Tax treatment of profit distribution plans

(Clauses 6−10, 82, 83, 85, 88 and 108)

Summary of proposed amendment

The tax treatment of profit distribution plans (PDPs) is being amended so that shares issued under a PDP will be treated as a taxable dividend. This will mean PDPs are given the same tax treatment as other similar arrangements.

Application date

The amendments will apply to shares that are issued under PDPs from 1 July 2012.

Background

A PDP is a scheme used by companies to retain capital. Under a PDP a company issues bonus shares to all shareholders and offers to repurchase the shares immediately after the shareholder receives them. If the shareholder does not elect for the company to repurchase some or all of their bonus shares, the default option is for the shareholder to retain the bonus shares.

The current tax treatment of PDPs was the subject of a specific Inland Revenue product ruling in 2005 (BR PRD 05/08). The ruling held that, subject to certain conditions, a distribution of shares under a PDP is treated as a non-taxable bonus issue and consequently does not constitute a dividend in the hands of the shareholder. If shareholders elect for their shares to be repurchased, the cash amount they receive is treated as a taxable dividend and imputation credits can be attached.

In April 2009, the Government announced its intention to amend the law to ensure that bonus issues of shares distributed under PDPs are taxed in the same way as shares issued under other dividend reinvestment plans.

In June 2009, officials released the consultative issues paper, The taxation of distributions from profit distribution plans. The issues paper proposed that a distribution of shares under a PDP should be treated as a taxable dividend.

The key concerns that the Government has with the tax treatment of PDPs are:

Inconsistent tax treatment with other arrangements

There are other arrangements that are substantially similar to PDPs. For example, under both a dividend reinvestment plan and a bonus issue in lieu, shareholders are effectively given the choice of whether to receive shares or a cash dividend. Under these plans, regardless of whether shareholders receive shares or a cash dividend, they are treated as receiving a taxable dividend. To ensure consistency and coherence in the tax system, a similar tax treatment should be afforded to PDPs. While accepting that the legal form of each plan differs, in substance they are the same and can be used as a means to retain capital in a company.

Potential for imputation credit streaming

The current tax treatment of PDPs effectively allows for streaming of imputation credits through a shareholder self-selection process. This can occur when shareholders elect for the company to repurchase their bonus shares depending on whether or not they can utilise imputation credits that would be attached to a cash dividend. Shareholders that are unable to utilise imputation credits (for example, exempt or non-resident taxpayers) may elect to receive bonus shares that are non-taxable. As the bonus shares are non-taxable, imputation credits will not be attached, preserving the credits for shareholders who can best use them. This defeats the current policy settings that are in place for the imputation system.

Shareholders may not be taxed at their correct tax rate

PDPs are attractive to shareholders on high personal tax rates, relative to alternative share reinvestment plans. This is because high-rate shareholders are able to choose to receive the non-taxable bonus issue of shares, meaning they are effectively taxed at the company tax rate, rather than at their personal tax rates. By contrast, New Zealand taxpayers on personal tax rates below the company tax rate will tend to prefer the cash dividend because the imputation credits attached to it will generally reduce their tax liabilities.

The Government deferred its final decisions on the taxation of distributions from PDPs until after the Victoria University Tax Working Group (TWG) and the Capital Market Development Taskforce (the Taskforce) reported.

While the TWG did not comment on PDPs, the Taskforce stated that it:

…considers it important that the tax system treats substitutable transactions neutrally. If PDPs are substitutable for ordinary dividend payments with optional reinvestment, the tax treatment should ideally be identical in both cases. The same goes for other close substitutes. Otherwise, there is a danger that investment decisions will be biased towards companies that offer PDPs, and that there could be significant loss of tax revenue from normal dividend taxation.

At the same time, the Taskforce considers it desirable that the tax system does not impede the supply of capital. A decision on the tax treatment of PDPs should, therefore, take into account the fact that PDPs are an effective way for companies to raise capital.

Recommendation: We recommend that changes to the tax treatment of PDPs should be made as part of a broader review of tax settings and take into account any adverse impacts on capital-raising costs.

Following the Taskforce’s report, the Government decided that the tax treatment of PDPs should be amended as originally proposed. Consultative draft provisions were sent to interested parties in May 2011, and the feedback received on the drafting has been taken into account in determining the changes made in this bill.

Detailed analysis

A definition of “profit distribution plan” is being inserted into the Income Tax Act 2007. In addition, amendments are being made to ensure that, for tax purposes, bonus shares issued under a PDP are treated in the same way as a bonus issue in lieu. These amendments include changes to the rules for available subscribed capital, resident withholding tax and non-resident withholding tax.

If a shareholder elects, as part of the PDP, for the company to repurchase their shares, the cash amount they receive will not be treated as a taxable dividend, but rather the receipt of the bonus shares will be treated as a taxable bonus issue. This is to prevent double taxation.

Amendment to the tax treatment of bonus issues in lieu

The tax treatment of bonus issues in lieu is being amended so that the amount of a dividend is the money or money’s worth offered as an alternative. Previously, resident withholding tax was required to be deducted from the alternative amount. The new tax treatment is not expected to have any significant effects to the tax treatment of bonus issues in lieu, but is intended to make the tax treatment simpler.

For the purposes of a PDP, the amount of the dividend will similarly be the amount offered by the company for the repurchase of the share.

Remedial amendment to filing requirements

A minor amendment is being made to the current filing requirements for natural person taxpayers. This change is necessary to reflect changes in the personal tax rates.