First published in Taxation Today, April 2011.
New rules intended to make PIEs more attractive to non-resident investors have been included in the Taxation (Tax Administration and Remedial Matters) Bill 2010 (the Bill), currently before Parliament. The proposed new rules are a further step towards the Government's goal of turning New Zealand into a funds management hub. This article reviews and comments on the proposed rules.
Currently, non-residents investing in a portfolio investment entity (PIE) are taxed on their returns at the top PIE tax rate of 28 per cent, irrespective of the nature and source of the PIE's income. In many cases that treatment compares unfavourably with direct investment in the underlying assets from which the income is generated. To the extent to which the income of the PIE arises from assets located offshore, it clashes with the principle that non-residents should only be taxed here on their New Zealand-sourced income.
The 28 per cent New Zealand tax liability suffered by non-resident investors in New Zealand PIEs is seen as a significant disincentive for non-residents to invest in a New Zealand PIE. It is likely to be one of the reasons why statistically few non-residents currently invest in New Zealand PIEs.
The Government wishes to increase the level of offshore participation in our managed funds industry. It has clearly signalled its desire for New Zealand to promote itself as an international funds management hub competing head-on with the traditional funds management centres such as Luxembourg and Dublin, but with a particular focus on the Asia-Pacific region, where geography and our ability to compete on price should be advantages for us.
Reforms to the PIE rules to remove this disincentive were signalled in the 2009 Jobs Summit. The proposals were then discussed in an Official's Issues Paper, Allowing a zero-percent tax rate for non-residents investing in a PIE, published by Inland Revenue's Policy Advice Division in April 2010. Draft legislation based on the recommendations in that paper was then introduced to the Bill by way of Supplementary Order Paper No 220, released on 5 April 2011 (the SOP).
The proposed reforms build on and extend, rather than significantly change, the existing PIE regime. As funds industry figure Craig Stobo has pointed out1, the PIE regime conveniently already allows for the taxation of investors at different rates. Building the desired incentives for non-residents into the existing regime is an extension of the current rules, rather than a wholesale reform of those rules. Nevertheless, the reforms clearly add another level of complexity to an already intricate PIE administration.
The Officials' Issues Paper discussed two approaches to removing the tax barrier for non-residents to invest in New Zealand PIEs. Two new categories of PIEs were proposed:
- PIEs which derived only foreign-sourced income (referred to in the subsequent Regulatory Impact Statement (the RIS) accompanying the draft legislation as Category 1 PIEs) would be entitled to apply a zero per cent tax rate to income attributed to non-resident investors (a small threshold of New Zealand sourced income would be permitted, primarily in order to allow the PIE to maintain reserves in New Zealand in order to meet certain expenses). These PIEs would be open to investment by non-resident and resident investors. The tax treatment of New Zealand residents would not change from that presently applicable.
- PIEs (Category 2 PIEs) which derived both foreign-sourced and domestic income would apply a variety of tax rates to income attributed to non-resident investors. As for Category 1 PIEs, the zero-rate would apply to foreign-sourced income attributed to non-residents. Different tax rates would apply to New Zealand-sourced income attributed to non-residents, depending on the nature of that income (for example, a 15 per cent rate would apply to non-imputed dividends where the non-resident was eligible for double tax agreement protection). As for Category 1 PIEs, the tax treatment of amounts derived by New Zealand residents would not change.
Submissions generally favoured the second approach (subject to concerns over complexity) or introducing both new categories into the legislation, on an elective basis.
Both options, on an elective basis, have been included in the Bill. New rules mean new nomenclature. Both new types of PIEs are referred to generically in the draft legislation as "foreign investment PIEs". The Category 1 and Category 2 designations did not make it into the Bill – there are no specific definitions of these new types of PIEs. Rather, the draft legislation refers to them as foreign investment PIEs applying a zero-rate and foreign investment PIEs applying variable rates, or words to that effect. Possibly the reason for not including new definitions was that these PIEs are to a certain extent just different forms of multi-rate PIEs. However, at the risk of adding to a crowded s YA 1, defined terms would probably be helpful in deciphering already complex legislation.
