Chapter 1 – Introduction
1.1 Purpose of This Report
1.2 Submissions
1.3 Context of the Reforms
1.4 Criteria for Evaluation of Proposals
1.5 Objectives of International Tax Reform
1.6 Regimes Proposed in the Consultative Document
1.7 Summary: Main Building Blocks
1.1 Purpose of This Report
1.1.1 This is Part 1 of the Report of the Consultative Committee on Full Imputation and International Tax Reform. It deals with the Committee's recommendations on the main elements of the international tax reforms. Our aim in presenting this report is to enable you to give taxpayers as much certainty as possible before 1 April 1988, the implementation date proposed in the Consultative Document on International Tax Reform (the "CD") for the regimes to apply to undistributed income.
1.1.2 To this end, the report concentrates on the Committee's recommendations on the main building blocks of the international tax reforms and, in particular, the boundaries of the regime and the transitional provisions. In this way, we hope that, once you have considered our recommendations, taxpayers will know with as much certainty as is practicable at this stage whether they are affected by the regime and, if so, when it will first affect them and broadly how it will do so. Where we have not finalised our views, we say so or refrain from commenting.
1.1.3 A number of details are still to be considered. We will address these in Part 2 of our report which will accompany the draft legislation. A separate report will also be prepared on full imputation and the corresponding draft legislation.
1.1.4 Given the Committee's reporting deadline of 31 March 1988, we began meeting on 22 December 1987 in an endeavour to identify the major issues. We have met regularly, usually several times a week, since then. Since our brief includes the preparation of draft legislation, we have engaged three legal draftsmen to assist with this task. As a result, the draft legislation is well advanced, though considerable detail has still to be decided.
1.2 Submissions
1.2.1 A total of 209 submissions were received by the Committee. Of these, 108 dealt only with the international tax reforms, 49 dealt only with imputation and 47 commented on both. Given our reporting deadline, we have been able to hear only a small number of oral submissions. Committee members have, however, discussed the CD proposals widely with tax practitioners and business people. In addition, Committee members attended the Institute of Policy Studies seminar on the reforms, which was held in Wellington on 2 February 1988, and the annual conference of the New Zealand branch of the International Fiscal Association, held at Wairakei on 26-27 February 1988, which was focussed entirely on the international reforms and imputation. These were helpful in providing feedback on the CD proposals and alternatives advocated by practitioners.
1.3 Context of the Reforms
1.3.1 The international tax reforms are part of a wider package of reforms which includes substantial reductions in statutory tax rates and removal of tax concessions for superannuation and life insurance. The Committee recognises that the Government regards an effective international regime as part of the trade off for lower tax rates and, indeed, a prerequisite for the latter. In addition, the reforms should be mutually consistent and should reinforce one another as far as possible. For example, the effectiveness of the superannuation fund tax reforms depends in part on the international tax regime covering offshore vehicles which could substitute for domestic superannuation funds. The Committee has kept these linkages in mind in considering the present proposals.
1.3.2 The reforms must also be seen in the context of future tax reforms, particularly the possible introduction of a capital gains tax and interjurisdictional allocation rules (such as transfer pricing and expense allocation provisions). The latter are necessary to ensure that New Zealand collects the appropriate amount of revenue from domestic investments owned by non-residents. This objective is not addressed in the current international proposals, which are aimed at taxing New Zealand residents on income diverted from New Zealand and foreign-source income derived through offshore companies and trusts.
1.4 Criteria for Evaluation of Proposals
1.4.1 There are a number of criteria which are conventionally used to evaluate tax reforms. These have formed the basis of the Committee's framework for considering the CD proposals and possible alternatives. In brief, we believe the reforms should be:
a equitable. The effectiveness of the reforms will depend to a large extent on voluntary compliance by taxpayers. This is much more likely to occur if they are perceived to be fair;
b efficient, in the sense of minimising additional administrative and compliance costs and the impact of the tax system on business decision-making; and
c as far as possible, simple to implement and certain in their impact.
1.4.2 We would add that taxpayer perceptions of the reforms will be enhanced if they are consistent with existing income tax principles and give adequate recognition to the need for transitional measures.
1.5 Objectives of International Tax Reform
1.5.1 The CD has two main objectives: to
"a protect the domestic tax base from arrangements which seek to avoid or defer New Zealand tax by the accumulation of income in offshore entities; and
b reduce the extent to which the tax system encourages offshore investment relative to investment in New Zealand and biases the form in which offshore investment is made."
(CD, page 1)
1.5.2 There is no sharp distinction between tax avoidance and tax deferral since the latter amounts to a permanent reduction in the present value of the tax collected by New Zealand. The avoidance problem which the CD identifies and which was the target of the controlled foreign company ("CFC") measures announced in Annex 4 of the 1987 Budget is essentially the use of controlled tax haven vehicles, whether companies or trusts, to avoid New Zealand tax by the diversion of New Zealand-source income. There is widespread agreement amongst parties making submissions that the Government is fully justified in addressing this problem. The Committee certainly endorses this view. There is also general, though less solid, support for a regime which taxes the accumulation of foreign-source income in tax haven entities.
