The Government’s recently released Government Tax and Social Policy Work Programme proposed a much-needed review of the foreign investment fund (FIF) tax rules. While this review is a welcome step, ideally this would also encompass a review of the transitional resident rules. This wider review would better align both regimes with their intended objectives and global best practice.

What are the FIF rules?

The FIF rules tax New Zealand tax residents on interests in foreign companies (which includes most investment funds and unit trusts) over which they do not exercise control (the separate controlled foreign company (CFC) rules apply to controlled offshore subsidiaries). The FIF rules also apply, somewhat haphazardly, to foreign life insurance policies.

FIF income is generally “deemed” income, in the sense that it is calculated under certain specified methods largely without reference to actual cash receipts.

The principal method taxes an amount equal to 5% of the market value of a person’s FIF investments at the start of the relevant tax year (called the fair dividend rate (FDR) method). The main alternative method taxes the difference between (i) the market value of a person’s FIF investments at the end of the tax year plus any cash distributions received during the year; and (ii) the market value at the start of the tax year and any acquisition costs in that year (the comparative value (CV) method).

Individuals and family trusts can switch between the FDR and CV methods from tax year to tax year, based on which method produces the most favourable result. In high performing years, the FDR method is likely to be preferable (because taxable income is ‘capped’ at 5% of opening value), while a switch to CV is favoured in poor performing years.

Other investors, including New Zealand unit trusts and KiwiSaver funds (which are invariably PIEs), are effectively locked into the FDR method, but with an ability to manage their exposure by applying the 5% calculation at more regular intervals. Two other FIF calculation methods apply in certain more unusual scenarios.

Problems with the FIF rules (and some suggested fixes)

In our experience, in the case of both private investors and fund managers the FIF rules function relatively satisfactorily in relation to a ‘vanilla’ portfolio of liquid, listed international equities, or international funds, where valuations and information as to distributions, changes to capital structure and other matters are readily obtained.

However, the FIF rules can operate punitively where a New Zealand resident holds a non-controlling interest in a private overseas company, particularly one that is not paying regular dividends and cannot be traded because of the terms of a shareholders’ agreement or other restrictions. In these scenarios there can be significant, and in some cases unmanageable, ‘dry’ tax liabilities under the FDR method, with the CV method not producing a better result because the underlying value of the investment is increasing.

We are aware of situations in which migrants holding minority shareholdings in private overseas companies choose, towards the end of their period of transitional residence (discussed in the next section), to leave New Zealand rather than face the full implications of FIF taxation of unrealised gains.

Existing FIF exemptions need an overhaul

There are some limited exemptions that operate to mitigate these punitive outcomes in certain circumstances. The key one applies for up to ten years where a New Zealand company “flips” to controlling overseas ownership with the New Zealand founders and other shareholders retaining a minority interest in a new offshore holding company. This is intended to accommodate venture capital investments in New Zealand resident start-up companies where offshore equity financing is obtained through the non-resident holding company structure.

However, the exemption only applies where the new offshore holding company is established in a so-called “grey list” jurisdiction (Australia, Canada, Germany, Japan, UK, USA, Norway or Spain) and a minimum level of operations is maintained in New Zealand. We hope that the review will result in these requirements being diluted so that this exemption can operate in a broader range of scenarios.

Similarly, existing FIF exemptions for FIF interests acquired under employee share schemes have limited application in that they apply only where the employee has not yet had their “taxing date” under employee share scheme tax rules, or where the company issuing the shares is established in a “grey list” jurisdiction and the terms of the scheme prohibit trading in the shares. Aspects of these exemptions should be reviewed, including whether the “grey list” limitation remains necessary or appropriate.

High compliance burden adds insult to injury 

What can make the above punitive outcomes even more egregious, is that determining how the FIF rules apply, and then complying with them, can lead to migrants and ordinary residents incurring considerable adviser costs. The complexity likely results in a measure of non-compliance by FIF holders, whether inadvertent or as result of compliance being too hard and expensive.

As well as complexity, there is some apparent incompleteness. For example, although foreign life insurance policies are within scope of the FIF rules, exactly which FIF income methods are applicable to such a policy and what elements of the policy should be included in calculating FIF income, appears to be as much a mystery for Inland Revenue as for taxpayers. Such incoherence in the rules undermines the integrity of the tax system.

The complexity, confusion and costliness created by the FIF rules means they are a considerable cause of friction within the tax system. As such, a review of the rules is timely.

Transitional resident rules

The Work Programme does not include a review of the transitional resident rules, but it would be sensible for these rules to be reviewed alongside the FIF rules.

The transitional resident rules are intended to attract high net worth individuals (new migrants and persons who have been non-New Zealand tax resident for 10 years) to move to New Zealand and, once settled, to invest here. A transitional resident is provided with a New Zealand tax holiday for the first 48 months of New Zealand residence on overseas income such as FIF income (although employee and contractor income are taxed). Generally, the person is treated as if they were not New Zealand tax resident.

Painful fishhooks

As interpreted by Inland Revenue, the transitional resident rules have some fishhooks. These do not appear to have been identified in the generic tax policy process prior to enactment – and can result in a person being ostensibly treated as non-resident in some respects during the 48-month period, but with actions taken in that 48-month period later having adverse tax consequences that would not have risen if the person was “really” non-resident when the action was taken.

For example, if a person only makes a settlement on a trust while a non-New Zealand resident, offshore income derived by the offshore trustees after the person becomes an ordinary New Zealand tax resident is not taxable in New Zealand. By contrast, if an ordinary New Zealand tax resident makes a settlement on an offshore trust, the offshore income is taxable in New Zealand and the settlor is liable for that tax as agent of the offshore trustees.

The position of a transitional resident, as the law is interpreted by IRD, is a hybrid of the two positions. If a transitional resident makes a settlement on an offshore trust during the 48-month period, any offshore income of the trustees in that period is not taxable in New Zealand (ie the person is treated as if non-resident). But once the transitional resident period ends, any subsequent offshore income of the trust is taxable in New Zealand with the ex-transitional resident liable as agent for the tax. This means that the settlement on the trust while a transitional resident is retrospectively recharacterised as the act of an ordinary resident. This can lead to punitive and apparently unintended outcomes in practice.

It was not until Inland Revenue issued an Interpretation Statement on the taxation of trusts in 2018, some 12 years after the transitional resident rules were introduced, that this view was articulated. No principled explanation for this outcome was proffered. It is a prime example of why the transitional resident rules should be reviewed to determine whether they fit with the objectives of attracting overseas talent.

Global environment calls for more radical review

At the same time, thought should be given to extending the transitional resident period or perhaps, more radially, overhauling the entire approach. Australia has a similar 4-year exemption for foreign income derived by “temporary resident” visa holders (for “temporary resident” New Zealand citizens, there is no time limit) and the UK Government is planning comparable rules. If New Zealand wants to attract wealthy migrants and skilled workers, it needs to be ahead of competing jurisdictions in this area. Spain takes a different, interesting approach to attract skilled workers: foreigners (not being Spanish resident for the previous 5 years) who move to Spain for an employment offer are taxed on their income (capped) at a lower rate for up to 6 years (colloquially known as Beckham’s law).

The global environment for attracting high net worth migration and highly mobile skilled labour is very competitive. If New Zealand wants to be an attractive destination, the FIF regime and the transitional resident rules require an overhaul.

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