Remedial amendments to the portfolio investment entity tax rules

Sections  CB 4B, CP 1, CX 44C to CX 44E, DB 17, DB 43B, DB 43C, EB 2, EX 1, HL 5 to 10, HL 11B, HL 12, HL 14, HL 15, HL 16, HL 19, HL 20, HL 21, HL 23, HL 23B, HL 24, HL 26, HL 27,  HL 28, HL 30, HL 31, IG 1, KI 1, LD 10, LD 10B, LD 11, NG 1, and OB 1 of the Income Tax Act 2004; sections 31B, 33A, 36 and 57B of the Tax Administration Act 1994; section 53 of the Companies Act 1993; and section 97B of the Taxation (Savings Investment and Miscellaneous Provisions) Act 2006

A number of technical amendments have been made to the portfolio investment entity tax rules to give effect to the policy intent of the rules.  The changes provide collective investment entities that elect to be portfolio investment entities with the necessary flexibility to implement the rules and ensure that different commercial arrangements can be accommodated.  The amendments also make a number of technical corrections to the rules.  These changes will enable a smooth introduction of KiwiSaver and the portfolio investment entity rules on 1 October 2007. 

Background

The new tax rules for portfolio investment entities were enacted at the end of 2006 and address a number of long-standing problems with the taxation of collective investment vehicles.  The effect of the new rules is that, from 1 October 2007, people that invest in a collective investment vehicle that elects to be a portfolio investment entity will be taxed in a broadly similar manner to a person that made the same investment directly.  This is achieved by providing portfolio investment entities with tax relief on certain Australasian share gains, applying the new fair dividend rate method for non-Australian share gains, and ensuring that the investment earnings that low-income people derive through portfolio investment entities are taxed at 19.5%. 

Since the rules were enacted, a number of technical issues with the application of the rules have arisen.  These changes address these issues and provide collective investment vehicles with the necessary flexibility to implement the new rules.

Key features

Section HL 20 has been amended to provide that the portfolio entity tax liability is calculated for a portfolio calculation period and a portfolio investor class and each investor in the portfolio investor class.

The new section HL 23B allows portfolio tax rate entities that pay tax under sections HL 21 or HL 23 to make voluntary payments of tax when an investor partially reduces their interest in a portfolio investor class.  As the amount of tax that is paid under section HL 23B is voluntary it is left to the discretion of the entity to calculate the amount of tax payable.  This will accommodate the different ways entities calculate tax when an investor partially exits a portfolio investor class.  

A number of changes have been made to section HL 27 to deal with various issues that have arisen in relation to the way portfolio tax rate entities allocate and use tax credits.  One of the main changes ensures that tax credits attributable to an investor in a portfolio tax rate entity that is itself a portfolio tax rate entity, can flow through to the portfolio tax rate entity investor without limitation. 

Section HL 28 has been amended to set more appropriate rules on a portfolio investment entity's use of portfolio entity formation losses.  Broadly, the new rules will require portfolio investment entities to spread the use of portfolio entity formation losses over three years.  These losses cannot be used to offset net income when the portfolio investment entity has income covered by New Zealand tax credits.

The definition of "portfolio investor rate" in section OB 1 has been amended so that the top rate of tax in a portfolio tax rate entity is 30% (instead of 33%).  This amendment applies from the 2008-09 and later income years.   

Application dates

The application date for most of these changes is
1 October 2007, to coincide with the commencement of the portfolio investment entity rules.  The amendment that reduces the top rate of tax in a portfolio tax rate entity from 33% to 30% applies from the 2008-09 and later income years.  The amendment to the Taxation (Savings Investment and Miscellaneous Provisions) Act 2006 that ensures entities can elect on or after 1 April 2007 to be a portfolio investment entity applies from 1 April 2007. 

Detailed analysis   

Calculation of portfolio entity tax liability for an investor as a member of a portfolio investor class

Section HL 20 has been amended to ensure that the portfolio entity tax liability is calculated for a portfolio calculation period and a portfolio investor class and each investor in the portfolio investor class.  Before the amendment, the portfolio entity tax liability was calculated for a portfolio calculation period and an investor (that is, as being the sum of the portfolio entity tax liability for each portfolio investor class that the investor is a member of).  There was no ability for a portfolio tax rate entity to calculate the tax liability for
the investor as a member of a portfolio investor class.

