New rules for use of portfolio entity formation loss

The new legislation:

• Removes the requirement to reduce the amount of any rebate under section KI 1 or a deduction under section DB 43 in relation to portfolio entity formation losses used in a tax calculation period.  Portfolio investor allocated losses can be rebated without restriction and similarly there is no reduction in the amount of loss allowed as a deduction to zero-rated investors in portfolio tax rate entities.  Sections KI 1(3) and DB 43(2) have been repealed to achieve this.
• Allows a portfolio tax rate entity to use portfolio entity formation loss without restriction to reduce class net income for a portfolio investor class in a portfolio allocation period, if the total portfolio entity formation loss of the entity is less than 5 percent of the total market value of the entity's portfolio entity investments.  Section HL 28(3) has been replaced by new section HL 28(3)(a) to achieve this.
• Allows a portfolio tax rate entity, whose portfolio entity formation loss exceeds 5 percent of the entity's market value, to use on each day of the first three years of the entity's existence, up to 1/1095 of the total portfolio entity formation loss of the entity to reduce any class net income for a portfolio investor class of the entity on that day.  Under this change;
  • when there is insufficient class net income for a portfolio investor class on a day, the day's allocation of portfolio entity formation loss can be carried forward and added to the next day's allocation of portfolio entity formation loss;
  • if there is an amount of portfolio entity formation loss that has not been used after the end of the three-year period, the total amount of unused portfolio entity formation loss can be used without restriction to reduce class net income for a portfolio investor class and a portfolio allocation period.

New sections HL 28(4) and (5) contain the formula for calculating the amount of portfolio entity formation loss that may be allocated to a portfolio allocation period.

New Zealand tax credits must be used before portfolio entity formation losses

Portfolio entity formation losses allocated under new section HL 28(3) cannot be used to reduce the class net income of a portfolio investor class of an entity if sufficient New Zealand tax credits are available in a portfolio allocation period to offset the portfolio entity tax liability that would otherwise arise.

New Zealand tax credits are defined as imputation credits, credits for resident withholding tax, dividend withholding payment credits and Maori authority credits.  There is no restriction in relation to the use of portfolio entity formation losses where a portfolio investor class has foreign tax credits (that is, credits for foreign NRWT deducted) in an allocation period.

Under new sections HL 28(6) and (7), the amount of portfolio entity formation loss allowed to be allocated to a portfolio allocation period is the lesser of:

• the maximum allowable portfolio entity formation loss for the allocation period (calculated under section HL 28(4)); or
• the amount by which the class net income of a portfolio investor class for the allocation period exceeds the total New Zealand tax credits allocated to the period, grossed up to an amount by dividing by the statutory rate of tax for a company.

Clarification that formation losses can be held at the entity or portfolio investor class level

While section HL 28 treats portfolio entity formation losses as arising at the entity level, a portfolio tax rate entity can choose for portfolio entity formation losses to be held at a portfolio investor class level.  When calculating class taxable income under section HL 19, a class's shares of a portfolio entity formation loss should be determined.  The methodology for determining each class's share is left to the entity.  It therefore follows that the rules do not prevent an entity from dividing the entity's formation losses between classes on becoming a portfolio tax rate entity.

Investor fees to be allowed as a deduction against portfolio entity tax liability for an investor

The formula in section HL 20(4) which calculates the portfolio entity tax liability for an investor in a portfolio investor class has been amended to allow certain fees relating to an investor's portfolio investor interest to be taken into account.  That is, a deduction for fees charged to an investor's account (calculated as the amount of fees multiplied by the portfolio investor rate of the investor) can be used to directly reduce the portfolio entity tax liability for the investor.  The fees that would be deductible are those that are charged to the investor for ongoing management and administration services, including switching fees, in relation to their portfolio investor interest.  These fees should be spread over each portfolio allocation period the investor is present in a portfolio investor class.

As the fees charged are specific to the investor, section HL 20(4) is the appropriate mechanism to ensure that each investor's individual fee circumstances are accurately reflected.  The formula also takes into account any fee rebates credited to the investor's account (these rebates would increase the portfolio entity tax liability of the investor, as they would be taxable if paid directly to the investor).

This change to allow fees to reduce the income tax payable by the entity, on behalf of investors, is designed to prevent investors having to file a tax return to get a deduction separately.  Consequently, new section DB 43C has been added to prevent fees charged by portfolio tax rate entities that are included in the portfolio entity tax liability calculation under section HL 20, being deductible separately to the investor.  Similarly, new section CX 44E has been added to prevent any fee rebates being separately taxable to the investor.  These amounts are treated as excluded income to the investor.

Consequential changes to reflect the deduction of fees and addition of fees rebates have also been made to section HL 24, which calculates the portfolio investor allocated income and portfolio investor allocated loss for an investor.

Unlisted companies allowed to temporarily qualify as a portfolio listed company

New section HL 11B allows certain unlisted companies to temporarily be treated as portfolio listed companies if they meet a number of criteria.  These criteria include:

• the company would meet paragraph (a) of the definition of "qualifying unit trust" in section OB 1 (if it were a unit trust); and
• the company has resolved to become listed on a recognised New Zealand exchange if it were to obtain the required consents; and
• the company has applied to the Securities Commission for an exemption to disclose in its prospectus its intention to become a listed company; and
• the company satisfies the Commissioner that it would apply to become a listed company if it obtained the required consents.

The company must be listed on a recognised exchange within two years from when it first elected to be a portfolio investment entity in order to retain portfolio listed company status.

The definition of "portfolio listed company" has been consequentially amended so that a company that is eligible under section HL 11B temporarily qualifies as a portfolio listed company. 

Foreign investment vehicles can invest through other foreign investment vehicles

Section HL 5 has been amended to allow a foreign investment vehicle to own more than 20 percent of another foreign investment vehicle.  This allows a foreign investment vehicle to hold investments through other foreign investment vehicles.

Section HL 5 also allows foreign investment vehicles to hold their investments through trusts when the foreign investment vehicle is the sole beneficiary.