LIN V COMMISSIONER OF INLAND REVENUE – IN THE COURT OF APPEAL OF NEW ZEALAND
In this case, the Court of Appeal had to deal with whether Ms Lin was entitled to a credit against income tax liability in New Zealand arising due to CFC companies in China for tax spared by China on income earned there by the Chinese CFC companies.
BACKGROUND OF THE CASE
Ms Patty Lin is a New Zealand resident emigrated from Taiwan in late 2001. Between the tax years 2005 and 2009, Ms Lin had a 30 per cent interest in five Chinese companies. Each company was defined as a Controlled Foreign Companies (‘CFC’) for New Zealand tax purposes. The income derived from the Chinese companies was attributed to Ms Lin for New Zealand tax purposes under the CFC regime.
During the assessment, the Commissioner attributed $4,605,162.98 as CFC income of Ms Lin for the relevant years from 2005 to 2009. Tax thereon was computed at $1.796 million. Tax credits for Chinese tax actually paid by the Chinese companies to the extent of $926,968.12 was allowed. The contention of Ms Lin to allow credit for New Zealand tax payable on her attributed CFC income for the Chinese tax spared i.e. $588,135.91 was not appreciated and refused by the commissioner. Accordingly, the assessment was completed by arriving at tax liability of $869,000.
Against the order of the commissioner, an appeal was filed before the High Court wherein it was observed that if Ms Lin had undertaken the relevant business activity personally in China, she would have been taxed on the resulting income in New Zealand as per residence based taxation. In that event, she would have been entitled to credits both for the tax actually paid in China and the tax spared to her there. Drawing analogy from this, the High Court held that Ms Lin was entitled to foreign tax credit for both tax paid by and tax spared to the CFCs in China.
The Commissioner of Inland Revenue filed an appeal against the High Court Order to the Court of Appeal on the ground that the critical provisions of the China DTA and their application to New Zealand domestic law was misconstrued and raised the following issue –
Whether Ms Lin was entitled to a credit against income tax liability in New Zealand for tax spared by China on income earned there by the Chinese companies.
ARGUMENTS AND ANALYSIS
New Zealand taxes its residents on worldwide income regardless of source. In the year 1988, New Zealand had introduced CFC regime to prevent its residents from deferring or avoiding tax by accumulating income in non-resident companies. As per CQ2 of Income tax Act, 2007, CFC regime applies to all taxpayers who have an income interest of greater than 10 per cent in a foreign company. A New Zealand resident shareholder is subject to tax on his or her pro rata share of the CFC’s profits, calculated as if the CFC were a New Zealand resident company, on a current or accrual basis irrespective of receipt [refer EX21 of Income tax Act 2007]. This income is described as attributed CFC income.
The operation of the CFC rules was summarised in the High court order as follows-
- If a foreign company is controlled by one or more New Zealand tax residents and their associates, the company is a CFC.
- The New Zealand resident will have a control interest in the CFC which is broadly equivalent to the resident’s ultimate holding in the CFC.
- The profits of the CFC are notionally calculated according to New Zealand’s income tax requirements.
- A percentage of the profits so calculated is attributed to the New Zealand resident in proportion to the resident’s control interest and taxed at the New Zealand tax rate which would apply to the resident’s personal income.
- The resident to whom income is attributed may or may not actually receive income.
The aforesaid CFC regime was changed in December 2009 to introduce a distinction between passive and active incomes wherein it was provided that only passive income of a CFC (such as interest) is taxed to a New Zealand resident holding a control interest in the CFC. It was observed that China DTA was signed in 1986 prior to introduction of CFC regime in New Zealand. All share the same premise of revenue reciprocity: 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.
Generally, tax treaties are based on one model convention or a blend of two i.e. the OECD Model and the UN Model. OECD Model adopts a residence-based approach favourable to capital exporters whereas UN Model adopts a source-based approach favourable to capital importers. The China DTA is largely based on the OECD model. It was argued on behalf of Ms Lin that the intention of parties was to be discerned by interpreting the ordinary meaning of the treaty’s terms in context and in the light of its object and purpose. The context also takes account of its contemporary background. Resort can also be made to subsequent agreement about the treaty’s interpretation including, in this case, OECD commentaries.
