Amendments to the off shore portfolio share investment rules

2009 amendments to the offshore portfolio share investment rules address identified technical problems or amend the rules to cater for different circumstances.

Sections CD 36, EX 31(2), EX 37, EX 46, EX 46(10)(cb), EX 47, EX 51, EX 52, EX 53, EX 56, EX 59, EX 59(2B), EX 62 and EX 66B of the Income Tax Act 2007; sections CD 26, EX 33(4), EX 40B, EX 44, EX 44C, EX 44D, EX 45B and EX 47 of the Income Tax Act 2004; sections 61, 91AAO and 183 of the Tax Administration Act 1994

A number of remedial amendments have been made to the tax rules for offshore portfolio investment in shares. These amendments ensure that the new rules achieve their intended policy effect.

Background

New tax rules for offshore portfolio investment in shares were enacted by the Taxation (Savings, Investment, and Miscellaneous Provisions) Act 2006. The rules, which apply for income years beginning on or after 1 April 2007, generally apply to an investment by a New Zealand resident in a foreign company when the investor owns less than 10% of the company. Under the new rules, offshore portfolio investment in shares is taxed consistently, regardless of the country where the investment is located and whether the investment is made by an individual directly or through a collective investment vehicle. 

The tax rules for offshore portfolio investment in shares mainly relate to the foreign investment fund (FIF) rules. The main changes were removal of the “grey list” exemption in the FIF rules and introduction of the new fair dividend rate method – which broadly taxes 5% of a person’s offshore share portfolio’s opening value each year.

Key features

The following amendments outlined in this TIB report are of a remedial nature and address technical problems that were identified with the new rules or amend the rules to cater for different circumstances. All the amendments are consistent with the policy intent of the new tax rules for offshore portfolio investment in shares.

Application dates

The amendments contained in the Income Tax Act 2007 are generally effective from 1 April 2008 (any variation from this date is noted in the following text). The smaller number of amendments to the Income Tax Act 2004 are effective from 1 April 2007.

Detailed analysis

Venture capital exemption

Several aspects of the exemption in the FIF rules for interests in grey list companies which own New Zealand venture capital companies – section EX 37 of the Income Tax Act 2007 and section EX 33(4) of the Income Tax Act 2004 – have been clarified. First, ownership of the New Zealand company has been defined as “holding more than 50% of the voting interests in the company”. This amendment makes it clear when the 10-year limitation for the exemption ends. Secondly, an amendment has been made to clarify that the company that carries on business in New Zealand is a New Zealand-resident company.

Australian-resident listed company exemption

The exemption from the FIF rules for shares in Australian-resident companies listed on the Australian Stock Exchange has been amended to cater for companies which are the subject of court-approved reorganisations. In particular, the requirement in section EX 31(2) of the Income Tax Act 2007 that shares in the company be included in an approved Australian Stock Exchange index has been expanded. It now includes the situation when the shares are included in an approved index at the beginning of the final month of the preceding income year, if the shares are cancelled or transferred in the first month of an income year under a court-approved arrangement.

Comparative value method and currency conversion rules

A clarifying amendment has been made to the “opening value” definition in the comparative value method in the FIF rules (section EX 51 of the Income Tax Act 2007 and section EX 44 of the Income Tax Act 2004) to ensure that the correct exchange rate is used.

The opening value definition in the comparative value method refers to the market value of the person’s interest at the end of the previous income year. If a person has chosen to use the average exchange rate (the average of the close of trading spot exchange rates for the 15th day of each month that falls in the year), it is the average exchange rate applying for that previous year which should be used to calculate the opening value for the current year. This approach is necessary to ensure that exchange rate gains and losses are reflected in FIF income or loss under the comparative value method over different income years.

Therefore the comparative value method provisions have been amended to ensure that it is the relevant exchange rate applying in the previous income year that is used to calculate the opening value for the current year.

Comparative value method loss restriction

The comparative value method in section EX 51 of the Income Tax Act 2007 has been amended so that the loss restriction rule under this method applies to foreign superannuation and foreign life insurance interests. Without this amendment investors would be able to claim a loss under the comparative value method for these interests but limit any gain to 5% under the fair dividend rate method.

This amendment applies for the 2009-10 and subsequent income years.

