Reforms have been proposed to the taxation of returns derived by New Zealand residents from foreign superannuation schemes.  The proposed changes will be relevant to many expatriate New Zealanders who have returned home, and many other migrants to this country, where they have retained their interests in foreign schemes.

Current tax treatment

The current tax treatment of returns from foreign superannuation schemes is complex.  Tax outcomes can differ depending on the nature of the particular scheme.  This complexity has, the Inland Revenue notes, contributed to non-compliance.  A key driver of the reforms is to simplify the relevant tax rules, with the expectation that compliance levels will increase.

Since the early 1990s, most New Zealand residents with an interest in a foreign superannuation scheme have been taxed on that interest under the “foreign investment fund” or “FIF” rules.  The FIF rules tax New Zealanders on their offshore equity investments on an accrual, rather than a receipt, basis.  This usually means that a taxable return will be deemed to have been derived by the New Zealand resident (resulting in a potential tax liability), irrespective of whether an actual cash amount has been received.  This typically discourages New Zealand residents from maintaining offshore investments simply to defer receipt of investment returns (and the resulting tax liability).

The FIF rules are complex.  Various methods are prescribed under the rules to calculate income deemed to have been derived from foreign investments.  The most common is the “fair divided rate” or “FDR” method.  This deems a 5% return to have been derived by the New Zealand resident from the offshore investment, regardless of actual receipts from the investment (or even whether the investment has been profitable at all).  When actually received, cash returns from the investment (such as, in the case of interests in foreign superannuation schemes, pensions or lump sum payments) are not subject to further tax.

There are a number of exemptions from the FIF rules, however.  If the FIF rules do not apply, returns from foreign superannuation schemes are generally taxed in New Zealand on a cash receipts basis.  The exact tax treatment of these receipts can differ however, depending on whether the receipt is in the form of a periodic pension payment or a lump sum payment.  For lump sum payments, the method of taxation will depend on the nature of the underlying scheme - there is the potential for the entire sum to be taxable, for it to be partially taxable or for it to be entirely exempt.

In other words, whether or not the FIF rules apply, applying the existing rules for the taxation of returns from foreign superannuation schemes is not a simple matter.

Proposed new rules

An attractive feature of the proposals is that one set of rules would apply to all interests in foreign superannuation schemes.  The difficulty of determining whether the FIF rules apply and then correctly applying those rules, where relevant, will be removed.  Instead, all returns from foreign superannuation schemes will be taxed upon receipt (or distribution, if different). 

That said, the tax treatment will differ depending on whether the return from the scheme is in the nature of a periodic pension payment or a lump sum.  The tax treatment of pension payments is more simple.  These will be taxed upon receipt at the recipient’s marginal tax rate.  This would be the case irrespective of whether the payment is received from a past employer, an intermediary such as a trust or from a foreign company or unit trust.

The treatment of lump sum payments would be more involved (but still relatively simple compared to the treatment under the existing rules).  A tax liability would arise to the New Zealand resident at the time of withdrawal of the lump sum from the scheme, or on the transfer of that sum to another scheme.  In most cases however only a portion of the lump sum would be regarded as taxable income for the New Zealand resident. 

The portion of the lump sum which is taxable would depend on the length of time the recipient has been living in New Zealand since his or her return or migration.  This is referred to in the Inland Revenue proposal as the “inclusion rate”.  For example, if the recipient has been living in New Zealand for 5 years since arrival in New Zealand, then 30% of the lump sum payment would be taxable income to that person and taxed at his or her marginal tax rate. 

The proposed “inclusion rates” are as follows:

Click here to view the table.

The Inland Revenue notes that the inclusion rates are designed to approximate the tax on investment gains that would ordinarily have arisen to the recipient had the original lump sum been invested in New Zealand during the period in which that person has been a New Zealand tax resident (essentially, since migration here).  After paying tax on the lump sum, the Inland Revenue says, the recipient should be in approximately the same position as if they had instead transferred the amount to New Zealand on first migration and derived taxable interest income here from that point.

The stated aim of this approach is to reduce any preference the recipient may have between bringing the foreign superannuation to New Zealand when they first arrive here, or transferring it at a later date.  The zero percent inclusion rate,  applicable for the first two years, operates as an incentive for recent migrants or returnees (not being transitional residents) to bring their foreign superannuation to New Zealand with no New Zealand tax consequences.

Existing concessions

New Zealand’s “transitional resident” rules provide temporary relief to migrants or long-term expatriates who have returned to New Zealand from tax on their foreign-sourced income (other than income from personal services, but including income from foreign superannuation schemes).  Transitional residents will continue to have this four year exemption from tax on returns from foreign superannuation schemes (whether in the form of pensions or lump sum payments).  Existing concessions for certain returns from Australian superannuation schemes will also be unaffected by the proposed reforms.  These include the tax-free status of certain lump sum retirement payments arising in Australia and transfers of savings in qualifying Australian superannuation schemes to schemes in New Zealand.

Under existing rules, a New Zealand resident who has a foreign tax liability in respect of a benefit derived from a foreign superannuation scheme would usually be entitled to a credit for that tax against New Zealand tax payable on that benefit.  That is not expected to change as a result of these proposed reforms.

Timing of proposed changes

The new rules are proposed to apply with effect from the 2011 – 2012 tax year (i.e., for most people, to amounts received from foreign superannuation schemes on or after 1 April 2011).

People who have applied the FIF rules to their interest in a foreign superannuation scheme and as a consequence have returned income for the 2010 – 2011 income year (i.e. by 31 March 2012) will be required to continue to use the FIF rules in respect of their interest in the scheme.  Despite the complexity of those rules, the intention is to prevent those people from being subjected to tax again when they actually receive lump sum payments or pension payments from the scheme.

Concessions are also proposed for New Zealand residents who have not complied with the existing tax rules with respect to certain past returns from foreign superannuation schemes, if disclosures are made within prescribed periods.

The reforms remain proposals at this stage.  Draft legislation has not yet been distributed.  Assuming the proposals proceed, the nature and scope of the reforms may yet change.