However, the court observed that it is perhaps trite to observe that each treaty is the result of a discrete round of bilateral negotiations. The final instrument reflects the parties’ agreement on what terms and conditions are appropriate to their particular relationship. Mr Clews arguing for Ms Lin had sought to pre-empt an interpretation difficulty for Ms Lin arising from the plain meaning of Article 23 of the China DTA by referring to comparable provisions in double tax treaties negotiated by New Zealand with two other countries shortly after the China DTA. Mr Clews also submitted that one should construe Article 23 in the same way as differently worded companion provisions in the other treaties. This was not accepted by the Court of Appeal which stated that each treaty must be construed discretely, in accordance with its own particular terms.
The Commissioner’s case is that the plain meaning and purpose of Article 23 of China DTA is to provide relief from juridical double taxation alone. However, Mr Clews argued making reference to various provisions of the OECD Model and its updated Commentaries that Article 23 is directed to relieving against both juridical and economic double taxation. Mr Clews main proposition was that there is only one source of income at issue in this case. Accordingly, “the income derived” in terms of Article 23(2)(a) must refer to the deemed or attributed income of the CFC, which was earned in China. The competing arguments can be distilled to a difference about whether Article 23 operates on the premise of tax residence or income source.
It was observed by the High Court that the CFC regime results in economic double taxation. It subjects the CFC’s profits to corporate tax in its own jurisdiction while providing for taxation of the same or derivative income in the investor’s hands in New Zealand. In the result, two separate legal persons in two different countries are taxed on the same income: the CFC directly in China, and the investor by attribution in New Zealand. The underlying policy of the CFC regime is to maintain New Zealand’s tax base. By comparison, the purpose of tax sparing provisions such as the concessions available to the Chinese CFCs is to preserve the effect of incentives designed to attract foreign investment in a developing state. This may not be important to the plain meaning of Article 23.
The Court of Appeal observed that the meaning of the provision is clear and does not require us to resort to extraneous materials for assistance. The Court of Appeal rejected the approach of the High Court in treating Article 23(2) and (3) as separate provisions meriting discrete analysis, without reference to Article 23(1).
Mr Goddard QC arguing on behalf of the revenue authorities stated that Article 23(1) is the start point and its plain purpose is to eliminate 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. Article 23(1) is the companion provision to Article 23(2)(a). In the absence of contrary intention, it can be inferred that both relieve against juridical double taxation, allowing only credits for taxes actually paid by a domestic resident in the foreign jurisdiction.
Further, it was submitted that Article 23(2)(a) of China DTA entitles a New Zealand resident to claim tax credit only in respect of “Chinese tax paid” on income derived by such resident in China. Tax spared in China is not “Chinese tax paid” by the New Zealand resident. 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 tax imposed on two different persons is “in respect of” two different income streams. Article 23 excludes a proposition that the “income derived” refers to the deemed or attributed income of the CFC under New Zealand legislation.
The Court of Appeal expressed its disagreement with the High Court order wherein it was held that the phrase “payable … by a resident of New Zealand” provided under Article 23(3) and 23(2)(a) 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.
Mr Clews summarily argued by answering some questions like What is the “income derived” by Ms Lin in China? It is undisputedly attributed CFC income. Further, Has Ms Lin paid Chinese tax “in respect of [attributed] income”? The answer must also be in the affirmative because there is only one income stream which is taxed to two different entities. One entity is the Chinese CFC, the other is the New Zealand shareholder. The “income derived” is, in all but name, Chinese income derived by Ms Lin from a source there. The High Court has agreed that the phrase should be read broadly to incorporate the tax liability of the Chinese CFC companies.
Further, Mr Clews relied on the on the phrase “in respect of” appearing in Article 23(2)(a) to construe that a connection between tax paid in China and tax payable in New Zealand is through the direct attribution regime under the CFC rules. The High Court accepted Mr Clews argument that tax paid “in respect of income” is not necessarily only tax paid on income. However, the Court of Appeal expressed its disagreement and observed that the phrase “in respect of” is amorphous and can lead to linguistic uncertainty and confusion. It is often used where one word would more accurately convey its meaning and purpose. The phrase is used in three separate places in Article 23(2)(a). The Court was satisfied that the phrase “in respect of” is used synonymously with “on” in all three places in art 23(2)(a). Its meaning should be consistent throughout. Article 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; that is the essential precondition to a credit in New Zealand.
Further, the Court of Appeal did not agree to the reasoning provided in the High Court wherein it was held that the exclusion in art 23(2)(a) “in the case of a dividend, tax paid in respect of the profits out of which the dividend is paid”. By negating an obligation to grant a tax credit for only one type of economic double taxation in the form of dividends, the parties intended a credit to be given to counter other types of economic double taxation. Accordingly, it was held that the fact that the exclusion did not appear in the OECD Model does not lead to this inference. The terms of the exclusion are specific. It relates expressly to a dividend paid on profits. It does not assist in resolving this issue.