Criteria for using the fair dividend rate method - hedging requirement

The fair dividend rate method cannot be used for certain types of investments that are broadly the same as New Zealand dollar denominated debt investments. One of these exclusions is contained in section EX 46(10)(c) of the Income Tax Act 2007. The section provides that the fair dividend rate method cannot be used for an interest in a non-resident entity that holds, directly and indirectly, assets of which 80% or more by value consist of financial arrangements or fixed-rate shares that are denominated in New Zealand dollars or are hedged back to New Zealand currency with that hedging being at least 80% effective.

New section EX 46(10)(cb) clarifies that the instrument which hedges the investment to New Zealand currency can be held by the New Zealand investor as well as a non-resident entity. In determining whether the non-resident in which the interest is held holds directly or indirectly assets of which 80% or more by value consist of financial arrangements or fixed-rate shares, intra-group financial arrangements are ignored. Also, the new provision does not apply if the non-resident entity (in which the New Zealand resident invests) is listed on a recognised exchange and is not a foreign investment vehicle (ignoring section HL 10(4) which narrows the “foreign investment vehicle” definition). The purpose of these restrictions in new section EX 46(10)(cb) is to ensure that in-substance, equity investments are not caught.

Excluding managed funds from grey list exception in fair dividend rate method

The fair dividend rate rules were amended by the Taxation (Business Taxation and Remedial Matters) Act 2007 to provide that there is no FIF income for an interest if the interest is a 10% or more holding in a grey list company at the start of an income year. This ensures there is no FIF income if that holding falls below 10% during the year. This treatment is consistent with the general fair dividend rate treatment, which ignores purchases of shares during a year (other than quick sales).

However, this 2007 amendment should not generally apply to managed funds that hold shares in a foreign investment vehicle because the remaining grey list exemption for 10% or more interests does not apply to managed funds such as portfolio investment entities. Instead, the fair dividend rate method applies to these investments. Accordingly, an exclusion has been made to this amendment for managed funds (portfolio investment entities, entities eligible to be portfolio investment entities or life insurance companies) that hold interests in foreign investment vehicles (as defined in section YA 1 of the Income Tax Act 2007 and section OB 1 of the Income Tax Act 2004).

A managed fund is therefore able to use the fair dividend rate method for a 10% or more interest in a foreign investment vehicle that is resident in a grey list country (as it was previously able to for an interest in a foreign investment vehicle resident in a non-grey list country). This exclusion has been achieved by amendments to the fair dividend rate method provisions in the Income Tax Act 2007 (sections EX 52 and EX 53) and the Income Tax Act 2004 (sections EX 44C and EX 44D). 

Related amendments have been made to sections EX 59 and CD 36 of the Income Tax Act 2007 and sections EX 47 and CD 26 of the Income Tax Act 2004 to ensure that the dividend exclusion continues to apply for a managed fund holding an interest in a foreign investment vehicle.

Cost method: transitional rule

The cost method in the FIF rules was amended by the Taxation (Business Taxation and Remedial Matters) Act 2007 to allow investors to use their actual cost for their opening value under that method, instead of having to obtain an independent valuation, for interests acquired in the 2005–06 or 2006–07 income year. This amendment was designed to reduce compliance costs for taxpayers using the cost method for the 2007–08 income year, the first income year that the cost method is used for.

An amendment has been made to the cost method in section EX 56 of the Income Tax Act 2007 and section EX 45B of the Income Tax Act 2004 to ensure that the opening value option is available only for the 2007–08 income year and not future income years. This is because the opening value does not include an uplift factor for the previous year’s FIF income to act as a proxy for an increase in the value of the investment.

Cost method: effect of previous year’s quick sale gains on opening values

The cost method in section EX 56 of the Income Tax Act 2007 has been amended so that the formulas for calculating the opening value do not include the previous year’s quick sales gains. Quick sale gains from the previous year should not be included in calculating the opening value because this would overstate FIF income in the current year.

Management fee rebate received from an offshore fund

New section EX 59(2B) of the Income Tax Act 2007 ensures that management fee rebates received from an offshore fund manager in relation to a FIF interest are not excluded by section EX 59(2) from being treated as income of the New Zealand-resident investor if the investor was allowed a deduction for the fee. 

This amendment applies for the 2009-10 and subsequent income years.

