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Terry Baucher says there is danger in an IRD-sponsored 'hidden policy shift', one that will likely provide 'an even greater incentive' to invest in property

Terry Baucher says there is danger in an IRD-sponsored 'hidden policy shift', one that will likely provide 'an even greater incentive' to invest in property
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By Terry Baucher*

If anything should be the focus of 'Making Tax Easier' it should be the foreign investment fund (FIF) regime.

Instead, a new tax bill is set to introduce a couple of unwelcome twists to this notoriously complicated set of rules.

The FIF regime in its current iteration has been with us since 1 April 2007 and is therefore reasonably settled law.

However, the recently released Taxation (Annual Rates for 2015–16, Research and Development, and Remedial Matters) Bill includes an amendment which on closer inspection seems more of a policy shift than remedial. 

The main part of the Bill contains some interesting proposals around research and development together with sensible changes to clarify the GST treatment of bodies corporate. 

The rest of the Bill "proposes a suite of measures to ensure the tax system is well maintained and that the tax and social policy rules operate as intended". 

This rather bland phrase includes topics such as Child Support, Working for Families, charities and tax administration. 

In addition there are also some remedial revisions to the rules on foreign superannuation schemes.

Also included is a new provision effective from 1 April 2015, which I consider will unfairly impose a hefty tax charge on a large number of taxpayers.

The measure makes it mandatory to apply the "schedule method" to lump-sum withdrawals and transfers from a foreign superannuation interest where a taxpayer has less than $50,000 of FIF interests.

The problem I have with the proposal is that the schedule method takes no account of the actual performance of the superannuation scheme.

Instead the taxable amount is determined by how long a person has been resident in New Zealand.

This approach might have the advantage of simplicity but ignoring the actual investment performance of the superannuation scheme is unfair and likely to lead to over-taxation.

There is an alternative formula method available for defined contributions schemes, which, although complicated, does at least take into account the real investment returns.

The proposed legislation is likely to apply to those with sums scattered across several pension schemes who wish to take advantage of the new UK pension rules effective from 6th April. 

Broadly speaking these new rules will make it easier to withdraw sums from UK pensions for those aged 55 and over.  Many UK migrants and returning Kiwis have relatively small amounts of funds invested in pension schemes which have underperformed.  Using the new rules to withdraw/transfer these funds seems a valid approach.  However, the tax cost from applying the schedule method to any withdrawals and transfers could be costly and unfair. 

I will be submitting on this point to the Finance and Expenditure Committee and I urge you to do so as well.

Submissions are due by 30th April and details about submissions can be found here.

A hidden Easter Egg?

But what really caught my eye was tucked away under the heading "CFC remedials".

This turned out to be legislation relating to the use of the "Fair Dividend Rate" (FDR) method for calculating FIF income which appears likely to increase the tax paid by managed funds.

Under the usual FDR method, FIF income is deemed to be 5% of the FIF’s opening value at the start of an income year.  A variation, the "unit-valuing funds" method allows certain investment funds to make the FDR calculation on the value of the investment on each day of the year – that is, they must make 365 calculations rather than just one.  This gives a more accurate result as it takes into account change in value throughout the year.

Investment funds using this methodology could make the choice between the ordinary FDR method or the unit-valuing funds approach after the end of an income year, thereby picking the method which produces the least income.

A perfectly reasonable approach you might think?

Not so according to Inland Revenue which proposes limiting the ability in future to switch between methodologies. This is on the basis, "This was not an intended feature of the rules as it was expected that taxpayers would choose one or the other method and use that consistently. The change proposed in this bill is intended to restore the original policy intention."

It’s common for new legislation to require remedial amendments usually to correct unexpected results from inadvertent drafting errors. Such amendments form part of every tax bill. Any problems are usually ironed out within one or two years of the initial legislation. However, the current FIF regime legislation was passed in December 2006.  

A hidden policy shift

In my view a legislative change suggested more than eight years after the original legislation is a hidden policy shift not a remediation.

This seems particularly so given the likely effect of the change will be to increase the tax paid by managed funds.

As is often the way the "remedial" legislation tackles the symptom not the causes.

When the original FIF legislation was proposed many critics said the FDR rate of 5% was too high and would lead to over-taxation.

Taxpayers using all available options to minimise their taxable income is therefore a rational response to perceived over-taxation.

A better policy response would have been to consider whether the current fair dividend rate of 5% is too high.

It’s also worth remembering the words of then opposition MP Dr the Hon Lockwood Smith. In December 2006 he concluded his speech opposing the new FIF legislation as follows:

"... this legislation will distort investment.  It will provide a serious disincentive to invest offshore in a diversified portfolio.  This legislation will provide an even greater incentive for New Zealanders to bring back their money from overseas and invest in residential property here in New Zealand.

People get the capital gains tax free and the returns are far better, so why would they not?

This is bad legislation because of all those complexities and distortions."

The Government has changed since 2006 but the issues identified remain. (They are also especially ironic in the wake of recent comments from the Reserve Bank Deputy Governor Grant Spencer).

In that context instead of sliding through an effective tax increase through "remedial" legislation wouldn’t it have been better to address the issue of potential over taxation by reviewing the basis of the FDR calculation?

Incidentally, the original FIF legislation was changed after over 2,000 submissions were made. So if you want to make a difference make a submission to the Finance and Expenditure Select Committee on the Bill by 30th April.

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*Terry Baucher is an Auckland-based tax specialist and head of Baucher Consulting. You can contact him here »

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3 Comments

In the interests of  fairness FIF has always been an outlier with the basic assumption that 5% was a fair and reasonable rate to tax against. At the other end of the scale is of course property investment.

Many growth companies pay little or any dividend in the early years so it discourages NZ tax residents to try to increase their diversified portfolios beyond Xero as an example. If it assumed that in some future date that resident will spend the money and probably in NZ then a future source of income for the country is discouraged.

In fact the recent level of share markets abroad makes it very difficult to find a 5% yield let alone an average across a portfolio.

This one needs more attention!

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Indeed. They call it the fair dividend rate system. The current global dividend yield for a market capitalisation weighted protfolio is 2.3% Yet you are taxed as if you made 5%.

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Their "making tax easier" is just a shell game for the new things they want to introduce that they know won't fly otherwise.

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