Getting around the inevitable

By TERRY UPTON*

A wise man once said that only two things are inevitable - death and taxes.

Well, I have news. While death continues to be an inexorable certainty, tax is much more manageable these days.

You just have to be aware of an innovative and perfectly legal managed fund structure that was introduced to this country in late 1998. It allows most New Zealanders to invest in a way that means they don't hand over a large proportion of their returns to the tax collector.

To begin, let's take a look at the standard income tax regime in New Zealand, which works like this:

* Income $0-$9500: tax rate 15 per cent.

* Income $9501-$38,000: tax rate 21 per cent (on average, income between $0 and $38,000 is taxed at 19.5 per cent).

* Income $38,001-$60,000: tax rate 33 per cent.

* Income $60,001-plus: tax rate 39 per cent.

That's the story for income. When it comes to capital gains - the profit you make by selling an investment for more than it cost - the average Kiwi thinks there is no such thing as a capital gains tax in this country. But there most definitely is.

If you buy some shares and sell them in a couple of years for more than your original purchase price there will most likely be no tax to pay. But if you are a particularly active buyer and seller you might have to include any capital gains in your income, and be taxed on them.

Under New Zealand law, if you buy and sell assets such as shares or property, deciding whether you are a "trader" who is subject to capital gains tax comes down to three questions:

* How often do you buy and sell?

* Are you in the business of buying and selling investments in an attempt to make profits?

* What was your "dominant purpose" when you made the investment? Did you do it to produce medium to long-term income and/or capital appreciation? Or were you making the purchase with a specific eye towards selling for a profit? The first activity does not generally result in a tax on any gains; the second does.

Unfortunately, the law remains incredibly vague on just what each of these conditions means.

For example, what is "frequent" buying or selling? Twice a year? Ten times a year? No one really knows because Inland Revenue has never issued a precise definition of what it considers frequent.

That said, common sense suggests a minimal number of annual buy and sell orders should not qualify for taxation, while active market participants would most likely be relieved of a large percentage of any profits when investments are sold.

So, as a private party you can trade occasionally and not be subject to capital gains tax.

What about professionally managed funds? Boiled down, there are essentially two types of managed funds - active funds and passive (or index) funds.

Active funds are run by professional managers who attempt to beat the markets. When the market is rising they try to do better and when the market is falling they try to at least cushion the losses.

Passive managers simply follow an underlying index such as the NZSX40 or the S&P500. This type of manager buys and sells only to replicate changes in the index they mirror.

Whether active or passive is better is another issue, and one that is much debated. But from a tax point of view, the important thing is that passive funds do not pay capital gains tax but active funds do. Why? Because Inland Revenue regards actively managed funds as traders, so they are taxed on both income and capital gains.

All superannuation funds are taxed at 33 per cent on income and gains. So, too, are funds offered through life insurance companies. Unit trusts are taxed at 33 per cent, but some offer imputation credits which can be used by investors in lower brackets to offset other income such as interest on bank deposits. And some managed investments are set up as "group investment funds", which may be taxed at your individual tax rate - 19.5, 33 or 39 per cent.

Are you totally confused at this point?

Want to know how to steer clear of these complex tax issues altogether?

Let me explain how investors who are not traders can manage tax on fund investments in a much more efficient manner.

Investors are often warned that it is unwise to save or invest in anything that is marketed solely on the basis of tax benefits. Always investigate the underlying economic benefits as well. But let's get real; if you can legally avoid tax, why not look into it?

In November 1998, a new form of managed fund programme was introduced in New Zealand which effectively stands outside the traditional tax regime for those people not deemed to be traders. Rather than pay income tax, these funds pay only a 2 per cent "approved issuer levy".

fxdrop, 3, 60 N OW, I know this all sounds too good to be true. But bypassing standard income tax by paying this levy is perfectly legal. For a fund to qualify for the advantage, three conditions must exist:

* The individual investor must not be deemed to be a trader for tax purposes (most New Zealanders are not).

* The investment must be set up in Australia as an Australian tax resident, though the fund can invest in a number of locations. Generally, tax will be withheld in Australia only to the extent that income or gains come from that country. This usually amounts to little or none for these investments.

* Income and capital gains are rolled up into the unit value and distributed to investors annually, in the form of a "bonus issue", which is not taxable as dividend income to New Zealand investors.

Because of the last requirement, these funds do not distribute regular income. That means most investors should view them as vehicles for accumulating wealth, rather than a source of income.

However, units can be sold occasionally to provide income. You just want to ensure that such activity is infrequent and that the amounts are varied, to avoid any appearance of trading activity.

So, what sort of investments are these? To date there are fewer than a dozen on offer, but they range from cash accounts to pooled mortgage funds to traditional managed funds involving various investments - including shares.

Think about it, you can now make sure your savings and investments are not subject to normal tax. That means the average person can retain much more of the return on his hard-earned investment dollar.

Traditionally, some New Zealand investors who want to reduce their tax costs have used listed investment trusts, based in Britain. Like the newer Australian-based funds, these trusts are not taxed on their capital gains but they do pay tax on income.

Not all Australia-based managed investments come with these tax advantages. To check, have a look in the investment statement to see if a fund is referred to as an "Australian tax resident". The investment statement should also say that the distributions will be in the form of "additional units" and that these will "constitute a non-taxable bonus issue to New Zealand investors". And, if you have any doubts, get independent tax advice.

Investors thinking of using these innovative, tax-efficient investments should also get independent tax advice beforehand, to make sure they are not likely to be classified as a trader. But, to repeat, the structure is perfectly legal and these programmes are now offered by a number of leading New Zealand financial institutions.

So are death and taxes really inevitable? For the moment it appears we've got one of them pretty well licked. A bit of work still to do on that small matter of death, however.

* Terry Upton is an Auckland investment adviser.

* Email Terry Upton

* Disclosure of interest: Upton actively markets Australian-domiciled funds and personally maintains investments in three.