21E(14), and definition of associated non-attributing active CFC in section YA 1

The Act expands the scope of income that can be excluded from attributed foreign income, by permitting some companies, which are not recognised for tax purposes in the country they operate in, to nevertheless be treated as resident in that country.

The Act also adds requirements to prevent abuse of the rules that allow some income to be ignored.

Application date

The changes apply to income years beginning on or after 1 July 2009.

Key features

  • Income that a controlled foreign company receives from a non-attributing active CFC (an active business) resident in the same country may be ignored for tax purposes even if one or both CFCs are not liable to tax in that country.
  • Income that a controlled foreign company receives from rental property in the same country may be ignored even if the CFC is not liable to tax in that country.
  • Income that a controlled foreign company receives from telecommunications services between the country in which it is resident and New Zealand may be ignored even if the CFC is not liable to tax in that country.
  • A CFC may be part of a test group in the country in which it is resident, even if it is not liable to tax in that country.

For these to apply, all the following requirements must be met:

  • The CFC is a resident of the country in question under section YD 3 (this does not require liability to tax).
  • The CFC is wholly owned (directly or indirectly through a wholly owned chain of companies) under the laws of both New Zealand and the foreign country, by another CFC that is resident in that country under section YD 3.
  • That other CFC is liable to tax in the jurisdiction on the income of the CFC by reason of its domicile, residence, place of incorporation or centre of management, in the same period as the CFC would be liable if it were an ordinary company liable to tax.
  • Neither the CFC nor the other CFC is treated as a dual-resident.
  • Neither the CFC nor the other CFC has a fixed establishment or a permanent establishment outside the country.

The first, fourth and fifth requirements are extended to apply to all companies, not just those that are not liable to tax in a particular country. If these requirements are not met, it will not be possible to use the exemptions for payments from a non-attributing active CFC, rent from property in the same country or income from telecommunications services between the CFC's country of residence and New Zealand, or to be in a test group, regardless of liability to tax.

As well as applying to CFCs, the changes also apply to FIFs that use the attributable FIF income method.

Detailed analysis

Same country exemptions

Existing law provides that amounts that would be included in attributed foreign income for taxpayers with interests in foreign companies may be ignored in some cases where the income arises in the same country as the foreign company (see paragraphs EX 20B(5)(c), (7)(a), (7)(c), (11)(a), (12)(a), and paragraphs EX 21D(1)(a) and 21E(2)(a)).

To take advantage of these "same country exemptions", the foreign company must show it is resident in that country by reason of liability to tax.

When same country exemptions do not apply (not liable to tax)

Some entities that New Zealand considers to be foreign companies are not treated as taxable entities in the country in which they are registered or organised. For example, a
United States Limited Liability Company (LLC) such as a so-called "Delaware company" is often considered by the United States to be analogous to a partnership for tax purposes. In that case, it is not liable to tax in that country (though its shareholders may be) and the foreign company is not able to take advantage of the same country exemptions.

When the current position is logical

Excluding entities such as LLCs from the same country exemptions is often the correct result. For example, if an LLC owns an ordinary active company in the same country, and is able to extract the profit from that active company in the form of an interest payment, there may be very little foreign tax imposed on the income of the LLC, its shareholders, or the active company. In that case, it would not be appropriate to exempt the income from New Zealand tax.

When the exemptions should apply even though there is no liability to tax

However, there are cases when excluding entities such as LLCs from the same country exemptions is unnecessary and even counterproductive.

In particular, if the LLC is wholly owned by another company in the same country, and that other company is liable for tax on the LLC's income, the outcome should be similar to the case in which all of the companies are liable to tax in that country. In those cases, normal tax is paid on the active income of the group in the foreign country and New Zealand should be prepared to exempt the income here.

Remedial amendments when liability to tax is not an issue

The widening of the same country exemptions to entities that are not liable to tax in the foreign country has highlighted some situations in which the existing exemption - for entities that are liable to tax in the foreign country - may be too wide.

Companies may be resident by reason of liability to tax in more than one country. Or they may be resident in one country but conduct significant operations in another. In that case, it may not be appropriate to assume that the country in which income is being earned is ultimately taxing the income.

Imposing additional conditions on the same country exemptions for all entities

Sections EX 20B(7)(a), EX 20B(11)(a), EX 21D(1)(a) and EX 21E(2)(b), subsections EX 20B(16), EX 21D(10), EX 21E(14), and definition of associated non-attributing active CFC in section YA 1

To limit the use of the same country exemptions to cases when it is more likely that active income is being taxed normally by the relevant foreign country, there are three additional conditions for residence.

These are:

  • first, that the CFC is a resident of the country in question under section YD 3;
  • secondly, that the CFC is not treated as a dual-resident; and
  • thirdly, that the CFC does not have a fixed establishment or a permanent establishment outside the country.

The existing section YD 3 determines a single country of residence of a CFC (it does not require liability to tax).

A CFC is regarded as a dual-resident if one or more of three conditions is met:

  • The CFC is treated as a resident of a country other than the country in section YD 3 under the law of the relevant jurisdiction.
  • The company is liable to income tax by reason of its domicile, residence, place of incorporation, or centre of management in a country other than the country in section YD 3.
  • The company is treated as a resident of a country other than the country in section YD 3, under an agreement that would be a double tax agreement if New Zealand was a party to it.

"Fixed establishment" is a defined term in the Income Tax Act. "Permanent establishment" is an analogous term used in double tax agreements and extensively discussed in the OECD's commentary to the Model Tax Convention on Income and on Capital.

Widening the same country exemptions for entities with no liability to tax

Sections EX 20B(7)(a), EX 20B(11)(a), EX 21D(1)(a) and EX 21E(2)(b), subsections EX 20B(16), EX 21D(10), EX 21E(14), and definition of associated non-attributing active CFC in section YA 1

At the same time as clarifying the requirements for all companies that use the same country exemptions, the new Act widens the scope of the exemptions to include entities that are not liable to income tax because they are not considered to be taxable entities in the country where they are resident.

A CFC that is not liable to tax in the relevant country may still make use of the exemption if it meets the conditions for residence (see previous section) and two further conditions are met:

  • the CFC is wholly owned, under the laws of New Zealand and the foreign country, either directly or through a chain of wholly owned companies, by another CFC that meets the conditions for residence in the previous section; and
  • the other CFC is liable to tax on the income of the CFC in the relevant country by reason of its domicile, residence, place of incorporation or centre of management, in the same period as the CFC would be liable if it was an ordinary company liable to tax there.

Example: Using same country exemptions when not liable to tax

Hold Co owns 100% of LLC Co, which in turn owns 100% of Op Co. All three companies are CFCs incorporated in and managed from the United States, and are treated as residents of the United States under section YD 3. None of the companies has operations outside the United States.

Op Co and Hold Co are liable to tax by reason of residence in the United States, but LLC Co is treated as a partnership for tax purposes and so is not liable to tax.

Op Co is a non-attributing active CFC.

Op Co pays interest to LLC Co.

The interest is not subject to tax in the United States in the hands of LLC Co, but is subject to tax in the hands of Hold Co.

LLC Co can ignore the payment of interest from Op Co, even though it is not liable to income tax in the United States. LLC Co is wholly owned by owned by Hold Co, and Hold Co is liable to tax in the United States on LLC Co's income (including interest income).