Venture capital exemption

Section CW 11B of the Income Tax Act 2004 and section CW 12 of the Income Tax Act 2007

Section CW 11B of the Income Tax Act 2004 and the equivalent provision in the Income Tax Act 2007 have been amended to address concerns that the existing legislation may not operate as intended when the venture capital exemption applies on the basis of a Tax Information Exchange Agreement (TIEA) rather than a double tax agreement (DTA).

Background

Section CW 11B was introduced, with effect from 1October 2005, with the intention of facilitating increased offshore venture capital investment into New Zealand. The section removes a potentially significant tax obstacle to in-bound venture capital investment, by removing any risk that a qualifying non-resident venture capital investor selling shares in an eligible New Zealand company could be subject to New Zealand income tax on any gain arising from the sale.

One of the requirements of section CW 11B is that the investor must be from a jurisdiction approved by the Governor-General by Order in Council. Broadly, a jurisdiction will be approved only if effective exchange of information arrangements are in place with New Zealand. Until recently, New Zealand has only entered into exchange of information arrangements through its DTAs. It is understood that most venture capital investment is structured to come through nil or low-tax jurisdictions. However, New Zealand generally does not conclude DTAs with nil or low-tax jurisdictions. Therefore section CW 11B may have had limited effect on encouraging venture capital investment into NewZealand.

New Zealand is now negotiating TIEAs with nil or low-tax jurisdictions. TIEAs will satisfy the requirement for effective exchange of information arrangements. However, the existing legislation needed to be amended to ensure that it operates correctly when the relevant treaty is a TIEA rather than a DTA.

Key features

Determining the residence of the investor

Section CW 11B requires a determination of the investor's residence. Two tests for residence are prescribed: in the presence of a DTA between New Zealand and the other jurisdiction, residence is to be determined under the DTA; in the absence of a DTA, residence is to be determined under the domestic law of the other jurisdiction.

Technically, a TIEA is a DTA for the purposes of the Income Tax Act, but TIEAs do not generally include any tests for residence. Therefore an investor from a nil or low-tax jurisdiction may fail to satisfy the residence requirement of section CW 11B for purely technical reasons.

The tests for determining the investor's residence have therefore been amended to provide that, notwithstanding the existence of a DTA, if residence cannot be determined under that DTA then it is to be determined under the domestic law of the other jurisdiction.

Reference to "taxation laws"

Section CW 11B defines three separate categories of qualifying investor - "foreign exempt person", "foreign exempt entity" and "foreign exempt partnership". Each definition requires the investor to be specifically treated in a certain manner by the taxation laws of the jurisdiction concerned. Broadly, the intention is that the investor must be tax-exempt in their home jurisdiction, and hence unable to claim any relief or benefit for New Zealand tax (in other words, they have no home jurisdiction tax to credit New Zealand tax against).

A nil or low-tax jurisdiction may not actually impose income tax, but because there is no specific taxation law rendering the investor exempt, section CW 11B could fail to apply.

The wording of section CW 11B has therefore been amended to ensure that investors from nil or low-tax jurisdictions do not fail to qualify simply because their home jurisdiction has no applicable taxation laws.

Mechanism for detecting New Zealand ownership of offshore entities

Many nil or low tax jurisdictions operate an "offshore sector", in which it is relatively simple to set up a foreign-owned legal entity such as an international business company (IBC). However, section CW 11B contains no mechanism for detecting, for example, the case of a New Zealander setting up an IBC in a nil or low-tax jurisdiction to hold shares (either directly or indirectly) in a New Zealand company. Therefore, by means of a simple structuring arrangement, a New Zealander could gain access to an exemption from any gain on the sale of shares that would otherwise be taxable in New Zealand.

A "look-through" rule has therefore been inserted into the legislation to prevent any New Zealand direct or indirect owner or member of an offshore entity established in a nil or low tax jurisdiction from gaining the benefit of the section CW 11B exemption.

Application date

The amendments apply from 19 December 2007.