COMMISSIONER OF INLAND REVENUE v LIN [2018] NZCA 38

COMMISSIONER OF INLAND REVENUE v LIN [2018] NZCA 38 [8 March 2018]IN THE COURT OF APPEAL OF NEW ZEALANDCA308/2017[2018] NZCA 38BETWEEN COMMISSIONER OF INLANDREVENUEAppellantAND PATTY TZU CHOU LINRespondentHearing: 7 February 2018Court: Harrison, Cooper and Asher JJCounsel: D J Goddard QC and JBY Cheng for AppellantG D Clews and S J Davies for RespondentJudgment: 8 March 2018 at 11.30 amJUDGMENT OF THE COURTA The appeal is allowed.B The declaration made in the High Court setting aside the appellant'sassessments of the respondent's income tax liability for the 2005 to 2009income years is set aside.C The respondent's income tax liability for the 2005 to 2009 income years isto be assessed consistently with this judgment.D The respondent must pay the appellant costs for a standard appeal on aband A basis and usual disbursements. We certify for second counsel.E The order made by the High Court for payment of costs by the appellantin that Court is set aside. Costs should be fixed in the High Court inaccordance with this judgment.____________________________________________________________________REASONS OF THE COURT(Given by Harrison J)Introduction[1] The Commissioner of Inland Revenue's appeal from a decision of Thomas J inthe High Court raises this issue:1 is a New Zealand resident entitled to a credit againstincome tax liability in New Zealand for tax spared by China on income earned thereby companies in which the resident has a relevant income interest?[2] While the issue can be stated shortly, its resolution requires us to interpretrelevant provisions of the double tax agreement between New Zealand and China(the China DTA)2 and its relationship to domestic revenue legislation, in particular theControlled Foreign Companies regime (the CFC regime) in the Income Tax Act 2007("the 2007 Act") and earlier versions of that legislation.3Facts[3] The parties filed an agreed statement of facts in the High Court. Those whichare relevant to the issue on appeal are as follows:(a) The respondent, Patty Lin, emigrated from Taiwan to New Zealand inlate 2001 and became a New Zealand tax resident from that date.(b) Between 2005 and 2009, the relevant tax years, Ms Lin had a30 per cent interest in five companies which were resident in China for1 Lin v Commissioner of Inland Revenue [2017] NZHC 969, [2017] NZCCLR 24.2 Double Taxation Relief (China) Order 1986, sch 1.3 We discuss the CFC regime later in this judgment.tax purposes. Each company was defined as a CFC for New Zealandpurposes.(c) As a result, the income derived by four of the five Chinese companieswas attributed to Ms Lin for New Zealand tax purposes under the CFCregime. As Thomas J noted in the High Court, Ms Lin never actuallyreceived the income.4 The Commissioner attributed to Ms Lin CFCincome from the Chinese companies totalling $4,605,162.98 over therelevant period from 2005 to 2009.(d) The New Zealand tax payable by Ms Lin on this income was about$1.796 million. The Commissioner allowed Ms Lin tax credits underNew Zealand domestic law of $926,968.12. Her New Zealand taxliability on her attributed CFC income was offset by that amount forChinese tax actually paid by the Chinese companies. In the result, theCommissioner assessed Ms Lin as liable to pay attributed tax of$869,000.[4] The parties' point of contention arises from certain tax concessions granted tothe Chinese CFCs under Chinese domestic law. The Chinese companies were sparedfrom paying tax totalling $588,135.91 which would otherwise have been imposed ontheir incomes. The Commissioner refused to allow Ms Lin a further credit forNew Zealand tax payable on her attributed CFC income for the Chinese tax spared.[5] In May 2011 Ms Lin disposed of her interests in the Chinese companies and,in exchange, obtained full control of UBP Ltd (a New Zealand registered companywhich operates a meatworks and export business in the King Country). It was commonground, as Thomas J recited, that if Ms Lin, not the Chinese CFCs, had undertaken therelevant business activity personally in China she would have been taxed on theresulting income in New Zealand because of her residence here.5 In that event, she4 Lin v Commissioner of Inland Revenue, above n 1, at [6].5 At [11].would have been entitled to credits both for the tax actually paid in China and the taxspared to her there.6[6] In the High Court, Thomas J found that the Commissioner erred. She wassatisfied that Ms Lin was entitled to credits both for tax paid by and tax spared to theCFCs in China.7 She issued a declaration that the Commissioner's assessments ofMs Lin's income for the 2005 to 2009 income years were incorrect and set them aside.8Ms Lin's income tax liability for those years was to be assessed in accordance withthe judgment.