Attributable income

Section EX 20B of the Income Tax Act 2007

Section EX 20B insets a definition of income that is attributable to a CFC (referred to in the legislation as the attributable CFC amount). This definition is central to the new CFC rules. The definition is applicable, in the first instance, in the active business test to decide whether a CFC is active or passive. If the CFC fails the active business test, it will have attributable income that must be attributed to the New Zealand shareholders.

Key features

Attributable income (section EX 20B of the Income Tax Act 2007)

The definition of "attributable CFC amount" can be divided into broad categories. The types of income that come under the definition include interest, royalties and rents, being income that is highly mobile and not location-specific. However, exceptions apply when the income is associated with an active business and there is limited risk to the New Zealand tax base.

The broad categories of attributable CFC amount are as follows:

• certain types of dividend;
• interest;
• royalties;
• rents;
• other attributable income (income from offshore insurance businesses, life insurance policies, personal services and the disposal of revenue account property);
• certain income related to telecommunications services; and
• base company services income.

A number of exceptions are also provided for under section EX 20B. For example carve-outs are provided for certain royalty payments, certain rents and telecommunication services. If an item of income falls within the scope of any one of the exceptions, that item of income will be excluded from the definition of "attributable CFC amount" unless that item of income is caught in another paragraph of subsection EX 20B(3) or (4).

Detailed analysis

Certain types of dividend (subsections EX 20B(3)(a) to (c))

The dividends that are included in the attributable CFC amount match the foreign dividends that would be subject to income tax (not exempt under section CW 9) if received by a company resident in New Zealand. They also include unimputed dividends received from New Zealand companies. More specifically, the attributable dividends are:

• dividends from a less than 10 percent interest in a FIF described in sections EX 31, EX 32, EX 36, EX 37, EX 37B or EX 39 (section EX 20B(3)(a)). These comprise shares in ASX-listed Australian companies, Australian unit trusts with adequate turnover or distributions, certain venture capital investments into New Zealand companies that have since migrated to a grey list country, and shares in Guinness Peat Group plc;
• dividends from fixed-rate foreign equity (section EX 20B(3)(c));
• dividends from deductible foreign equity (section EX 20B(3)(c));
• dividends received by CFCs from New Zealand companies to the extent that they are unimputed (section EX 20B(3)(b)).

If the CFC holds an attributing interest in a FIF that is calculated using the comparative value, deemed rate of return or fair dividend rate methods, any dividends from this FIF will not be included in the attributable CFC amount. This is because these FIF interests have no income other than FIF income under section EX 59(2).

Fixed-rate foreign equity and deductible foreign equity are defined in section YA 1.

Fixed-rate foreign equity includes foreign dividends that are a specific, fixed percentage of the amount paid for the equity (as well as variations on this) and any dividend that is regarded as equivalent to payment for money lent.

A deductible foreign equity distribution is a dividend where the foreign company paying the dividend (or another company owned by or on the same group as the foreign company which pays the dividend) is allowed a deduction for the payment of the dividend against foreign income tax.

Subsection EX 20B(3)(b) deals with dividends paid by a New Zealand company to the CFC. A New Zealand dividend that is fully-imputed will not be included in the attributable CFC amount. A partly imputed dividend will only be attributed to the extent to which it is not imputed.

Note that although there is an exemption for dividends paid within a New Zealand wholly owned group (section CW 10), a dividend paid by a New Zealand company to a CFC that is in the same wholly owned group as the New Zealand company will still be attributable to the extent to which it is not imputed.

Financial arrangement income and interest (subsections EX 20B(4) and EX 20B(12))

The definition of "attributable CFC amount" includes income from financial arrangements held by a CFC. Section EX 20B(4)(a) and (b) sets out the criteria when financial arrangement income is caught within the definition of "arrangement income". Paragraph (a) includes a financial arrangement or short-term agreement for sale and purchase for which the CFC has made an election under section EW 8 (Election to treat certain excepted financial arrangements as financial arrangements) into the definition of "arrangement income". However, income from a financial arrangement that is not a derivative instrument is not attributable if the financial arrangement is:

• a loan provided by the CFC to an associated active CFC in the same jurisdiction (section EX 20B(12)(a)); or
• an agreement for the sale or purchase of property or services or a hire purchase agreement that is entered in the ordinary course of a business by the CFC or for property or services produced or used in the CFC's business (section EX 20B(12)(b)).

