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New rules for taxing controlled foreign companies and foreign dividends: Mechanics of attribution

Mechanics of attribution

Sections CQ 2, DN 2, EX 18A, EX 20C to EX 20E and EX 21 of the Income Tax Act 2007

There is a signposting provision in section EX 18A showing the scheme for finding a person's attributed CFC income or loss under the new rules.

Sections CQ 2 and DN 2 provide that a person has attributed CFC income or loss if the person has an income interest of 10 percent or more in a CFC that has net attributable CFC income or loss and is not a non-attributing active CFC or a non-attributing Australian CFC. Special rules apply to income from personal services.

The rules for calculating net attributable CFC income or loss for a CFC are set out in sections EX 20C to EX 20E and section EX 21 as follows:

  • Section EX 20C provides that net attributable CFC income or loss is to be calculated using a prescribed formula and lays down the main rules concerning deductibility of expenditure.
  • Sections EX 20D and EX 20E make provision regarding the deductibility of interest expenditure for excessively debt-funded CFCs.
  • Section EX 21 applies the Act (subject to certain modifications) for specified purposes as though a CFC were a New Zealand resident. Those specified purposes include the calculation of net attributable CFC income or loss.

Key features

Net attributable CFC income or loss is the income or loss of a CFC that is attributed to New Zealand residents with an income interest of 10 percent or more. Non-attributing active CFCs and non-attributing Australian CFCs are not subject to attribution other than for any income or loss derived from personal services.

The starting point for calculating net attributable CFC income or loss for a CFC is to determine the attributable CFC amount in accordance with section EX 20B. This amount is then reduced to reflect expenditure incurred by the CFC, giving a net figure.

As a general rule, deductions for expenditure incurred other than under a financial arrangement will be allowed if the expenditure is incurred by the CFC in deriving an attributable CFC amount. Different rules apply to expenditure incurred by a CFC under financial arrangements because of the difficulties associated with matching debt to particular income streams.

Of expenditure (typically, interest) incurred under financial arrangements that provide funds to the CFC, only a fraction is deductible. The fraction is based on the value of the attributable assets of the CFC as a proportion of its total assets. If a CFC is excessively debt-funded, the fraction is calculated by reference to the assets of all the interest holder's CFCs. The same rule applies to certain dividends that are deductible for the purposes of calculating net attributable CFC income or loss, namely distributions relating to fixed-rate foreign equity and deductible foreign equity distributions made by the CFC to New Zealand-resident companies or to other CFCs.

The rules provide flexibility for intra-group financing arrangements, recognising that multinationals may operate financing subsidiaries to obtain debt finance on behalf of the group and then on-lend the funds to operating subsidiaries. An adjustment for on-lending may be made when calculating the net attributable CFC income or loss of a CFC. The effect of the adjustment is to allow a full deduction for expenditure incurred under financial arrangements that provide funds to the CFC and for any deductible dividends to the extent the funds are on-lent to associated CFCs. A similar adjustment may be made when determining whether a CFC is excessively debt-funded.

Expenditure incurred under financial arrangements such as derivative instruments that do not provide funds to the CFC is either deductible or non-deductible according to whether any income derived from the arrangement would be included in the CFC's attributable CFC amount.

Detailed analysis

When attributed CFC income or loss arises

Section CQ 2 sets out when a person has attributed CFC income from a foreign company. A number of criteria must be satisfied, including that the foreign company is a CFC with net attributable CFC income under section EX 20C (subsection (2)(f)(i)). Section DN 2 makes equivalent provision in relation to attributed CFC loss.

In general, a person does not have attributed CFC income or loss from a CFC that is a non-attributing active CFC or a non-attributing Australian CFC (section CQ 2(1)(h) and (i) and section DN 2(h) and (i)).

Income from personal services

Sections CQ 2(2B) and DN 2(2) make special provision for income or loss derived by a CFC from personal services under section EX 20B(3)(h). This income is always subject to attribution: under sections CQ 2 and DN 2 if the CFC is a non-attributing active CFC or a non-attributing Australian CFC; otherwise, under section EX 20B(3)(h) and (9). In view of this, income from personal services may be disregarded for the purposes of determining whether a CFC is a non-attributing active CFC (section EX 21D(7)(a)). Where such income is attributed under the CFC rules, the equivalent attribution rule in subpart GB does not apply (section GB 27(3)(e)).

