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.

Background

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.

Key features

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.

Application date

The new provisions are temporary. They apply for income years beginning on or after 1 July 2009 and ending before 1 July 2013.

Detailed analysis

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.

Example

CFC Co has an interest-only loan of US$100 million, which it takes out at the end of the 2010 income year.

The NZD-USD exchange rate at the beginning of the 2011 year is 0.76. At the end of the 2011 year it is 0.74. There is a currency loss of 100 ÷ 0.74 - 100 ÷ 0.76 = NZ$3.6 million, and a loan currency amount of - $3.6 million.

The exchange rate at the end of the 2012 year returns to 0.76. There is a currency gain of NZ$3.6 million and a loan currency amount of + $3.6 million.

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.

Example

CFC Co has financial arrangement income of $50 million for the 2011 income year. This consists of an interest expense of $150 million and a loan currency amount of $200 million (a gain). The $50 million is all included in the item attributable CFC. Therefore, the loan currency amount is also included in the item attributable CFC and the included currency amount is $200 million.

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.

Example

Alter Co, a CFC, has borrowed money and on-lent 40% of the money to an associated active CFC. Apart from the on-lent money, 80% of Alter Co's assets produce active (non-attributable) income. Because of its borrowing, Alter Co has financial arrangement expenditure of $10 million for the 2018 income year. This consists of an interest expense of $5 million and a loan currency amount of -$5 million (a $5 million currency loss).

$2 million of the $5 million currency loss is included in the item "other deductions" in the formula in section EX 20C(2). That is, 40% of the $5 million loss is not part of limited funding costs under subsection EX 20C(5). The $2 million is fully deductible under paragraph EX 20C(9)(b). The included currency amount is -$2 million (-$10 million x 50% x 100% x 40% = -$2 million).

$3 million of the $5 million currency loss is included in the item "limited funding costs" in the formula in section EX 20C(2). The item "fraction" is 20% because Alter Co has 20% of its assets that generate attributable income. Therefore, the included currency amount is -$0.6 million (-$10 million x 50% x 20% x 60%).

Total included currency amounts for the 2018 year are -$2.6 million.

In summary:

  $m  
Loan currency amount -5  
Other amounts -5  
Loan currency amount as percentage of total 50% [1]
Contribution of loan currency amount to other deductions -2 (40% x -10 x [1]) [2]
Applicable fraction 100% [3]
Included currency amount -2 [2] x [3] = [4]
Contribution of loan currency amount to limited funding costs -3 (60% x -10 x [1]) [5]
Applicable fraction 20% [6]
Included currency amount -0.6 [5] x [6]
Example

CFC Co has financial arrangement expenditure of $350 million for the 2012 income year. This consists of an interest expense of $150 million and a loan currency amount of -$200 million (a loss). This $350 million is all included in the item "limited funding costs" in the formula in section EX 20C(2). However, the item "fraction" in the formula in section EX 20C(2) is zero because CFC Co has no assets that generate attributable income. Therefore, the included currency amount is zero.

Example

Fortune Co has financial arrangement income of $1 million for the 2011 income year. This consists of an interest expense of $150 million and a loan currency amount of $151 million (a gain). The $1 million is all included in the item -"attributable CFC" in the formula in section EX 20C(2). Therefore, the included currency amount is $151 million.

Short Co has financial arrangement expenditure of $1 million for the 2011 income year. This consists of an interest expense of $150 million and a loan currency amount of $149 million (a gain). The $1 million is all included in the item limited funding costs in the formula in section EX 20C(2). Short Co has no assets that generate attributable income, so the item fraction in the formula in section EX 20C(2) is zero and the included currency amount is also zero.

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).

Example

CFC Co's included currency amounts for 2011 and 2012, before taking into account earlier adjustments, are $200 million. This amount exceeds the total of loan currency amounts, which is nil, by $200 million.

Suppose that once the calculation for 2011 and 2012 is done, $50 million of the excess is able to be applied to effectively increase deductions in the 2011 year.

In 2013, and assuming no further exchange rate change, the total of included currency amounts for the period 2011-2013 will be $150 million, being $200 million less $50 million of earlier adjustments. The excess of this amount over total loan currency amounts is $150 million, which is the amount that may be available to provide further relief.

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.

Example

CFC Co has financial arrangement income of $50 million in 2011, consisting of a $200 million foreign exchange gain and a $150 million interest expense, and financial arrangement expenditure of $350 million in 2012, consisting of a $200 million foreign exchange loss and $150 million of interest expenditure.

The total of the loan currency amounts in 2011 and 2012 is $0. The item fraction is zero in the formula in section EX 20C(2), so that the total of included currency amounts for 2011 and 2012 is $200 million. Thus, the excess of included currency amounts over loan currency amounts is $200 million.

In the formula in paragraph (5)(c) the loan contribution made in 2011 is $50 million and fraction is 1. In 2012, the loan contribution is -$350 million and fraction is 0. As a result, the total current adjustment is limited to $50 million.

