Brian Fallow: Tax change not so dark as it's painted

Eyes narrow and lips curl at the very mention of a capital gains tax.

Let's put that phrase to one side for the moment.

Is the Government's proposed overhaul of the tax treatment of portfolio investment a good deal for investors?

On the face of it, collectively it must be, because the Government expects to lose something like $50 million a year in revenue. That is money left in investors' pockets.

But inevitably, in a suite of proposals designed to reduce the distortions and anomalies in the existing regime, there are losers as well as winners.

The area has become a tangled mass of complexity and inconsistency, with different rules depending on whether the investment is direct or through an intermediary, active or passive, in New Zealand or offshore and, if offshore, in which country.

Under the new regime people who invest in New Zealand companies via managed funds rather than by holding the shares directly or through passive, "tracker" funds, will no longer have their returns eroded by a capital gains tax.

If they invest in foreign companies by way of managed funds they will still be subject to a capital gains tax as they are now, the only difference being that they will be taxed as the gains accrue and not when they are realised by the fund selling the shares. In practice, fund managers turn over their investments sufficiently often for that not to make a lot of difference to the tax lability.

The people who miss out under the proposed changes are individuals who invest directly, or through passive funds, in the seven "grey list"countries: Australia, Britain, Canada, Germany, Japan, Norway and the United States.

At present they pay New Zealand tax only on the dividends they receive.

Under the proposed new regime they will be taxed on the increase in the value of the shares as well.

The new regime achieves neutrality in the treatment of offshore portfolio investment by imposing on all of it the toughest rules under the existing regime.

But is the proposed regime unduly harsh?

And will it, as critics claim, distort investment decisions and "ghettoise" investors' money in New Zealand's rather small market?

You might argue that New Zealand doesn't need a capital gains tax on financial assets because the tax authorities are really, really good at getting their pound of flesh at the company level.

And what they don't get at the company level they get when profits are distributed.

While the company tax take is high by international standards, that is offset by the fact that dividends typically come with credits for the shareholder's share of the company tax paid.

And, unusually, there is no capital gains tax on the share price rise (except when intermediated through actively-managed funds, and that, as we have seen, is due for the chop).

Offshore, it is a different story, or rather a whole lot of different stories.

But broadly speaking, if the investor is getting off lightly at the company tax level, the extra return will be pushing up his dividends or (more likely) the share price to reflect higher levels of retained earnings.

That in brief is the case for taxing distributions and capital gains - to sweep up, if you like, the tax foregone at the level of the underlying business.

On this line of argument the new rules for foreign investment are no harsher than those for the domestic kind, merely different.

But what if the investor is not getting off lightly at the company tax level? Then it is double taxation.

The grey list is, in effect, a list of countries exempted from the tough foreign investment fund regime which was drawn up in the wake of Winebox-like rorts involving tax havens.

The assumption was that the countries on the list taxed underlying businesses at a similar rate to New Zealand and that it was reasonable therefore to treat investors putting money into those countries roughly the same as those investing at home.

The trouble for the tax authorities is that that is an increasingly unsafe assumption. Dreaming up vehicles for minimising tax is a huge industry, not least in Britain and the US.

The grey list is arbitrary: why include Germany, for instance, but not France? But a longer list would make the problem of identifying and plugging holes in larger countries' tax bases even worse.

That leaves the difficult issue of those investments which are genuine exercises in prudent diversification and which are not about minimising tax and where double taxation applies.

The designers of the proposed regime effectively shrug their shoulders and say: "tough".

Unlike corporate investment where controlling stakes are involved, it is not the norm for countries to give tax credits to portfolio investors for their share of company tax paid in another country.

Even between the CER partners there is no mutual recognition of imputation or franking credits.

Administrative complexity may the reason, or it may just be the natural inclination of tax authorities to guard their own tax base.

So does this amount to a recipe for impeding the flow of portfolio investment overseas?

It is not obvious that it will.

The lion's share of that investment is intermediated through actively-managed funds, whose position and that of their underlying investors is not materially affected.

If anything, the regime still favours offshore investment in that no tax accrues if the shares fall in value, even if a dividend is paid. Domestically the dividend is still taxable income even if the shares have fallen in value.

The overall package of changes to the domestic and foreign investment rules benefits smaller investors who use collective investment vehicles to spread risk and compensate for the limitations of their knowledge and information.

Those who invest directly in overseas shares are likely to be richer and more knowledgeable (or at least more confident). They will be worse off.

But the general rule applies: the broader the tax base, the lower the rate can be.