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Bill: greater fairness in taxing investment income

Hon Dr Michael Cullen
Minister of Finance

Hon Peter Dunne
Minister of Revenue

17 May 2006 Media Statement

Tax bill delivers greater fairness in taxing investment income

Wide-ranging reform of the taxation of investment income is the focus of a bill introduced into Parliament today.

“This long overdue reform puts the tax treatment of different types of share investment on an equal footing, introducing greater fairness and reducing distortions in investment decisions,” Finance Minister Michael Cullen and Revenue Minister Peter Dunne said today.

“It will cost the government about $110 million a year in forgone tax revenue to realign the system, but the cost is worth it to resolve the problems and foster a savings culture in New Zealand.

“The current tax rules on investment income operate very unevenly. They overtax some investors, they favour direct investment by individuals over investment through funds, and they favour investment in some countries over investment in others.

“For people who invest through New Zealand-based managed funds, the new rules will remove several tax disadvantages that discourage saving through funds. One of the key improvements is that lower income investors, whose investment income is currently over-taxed at 33%, will be taxed at their correct rate.

“The other big improvement is that managed funds will no longer be taxed on their share gains from New Zealand and Australian companies, which puts them on an equal tax footing with direct investors.

“Changes to the taxation of investment in offshore shares are based on the principle that if you live in New Zealand you are expected to contribute to New Zealand by paying New Zealand tax on all your income, whether it comes from New Zealand or overseas.

“That is not happening at present. The current tax rules allow individuals who invest directly in offshore shares in eight countries – such as the US and UK – to pay little or no tax in New Zealand on their investment income, since companies in those countries often pay low or no taxable dividends. In the meantime, investors in shares in other countries – such as Singapore and Korea – are fully taxed in New Zealand on their income.

“Nearly all of the protest over the proposed changes is coming from a group of investors who have investments in countries that are favoured by the current tax rules, and who will now have to pay the same level of New Zealand tax on their income as all other direct investors in overseas shares.

“What the changes do is equalise the New Zealand tax treatment of shares in traditional and emerging markets.

“Under the new rules, offshore portfolio investment in shares will be taxed more consistently, whether made by individuals directly or through managed funds, and regardless of the country invested into.

“Most individuals holding overseas shares outside Australia will not be affected by the changes because those whose shares cost less than $50,000 will be exempted. It means that, for all practical purposes, a couple could hold, between them, shares costing up to $100,000. However, direct investors with substantial share portfolios in countries favoured by the current rules will generally pay more tax, which is only fair.

“The reform aims to achieve a coherent and balanced tax treatment of New Zealanders’ investment income,” they said.

Other changes in the bill include:

- “Salary sacrifice”: changes to the employer superannuation contribution rules to minimise the use of excessive salary sacrifice as a means of paying less tax

- Australian superannuation schemes: changes to resolve compliance problems for people in New Zealand who have interests in Australian super schemes, and to remove a potential disincentive for skilled migrants coming to work in New Zealand.

- Geothermal wells: changes to the tax treatment of expenditure on geothermal wells, to remove uncertainty about the deductibility of capital losses arising from failed wells drilled in New Zealand.

- Sale of patent rights: changes allowing vendors to spread income from sales of patent rights evenly over three years, to alleviate potential cashflow problems that may constitute a barrier to investment in research and technology.

- Investigation of tax evasion and avoidance: changes allowing Inland Revenue to remove documents for inspection.

- Tax rates: confirmation of the income tax rates that will apply for the 2006-07 tax year.

- Fringe benefit tax: clarification that motor vehicles acquired before 1 April 2006 should be valued at cost after that date.

Full information on these and other matters in the Taxation (Annual Rates, Savings Investment and Miscellaneous Provisions) Bill is available in the commentary on the bill, published at http://www.taxpolicy.ird.govt.nz/


Taxation of investment income: questions and answers

Investment through New Zealand-based managed funds

Q. How will the changes benefit individual investors?

A. Investors who have a 19.5% tax rate will be taxed on their savings at this rate, instead of 33% (which is the tax rate, at present, for most of those who invest in managed funds).

Investors will also benefit from not being taxed on capital gains made on New Zealand and Australian companies if they invest in them through a portfolio investment entity. Currently, these gains are usually taxed if shares are held via a managed fund but are not generally taxed if held directly. This creates a significant disadvantage to using managed funds and other collective investment vehicles to invest in New Zealand and Australian companies.

All investors in managed funds that elect into the new rules and trade in New Zealand and Australian shares will be better off.

Q. Will investors on the 39% rate have to pay more tax on their investment income?

A. No, the maximum tax rate will be 33%, to encourage existing savers to continue to save and to encourage collective investment vehicles to adopt the new rules.

Q. Will the new rules apply to all managed funds and investment vehicles?

A. No. The new rules are limited to managed funds and collective investment vehicles that meet certain criteria. To qualify, a vehicle must be a genuine savings and investment entity because the purpose of these changes is to put investment through intermediaries on a similar tax footing to that of direct investment. It is therefore important to distinguish genuine investment and savings vehicles from other entities.