Net attributable CFC income or loss

Net attributable CFC income or loss is calculated under sections EX 20C to EX 20E and provides the basis for attribution to resident shareholders, much as branch equivalent income did previously.

Net attributable CFC income or loss is the CFC's attributable CFC amount, determined under section EX 20B, less the CFC's allowable expenditure. The relevant formula is found in section EX 20C(2) and refers to two categories of allowable expenditure - limited funding costs and other deductions.

Limited funding costs

The item, limited funding costs, is an adjusted amount, based on a CFC's funding costs as defined in section EX 20C(6)(a). Limited funding costs are not fully deductible under the formula in section EX 20C(2); deductions are restricted by applying the fraction found under section EX 20C(8).

Funding costs comprise expenditure incurred under financial arrangements that provide funds to the CFC and distributions relating to fixed-rate foreign equity and deductible foreign equity distributions made by the CFC to New Zealand-resident companies or to other CFCs.

When determining limited funding costs from funding costs, an adjustment may be made under section EX 20C(5). The adjustment is based on the value of funds on-lent by the CFC to associated CFCs (group funding) as a proportion of the CFC's own funding. Where funding costs exceed limited funding costs, the difference is allowed as other deductions (section EX 20D(9)(b)). The significance of this re-characterisation is that, under the formula in section EX 20C(2), other deductions are allowed in full rather than being restricted through the application of a fraction.

The effect of this adjustment is that, if a CFC borrows and then on-lends funds to an associated CFC, it is allowed a full deduction for its own interest expenditure on those funds. Thus, if a quarter of a CFC's funding is on-lent to associated CFCs, three-quarters of its funding costs will be included as limited funding costs subject to restriction, with the remainder being fully deductible. The adjustment is arithmetical and does not allow for borrowed funds to be matched to amounts on-lent.

Other deductions

The item, "other deductions", is defined in section EX 20C(9). As noted earlier, other deductions are allowed in full rather than being restricted through the application of a fraction.

Paragraph (a) of section EX 20C(9) deals with deductions not relating to financial arrangements and shares. This expenditure is deductible if it is (i) incurred for the purpose of deriving an attributable CFC amount and (ii) not incurred for the purpose of deriving an amount that is not an attributable CFC amount. If an item of expenditure relates to both attributable and non-attributable amounts, the combined effect of subparagraphs (i) and (ii) is to require apportionment of that expenditure.

Paragraph (b) deals with any funding costs excluded from limited funding costs by virtue of the on-lending adjustment described earlier.

Paragraph (c) deals with deductions relating to financial arrangements that do not provide funds to the CFC. Deductions are allowed only if they relate to an arrangement referred to in section EX 20B(4), namely one that would produce an attributable CFC amount if it produced a net gain rather than a net loss.

Fraction

Section EX 20C(8) defines the item "fraction" that is applied under the formula in section EX 20C(2) to restrict deductions for limited funding costs. Section EX 20C(10) to (12) and sections EX 20D and EX 20E are also relevant.

Typically, the fraction is based on the proportion, by value, of the CFC's assets that produce an attributable CFC amount (section EX 20C(10) and (11)). Thus, a CFC that uses one-third of its assets to earn attributable CFC amounts will be able to set one-third of its limited funding costs against those amounts when calculating its net attributable CFC income or loss. If an asset is used to derive both attributable and non-attributable amounts, its value will need to be apportioned. Asset values are adjusted to reflect any adjustment for on-lending under section EX 20C(5).

As a backstop against structures that concentrate debt in CFCs with mainly attributable assets in order to maximise allowable deductions, section EX 20C(8)(b) caps the fraction for a CFC that is excessively debt-funded at the amount calculated under section EX 20D. This cap is determined by reference to the assets of all the interest holder's CFCs (section EX 20D(9) to (13)). A CFC is considered to be excessively debt-funded if it has a debt-asset ratio, determined under section EX 20D(4), of more than 0.75 and also has a relative debt-asset ratio, determined under section EX 20E, of more than 1.10.

Detailed calculation rules

Section EX 21 sets out detailed calculation rules which apply for the purposes specified in subsection (1) - calculating the attributable CFC amount under section EX 20B, calculating net attributable CFC income or loss under section EX 20C, and determining under section EX 21D whether a CFC is a non-attributing active CFC. Subsection (2) provides that, for those purposes, the rules in the Act are applied as if the CFC were always a New Zealand resident, subject to the modifications set out in the rest of the section.