RFRM: a flat tax on foreign investments?

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The higher your income, the lower your tax rate (and vice versa). Sound like a good idea?

Wednesday, March 20th 2002, 9:34AM

Recent comments by Finance Minister Michael Cullen indicate that serious consideration is being given to taxing foreign investments under the Risk Free Return Method ('RFRM') which was recommended to the Government by the McLeod Review last year.

RFRM would constitute a radical change to the taxation of foreign portfolio investments and would spell an end both to the unpopular FIF regime and the confusing distinction between investments in the grey-list and non grey-list countries.

How would it work? The basics of the regime are disarmingly simple: the taxable income arising from an offshore investment would be calculated by taking the investment's market value at the beginning of the income year and multiplying it by a fixed percentage (the risk free rate). That percentage would be set at the then current rate of return on Government Stock, reduced by the rate of inflation.

For example if the risk free rate was set at 4%, taxable income from an investment worth NZ$10,000 would be $400, with tax on that at 39% being $156.

The regime's apparent simplicity belies its radical contrast with the current treatment of foreign investments. It would no longer matter:

• In which country the investment was held.
• Whether the investment was part of a trading activity or held on capital account.
• The extent of any dividends.
• Whether there was a realisation of any gain or loss.

There would be:

• No tax on dividends.
• No tax on realised gains or losses.
• No deduction for interest paid on borrowings to fund the investment (although such borrowing would reduce the value of the investment on which the RFRM liability is based).
• No credits for foreign tax, and
• No reconciliation between income taxed under the RFRM regime and the actual returns from an investment.

RFRM is comparable to a Wealth Tax. Some may perceive it as a de facto Capital Gains Tax - in particular insofar as it would affect capital account investors who currently derive most of their income from gains on sale rather than from distributions.

Investors will eventually need to give considerable thought to changing their portfolios as RFRM would increase the post-tax volatility of equity returns (for trading investors) and alter post-tax relativities between:

• New Zealand and offshore investments
• Debt and offshore investments
• 'Grey-list' country investments and FIF investments
• Growth (non-distributing) investments and income yielding investments
• Investments in New Zealand actively managed funds and investments in New Zealand funds which track foreign indices (the latter's Binding Rulings-based tax free status of gains on sale would be overridden by the enactment of RFRM).

Investors should not panic and adjust their portfolios in anticipation of RFRM. The following intimidating list of issues that would need to be resolved before such a regime is introduced would hamstring any attempt to introduce the regime in less than two years:

• How will RFRM interface with the tax treatment of investing entities (especially managed funds) and the imputation regime?
• How will acquisitions and disposals during a year be incorporated into the RFRM tax base?
• How will RFRM apply where a reliable market value reference is not easy to establish?
• How will existing investments transition into the new regime?
• Will there be any relief for investors with tax to pay but no income to pay it out of?

It seems likely that initially RFRM will only apply to portfolio investments in foreign shares and unit trusts. A major issue looms as to whether the regime is "the thin end of the wedge" and a precursor to its application to New Zealand equity and unit trust investments, as well as to foreign non-portfolio investments and CFCs. Again, these issues need to be addressed explicitly in the lead up to the decision to introduce RFRM to New Zealand.

The prospect of an RFRM will pose significant challenges for tax policymakers, advisors, and, most critically, fund managers and investors. If it does come in, let's all hope for a better performing foreign equity market (and no significant appreciation of the NZD) to relieve the unappetising prospect of notional but taxable gains and real but non-deductible losses.

Information contributed by Paul Mersi and John Shewan -Tax Partners in PricewaterhouseCoopers

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