Tax changes a type of savings incentive

Plans by the Government to introduce a risk free rate of return method (RFRM) for taxing investments and shares is being cautiously greeted by many in the savings industry.

The idea, which was first raised in the McLeod tax review last year, has the potential to simplify tax returns on savings and remove some of the advantages enjoyed by a number of offshore investment vehicles.

Finance Minister Michael Cullen says more details on introducing RFRM will be released in the budget on May 23.

Cullen hasn't spelt out what areas he wants to use RFRM in, however it seems he is clearly targeting offshore investments, as opposed to domestic ones.

This appears logical as the McLeod review suggested the Government should experiment with the idea, rather than introduce it holis-bolis. Also the tax treatment of international investments is very messy at the moment with a range of different regimes including FIF and CIC.

The head of the tax review committee, Rob McLeod says: "(The Government) should experiment. In other words evolve into it. Don't revolve or revolt into it. Just pick off a couple of troublesome ideas."

BT Funds Management chief executive Craig Stobo describes RFRM as a "very interesting" development and one which would be good for the savings industry.

"I think it's a good start. I like the idea and concept," he says.

He believes RFRM should be extended from the international area to the domestic scene.

"If (Cullen's) keen on concept then we could clean the domestic stuff up pretty quickly."

However, Stobo acknowledges that cleaning up the domestic environment would be politically more difficult than the international one.

One of the big issues for the Government is when to introduce such as system. Cullen told Good Returns at the Chartered Accountants tax conference late last year that the "largest stumbling block" in introducing RFRM was the markets.

It would be very difficult to introduce such a regime in the past year or so as investors' portfolios have gone backwards, yet they would, under RFRM, have to pay tax, while currently they can get credits.

Investment Savings and Insurance Association chief executive Vance Arkinstall, has expressed reservations about RFRM.

He says, in a press release, that RFRM should "be a matter of some concern to savers in New Zealand".

He says that unfriendly taxation regime is the biggest barrier to savings in New Zealand, and suggests RFRM does nothing to make it more friendly.

In fact he argues that introducing such a regime "may close one of the only opportunities for small savers".

These opportunities, while not specified, clearly relate to the tax-effective United Kingdom based Open-Ended Investment Companies (OEIC) which are sold in New Zealand by six managers (AMP, ING, Challenger, RSA, Public Trust, Barings).

OEICs have been in the market for more than a year and, according to Good Returns' quarterly survey of these funds, command assets of around $120 million, compared to the $19 billion invested in retail New Zealand managed funds.

Arkinstall's other argument is that the minister "has been seized by revenue priorities rather than addressing the fundamental problems within the New Zealand taxation system that act against encouraging increased private saving."

McLeod says that under RFRM the Government is likely to earn less tax from savings, therefore investors, on average would be paying lower taxes.

He says the change would mean that investors get to keep more of their savings, therefore it could be seen as a tax incentive.

McLeod says one of the key things RFRM does is change the Government's relationship with investors. Currently it has an equity type stake and 'owns' a third of all an investor's holdings as it get tax on them. However, it also shares on the upside as well as the down.

Under RFRM the relationship is more like debt rather than equity as an investor pays tax on the amount of capital they have at the start of the year. This tax is levied on that capital making a, say, 4% return.

McLeod says any investor should be hoping to make more than the risk-free rate of return (otherwise there is no point investing) and that any gains above this rate under RFRM are essentially tax free.

If investors are worried about the tax payable each year they can hedge way the liability by investing the appropriate sum of money in cash or fixed interest which is going to provide them with the returns necessary to cover their tax bill.

This can be done as each year's tax is calculated on amount of capital invested at the start of the financial year, as opposed to the current system where tax is calculated at year's end.

McLeod's instinctive view is that such a system would encourage people to invest sensibly as opposed to chasing investments because of their tax status.

PricewaterhouseCoopers tax partner Paul Mersi quite likes the idea, but wants to see more work done on it.

Any tax changes need to treat savings "equitably and simply," he says.

Mersi characterises RFRM as being simple, but arbitary.

"It charges everybody the same for a given quantum of investment," he says. "It's more even handed and gives less regard to where your investment is."

In a sense it's radical because a person's tax liability is disconnected from the performance of an investment.

Mersi acknowledges there is a need for some improvement in international tax rules.

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