Changes to Tax Rules

Proposed Changes to New Zealand’s International Tax Rules

In recent years New Zealand has been overhauling its International Tax rules. This started with changes being made to the controlled foreign company (“CFC”) rules. The changes made were to incorporate an exemption for the derivation of “active income”. The next major step is proposed changes to the Foreign Investment Fund (“FIF”) Rules.

Rationale for Changes

In recent years officials have been driven by the premise that investment decisions should be neutral. Therefore, importance has been placed on the fact that tax issues should not be driving business decisions.

Ever since the New Zealand’s international tax rules had been implemented in 1988, there had been concern that they placed a high tax and compliance burden on investors. In recent years the New Zealand Government has started to address these concerns by introducing new rules for the taxation of CFC’s. The next step in this process is to overhaul the taxation of non-portfolio FIF’s.

Proposed changes to FIF rules

In October 2010 the Taxation (International Investment and Remedial Matters) Bill (“Bill”) was introduced to Parliament. The Bill has proposed significant changes to the FIF rules, and in particular the taxation of non-portfolio FIF’s. Generally speaking, a non-portfolio FIF is where there are New Zealand interests of between 10% and 50% in offshore entities that are not controlled by New Zealanders (e.g. Joint Ventures).

The proposed changes to the FIF rules introduces a new method for calculating income from investments in non-portfolio FIF’s. The new method is termed the “attributable FIF income” (“AFI”) method. Under the AFI method a taxpayer will only be taxed on passive income that is derived by the FIF that they have invested in. However there are two exemptions:

  • The “active business exemption”. If the non-portfolio FIF (either independently or part of a consolidated group) has less than 5% of its income deemed to be passive, it will satisfy the “active business test”.
  • The “Australian exemption”. This applies to FIF’s that are resident in Australia, subject to tax in Australia, and are not entitled to certain Australian Tax concessions.

If a non-portfolio FIF falls under either of these exemptions, there is no income attributable to the New Zealand investor (under the AFI method). Traditionally non-portfolio FIF investors were able to get some form of relief from returning income in New Zealand by the “grey list exemption” (i.e. if the non-portfolio FIF was resident in a grey list country there would be no need to return any FIF income in New Zealand). However the Bill has proposed repealing the “grey list exemption” and introducing the “active business exemption” and the “Australian exemption” instead.

If an investor is unable to acquire sufficient information to use the AFI method, one of the alternative methods (in most cases this will be the fair dividend rate method or the cost method) of calculation will need to be used. In addition, a non-portfolio FIF investor may elect to use one of the alternative FIF calculation methods (if it is more suited to their individual circumstances).

In addition, it is proposed that any dividends paid by a non-portfolio FIF will be exempt (like with CFC’s), and that non-portfolio FIF’s be subject to the outbound thin capitalisation rules.

Consequences of Proposed Changes

If the proposed changes are implemented, they would largely align the tax treatment of investments in non-portfolio FIF’s and investments in CFC’s.  However, the proposed new FIF rules differ from the existing CFC rules in two key respects:

  • The “active business test” will be relaxed to enable investors to use consolidated accounting information to apply the test to chains of FIF’s (including FIF’s that are in different jurisdictions).
  • The exemption for payments of interest, rent, and royalties from an active CFC to an associated CFC is being modified so that a similar exemption applies when a FIF holding company controls an active FIF.

In addition, the proposed changes mean that, if implemented, there will be two separate FIF regimes going forward.

Public Comments on the Bill

Subsequent to the Bill being introduced, the public was asked to comment on it contents. An officials report was released by the Finance and Expenditure Committee (“FEC”) in the middle of last year, outlining some of the feedback. There was a wide variety of submissions on the Bill. We set out some of the major ones below.
FIF Rules should be repealed

A popular submission was that the FIF rules should be repealed (as was recently done in Australia). It was argued that because Australia had done this, New Zealand should follow suit to remain internationally competitive.

The FEC did not support this submission. It noted that repealing the FIF rules would not fit with one of the primary goals of the Bill, which is to align the various rules in relation to the taxation of outbound investment.

The Grey List should be retained

There was widespread support for the retention of the grey list. The reasons for supporting the grey list were:

  • Removing the exemption will significantly increase compliance costs.
  • The grey list helps define the focus of the FIF rules as being concerned with tax avoidance and the deferral of income from low tax jurisdictions.
  • There will be minimal additional tax collected by removing the grey list (a credit is likely to be available in New Zealand for tax paid in the grey list country).
  • An exemption is available for Australia and the same should apply to other countries that had traditionally been regarded as having a similar tax system.

The FEC did not accept any of these arguments. The FEC made the point that the grey list was removed for portfolio FIF interests in 2007 and CFC interests in 2009. In this regard, the FEC also noted that the reasons for removing it for non-portfolio FIF interests are the same.

Progress of the Bill

The Bill had not been passed into law at the date of publication of this article. This is because the Bill was not enacted into legislation prior to Parliament being dissolved, immediately prior to the 2011 New Zealand general election. This meant that the Bill lapsed.

The Bill is expected to be enacted in to law in the near future. When the Bill first came out it was proposed that the changes take effect from 1 July 2011. However, with the delays in the enactment of the Bill, it is expected that the changes will take effect from the start of the 2012-2013 tax year.

Conclusion

The forthcoming enactment of the Bill is a positive step for international investment in New Zealand. The “active income exemption” for non-portfolio FIF interests should encourage international investment, with the resulting decrease in the compliance costs and tax burden.

However commentators have been critical of this new regime. Firstly, there is the view that more consideration should have been given to repealing the FIF rules and introducing a robust specific anti-avoidance provision (as Australia have done). Secondly, some commentators have expressed concern over the complexity of the AFI method. There was an expectation that a greater effort would have been made to simplify these rules, especially given CFC’s are already subject to a complex regime.

To reduce complexity in this area, it is hoped that in the future the Government overhauls the tax rules in relation to outbound investment. However, the Government has indicated that such an exercise will not be undertaken in the near future, due to the costs involved.