Not all PIEs are eligible to offer the concessionary tax treatment to their non-resident investors. The eligibility criteria are noted below, and then the tax treatment of the new types of PIEs is discussed more generally.
Most of the new rules relating to foreign investment PIEs are set out in the proposed ss HM 55B to 55H of the Income Tax Act 2007 (the ITA 2007).2 New s HM 55B contains specific eligibility criteria for a PIE wishing to become a foreign investment PIE.
A key point is that only multi-rate PIEs may apply. At this stage at least, the new rules are in effect an extension to the rules applicable to multi-rate PIEs only (although from a drafting perspective new ss HM 2(2)(a) and HM 2(4) clarify that the foreign investment PIE is a new category of PIE in its own right). The RIS did note that submissions had called for the reforms to be extended to listed PIEs, but that further analysis was required on this issue before such a move was taken. Extending the new rules for non-residents to listed PIEs would involve a more substantial re-write of the listed PIE provisions - it could be a case of seeing what impact the new rules have in the context of multi-rate PIEs before such an exercise is undertaken.
The criteria at new s HM 55B include restrictions on the nature of investments a foreign investment PIE may make. To qualify as a foreign investment PIE, the PIE may not:
- Invest in New Zealand land (or in a land investment company); or
- Derive income from the disposal of interests in New Zealand land or from a lease of, or other interest in, New Zealand land.
These restrictions are not intended as a backdoor means of preserving New Zealand land for New Zealanders. According to the RIS, the restrictions resulted from a concern over the complexity of the new rules. Ordinarily, income (net of expenses) of a non-resident from interests in land would be subject to New Zealand tax (without double tax agreement protection). By contrast, investments by a non-resident in other asset classes such as equities or debt instruments would be taxed on a gross basis under the non-resident withholding tax (NRWT) regime. The RIS notes that the need to calculate deductions and expenses attributable to non-resident investors (in effect, with regard to investments in land) had been specifically identified as an area of concern. The solution adopted by the drafters of the legislation is to deny foreign investment PIEs the ability to invest in land – a blunt but effective means of addressing the concern.
The zero-rate option
The tax treatment of Category 1 PIEs is relatively straightforward in comparison to that of Category 2 PIEs (reflecting their status as, in effect, a subset of Category 2 PIEs). Consistent with the proposals in the issues paper, PIEs which derive only foreign-sourced income will be entitled to apply a zero per cent tax rate to income attributed to non-resident investors who elect to use the new rate. The key provision is new s HM 55F – subs (2) of that section legislates the distinction between Category 1 and 2 PIEs, and subs (3) permits the use of the zero per cent rate by the former. That provision also confirms that a Category 1 PIE is not required to identify the nature of the foreign income attributed to eligible non-resident investors, a key difference between Category 1 and Category 2 PIEs.
Only "notified foreign investors" will be eligible for the new rate. This term, which is used generically for relevant investors in both Category 1 and Category 2 PIEs, describes non-residents who meet the criteria contained in new subs HM 55D(3) and who notify the PIE that they wish to have the benefit of the new rules. The eligibility criteria are relatively simple - a notified foreign investor may not be resident in New Zealand, be a controlled foreign company or be a non-resident trustee of a trust that is not a foreign trust.
Foreign investment PIEs will be required to obtain certain additional information from notified foreign investors, set out in new s 28D of the Tax Administration Act 1994. Information includes the full name and date of birth of the investor, their country of tax residence and their tax file number in that jurisdiction. The prescribed information may be changed or extended by the Commissioner of Inland Revenue at any time. The RIS notes that this additional information requirement is imposed in order to facilitate meeting of OECD information exchange requirements. Depending on the nature of the non-resident investor, this information may not always be straightforward to obtain (however, the burden is in practice on the investor wishing to take advantage of the new rates, not the PIE manager).
