Company tax rate reductions - consequential and transitional amendments

Sections ME 8(1), MG 8(1) and MG 10(1) of the Income Tax Act 2004; sections CD 43(27)(b), GB 27(3), HA 15, LE 8, LE 9, LF 1, LF 6, LF 7, LP 2, LP 5, LP 8, OA 18, OB 7B, OB 16(1), OB 73, OB 75, OB 78, OB 80, OC 29, OD 1, OD 22, OE 2, OP 99, OZ 7 to OZ 17, RE 2(5)(i) and YA 1 and Table O1 of the Income Tax Act 2007; sections 140B, 140BB, 140C and 140CA of the Tax Administration Act 1994

A number of mainly transitional amendments have been made to the Income Tax Act 2007 and the Tax Administration Act 1994 in relation to imputation and dividend withholding payment (DWP) credit ratios, qualifying company election tax (QCET), branch equivalent and conduit memorandum accounts and foreign investor tax credits (FITC). These changes follow the reduction in the company tax rate, the tax rate for widely held savings vehicles and the top rate for portfolio investment entities (PIEs) from 33% to 30%. In addition, a few changes were made to the Income Tax Act 2004.

All section references are to sections of the Income Tax Act 2007 unless otherwise specified.

Background

In July 2006, the government released the Business Tax Review discussion document for public comment. It set out a range of possible business tax initiatives, including reducing the company tax rate to 30%, to help transform the New Zealand economy by enhancing productivity and improving our international competitiveness.

The resulting reduction in the company tax rate is intended to encourage more investment into New Zealand by businesses that have decided to locate here. This will tend to increase New Zealand's stock of plant, equipment and buildings, which will boost labour productivity.

The lower tax rate is also intended to reduce biases between different investments that companies undertake, leading to further capital productivity.

Finally, the reduction in the company tax rate will tend to encourage New Zealand companies to stay here, rather than shift to Australia or elsewhere. It will also increase the after-tax profits of companies, which means more funds are available for reinvestment.

Key features

Imputation and DWP credit ratios

The reduction in the company tax rate to 30% will automatically cause the maximum imputation credit ratio and the DWP ratio ("the tax credit ratio") to fall to 30/70 credits to cash. To ensure that shareholders are not disadvantaged by this, a transitional period has been introduced. During this period, a company will be able to allocate imputation and DWP credits at a maximum tax credit ratio of 33/67 on profits that have been taxed at 33%. The transitional period will run from the beginning of a company's 2008-09 income year to the end of its 2009-10 tax year (being 31 March 2010).

When the 33/67 tax credit ratio is used during the transitional period, the amount of imputation and/or DWP credits included as a credit against shareholder companies and widely held savings vehicles income tax liability will be capped at the 30/70 tax credit ratio, although the full credit will flow through to any imputation credit accounts.

Attribution of income from personal services

Relief is provided from double taxation by exempting dividends when a company paying dividends meets certain criteria.

Branch equivalent and conduit memorandum accounts

Effectively the net balances in these accounts that relate to periods when the tax rate was 33% will be reduced to reflect the lower corporate tax rate. This is necessary because credits in these accounts will be used to match future actual or potential income tax liabilities that will have been calculated using the lower company tax rate.

FITC

A reduction in the company tax rate will affect how FITC is calculated. When a dividend is imputed at 30/70 or less, the new 30/70 FITC formula will apply. If imputation credits exceed 30/70, they will be apportioned between 33% credits and 30% credits. As a result, two FITC formulas will apply during the transitional period.

Application dates

Most of the amendments apply from the beginning of the 2008-09 income year. The main exceptions are:

• the amendments that relate to a portfolio tax rate entity that does not choose to be subject to section HL 22, which will apply on and after 1 April 2008; and
• the removal of the references to imputation years in sections ME 8, MG 8 and MG 10 of the Income Tax Act 2004, which applies from 1 October 2007. This ensures that the maximum ratio by which a dividend can be credited is income-year related, and not imputation-year related.

Detailed analysis

The legislative changes are broadly grouped into two areas:

• new sections OZ 7 to OZ 17 (which are the substantive transitional amendments), and the "sign posts" to these sections; and
• a new imputation and DWP penalty tax in the Tax Administration Act for companies that over-distribute their 33/67 tax credits during the transitional period.

