KEY POINTS:
The Government is to give long-awaited relief to companies chafing under New Zealand's stringent tax treatment of overseas subsidiaries.
It will introduce a distinction between active and passive income of a controlled foreign company (CFC) and exempt the active income from New Zealand tax.
The exemption will extend to ordinary dividends paid by CFCs to their New Zealand parents.
The change would allow a company with a manufacturing operation in China, for example, to benefit from tax concessions there without having the effective tax rate on its Chinese profits topped up to 33 per cent in New Zealand.
The present rules are intended to neutralise any tax incentive for a New Zealand company to invest overseas rather than at home, but instead they create an incentive to move the company's residence and head office overseas to be able to benefit from lower tax rates on offer.
The Government said yesterday a simple "active business" test would be developed to exempt all CFCs with less than 5 per cent passive income, no matter where they did business. The current grey list would be abolished.
Even if a CFC did not meet the active business test, only its passive income would be taxed in New Zealand.
But there is a potential sting in the tail of the change.
Interest allocation rules will limit the extent to which New Zealand businesses can use interest costs relating to overseas investments which are outside the New Zealand tax base.
The IRD is concerned that otherwise exempting active income would create an incentive for companies with outbound investment to over-allocate their global interest costs against their New Zealand income.
So it proposes to mimic the thin capitalisation rules which apply to inbound direct investment.
Deloittes tax partner Thomas Pippos said the devil, as always, would be in the detail.
Further consultation will be undertaken with a view to introducing legislation early next year, to take effect in the 20010/10 tax year.
The position now
* Fictional New Zealand company NZ Co has a manufacturing subsidiary in China which makes a profit of $100. Chinese tax law exempts foreign investors from tax in their first and second profitable years and imposes a 15 per cent tax rate in the third, fourth and fifth years.
* But NZ Co has to pay tax at 33 per cent of its global profits, so the IRD would take $33 in the first two years and $18 in the next three.
Under planned changes
* The Chinese subsidiary's income is not taxable in New Zealand.
* NZ Co gets to keep the whole $100 in the first two years, and $85 in the following three.
* This puts it on the same footing as other foreign investors in China, and removes a reason for it to quit New Zealand.
