By Terry Baucher*
Over the past two years I’ve written regularly on the tax treatment of foreign superannuation schemes, charting the issues and the Inland Revenue’s response.
The principal issues which were unclear were whether foreign superannuation schemes were subject to the Foreign Investment Fund (FIF) regime, and what was the tax treatment on transfer?
“Probably”, and “Not sure” in case you’ve forgotten.
On Monday, the Minister of Revenue introduced the Taxation (Annual Rates, Foreign Superannuation, and Remedial Matters) Bill into Parliament which should prove the final chapter in this saga.
The legislation largely follows the proposals set out in an Inland Revenue issues paper released in July last year (explained here in an earlier column) but also incorporates some of the submissions made in respect of the issues paper.
The new rules will take effect from 1 April 2014.
Under the proposed legislation, interests in non-Australian foreign superannuation schemes will no longer be taxed on an accrual basis under the FIF regime or as if a transfer represents a distribution from a company or trust.
Instead under a new set of rules a tax charge will arise when either a cash withdrawal is made or an amount is transferred into New Zealand or Australian superannuation schemes.
Withdrawals in the first four years after a person becomes resident will not be taxable.
Note that these rules will not apply to interests in Australian superannuation schemes which are generally exempt under the New Zealand-Australian double tax agreement.
The Schedule Method
After the four-year exemption period, a person’s tax liability on a withdrawal will generally be calculated by reference to a particular fraction based on how long the person has been a New Zealand resident before making the withdrawal. This is the “schedule method”, the new name for the “inclusion rate” described in last year’s issues paper. This fraction will be applied to the withdrawal to determine the person’s taxable income. The relevant fraction starts at 4.76% and rises each year until it reaches 100% for transfers made in the 26th and subsequent income year after the end of the initial four year exemption.
For example, Lucy became a tax resident on 14 July 2016 so her four year exemption expired at the end of July 2020. She withdraws a lump sum of $50,000 on 27 January 2024. There are three income years beginning in Lucy’s assessable period, so Lucy is required to use the schedule year fraction for year three. The corresponding schedule fraction is 14.06%, so her assessable income will be $7,030 (being $50,000 x 14.06%). Assuming Lucy’s tax rate is 33%, she will be liable to pay $2,319.90 of tax on her $50,000 lump-sum. (Note it appears under this example that as Lucy's exemption period expired after the start of the 2020-21 income year, then transfers in the rest of that income year are not caught. It will be interesting to see if this treatment is amended before enactment).
The Formula Method
An alternative method ("the formula method") will allow holders of defined contribution schemes to calculate the actual gains.
This rather involved method will incorporate an interest factor to compensate for the implied benefit from deferring taxation of the gains and income until transfer.
Both methods assume a growth/interest rate of 5% which is intended to reflect that the payment of tax has been deferred until receipt. The 5% supposedly also acts as an effective cap should the actual gains prove greater (we should be so lucky, eh?).
Those persons who complied with the FIF rules prior to the introduction of this legislation on 20th May 2013 will have the option to either continue to return income under the FIF rules, or to apply the new rules instead. If they continue to apply the FIF rules, any withdrawals or transfers in relation to that foreign superannuation interest will not be taxed under the proposed new rules.
These proposals have the great merit of simplicity and should eliminate the uncertainty of treatment which has been a problem since it was first identified in 2006.
So far, so good, but the legislation also contains a couple of troubling proposals.
The first is that it will apply to all transfers even those made into a locked-in scheme such as a KiwiSaver fund.
In this case it’s proposed to allow the taxpayer to withdraw an amount up to the value of the tax due from their KiwiSaver scheme.
This sounds all well and good but ignores the fact that where the transfer is made from a UK pension fund, withdrawing funds would possibly either invalidate the transfer or trigger a 55% tax charge in the UK.
I also struggle with the concept that a person who makes a transfer but cannot access the transferred funds until a later date has somehow derived income.
The other issue relates to the treatment of transfers made prior to the commencement of the new rules.
According to the Regulatory Impact Statement released with the legislation, the rules relating to the taxation of lump-sum transfers were so complex they “resulted in significant levels of non-compliance, which has been estimated to be approximately 70%”.
Now you might think this level of non-compliance would be a good reason for an amnesty particularly given the admitted complexity of the legislation. You would be wrong.
Instead the legislation proposes that for transfers made between 1 January 2000 (the choice of this date is not explained), and 31 March 2014, persons will have the option to either apply the rules that applied at the time of transfer (you know the ones Inland Revenue never explained) or opt to pay tax on only 15% of the lump-sum amount transferred. If the 15% option is chosen no penalties and interest will apply from the tax year in which the original transfer was made.
A 'distasteful double standard'
According to the Regulatory Impact Statement, an “amnesty is not recommended as it would create an unfair advantage for non-compliant people over people who have complied with the law and fulfilled any resulting tax obligations”.
Contrast this declaration with the lack of official action following the release on Tuesday and Wednesday of reports by the Inspector-General of Intelligence and Security and Independent Police Conduct Authority. In my view a distasteful double-standard applies here.
On the one hand no official action will be taken against Government officials and officers who either “arguably” breached the law or acted "unlawfully, unjustifiably and unreasonably".
By contrast taxpayers are expected to pay tax on transactions involving law which is in the Inland Revenue’s own words “complex” and “difficult to understand” and about which the Inland Revenue offered no guidance.
Is that not “unfair”?
If the Inland Revenue is concerned about equity it could either allow those taxpayers who previously paid tax in relation to a transfer to reassess their position using the proposed 15% option or refund the tax paid. That it won’t do so demonstrates its desire to raise revenue has trumped equity.
As an interim proposal I suggest the start date for transactions to be subject to this concessionary relief is brought forward to 1 January 2011 which was the year when the Inland Revenue first made some public utterances on the issue.
Very obviously, I recommend anyone who may be affected by these proposals to contact their professional advisor to determine their position.
I also recommend you make submissions to Parliament’s Finance and Expenditure Select Committee when it considers the Bill.