High Court rules on tax sparing provision in treaty with China
Tax Alert - July 2017
By Emma Marr and April Wong
In a recently released decision, Lin v CIR, the High Court found that tax relief under the New Zealand/China Double Tax Agreement (China DTA) is available for tax payable under the controlled foreign company (CFC) regime, and that New Zealand tax credits are available for tax paid by a CFC in China and also for tax spared in China.
Although the scope of the CFC rules is narrower than it was at the time the income was earned in this case, the decision is still a helpful guide to the interaction between the CFC rules and our double tax treaties. It also clarifies the ambit of the tax sparing articles in double tax agreements, and in this case a New Zealand taxpayer was allowed a tax credit in New Zealand for tax paid by her CFC’s in China, and for tax those companies had been spared under Chinese exemptions
As New Zealand has tax sparing arrangements with China, Fiji, India, Korea, Malaysia, Papua New Guinea, Singapore and Vietnam, this decision is of wider interest to investors in those countries, as it provides guidance on how New Zealand resident taxpayers could qualify for foreign tax credits for tax spared in those countries.
Lin v CIR is an interesting case both in its analysis of how the DTA applies to CFC income and tax sparing, but also more generally for its consideration of the interface of domestic laws and DTAs, the negotiation process of DTAs, and the different aids for interpreting DTAs.
Ms Lin is a New Zealand tax resident who from 2005 – 2009 indirectly held controlling interests in five Chinese companies. Under the CFC rules, income earned by the Chinese companies was attributed to Ms Lin, so she was liable for New Zealand tax on this income, even though she never actually received any cash income. The income amounted to $4.605 million, for which the Commissioner allowed tax credits of $926,968 for tax paid in China by the companies.
Under Chinese tax law, the companies were also relieved of tax totalling $588,135 (tax spared). If this amount was credited against her New Zealand tax liability, Ms Lin’s tax liability would have been reduced to approximately $281,000. However, the Commissioner refused to allow Ms Lin to claim any tax credits for the tax spared. The dispute between Ms Lin and the Commissioner came before the High Court.
Thomas J in the High Court held that the China DTA allows a credit against New Zealand tax payable by Ms Lin on her CFC income, for Chinese tax paid by a CFC, and that tax payable in China includes any tax spared amount.
While this was certainly good news for Ms Lin, who escaped an otherwise hefty shortfall penalty and increased income tax liability, what does this mean for future taxpayers who hold attributable CFC income overseas? Further, do tax sparing provisions always give rise to a claimable foreign tax credit in New Zealand?
What is tax sparing?
Tax sparing is a way of ensuring that a tax incentive granted to an entity in (usually) a developing country is not simply transferred to the revenue authority in a developed country. A tax incentive is designed to fuel growth in the developing country. If the non-resident shareholder of the entity doesn’t get a tax credit for that amount, and has to pay tax in their own jurisdiction, the tax incentive has turned into tax revenue for the home country of the shareholder. The overall rationale of enabling foreign investors to get the benefit of tax incentives is to create an increase of inbound capital flows to the developing country, which may contribute towards economic development.
Whether or not the tax sparing provision in the China DTA applied to allow Ms Lin a tax credit for tax spared in China was the key question for the High Court. If the Chinese tax concessions would reduce the Chinese companies’ tax liability in China, but Ms Lin couldn’t get any New Zealand tax credits for them, the tax concessions would transfer tax revenue from China to New Zealand. If the tax sparing provision applied to the tax spared in China, Ms Lin, rather than the New Zealand Government, would get the benefit of the Chinese tax concessions and the investment incentives behind tax sparing would remain intact.
The China DTA – interpretation and application
Counsel for the Commissioner and Ms Lin engaged in thorough debate on the correct interpretation of Article 23 of the China DTA, namely whether Article 23 relieved attributed CFC income from double taxation, and if so, whether Ms Lin qualified for a foreign tax credit for the Chinese tax spared. The Court had the benefit of two well qualified experts, Professor Craig Ellife (expert witness for Ms Lin) and Robin Oliver (expert witness for the Commissioner) in interpreting the China DTA. The Court considered and answered two questions, outlined below.
1. Does Article 23 relieve attributed CFC income from double taxation?
The China DTA allows a tax credit to a New Zealand resident for “Chinese tax paid … in respect of [CFC] income derived by a resident of New Zealand” (Article 23(2)(a) of the China DTA). There was significant dispute between the parties as to the meaning of the phrase “in respect of”. The Commissioner took the position that Article 23(2)(a), which provides relief against double taxation, could never apply to CFC attributed income because the tax was paid by the CFC, not by the New Zealand taxpayer. Counsel for Ms Lin submitted that the proper construction of Article 23(2)(a) is to focus on the tax and not the payer, therefore tax paid by a CFC should give rise to a tax credit to Ms Lin.
Thomas J concluded in favour of Ms Lin, after considering the background to the negotiation of the China DTA, the OECD and the UN Model Conventions, and the commentaries to those Conventions, which assist in interpreting DTAs. He also considered the principles governing the interpretation of international treaties, as set out in the Vienna Convention on the Law of Treaties 1969. This background information persuaded him that the Court should adopt an expansive interpretation of the words “in respect of”, also finding support in the domestic tax legislation. Thomas J noted that the position taken by the Commissioner would mean that Article 23 could never apply to attributed CFC income.
Thomas J found that if the Inland Revenue was content to ignore the statutory form of the CFC in taxing Ms Lin – ie, even though the relevant income was derived by the CFC and not Ms Lin she was still taxable on that income – then it should also disregard the statutory form in allowing a tax credit. Therefore, the tax paid by the CFC should give rise to a tax credit for Ms Lin.
2. If the answer to (1) is yes, is a tax credit for allowed for tax spared for the CFCs in China?
The tax sparing rule in Article 23(3) of the China DTA refers specifically to “tax payable… by a resident of New Zealand”. As tax spared to the Chinese Companies is tax payable by the CFCs, rather than Ms Lin, the Commissioner argued that Article 23(3) precluded Ms Lin from obtaining any tax credit in respect of tax spared to a CFC. On the other hand, counsel for Ms Lin argued that the provision includes tax which is deemed to have been paid by a New Zealand resident under Article 23(2)(a), even though that tax in reality has been paid by the CFC.
Thomas J again preferred the case brought by Ms Lin, finding that as the CFC rules deem the income of the CFC to have been earned by the shareholder, the tax paid by the CFC is deemed to have been paid by the owner, i.e., Ms Lin. When this analysis is extended to Article 23(3), the only logical conclusion is that tax paid or payable by a New Zealand resident includes tax which is deemed to have been paid or to be payable by Ms Lin for the purposes of Article 23(2)(a).
The outcome of Lin v CIR would suggest that the courts take a broad pragmatic approach in interpreting tax sparing provisions to give taxpayers the opportunity to utilize foreign tax credits and reduce their income tax liability accordingly.