Income from financial arrangements that are derivative instruments is attributable if the derivative instrument is held for the purposes of dealing in the derivative instrument, is not entered in the ordinary course of the CFC's business or is a hedge instrument for attributable income or for a transaction that produces income that is attributable (section EX 20B(4)(b)).

Under the financial arrangements rules, an instrument will give rise to either income or expenditure. If an arrangement gives rise to income, that income is included in a CFC's attributable CFC amount, subject to the rules described above. Expenditure under a financial arrangement is dealt with separately, under the rules for calculating net attributable CFC income or loss in sections EX 20C to EX 20E. There is no "netting off" between financial arrangements. Thus, if a CFC holds one financial arrangement giving rise to income and another that gives rise to, say, an equal amount of expenditure, income and expenditure from the two instruments cannot be directly offset against each other. Rather, income from the first arrangement must be included as appropriate under section EX 20B and expenditure under the second arrangement must brought in under sections EX 20C to EX 20E.

Royalties (subsection EX 20B(5))

The general rule under the new international tax rules is that royalties (as defined in section CC 9 of the Income tax Act 2007) are included within the definition of "attributable CFC amount" unless they fall under one of four exceptions. The four exceptions ensure that when there are genuine commercial reasons for the intellectual property to be owned by a CFC, any royalties the CFC derives from that property will not be subject to attribution. The four exceptions are:

1. Third-party active royalties (subsection EX 20B(5)(a))
   This refers to royalties received by a CFC from a third party where:
   • the CFC has created, developed, or added substantial value to the intellectual property;
   • the CFC is regularly engaged in the activity of creating, developing, or adding substantial value to the intellectual property; and
   • the property does not have a prior link to New Zealand.
   
   
2. Related-party active royalties (subsection EX 20B(b))
   This refers to royalties received by a CFC from a related CFC where:
   • the CFC has created, developed, or added substantial value to the intellectual property;
   • the CFC is regularly engaged in the activity of creating, developing, or adding substantial value to the intellectual property;
   • the royalty is at an arm's-length amount under transfer pricing rules; and
   • the property does not have a prior link to New Zealand.
   
   
3. Same jurisdiction active royalties (subsection EX 20B(5)(c))
   This refers to royalties received by a CFC from a related CFC where:
   • the related CFC is within the same jurisdiction as the CFC;
   • the related CFC would pass the active business test; and
   • the property does not have a prior link to New Zealand.
   
   
4. Royalties from property owned by a New Zealand resident (subsection EX 20B(5)(d))
   This refers to royalties received by a CFC from a third party where:
   • the intellectual property is owned by a New Zealand resident and is licensed to the CFC; and
   • it is licensed between the New Zealand owner and the CFC for an arm's-length amount applying transfer pricing rules.

Third-party active royalties (subsection EX 20B(5)(a))

Royalty payments received from a third party are not considered to be attributable if the CFC satisfies the criteria set out in section EX 20B(5)(a). The criteria are:

• the CFC has created, developed, or added value to intellectual property;
• the CFC is regularly engaged in the activity of creating, developing, or adding substantial value to the intellectual property;
• the royalty is paid by a person who is not associated with the CFC; and
• the intellectual property does not have a prior link to New Zealand.

 

Related-party active royalties (subsection EX 20B(5)(b))

Royalty payments received from a related party are not considered to be attributable if the CFC meets the criteria set out in section EX 20B(5)(b):

• the CFC has created, developed or added value to intellectual property;
• the CFC is regularly engaged in that activity;
• the royalty is paid by a person who is not associated with the CFC;
• the royalties are at an arm's-length amount under transfer pricing rules; and
• the intellectual property does not have a prior link to New Zealand.

The criteria for this exclusion are the same as those in the third-party active royalty exclusion (section EX 20B(5)(a)), with the additional requirement that the royalty must be at an arm's-length amount under transfer pricing rules (section EX 20B(5)(b)(iv)).

 

Same jurisdiction active royalties (subsection EX 20B(5)(c))

Royalty payments received from a related party are not attributable if it meets the criteria set out in section EX 20B(5)(c):

• the related CFC is liable to tax in the same jurisdiction as the CFC;
• the related CFC would pass the active business test; and
• the property does not have a prior link to New Zealand.

