Annex 3 – Foreign Investment Funds

1 Characteristics of Foreign Investment Funds
2 Need to Counter Taxation Advantages of Foreign Funds
3 Basis for Taxing Funds
4 Definition of Foreign Investment Fund
5 Measurement of Assessable Income
6 Overlap with Controlled Foreign Company Regime


1 Characteristics of Foreign Investment Funds

1.1 Foreign investment funds are usually entities resident in tax havens which hold portfolio interests in shares, or which invest in financial arrangements, real estate, commodities, currencies or a range of such investments. The funds often re-invest their income to increase their value, or they may distribute the income to investors in non-taxable forms.

1.2 A typical foreign investment fund is one which invests the savings of its members in order to provide them with retirement benefits, such as pension or lump sum superannuation. Its constitution is often not a material consideration. It may be organised in a form that has a fiscal personality apart from its members, such as a company or unit trust. Such a fund is 'foreign' if it is not a New Zealand resident for tax purposes.

1.3 The shares or units of some funds are listed on public stock exchanges. Other funds are not listed but offer to re-purchase the shares of members, usually at a price that is published from time to time. Sometimes the price is guaranteed not to fall below a certain minimum, perhaps related to the value of the investments of the fund verified by an independent valuer.

2 Need to Counter Taxation Advantages of Foreign Funds

2.1 Where a foreign investment fund is based in a jurisdiction that levies little or no income tax, or where the investments of the fund are taxed at a lower rate than comparable investments in New Zealand, residents who invest in the fund enjoy a fiscal advantage over other New Zealanders who invest domestically. Some funds distribute dividends to their members. Others, however, may 'roll up' their profits each year into more investments so that members must sell their shares or units in order to realise a return. Where a fund rolls up its income, the fiscal advantage may be enhanced since the investor's proceeds on realisation are generally treated as a capital receipt not subject to income tax.

2.2 If the international tax regime did not embrace foreign investment funds, they would provide residents with an easy opportunity to shelter income from New Zealand taxation and thus defeat the intent of the regime. Other countries have found it necessary to deal with such funds, which were being used to circumvent their own international tax regimes. New Zealand must also address foreign investments funds, especially in the light of current proposals to reform the tax treatment of life insurance and superannuation. Domestic superannuation funds are to lose their tax exempt status whereas many foreign investment funds, which provide superannuation benefits, may enjoy significant tax advantages. If, for tax reasons, residents were induced to invest in these foreign funds, a considerable switching of investment would occur to the detriment of both the New Zealand tax base and domestic savings institutions.

3 Basis for Taxing Funds

3.1 Investors may obtain tax benefits through foreign investment funds without controlling them. They will therefore slip outside the controlled foreign company regime. Residents should nonetheless be taxed on fund income accruing to their benefit. However, since they do not have control and are unlikely to be able to report income measured according to New Zealand rules, an alternative basis of taxation is necessary. It is considered that, as a proxy or surrogate measure for the direct taxation of income as conventionally defined, the comparative-value basis of taxation (see section 5 below) is appropriate in the following circumstances:

  • where an investor has straightforward access to the underlying income of the fund. This will be the case where there are well-defined means of buying and selling interests;
  • where the value of the interest is likely to reasonably reflect the underlying income. This will be the case where the investments are essentially of a passive nature and producing systematic gains;
  • where it is apparent that the investor is obtaining a tax advantage. This will be the case where the foreign tax levied is lower than the comparable tax in New Zealand.

3.2 It is considered that the regime should apply to any interest held by a New Zealand resident in a foreign investment fund (as defined in section 4 below) where the effect of making the investment is to reduce the tax that is levied on the income earned through the fund to a level below that which would be paid had the income been taxed in New Zealand as it accrued. However, as those subject to the regime will generally have non-controlling interests, and therefore limited access to information, the effect test will often involve an element of subjectivity. Comprehensive disclosure is therefore essential to ensure its effectiveness. Moreover, other factors such as the domicile or residence of the fund and its distribution policy should be taken into account.

4 Definition of Foreign Investment Fund

4.1 A foreign investment fund will be defined by reference to its investments. A fund is any legal entity which derives its income or value primarily or substantially from portfolio (or non-controlling) investments in shares, or from investments of a passive nature.

4.2 Thus, investments characterising an entity as a foreign investment fund include non-controlling investments in companies, trusts, partnerships and other business and investment entities, and investments in land held for rent or other investment return, financial arrangements, annuities, bullion, commodities, foreign currency, rights to royalties, and rights or options to acquire any of these. Fund investments would generally not include controlling interests in active businesses or in companies that carry on active businesses.

4.3 Funds subject to the regime include entities whose primary investments are in other foreign funds, even where those investments represent controlling interests. Hence, a non-resident holding company that controlled a number of trading subsidiaries would not be a fund for purposes of the regime, but it would be if it controlled several investment funds.

4.4 The characterisation of investments is critical because an entity earning mainly active rather than passive income would not be a fund and would fall outside the regime. The distinction between active and passive income is hot precise, so at the margin there will be pressure on the definition of a fund. In order to prevent passive income being disguised as active income, the need for a special anti-avoidance rule is being considered.

5 Measurement of Assessable Income

5.1 A New Zealand resident subject to tax on an interest in a foreign investment fund will be taxed on distributions received plus or minus the change in value of the interest from the beginning to the end of the taxpayer's income year. If there is a market for interests in the fund, eg by way of stock exchange listing, market prices will be employed. Otherwise quoted redemption prices offered by fund organisers will be used.

5.2 In the absence of such data, taxpayers will be required to value their interests in offshore funds by some commercially acceptable means. For example, a fund may provide members with market valuations of investments from time to time.

5.3 Where reliable valuation is unavailable, it will be necessary to impute a rate of return on the taxpayer's original investment in the fund and tax the notional income derived.

6 Overlap with Controlled Foreign Company Regime

6.1 The definitions of 'controlled foreign company' and 'foreign investment fund' may overlap. Consider a holding company controlled by five or fewer New Zealand residents that invests primarily in portfolio shares. It would be a controlled foreign company as well as an offshore fund. Residents holding more than a 10 percent interest could be subject to tax twice. Hence, a resident in this position will be required to report on a branch-equivalent basis.