Portfolio class land loss

2010 amendment to the Income Tax Act clarifies that land-owning PIEs investing offshore can allocate losses from foreign exchange contracts to their investors.

Amendments have been made to clarify that land-owning portfolio investment entities (PIEs) that invest offshore can allocate tax losses that arise from foreign exchange contracts to their investors.

Background

Generally, at the end of the year, a PIE receives a cash rebate from Inland Revenue for any tax losses it has made. The PIE then allocates this loss to its investors. An exception to this is that PIEs that invest predominantly in land or land-owning companies ("land PIEs") cannot receive a cash rebate for their tax losses at the end of the year. This is to prevent excessive tax losses arising from heavily geared land investments.

Previously, a problem existed for land PIEs with portfolio investments in foreign land-owning companies. As these investments are often denominated in foreign currency, the PIEs typically enter into foreign exchange hedging contracts to remove or reduce the currency risk associated with the investment. The hedging contracts result in a loss if the foreign currency in which the investment is held appreciates against the New Zealand dollar. Under the previous rules, the PIE was required to carry forward the losses that arose as a result of the hedging contract rather than allocate them to its investors.

Key features

An amendment has been made to the definition of "portfolio class land loss". This was done to clarify that PIEs that own land offshore can allocate tax losses arising from foreign exchange contracts to their investors.

Detailed analysis

PIEs that have investments in foreign land-owning companies typically remove or reduce the currency risk associated with the investment by entering into foreign exchange hedging contracts. These contracts fall within the definition of a financial arrangement, and associated gains and losses are taxable or deductible.

As a result, in years where the foreign currency in which the investment is held appreciates against the New Zealand dollar, the foreign exchange financial arrangement will produce a tax-deductible loss. The land PIE's investment in the foreign land-owning company is generally subject to fair dividend rate (FDR)taxation at 5% and, therefore, always generates income for tax purposes. As the land investment itself cannot generate a tax loss, this was not the type of investment intended to be subject to the land loss rules when they were designed.

In certain years the FDR income generated will not be sufficient to offset the foreign exchange loss and an overall tax loss can arise. Amendments to sections HL 32 and HM 65 of the Income Tax Act 2007, and to section HL 30 of the Income Tax Act 2004 change the definition of "portfolio land class loss" to clarify that the land PIE is not required to carry such losses forward but can instead allocate tax losses that arise from foreign exchange contracts to its investors. This is consistent with the policy intent of the PIE rules when they were enacted.

Application dates

The amendments to section HL 32 of the Income Tax Act 2007 and section HL 30 of the Income Tax Act 2004 will apply from 1 October 2007, the date the PIE rules were introduced.

The amendment to section HM 65 of the Income Tax Act 2007 will apply from 1 April 2010, the date the rewritten PIE rules apply from.