While this exclusion only applies to related parties, it is important to note that the requirements are different from the related-party active royalty exclusion under section EX 20B(5)(b).

In particular, the CFC paying the royalty must pass the active business test, in the absence of applying this royalty exclusion (section EX 20B(5)(c)), the same jurisdiction rent exclusion (section EX 20B(7)(c)) and the same jurisdiction financial arrangement exclusion (section EX 20B(12)(a)). This issue of circularity will be discussed in more detail at the end of this section.

 

Regularly engaged in creating, developing or adding substantial value to intellectual property (subsection EX 20B(5)(a) and (b))

Central to the third-party active royalty and related-party active royalty exclusions is the requirement that the CFC be regularly engaged in creating, developing or adding substantial value to intellectual property. The requirement that the CFC be regularly engaged in creating and/or enhancing intellectual property is aimed at ensuring that there is a genuine commercial rationale for the intellectual property to have been developed by a CFC in that particular jurisdiction. The exclusions are not intended to apply to CFCs that create and/or enhance intellectual property on a one-off basis.

 

 

Property linked to New Zealand (subsection EX 20B(13), (14) and (15))

Of the four royalty exclusions, three of them require that the intellectual property generating the royalty income not be linked to New Zealand. The reason for this is that intellectual property is highly mobile and can be easily transferred and held offshore, royalties relating to intellectual property that has a link to New Zealand are therefore attributable. However, it is recognised that there may be legitimate commercial reasons for intellectual property to be held offshore, therefore there is a mechanism in the legislation to allow the intellectual property to break its link to New Zealand.

Section EX 20B(14) sets out the situations when the intellectual property will create a link with New Zealand. It includes situations that are relatively straightforward. Subsection EX 20B(15) sets out the circumstances where the intellectual property's link to New Zealand is broken. In particular, this is when the intellectual property is sold offshore to an unrelated third party that is not a New Zealand CFC. Note that the intellectual property can re-establish its link to New Zealand, if at any time, it meets any one of the situations set out in subsection (14).

 

 

Royalties from property owned by a New Zealand resident (subsection EX 20B(5)(d))

Royalty payments received from a third party on property that is owned by a New Zealand resident are not attributable if the payments meet the criteria in section EX 20B(5)(d):

• the intellectual property is owned by a New Zealand resident and licensed to the CFC; and
• it is licensed between the New Zealand owner and the CFC for an arm's-length amount applying transfer pricing rules.

Note that if the property is owned by a New Zealand resident that is treated as non-resident under a double tax agreement, that person will not meet the residence requirement of this exclusion (section EX 20B(5)(d)(ii)).

This exclusion also contemplates the situation where an upper-tier CFC may sublicense the property to a lower-tier CFC which then licenses it to a third party (section EX 20B(5)(d)(i)).

 

Rents (subsections EX 20B(3)(e), EX 20B(6) and EX 20B(7))

The general rule is that rent earned by a CFC will be treated as attributable income. Section EX 20B(6) sets out the types of rental payment that are subject to attribution. The following rents are attributable:

• a lease or sublease of land;
• a lease or sublease of personal property;
• a licence to use intangible property; and
• a hire or bailment.

However, it is recognised that rent is often associated with running an active business. For example, a CFC may be in the business of letting or it may hold property used by related CFCs for the purposes of running an active business and receive rental income from those CFCs.

For that reason, subsections EX 20B(7)(a) and (b) exclude rent from third parties from attribution if it is derived from a lease of real or personal property in the same jurisdiction as the CFC.

Furthermore, rent received by a CFC from a related CFC is not attributable when the related CFC would pass the active business test, as long as both CFCs are liable to tax in the same jurisdiction (section EX 20B(7)(c)).

 

Section EX 20B(7)(d) (Payment under hire purchase agreements and finance leases) and payments that fall within the definition of "royalty" under section CC 9 of the Income Tax Act 2007 are not considered as rent under the definition of "attributable CFC amount", but may be - and are likely to be in some cases - attributable under other provisions. For example, income from finance leases is attributable as arrangement income and payments that fall within the definition of "royalty" will be attributed under the royalty provision.

In the case of licence fees received for the use of intangible property, the royalty provisions will apply to these payments, as the royalty exclusions in subsection EX 20B(5) will apply (see subsection EX 20B(7)(g)). In short, the royalty exclusions are still applicable to rents from a licence to use intangible property, even though these payments fall outside the scope of the definition of "royalty".

