Gains on liabilities of controlled foreign companies
2011 changes to the Income Tax Act relating to investors in controlled foreign companies who have been taxed on foreign exchange rate gains on liabilities.
Sections DZ 19, EX 20C and EZ 32C of the Income Tax Act 2007
New and temporary provisions have been added to the Income Tax Act 2007. These provide relief to investors in controlled foreign companies who have been taxed on foreign exchange rate gains on liabilities, if certain requirements are met.
The taxation of investments in controlled foreign companies (CFCs) was reformed in 2009. Investments in CFCs are now taxed only when the CFC earns passive income such as financial arrangement income, royalties and rent.
In unusual cases involving foreign currency loans and significant foreign exchange movements, financial arrangement income may arise from money that a CFC has borrowed; that is, from a liability. This may result in taxation of the investment in the CFC.
In general, it was not intended that a CFC's borrowing on its own would affect its taxation. Even CFCs undertaking entirely active businesses - manufacturing, retailing and so on - need to borrow money to finance their operations. Such CFCs would not be able to claim deductions for financial arrangement expenditure, so taxation of financial arrangement income can result in over-taxation when exchange rates fluctuate.
However, there are concerns that simply ignoring financial arrangement income from liabilities might open a loophole. Indeed, legislation was enacted to close such a loophole in the old controlled foreign company rules.
Therefore, as a temporary solution to the problem that has been identified, deductions for some financial arrangement expenditure are instead allowed to offset taxation of financial arrangement income.
This solution applies only to holding companies in a narrow range of circumstances. Further work is being undertaken to establish whether a more comprehensive but less complex solution can be developed that does not pose unacceptable risks to the tax base.
Investors in a CFC may be entitled to claim deductions for financial arrangement expenditure that would otherwise be denied under section EX 20C(2) because the item "fraction" in the formula in that section would be less than 1, if the CFC:
- is not a banking or insurance business and is not controlled by one;
- has a main activity of borrowing to invest in shares in foreign companies that it controls;
- has financial arrangements that are liabilities providing funds to the CFC (loans);
- has net foreign currency gains or losses on the loans, and any net currency gains included in the investors' income exceed the total net currency gains or losses; and
- has net gains (taking into account the whole arrangement, not just currency movements) from the loans that are included in the investor's income.
Net gains and losses are to be calculated over a period that will generally include the current year and the preceding four years (the offset period).
In such cases, the excess of the net currency gains that are taxed over the total net currency gains is available to reverse the denial of deductions, including denial in a prior period within the offset period.
However, the total reversal of denied deductions may never exceed the total net gains (currency or otherwise) from the arrangements in question. That is, relief provided by the new provision will never go further than effectively ignoring the arrangements altogether.
If the investor has a net loss from the CFC as a result of reversing the denial of deductions, or an increased net loss, the loss or increase in the loss may be carried back to an earlier year in the offset period.
The amount of loss that may be carried back to a year must not exceed the lesser of:
- the amount of net income in that year that is due to currency movements on loans; or
- the amount of net income in that year from the loans (whether due to currency movements or otherwise).
The new provisions apply on a per-CFC basis. It is not possible to average currency movements across CFCs.
The new provisions are temporary. They apply for income years beginning on or after 1 July 2009 and ending before 1 July 2013.
Subsection EZ 32C(1) - when the provision applies
The new provision in section EZ 32C applies if a number of conditions are met.
Paragraph (a) - CFC not involved in banking or insurance
If the CFC is in the business of banking or insurance, or is controlled by a person in a business of banking or insurance, the provision does not apply.
Paragraph (b) - CFC's main activity is borrowing to invest in shares
The provision does not apply unless the CFC's main activity is borrowing to invest in shares in foreign companies that it controls.
That is, the provision is intended only for use by holding companies which debt-fund the capitalisation of subsidiaries.
Paragraph (c) - CFC has loans and anti-avoidance rule does not apply
For the provision to apply, the CFC must be a party to financial arrangements that are liabilities of the CFC and that provide funds for the CFC (put briefly, loans). The provision is intended only to relieve tax effects that arise from currency gains on money the CFC has borrowed.
