Richard Scoular: There's capital to be gained

In his Budget speech, Finance Minister Michael Cullen said proposed changes to the taxation of overseas investment by New Zealanders would "lead to accusations of extending the capital gains tax regime".

But to most people, a tax on increases in the value of share investments is a capital gains tax. And that's what he has proposed.

The Budget contained good news over tax on domestic investment. Under existing rules, individuals have generally been penalised if they invest in shares through a unit trust or similar collective investment vehicle rather than investing in the sharemarket directly.

From April 2007, individuals investing in New Zealand shares will broadly be taxed in the same way, whether they hold the shares directly or through a collective investment vehicle.

This is to be achieved by:

* Removing the tax on gains on New Zealand shares earned by collective investment vehicles.

* Attributing income derived by the collective investment vehicle directly to individual investors and taxed at their marginal tax rate.

Cullen should be applauded for putting collective investment vehicles on the same footing as direct investment.

He could have aligned the tax treatment of direct and indirect investment by taxing gains derived by direct investors. But that would mean introducing an unpalatable capital gains tax.

Consistency between the taxation of direct and indirect investment in New Zealand shares is, therefore, broadly achieved.

But then it gets much harder.

Can Cullen achieve consistency between the taxation of investment in New Zealand shares and investment in overseas shares?

Direct investors and collective investment vehicles investing in shares outside countries on the government's "grey list" are subject to capital gains or wealth tax.

Direct investment in shares in a company in one of the seven (soon to be eight) "grey list" countries (United States, Australia, Britain, Canada, Japan, Germany and Norway) is generally only taxed in New Zealand on the dividend return. In other words, there is no capital gains tax. New Zealand funds investing in the grey list are generally subject to New Zealand tax on realised gains in value of shares, as well as on the dividend return.

Officials, and presumably Cullen, see the grey list as causing distortion. (Most overseas investment goes into English-speaking countries in the grey list.)

The Budget indicates that the answer to the distortion caused by the grey list will be to tax gains on all investments in overseas shares and impose the tax on an accrual, or unrealised, basis.

This is the extension of the capital gains tax that Cullen does not wish to be accused of proposing.

More details are to be released in a discussion document in the next few weeks.

But the Budget suggests we are heading for rules under which there is:

* No tax on gains, including when realised, on domestic investment.

* Full tax on an unrealised basis on gains on overseas investment.

This would seem to create a far greater distortion than any under the existing rules. Not since Muldoon days will there have been such legislative support for domestic investment.

Not surprisingly, it's unlikely the New Zealand Superannuation Fund will be obliged to invest a disproportionate amount of its money here.

Realistically, we will probably have to accept the grey list will be abolished and the capital gains tax on overseas investment will be extended.

In the December 2003 officials' paper on the issue, "Taxation of non-controlled offshore investment in equity", Inland Revenue and Treasury officials seemed to recognise that the distortion caused by full taxation of overseas investment needed to be softened.

The officials' paper traversed the economic theories as to how New Zealand should tax to ensure the best result for the economy (as opposed to the particular investor).

They proposed taxing 70 per cent (rather than 100 per cent ) of accrued gains on overseas shares.

This figure is an attempt to align the amount of tax collected under new rules with the amount of tax a collective investment vehicle pays on grey list investments.

It is based on an estimate that a collective investment vehicle on average holds shares for four years before disposing of them.

To collect the same amount of tax on an unrealised basis, 70 per cent of the gain would have to be taxed.

The Investment Savings and Insurance Association has been proposing 50 per cent as the appropriate amount to tax. It acknowledges that there is no rational economic basis for whatever number is ultimately used.

The Budget papers suggest it could be 100 per cent.

The practical question should be: will an investor prefer to invest in New Zealand shares on which gains will not be taxed, or an equivalent overseas investment on which 50 per cent, 70 per cent or 100 per cent of the gains will be taxed in New Zealand?

If the intention is that tax should allow investors to have a diverse portfolio, doesn't even the 50 per cent number seem a little high?

The objective should be to attempt to leave investors relatively indifferent from a New Zealand tax perspective as to whether they invest in domestic or foreign shares.

* Richard Scoular is a partner at law firm Russell McVeagh, specialising in taxation, cross-border, mergers and acquisitions and structured finance.

Grey matter

* The seven "grey list" countries are the United States, Australia, Britain, Canada, Japan, Germany and Norway.
* Most overseas investment goes into the English-speaking countries.
* Investments in "grey list" countries are generally only taxed in New Zealand on the dividend return.
* In other words, there is no capital gains tax.