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Tax issues outlook for 2006: another watershed year?

PricewaterhouseCoopers tax partner Paul Mersi says 2006 ansthe crunch year for tax issues.

Thursday, February 23rd 2006, 7:04AM

Two years ago on Good Returns, I described 2004 as having “all the signs of being a watershed year…with the potential for much angst and gnashing of teeth”, and I put the blame squarely on the then recently released IRD/Treasury Paper, Taxation of Non-Controlled Offshore Investment in Equity.

Well, it’s 2006, that pill has been swallowed (some might say it was administered digitally), and further doctor-patient interaction has in the meantime resulted in a change of medication (last year’s discussion document: Taxation of Investment Income).

As it stands today, many patients are not responding well to the medication and the doctors appear to be getting frustrated.

Enough of the metaphor. 2006 really does look like being the crunch year for New Zealand managed funds, the industry, and investors.

A decision by government is imminent on what it is going to do in the wake of what must be a record number of submissions received late last year on the proposed optional look-through tax treatment for collective investment vehicles (CIVs) and on the controversial and unpopular proposal to remove the Grey List for offshore investment.

These decisions will have far-reaching effects on the New Zealand funds management industry and on investors, and if, as still seems likely, the changes do come in as currently proposed from April 1 next year, key strategic business decisions are going to have to be made very quickly by all those affected.

Much has been written on the details of both of the proposals and I do not seek to describe them again here. I will take the opportunity, though, to focus on some of the major issues associated with them.

At their essence, the changes are motivated by the prima facie laudable desire for improving tax neutrality, i.e. taking tax out of investment decision-making (whether direct versus indirect, New Zealand versus offshore, or superannuation versus other vehicles).

Things are never that simple though. The international portfolio changes are problematic because the government has a fundamentally different concept of what should be taken into account in determining neutrality.

Even the ostensibly benign proposal to allow CIVs to be taxed on a look-through basis suffers because certain non-neutralities will persist, which will leave managed funds with a potentially insoluble dilemma (whether to elect-in) and extra costs (with some uncertainty over the benefits).

I will explain these further.

Taxation of offshore portfolio investment
These proposals have clearly struck a nerve among the investment and advisory community.

However, there is a strong drive behind these proposals and I think we will see little watering down of them (unless politicians become concerned by the voting impact).

By any measure, the various new international regimes that have been proposed over the past two years have all been pretty tough, but they are borne out of long-standing frustration at government level with investment products constantly chipping at the edges of the current Grey List safe harbour (i.e. giving New Zealand investors access to investments with little or no tax paid here or elsewhere).

This frustration is on top of long-standing disquiet within officials’ ranks at the continued existence of the Grey List.

In short, as long as officials retain their view that New Zealanders should pay the same amount of New Zealand tax on offshore investments as on New Zealand investments – even if offshore investments are already suffering tax elsewhere – we are destined to see the end of the Grey List.

While the proposals in the discussion document do contain some concessions which will soften the blow for some investors (and, ironically, compromise neutrality), at their heart the proposals as they stand will hit most investors pretty hard. Interestingly, those who hold their offshore equity exposures through New Zealand-based CIVs are pretty much already subject to this kind of tax regime.

Many submissions made strong points regarding investment in Australia and given the high degree of trans-Tasman business ownership and interaction, it would seem sensible for at least investments into Australian companies to be treated similarly to those in New Zealand companies.

Of most concern to me, though, in relation to the proposed taxation of offshore investment, is the integrity of their application.

It is one thing to create a situation where legislation taxes investors comprehensively on particular forms of income, but if a high level of compliance cannot be achieved/enforced in practice, then it is simply a bad tax.

The risks in relation to the current proposals seem particularly high in this regard as there seems both to be high level of dissatisfaction with the proposals from investors, and critically, significant uncertainty about how the Inland Revenue Department (IRD) can corroborate whatever income is declared (if any) by investors.

