Chapter 3 – Foreign Investment Funds
3.1 Avoidance Problems: Need for an Alternative Regime
3.2 Coverage of the Regime
3.3 Foreign Investment Fund Regime
3.1. Avoidance Problems: Need for an Alternative Regime
3.1.1 If, as recommended by the Committee, the BE regime applied only to the non-minor shareholders of controlled foreign companies, the types of offshore investment outside the regime would be:
a minor or non-controlling shareholdings in companies resident in high tax jurisdictions;
b minor or non-controlling shareholdings in companies resident in low tax jurisdictions ("tax havens"); and
c interests in investment companies,unit trusts, mutual funds and similar entities, which collectively may be referred to as "foreign funds".
3.1.2 The CD proposes that the CV regime should apply to all of these types of investment. In the light of the concerns about the CV regime outlined in chapter 1, the Committee considers that it could be justified now only where there is a serious avoidance problem that exists or can reasonably be expected to develop. Outside that area and CFCs, the taxation of the gains, other than dividends, that residents derive from offshore investments should await the introduction of a general capital gains tax.
3.1.3 In the Committee's view, minor or non-controlling shareholdings in companies resident outside tax havens clearly fall in the category of investments that are best taxed under a capital gains tax. These companies cannot be used by the investor to erode the New Zealand tax base and the most important of them, publicly listed companies, generally distribute a substantial proportion of their income as dividends which are already taxed or will suffer a similar impost under the Government's new proposals.
3.1.4 Minor or non-controlling shareholdings in tax haven companies are a possible source of concern. The majority of problem cases will, however, be passive investment vehicles which would fall into the foreign investment fund regime discussed in section 3.3.
3.1.5 Offshore funds, especially those located in tax havens, are clearly the biggest avoidance problem. The Committee therefore favours the introduction of a foreign investment fund regime targeted at investment vehicles which confer significant tax benefits, such as unit trusts based in tax havens.
3.2 Coverage of the Regime
3.2.1 In summary, the two building blocks of the Committee's proposals for companies would be:
a the BE regime to apply to controlled foreign companies which do not meet the grey list test outlined in chapter 2; and
b a foreign investment fund regime to apply to investment vehicles.
3.2.2 Between these two types of investment, no regime would apply. Three arguments have been advanced for a regime which applies to all foreign investments. The first is that complete coverage is needed to catch taxpayers who have control of an foreign company but manage to avoid the control test. The response in other countries to vehicles which side step the control test has been to introduce an offshore fund regime. We would similarly expect that many of these non-controlled vehicles would fall into the foreign investment fund regime proposed by the Committee. With a comprehensive definition of control and a wide foreign investment fund definition, the remainder of the problem does not justify the administration and compliance costs of a fully comprehensive regime. We would also note that most companies find real minority interests disadvantagous. Minority interests will be all the more unattractive as a result of these reforms since a substantial though minority shareholder in a non-resident company could be tipped into the BE regime by the purchase of a possibly small interest in the company by another New Zealand resident.
3.2.3 The second argument for comprehensive coverage is that a CV or comparable regime is needed to discourage resident companies from "going offshore", by penalising their New Zealand resident shareholders. By going offshore it is meant that a New Zealand company would establish a non-resident holding company which would own its New Zealand and foreign subsidiaries. No New Zealand company would then own foreign assets. Thus, the corporate group would avoid the international regime. Under the CD proposals, however, the resident shareholders in the foreign company would fall into the relatively draconian CV regime, thereby discouraging such restucturing.
3.2.4 It is obvious that this restructuring does not result in a shift of physical assets out of New Zealand. In addition, the resident shareholders end up in no better position than residents who own shares in what are now non-resident companies. Furthermore, the tax advantages are not one-sided since the restructured company would lose the ability to pass imputation credits for New Zealand tax paid through to its resident shareholders. In addition, non-resident dividend withholding tax on dividends paid out of New Zealand and dividend withholding payment on incoming dividends might also be incurred. Moreover, there are commercial constraints on this process since, at the end of the day, New Zealand companies are dependent on New Zealand shareholders for their equity base and need to maintain good relationships with them. The Committee therefore considers that the second argument is not sufficient to warrant a fully comprehensive regime at this stage.
3.2.5 The third argument is that a comprehensive regime would extend the tax base and permit a further reduction in tax rates. If revenue were the objective, however, it would be necessary to evaluate alternative sources which might better meet the efficiency, equity and simplicity objectives of tax reform. As argued elsewhere, the Committee considers that the taxation of foreign equity investments outside tax havens is best left to a capital gains tax regime and could not be advanced now without a real cost in taxpayer attitudes towards voluntary compliance.
