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Allowing a zero percent tax rate for non-residents investing in a PIE

2. Benefits and risks of applying source-based taxation to non-resident PIE investors

2.1 Certain sectors of the financial services industry consider that, with the appropriate tax treatment in place, they could market investments in foreign assets through New Zealand PIEs to non-resident investors, resulting in the following benefits.

Consistency with New Zealand’s source-basis taxation model

2.2 Introducing a tax exemption for foreign-sourced income derived by a non-resident through a PIE would ensure consistency with New Zealand’s source-basis taxation model.

2.3 New Zealand generally operates a source-basis taxation system where residents are taxed on their worldwide income and non-residents are taxed on their New Zealand-sourced income. However, non-residents investing in foreign assets through a PIE are currently taxed as if they were a New Zealand resident. This treatment is inconsistent with the way that investors would be taxed if they invested directly, and is inconsistent with our source-basis taxation system.

Cost reductions for existing New Zealand firms who manage foreign funds

2.4 Currently, very few New Zealand firms manage investments for non-resident investors. This is due to the intensely domestic orientation of the local financial services industry. However, the financial services industry estimates that a tax exemption, such as that suggested in this issues paper, would result in $1 million a year cost savings based on the difference between foreign and local administration costs.

Creation of new firms and relocation of foreign-based activity to New Zealand

2.5 It has been suggested that the tax exemption (in combination with some other regulatory measures) could lead to a percentage of global market back-room and administrative services being migrated to New Zealand. New Zealand is seen as being a suitable base for these services because of the regulatory framework, political stability, lack of corruption and exchange controls, and the difference in time zones which allows New Zealand to process overnight transactions which are made that day in Europe or the United States.

2.6 The financial services industry estimates that New Zealand could gain a market share of these activities after 10 years of development. Assuming revenues of 1 percent of assets under management and a 30 percent profit margin, this could create approximately NZ$1 billion of profits and approximately NZ$300 million in taxes.

Spin-offs for local investors

2.7 The development of an “export”-focussed investment industry could have positive spin-off effects for New Zealand investors accessing the benefits of scale in the new funds. This could lead to a decrease in aggregate fees charged for fund administration and investment management services.

2.8 The potential benefits and costs of the suggested changes require further investigation. They include weighing the value of these potential back-room and administrative services against the fiscal costs and potential fiscal risks of implementing an exemption for foreign-sourced income derived by a non-resident through a PIE.

Fiscal implications

2.9 The estimated fiscal cost of exempting foreign-sourced income derived by a non-resident through a PIE from New Zealand tax will depend upon the amount of foreign-sourced income currently derived by non-residents through managed funds.

2.10 Information provided by the funds management industry indicates that as at December 2008, overseas investments accounted for 40 percent ($22 billion) of total funds invested of $56 billion. With respect to the residency of investors, officials understand that less than 1 percent of investors in the New Zealand funds management industry are non-residents. Therefore, using the fair dividend rate of 5 percent as a measure of the returns earned on these investments, the estimated fiscal cost would be less than $10 million per annum.[3]

2.11 In carrying out a cost-benefit analysis, thought needs to be given to administrative and compliance costs associated with the suggested changes. These will depend on the detail of the particular option selected, should the Government decide to proceed.

Ability for investors to re-characterise New Zealand-sourced income

2.12 Generally, income derived by an investor from a PIE is excluded income. This means an investor is able to claim tax deductions relating to that income – for example, management fees and interest incurred in borrowing to purchase units in the PIE.

2.13 In order to provide an exemption for foreign income derived by a non-resident investor in a PIE, PIE income that relates to offshore investments and that is allocated to a non-resident investor could be deemed to be foreign-sourced income of the investor. This would not be assessable income for New Zealand tax purposes. As a result, there would be no allowable deductions arising from the PIE investment to offset against any other New Zealand-sourced income. The technical position achieved would be consistent with a non-resident investing directly in foreign investments and with source-based taxation.

2.14 However, because of the fungibility of money, exempting foreign-sourced income derived by a non-resident through a PIE from New Zealand tax could still give rise to a practical fiscal risk. Even if a deduction is not technically available, it may be difficult to trace where funds have been applied.

2.15 This risk exists already with branch activities and is not an issue specific to exempting foreign-sourced income derived by a non-resident through a PIE from New Zealand tax.