[7] The Commissioner appeals on the ground that the Judge misconstrued criticalprovisions of the China DTA and their application to New Zealand domestic law.Legislative framework[8] Subpart BH of the 2007 Act provides for double tax agreements betweenNew Zealand and foreign states. Such agreements come into force throughdeclarations made by Order in Council.9 By s BH 1(4) a double tax agreement haseffect (except in the case of tax avoidance arrangements) in relation to income taxdespite anything else provided in the 2007 Act and is effectively incorporated intoNew Zealand domestic law.[9] The CFC regime is the starting point for our analysis. New Zealand taxes itsresidents on worldwide income regardless of source. One of the means of effectingthat revenue precept is through the CFC regime. This was introduced in 1 April 198810to prevent New Zealand residents from deferring or avoiding New Zealand tax byaccumulating income in non-resident companies.11[10] In summary, the CFC regime operates as follows. Income earned by a foreigncompany is foreign income of a non-resident of New Zealand. In the event of a6 At [11].7 At [100].8 At [105].9 Income Tax Act 2007, s BH 1(1)(c).10 Income Tax Amendment Act (No 5) 1988.11 Inland Revenue Department Tax Information Bulletin Vol 2 No 3 (October 1990) at 10.)distribution of profits on shares, such as by payment of a dividend, the New Zealandresident recipient is liable for tax. Without a distribution, however, the company'sincome stream would not be subject to New Zealand tax. The shareholder couldaccumulate the equivalent dividend amount, which may be reflected in acorresponding increase in share value on sale of the shares for a capital gain. In thatevent, New Zealand would not receive any tax on an income stream which thecompany had converted into capital through its deferment practices. The CFC regimeforeclosed that avenue for revenue deferment or avoidance.[11] The CFC regime applies to all taxpayers who have an income interest of greaterthan 10 per cent in a foreign company.12 A New Zealand resident shareholder issubject to tax on his or her pro rata share of the CFC's profits, calculated as if the CFCwere a New Zealand resident company, on a current or accrual basis irrespective ofreceipt.13 This income is described as attributed CFC income.14[12] Thomas J succinctly summarised the operation of the CFC rules in this way:[44] Broadly speaking, New Zealand's CFC regime operates as follows:(a) If a foreign company is controlled by one or moreNew Zealand tax residents and their associates, the companyis a CFC.(b) The New Zealand resident will have a control interest in theCFC which is broadly equivalent to the resident's ultimateholding in the CFC.(c) The profits of the CFC are notionally calculated according toNew Zealand's income tax requirements.(d) A percentage of the profits so calculated is attributed to theNew Zealand resident in proportion to the resident's controlinterest and taxed at the New Zealand tax rate which wouldapply to the resident's personal income.(e) The resident to whom income is attributed may or may notactually receive income.12 Income Tax Act 1994, s CG 6; and Income Tax Act 2007, s CQ 2.13 See Income Tax Act 2007, s EX 21.14 Section CQ 2.[13] As Thomas J also pointed out, the CFC regime was changed in December 2009to introduce a distinction between passive and active incomes.15 As a result, onlypassive income of a CFC (such as interest) is taxed to a New Zealand resident holdinga control interest in the CFC. Our determination of the issue raised on appeal is thusof limited significance.China DTA[14] The China DTA was signed in 1986, shortly before the CFC regime came intooperation. It is common ground that Chinese authorities would have been aware ofNew Zealand's intention to introduce the CFC regime. The treaty is entitled"Agreement between the Government of New Zealand and the Government of thePeople's Republic of China for the Avoidance of Double Taxation and the Preventionof Fiscal Evasion with respect to Taxes on Income".[15] The China DTA is one of New Zealand's 40 bilateral DTAs. All share the samepremise of revenue reciprocity: one country foregoes some of its income tax rightsover source or residence taxation in return for the other country foregoing some of thesame rights. The common economic purpose is to ensure that income is taxed onlyonce.