Technical issues

The amending Act (the Taxation (Business Taxation and Remedial Matters) Act 2007) contains a number of errors relating to the company tax rate change, generally attributable to the almost contemporaneous introduction of the Income Tax Act 2007. This item presumes that these errors have been fixed, but notes the corrections when appropriate. These errors are scheduled at the end of this TIB item. Generally they will be corrected retrospectively.

Terminating provisions

Imputation and DWP crediting ratios - now income year related

From the 2008-09 income year, the maximum imputation credit ratio in section OA 18 will change automatically from 33/67 to 30/70, in line with the company tax rate reduction. Sections ME 8, MG (8) and MG (10) of the Income Tax Act 2004 have had the reference to imputation year removed, so it is clear that the maximum permitted crediting ratio is income year related, not imputation year related. Section OA 18 of the Income Tax Act 2007 will be retrospectively amended to also provide this effect.

Moving directly to a maximum 30/70 imputation credit ratio in 2008-09 would have been the simplest option. However, it might have been difficult for some companies that want to distribute profits that have been taxed at 33% with full credit for these taxes before 2008-09.

A maximum tax credit ratio of 30/70 applying from 2008-09 would have potentially disadvantaged shareholders on income derived by companies before the new rate applied. "Trapped" credits may have occurred when the underlying tax that generated unused imputation credits was paid at 33%.

A number of shareholders would also have been disadvantaged because they would have needed to pay more tax than if the distribution had been made before the reduction in the company tax rate.

Override of maximum tax credit ratio - new transitional section OZ 8

An immediate credit ratio change to 30/70 for dividends at the start of companies' 2008-09 income year has the potential to disadvantage some groups of shareholders if the income that underpins the dividend has been taxed at 33%. In particular, presuming that for New Zealand shareholders company tax is a withholding tax, there would not be a full flow-through of credit for the underlying tax.

To deal with this problem, new section OZ 8 allows companies a transitional period in which the core imputation and DWP maximum ratios set out in section OA 18 can be overridden. The section sets out how companies can elect to allocate imputation and DWP credits up to a maximum ratio of 33/67 from the 2008-08 income year until the end of their 2009-10 tax year (being 31 March 2010), to the extent the underlying income was taxed at 33%.

The transitional rule has been crafted to ensure that the underlying income could have been that of another company, where that income has been passed up by way of dividend to a corporate shareholder (the corporate intermediary), whether in the transitional period, or before it. The corporate intermediary must be able to confirm that the relevant credits arose at the 33% tax rate. It could be that the dividend was fully credited at 33/67, or the corporate intermediary may have specific knowledge that the credits result from tax paid at 33%.

RWT may be deducted from a dividend or interest received by a company. When RWT has been deducted while the company tax rate was 33% the resulting imputation credits can be allocated at a ratio up to 33/67. However, RWT may be deducted at 33% when the company tax rate is 30%. This latter RWT is not available for 33/67 imputation credits as the credit does not arise from the application of the old company tax rate.

New transitional section OZ 9 - benchmark dividends

New section OZ 9 alters the benchmark dividend ratios in sections OB 61(4) and OC 48(4) when an election has been made to use the 33/67 tax credit ratio. Its purpose is to ensure that a change of tax credit ratio from 33/67 does not necessarily cause the benchmark dividend ratio to be changed.

In particular, companies can pay a subsequent dividend at the 30/70 ratio without having to go through the ratio change processes. This applies when a subsequent dividend is credited at 30/70 and the benchmark dividend is 33/67 because it was paid out before the start of the company's 2008-09 income year (in either the 2007-08 tax year for early balance date companies, and in the 2008-09 tax year for late balance date companies).

Likewise, when a subsequent dividend is credited at 30/70 and the benchmark dividend is 33/67 (which was paid using the provisions of section OZ 8 to over-credit), no ratio change declaration is necessary if the reversion is caused by the 33/67 credits running out.

Shareholders' tax credits - transitional section OZ 10

It should be noted that section OZ 10 will be retrospectively amended to have the following effects.

