Latest developments in changes to the FIF rules

Hayden Roberts, Solicitor | Tuesday 12 July 2011

First published in Taxation Today, June 2011.

The Finance and Expenditure Committee (FEC) recently reported back to Parliament on the Taxation (International Investment and Remedial Matters) Bill (the Bill). That Bill, introduced to Parliament in October 2010, proposes significant changes to the foreign investment fund (FIF) rules. If implemented the changes would largely align the tax treatment of investments in non-portfolio FIFs and controlled foreign companies (CFCs) for income years commencing on or after 1 July 2011 (see Taxation Today Issue 35 (November 2010) for a review of the proposals). This article discusses the FEC's report to Parliament on the Bill, as that report relates to the proposed changes to the FIF rules.

Recap of proposed changes to FIF rules

The Bill introduces an "attributable FIF income" method (the AFI method) for calculating an investor's income from an investment in a non-portfolio FIF. Under the AFI method, only the passive income of a FIF (and not the active income) will be attributed to an investor, unless the FIF satisfies one of two exemptions:

• The "active business exemption", which requires a non-portfolio FIF to satisfy the "active business test" of having less than 5 per cent of its income deemed to be passive; or

• The "Australian exemption", for FIFs resident and subject to tax in Australia which are also not eligible for certain Australian tax concessions.

Where a FIF meets the criteria for one of the above exemptions, no income of that FIF will be attributed to a New Zealand investor under the AFI method. These two exemptions are available to investors at the expense of the current grey-list exemption for non-portfolio FIF interests, which the Bill proposes to repeal.

In circumstances where an investor holds a portfolio interest in a FIF, or is unable to obtain sufficient access to the information of a FIF to use the AFI method, the fair dividend rate (FDR) and cost methods of calculation will generally remain available. An investor may also make an election to use the FDR or cost methods instead of the AFI method.

Officials' Report

The general theme of the submissions to the FEC was that the introduction of an active income exemption should be applauded, but that more effort should be made to reduce the compliance costs that will be associated with the AFI method. The remainder of this article details the submissions made to the FEC, and the responses to those submissions.

The FIF rules should be repealed

A popular submission was that New Zealand should repeal its FIF rules, as has recently been done in Australia. Submitters argued that because Australia has moved towards a full exemption regime for FIF investments, it is necessary that New Zealand's FIF rules be repealed to provide an internationally competitive tax regime for New Zealand companies looking to expand offshore.

On 14 July 2010 Australia passed the Tax Laws Amendment (Foreign Source Income Deferral) Act (No. 1) 2010, repealing its FIF provisions as of the 2010-2011 income year. The new general exemption on income tax for FIF investments is to soon be accompanied by a specific anti-avoidance provision which aims to prevent the avoidance or deferral of tax from investing offshore (the anti-roll-up rule). The draft legislation for the anti-roll-up rule, as detailed in (Australian) Exposure Draft 1793 – Tax Laws Amendment (Foreign Source Income Deferral) (No. 2) Bill 2010: Anti-roll-up rule, will operate where:

• An investor has an interest in a "foreign accumulation fund"¹;

• The investor is deemed to derive a "tax deferral benefit"² under a scheme for the income year; and

• It is reasonable to conclude that an entity that entered into or carried out the scheme did so for the sole or dominant purpose of that entity or another entity obtaining a tax deferral benefit.³

The target of this legislation is investment in FIFs that reinvest interest-like returns. The rule is narrowly defined in order to target what could be seen as the most abusive cases of tax deferral.

The FEC recommended that the Australian approach not be adopted in New Zealand. In the FEC's view, the limited scope of the proposed Australian anti-roll-up rule would not provide an adequate guard against the fiscal risk of New Zealand taxpayers shifting passive income-producing assets offshore. It was also noted that such a system would not be suitable in New Zealand because there is no general capital gains tax, such as there is in Australia.

It also noted that this approach would not satisfy one of the primary goals of the Bill, which was to align the various rules applying to the taxation of outbound investments. An exemption for FIF investments would lead to stark differences in the tax treatment of an investment depending upon whether it was in a FIF or a CFC. Such differences, the FEC observed, could distort decisions about the size of an interest to hold in a foreign investment and put pressure on the boundary between the CFC and FIF rules.

The grey-list exemption should be retained

As was the case with the introduction of the new CFC regime in 2009, the Bill proposes to remove the grey-list exemption for non-portfolio FIF interests (although non-portfolio FIFs in Australia will remain exempt). The submissions opposed this on the grounds that:

• There is little scope for investors to use the grey-list exemption for non-portfolio FIFs to avoid or defer tax, yet removing the exemption will cause a significant increase in compliance costs;

• The retention of the grey list helps define the focus of the FIF rules as a regime that is concerned with tackling avoidance and the deferral of income from low or nil tax jurisdictions;

• Very little additional New Zealand tax will be collected as a result of removing the grey-list exemption, as a credit is likely to be granted in New Zealand for tax paid in the grey list country; and

• Because an Australian exemption is to be introduced, the same logic should apply to other countries that New Zealand has previously regarded as having a similar taxation system.

The FEC was not convinced by these arguments. It noted that the grey-list was removed for portfolio FIF interests in 2007, CFC interests in 2009, and that the reasons for removing it for non-portfolio FIF interests in the Bill are the same.

The FEC responded to these suggestions by noting:

• The grey-list is arbitrary and distortionary, and creates a preference to invest in traditional, high tax jurisdictions;

• The assumption of comparable taxation in the grey-list countries cannot be relied upon for passive income;

• The technical differences in other grey-list countries' treatment of entities would allow for income to flow through grey-list entities without being taxed (the examples given for this were Australian unit trusts and United States limited liability companies); and

• The introduction of an Australian non-portfolio FIF exemption is justified on the grounds that many smaller businesses first invest in Australia when investing offshore, and the close relationship between the two countries' revenue authorities means that any differences can be readily identified and monitored (which is not the case for the other grey-list countries).