Conclusion
In light of the above discussion, the Court of Appeal held that Article 23(2)(a) relieves solely against juridical double taxation. Disregarding the legal nature of the relationship between Ms Lin and the Chinese CFCs and focus instead on the substantive source of “the income derived” may not be correct. 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 Article 23(2)(a) on the source of “the income derived by a resident of New Zealand”, Accordingly, the CFC attribution regime to circumvent the plain meaning of Article 23 must fail.
India Perspective
Concept of Tax sparing credit is found in some of the tax treaties which India has entered into with countries like Mauritius, Bangladesh, Jordan, Oman, Spain, Singapore etc. Some treaties specifically list out the specific exemption/deduction provisions of the Domestic Law under which the Tax “spared” will qualify for the Tax Credit (refer DTAA’s with Singapore, Mauritius, Bangladesh, Spain). There are treaties which provides a much more general Tax sparing provision which grants the benefit to “ Tax which would have been payable but for the tax incentives granted under the laws of the Contracting State and which are designed to promote economic development”. (refer DTAA’s with Oman and Jordan).
In a recent ruling, the Delhi Tribunal in case of Polyplex Corporation Ltd[1] has upheld the taxpayer’s claim for tax sparing credit relating to dividend from its subsidiary in Thailand under the India-Thailand DTAA. The Tribunal noted that the concept of “tax sparing credit” is important for many developing countries to ensure that incentives offered by them to foreign investors yield results. The Tribunal referred to the UN Model commentary and Klaus Vogel notes regarding article 23 about the tax sparing credit.
The Tribunal rejected the Revenue’s stand that since no tax had actually been paid in Thailand, the question of double taxation did not arise and hence no foreign tax credit (FTC) claim could be allowed to the taxpayer. Thus, the Tribunal held that where Indian company received dividend from Thai subsidiary, though assessee was not liable to pay any tax in Thailand by virtue of exemption granted as per Investment Promotion Act of Thailand, in view of fact that dividend so received was taxable under Thailand Revenue Code at rate of 10%, assessee would be entitled to credit of such taxes deemed to have been payable in Thailand.
The Hyderabad Tribunal in the case of Dr. Reddy’s Laboratories Ltd[2] had allowed the taxpayers claim relating to tax sparing credit as per Article 25 of the India- Cyprus tax treaty. The Tribunal has held that where assessee had granted loan to its subsidiary in Cyprus and received interest which was taxable in both countries, assessee was entitled to deduction of tax deemed to have been paid on interest income in Cyprus under article 25(2) of DTAA between India and Cyprus.
However, the judgement of the Court of Appeal of New Zealand deals with the issue of entitlement of tax credit in New Zealand for tax spared by China on income earned there by the Chinese companies and taxable in the hands of shareholder (under CFC regime). In India, concept of CFC was first proposed to be introduced as part of proposed Direct Tax Code, 2010, which was retained in revised draft of Direct Tax Code, 2013.
As per CFC Rules introduced in Direct Tax Code, profits earned by a Controlled Foreign Company, located in territory with a lower rate of taxation, will be included in taxable profits of parent company located in India. For this purpose, Controlled Foreign Company shall be a company;
- Which is a resident of a territory with lower rate of taxation;
- Shares of which are NOT traded on any recognized stock exchange in such territory;
- Which is controlled by Indian residents, individually or collectively; and
- Which is not engaged in active trade or business and more than 25% of whose income comes from passive sources such as dividend, interest, capital gains, income from house property, royalty, annuity payments, etc
Direct Tax Code provisions had ensured that profits of CFC which are taxed in hands of parent company once, are not taxed again when such profits are actually repatriated in form of dividend by CFC to parent company. However, there is no provisions in the Income Tax Act, 1961 where CFC Rules have been enacted. Accordingly, the above judgement of the Court of Appeal which dealt with granting of tax sparing credit in the hands of shareholders for taxes spared to CFC entities, may not have any precedent or persuasive in the absence of CFC regime in India.
[1] Polyplex Corporation Ltd v ACIT [2019] 103 taxmann.com 71 (Delhi – Trib.)
[2] Dr. Reddy’s Laboratories Ltd v ACIT [2017] 78 taxmann.com 63 (Hyderabad – Trib.)