3.2.6 The Committee therefore concludes that there is insufficient justification for a fully comprehensive regime at this stage. If a problem emerges, additional measures could be considered. In order to monitor developments and encourage compliance, it is desirable to have comprehensive disclosure requirements. For example, all taxpayers could be required to disclose offshore interests that fall outside the BE and foreign fund investment regimes. This would enable the Inland Revenue Department to request further information where necessary and hence keep abreast of responses to the new measures. We consider that the approach of aiming to define the extent of the problem, if any, resulting from incomplete coverage is preferable to implementing an across-the-board regime now.
Recommendation
3.2.7 The Committee therefore recommends that the CV regime apply only to interests in foreign investment funds, as discussed in section 3.3.
3.3 Foreign Investment Fund Regime
3.3.1 The definition of a foreign investment fund can potentially be very wide. The regime should be targeted at non-resident entities which provide significant tax advantages compared with comparable entities in New Zealand. This is the case when the income of the entity is untaxed or only lightly taxed compared with the tax that would be levied on such income in New Zealand. For example, a unit trust based in a tax haven which invests in debt securities would offer significant tax advantages to New Zealand investors compared with an identical unit trust in New Zealand. A unit trust investing exclusively in shares, however, offers tax advantages only to the extent that it permits dividend income to be converted into capital gain. A diversified foreign investment fund will, however, typically own non-controlling interests in companies, debt instruments and other investments.
3.3.2 The other targets of the foreign fund regime are entities which slip outside the BE regime because they provide tax benefits which do not depend on control. This will generally be feasible among non-associated persons only when there are well-defined means of purchasing and disposing of interests and regularly quoted prices for them so that members can monitor fund performance. Thus, such funds will typically be listed on a stock exchange or have redemption arrangements under which investors can sell their interests to the fund manager at a price based on the net assets of the fund.
3.3.3 In order to address the tax advantages offered by these types of fund, the Committee favours a regime based on the Canadian one. According to Canadian tax practitioners, this has largely eliminated the marketing of tax haven funds in Canada. The key criteria for the application of the regime would be that:
a the fund (which would include any legal entity) derives its income or value primarily or substantially from holding or trading in portfolio investments in shares, investments in debt instruments, real property, commodities, royalty agreements, etc; and
b the effect of the residence of the entity for tax purposes and its distribution policy is to reduce the tax payable on the income of the entity below what it would be had the income been taxed in New Zealand as it was derived.
3.3.4 We would define a "portfolio investment" as a non-controlling interest where the investor has no significant influence over the investee. The term is incorporated in the foreign investment fund definition not because we believe that there are particular tax advantages in holding shares in foreign funds (apart from the deferral or avoidance of tax on dividends) but because such investments are characteristic of the type of fund we have in mind.
3.3.5 An effect test such as that outlined in (b) is to some extent subjective but it is necessary to target the regime on entities in low tax countries. Taxpayer compliance would be encouraged by comprehensive disclosure requirements.
3.3.6 Canada taxes residents on the basis of a prescribed rate of interest applied to the amount of their investment in such funds. Because there will usually be a quoted price for interests in such funds which reflects the underlying income they accumulate, the Committee considers that the CV regime could apply to such investments. Thus, the investor would be taxed on the difference between the market price of the interest at the end of the income year and the equivalent value at the beginning of the year, plus any distributions received during the year. Where a taxpayer was subject to both the BE and offshore fund regimes, the former should apply.
3.3.7 It may be necessary to include an anti-avoidance rule aimed at entities which are in substance foreign investment funds but which are structured to avoid the regime. Further comment on the Committee's recommended regime for foreign investment funds is provided in Annex 3.
Recommendation
3.3.8 The Committee therefore recommends that:
a in addition to the BE regime, there be a foreign investment fund regime to apply to interests in entities which:
i derive their income or value primarily or substantially from holding or trading portfolio investments in shares, investments in debt instruments, real property, commodities, etc; and
ii the effect of the residence of the entity for tax purposes and its distribution policy is to reduce the tax payable on the income of the entity below what it would be had the income been taxed in New Zealand as if it were derived by the investor;
b the taxable income derived by a resident from an interest in a foreign investment fund be calculated as the increase in the market value of the interest over the income year, plus any distributions receivable; and
c where an interest in a non-resident entity falls within both the BE and foreign investment fund regimes, the BE regime apply.