New Zealand
Mathew McKay and Jarrod Walker
Bell Gully
New Zealand
Ambitious moves to promote New Zealand as a regional financial hub and attempts to curb New Zealanders' traditional appetite for real estate investment have been two driving forces behind tax reform over the past 12 months, believe Mathew McKay and Jarrod Walker of Bell Gully.
Though a relatively quiet period after a swathe of significant reforms the previous year, these themes have resulted in the introduction of a look through company (LTC) regime, removal of depreciation on buildings, and a number of proposals designed to increase foreign investment that are likely to be enacted in the short to medium term. Meanwhile, talk of a capital gains tax has gained momentum with the country's main opposition party promising to introduce such a tax if elected.
Look through companies
The LTC regime was enacted with effect from April 1 2011. The LTC regime effectively replaces the qualifying company and loss attributing qualifying company (LAQC) regimes. LAQCs have been a favoured vehicle for residential property investment purposes because shareholders can access losses arising from interest costs, while capping any tax on net rental income at the corporate tax rate. The days of LAQCs were numbered once the government decided to remove incentives encouraging investment in property.
LTCs are companies for legal purposes but have look through treatment for tax purposes. Their tax treatment reflects the treatment of limited partnerships (LPs). An LTC's income is attributed to its shareholders, enabling shareholders to benefit from lower tax rates to the extent that their marginal rate is lower than the corporate rate (presently 28%). Losses also flow through to the shareholders, subject to a loss limitation rule which limits the ability of shareholders to access losses in an LTC to the level of their economic interest in those losses (in broad terms, their contribution to the company).
Only a natural person, a trustee or another LTC may hold shares in an LTC. An LTC must have five or fewer "look-through counted owners" and there are rules aggregating the interests of relatives for this purpose. Non-residents can be shareholders in an LTC. It is worth noting that New Zealand LPs are available to a wider class of investors and the number of investors is unlimited.
Shareholders who sell their shares in an LTC are treated as having disposed of their interest in the assets of the LTC. The tax consequences will therefore vary depending on the nature of those assets.
Those establishing a business venture or investment vehicle, especially those acting in conjunction with other business partners or co-investors, may wish to consider whether the LTC is an appropriate vehicle through which to structure that business or investment. There are no restrictions on the nature of assets which can be held by an LTC.
Depreciation of buildings removed
Another change has been removal of the entitlement to a depreciation deduction for buildings having an estimated useful life of 50 years or more, from April 1 2011. In practice, this captures most buildings in New Zealand. Signalled in the 2010 Budget, this was another reform designed to remove tax incentives to invest in property. Landlords and other property investors are most affected by this.
Despite the change in treatment for buildings themselves, building fit-out remains depreciable. New Zealand revenue authorities have taken a relatively generous view of what constitutes fit-out in the context of industrial and commercial buildings. Nevertheless, the distinction between a building and its fit-out is not always clear and this reform can be expected to increase the tensions which can arise.
Reforms to PIE rules designed to increase foreign investment
The New Zealand government wishes to increase the level of offshore participation in our managed funds industry, and to promote New Zealand as a funds management hub competing with the traditional funds management centres such as Luxembourg and Dublin (with a geographical focus on the Asia-Pacific region). As part of that goal, reforms have been proposed to make portfolio investment entities (PIEs) more attractive to non-resident investors. The reforms are before Parliament and are likely to be introduced into law soon.
PIEs are collective investment vehicles which offer tax incentives to most investors. The regime was introduced several years ago in conjunction with a voluntary national superannuation initiative, KiwiSaver, with a broad goal of increasing New Zealanders' savings levels. The most common type of PIE (known as a multi-rate PIE) pays tax on gains on behalf of individual investors at their marginal tax rates. Gains on disposals of New Zealand and certain Australian listed shares are exempt from tax.
PIEs have not generally been attractive to non-residents on the basis that non-resident investors are taxed at the top PIE tax rate of 28% on net income attributable to them, irrespective of the nature and source of the PIE's income. In many cases that treatment compares unfavourably with the tax treatment of a non-resident investing directly in the underlying assets from which that income is generated. To the extent to which the income of the PIE arises from assets located offshore, taxation on this basis is inconsistent with the principle that non-residents should only be taxed on their New Zealand-sourced income.
The key feature of the new rules is that PIEs which derive only foreign-sourced income would be entitled to apply a zero per cent tax rate to income attributed to non-resident investors. PIEs which derive both foreign and domestic-sourced income would apply different tax rates to income attributed to non-resident investors, depending on the nature of that income, intended to match the tax treatment of direct investment in the underlying asset by the non-resident. For example, if the non-resident investor is eligible for double tax agreement protection, a 15% tax rate would apply to dividends which would otherwise have been subject to non-resident withholding tax (NRWT) at 30%. This matches the tax treatment of the non-resident if the non-resident had invested directly in shares in the dividend paying company.
Proposed withholding tax changes for widely held bonds
Other proposals also focus on the government's goal of deepening New Zealand's capital markets and encouraging non-resident investment in New Zealand.
At present, non-resident withholding tax (NRWT) applies to a payment of interest to a non-resident at the rate of 15%. This is often reduced to 10% under a double tax agreement, if applicable. NRWT may be reduced to zero where the approved issuer regime is utilised and an approved issuer levy (AIL) equal to 2% of the gross amount of the interest is paid by the borrower.