In addition, at the time the financial arrangement is entered into, or at a later time when the terms of the arrangement are altered, there must not be any reasonable expectation that the CFC will have more income than expenditure from the financial arrangement.
This is an anti-avoidance rule to prevent use of the provision when, through manipulation, a person might deliberately create income from a liability to take advantage of the relief offered.
The provision is meant to apply in the much more likely situation that a person has taken a loan on arm's-length terms with an expectation that there will be net expenditure on the loan (interest expenditure will exceed net exchange rate gains).
Paragraphs (d) and (e) - CFC is affected by currency movements on its loans, and calculation of loan currency amount
As a result of foreign exchange rate movements the CFC must have had gains or losses from its loans in at least two periods within a certain period (usually a five-year period, but see subsection (9)). The provision is only useful when there is an exchange rate loss that has been effectively ignored in one period, but a gain in another that has been taxed.
The example below is a loan denominated in United States dollars. Conversion to New Zealand dollars required under section EX 21(7), along with movements in the NZD-USD exchange rate, lead to increases or decreases of the outstanding loan principal. Those increases or decreases are gains or losses.
The amount of currency gain or loss for a particular loan in a particular income year is called the loan currency amount.
Paragraphs (f) and (g) - there has been expenditure relating to the loan in a period and some of the expenditure has not been taken into account for tax purposes
The provision is only useful if there has been some denial of deductions for financial arrangement expenditure under section EX 20C(2) because the item fraction is less than one. The effect of the provision is to reverse some or all of the denial in such a case.
Paragraph (f) contains the requirement that a loan currency amount must have been included in the calculation of expenditure that contributes to the item "limited funding costs" in the formula in section EX 20C(2), limited funding costs being subject to multiplication by the item "fraction".
Paragraph (g) contains the requirement that the item fraction, in the year that limited funding costs includes a contribution from a loan currency amount, is less than 1.
Paragraph (h) - person chooses to use the provision or has used it in the past
Use of the new provision in section EZ 32C is optional. It does not apply unless the taxpayer elects to apply it.
However, once it has been used to reduce income or increase loss in an income year, it must continue to be used in every later income year.
Subsections (2) and (3) - calculation of included currency amount
If all the requirements in subsection (1) are met, the provision in EZ 32C operates firstly by comparing amounts of currency gain or loss (loan currency amounts determined in subsection (1)) to amounts of currency gain or loss that would be subjected to tax under the CFC rules.
Roughly speaking, if more net gain would be subjected to tax than has actually arisen, then the difference should be available to relieve tax obligations.
Subsection (2) defines amounts of currency gain or loss that would be subjected to tax under the CFC rules. These are called included currency amounts. Subsection (3) defines the items used in the formula in subsection (2).
A loan currency amount for a particular arrangement and a particular year is an included currency amount to the extent it contributes to items in the formula for net attributable CFC income or loss in subsection EX 20C(2), other than the item "later losses" in that formula. Where the loan currency amount contributes to more than one item, a separate included currency amount is calculated for each item.
If the loan currency amount relates to a financial arrangement for which there is income in the relevant year, then to the extent that the loan currency amount is included in the item "attributable CFC" in the formula in section EX 20C(2), the loan currency amount is an included currency amount.
If the loan currency amount relates to a financial arrangement for which there is financial arrangement expenditure in the relevant year, then there are two ways in which the amount may be an included currency amount.
Firstly, to the extent the expenditure contributes to the item "other deductions" in the formula, the loan currency amount is an included currency amount. And secondly, to the extent the expenditure contributes to the item "limited funding costs" in the formula and is not reduced by the item "fraction", the loan currency amount is also an included currency amount.
When the included currency amounts exceed the loan currency amounts for a CFC, the excess may be available to reverse the effective denial of deductions in section EX 20C(2) (if the item fraction is less than 1). To the extent effective denial is reversed, part of the excess is not available to be used again. This is reflected in the item earlier adjustments in the formula in subsection EZ 32C(2).
Subsection (4) - when denial of deductions may be reversed
Subsection (4) states that effective denial of deductions may be reversed when the included currency amounts are both positive and in excess of the loan currency amounts. That is, when more net currency gain has been taxed than has actually arisen.
