Chinese tax sparing credits available to CFC shareholder

The High Court has held that the Double Taxation Relief (China) Order 1986 (China DTA) has direct effect in New Zealand and that pursuant to the China DTA, a taxpayer (Ms Lin) was entitled to credits for tax paid by and tax spared to Chinese companies defined as controlled foreign corporations (CFCs) for New Zealand purposes.

The background

This case concerned an investment held in five companies established in China (the Chinese companies) and the tax consequences to Ms Lin of that investment. Ms Lin was a New Zealand resident and, as such, was subject to New Zealand tax regardless of where it was sourced.

During the 2005 to 2009 tax years Ms Lin held a 30% stake in two companies, each of which was registered in the British Virgin Islands. Because of her shareholding in the companies, Ms Lin was considered to hold a control interest in the Chinese companies. Each of the companies was defined as a CFC for New Zealand purposes under the CFC regime. Ms Lin never actually received the income.

Over the course of the tax years in dispute, Ms Lin was attributed with personal income from the Chinese companies totalling $4.605m. The New Zealand tax due on this income was approximately $1.796m. The Commissioner allowed tax credits from China of $926,968 to offset Ms Lin’s New Zealand tax liability on her attributed CFC income for Chinese tax paid by the Chinese companies in relation to that income, leaving some $869,000 due from Ms Lin.

Under Chinese domestic tax law, tax concessions were available to the Chinese companies so they were relieved of Chinese tax which would otherwise have been imposed on their incomes (tax spared). The amount of Chinese tax spared to the Chinese companies totalled $588,135. If credited against her New Zealand liability, Ms Lin’s tax liability would have been reduced to approximately $281,000. However, the Commissioner refused to allow any credit in respect of tax spared to the Chinese companies. Ms Lin was assessed by attribution for New Zealand tax on a 30% share of the income derived by the Chinese companies.

Ms Lin refused to pay New Zealand tax on the portion of her CFC income which was derived from tax spared to the Chinese Companies. In July 2015, the Commissioner imposed shortfall penalties.

Ms Lin disposed of her interests in the Chinese companies in May 2011 in exchange for full control of a company registered in New Zealand.

Ms Lin contended that in assessing her, the Commissioner had failed to allow her the full tax credits to which she was entitled under the China DTA and under the related New Zealand domestic law. She maintained that she was entitled to a credit for the tax spared by the Chinese government to the Chinese companies. The Commissioner contended that Ms Lin was not entitled to tax credits for tax spared to the Chinese companies under the China DTA and that New Zealand’s domestic legislation regarding tax credits could not be read in the manner Ms Lin contended.

The outcome of the case turned upon the interpretation of Art 23 of the China DTA and specifically, its application in the context of income derived from a CFC. The issues to be determined in respect of Art 23 were as follows:

(a) Does “Chinese tax paid … in respect of [CFC] income derived by a resident of New Zealand” include Chinese tax paid by the CFC itself, as opposed to tax which is paid directly by the New Zealand resident?

(b) If the answer to (a) is “yes”, is the New Zealand resident also entitled to a credit for tax spared to the CFC under Art 23(3)?

(c) If the answer to (b) is “yes”, what is the effect of Art 23 upon the assessment of CFC income under New Zealand’s domestic income tax legislation?

The High Court’s decision

The High Court gave judgment for Ms Lin and declared that pursuant to s 138P of the Tax Administration Act 1994, the Commissioner’s assessments and default assessments in respect of Ms Lin’s income tax for the 2005, 2006, 2007, 2008 and 2009 income years were incorrect. The Court found as follows:

The meaning of “Chinese tax paid … in respect of [CFC] income derived by a resident of New Zealand”

1. “Chinese tax paid … in respect of income derived by a resident of New Zealand from sources in the People’s Republic of China” includes Chinese tax paid by the CFC itself. The effect of Art 23(2)(a) of the China DTA was therefore that Chinese tax paid by a CFC must be allowed as a credit against New Zealand tax payable by Ms Lin on her CFC income.

2. Paragraph 3 of the OECD Commentary on Arts 23A and 23B describe international juridical double taxation as arising in three cases. The expanded definition of juridical double taxation was helpful to the CFC analysis because CFC attributed income could be considered as falling into para 3(b), that is, income is derived from China and both China and New Zealand impose tax on that income. Some significance was attached to the fact that para 3(b) refers to a person who derives income from the other contracting state. Analysed in this way, taxation of CFC attributed income could be considered to fall within the definition of or be deemed to be juridical double taxation and covered by Art 23.

3. Further support for this interpretation was found in the OECD commentary on Arts 23A and 23B regarding the tax treatment of partnerships.

4. The double taxation of partnerships and partners can be conceptualised as a form of juridical double taxation which arises because the existence of the corporate entity in the State of source is ignored and the individual taxpayer is deemed to have paid tax in both the State of source and the State of residence. The conceptualisation is consistent with the general statement in para 1 of the OECD Commentary on Arts 23A and 23B

5. The principles espoused in the partnerships discussion can be extended by analogy to CFCs. The problems faced by Ms Lin in the present case arose because the contracting states, China and New Zealand, treated CFCs in a different way. China treated CFCs as corporate entities with separate legal personality. New Zealand treated CFCs as fiscally transparent entities under the CFC rules. On this basis, CFCs can be considered to be entities “such as partnerships”.

The application of tax sparing provisions to CFC income

6. A New Zealand resident is entitled to a credit for tax spared in China to the CFC. This enables Art 23 to be read in a principled way, giving effect to its purpose of relieving double taxation.

7. This interpretation is underscored by the evidence about the way in which DTAs are negotiated, the research done by each country into the other’s tax systems and policy and the inference that both parties would have known at the time of entering into the China DTA that New Zealand intended to implement a CFC regime in the near future.

8. This interpretation of Art 23(3) also respects the purpose of the tax sparing provision in the China DTA to encourage investment in China by ensuring that the benefit of the Chinese tax concessions remains with investors rather than New Zealand tax collectors.

The effect of Art 23 on New Zealand’s domestic income tax legislation

9. The China DTA has direct effect in New Zealand and therefore pursuant to the China DTA, Ms Lin is entitled to credits for tax paid by and tax spared to the CFC. New Zealand’s domestic legislation must be interpreted consistently with and give effect to New Zealand’s obligations under the China DTA. The relevant provisions are ss LC 4(1) of the Income Tax Act 1994, LC 4(1) of the Income Tax Act 2004 and LK 1 of the Income Tax Act 2007. These sections set out the relevant foreign tax credit provisions relating to attributed CFC income and reference in them to “tax paid or payable” must therefore include tax spared to CFCs.

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