Imputation credits and transfers

2005 amendment covering imputation credits and transfers, and the transfer rules in the Income Tax Act.

Section MD 4 of the Income Tax Act 1994

Introduction

Taxpayers can elect that a credit arises to the imputation credit account (ICA) or dividend withholding payment account (DWPA) in certain circumstances when overpaid tax was transferred before the comprehensive transfer rules in the Income Tax Act came into effect.

Background

The company imputation system ensures that company shareholders are not taxed twice on company income - once in the hands of the company, and again when profits are distributed as dividends.

Briefly, companies keep an ICA which records the tax payments made by the company as credits and amounts allocated to dividends as debits. If a company's ICA has a debit balance at 31 March in any year, the company is liable to pay further income tax. This ensures that imputation credits attached to dividends do not exceed the net amounts of tax paid by the company.

To ensure that imputation credits are associated with whoever owns the company when the tax is paid, there is a "continuity debit" to the ICA whenever there is a significant change in ownership (direct or indirect) of the company. If a company that has suffered a breach in continuity is also due a tax refund for a tax overpayment that arose before the continuity breach, this refund (to the extent of the debit) can still be paid without further affecting the ICA balance.

Similar rules apply to withholding payments.

Section MD 4 (which was repealed in 2003) ensured that a taxpayer could not take undue advantage of the imputation or dividend withholding payment rules when transferring overpaid income tax or dividend withholding payment to another year or to another tax type (such as PAYE or GST) or to another taxpayer. However, where there had been a prior breach in shareholder continuity, section MD 4 did not work appropriately.

 

Example

Company A makes an income tax payment of $100, taking the ICA balance to $100. Subsequently, there is a breach of shareholder continuity, leading to a debit in the ICA. Later it is determined that the $100 is an overpayment and a refund is sought. After the overpaid tax is refunded, the company pays the amount back to Inland Revenue (say, in satisfaction of the next provisional tax payment due).

For the purposes of determining whether a refund can be made, the balance in the ICA can be increased by the breach of continuity debit of $100 under section MD 2(4). Therefore the refund can be made in this case.

A second debit relating to the refund is recorded only if the refund is greater than the breach in continuity debit (section ME 5(1)(e)(iii)). Therefore no further debit will arise to the ICA when the refund is made.

When the refund has been subsequently paid back to Inland Revenue for offset against the next provisional tax liability, a credit will arise in the ICA for the payment.

Imputation credit account
Transaction Debit Credit Balance
Payment   $100 $100 Cr
Breach in shareholder continuity $100   Nil
Refund Nil   Nil
Payment of provisional tax   $100 $100 Cr
Before this amendment, section MD 4 denied the second imputation credit if a transfer was made instead of a refund and payment.

Generic transfer rules introduced in 2002 provide a better result than section MD 4 did, so section MD 4 was repealed by the Taxation, (GST, Trans-Tasman Imputation and Miscellaneous Provisions) Act 2003. The issue described above, however, continued to exist for transfers made before the section was repealed.

Key features

The now repealed section MD 4 provided that a credit did not arise to the ICA or DWPA if overpaid tax was transferred. New subsections (2) and (3) have been added to section MD 4 to provide for a credit (a permitted credit) to arise in some circumstances.

Section MD 4(2) provides that section MD 4(1) does not prevent a permitted credit if:

  • the transferred tax could have been refunded instead of transferred; and
  • between the time when the tax which gave rise to the overpayment was paid and the date of the request for the transfer, the company suffered a breach in shareholder continuity and a debit arose accordingly to the ICA or DWPA; and
  • the taxpayer elects that the permitted credit arises.

The permitted credit arises under section ME 4(1)(a) or section MG 4(1)(a) as tax or dividend withholding payment "paid". For the purposes of those sections "paid" includes "distributed, credited, or dealt with in the interest of" and, therefore, includes an amount transferred.

New subsection (3) provides that the amount of the permitted credit is the amount transferred less the amount of the debit that would have arisen under section ME 5(1)(e) if the overpayment had been refunded.

Application date

The amendment has effect from the start of the 1997-98 year (when section MD 4 was introduced) to the date when section MD 4 was repealed (1 April 2003).

Detailed analysis

A permitted credit can arise to an ICA if section MD 4(2) is satisfied. Section MD 4(2) is satisfied if:

  • a company was entitled to a refund of overpaid income tax (section MD 2(4)); and
  • the overpaid tax was transferred, either at the taxpayer's request or on Inland Revenue's initiative; and
  • a breach of shareholder continuity occurred between the time when the tax that led to the overpayment was paid and the time the transfer was made; and
  • a credit would have arisen to the ICA if the:
    • overpayment had been refunded;
    • and the refunded amount had been repaid in satisfaction of a tax liability; and
  • the company requests that section MD 4(2) and (3) apply to the transfer.

New subsection (3) provides that the amount of the permitted credit is the amount transferred less the amount of the debit that would have arisen under section ME 5(1)(e) if the overpayment had been refunded.

Example

Company B's ICA balance at 31 March 2000 is $100. A breach in shareholder continuity occurs on 30 June 2000. As a result, a debit arises to the ICA of $100 and the ICA balance is now nil.

Company B pays tax of $50 on 7 July 2000, bringing the ICA balance to $50.

On 30 April 2001 an income tax overpayment of $150, which arose before the breach in shareholder continuity, is identified. Company B applied to have $150 transferred to 2002 provisional tax. This was done, but under section MD 4, as it applied in 2001, no credit arose to the ICA for the transfer. At that stage there was no provision that allowed a debit to arise relating to a transfer of overpaid tax.

In 2004, Company B requests that subsections MD4(2) and (3) be applied.

Under section MD 4(3) the permitted credit will be the amount transferred less the debit that would have arisen if the amount transferred had been refunded instead of transferred. Section ME 5(1)(e)(iii) provides that a debit arises to the ICA when a refund is made, except to the extent of a debit that arose upon a previous breach in continuity.

In the example, a previous debit of $100 arose upon a breach of continuity. Therefore, had $150 been refunded, the debit that would have arisen to the ICA would have been $50. Accordingly, the permitted credit will be the amount transferred ($150) less the debit that would have arisen under section ME5(1)(e)(iii) if the transferred tax had been refunded ($50). The permitted credit is, therefore, $100. Entries in the ICA would be:

Imputation credit account
Transaction Debit Credit Balance
Balance 31 March 2000     $100 Cr
Breach in shareholder continuity $100   Nil
Payment 7 July 2000   $50 $50 Cr
Transfer Nil   $50 Cr
Permitted credit   $100 $150 Cr
This is the result that would have occurred had the overpaid tax been refunded and repaid.