Proposals are now before Parliament to provide for a zero percent AIL for certain New Zealand dollar denominated widely-held bonds which are listed on a recognised exchange or otherwise traded in a securities market. There are several criteria that a bond will need to meet to qualify for the new zero rate of AIL. The new rate will not be available for private placements, regardless of how many investors take up the securities.
Reforms to FIF rules
New Zealand's controlled foreign company (CFC) and foreign investment fund (FIF) rules tax New Zealand residents on their foreign investments (subject to certain exceptions). Broadly speaking, the CFC rules impute income to New Zealand resident investors from investments in a foreign company which is controlled by five or fewer New Zealand residents. The FIF rules apply to investments in a foreign company which is not a CFC, typically smaller interests of less than 10%.
An active income exemption was introduced with respect to CFCs in 2009. In October 2010, draft legislation was proposed to enact a similar exemption for non-portfolio FIF investments (investments of 10% or more in a FIF). This draft legislation is now before Parliament.
Under the FIF rules, income from non-portfolio FIF interests is not imputed to investors in relation to interests held in grey list countries: Australia, Canada, Germany, Japan, the UK, the US, Norway and Spain. These are countries which are regarded as having tax systems comparable to New Zealand's. The revised rules will replace the grey list exemption with two new exemptions. Firstly, an active business exemption will exclude from attribution all income from a FIF that generates less than 5% of its income from passive sources. Secondly, income from a FIF that is resident and subject to tax in Australia will be excluded from attribution provided the FIF is not eligible to receive certain Australian tax concessions.
The reforms will introduce a new method for calculating an investor's income from an investment in a non-portfolio FIF. This is the attributable FIF income (AFI) method. Under this method, only the passive income of a FIF will be attributed to an investor. Complex rules exist for determining whether income is active or passive, though broadly speaking passive income will be income in the form of dividends, royalties, rent and interest. In circumstances where an investor is unable to obtain sufficient access to the information of a FIF to enable use of the AFI method, or the investor holds a portfolio interest of less than 10% in the FIF, the fair dividend rate, or cost methods, will continue to be available in most cases. These rules deem a 5% rate of return to the investor on the market value or cost of the FIF interest.
Following the introduction of this draft legislation, several submissions were made to Parliament's Finance and Expenditure Committee that New Zealand should repeal its FIF rules, as proposed in Australia. Draft legislation in Australia proposes to replace Australia's FIF regime with a specific anti-avoidance provision which aims to prevent the avoidance or deferral of tax from investing offshore. The New Zealand committee rejected this submission, saying such treatment would create an arbitrary distinction between the treatment of investments in CFCs and FIFs, and the specific anti-avoidance provision would not provide an adequate guard against the fiscal risk of New Zealand taxpayers shifting passive income-producing assets offshore.
Update on repeal of gift duty
The repeal of gift duty, payable on gifts on a progressive scale by reference to the value of the gift, was signalled in 2010 and is expected to take effect with respect to gifts made on or after October 1 2011. Gift duty is one of the relatively few duties or levies New Zealand retains in addition to the general income tax and goods and services tax regimes. For example, New Zealand has no estate duty, inheritance tax or stamp duty on the sale or other transfer of assets. The repeal of gift duty will be significant for estate planning purposes. In practice the duty raised little revenue for the government with widespread use of debt forgiveness programmes taking advantage of the NZ$27,000 ($22,000) annual gift duty exemption.
Supreme Court tax avoidance decision awaited
The past year has been relatively quiet in terms of significant case law in the tax avoidance area, when compared to recent years. At the time of writing, a significant decision is expected soon. The decision of the Supreme Court (New Zealand's highest court) in Commissioner of Inland Revenue v Penny and Hooper will be the first opportunity the Supreme Court has had to consider the application of the general anti-avoidance provision in the Income Tax Act since the landmark decision Ben Nevis Forestry Ventures Limited and Ors v Commissioner of Inland Revenue in 2008. Penny and Hooper concerns two surgeons employed by companies owned by family interests. The Commissioner of Inland Revenue alleges that the companies' payment of below-market salaries to the surgeons is tax avoidance. The decision has wide potential significance in New Zealand, where there are a large number of people who structure their professional or trade arrangements through personal or family-owned companies.
A capital gains tax?
There has been considerable public and media discussion in New Zealand in recent years over the merits of introducing a capital gains tax. At present New Zealand has no general capital gains tax, though various regimes such as the financial arrangements rules and the FIF rules approximate capital gains taxation in certain ways. Many see a capital gains tax as a means of changing New Zealanders' historical preference for investing in real estate, with a resulting influence on residential house prices.
The government has stated it does not favour the introduction of such a tax, instead taking other measures to remove tax incentives for investing in real estate. These include the removal of the ability to depreciate buildings for tax purposes and the repeal of the LAQC regime referred to above.
The Labour opposition party has recently announced that it will introduce a capital gains tax if elected in 2011. With the general election to take place in November 2011, this facet of the campaign will be keenly followed by New Zealanders as well as non-residents with assets in New Zealand.
Mathew McKay (mathew.mckay@bellgully.com) is a partner and Jarrod Walker (jarrod.walker@bellgully.com) is a senior associate of Bell Gully in Auckland, New Zealand