Brian Fallow: Taskforce wants level tax playing field

Beyond the family home, rental property is the largest asset class New Zealanders invest in. Photo / Dean Purcell

The Capital Markets Development Taskforce makes a cogent case for tax reform to restore neutrality to the investors' world.

The tax system, it declares, should not create incentives to invest in one class of asset over another, or through one kind of vehicle over another.

Yet the tax laws are riddled with such distortions.

Some are of long standing, like the lack of any comprehensive taxation of capital income, which has the effect of encouraging investment in residential property.

Others arise from political ad-hockery, like the previous government's introduction of a new top income tax rate of 39 per cent (now reduced to 38 per cent) and portfolio investment entities (PIEs).

Comprehensive tax reform recommendations are outside the taskforce's remit. That task belongs to the tax working group chaired by Bob Buckle.

But there is a lot of overlapping membership between the two: investment banker Rob Cameron, senior Inland Revenue official Matt Benge, Ernst & Young managing partner Rob McLeod, economist Gareth Morgan and NZX chief executive Mark Weldon.

So it is not surprising that, having acknowledged the tax working group's primary role in advising the Government in this area, the capital markets group goes on to unburden itself of some quite detailed views about what is wrong with the status quo and how it might be remedied.

The taskforce favours retaining imputation, under which dividends come with credits for the shareholder's share of the tax the company has paid, even though New Zealand and Australia are just about the only countries to have such a system.

It is intended to tax domestic shareholders of companies at their marginal personal rates.

But they note that when it was introduced the company tax rate and the top personal rate were the same. Since then the former has been cut and the latter increased, undermining the coherence and robustness of the system.

Another problem is the absence of mutual recognition of imputation or franking credits between New Zealand and Australia.

This creates an incentive for Australian companies investing in New Zealand to structure their affairs so that profits (and imputation credits) are recognised there rather than here, for the benefit of their Australian shareholders.

A key uncertainty is whether the Australians, who are also reviewing their tax system, will keep imputation or opt for some version of the "classical" system under which dividends are fully taxed but the company tax rate is lower.

The Australian review, headed by Treasury Secretary Ken Henry, is due to report to the Australian Government this month, though it is likely to be March before the report is publicly available.

Removing imputation would only fund a small cut in the company tax rate, to maybe 28 per cent, so other significant sources of tax revenue would be needed if large company tax cuts were to be made in a revenue-neutral way.

But it notes that such a switch might be necessary if other countries make deep cuts in their company tax rates.

One of the scenarios for which the tax working group got officials to crunch the numbers for was aligning the top personal and trust rates at 30 per cent and cutting the company rate to 25 per cent. That would cost $2.3 billion in revenue foregone.

Another scenario also aligned the top personal and trust rates at 30 per cent, but cut the company rate to 20 per cent and removed imputation. The net fiscal cost in that case was $3.2 billion.

A taskforce concerned with improving New Zealand's capital markets cannot overlook the fact that, beyond the family home, rental property is the largest asset class New Zealanders invest in.

Any bias in the tax system in favour of property is liable to be at the expense of other potentially more economically nourishing investment.

It questions the appropriateness of allowing depreciation deductions on rental properties when they tend to appreciate, rather than depreciate, over time.

Unless the appreciation can be entirely attributed to rising land values that seems over-generous to landlords. Officials have estimated that denying depreciation on buildings would be worth about $1.3 billion in additional tax.

Another option would be to apply the risk-free return method (RFRM), to address a tax bias in favour of rental property.

Under this system the net equity in a property is deemed to earn whatever an appropriate Government bond yields, say 6 per cent, and that sum is taxed.

The potential revenue from applying RFRM to rental property has been put at around $800 million a year, compared with the minus $150 million the sector delivers now because of the ability to uses losses to shelter other income.

The taskforce sees another, significant bias in favour of investment in, or through, PIEs where the tax rate is capped at 30 per cent. It calls for it to be removed.

Some other structures, including certain superannuation schemes and trust-owned companies, can also be used to save investors in the top tax bracket some of the tax they would pay if they held shares or interest-bearing securities directly. But PIEs have been particularly popular.

Another area where the taskforce says change might be justified is the thin capitalisation rules.

These rules limit the extent to which foreign-owned companies can minimise the tax they pay in New Zealand by having highly geared subsidiaries, giving rise to lots of deductible interest payments.

The suspicion is that the current safe harbour allowing 75 per cent debt financing is too generous and also that it encourages foreign firms to have wholly-owned subsidiaries here rather than partly-owned ones which would allow some local equity participation.

Officials estimate dropping the threshold from 75 per cent to 60 per cent would increase revenue by about $200 million.

The taskforce said that if the tax working group's recommendations did not address some of the specific biases it had identified, they should be addressed in the ordinary course of the generic tax policy process.

Some of them are in fact being dealt with in that way, Revenue Minister Peter Dunne said.

For example, the taskforce endorsed changes suggested in an officials' paper released in September which would exempt certain interest payments from non-resident withholding tax and from the approved issuer levy, he said.

Those changes are being suggested because the current rules may be hindering the development of a domestic bond market.