1.5.3 The anti-deferral objective is much more contentious and there is considerable opposition in submissions to a comprehensive anti-deferral regime. The CD regards the deferral problem broadly as the absence of taxation on an accrual basis of residents on income they earn through non-resident companies and trusts. At present, New Zealand tax is collected on income derived by foreign companies owned by New Zealand residents only when it is distributed to non-corporate resident taxpayers. In the case of trusts, New Zealand tax is collected, if at all, only when distributions are made to resident beneficiaries.
1.5.4 The CD proposals pursue the anti-deferral objective primarily by aiming to tax residents on the undistributed income of non-resident companies and trusts in which they have an interest or a connection as a settlor. This objective is also behind the introduction of a withholding payment to apply to foreign-source non-portfolio dividends received by resident companies, as announced in the Government Economic Statement of 17 December 1987.
1.5.5 Thus, the thrust of the reforms is to tax all residents, including companies, on the income that they actually receive from foreign entities (i.e. non-resident companies and trusts) and on certain undistributed income. The taxation of income on receipt is well within the current concepts of the income tax system (though other considerations may suggest that dividends received by companies should be taxed differently from dividends received by individuals). As commercial transactions have become more sophisticated, both the accounting and the income tax concepts of income have of necessity been extended in many areas to include not only income received but income which can be said with reasonable certainty to have accrued. It is fully consistent with this extended definition of income to tax residents on the undistributed income of non-resident entities that can reasonably be assumed to have accrued to them. This does not require that they have legal title to the income. It is sufficient that they possess the power to give themselves legal title. We therefore do not regard it as offensive to income tax principles that residents are taxed on income over which they have power of disposition, even if they have not received it. We would, however, go no further than this. It is not reasonable to tax residents on income that they may never receive.
1.5.6 One of the Committee's main reservations about the CD proposals is that they pursue the anti-deferral objective to its extreme limits without giving enough attention to conventional income tax principles or to the administration and compliance problems which arise. In some cases, taxation would be levied on amounts that were well beyond the income to which a taxpayer had any reasonable chance of access. Moreover, at some point, the administration and compliance costs would be excessive relative to the revenue that could be expected.
1.5.7 The CD supports the anti-deferral objective on the basis that "a broadening of the tax base with respect to foreign income is required to permit cuts in the rates of income tax applicable to both individuals and companies" (CD, page 15). This is seen as the primary justification for the comparative value ("CV") regime (under which residents would be taxed on the annual change in the market value of their interests in foreign companies), though it has also been advanced on other grounds which will be discussed below. The Committee strongly supports the objective of broadening the tax base and lowering income tax rates. We believe that this objective also has widespread support amongst the business community. There is, however, strenuous opposition to pursuing it through what is in effect an accrual nominal capital gains tax, i.e. the CV method. The CV method is not defended in the CD as a capital gains tax. There is no discussion of the fundamental design issues associated with such a tax, such as whether it should tax only real or nominal gains and whether it should apply on an accrual or realisation basis. Given the complete novelty of the CV proposal, its lack of any international precedent, its valuation problems, its cash-flow consequences and the absence of a convincing justification for it in the CD, it is not surprising that the proposal found no support amongst those who made submissions.
1.5.8 This raises the Committee's other main concern. The CD gives too little weight to the importance, in a tax system based on voluntary compliance, of acknowledging taxpayer perceptions of "fairness". If the CV regime were implemented as proposed, it would encourage evasion and stretch the limits of avoidance because taxpayers would regard it as very unfair. The objective of retaining taxpayer goodwill should be kept in mind.
1.5.9 The second objective referred to in paragraph 1.5.1, of reducing the extent to which the tax system encourages offshore investment, is intimately linked with the first objective. To the extent that tax payable on foreign investment is avoided or deferred relative to the tax that would be payable in New Zealand, the tax system will influence decisions to invest in New Zealand or overseas. Most decisions to invest offshore are not tax driven though, as an important business cost, taxes must obviously be taken into account and will influence decisions to repatriate or reinvest income. The CD objective refers to the impact of taxes on the marginal investment decision, that is, where other factors are in balance, tax considerations might tip the scales in favour of investing offshore rather than in New Zealand.
1.5.10 This objective can be addressed in terms of the criteria of "capital export neutrality" (which holds when foreign- and domestic-source income are taxed in the same way so that residents are indifferent on tax considerations between investing offshore or domestically) and "capital import neutrality" (which holds when the tax treatment of foreign investments is determined solely by the rules applying in the country in which the investment is located). Many submissions explicitly or implicitly advocated the latter approach in order that New Zealand firms could compete with foreign firms. It was pointed out that no other country has a regime comparable to that proposed in the CD.
1.5.11 To a large extent, the international competitiveness argument advanced in submissions reflects the immediate and potentially adverse impact the CD proposals would have on existing investment. The Committee considers that these concerns can be addressed by providing adequate transitional arrangements. As to the future, we recognise that tax is only one factor affecting competitiveness. In the long run, New Zealand as a whole is best served by an efficient tax system: that is, one which is neutral between domestic and foreign investment. The Committee therefore supports the second objective of the CD, though there are major constraints on the extent to which it can be achieved. We comment further on this issue in section 2.3.
