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Tax compromise on offshore investment issue

Hon Dr Michael Cullen
Minister of Finance
Hon Peter Dunne
Minister of Revenue

15 September 2006 Media Statement

Tax compromise on offshore investment issue

Finance Minister Michael Cullen and Revenue Minister Peter Dunne have today unveiled a proposed way forward on offshore investment tax changes.

The changes are part of the tax bill now before the Finance and Expenditure Select Committee.

"Like the committee, we have both received considerable correspondence on this issue. We will be writing to the committee outlining a suggested solution that builds on alternatives raised in submissions. We are proposing to apply a "fair dividend rate" to calculate tax on overseas shares," said the Ministers.

"This would tax individuals on a maximum of 5 per cent of the value of their offshore shares in a given year. However, unlike the proposal in the bill, where their shares have made a return in excess of 5 per cent, there would be no amount to carry forward as an excess gain (to be taxed in a later year). The fair dividend rate approach would not target capital gains, but rather something approximating a reasonable dividend yield.

"Individual investors would be able to pay tax on a fair rate lower than 5 per cent if they can show that their offshore portfolio share investments made a return of less than 5 per cent. Where an individual investor’s shares make a negative return, no tax would be payable.

"Any dividends derived would be counted for the purposes of calculating the investor’s overall return. However, the maximum amount taxable in a year would be limited to 5 per cent of the opening value of an investor’s shares (including situations where a dividend in excess of 5 per cent has been derived).

"Our intention all along has been to ensure greater fairness in the taxing of overseas investment income. The current rules create unfair tax advantages for direct investors over other savers, such as ordinary lower and middle-income people, who use managed funds that are taxed on the funds' earnings.

"We want to eliminate the tax advantages some investors have enjoyed for many years. A number of offshore investment vehicles pay no or very low dividends so that their investors avoid paying tax. They should be paying their fair share of tax. That is only reasonable if all of us are to fairly share the cost of providing hospitals, schools, roads and other government services.

"We also want to encourage greater diversification so investment decisions are driven by returns, not tax advantages. The new rules try to put all those investing outside New Zealand and Australia – individuals and managed funds – on a similar footing. The tax changes we are suggesting preserve these aims.

"It is important to remember too that this is not a tax grab. The government is lowering the tax burden on many lower income savers and eliminating taxation of capital gains on New Zealand and Australian equities for savers using managed funds. All up the government will be foregoing around $140 million a year in revenue to ensure greater fairness. We believe this is a price worth paying to remove distortions in investment markets.

"We have certainly listened to the concerns of the many submitters and are pleased there is an emerging consensus around the fair dividend rate as a way forward.

"We hope the select committee will now work with this proposal as a basis for ensuring fairness in the tax treatment of investment income."

--

Questions and answers

How would the fair dividend rate work?
Individuals would apply the "fair dividend rate" based on the market value of shares held at the start of the year. That is, if an investor holds $100,000 of offshore shares at the start of the year, their taxable income would be $5,000 (unless they are able to show that their investment has returned less than 5 per cent or has made a negative return).

Examples

Where an individual makes a total return of more than 5 per cent
John holds offshore shares that have a market value of $100,000 at the start of the year. These shares are worth $115,000 at the end of the year. John also derives a $10,000 dividend.

Under the fair dividend rate approach, John would either pay tax on 5 per cent of $100,000 or a lower amount if his return for the year is less than 5 per cent. No tax would be payable if he made a negative return.

John’s total return for the year is the $15,000 capital gain on his shares and the dividend of $10,000. His total return is therefore $25,000. However, his taxable income for the year would be limited to 5 per cent of the opening value of his shares. This would result in taxable income of $5,000. (Note: under the fair dividend rate method dividends would not be separately taxed)

Where an individual makes a total return of less than 5 per cent
Mary also holds offshore shares that have a market value of $100,000 at the start of the year. These shares increase in value to $102,000 at the end of the year. Mary also receives a $1,000 dividend.

As in the previous example, Mary would pay tax on 5 per cent of $100,000 (her opening value) unless she can show that she made a return of less than this.

Mary’s total return for the year is $3,000 (comprised of a capital gain of $2,000 and a dividend of $1,000), which is less than 5 per cent of her opening value of $100,000. Therefore, Mary would only be taxable on $3,000.

Where an individual makes a negative return
Judy holds offshore shares that have a market value of $100,000 at the start of the year, which decrease in value to $75,000 at the end of the year. She also receives a $10,000 dividend.

As in the previous examples, Judy would be taxable on 5 per cent of the opening value of her shares unless she can show that her total return for the year is less than 5 per cent.

Judy’s total return for the year comprises a capital loss of $25,000 and the dividend of $10,000. Her net return is therefore a loss of $15,000. Because Judy has made a negative return on her offshore shares, no tax would be payable under the fair dividend rate approach.

Why set a 5 per cent rate?
This represents a realistic rate based on historical returns on equity investments. These have averaged around 8 per cent over the latter half of the last century.

Isn't this still a capital gains tax?
This is not a tax on capital gains. A capital gains tax taxes the difference between the purchase and sale price of an investment. The proposal does not do this. Instead it is designed to tax income derived from investment. In New Zealand we tax income from investments by taxing the dividends. A number of offshore investment vehicles pay no or very low dividends so that their investors avoid paying tax. This creates unfairness and gives these companies a tax advantage over New Zealand companies and their investors.

Indeed the proposal also removes the existing capital gains tax on investments into non-grey list countries. Currently they are subject to 100 per cent taxation of capital gains. Under this proposal they will be taxed on a reasonable dividend rate instead of capital gains.

How much will this cost the government compared to the last proposal?
The current proposals will cost the government about $110 million a year in foregone revenue. If adopted, the new proposals will cost about $140 million a year. This is because the new approach softens the tax treatment of individuals and managed funds investing offshore.

Why not allow losses to be claimed against income?
The method does not target capital gains; therefore capital losses should not be allowed as a deduction.

What happens to the GPG exemption?
There are a number of details the committee will have to decide on, including this.

Will the $50,000 threshold still apply for individuals?
We are not proposing to change this.

How would the fair dividend rate apply to managed funds?
In order for managed funds to apply the new rules simply it is necessary that they know what the fair rate of return is at the beginning of a period. Therefore, managed funds would use a version of the fair dividend rate method that would tax 5 per cent of the value of their offshore portfolio share investments each year. There would be no variation to this rate, to provide certainty, and also to limit the potential fiscal cost.


ENDS

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