[16] Double taxation is a term used to describe two different revenue concepts.One concept is juridical double taxation, where comparable taxes are imposed by twodifferent states on the same taxpayer for the same subject matter and for identicalperiods. This residence-based approach favours capital exporters. Economic doubletaxation is a different concept, occurring where the same income stream includingderivative income is taxed in the hands of different taxpayers. This source-basedapproach favours capital importers. The most obvious example of the latter is wherea shareholder is taxed on dividend income which has already been taxed upstream atthe level of corporate profits.[17] Double tax treaties are generally based on one model convention or a blend oftwo. One is the model drafted by the Organisation for Economic Cooperation and15 Lin v Commissioner of Inland Revenue, above n 1, at [46].Development (the OECD Model) which adopts a residence-based approach favourableto capital exporters; the other is the United Nations Model Double TaxationConvention between Developed and Developing Countries (the UN Model) whichadopts a source-based approach favourable to capital importers. The China DTA islargely based on the OECD model.[18] This appeal centres on the proper construction of art 23 of the China DTAwhich states:Methods for the elimination of double taxation1 In China, double taxation shall be eliminated as follows:Where a resident of China derives income from New Zealand, theamount of tax on that income payable in New Zealand, in accordancewith the provisions of this Agreement, may be credited against theChinese tax imposed on that resident. The amount of credit, however,shall not exceed the amount of the Chinese tax on that incomecomputed in accordance with the taxation laws and regulations ofChina.2 In the case of New Zealand, double taxation shall be avoided asfollows:(a) Subject to any provisions of the laws of New Zealand whichmay from time to time be in force and which relate to theallowance of a credit against New Zealand tax of tax paid ina country outside New Zealand (which shall not affect thegeneral principle hereof), Chinese tax paid under the laws ofthe People's Republic of China and consistently with thisAgreement, whether directly or by deduction, in respect ofincome derived by a resident of New Zealand from sources inthe People's Republic of China (excluding, in the case of adividend, tax paid in respect of the profits out of which thedividend is paid) shall be allowed as a credit againstNew Zealand tax payable in respect of that income;3 For the purposes of paragraph 2(a), tax payable in thePeople's Republic of China by a resident of New Zealand shall bedeemed to include any amount which would have been payable asChinese tax for any year but for an exemption from, or reduction oftax granted for that year or any part thereof under any of the followingprovisions of Chinese law:(emphasis added)[19] The China DTA, like all double tax treaties, is to be interpreted according tothe same principles applying to private contractual instruments.16 The parties'intention is to be discerned by interpreting the ordinary meaning of the treaty's termsin context and in the light of its object and purpose.17 The context also takes accountof its contemporary background. Resort can also be made to subsequent agreementabout the treaty's interpretation including, in this case, OECD commentaries.18[20] It is perhaps trite to observe that each treaty is the result of a discrete round ofbilateral negotiations.19 The final instrument reflects the parties' agreement on whatterms and conditions are appropriate to their particular relationship. We mention thispoint now, to answer briefly an argument advanced by Mr Clews for Ms Lin.He sought to pre-empt an interpretation difficulty for Ms Lin arising from the plainmeaning of art 23 of the China DTA by referring to comparable provisions in doubletax treaties negotiated by New Zealand with two other countries shortly after theChina DTA. In Mr Clews's submission we should construe art 23 in the same way asdifferently worded companion provisions in the other treaties. We do not accept thatsubmission. Each treaty must be construed discretely, in accordance with its ownparticular terms.Analysis[21] The Commissioner's case is that the plain meaning and purpose of art 23 is toprovide relief from juridical double taxation alone; Mr Clews argues by reference tovarious provisions of the OECD Model and its updated Commentaries that art 23 isdirected to relieving against both juridical and economic double taxation. His centralproposition is that there is only one source of income at issue in this case. Accordingly,"the income derived" in terms of art 23(2)(a) must refer to the deemed or attributedincome of the CFC, which was earned in China. The competing arguments can bedistilled to a difference about whether art 23 operates on the premise of tax residenceor income source.16 Anson v Commissioners for Her Majesty's Revenue and Customs [2015] UKSC 44 at [56].17 At [56].18 At [58].19 Chatfield & Co Ltd v Commissioner of Inland Revenue [2015] NZHC 2099 at [53].