Other attributable CFC amounts

The definition of "attributable CFC amount" includes types of income other than dividends, interest, royalties and rents. These types of income relate to:

• offshore insurance businesses;
• life insurance policies;
• personal services; and
• the disposal of revenue account property.

Income from offshore insurance business (subsection EX 20B(3)(f))

Section EX 20B(3)(f) generally treats the premium of an insurance contract or a reinsurance contract as attributable income. However, when this type of income forms the core part of a CFC's insurance business, that CFC can apply for a Commissioner's determination. A process has been established (see Determination of active insurance active business) to enable active insurance CFCs to be considered to have passed the active business test (and be treated as a non-attributing active CFC). This is a temporary measure until special rules are considered for extending the active income exemption to financial institutions.

Income from life insurance policies (subsections EX 20B(3)(g) and EX 20B(8))

Income from life insurance policies is generally treated as attributable under section EX 20B(3)(g). Subsections EX 20B(8)(a) to (c) sets out the circumstances when the income from life insurance policies is considered an attributable CFC amount. Accordingly, income a CFC derives from holding a life insurance policy is treated as attributable income (subsections EX 20B(8)(a) and (b)). Additionally, income from a disposal of the life insurance policy is also attributable to the extent that these policies are on revenue account (section EX 20B(8)(c)).

However, section EX 20B(8) provides that income from life insurance policies that are FIF interests is not subject to attribution under the CFC rules, as that income is already attributed under the FIF rules. Net gains from the disposal of such interests will continue to be attributable where the net gain is not taxable under the FIF rules.

Income from personal services (subsections EX 20B(3)(h), EX 20B(9) and GB 27(3)(e))

Income from personal services is treated as attributable if it meets the criteria set out in subsection EX 20B(9). However, there is an important distinction between income from personal services and other forms of attributable income because this income will always be subject to attribution irrespective of whether the CFC passes the active business test. Another way to look at this is that a non-attributing active CFC will still be required to attribute any personal services income it receives even if it passes the active business test - because less than 5 percent of its total income is income that is subject to attribution.

Furthermore, such income will be disregarded for the purposes of applying the active business test (see subsections EX 21(D)(7) and EX 21E(12)(c)).

In many ways the criteria set out in subsection EX 20B(9) is an extension of the domestic attribution rule for income from personal services (see sections GB 27 to 29).

The personal services income will be considered as attributable income if it meets all of the following criteria:

• The "working person" is a New Zealand resident.
• The personal services are not essential support for a product supplied by the CFC.
• The individual and the CFC are associated persons under section YB 3 (Company and non-corporate 25 percent interest holder) or the individual is a relative of a person associated with the CFC under section YB 3 at the time the services are performed.
• At least 80 percent of the CFC's gross income from personal services during the tax year relates to services personally performed by the individual (or a relative of the individual).
• Substantial business assets are not a necessary part of the business structure that is used to derive the income from personal services. (That is, to derive the income, the CFC uses depreciable property that, at the end of the accounting period, has a total cost of more than either $75,000 or 25 percent or more of the CFC's total assessable income from services performed in that period.)

Note that section EX 20B(9)(b) provides that when the services personally performed by the individual are essential support for a product supplied by the associated entity, they are not subject to attribution. This is because the provision is not intended to apply to income earned from services that are provided in relation to the sale of goods by a CFC. Therefore income from personal services is not subject to attribution if the services are essential support for a product supplied by the CFC.

Another important point to note about the personal services rule under the CFC rules is that if the personal services income is attributed under those rules, the domestic attribution rule will be "switched off" (subsection GB 27(3)(e)). This will ensure that the personal services income will only be attributed once to the "working person".

Income from the sale of shares (subsections EX 20B(3)(i) and EX 20B(10))

Section EX 20B(3)(i) defines income from the sale of shares that are on revenue account as attributable CFC income while section EX 20B(10) sets out the exceptions to this. Revenue account gains are disregarded when a CFC sells an interest in a FIF whose income is calculated using either the comparative value, deemed rate of return, fair dividend rate or the cost method. This is consistent with the way in which these gains would be treated if held directly by a New Zealand company.