The new approach will allow portfolio tax rate entities to calculate a tax liability for an investor as a member of a portfolio investor class and apply the investor's share of the tax credits for the class (both foreign and New Zealand) accordingly.  The provisions relating to foreign and New Zealand tax credits have also been amended so that credits can be allocated to an investor and used to reduce their liability as a member of a portfolio investor class.  This is discussed in more detail below.

It is important to note that these changes would not generally prevent a portfolio tax rate entity from applying an investor's tax credits to reduce the investor's portfolio entity tax liability across all their classes.  That is, in addition to allowing a portfolio investor class-based approach to calculation of tax liabilities and utilisation of credits, the amended rules will also support the former approach of allowing an investor's portfolio entity tax liability to be reduced by all of the investor's available foreign and New Zealand tax credits.  The way tax credits can be utilised (especially foreign tax credits) is relevant where a tax liability is triggered when an investor reduces their interest in a portfolio tax rate entity.

The new approach is designed to accommodate the different commercial arrangements that a portfolio tax rate entity may have. 

Payment of tax on switches between portfolio investor classes and partial exits

New section HL 23B allows portfolio tax rate entities that pay tax under section HL 21 or HL 23 to make voluntary payments of tax when an investor fully or partially exits a portfolio investor class.

This change allows portfolio tax rate entities to pay tax when an investor switches from one investor class to another within the same entity, and also to accommodate partial exits from a portfolio investor class (which may be a reduction in an investor's interest in the entity rather than a switch to another class).  In both cases, without the amendment, the rules would not have triggered a tax liability.

Before this amendment, an investor that switched between portfolio investor classes would not have triggered a taxable event under the rules.  This is because, for portfolio tax rate entities that pay tax under section HL 21 or HL 23, the previous rules provided that a taxable event would arise mid-period only if there was a so-called "portfolio investor exit period".  A portfolio investor exit period arises when an investor's portfolio investor interest (defined in the context of their interest in the entity) is less than their portfolio entity tax liability.  Therefore, a switch between portfolio investor classes would not have triggered a portfolio investor exit period as it would not have resulted in a reduction in an investor's interest in the entity (that is, a reduction of the interest relating to one class would be offset by an increase in the interest relating to another class).

Similarly, a withdrawal from a portfolio investor class would not have triggered a taxable event if the interest being withdrawn was not sufficiently significant to give rise to a portfolio investor exit period.  That is, a taxable event would not have been triggered if the remaining interest in the entity exceeded the tax liability that would otherwise have arisen in respect of the amount withdrawn.  This is what is referred to as a partial exit.

A portfolio tax rate entity that pays tax under section HL 21 or HL 23 now has the option of treating switches between investor classes as a taxable event under section HL 23B and, as a result, section HL 7.  That is, if an investor withdraws from a portfolio investor class (either completely or partially) and reinvests the funds in another portfolio investor class of the same entity, then the entity can elect to pay the tax for the part of the year before the withdrawal.

Similarly, if there is a partial exit from a portfolio tax rate entity that pays tax under section HL 21 or HL 23, the entity can elect to pay tax for the portion of the interest that was withdrawn.  This includes switches between portfolio investor classes that are not complete withdrawals.

As the application of section HL 23B is voluntary, a portfolio tax rate entity that pays tax under section HL 21 or HL 23 can choose not to pay tax for investors switching between classes, or when there are partial exits from a portfolio investor class or the entity as a whole.

Income allocated by portfolio tax rate entities to partial withdrawals

If an entity elects to make optional payments of tax on reductions of investor interests, the portfolio entity tax liability referred to in the new section HL 23B is up to the portfolio tax rate entity to determine.  Because the payment of tax is voluntary it is left to the discretion of the entity to calculate the amount of tax payable.  In any case, an accurate tax calculation for the investor as a member of a portfolio investor class is required at the end of a quarter or a tax year.