1.5.12 Wherever there is cross-border investment, there are at least two tax jurisdictions involved: the country in which the investment is sourced and the country in which the investors are resident. The interests of the respective revenue authorities are to some extent in conflict because the residence country typically allows a tax credit, within limits, for the tax levied by the source country. Tax treaties resolve the conflicting interests to some extent but unilateral tax changes can affect the balance. For example, Australian companies have an incentive to minimise the New Zealand tax they pay, even if this means increasing their Australian tax, since the Australian imputation scheme allows credits for Australian but not foreign company tax. Thus, another general objective of reform of New Zealand's international tax regime should be to ensure that New Zealand collects its share of tax, especially on income that has a New Zealand source. This is the objective of allocation rules which we referred to in section 1.5.
1.6 Regimes Proposed in the Consultative Document
1.6.1 The scope and nature of the international tax regime should be determined in the light of the above objectives and the criteria for evaluation outlined in section 1.4. The CD proposes two broad options for taxing on an accrual basis income derived by residents through offshore entities. The first is to tax residents each year on "their share" of the underlying income of the offshore entity. This is the approach taken under the branch-equivalent ("BE") method. The second approach is to tax residents on the distributions they receive from the offshore entity and the capital gain or loss that accrues to them each year. This is the all-embracing approach of the CV method.
1.6.2 These two approaches differ because taxable income may be less than comprehensive but, given a reasonably broad tax base, the primary difference is that the BE method taxes what may be termed systematic gains (which are due primarily to the accumulation of assets within companies as a result of retained earnings), whereas the CV method taxes both systematic and non-systematic or unanticipated gains. From the point of view of the efficiency of the tax system, it is not necessary to tax unanticipated or windfall gains and losses. Because such gains cannot be anticipated, they cannot influence investment decisions. Thus, the case for taxing them must rest on some notion of fairness.
1.6.3 Another way of viewing the difference between the two methods is that BE income is taxable income as currently defined whereas CV income is the much less conventional economic concept of income. The Committee prefers the approach, wherever feasible, of taxing residents on the underlying income of foreign entities since this focuses on systematic or planned gains and is consistent with the principles of the current tax system.
1.6.4 Where this approach (i.e. the BE method) is not feasible, the CD falls back on the CV method. Some of the Committee's concerns about the CV approach were referred to above. An accrual alternative to the CV method would be to tax residents each year on their share of the reported income of foreign companies based on the companies' audited accounts. In order to avoid taxing residents on the undistributed income of foreign companies which they never receive, it would be desirable to have a post facto wash up on disposal of shares. This post facto adjustment would determine the actual gain or loss derived by a taxpayer on a foreign investment by calculating the distributions received and the capital gain or loss. Thus, a realisation-based capital gains tax is an inherent part of this approach.
1.6.5 The Committee do not advocate the adoption of this approach now. We mention it mainly to suggest that there are alternatives to the CV method that would meet the Government's objectives and in some respects are preferable to the CV method. The option outlined would be best examined in the context of the current investigation of capital gains taxes and should be introduced only as part of a general capital gains tax.
1.6.6 The CV method does, however, have a role as part of the current reforms where there are systematic or expected gains resulting from the accumulation of income in an offshore entity, such as may be the case for some unit trusts and mutual funds. We comment further on this in chapter 3.
1.7 Summary: Main Building Blocks
1.7.1 The Committee's proposals are developed in the following chapters. The main elements are:
a the BE regime to apply to non-minor shareholders of controlled companies which are either:
i resident outside of the United States, the United Kingdom, West Germany, Canada, France, Japan or Australia; or
ii if resident in one of those countries, fail the grey list test outlined in section 7 concerning the effect of significant tax preferences in those countries;
b a foreign investment fund regime to apply to residents with interests in certain investment vehicles domiciled in low tax countries;
c the settlor regime to apply to resident trusts (i.e. those with a resident settlor);
d transitional arrangements under which taxpayers would be exempt from:
i the BE regime until 1 April 1990 in respect of interests acquired on or before 17 December 1987 in companies which are not resident in low tax jurisdictions specified in a transitional list;
ii the BE regime until 1 April 1989 in respect of interests acquired after 17 December 1987 in companies resident in a country listed in (a)(i);
iii the settlor regime in respect of settlements made on or before 17 December 1987 where the settlor so elects, in which case an alternative regime would apply to distributions to beneficiaries and to the settlor where he or she had a debt, guarantee or other form of financial assistance outstanding to the trustee;
e strict disclosure requirements and penalties for non-compliance;
f eventually, but we would hope within a relatively short time, the extension of the income tax base to include capital gains on both domestic and offshore investments, including offshore investments not covered by the present proposals; and
g also as a matter of priority, the introduction of interjurisdictional allocation rules to ensure that New Zealand collects the appropriate amount of revenue, particularly in relation to New Zealand-source income.