Foreign tax credit - calculation of New Zealand tax payable on foreign sourced income

Section LJ 5 of the Income Tax Act 2007

Key features

Section 101 of the Taxation (Tax Administration and Remedial Matters) Act 2011 amends section LJ 5 of the Income Tax Act 2007 to ensure that a taxpayer, when determining the amount of their foreign tax credits for foreign sourced income, must take into account any excess of deductions over income from any source (including New Zealand sourced income). This adjustment is made to ensure that the foreign tax credits allowed do not exceed the amount of New Zealand tax payable calculated in relation to the taxpayer's notional income tax liability.

Detailed analysis

The Rewrite Advisory Panel agreed that, prior to this amendment, the formula in section LJ 5(4) of the 2007 Act incorrectly takes into account deductions that are not attributable to any particular income source. This could result in foreign tax credits exceeding the New Zealand tax that is calculated in relation to the taxpayer's net income, after applying a loss balance under section IA 4(1)(a).

This approach ensures that, on an item by item basis, excess deductions incurred in deriving a particular amount of income are spread across all foreign tax credit calculations. The amendments to section LJ 5 clarify a number of points. The clarifications are as follows:

• The calculation, under section LJ 5(2), of the maximum foreign tax credit allowed for each segment of foreign-sourced income is explicitly placed on an income year approach.
• The result of the calculation in section LJ 5(2) cannot give a negative result.
• If the maximum amount of foreign tax credit calculated under section LJ 5(2) exceeds a person's notional income tax liability, the person must apply section LJ 5(4B) to adjust downward each maximum amount of foreign tax credit calculated under section LJ 5(2).
• In the formula in section LJ 5(4B), the meaning of the term "New Zealand tax" is being amended in section LJ 5(4C) to:
  • include all segments of income, wherever sourced; and
  • exclude expenditure that does not satisfy the nexus test under section DA 1, for each segment of income (for example, a deduction under section DB 3 for expenditure incurred in preparing an income tax return).