Questions and Answers: International Tax Discussion Document
1. What are the major changes for New Zealand’s international tax
rules contained in the discussion document?
The discussion document explores three key areas for change:

Relaxation of the current controlled foreign company (CFC) rules by
introducing an active income exemption. In broad terms, “active”
income would include income derived from active business, such as
manufacturing or industrial activity. In contrast, passive income,
which includes investment-type income such as dividends, interest,
rents and royalties, would continue to be taxed on an accrual basis.

Related changes to other aspects of our international tax rules such
as the interest allocation rules, to protect the New Zealand domestic
tax base.

Possible changes to New Zealand’s tax treaty policy on non-resident
withholding tax (NRWT) on dividends, interest and royalties.
2. What are these changes intended to achieve?
The possible changes outlined in the discussion document are aimed at
improving New Zealand’s international competitiveness. They would bring
New Zealand’s international tax system into line with international norms,
recognising that there could be costs to being different. The tax system plays
an important role in fostering a competitive business environment and, as
such, is a key focus of the government’s Economic Transformation agenda.
The changes are aimed at promoting an enabling environment that allows
New Zealand firms to internationalise and makes New Zealand better able to
attract and retain capital.
Controlled foreign company (CFC) rules
3. What are the CFC rules and how are our rules different?
New Zealand’s current CFC rules are designed to tax all offshore income of
CFCs as it accrues, with a credit for foreign taxes paid. This approach is out
of step with international norms, where active income is generally exempt
from tax or has tax deferred until it is returned in the form of dividends.
Australia, for example, has an active income exemption in its CFC rules.
4. Who will benefit from the proposed exemption for offshore active
income?
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An exemption for the active income of CFCs would benefit New Zealand firms
operating overseas by placing them on a more equal footing internationally. It
would remove an additional tax cost not faced by firms based in comparable
jurisdictions, such as Australia. These New Zealand firms would not only see
a potential reduction in their tax burden, but a reduction in tax compliance
costs would also be likely.
The example at the end of these questions and answers illustrates the
benefits of such an exemption for a New Zealand firm with a manufacturing
subsidiary in China.
5. How would the exemption for offshore active income improve
New Zealand’s international competitiveness?
An exemption for offshore active income would make New Zealand relatively
more attractive as a location for global firms. As the current CFC rules are
more comprehensive than those of other countries, New Zealand-resident
firms with offshore operations may face a higher tax burden than firms
resident in comparable jurisdictions, creating an incentive for New Zealand
firms to migrate. An exemption for offshore active income would align New
Zealand’s rules with those of other countries, removing this factor as an
incentive for firms to migrate, and would make New Zealand more attractive
for foreign investment. It would also reduce the tax costs for New Zealand
firms looking to expand their operations offshore.
6. What other changes to the international tax rules are likely to be
necessary if offshore active income is exempt from New Zealand
tax?
If offshore active income were exempt from New Zealand tax, consequential
changes to the interest allocation rules would be necessary to protect the
domestic tax base. The “grey list” exemption under the current CFC rules and
the conduit rules might no longer be necessary if offshore active income were
exempt from New Zealand tax.
7. What are the compliance cost implications for New Zealand firms?
CFC rules with an active/passive distinction could be simpler in operation than
our current rules for the types of firms and activities the change would seek to
benefit. A firm with genuinely active operations abroad would no longer face
the compliance costs of applying New Zealand tax rules to its foreign
operations that exist under the current CFC rules. If dividends could be
exempted, the firm would not need to comply with the dividend withholding
payment rules.
The one area of extra complexity could be the extension of our interest
allocation rules, which would be necessary to target the exemption
appropriately. However, these rules should affect only those firms that overallocate their global interest costs against their New Zealand income. In
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addition, these rules would rely on domestically available information, and
should be reasonably straightforward to apply.
8. How would the new rules compare with Australia’s?
Changes canvassed in the discussion document would bring our CFC rules
more in line with international norms and Australia’s system of taxing offshore
income. However, the design of the New Zealand system would need to
reflect the realities of our business environment and other features of our tax
system.
9. When will the government make decisions on the possible
changes?
The government recognises the importance of CFC reform for New Zealandbased firms with offshore CFC investment. Once submissions have been
received and analysed, the government expects to be in a position to make
decisions on the options by mid-2007.
Non-resident withholding tax (NRWT)
10. How would lower NRWT rates benefit New Zealand firms?
Lower treaty rates of NRWT would encourage inward investment. This would
complement a lowering of the company rate from 33% to 30%, one of the
options set out in the recent Business Tax Review discussion document.
Lower treaty rates of NRWT would also benefit New Zealand firms investing
offshore, because they would enjoy lower rates of foreign withholding tax.
This would increase after-tax returns from outbound investment, consistent
with the International Tax Review’s focus on international competitiveness.
11. Why is the case for reducing NRWT on dividends stronger for
direct investment than for portfolio investment?
The international trend is to reduce rates on non-portfolio dividends. For
example, Australia has agreed lower rates on such dividends with the United
States and the United Kingdom, amongst others. Lower treaty limits on
portfolio dividends are less common internationally. The OECD continues to
recommend NRWT of 15% on such dividends, which is consistent with New
Zealand’s current treaty policy.
12. Why might reduced rates on interest and royalties not be
justified?
There are likely to be material fiscal costs and avoidance implications. These
may outweigh any benefits associated with lower rates.
13. Why rely on double tax agreements? Why not just reduce rates in
domestic law?
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Reducing rates of NRWT makes sense only if done through bilateral treaty
negotiations because of the potential benefits of agreeing reciprocal changes
with our major trading partners, which will benefit New Zealanders investing
offshore.
Example – Impact of an active income exemption
The move to an active income exemption under New Zealand CFC rules
would be a significant policy shift designed to benefit New Zealand firms with
outbound investments.
Consider a New Zealand company, NZ Co, with a manufacturing subsidiary in
China, China Co, which earns a net income of $100. Under China’s foreign
enterprise income tax, special reductions in tax rates are provided in the first
years after an investment is made. This income is fully exempt in the first and
second profitable years, and a fifteen percent rate of tax applies in the third,
fourth and fifth years.
If China Co is in its first year of operation in China and is fully exempt from tax
in China, NZ Co would still be subject to tax on that income in New Zealand
under the current CFC rules. A company like NZ Co would be taxable in New
Zealand on its global profits of $100, and would pay $33 in tax. On the other
hand, if the foreign income were taxed in China at 15%, New Zealand would
provide tax credits for any taxes paid in China. The total tax that the NZ Co
faces would still have been $33 in total, but $15 would be paid to China and
$18 to New Zealand.
If there were an active income exemption, New Zealand firms would be able
to benefit from any tax exemption or reduced tax rate that China offers. The
income of China Co would not be taxable in New Zealand. Taxes payable in
New Zealand would be eliminated, and the net returns to New Zealand
investors would increase correspondingly. This treatment would be consistent
with other countries’ treatment of offshore active income and would remove
the current incentive for New Zealand firms to migrate to other countries to
gain access to the reduced taxation.
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Current rules
Foreign
income
exempt in
China
CFC income
New Zealand tax at
33%
$100
With active income
exemption
Foreign
income taxed
at 15% in
China
$100
Foreign
income
exempt in
China
Foreign
income taxed
at 15% in
China
Exempt
Exempt
$33
$33
$0
$0
Credits for foreign
taxes paid
$0
$15
$0
$0
Tax payable in China
$0
$15
$0
$15
New Zealand tax
payable
$33
$18
$0
$0
Returns to NZ
investors
$67
$67
$100
$85
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