“The proposed changes represent a fundamentally different approach to taxing New Zealand companies that have offshore operations,” Finance Minister Michael Cullen and Revenue Minister Peter Dunne announced upon the bill's introduction.

“The cornerstone of the reform is the exemption from tax of the offshore active income of New Zealand’s controlled foreign companies, regardless of where it is earned. That will bring our tax rules into line with the tax systems of comparable countries, particularly that of Australia, and remove a tax cost that similar companies in other countries do not face,” the Ministers added.

At present, New Zealand taxes the active income – such as income from manufacturing – from its offshore subsidiaries, whereas other countries do not.

The change is designed to encourage businesses with international operations to remain in New Zealand and enable them to compete on an equal tax footing in foreign markets.

“Further important features of the proposed changes are an exemption from tax of most foreign dividends paid to companies and measures to protect the tax base as a result of adopting an active income exemption," the ministers explained.

The changes introduced on Wednesday represent the first stage of the those to emerge from the government’s review of New Zealand's international tax rules and have been influenced by consultation with businesses and their advisors.

“Most aspects of the reforms were signalled in a series of consultative papers, although there has been further work to develop the detail in some areas," the ministers said.

Cullen and Dunne said that under the reforms, comprehensive attribution of income from controlled foreign companies (CFCs) to New Zealand owners will be replaced by attribution of passive income only. Passive income – such as interest – will continue to be attributable.

There will be some exceptions to attribution of passive income, however, to reduce compliance costs. For example, there will generally be no attribution of passive income for CFCs in Australia, which is usually the first country of choice for New Zealand's smaller businesses that want to expand overseas.

There will also be an exception for CFCs that pass an ‘active business’ test: no attribution of passive income will be required for CFCs whose passive income is less than five percent of total income.

Passive income will consist mainly of interest, rent, royalties and dividends. Certain services will also be classified as passive income, as will income from speculative derivative instruments and derivatives that hedge passive income.

Most dividends paid by a foreign company will be exempt from income tax when received by New Zealand companies, as was previously announced by the government. Deductible dividends and dividends on fixed rate shares will be continue to be taxable as interest, and fixed rate shares issued by foreign companies will be treated as debt. This is designed to prevent double New Zealand taxation, since a deduction will be allowed against the attributable income of the CFC.

As part of the exemption for ordinary dividends, there will be a change to the qualifying company rules: a qualifying company may no longer hold an attributing interest in a controlled foreign company or non-portfolio foreign investment fund. This change is designed to prevent foreign dividends being passed through to shareholders tax-free.

Interest allocation rules will be extended to cover New Zealand residents that have outbound interests in a CFC. Several ‘safe harbour’ provisions will, however, minimise the impact of the rules and permit much of the cost of debt-funding for a foreign investment to be deducted against the New Zealand tax base.

The present ‘grey list’ exemption from attribution of CFC income is being replaced with the active business test for CFCs in all countries, with one exception – Australian CFCs will generally continue to be exempt from the requirement to attribute any income to New Zealand residents.

The existing conduit relief mechanism, which exempts from tax the foreign-sourced income of New Zealand companies owned by non-residents, is being removed. Even so, the active income exemption and the foreign dividend exemption provide the same results as conduit relief for active income, Cullen and Dunne said.

The ministers added that companies’ foreign dividend payment accounts, branch equivalent tax accounts and conduit tax relief accounts will become unnecessary under the reform. It is the government’s intention that existing FDP credit balances can be carried forward for five years and BETA debit balances and conduit tax credits can be carried forward for two years, with legislation repealing them to be introduced at a later date. BETA credit balances will be cancelled from the beginning of the 2009-10 income year.

“The aim in developing this comprehensive reform has been to devise flexible rules that are consistent with the realities of the business environment and that help New Zealand businesses to expand their operations but keep their head offices in New Zealand,” the Ministers concluded.