Brian Gaynor: Tax plan should bring in billions

Changes to the taxation of overseas investments, as indicated by Finance Minister Michael Cullen in his Budget speech, could have major implications for investors and domestic asset prices.

Cullen has signalled the introduction of a tax on the unrealised gains on all overseas equity investments.

This will bring us into line with most other countries with one notable exception - investments in New Zealand equities will not be subject to a capital gains tax.

As most investment decisions are strongly influenced by tax considerations, the proposed changes could lead to a flood of money coming back into the country.

If implemented, they should have a positive impact on the sharemarket and property prices.

These four questions need to be answered:

* Why is the Government proposing a capital gains tax on overseas equity investments only?
* What is the existing tax regime?
* What are the proposed changes and when will they be implemented?
* What are the implications for investors and financial markets?

As the accompanying table illustrates, the managed funds industry has experienced low growth since 1996, particularly when compared with Australia.

Total funds under management have risen by only $20.3 billion, with $12.1 billion going overseas and just $8.2 billion staying in New Zealand (the figures include equities, fixed interest securities and other investment assets).

By comparison, managed funds in Australia have increased by A$489 billion over the same period, with A$391.4 billion staying at home and only A$97.7 billion going offshore.

Looking at it another way, 60c of every additional $1 of managed funds in New Zealand since March 1996 has gone overseas, compared with only 20c in $1 in Australia.

The strong New Zealand bias towards foreign investments has become more exaggerated since December 1999.

In that five-year period, a staggering 97c of every additional $1 of managed funds in New Zealand has gone overseas, whereas only 13c of every extra $1 of managed funds in Australia has been invested overseas.

A joint December 2003 study between the Inland Revenue Department and the Treasury, called "Taxation of non-controlled offshore investment in equity - An officials' issues paper on suggested legislative amendments", estimated that $22.6 billion was invested in foreign equities at the time.

This comprised $15.2 billion through managed funds and $7.4 billion either directly or through other vehicles.

A Reserve Bank spokesman said this week that stockbrokers had indicated that the latter figure was understated.

On this basis, it is realistic to assume that New Zealanders hold about $25 billion in the form of foreign portfolio equity assets.

The tax situation is complex because it involves two different sets of rules, one for the seven "grey-list countries" - Australia, Britain, the United States, Canada, Norway, Germany and Japan - and another for all other countries.

In simple terms, sharemarket investments in grey-list countries are only subject to tax on dividends; there is no capital gains tax except for individuals who are classified as traders.

Equity investments in all other countries are mainly taxed under the comparative value method. This is where the net appreciation (or depreciation) in a company's share price plus any dividends are deemed to be income to New Zealand investors and taxed accordingly.

As a result, there is a capital gains tax on the unrealised equity gains in non grey-list countries.

It is not surprising that an estimated 80 per cent of New Zealanders' foreign equity investments are in the grey-list countries. The joint IRD/Treasury study, which is the basis for this week's Budget announcement, believes that the grey-list exemptions encourage New Zealanders to go overseas because they pay tax only on the dividends received. This means that the total tax paid is minimal because foreign dividend yields are relatively low.

Officials also believe that the New Zealand tax take is reduced because the Government receives no tax on the earnings of these overseas companies.

A Kiwi investor who bought shares in Dell, the US computer company, a decade ago would have seen his or her investment multiply more than 50-fold but wouldn't have paid a cent in tax because Dell has never paid a dividend and is domiciled in a grey-list country.

By comparison, a US investor who invested in a successful New Zealand company would have to pay tax on his or her capital gains and on dividends received.

The IRD/Treasury study recommended the removal of the grey-list exemptions and the adoption of the non grey-list regime for all foreign equity investments. In other words, a capital gains tax on the unrealised profits of all overseas equity holdings.

The introduction of a capital gains tax on foreign investments is logical following the decision to remove the capital gains tax on domestic managed funds because there would have been a flood of money leaving New Zealand through the managed funds sector.

This would be unpalatable to the Labour Government, particularly with the introduction of the KiwiSaver programme.

From April 1, 2007, domestic equity investments through managed funds will no longer be subject to capital gains tax but it looks as though all overseas equity investments will be liable for a capital gains tax on unrealised profits.

Small portfolios will be exempt and there will be an annual tax cap to spread the payments over a number of years.

A discussion paper will be issued shortly which will contain most of the specific details. The December 2003 paper suggested that the capital gains tax might be applied to only 70 per cent of the unrealised profits.

The tax changes will make it far less attractive to go overseas, particularly as currency movements will also be subject to tax. Investors with large foreign holdings will be particularly annoyed if the dollar falls after the new regime is introduced in April 2007.

It is expected that the majority of new money going into the managed fund sector will be invested domestically, particularly KiwiSaver funds.

It is reasonable to assume that $10 billion of the $25 billion invested in overseas equities will come back to New Zealand. This will place a huge burden on Mark Weldon and his NZX staff to find sufficient companies for individuals to invest in.

If Weldon can't attract more companies to the NZX, what are the odds on another property boom?

* Disclosure of interest: Brian Gaynor is an executive director of Milford Asset Management.