Taxation of investment income – proposed reforms announced
The Government has released an announcement outlining its proposed reforms to the taxation of investment income. The key changes being proposed relate to:
- The taxation of collective investment vehicles.
- The taxation of foreign portfolio investments.
The announcement contains few changes from those previously proposed in the Government’s discussion document on the taxation of investment income (which was largely based on the Stobo Report). The areas where the announcement differs from the discussion document are minor in nature in our view and do not address the fundamental concerns raised in the majority of submissions on the discussion document regarding the taxation of foreign portfolio investments. The Government is promoting the changes as removing inequalities in the current tax treatment of investment income. However, to the extent that some inequalities are addressed, we consider that overall the changes, largely due to the taxation of foreign portfolio investments, introduce greater inequalities and are unlikely to increase New Zealanders’ overall levels of savings.
Taxation of collective investment vehicles
The proposed changes to the taxation of collective investment vehicles include:
- The adoption of a ‘look through’ tax treatment for collective investment vehicles (CIVs) which meet certain requirements, to be known as qualifying collective investment vehicles (QCIVs). This means investors in a QCIV will be taxed on their proportionate share of the QCIV’s income rather than the QCIV being taxed on that income. This removes the disadvantage that lower marginal tax rate investors currently face on investing through CIVs, which arises from the CIVs generally regarding their share gains as being on revenue account and subject to tax at 33%. This change is essential for KiwiSaver to work.
- A QCIV will pay tax on behalf of investors either at the 19.5% or at the 33% marginal tax rate. The announcement and the related releases indicate that the 33% rate will be a capped rate so that taxpayers who are on a 39% tax rate are not discouraged from saving through the QCIV.
To qualify as a QCIV under the proposed new rules a CIV generally will need:
- To have the provision of investment and savings services as its principal activity.
- To have at least 20 investors, with no individual investor holding more than a 10% ownership interest in the CIV (there are some limited exceptions to this rule, for example a QCIV investing into another QCIV).
- To not own more than 10% of any underlying entity (or 25% in certain circumstances).
- To not issue separate classes of units that stream different categories of income from the same assets to different unit holders.
- To meet New Zealand tax residence rules (or be liable for tax in New Zealand on its worldwide income if not for the fact it is a QCIV).
Investment vehicles meeting the required criteria can elect to become a QCIV from 1 April 2007. This requirement will be compulsory for KiwiSaver default funds.
While overall we consider the proposed changes to the taxation of QCIVs to be positive, the detail of the proposals, once released, will need careful examination, in particular to ascertain whether any 6% top-up risk exists for investors who are on the top marginal tax rate.
Taxation of foreign portfolio investments
The proposed changes to the taxation of foreign portfolio investments include:
- Removal of the current ‘grey list’ countries (with the exception of Australia to a degree). This means investors holding a portfolio of international investments in the existing grey list countries other than certain investments in Australia will now be taxed on both realised and unrealised gains, including capital gains. Thus, the unrealised gains / capital gains tax exposure that currently exists under the foreign investment fund (FIF) rules for portfolio investment in nongrey list countries will be extended.
- The exception to this proposed rule is that investors who do not actively trade their shares and who make direct investments in Australian resident entities whose shares are listed will only be taxed on dividends. (Being taxed on dividends is the current position for investment into grey list countries).
- Individual investors making direct international share investments outside Australian listed and resident companies will be outside of these rules if the total cost of the investments purchased is less than NZ$50,000. The FIF rules already contain a similar exclusion.
- Individual investors holding international share investments over the NZ$50,000 threshold will be subject to tax on a maximum of 85% of any increase in value of their international investments made during the year. The level of tax payable on international share investments will be subject to an annual 5% cap, with the latent tax exposure for the balance being rolled forward.
The proposed introduction of a capital gains tax on direct international share investments is very concerning. Following widespread objection against this in submissions on the discussion document, including in Phillips Fox’s submission, the Government has proposed to only tax 85% of the gains on international investments. However, this does not address the fundamental concern that it is a capital gains tax, and New Zealand does not have a generic capital gains tax.
We agree that the current FIF rules are a disincentive for investing into shares in non-grey list countries. However, we do not agree that extending that disincentive to all international share investments (other than certain Australian shares) will promote the Government’s goal of increasing New Zealanders' overall level of savings, or necessarily encourage investment in New Zealand.
The more likely result is investments will either be diverted into Australian resident listed companies or into real estate, which does not have a capital gains tax, as New Zealanders will view their options for investing in shares as being limited to New Zealand and Australia. In our view, the Government should be promoting diversity of investments and considering other ways of removing the current disincentive that exists in relation to investing in nongrey list countries (for example, by removing or reducing the unrealised gains / capital gains tax that exists under the FIF rules).
In our view, if the Government wishes to introduce a capital gains tax it should do so in a considered manner, having considered the impact of doing this across all forms of investment. It should not link it with the QCIV reforms, which are a separate and unrelated matter.
Introduction of the Bill
It is anticipated the Bill outlining these proposed changes will be introduced in May 2006. Interested parties will have the opportunity to make additional submissions on the proposed Bill at the Select Committee stage. We will keep you updated on the Bill once it is introduced. For a more detailed summary of the proposed changes and a copy of the Ministerial Announcement please refer to the IRD Tax Policy website: www.taxpolicy.ird.govt.nz/
This publication is intended as a first point of reference and should not be relied on as a substitute for professional advice. Specialist legal advice should always be sought in relation to any particular circumstances and no liability will be accepted for any losses incurred by those relying solely on this publication.