Sections LE 8 and 9, and sections LF 6 and 7 set out rules that determine or limit, in particular circumstances, the amount of imputation credit or FDP credit regarded as being attached to a dividend for shareholders. At a 30% company tax rate, this maximum is expressed by the ratio 30/70.

As discussed above, section OZ 8 allows for over-credited dividends to use a 33/67 ratio during the transitional period. This means that sections LE 8 and 9 and sections LF 6 and 7 need to be overridden to allow for the new section OZ 8 over-credited dividends. New section OZ10 increases the maximum tax credit ratio to 33/67 in sections LE 8 and 9 and sections LF 6 and 7, when the actual tax credit ratio of the dividend is greater than 30/70 and less than or equal to 33/67 to allow for over-credited dividends.

Limits on the amount of shareholders' tax credit - transitional section OZ 11

Section OZ 11 limits the imputation and FDP credits attached to dividends received that can be claimed as a credit against their tax liability by taxpayers whose tax rate is 30% (new tax rate persons). These taxpayers are companies and the various savings funds whose tax rate is 30%. The credit against tax liability is limited to 30/70, if the crediting ratio of the actual dividend received is higher than this.

The section LA 9 pointer to section OZ 11 will be retrospectively repealed and instead, a pointer in section LE 1(1) will be provided, to go with the existing section LF 1(1) pointer.

The policy rationale for the limitation is set out in the following example. Consider a new tax rate person that receives $100 of income during the 2007-08 income year and pays tax of $33 on this income. No further income tax implications would arise if the income was passed out to the new tax rate person as a dividend during the 2007-08 income year. This is the appropriate policy outcome, given that the company tax rate and tax rate on savings vehicles were aligned for the 2007-08 income year at 33%.

If, however, the dividend was received during the new tax rate persons' 2008-09 income year as a 33/67 dividend, in the absence of capping, the shareholder would have a grossed-up dividend of $100 on which $30 of gross tax would be payable. If section OZ 11 had not been introduced, this would be offset by a tax credit of $33, which would lead to a net tax credit of $3. This $3 of net credit would offset the tax due on $10 of other income, which is inappropriate.

(Note that where the recipient of the dividend is a company that keeps an imputation or FDP credit account, the full credit is credited. This is conceptually necessary to ensure that shareholders in this company can also receive the benefits of the 33/67 credit ratio.)

Credits for non-resident investors - transitional section OZ 12

Note that sections LP 2(2) and OZ 12 will be retrospectively amended to have the following effects.

In the Income Tax Act 2007, the amount of the credit for dividends paid to non-resident investors is determined according to the amount of the imputation credits that would have been allocated to the shareholder in the absence of subpart LP. ²⁰ The credit is calculated by multiplying the amount of imputation credits that would have been attached by a formula in section LP 2(2). This formula, as amended by the Taxation (Business Taxation and Remedial Matters) Act 2007, uses a ratio of 7/10. Given that the rewrite of the Income Tax Act changed the basis of the formula, this ratio should be 7/17, and this change will be made retrospectively.

However, this formula is not appropriate when the dividend is imputed at a higher ratio than 30/70 under the transitional rules. Transitional section OZ 12 provides that the section LP 2(2) formula shall be 67/120 when the dividend is imputed to 33/67. This will be retrospectively amended to 67/187 because of the change in the methodology from the Income Tax Act 2004 to the Income Tax Act 2007.

When the dividend is imputed between 30/70 and 33/67, the credits are apportioned and the section LP 2(2) formula is amended to 67/120 (and as above, this will be retrospectively corrected to 67/187).

Section OZ 12 also amends the relevant tax rate in the section LP 8(2) formula to 33% where appropriate, to parallel the treatment described above, and modifies the effects of section LP 5 to allow for the transitional formula.

Available subscribed capital amount - transitional section OZ 13

The concept of "available subscribed capital" is relevant when a company cancels its shares and pays consideration to compensate a shareholder for the cancellation. The calculation required to ascertain the extent of crediting of a dividend is set out in section CD 43(26). When the actual credit ratio exceeds 30/70 it is deemed to be 30/70 for the purposes of section CD 43(26).