The new rules will be optional, meaning that all savings vehicles do not have to adopt them. However, those that do will be able to offer their lower income investors the benefits of being taxed at their correct tax rate, and the benefit of tax-free capital gains on shares in New Zealand and Australian companies to all their investors. Savings vehicles that do not adopt the new rules will continue to be taxed as they are at present.

Investment in offshore portfolio shares

Q. What’s wrong with the present rules on taxing offshore investment in shares?

A. The current tax rules are riddled with inconsistency and biases, and some investors pay less tax than others on similar investments. Individuals who invest directly in a company resident in one of the eight so-called “grey list” countries generally pay tax only on dividends. On the other hand, if they invest in a “grey list” country via a New Zealand managed fund they will typically be taxed on 100% of realised capital gains on these investments. The new rules will generally align the tax treatment of investment directly and via managed funds in those countries.

Direct investors in shares in the remaining countries have a much higher tax burden, since they pay tax on 100% of the increase in the value of their shares each year. They will be significantly better off under the new rules because, unless dividends are higher, they will pay tax on 5% of the opening value of their shares each year, limited to 85% of any gain they make. This will remove biases to investing in emerging destinations such as high-growth countries in Asia.

The changes to the taxation of investment in offshore shares are based on the principle that if you live in New Zealand you are expected to contribute to New Zealand by paying New Zealand tax on all your income, whether it comes from New Zealand or overseas. They balance the need for direct investors in “grey list” countries to pay their fair share of tax against the significant tax barriers facing investors who wish to invest outside New Zealand’s traditional investment destinations.

Q. How will the changes affect GPG investors, who have been encouraged to write to the government in protest?

A. Most won’t be affected. A quick glance at the share register shows that most have shares costing less than $50,000, so are below the threshold where the changes kick in. It means that a couple could hold shares costing up to $100,000, if each individual was below the threshold, without being affected by the new rules.

Q. What will be the effect of the rules on other individual direct investors?

A. Most will not be affected. Investors in Australian-resident listed companies will generally pay tax only on their dividends (the same treatment that will be accorded to investors in New Zealand-resident investment vehicles). Investors will be able to have investments outside Australia that cost NZD$50,000 or less in total ($100,000 per couple) and continue to pay tax only on dividends.

For substantial share portfolios outside Australia, taxable income in most years will be limited to 5% of the investment’s value. (In most cases less than 2% of the value of the investment will be payable in tax.)

For substantial portfolios that are now heavily weighted towards the “grey list”, individual direct investors are likely to pay more tax under the new rules.

For investments in non-“grey list” countries, investors will pay significantly less tax than they do under the current foreign investment fund rules. This should encourage savers to look beyond New Zealand’s traditional investment destinations to high-growth economies in Asia, Latin America and Europe.

Q. Will any excess capital gains be taxed under the 5% cap method?

A. Yes. When the portfolio is sold and the proceeds not reinvested in other offshore shares, 85% of the excess gains will be taxed. This treatment brings the taxation of direct investment income closer to that of income from investments in managed funds.

Q. Why is a special case being made for investment in Australian companies?

A. Australian-resident listed companies are treated differently because they pay out a high proportion of their earnings as dividends. (Dividend distribution is encouraged by the Australian tax system.) It should result in a reasonable level of tax being collected from such investments.

Second, New Zealand has a closer economic relationship with Australia. Making a special case for Australia will help to move the two countries closer towards a single market for the purposes of investment and is therefore consistent with this relationship.

For these reasons, taxing only dividends received from Australian companies is a reasonable approach, while being a simpler approach as well.

Q. Will compliance costs increase as a result of the new tax rules for offshore investments?

A. For most ordinary direct investors in offshore shares, the changes should not result in an increase in tax compliance costs. For example, an investor with some Australian shares and a portfolio costing NZD$50,000 or less outside Australia would continue to pay tax just on dividends. Investors with significant share portfolios outside Australia will face some extra compliance costs under the “5% cap” method. The additional costs will arise because investors will have to value their portfolio each year and keep track of carried forward amounts. Many already use an accountant to assist with their tax obligations so this should not be a big problem.

Q. Why do the changes discriminate against individuals who invest directly in offshore shares?

A. They don’t. They simply correct the imbalance in the current rules, which give favourable treatment to investments into certain countries and require more tax from investments made into others. Investors into the eight “grey-list” countries will lose their favoured tax treatment and be treated equally to investors in other countries.

Investors into companies resident outside the “grey list” currently pay tax on 100% of their gains. The new rules will significantly benefit them because they will generally pay tax on 5% of the opening value of their shares each year, limited to 85% of any gain they make.

Under the new rules, offshore portfolio investments in shares will be taxed more consistently, whether individuals make them directly or through managed funds.

Q. So if I have investments in a managed fund will I be better off or worse off?

A. Generally, if you invest in a fund you will be better off under the new rules. For example, if your fund invests in Australian and New Zealand shares the capital gains on these investments will no longer be taxed. In many cases funds investing outside Australia and New Zealand will only be taxed at 85% of their gains, instead of the current 100%. You may also get a better return because your income will be taxed at your marginal tax rate, capped at 33%.


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