Change of method by taxpayer in the first year

An amendment to section EX 62 of the Income Tax Act 2007 allows individuals a one-off opportunity to change their FIF calculation method from the accounting profits or branch equivalent methods to the fair dividend rate method. The change must be made for the 2008–09 tax year if the person has not filed a return for that year before the date of Royal assent. If the person has filed a return for the 2008–09 tax year before the date of Royal assent, the change to the fair dividend rate method will be effective for the 2009–10 tax year.

Deemed disposal and re-acquisition when FIF becomes New Zealand-resident

An amendment has been made to deal with the situation where a non-resident entity becomes a New Zealand resident, thereby ceasing to be a FIF. New section EX 66B of the Income Tax Act 2007 treats individuals with an interest in the entity as having disposed of and reacquired their interest at market value.

This amendment applies for the 2009–10 and subsequent income years.

Drafting consistency amendment

To achieve consistency with other references to the comparative value method in sections EX 46(4)(a)(i) and EX 62(2)(c), section EX 47 of the Income Tax Act 2007 has been amended by replacing the reference to “start of the income year” with “end of the income year”. Therefore, a person who is not allowed to use the fair dividend rate method for an attributing interest is required to use the comparative value method for that interest, or the deemed rate of return method if the comparative value method is not practical because the person cannot obtain the market value of the interest at the end of the income year. The same change has been made to the corresponding provision in section EX 40B of the Income Tax Act 2004.

Income Tax Act rewrite-related amendments

A number of remedial amendments have been made to the FIF rules in the Income Tax Act 2007 to ensure that there has been no inadvertent change to the rules as part of the Income Tax Act rewrite process. The significant rewrite-related amendments are:

  • The fair dividend rate rules in sections EX 52 and EX 53 of the Income Tax Act 2007 have been amended to allow an investor to offset a net loss from one FIF interest against the net gain from another FIF interest. This reinstates the position that exists under the Income Tax Act 2004. The fair dividend rate rules in the Income Tax Act 2004 pooled the results for all attributing interests for which an investor used the fair dividend rate method. In contrast, the fair dividend rate rules in the Income Tax Act 2007 deal separately with each FIF in which an investor holds attributing interests. This approach prevents an investor offsetting, under the quick sale gains part of the fair dividend rate formula, a net loss from one FIF interest against a net gain from another FIF interest.
  • The references to treating certain shares as debt have been removed from sections EX 46 and EX 47. This prevents the wording of a number of provisions in sections EX 46 and EX 47 of the Income Tax Act 2007 giving the incorrect impression that certain types of shares for which the fair dividend rate method may not be used are instead treated as debt for the purposes of the Income Tax Act 2007 (and therefore subject to the financial arrangement rules rather than the FIF rules). It is intended that these shares be taxed under the comparative value method in the FIF rules.
  • For the purposes of applying the fair dividend rate method, an original share in a foreign company that is subject to a returning share transfer should be treated as being held by the share supplier and not the share user. This amendment was made by the Taxation (Business Taxation and Remedial Matters) Act 2007 to the fair dividend rate method provisions in the Income Tax Act 2004 but was inadvertently not made to the corresponding provisions in the Income Tax Act 2007. This omission has been rectified by amendments to sections EX 52 and EX 53 of the Income Tax Act 2007.
Disclosure of foreign interests

Section 61 of the Tax Administration Act 1994, containing the disclosure requirements for interests in foreign companies or FIFs, has been amended to facilitate electronic filing. One of the problems for electronic filing under the previous rules was the requirement that the disclosure must be “with that person’s return of income”. This has been replaced by a requirement that the disclosure be made within the time allowed for providing a person’s return of income for the year. 

The first reference to “tax year” in section 61(1) has also been replaced with “income year” to cater for persons with non-standard balance dates. This amendment is a correction since references to years in the international tax rules – which include section 61 of the Tax Administration Act 1994 – have always included non-standard accounting years since their inception in 1988. The amendment is effective from 1 April 2005.

Application date of fair dividend rate determinations

An amendment has been made to section 91AAO of the Tax Administration Act 1994 to allow portfolio investment entities that return their income on a quarterly basis to apply a fair dividend rate determination retrospectively for a quarter beginning before the date that the determination is made.

Suspending obligation to pay tax on foreign investment fund income

Section 183 of the Tax Administration Act 1994, which allowed the payment of tax on FIF income to be suspended in very limited circumstances, has been repealed as a tax simplification measure. This complicated provision was not used in practice and had also been superseded by exemptions enacted in 2006 for new migrants.