Dividends from qualifying companies - transitional section OZ 14

When a qualifying company pays a dividend, the amount of the dividend that is taxable is limited to the amount that can be fully credited with imputation of FDP credits. The formula for this is set out in section HA 15. This provision has been over-ridden by section OZ 14 to allow for dividends to be over-credited during the transitional period.

Statutory producer boards and co-operative companies - transitional section OZ 15

Statutory producer boards and co-operative companies which are imputation credit account or FDP companies may allocate imputation credits or FDP credits to cash distributions and to notional distributions.

For a statutory producer board, the allocation of imputation credits to cash distributions must be done according to the formula in section OB 73(4). Section OB 75(2) allocates imputation credits for statutory producer boards' notional distributions.

For a co-operative company, the allocation of imputation credits to cash distributions must be done according to the formula in section OB 78(3). Section OB 80(2) allocates imputation credits for co-operative companies' notional distributions.

Transitional section OZ 15 amends the imputation provisions relating to statutory producer boards and co-operative companies to allow them to credit at 33/67 during the transitional period.

Branch equivalent tax account (BETA) and conduit tax relief account (CRTA) - transitional sections OZ16 and OZ 17

All entries that relate to 2007-08 and earlier years are to be adjusted to reflect the reduced company tax rate of 30% by multiplying them by 30/33.

Other amendments

Attribution of income from personal services

The attribution rule is an anti-avoidance rule designed to buttress the 39% rate. It targets higher income individuals who channel their income through an intermediary, frequently a company. It does this by deeming, in defined circumstances, the person providing the personal services to derive income that would otherwise be derived by the intermediary. Some double taxation can occur when the attribution rule is applied to income derived by a company because the cash still has to be extracted from the company as dividends.

Section OB 16 provides for an imputation credit to arise when income is attributed to help limit the double taxation. Before the tax rate changes, the credit was 49.25% of the amount attributed, which partially or fully relieves, depending on the circumstances, the double taxation that could otherwise occur. As a result of the change in the company tax rate to 30%, the imputation credit that arises under the section has been reduced to 42.86%, consistent with the new maximum imputation credit ratio of 30/70.

The reduction to 42.86% increases the potential for double taxation to arise. Further relief against double taxation has been provided (by way of amendments included at the request of the Finance and Expenditure Committee) by the new sub-section GB 27(4). After further amendment, this will allow the company, subject to meeting certain criteria, to elect to pay out the underlying cash that relates to the amount attributed as an exempt dividend. The election is made merely by paying out the dividend using the qualifying company mechanism discussed in the next paragraph and making the appropriate ICA entry.

This relief is provided by ensuring that dividends paid by eligible companies are either fully imputed or exempt from tax, as if the company was a qualifying company. When a company uses this treatment, any credit that arises under section OB 16 in respect of the attributed income should be contemporaneously cancelled on the last day of the relevant tax year, but before the debit from paying the dividend arises. The legislation will be retrospectively amended to achieve this last point.

Relief applies if a company's only activity is the one from which the income has been attributed. Also, it would be acceptable if it earned some incidental interest. The legislation is currently incorrect on the temporal aspects of this - and will be amended so that the qualifying company treatment concession will only apply when a company has never earned any income other than from the provision of personal services, or from interest/financial arrangements. These amendments will be in the June 2008 tax bill which should be enacted before 31 March 2009, the first date that these amendments become practically effective.

If a company engaged in other activities, dividends would be subject to tax in the normal way, and a credit would arise under section OB 16. This prevents the concessionary qualifying company type exempt tax treatment being manipulated to gain unintended benefits.

Section 103 of the Taxation (Business Taxation and Remedial Matters) Act 2007, which introduced new section GC 14EB into the Income Tax Act 2004, will be retrospectively repealed. The concessionary qualifying company treatment is intended to apply only to dividends paid out in relation to the 2008-09 and subsequent years' income.

Section OB1 - definitions Two new definitions reflect the reduced company tax rate:

• New tax rate person - a person who uses a 30% basic tax rate that applies from the 2008-09 and later income years and a portfolio tax rate entity - that is, companies and savings vehicles.
• Old company tax rate - the 33% tax rate that applied before the 2008-09 income year.

Imputation and DWP penalty ta

Section 140B of the Tax Administration Act provides that where an imputation credit account has a debit balance at 31 March 2010, the company must pay further income tax equal to the debit balance plus a 10% imputation penalty tax.