Income from the disposal of share options (subsection EX 20B(3)(j))

Section EX 20B(3)(j) provides that income from the disposal of share options held on revenue account is treated as attributable income. This is consistent with the treatment of income from the disposal of shares held on revenue account, as discussed above.

Income from the disposal of revenue account property (subsection EX 20B(3)(k))

Gains from the disposal of revenue account property held by a CFC that is not used in an offshore active business will be treated as attributable income (section EX 20B(3)(k)).

However, this rule does not apply to income from the disposal of revenue account property if the property is a share, financial arrangement or life insurance policy, as these items are dealt with specifically in other parts of the definition of attributable CFC amount.

Base company income (subsection EX 20B(3)(l))

Under subsection EX 20B(3)(l), income derived by a CFC for a service that is wholly or partly performed in New Zealand is defined as attributable income of the CFC.

International telecommunications services are excluded from the base company income rule. Income derived from telecommunication services are dealt with in another subsection.

Income from telecommunications services (subsections EX 20B(3)(m) to (n) and EX 20B(11))

Certain income from telecommunications services is attributable income.

Income from the use of a telecommunications asset outside any country (subsection EX 20B(3)(m))

Income derived from the use of a telecommunications asset that is wholly or partly located outside any country is attributable income. In the event that only part of the asset is located outside any country, apportionment will be required.

This rule only applies if the asset is owned by the CFC or another CFC that is associated with the CFC.

Assets that are subject to this subsection include (but are not limited to) telecommunications cables, satellites, and associated plant, equipment and facilities. The rule does not apply to a cellphone handset or transmitting equipment located on board a ship or aircraft.

The types of income that would be derived from the use of a telecommunications asset include (but are not limited to) income from the transmission of telecommunications data using the asset; the lease of the asset; and the licence or sale of rights - whether direct or indirect - to use the asset.

Income when telecommunications services performed in New Zealand (subsections EX 20B(3)(n) and EX 20B(11))

Consistent with "base company income", income as a result of providing a telecommunications service is generally taxable to the extent the service is physically performed in New Zealand (paragraph EX 20B(3)(n)).

However, an exception is made when the service is the transmission, emission or reception of information between New Zealand and the CFC's country of residence (subsection EX 20B(11)). In this instance, there is a decreased likelihood that the CFC has been established to escape New Zealand tax, because such a service typically must be partly performed in both locations. There also appears to be a greater-than-normal degree of practical difficulty in calculating the income attributable to services performed in New Zealand.

The exception applies only if two requirements are met. The first requirement is that there be a close connection between the CFC and a network operator. The term "network operator" is defined in the Telecommunications (Interception Capability) Act 2004. A sufficiently close connection exists if:

• the CFC is a network operator; or
• a person who is a network operator holds a 50 percent or greater income interest in the CFC; or
• a person who has a 50 percent or greater voting interest in a network operator also holds a 50 percent or greater income interest in the CFC.

The second requirement is that the service is not performed using equipment or staff of the CFC, or of an associated CFC, that is physically located in New Zealand. The expectation is that the New Zealand owner of a telecommunications CFC would use its own equipment and staff at the New Zealand end of the connection, rather than the CFC's. The second requirement reduces the incentive to substitute the CFC's staff or equipment merely to escape the tax that the New Zealand owner would ordinarily pay on these New Zealand operations.

The exception in subsection EX 20B(11) is only an exception to paragraph EX 20B(3)(n). For example, if paragraph EX 20B(3)(m) applies to an amount of income to which subsection EX 20B(11) also applies, the income is attributable.

Exclusions for rent, royalties and interest received from an associated CFC in the same jurisdiction (subsections EX 20B(5)(c), EX 20B(7)(c) and EX 20B(12)(a))

As noted in the sections above, certain rent, royalties and financial arrangement income from associated active CFCs in the same jurisdiction as the CFC is excluded from attribution (see subsections EX 20B(5)(c), (7)(c) and (12)(a)).

There is a possibility that the status of the associated CFC cannot be determined, because the associated CFC itself needs to apply the same exclusions.

As a solution to this circularity problem, when a CFC (CFC A) determines the status of an associated CFC (CFC B), it will do so without applying any of the exclusions to CFC B. That is, for this purpose only, CFC B's status is to be determined assuming that any rent, royalties or interest it receives from an associated CFC in the same jurisdiction is subject to attribution.