The ability for New Zealand investors to re-characterise as non-resident investors

2.16 There are also concerns that New Zealand investors could restructure to take advantage of the exemption.

2.17 A New Zealand investor who invests in a PIE that invests in foreign investments would currently have a prescribed investor rate (PIR) based on their marginal tax rate up to a maximum of 30%. However, if the changes suggested in this issues paper were to go ahead, the New Zealand investor could establish a foreign company which then invests in the PIE. The foreign company would be a controlled foreign company (CFC).

2.18 Under the new international tax rules, passive income derived by a CFC is attributable to and taxed in New Zealand. The definition of passive income does not include PIE income. As a result, it would constitute active income and no New Zealand tax would be collected.

2.19 This issue could be addressed by amending the definition of “passive income”. However, if the CFC were an Australian company, it would be a grey list entity and therefore not subject to the attribution rules.

2.20 One potential solution to this issue could be to limit the exemption to individual non-resident investors or to exclude CFCs and non-resident trustees of trusts with a New Zealand settlor.

2.21 This solution could be viewed as undesirable as it would prevent the zero percent rate applying to many investors to whom it should apply – for example, foreign companies with no New Zealand shareholders.

Manipulation of expenses between investor classes

2.22 There are also concerns that investors could restructure their apportionment of deductible expenses to take advantage of the exemption. This is unlikely to be possible within an investor class because of the comprehensive rules regarding attribution of income and expenses to individual investors. However, it may be possible between investment classes. This would occur where deductible expenses are disproportionately applied to investor classes which hold New Zealand-sourced assets as against classes which invest in foreign assets.

International tax policy concerns with a tax exemption for offshore funds

2.23 The 1998 OECD report, Harmful Tax Competition — An Emerging Global Issue, outlined the factors used to identify harmful tax practices as:

  • A low or zero effective tax rate on the relevant income.
  • Ring-fencing to restrict the tax benefits to non-residents or prevent non-residents from accessing the domestic market. Ring-fencing effectively protects the sponsoring country from the harmful effects of its own incentive regime, so that the regime only has adverse effects on foreign tax bases. As a result, the country offering the regime may bear little or none of the financial burden of its own preferential tax legislation.
  • A lack of transparency in the way the regime is designed and administered. Non-transparency is a broad concept that includes favourable application of laws and regulations, negotiable tax provisions, and a failure to make administrative practices widely available.
  • A lack of effective exchange of information in relation to taxpayers benefiting from the operation of the preferential tax regime.

2.24 The OECD report recommended that member countries refrain from adopting new measures or extending the scope of existing measures that constitute harmful tax practices. As an OECD member, New Zealand is obligated to refrain from introducing any tax regime that contravenes the principles set out above.

2.25 The proposal to have a zero percent tax rate for non-resident investors in a PIE also raises wider international relationship issues. One of the conclusions from the April 2009 G20 summit was that member countries agreed to enforce sanctions on “tax haven” countries that are noncompliant with Article 26 of the OECD model tax convention for income and capital. Article 26 deals with tax information-sharing agreements between countries. Member countries also asked the OECD to publish a list of tax havens and their compliance with the information-sharing regulations. Therefore, the ramifications of introducing a harmful tax practice are wider than New Zealand’s OECD membership responsibilities, and we should adopt a cautious approach in this area as:

  • the boundaries of what is harmful tax competition are not clear cut;
  • there is more scrutiny when introducing new regimes compared with extending or retaining existing regimes; and
  • the proposals raise concerns about New Zealand’s ability to meet its disclosure of information obligations.

2.26 The risks associated with New Zealand’s international tax obligations will need to be considered carefully when suggesting different options for exempting foreign-sourced income derived by a non-resident through a PIE from New Zealand tax.

 

3 Estimated fiscal cost = $21,000,000,000 foreign investments made by managed funds * 5% FDR * 1% non-resident investors * 30% current NZ tax rate. In addition to the cost of exempting the foreign-sourced income of non-residents from New Zealand tax, some of the proposals include a de minimis exemption for certain investments in New Zealand assets. Allowing non-residents to have a zero percent tax rate in respect of New Zealand-sourced income will have an additional fiscal cost, depending on the de minimis limit selected.