If a company elects to over-impute dividends in accordance with the new section MZ 10, and in doing so, causes a debit balance to arise in relation to the number of 33/67 credits, a new 10% transitional imputation penalty tax will apply.

New section 140BB - imputation penalty tax payable in some circumstances

New section 140BB sets out how the transitional imputation penalty tax should be applied and calculated. The 10% penalty will only be applied at 31 March 2010 if the taxpayer has distributed more 33/67 credits than were available.

When a taxpayer is in a debit position in both their 33/67 and overall imputation account, two imputation penalties will apply. However, the section 140B penalty will be reduced to the extent of any section 140BB penalty.

New section 140CA - dividend withholding payment penalty tax in some circumstances

New section 140CA sets out how the transitional DWP penalty should be applied and calculated.

It applies to the FDP account in exactly the same way as section 140BB applies to the imputation account.

Resident withholding ta

The resident withholding tax rate for interest and dividends is unchanged. Inland Revenue is currently considering the merits of an operational review of RWT to determine whether efficiencies can be made.

As a result, when a taxpayer who is subject to RWT receives a dividend fully imputed using the 30/70 tax credit ratio, they will be subject to withholding tax deductions of 3%.

A concession has been made for unit trusts and group investment funds that have not previously accounted for RWT on dividends. These entities will be able to calculate RWT at 30/70ths of the cash dividend. The amount payable will be after deducting any imputation credits. This will generally mean that no RWT is payable by those entities. The rationale for the concession is that a number of unit trusts and group investment funds that pay dividends have no RWT system in place as to date they have only paid fully imputed dividends and therefore have not needed to deduct RWT. It is inappropriate to require these entities to implement systems to account for RWT at 33/67 when consideration is being given to reviewing the RWT system.

Clarification of policy - business restructuring to take advantage of the reduction in the company tax rat

In a very high percentage of cases the restructuring of a business into a corporate form cannot be considered to be "tax avoidance". However, applying the tax avoidance provisions may be considered if the restructuring results in the alienation of income that is essentially personal services income. In some cases the alienation also effectively undermines some of the government's social assistance programmes, such as Working for Families tax credits, which are based on the tax definition of "assessable income".

For example, surgeons who corporatise their private practice but don't receive most of the taxable income from that structure may be asked if their use of the corporate structure is appropriate from a taxation perspective.

Schedule of proposed legislative changes

The following table contains the extraneous section MZ references in the Income Tax Act 2004 that will be retrospectively repealed:

The following changes are also proposed for the Income Tax Act 2004, on the basis that they are supposed to apply from either 1 April 2008 of the 2008-09 income year and therefore don't belong in the Income Tax Act 2004:

• repeal of new section GC 14EB (section 103 of the amending act);
• repeal of new subparagraph NF 1(2)(xi) (subsection 179(2) of the amending Act);
• repeal of the amendments to subsection NF 8(1) (section 180 of the amending Act); and
• repeal of the new section OB 1 definition of "old company tax rate" (subsection 182(31) of the amending Act).

The following changes are proposed to the Income Tax Act 2007:

• subsection GB 27(4) will be amended to ensure that the relevant company from which the income is attributed will qualify for the exempt qualifying company treatment if its only income has never been from the personal services that have been attributed, or from interest income;
• the section LA 9 pointer to section OZ 11 will be repealed;
• section LP 2(2) will be amended to change the tax credits for supplementary dividends formula to 7/17;
• subsection LE 1(1) will be amended to provide a pointer to section OZ 11;
• section OA 18 will be amended to remove the reference to "tax year" (the Income Tax Act 2007 does not use the term "imputation year");
• subpart OB will be amended to provide an imputation credit account debit when an attributing company elects to pay out an exempt dividend under subsection GB 27(4);
• the transitional section OZ 10 reference to subsections OZ 5(2) and (3) will be removed and replaced with references to sections LE 8 and 9, and sections LF 6 and 7;
• section OZ 12 which states how supplementary dividends are calculated when dividends are imputed to more than 30/70, will be amended so that the formula is 67/187.

²⁰ This is a change from the Income Tax Act 2004.