This effectively means that a portfolio tax rate entity has the option of calculating an investor's portfolio entity tax liability either on the actual interest that is redeemed, or it can choose to treat the interest being cancelled as a proportion of the investor's interest in the entity as a whole.  In the latter case, under section HL 23B the entity is able to calculate the tax liability on the interest redeemed as a proportionate share of the investor's tax liability for all portfolio investor classes that the investor has an interest in.  An example illustrates:

An investor has an interest in Class A and Class B of a portfolio tax rate entity that pays tax under section HL 23.  On two days the classes derive portfolio investor allocated income and portfolio investor allocated loss as outlined in Example 1.  At the end of day two the investor redeems 20 percent of their
interest in Class A.  The 20 percent redemption represents a 10 percent redemption of the investor's interest in the entity.

Example 1

Under the proportionate approach, total income for the investor is $50.  Therefore, given the investor redeems 10 percent of their interest in the portfolio tax rate entity, the entity could pay tax under section HL 23B on $5.  Alternatively, the entity could pay tax in relation to the amount actually redeemed.  This means that tax could be paid on 20 percent of income attributable to class A
(20% x $20 = $4).

Section HL 23B allows both approaches to calculating the tax liability when there is a partial exit from a portfolio investor class as outlined above.

Under the changes to the definition of "portfolio investor exit period" (in particular, paragraph (b) of the definition), a portfolio investor exit period arises where the portfolio entity tax liability for an investor for a portfolio investor class and any other class exceeds the investor's portfolio investor interest for the portfolio investor class and any other class.  In other words, a portfolio investor exit period arises if the total accumulated tax liability for the investor exceeds the value of their interest in the entity as a whole.

If a portfolio investor exit period arises, section HL 23(2) requires a tax payment, the amount of which is the portfolio entity tax liability of the entity for the portfolio investor exit period - that is, the total accumulated tax liability across all classes.

Option for a section HL 21 portfolio tax rate entity to pay tax rather than zero-rate when an investor withdraws

Under new section HL 23B, if an investor in a portfolio investor class of a portfolio tax rate entity that pays tax under section HL 21 withdraws their interest in the class or the entity in a quarter, the entity has the option of paying the tax relating to the quarter in which the exit occurs, rather than zero-rating the withdrawal.

If this is the case, then a portfolio investor exit period does not arise and the investor does not need to include any income relating to the quarter in which the withdrawal was made in their tax return.  This has the benefit of ensuring that the income relating to the period of the withdrawal remains excluded income of the investor.

Again, because the application of section HL 23B is voluntary, the entity would still have the option to zero?rate the investor.  In this case it would be the responsibility of the investor to pay the resulting tax liability.

Timing of optional tax payment

An optional payment of tax under section HL 23B must be made to Inland Revenue by the end of the month following the month in which the investor switch or partial exit occurred, in the case of an investor in a portfolio tax rate entity that pays tax under section HL 23.  Optional payments of tax relating to investors in portfolio tax rate entities that pay tax under section HL 21 are due at the same time as the normal quarterly tax payment.

Rebates under section KI 1 can also arise on investor switch or partial exit from a portfolio tax rate entity that pays tax under section HL 23.  The timing for payment of these rebates is the same as would occur if tax was payable.  An amendment to section HL 26(2) has been made to provide this rebate mechanism for partial exits.

Consequential amendments to the definition of portfolio investor exit period

The definition of "portfolio investor exit period" in section OB 1 has been consequentially amended to ensure that it applies generally on a portfolio investor class basis, and is therefore consistent with subpart HL.

However, a portfolio investor exit period continues to arise when there is a reduction in an investor's interest so that the investor's total remaining interest in the entity across all classes is less than the tax liability relating to the reduction.

For portfolio tax rate entities that pay tax under section HL 23, this means they are only required to pay tax for an investor on a part-year basis if there is a portfolio investor exit period.  However, as discussed above, these entities can make voluntary payments of tax under section HL 23B when investors partially exit a class or the entity as a whole.

For investors in portfolio tax rate entities that pay tax under section HL 21, a portfolio investor exit period does not arise if the entity has made a payment of tax under section HL 23B sufficient to meet the relevant portfolio entity tax liability for the investor.  This ensures that any income allocated in the quarter in which the investor withdrew their interest, and on which the entity has paid tax, is still considered as excluded income under section CX 44D. 

A section HL 7 adjustment

As the section HL 23B payment gives rise to a portfolio entity tax liability of the entity, an adjustment under section HL 7 to reflect the liability is required.  The maximum period for making this adjustment is discussed in more detail below.