Cullen's selective tax reform likely to frighten off investors

The Government's plans to tax New Zealanders' overseas investments are flawed, claim CRAIG ELLIFFE, BARNARD HUTCHISON and ANDREW RYAN*.

It is widely rumoured that Finance Minister Michael Cullen's Budget on Thursday will announce a decision to adopt a new tax regime for New Zealand residents' overseas investments.

If this happens it will be the only recommendation adopted from the comprehensive package suggested in October last year in the McLeod tax review.

The proposal involves the use of a method of taxation for overseas investments called the risk free return method.

Under this method investors are taxed on a nominal interest rate that matches the current bond rate, irrespective of the actual investment performance of the underlying share, bond, or unit trust.

At best the method will share the same offensive characteristic as the foreign investment fund regime that imposes tax in circumstances where there is no cash to actually fund the tax payment.

The risk free return method is even more offensive because by deeming an expected return one could be left in a position where (as for international investments for the last couple of years) an investment goes down materially and yet there is still a requirement to pay tax on it.

We would have preferred to see an international tax regime that had three broad principles of policy:

* A regime for new migrants in New Zealand so they are only taxed on their New Zealand sourced income after they have been a New Zealand resident for seven years.

The idea behind this is that it is important to attract foreign direct investment.

The economic evidence is that where a capital importing nation imposes higher taxes, not only does it act as disincentive for foreign investors, but when they do choose to invest they still expect the same rate of return, effectively passing a more significant cost to the New Zealand investor through increased prices.

Another argument is that it is still possible for overseas companies to structure their affairs to lower their effective tax rate.

Why not lower the headline rate and stand out from the crowd?

* A tax regime that would encourage residents to remain in New Zealand, particularly those with skills and capital. The challenge here is to retain and encourage those who contribute to our society and tax base.

* A tax regime that would encourage non-residents to become residents.

Recently we have seen people seeking to return to New Zealand who have invariably been horrified when told about the New Zealand tax regimes that are effective on their foreign investments.

Try explaining to them the benefit of paying New Zealand tax on an investment that had declined in value, which they had borrowed to invest in, that their interest payments would not be a deductible expense.

Rather than a regime that taxes people on gains that don't exist, and doesn't permit a deduction for funding costs, it would be better to explore some of the other suggestions that were contained in the review's report, such as:

* A regime for new migrants in New Zealand so that they are taxed only on their New Zealand sourced income for the first seven years after they become a resident.

* A maximum level of tax imposed on a single individual in any one year which would be capped at $1 million.

* A reduction in company tax rates in respect of non-resident ownership in the vicinity of 18 per cent, with a 2 per cent non-resident withholding tax.

New Zealand's company tax rate is comparatively high at 33 per cent. The average for the Asia Pacific region is currently at 31.05 per cent and trending lower.

In the OECD, for the second year running, no countries elected to raise their corporate tax rates and 12 members decided to cut their corporate tax rates.

On May 2 the Australian Federal Treasurer Peter Costello announced the Australian Government's new plans to review Australia's international tax arrangements.

In addition to looking at the double tax agreements' policies and processes, other key areas will be examined.

Remember, Australia has recently signed agreements with the United States and Canada and is negotiating with the United Kingdom so that the rate of withholding tax on royalties, interest and dividends, will be substantially reduced on the trade between those countries.

Would it be appropriate for New Zealand to do the same?

* Craig Elliffe is a tax partner, Barnard Hutchinson a consultant and Andrew Ryan a senior solicitor at Chapman Tripp. The views of the authors may not necessarily be those of Chapman Tripp.

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