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).

Example

Esra Co has two loans. In 2011, there is financial arrangement income of $50 from loan 1, comprising a $200 currency gain and $150 of interest expense. There is financial arrangement expenditure of $350 from loan 2, comprising a $200 currency loss and $150 of interest expense. The item fraction in the formula in section EX 20C(2) is zero.

For loan 1, there is no difference, since the included currency amount is positive. For loan 2, there is a difference of $200, being the positive amount subtracted from the included currency amount ($0) to get the loan currency amount (-$200).

The difference of $200 is able to be reduced if there is a total current adjustment. Since the total current adjustment in 2011 is only $50 (because of the item in paragraph (5)(c)) not all of the $200 can actually be reduced in 2011, and $150 will remain available to be reduced if there are suitable currency movements in later years

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.

Example

Luc Co has two loans. In 2011, there is financial arrangement expenditure of $250 from loan 1, comprising a $100 currency loss and $150 of interest expense. There is financial arrangement expenditure of $100 from loan 2, comprising a $50 currency gain and $150 of interest expense. The item fraction in the formula in section EX 20C(2) is 0.5 at all times.

For loan 1, there is a difference of $50 (the positive amount subtracted from abbr title="minus">-$50 to get abbr title="minus">-$100). For loan 2, there is no difference because the included currency amount is positive.

In 2011, the total current adjustment is zero, so no amount is actually applied to loan 1 at that time.

In 2012, there is financial arrangement income of $50 from loan 1 ($200 of currency gain and $150 of interest expense) and financial arrangement income of $150 from loan 2 ($300 of currency gain and $150 of interest expense).

For loans 1 and 2 in 2012, there is no available difference since included currency amounts are positive.

The total current adjustment for 2012 is $25. There is nothing to apply this to in 2012. However, the difference of $50 for loan 1 remains available in 2011. The total current adjustment of $25 may be applied to that arrangement in the 2011 income year.

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.

Example

Lana Co has three loans. In 2011, there is financial arrangement income of $50 from loan 1, comprising a $200 currency gain and $150 of interest expense.

Loans 2 and 3 are identical. There is financial arrangement expenditure of $175 from each, comprising a $100 currency loss and $75 of interest expense. The item fraction in the formula in section EX 20C(2) is zero.

For loan 1, there is no available difference. For each of loans 2 and 3, there is a difference of $100.

The total current adjustment for 2011 is $50. This is allocated according to the formula in paragraph (7)(d), giving $100 x $50 ÷ $200 = $25. $25 is applied to each of loans 2 and 3 in the 2011 year.

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.

Complete example

Example

CFC Co has no passive assets at any time, so that the item fraction in section EX 20C is always zero. It has a loan of US$1 billion.

In 2011, it makes a foreign exchange gain of NZ$200 million on the loan and has a NZ$150 million interest expense (after currency conversion). In the formula in section EZ 32C(2), the item "currency contribution" is NZ$200 million and the amount fraction is 1, giving an included currency amount of $200 million (and a loan currency amount of $200 million). The amount under section EZ 32C(5)(c) would be $50 million, being the amount included in the item attributable CFC.

In 2012, CFC Co makes a foreign exchange loss of NZ$200 million and has a NZ$150 million interest expense. The item "currency contribution" is -NZ$200 million and the amount fraction is 0, giving an included currency amount of $0 (and a loan currency amount of -$200 million). The amount under section EZ 32C(5)(c) would be zero because the item fraction in EX 20C(2) is zero.

The total amount of loan currency amounts is $0 and the total of included currency amounts is $200 million. This means that, in principle, up to $200 million is available for adjustments. However, summing the total amounts of arrangement income and expenditure (not just those due to currency) gives $50 million, so the total current adjustment in 2012 is limited to $50 million. This is allocated against the 2012 year, so that "later losses" in section EX 20C(2) becomes $50 million and $50 million is subtracted from net attributed CFC income or loss.

Suppose that the CFC has no income or loss other than from its loan and the CFC investor has no income or loss from other sources. Then there is a $50 million loss as a result of the operation of sections EZ 32C(7) and (10).

In 2011, if the loan had not been denominated in a foreign currency there would have been no net income, as opposed to $50 million of net income. Similarly, if the loan had not existed there would have been no net income. Therefore, the amount given by subsection EZ 32C(13) in relation to the 2011 year is $50 million. The loss of $50 million in the 2012 year may be carried back to 2011, leading to a refund of income tax paid on 2011 income. The loss then ceases to be available in the 2012 year.

In 2013, suppose that there is income from the arrangement of $100 million, made up of a foreign exchange gain of $250 million and interest expense of $150 million. At the end of 2013, the total current adjustment amount will be $100 million (note that this is after removal of $50 million because of the earlier adjustment made in 2012). This amount of $100 million will be available to apply to the 2012 year.