Terry Baucher shows why NZ's foreign investment fund regime is schizophrenic, overly-complex, and ripe for reform.

By Terry Baucher* (email)

If, as Benjamin Franklin famously said “In this world nothing is certain but death and taxes”, then in tax law nothing is more certain than the devil will be in the detail.

In my last column I looked at how apparently similar types of foreign investments have very different tax treatments under the Foreign Investment Fund (“FIF”) taxation regime.

So this time I thought I would illustrate how much devil is in the detail of the FIF regime with a few examples from cases I have encountered.

A case study

Tom and Jerry are a couple who have worked overseas for nine years in Sydney, London and New York.

They returned to New Zealand in 2009 to raise their two young children. Tom has an Australian super scheme with a value at 31 March 2011 of $100,000. He has a UK personal pension scheme valued at $80,000 at the same date.

Jerry also has an Australian super scheme the value of which at 31 March 2011 was $60,000. In addition she has overseas shares which originally cost $250,000 but were valued at $135,000 as at 1 April 2010 and $130,000 at 31st March 2011.

The shares produced dividends totalling $8,000 during the year to 31st March 2011. During the year Jerry bought shares in News International as a long term investment for a cost of $25,000 but then sold the shares for $26,000 when details of the News of the World phone hacking scandal began to emerge.

As the total cost of their FIF investments exceed $50,000 the full FIF rules must be applied to each of Tom and Jerry’s overseas investments at which point a few nasty devils emerge, one of which puts the kibosh on the common belief that there is no capital gains tax in New Zealand.

First the good news: both Tom and Jerry’s Australian super schemes are exempt from the FIF regime as there is a specific exclusion for Australian regulated superannuation funds.

From then on it’s all bad news. Although Tom’s UK personal pension scheme was built up from contributions both he and his UK employer made to it, the scheme does not qualify as an exempt “employment related foreign superannuation scheme”. This is because a change in UK tax law in 2006 allows a transfer of the accumulated benefits before retirement.

The exemption doesn’t apply even if Tom is either unaware that he could transfer the funds in his UK pension scheme to a “qualifying registered overseas pension scheme” or prefers to leave the funds in the UK.

The amount of FIF income from Tom’s UK pension scheme will be calculated as the lesser of 5% of the opening value of the scheme on 1 April 2010 (the so-called “fair dividend rate” method), or the total return over the year including capital growth, and dividends and other funds distributed (the “comparative value” method).

Tax madness

Whichever approach Tom adopts he is faced with funding a tax bill on an investment which doesn’t actually produce any cash.

Jerry can either apply the fair dividend rate of 5% to the value of her overseas shares as at 1 April 2010, or choose to be taxed on the total return for the year. 5% of the opening value of $135,000 is $6,750 whereas Jerry’s total return for the year is $135,000 - $130,000 plus $8,000 dividends for a total of $3,000. Jerry will therefore adopt the comparative method approach and be taxed on $3,000 of income.

Note that even though Jerry’s investments have almost halved in value she is still taxed on an increase in value even though overall she still has a loss on her investment. This is because the FIF rules look at gains over a tax year and not over the period the investments have been held. In addition a “quick sales adjustment” applies to the News International shares bought and sold during the year.

This adjustment is calculated as on the lower of 5 percent of the cost of the purchase or the actual gains made. 5% of the cost of $25,000 is $1,250 and as this is greater than the actual gain of $1,000 made, the “quick sales adjustment” treated as taxable FIF income is therefore $1,000.

What appears to be a tax free capital gain is therefore taxable under the FIF rules.

The above examples are not extreme and readers should be aware that the treatment of foreign investments is an area which will see increasing attention from the Inland Revenue. This was made clear when the Inland Revenue released details of their 2011-12 Compliance Focus Programme on 22nd July.

FIF at odds with savings push

The complexity of the FIF regime might perhaps be great at providing work for tax advisors, but it doesn’t seem to make a lot of economic sense given New Zealand’s poor savings record and huge overseas liabilities.

What the regime also shows up is a two-faced attitude towards the treatment of capital gains which borders on the schizophrenic. The end result is a regime which is unfair, overly complex and ripe for reform.

 *Terry Baucher is New Zealand tax specialist and consultant. You can find his columns in our new personal finance section.