[22] As Thomas J observed, the CFC regime results in economic double taxation.20It subjects the CFC's profits to corporate tax in its own jurisdiction while providingfor taxation of the same or derivative income in the investor's hands in New Zealand.21In the result, two separate legal persons in two different countries are taxed on thesame income: the CFC directly in China, and the investor by attribution inNew Zealand. The underlying policy of the CFC regime is to maintain New Zealand'stax base. By comparison, the purpose of tax sparing provisions such as theconcessions available to the Chinese CFCs is to preserve the effect of incentivesdesigned to attract foreign investment in a developing state. That tension is at play inthis case but is immaterial to the plain meaning of art 23.[23] The issue is best addressed by construing the text of art 23 as a sequential andrelated whole within its settled context. In our judgment, the meaning of the provisionis clear and does not require us to resort to extraneous materials for assistance. In theHigh Court, Thomas J treated art 23(2) and (3) as separate provisions meriting discreteanalysis, without reference to art 23(1). We are satisfied that the Judge was led intoerror by this approach. However, in fairness, it appears that much of the argument inthe High Court followed a largely diversionary focus on extraneous materials andanalogies with other legal structures, at the expense of a close textual analysis.[24] Article 23(1) is our starting point. Mr Goddard QC, who did not appear for theCommissioner in the High Court, emphasises its plain purpose of eliminating juridicaldouble taxation in China by limiting the entitlement of a resident of that country to acredit on tax actually paid in New Zealand on income derived here. Its focus is onresidence, not source, and it is not directed to economic double taxation. Article 23(1)is the companion provision to art 23(2)(a). While there are linguistic differencesbetween the two clauses, it would be unusual for the two countries to provide foreconomically asymmetrical goals. Symmetrical treatment of tax credits would be thelogical common objective for both. The necessary inference, in the absence of anycontrary intention, is that both relieve against juridical double taxation, allowing onlycredits for taxes actually paid by a domestic resident in the foreign jurisdiction.20 Lin v Commissioner of Inland Revenue, above n 1, at [67].21 At [67].[25] Article 23(2)(a) is directly to this effect. It entitles a New Zealand resident toa credit against tax payable in this country "for Chinese tax paid [on] incomederived by [that] resident from sources in China". Tax spared in China is not"Chinese tax paid" by the New Zealand resident. Ms Lin is "the resident ofNew Zealand" for these purposes. As Mr Goddard submits, in terms of art 23(2)(a)the "income" of the CFC was not "derived" by Ms Lin in China; and the tax paid orspared to the CFC was not payable, paid by or spared to Ms Lin. The tax imposed ontwo different persons is "in respect of" two different income streams. The co-extensive nature of these provisions excludes any scope for importing into the textualanalysis a proposition that the "income derived" refers to the deemed or attributedincome of the CFC under New Zealand legislation.[26] Article 23(3), which Mr Goddard also emphasises, confirms the focus ofart 23(2)(a) on "tax payable in China by a resident of New Zealand." Thus aNew Zealand resident who is liable to pay tax there on income derived in that countryis expressly entitled to the benefit of a tax sparing provision in China in the nature of"an exemption from, or reduction of tax granted". We disagree with Thomas J'sconstruction of art 23(3) that, when read in conjunction with art 23(2)(a), its use of thephrase "payable by a resident of New Zealand" includes tax deemed to have beenpaid or payable by the New Zealand resident on income or tax deemed to have beenearned or paid by the New Zealand resident through the CFC regime.22[27] Mr Clews neatly summarised his contrary argument by identifying andanswering two questions. First, he asks, what is the "income derived" by Ms Lin inChina? It is undisputedly attributed CFC income. Second, he asks, has Ms Lin paidChinese tax "in respect of [attributed] income"? Mr Clews says the answer must alsobe in the affirmative because there is only one income stream which is taxed to twodifferent entities. One entity is the Chinese CFC, the other is the New Zealandshareholder. The "income derived" is, in all but name, Chinese income derived byMs Lin from a source there. As we noted above, Thomas J agreed with Mr Clews thatthe phrase should be read broadly to incorporate the tax liability of the Chinese CFCcompanies.2322 At [97].23 At [61].