Subsection (4) is a precondition. Effective reversal of denial actually occurs in subsection (7). The reversal of denial makes nil or negative included currency amounts more negative; that is, it decreases nil or negative included amounts.
Subsections (5) and (6) - amount available for reversing denial of deductions
Subsection (5) says that the amount of denial that may be reversed is limited to the lowest of three amounts calculated for the CFC.
The first amount is the total of the included currency amounts for the offset period (subsection (9) describes the offset period). Relief will never exceed the amount of net currency gain that has actually been brought to tax.
The second amount is the excess of the total included currency amounts over the total loan currency amounts for the offset period. Relief is only available to the extent that the taxable net gain exceeds the actual net gain.
The third amount is the total of all amounts brought to tax under the relevant financial arrangements for the offset period, including currency gains or losses but also any other contributions. Relief is only available to the extent some net income has been brought to tax over the period (no relief is given if there has been net expenditure allowed in the calculation of net attributable CFC income or loss, even if the allowed expenditure is less than total net expenditure). The detailed calculation of total amounts is given by paragraph (5)(c) and subsection (6).
The maximum amount of denial that may be reversed is called the total current adjustment.
Paragraph (5)(c) and subsection (6) - calculating total contributions of the financial arrangement
The formula for the total of all amounts brought to tax under the relevant financial arrangement follows the model in subsections (2) and (3). However, instead of including all or part of currency gains or losses, all or part of all income or expenditure under the arrangement is included.
Subsections (7) and (8) - how to reverse effective denial
The total current adjustment is to be applied to reverse effective denial of deductions; that is, to allow more financial arrangement expenditure to be taken into account when it relates to currency movements and has been limited by a fraction that is less than 1 in section EX 20C(2).
Effective denial may be reversed in the current year or in any of the prior years in the offset period.
Subsection (7) requires that the total current adjustment be first used in the current accounting period of the CFC (the year for which the total current adjustment is calculated, referred to in subsection (1)). Any amounts remaining may then be used in earlier periods in the offset period, beginning with the earliest period.
Within an accounting period, cases are identified in which included currency amounts are nil or negative but would have been more negative but for the item fraction being less than 1 in section EX 20C(2).
The formula in paragraph (d) is applied to allocate the total current adjustment across the positive differences found in paragraph (c).
If the total current adjustment t is enough to reduce all positive differences in the accounting period, any remaining amount is available to be used in other years in the offset period.
If the total current adjustment is not enough to reduce all positive differences in the accounting period, the total current adjustment is to be used on a pro-rata basis to reduce all the positive differences.
Subsection (9) - when current period is able to be adjusted (the offset period)
Subsection (9) gives the periods in which, for any year in which section EZ 32C is applied, adjustments may be made. This is referred to in subsection (1) as the offset period, and is also the period from which figures are included for the calculations in subsections (4) and (5).
In general, the offset period is the current accounting period (when section EZ 32C is applied), as well as the previous four accounting periods.
However, it does not include any period corresponding to an income year that ends before 1 July 2009. This means that only years in which the new CFC rules apply (they were introduced in 2009) are included in the offset period.
The offset period may be shortened if the CFC has changed its residence or if its ownership has changed. This is intended as a safeguard against relief being transferred between jurisdictions or taxpayers.
Subsections (10) and (11) - adjustment of income
The application of section (7) results in decreased net attributable CFC income or increased net attributable CFC loss in the current year or an earlier year in the offset period, through the item later losses in the formula in section EX 20C(2) and subsection (10). It also results in increased financial arrangement expenditure for the relevant financial arrangement, in the unlikely event that such expenditure has not already been included, for the purposes of any base price adjustment, through subsection (11).
Subsection (12) and section DZ 19 - carrying back losses
Subsection (12) and section DZ 19 permit certain losses resulting from the application of section EX 32C to be carried back from an income year to an earlier year in the offset period.
This treatment may result in tax paid in an earlier year (because of currency gains at that time) being refunded in a later year because of subsequent currency losses.
The amount of loss that may be carried back may not reduce net income or increase net loss in the earlier year by more than would have been the case had all loan currency amounts in the year been reduced to nil or the relevant financial arrangements been completely ignored in that year.