A feature of the Category 1 PIE which generated comment in the consultation stage was the level of New Zealand-sourced income which the PIE was entitled to derive without forfeiting its zero-rate status [a concession provided for at new s HM 55F(2)(a)(ii)]. The thresholds are contained in the new s HM 55G, the key limits being for income from financial arrangements and equities. A Category 1 PIE may derive:
- New Zealand-sourced interest income from short term financial arrangements (arrangements having terms of not more than 90 days) provided that the value of the arrangements does not exceed 5 per cent of the total value of the PIE's investments; and
- Dividends from New Zealand resident companies provided that the value of the PIE's shares in New Zealand companies is not greater than 1 per cent of the PIE's investments.
A remedy period is built in to the legislation for breach of these thresholds [new s HM 55H(2)].
The justification for the financial arrangements threshold is that PIEs must maintain a small amount of cash reserves in New Zealand in order to meet applications, redemptions and day-to-day expenses. The rationale for the shareholding threshold is different - PIEs which track global equities indices may be required to hold New Zealand stocks if those stocks appear in the indices. This would be problematic for Category 1 foreign investment PIEs were it not for an appropriate threshold. The 1 per cent threshold proposed is presumably large enough to serve this purpose (interestingly the proposed threshold is not restricted to stocks actually included in those indices).
The variable rate option
The new rules for Category 2 PIEs are similar in theory to those applicable to Category 1 PIEs, albeit that they are more complex in nature.
Category 2 PIEs will be required to identify the source and nature of income attributed to a notified foreign investor and to apply a variety of rates to that income [new s HM 55F(4)]. The rates are set out in new table 1B to sch 6 of the ITA 2007. The new rates are:
- 30 per cent on unimputed dividends from a New Zealand resident company where the notified foreign investor is resident in a non-double tax agreement country;
- 15 per cent on unimputed dividends from a New Zealand resident company where the notified foreign investor is resident in a double tax agreement country;
- 1.44 per cent on amounts derived under a financial arrangement where that amount has a New Zealand source (reflecting the after-tax cost of the 2 per cent approved issuer levy);
- 0 per cent on fully imputed dividends from a New Zealand company; and
- 0 per cent on any foreign-sourced income.
Interestingly, the 1.44 per cent tax referred to at paragraph (c) above is not restricted to interest as defined for the purposes of the withholding tax rules. Income under a financial arrangement is a wider concept than interest for NRWT purposes. Inland Revenue has indicated that the drafting of the Bill on this point is deliberate, the rationale being simplicity of treatment of all financial arrangement income attributed to non-residents. However, this approach is inconsistent with the intention of replicating the treatment of non-residents investing directly in New Zealand assets. Submissions are expected on this feature of the draft legislation.
A foreign investment PIE receiving a dividend from a New Zealand resident company which is not fully imputed will be able to apply the NRWT rules to the dividend where it is paid to a notified foreign investor (new s HM 44B). This should allow the non-resident to obtain a tax credit in his or her home jurisdiction for the tax deducted (tax ordinarily paid by the PIE on income attributed to non-resident investors does not always entitle those investors to credits in their home jurisdictions). A PIE wishing to use these rules must pay the dividend to the notified foreign investor within two days of receiving it, a time restriction which PIE managers would need to watch carefully.
Submissions calling for more concessionary rates were rejected, presumably on the grounds that the reforms are designed to replicate direct investment for non-residents but not to advantage them further.
New s DB 54B denies the foreign investment PIE a deduction for expenses incurred in deriving income attributed to notified foreign investors. Given the prohibition on foreign investment PIEs investing in New Zealand land, this rule is consistent with the PIE reforms putting non-residents in the tax position they would have been in had they invested directly in the PIE's income generating assets.
The rules applicable to Category 2 PIEs are proposed to apply from the start of the 2012-2013 income year, while those applicable to Category 1 PIEs are to apply from the date of Royal assent. The bringing forward of the application date for the Category 1 PIE rules was in response to submissions, the RIS stating that it will allow some funds to launch prior to April 2012. No explanation is given as to why a similar starting date is not proposed for the Category 2 PIE rules, although given the extra complexity of those rules (and the uncertain date upon which the Bill will be passed into law), industry participants may well need the extra time to master the new rules and the administrative requirements they entail.