[28] Mr Clews also relies particularly on the phrase "in respect of" where it firstappears in art 23(2)(a). He says the words should be construed to require a connectionbetween tax paid in China and tax payable in New Zealand. That connection, he says,is through the direct attribution regime under the CFC rules. In the High Court,Thomas J accepted this argument, finding that tax paid "in respect of income" is notnecessarily only tax paid on income.[29] We disagree. The phrase "in respect of" is amorphous and can lead to linguisticuncertainty and confusion. It is often used where one word would more accuratelyconvey its meaning and purpose. The phrase is used in three separate places inart 23(2)(a). Mr Clews accepts the logic of consistency, of giving the same phrase thesame meaning wherever it is used in the same provision. He accepts also that wherethe phrase "in respect of" is used in the second place ("tax paid in respect of theprofits") and the third place ("tax payable in respect of that income") its meaning issynonymous with "on". The phrase refers to tax paid on profits out of which adividend is paid to the New Zealand resident; and to tax payable by the New Zealandresident on that income — that is, the "income derived by [a New Zealand resident"]from sources in China".[30] We are 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.Contrary to the Judge's view,24 we are satisfied that art 23(2)(a) requires the tax tohave 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.[31] Thomas J also placed reliance on the exclusion in art 23(2)(a) "in the case of adividend, tax paid in respect of the profits out of which the dividend is paid".25She noted that the exclusion was not included in the OECD Model.26 She inferredthat, by negating an obligation to grant a tax credit for only one type of economicdouble taxation in the form of dividends, the parties intended a credit to be given tocounter other types of economic double taxation.27 We disagree. The fact that the24 At [58]–[64].25 At [86]–[88].26 At [86].27 At [86]–[88].exclusion did not appear in the OECD Model does not lead to this inference. Theterms of the exclusion are specific. It relates expressly to a dividend paid on profits.It does not assist in resolving this issue.[32] Also, Thomas J accepted Mr Clews's submission that support for Ms Lin'sconstruction of art 23(2)(a) could be found in the OECD Commentary regarding thetax treatment of partnerships.28 Mr Clews did not press the same argument before us.We simply record that it does not assist where the text is plain.[33] In our judgment art 23(2)(a) relieves solely against juridical double taxation.Mr Clews's argument requires us to disregard the legal nature of the relationshipbetween Ms Lin and the Chinese CFCs to focus instead on the substantive source of"the income derived". The fact that the ultimate source is income attributed to Ms Linfrom the Chinese CFCs does not justify treating the two income streams, earnedseparately by the CFCs and Ms Lin, as one for revenue purposes, and ignoring theplain foundation of art 23(2)(a) on the source of "the income derived by a resident ofNew Zealand", Ms Lin. Mr Clews's reliance on the CFC attribution regime tocircumvent the plain meaning of art 23 must fail.Result[34] The appeal is allowed.[35] The declaration made in the High Court setting aside the appellant'sassessments of the respondent's income tax liability for the 2005 to 2009 income yearsis set aside.[36] The respondent's income tax liability for the 2005 to 2009 income years is tobe assessed consistently with this judgment.[37] The respondent must pay the appellant costs for a standard appeal on a band Abasis and usual disbursements. We certify for second counsel.28 At [73]–[84].[38] The order made by the High Court for payment of costs by the appellant in thatCourt is set aside. Costs should be fixed in the High Court in accordance with thisjudgment.Solicitors:Crown Law Office, Wellington for AppellantSimpson Western, Auckland for Respondent