IRD has released an exposure draft seeking comments on whether state income tax paid in the United States qualifies as a foreign tax credit in the New Zealand tax return.

The deadline for comment is 10 October 2012.

The issue affects New Zealand tax residents declaring foreign-sourced income, in this case from the United States. Under New Zealand, legislation tax credits for foreign tax paid are allowable, subject to limitations.

The question has been asked whether state income tax is allowable under these rules.

IRD concludes in the exposure draft that a tax credit for state tax paid is allowable, subject to the limitations under section LJ of the Income Tax Act.

A credit for overseas tax paid is allowable provided the tax is of ‘substantially the same nature as New Zealand income tax’.

State income tax should unarguably qualify as being of ‘substantially the same nature as New Zealand income tax’, in respect of being a tax imposed on income. It is pleasing to see that the IRD agrees in its exposure draft.

Most states of the United States impose a state tax. From a United States’ perspective, a deduction is taken in the Federal return if itemizing. Conversely, refunds of state tax are gross income in the year of receipt for taxpayers who claimed a deduction for the tax paid in the prior year.

Accordingly, determining the amount of state tax actually paid and available as a credit in the New Zealand return can be difficult.

Under the legislation of both countries, where there is a change in the amount of foreign tax actually claimable in any given year, resulting in a change in the tax liability, the taxpayer is required to amend the credit and have the return reassessed.

A change in the amount of tax credit claimable may not affect the tax liability, due to limitations which cap the amount of tax credit available to be no more than the tax that would have been payable on the foreign income, if it had been New Zealand-sourced income.