Foreign pursuits

By MARK FRYER

With just five shopping days left, tax reform is unlikely to rate as a pressing issue for most of us.

But come the New Year, anyone who has invested overseas, or is thinking of doing so, might want to pay a little attention to the Government's plan to change the way those investments are taxed.

This week, Inland Revenue and the Treasury released an "issues paper" outlining possible changes to the tax system.

While those changes are still up for debate, one option would be to impose tax on overseas investments which are now virtually tax-free.

And some investors would find themselves paying tax even if their overseas investments lose money.

Time to ask a few questions.

What's the problem?

In the words of Finance Minister Michael Cullen: "The main weakness of the present rules is that they tax similar offshore investments differently, depending on the country that is invested into."

While there's no question about that, the Government isn't just interested in consistency.

It's also worried by the popularity of overseas-based managed investments which allow New Zealanders to earn a return while paying almost no tax.

The recent fashion has been for Australian-based unit trusts, aimed at New Zealand investors, which several managers have launched over the past few years.

One selling point is that, because of the way the New Zealand and Australian tax systems interact, investors in this country can legally pay almost no tax on their returns.

While the Australian unit trusts have the highest profile, some other overseas managed investments offer a similar tax saving.

So they're after tax dodgers?

Not just them. As well as targeting the types of managed funds which have the Government particularly worried, the suggested reforms would cover a variety of overseas investments. That includes shares in foreign companies and investments in overseas-based unit trusts, super schemes and life insurance (but not employment-related overseas superannuation, or overseas insurance or super policies acquired by people before becoming New Zealand residents).

Some of the possible reforms would also change the tax on New Zealand-based passive funds investing in overseas shares.

What's the plan?

At this stage there is no definite plan, just two main options, with lots more choices over the details.

One option is called the Standard Return Rule, which offers a cunning way of taxing overseas investments - don't worry about how much they make, just pretend investors earn 4 per cent a year and tax them on that. This would apply to private investors, and also to locally based passive funds investing overseas.

How would that work?

Let's say that at the start of the tax year you have $10,000 worth of units in an Australian unit trust (or a British investment company, or directly owned Microsoft shares - the principle is the same).

Four per cent of $10,000 is $400, so at the end of the year you add $400 to your taxable income. Then you pay tax on that $400, at your personal tax rate. If you're in the 33 per cent bracket, for example, you pay $132.

Any dividends you receive would not be taxed.

What if your investment didn't produce any income?

Too bad; under this system you'd be taxed as though it had.

And what if the value of your investment had fallen over the year? Too bad again; you'd get no credit for a paper loss (nor would you be taxed on any paper gains). If that seems unfair, the tax paper points out, it's what already happens if you invest in New Zealand shares; the share price may have plunged, but if it pays a dividend you'll be taxed on it.

Credit would be allowed for any withholding tax paid overseas, and for any New Zealand imputation credits which may be attached to Australian dividends.

Why 4 per cent?

The aim (besides earning the Government some revenue it now misses out on) is to get rid of the tax incentive which encourages people to put their money into some overseas investments, rather than giving it to a New Zealand manager.

Having removed that incentive, the theory goes, investors will choose whatever promises the best returns, rather than worrying about minimising tax.

According to the issues paper, 4 per cent was chosen because it is around the average dividend yield on New Zealand shares. That means that international investors taxed under this system would pay about the same amount of tax as they would on a New Zealand share investment of similar value.

At least it's simple, isn't it?

The basic idea is straightforward enough - take the value of your overseas investments at the start of the year, multiply by 4 per cent, multiply the answer by your tax rate and send the result to Inland Revenue.

However, reality would be a little more complex. For one thing, rules would be needed to deal with investments which are bought or sold part way through the year.

An example in the issues paper, showing the tax calculations required by an investor who owns shares in an overseas company, buys more shares twice during the year, and makes two sales - not exactly an extreme scenario - shows that working out the annual tax bill would involve 16 separate calculations.

Anyone with several overseas investments, or an investor who puts in more money at regular intervals, could find the suggested system far from simple.

There are other complications too, such as how to handle exchange rate calculations and dealing with investments that can't easily be valued.

What was the other option?

If the Government doesn't go for the idea of automatically taxing overseas investments on a 4 per cent return, the other option is to apply something called the Offshore Portfolio Investment Rules.

As far as most individual investors are concerned, this would mean their overseas holdings would be taxed in one of two ways.

One way would impose a tax on any dividends received and on 70 per cent of any rise in the value of the investment.

The other option would be to again to assume a certain return - in this case it would be the rate on five-year Government stock, just under 6 per cent at present - and tax investors on that, regardless of how much they actually made.

Smaller investors (total overseas holdings costing less than $50,000) could choose either method but those with larger holdings would have to use the first.

Investors whose overseas holdings cost less than $15,000 would be exempt from these rules.

PricewaterhouseCoopers tax partner John Shewan says the Offshore Portfolio Investment Rules is so radical that it has no chance of becoming law. That would leave the Standard Return Rule, and its assumption that everything earns 4 per cent.

Can I ignore this for a while?

A perfectly reasonable option if you don't find tax policy fascinating.

At this stage all the Government has are some options. It's calling for submissions (due by February 15) and will then think things over. Even if things move at lightning speed, any changes to the tax law are likely to be at least a year away.

When the changes are decided, investors may want to think about reorganising their overseas investments, but even then tax won't be the only consideration. For example, anyone with money in a tax-free Australian unit trust would have to weigh up the extra tax against the cost of switching. Depending on the fund, there may be an early withdrawal fee, for example, or a guaranteed return may no longer apply.

Similarly, investments in passive funds which invest in overseas shares may lose their tax advantage, but investors may decide that such funds are still a good way of putting money into overseas markets.

However, if you're considering a new investment, it would be worth remembering that, whatever the Government eventually does, it appears determined to do something.

That's not to say that investing in anything which now offers a tax advantage is necessarily a bad idea - just that it better offer something else besides.

* To contact Personal Finance Editor Mark Fryer write to: Weekend Herald, PO Box 32, Auckland. Email: Mark Fryer. Ph: (09) 373-6400 ext 8833. Fax: (09) 373-6423.