The use of GAAP in applying the active business test

Under the CFC rules, as well as the rules proposed in the Bill, the active business test can be applied on an accounting basis, or on a more complex tax basis. However, a taxpayer may only elect to use the accounting basis where the investment entity's accounts comply with international accounting standards (IAS).

It was submitted to the FEC that taxpayers should be able to apply the active business test based on the FIF's local accounting standards, or local generally accepted accounting principles (GAAP), rather than IAS. This submission was supported by the suggestion that many jurisdictions, most notably the United States, do not use IAS. Further, where IAS accounts are not available, the active income exemption must be applied under the complex tax method, which is likely to drive many taxpayers away from the AFI method to the FDR method. Because FIF interest-holders do not have the same level of control as CFC interest-holders, and accordingly will be unavailable to obtain the level of information required to determine the IAS accounts, it was argued that the Bill should be amended to allow this concession.

This submission was accepted in part by the FEC. It agreed that the most compelling case concerns the United States, as it would be impractical for a non-controlling shareholder to insist that a United States company prepare IAS accounts for New Zealand tax purposes. Therefore, it was recommended that taxpayers should be able to apply the active business test based on accounts prepared in accordance with United States GAAP.

However, the FEC did not consider that there was a strong case for allowing the use of GAAP in countries other than the United States, as most other countries have adopted IAS or have standards that are close to IAS. The FEC's conclusion in this regard was in direct contrast to the submission that many countries do not in fact use IAS. It was also noted that there are risks from allowing local GAAP from other countries, as some GAAP standards may not correctly identify passive income, meaning that significant amounts of income could escape tax.

The CFC and FIF rules should be structured in a more coherent manner

Submissions were made that the CFC and FIF rules should be structured in a more comprehensible manner. There were two suggestions for how this may be achieved:

• For the CFC and FIF rules to be rewritten and restructured into portfolio and non-portfolio sections; and/or

• To have a separate stand-alone section for the FIF rules, which under the Bill will "plug in" to the existing CFC rules.

These concerns were noted by the FEC. It agreed that as a result of the reforms in 2007 and 2009, and now those proposed by the current Bill, the structure of New Zealand's CFC and FIF rules is not ideal. However, it also stated that any restructuring or rewrite would be a complex exercise that is not practical at this time, although such an exercise may be considered for inclusion as part of a future tax policy work programme.

Other submissions

The FEC accepted a submission that the exemption from attribution for interest, rent and royalty payments between FIFs in the same jurisdiction should extend to FIFs with the same parent company, rather than just applying to payments between parent and subsidiary companies.

The FEC also received, and declined, the following submissions:

• That the passive income threshold for the active business test should be raised from 5 per cent to 10 per cent or 15 per cent;

• That consolidated accounts of FIFs should be able to be used in calculating an investor's attributed income under the AFI method;

• That the comparative value method should be available for all companies, in addition to individuals and trusts; and

• That the branch equivalent method and accounting profits method should be retained for those investors not using the AFI method.

The FEC also suggested that investors with portfolio CFC interests should be able to use the AFI method in certain circumstances, even though that method is generally limited to non-portfolio investments. The reason was that several investors with portfolio investments in CFCs currently use the branch equivalent method, which the Bill replaces with the AFI method, and those investors may be placed in a much worse position if required to use the FDR or cost methods. This concession will be allowed where the portfolio interest is in a CFC, the shares in the CFC are not widely traded, and the investor is not a listed company or managed fund.

Conclusion

As it stands following the FEC's report, the proposed FIF rules are much improved from those first suggested in this current reform process. However, further progress could have been made on reducing unnecessary compliance costs for taxpayers. It remains probable that many investors will choose to apply the FDR method in order to avoid the costs of compliance with the AFI method.

It is disappointing that the FEC dismissed the option of repealing the FIF rules so readily. Although we agree with the FEC's view that the inherent uncertainties of the Australian approach in its current form may not be suitable for New Zealand's purposes, further consideration could have been given to alternatives. A repeal of the FIF rules, coupled with a more robust anti-avoidance provision in relation to FIF investments, could reduce taxpayer compliance costs without posing too great a risk to the New Zealand tax base.

The complexity of the AFI method also remains a concern. There was an expectation that greater improvements would have been made to simplify the AFI method in recognition of the fact that FIF investors lack the degree of control that CFC investors have. The CFC regime contains an already complicated set of rules, which will be even more difficult to apply once the new non-portfolio FIF rules are placed within the same framework. It is hoped that the FEC's recognition of the current confusion in this area is a sign of structural reform in the not too distant future, as the best method for simplifying the rules may be to completely redraft and restructure New Zealand's outbound investment legislation into a more accessible, coherent form.

 

¹ A foreign accumulation fund is defined as a non-resident entity that is not a CFC, which has investment returns that are subject to a low level of risk, and which does not distribute substantially all of its profits and gains for an income year within three months of year-end.

² A tax deferral benefit will be deemed to arise where the total profits and gains of the entity exceed the total distribution of profits and gains to an investor, during an income year.

³ Matters relevant to determining purpose will include: (a) the distribution pattern of the fund; (b) whether the tax payable by the investor on the tax deferral benefit, if it was included in the investor's income, would be materially different from the tax actually paid by the fund on the amount of the tax deferral benefit; and (c) any matters relevant to the general anti-avoidance provision.