Decision date: 8 March 2018
Case: Commissioner of Inland Revenue v Patty Tzu Chou Lin  NZCA 38
Act(s): Income Tax Act 2007 Subparts BH and LK; Agreement between the Government of New Zealand and the Government of the People’s Republic of China for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (New Zealand/China DTA)
Keywords: Controlled Foreign Companies, CFC, Double tax agreement, Article 23 New Zealand/China DTA, tax sparing, tax credits, OECD Model, UN Model
The Court of Appeal was satisfied that the Commissioner of Inland Revenue (“the Commissioner”) was correct in refusing to allow Patty Tzu Chou Lin (“Ms Lin”) a further credit for New Zealand tax payable on her attributed Controlled Foreign Companies (“CFC”) income for the tax totalling $588,135.91 that the CFCs had been spared from paying in China under Chinese domestic law.
The decision confirms that New Zealand residents will not be entitled to a credit against income tax liability in New Zealand for tax spared by China on income earned there by companies in which the resident has a relevant income interest.
Ms Lin is a New Zealand tax resident and her income is subject to New Zealand tax regardless of where it is sourced.
Between 2005 and 2009 (the tax years in dispute) Ms Lin had a 30 per cent interest in five companies which were resident in China. Each company was defined as a CFC for New Zealand tax purposes.
As a result, the income derived by four of the five Chinese companies was attributed to Ms Lin for New Zealand tax purposes under the CFC regime.
The Commissioner attributed to Ms Lin CFC income from the Chinese companies totalling $4,605,162.98. The New Zealand tax payable by Ms Lin on this income was about $1.796 million. The Commissioner allowed Ms Lin tax credits under New Zealand domestic law of $926,968.12. Her New Zealand tax liability on her attributed CFC income was offset by that amount for Chinese tax actually paid by the Chinese companies. The Commissioner assessed Ms Lin as liable to pay attributed tax of $869,000.
The Chinese companies were spared from paying tax totalling $588,135.91 under Chinese domestic law which would otherwise have been imposed on their incomes. The Commissioner refused to allow Ms Lin a further credit for New Zealand tax payable on her attributed CFC income for the Chinese tax spared.
The Court noted that subpart BH of the Income Tax Act 2007 (“the 2007 Act”) provides for double tax agreements between New Zealand and foreign states. Further, that by s BH 1(4) a double tax agreement has effect in relation to income tax despite anything else provided in the 2007 Act and is effectively incorporated into New Zealand domestic law.
The starting point for the Court’s analysis was the CFC regime. This regime was introduced to prevent New Zealand residents from deferring or avoiding New Zealand tax by accumulating income in non-resident companies.
Having discussed how the CFC regime operated, the Court then turned to the New Zealand/China DTA. The Court noted that the purpose of the New Zealand/China DTA is, like all of New Zealand’s DTAs, to produce revenue reciprocity. That is, one country foregoes some of its income tax rights over source or residence taxation in return for the other country foregoing some of the same rights. The common economic purpose being to ensure that income is taxed only once.
The appeal centred on the proper construction of art 23 of the New Zealand/China DTA. The Commissioner’s case was that the plain meaning and purpose of art 23 is to provide relief from juridical double taxation alone. Ms Lin’s counsel argued by reference to various provisions of the OECD Model and its updated Commentaries that art 23 is directed to relieving against both juridical and economic double taxation.
The Court considered that the issue was best addressed by construing the text of art 23 as a sequential and related whole within its settled context.
The Court agreed with the Commissioner’s submission that art 23(1) had the plain purpose of eliminating juridical double taxation in China by limiting the entitlement of a resident of that country to a credit on tax actually paid in New Zealand on income derived here. The Court noted that while there are linguistic differences between art 23(1) and its companion provision art 23(2)(a) they held that the necessary inference, in the absence of any contrary intention, is that both relieve against juridical double taxation, allowing only credits for taxes actually paid by a domestic resident in the foreign jurisdiction.
The Court agreed with the Commissioner’s submission that in terms of art 23(2)(a) the “income” of the CFC was not “derived” by Ms Lin in China; and the tax paid or spared to the CFC was not payable, paid by or spared to Ms Lin. The Court found that there was no scope to import a proposition that the “income derived” refers to the deemed or attributed income of the CFC under New Zealand legislation.
The Court disagreed with the High Court’s construction of art 23(3) that, when read in conjunction with art 23(2)(a), the phrase “payable … by a resident of New Zealand” includes tax deemed to have been paid or payable by the New Zealand resident on income or tax deemed to have been earned or paid by the New Zealand resident through the CFC regime. Instead the Court viewed 23(3) as confirming the focus of art 23(2)(a) as being on “tax payable in … China by a resident of New Zealand.”
Ms Lin’s counsel particularly relied on the phrase “in respect of” where it first appears in art 23(2)(a) and stated that it should be construed as requiring a connection between tax paid in China and tax payable in New Zealand. The Court disagreed and said that the phrase “in respect of” is synonymous with “on”. The Court was satisfied that art 23(2)(a) requires the tax to have been paid by a New Zealand resident on income derived by him or her in China, not by a third party CFC.
The Court concluded that art 23(2)(a) relieves solely against juridical double taxation. Ms Lin’s counsel’s argument required the Court to disregard the legal nature of the relationship between Ms Lin and the CFCs. The fact that the ultimate source is income attributed to Ms Lin from the Chinese CFCs does not justify treating the two income streams, earned separately by the CFCs and Ms Lin, as one for revenue purposes, and ignoring the plain foundation of art 23(2)(a) on the source of “the income derived by a resident of New Zealand”.