Money: Tax traps with foreign funds

By DENHAM MARTIN

Last week's article on the foreign investment fund (FIF) regime prompted several telephone calls to my office. There was a common theme to these.

First, it appears a number of people think that if a resident taxpayer holds shares in a company that is in a "grey list" country, that person is not required to pay tax in New Zealand on the dividends on those shares. This is not the case.

Given that the dividends will be taxable in New Zealand, the next issue raised by callers related to double taxation. Most inquiries concerned investments in Australian companies and, given the apparent confusion concerning franking credits, that topic is also discussed below.

To recap, the purpose of the FIF regime is to ensure that residents cannot avoid paying income tax in New Zealand simply by accumulating income in an offshore entity.

The regime can bring to tax in New Zealand certain gains made by NZ resident investors arising from investments in foreign companies and other entities and interests in certain foreign superannuation schemes. It does this by including in a taxpayer's gross taxable income all FIF income, as calculated under one of four methods.

FIF income can capture certain unrealised gains (gains that have not been paid out by way of dividend, for example).

There are a number of exclusions from the regime. The exclusion that has prompted the queries is the "grey list" exemption. In short, an interest in a foreign company that is resident in a "grey list" country will not be an FIF interest.

The "grey list" countries are Australia, Canada, Germany, Japan, Norway, Britain and the United States.

This exclusion simply determines whether the FIF regime applies to that investment and whether it will give rise to FIF income that would then need to be included in a taxpayer's gross income. It does not exclude the application in other provisions in the Income Tax Act that may make certain income taxable, for example, dividend income.

Dividend income is deemed to be included in a taxpayer's gross taxable income. As a New Zealand resident taxpayer is taxed on worldwide income, it is irrelevant whether the company paying the dividend is resident in New Zealand or resident overseas. The dividend must still be returned as income in New Zealand.

This gives rise to a concern over double taxation as the dividend would (likely) be subject to tax in the home country of the company. The home country will often impose that tax by way of a nonresident withholding tax, which is collected directly from the company paying the dividend.

Where it is an Australian company that is paying a dividend to a NZ resident taxpayer, nonresident withholding tax of 15 per cent may be imposed in Australia (the rate being limited to 15 per cent under the double tax agreement between Australia and New Zealand).

Whether the NZ taxpayer gets a cheque for the full dividend amount or a lesser amount depends upon whether the dividend is fully franked (the Australian equivalent to fully imputed). If it is, then those franking credits may be used to offset the nonresident withholding tax imposed in Australia. To the extent that there are insufficient franking credits to offset the nonresident withholding tax, a withholding of the tax will reduce the cash amount the taxpayer receives.

However, any unused franking credits are lost to the NZ taxpayer (unless he or she has other taxable income in Australia against which they can be used) as the franking credits cannot be applied against a NZ tax liability.

This lack of transferability of franking (and imputation) credits across the Tasman has been on the reform agenda for many years, but resolution of it may be some time away.

The amount of nonresident withholding tax actually paid should give rise to a foreign tax credit, which the taxpayer can use to offset against NZ tax liability. Where the nonresident withholding tax is not actually paid but is offset by the franking credit, this will not give rise to a foreign tax credit.

In summary, a New Zealand resident taxpayer must include in their gross income all dividends and all FIF income derived by them. The extent to which double taxation arises will largely depend upon the country in which the investment is held.

* Denham Martin is the principal of Denham Martin & Associates, lawyers specialising in advice on taxation and related matters.