Under our self-assessment approach to tax administration, many investors have not had to file tax returns for a number of years (and even if they have, they may not have needed thus far to declare any income or gains from those investments).

While the integrity of enforcement of the proposals does have consequences for the government in terms of revenue collection, and for the quality and “fairness” of our tax system as a whole, it is also a factor that influences the attractiveness of the look-through proposals for New Zealand-based CIVs.

Look-through treatment for NZ CIVs For as long as unit trusts have been treated for tax purposes as companies (and superannuation funds taxed at a flat rate) the managed funds industry has been frustrated with a tax system that imposes a different tax burden on investors depending on whether they invest directly or via a CIV and, if the latter, whether it is a New Zealand CIV or a foreign one.

On its face value (and in combination with exempting capital gains on New Zealand listed shares) the look-through proposal should see an end to that frustration.

Unfortunately for everyone, nothing is that simple. In particular, the cost-benefit equation for most New Zealand fund managers might not look that great. On the cost side, it is obvious that any such change must involve significant investment in systems, etc (and hopefully regime details will not blow these out further).

The costs don’t end there though. As currently proposed, the existing effective 33% cap applying to investments made through superannuation funds leaves trustees and managers in the untenable position of making at least some of their investors worse off by electing-in to the look-through regime.

Fund managers can “solve” this dilemma by establishing duplicate CIVs (one electing, one not) but this simply exacerbates the costs of a new regime in a situation where most fund managers already have more CIVs than they need (largely because of remnants of past tax regime changes).

On the benefit side, if economists are correct, removing current tax biases against investing in New Zealand-based CIVs should prima facie increase funds under management (which would have a flow-on benefit for fund managers through increased fees, etc).

What matters here though is not the ostensible neutrality achieved by legislating a look-through basis of taxation for CIVs, but the actual practical achievement of neutrality in how taxes are administered and enforced.

Fund managers must have confidence in both IRD’s willingness and ability to enforce the proposed international regime to the same high degree of compliance across all investors, whether all individuals, institutions, or CIVs.

Without robust reliable information, adequate resourcing, and an acceptance of the need to increase the interaction with taxpayers, the danger is that a high level of compliance will not be achieved, particularly among individual investors who do not see the proposed regime as being appropriate.

One could forgive fund managers being a little sceptical in this regard and thereby cautious about their ability to attract funds from those who would prefer to take their chances. …and then there is KiwiSaver And none of the decision making by fund managers as to how to react to these proposals is made any easier by the advent of KiwiSaver from April next year.

It is one thing for the government to force individuals to save, it would be quite another for the government to force individuals into a situation where the tax rate on income from such savings would be different than if they were saving in their own right.

For the government, therefore, the look-through regime is a necessity in the context of KiwiSaver.

It will thus presumably be a requirement of certainly default providers that they can administer a KiwiSaver fund under the new look-through regime.

Any fund manager who wants a slice of the KiwiSaver action will need to be ready to operate a CIV under the look-through regime.

This in turn could be a catalyst for rolling out look-through among other products, which in turn will put pressure on those fund managers who would rather have had more time to implement the new regime (or even to ignore it all together).

There are many who would like to simply wish-away the proposed changes to taxing offshore investments, even if that were at the cost of the look-through reforms (given that the government seems to be relying on the extra revenue from the former to compensate for the revenue lost under the latter).

I do not see any realistic chance of such wishes being fulfilled: the look-through regime has simply become a necessity for the government in the context of its KiwiSaver initiative, and it is also worth remembering that it was actually government frustration over the way in which the Grey List was being used that kick-started this whole round of discussion documents and issues papers.

It will be very interesting to see where the government decides to go on this in the next few weeks, and then, in the ensuing months, where fund managers and other players in the industry position themselves in reaction to these important changes.

I wonder whether in a year, I will be predicting 2007 to be yet another watershed year…?

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