Foreign investment fund (FIF) rules
Foreign investment funds 2008
Tax rules for offshore investment in shares, life insurance policies and superannuation funds have been amended - significantly widening how foreign investment fund (FIF) rules can be applied.
Understanding the new FIF rules, and reporting income, are two issues likely to arise as a result of amendments to the Income Tax Act 2004, applying on or after 1 April 2007.
The main changes are the removal of the Grey List exemption for a portfolio investment in a foreign investment fund (FIF) and the introduction of a new calculation method (fair dividend rate method or FDR), which broadly taxes 5% of the opening market value of such an investment each year.
The amended FIF rules generally apply to offshore investments and the FDR method generally applies to equity interests of less than 10% in foreign companies or unit trusts.
A minimum threshold applies to an individual investor and the trustees of some trusts (refer to CQ 5(5) of the Income Tax Act 2007). If the original cost of these investments totals NZ$50,000 or less at all times in an income year, the FIF rules do not apply for that year. The investor will continue to pay tax only on the dividends received if they hold the shares on capital account.
Until 31 March 2007, investments in foreign companies (share/unit investments) - which were tax residents and liable for income tax in Australia, Canada, Germany, Japan, Norway, the United Kingdom, the United States and Spain - were exempted from the FIF regime. Investors simply returned the dividends as received if they held the shares on capital account.
Losses from foreign investment funds were restricted to the amount of previously returned FIF income until 31 March 2007. From 1 April 2007, FIF losses from a portfolio (equity) investment or FDR allowed investments, calculated using the comparative value method, are reduced to nil in terms of section EX 51(7) and (8) of the Act.
Losses from investments which are treated as debt (guaranteed return type investments) or FDR-prohibited investments, are not covered by section EX 51(7) and (8), which means the losses are fully deductible due to the changes made to section DN 5 (Debt/Equity Distinction). Further to this, restricted FIF losses calculated under the CV method from prior years, are able to be used against net income in the year ending 31 March 2008 and later years.
The RWT Proxy rules were introduced by the Commissioner on 21 December 2004. This meant New Zealand fund managers were able to offer withholding tax facilities to their unit holders in relation to dividends received from investments in overseas unit trusts. This option was prompted by a law change in December 2004 which treated distributions to holders of units in foreign unit trusts as taxable dividends instead of non-taxable bonus issues. (Tax Information Bulletin Vol 17, No 7, September 2005, p 45). The system of RWT proxies was intended to reduce compliance costs; for many investors, withholding the correct amount of tax from distributions removed the need to file a tax return until the year ended 31 March 2007.
With the removal of the old Grey List exemption and the introduction of the FDR calculation method, the deduction of withholding tax by a RWT Proxy creates a mismatch between income and New Zealand tax paid.
An attributing interest in a FIF is a direct income interest in a foreign company, or the right to benefit from a foreign superannuation scheme,or the right to benefit from a foreign life policy.
The former Grey List exemption was only applicable if the company was a resident in the grey listed country and liable for income tax there. Shares in a company incorporated in the United States but tax-resident in the British Virgin Islands were never eligible for the Grey List exemption. The shares were always caught under the FIF rules if the total value of the investments exceeded the threshold of $50,000.
The former Grey List exemption did not apply to companies resident outside the grey list, or to an entitlement to benefit from a foreign superannuation scheme, or an interest in a foreign life insurance policy. These investments were always caught by the FIF rules.
Foreign withholding tax in terms of section YA1 of the Act means "a tax, other than a New Zealand tax, that is withheld from an amount of income; and is of substantially the same nature as NRWT".
The dividends article in the double tax agreement between New Zealand and the United Kingdom was replaced by Double Taxation Relief (United Kingdom) Amended Order 2004 SN 2004/181. With the application date of 1 April 2005, section LC 15 of the Income Tax Act 2004 has been repealed, therefore non- resident withholding taxes, deducted from dividends received from the United Kingdom, cannot be claimed as a foreign tax credit in New Zealand from the income year ending 31 March 2006.
Withholding tax deducted by the RWT Proxy gives rise to New Zealand tax credits and not foreign tax credits. This tax is New Zealand Withholding Tax and should be returned in box 14A (IR3/IR4) or box 10 (IR 6) even if the client has no New Zealand dividend income.
Individual or family trust investors can freely switch between the FDR and CV calculation method on a portfolio basis. The portfolio includes shares or units in foreign companies below 10%, but not investments that are treated as debt investments, and not the right to benefit from foreign life or superannuation schemes that are not foreign companies. The free choice of method enables an individual investor to return the lesser of the FDR (5% + quick sales adjustment) or actual return of the investment by using the CV method. On a portfolio basis a loss will be reduced to nil.
For foreign tax credit calculations, each attributing interest in a FIF is a segment. Whether or not a foreign tax credit for the portfolio is available depends on the income of each attributing interest in that portfolio, even if the total income of the portfolio is a loss which results in nil income.
Generally the following steps should be used to carry out the calculation:
- Is there New Zealand income tax payable on the total net income (New Zealand and foreign sourced) of the taxpayer? If the answer is no, then no foreign tax credits can be claimed.
- Otherwise, identify each segment:
- for FIF interests–each attributing interest that has FIF income is a segment;
- for dividends–generally the segment will be Australia unless using AP or BE methods;
- for interest–generally the segment will be by country; or
- for other income–the segment will be by country and by source or nature.
- Identify the information for each segment and determine if there is net income for the segment.
- Identify the foreign tax credit(s) associated with the segment.
- Total all the segments' income (do not offset segments with losses) and compare to the total net income. If the total income of segments (excluding those in a loss) is greater than total net income then an apportionment of foreign tax paid is required.
- Calculate the notional income tax liability on net income by multiplying it by the person's basic tax rate. Note this net income is after claiming losses brought forward and before allowing any tax credits.
- If an apportionment of foreign tax paid is required (see step 5), determine the apportionment ratio by dividing the notional income tax liability on net income by the total notional income tax liability for all segments (excluding those in loss).
- For each segment, calculate the maximum foreign tax credit. This will be either the notional income tax liability by segment, or if apportionment is required, the notional income tax liability by segment multiplied by the apportionment ratio, as calculated at step 7.
- For each segment, you can claim the lesser of the foreign tax actually paid for the segment and the maximum foreign tax credit for the segment, as calculated under step 8.
From 1 October 2007, entities that meet the definition of a portfolio investment entity (PIE) were able to elect into the new PIE tax rules. Unlisted PIEs generally pay tax on investment income based on the tax rates of their investors (which should be the prescribed investor rate). Because the PIE satisfies the tax liability, PIE income taxed on the correct PIR and PIE income taxed on a higher PIR are excluded income for individual investors. PIE losses are held within the PIE and are not an allowable deduction, for individual investors.
Date published: 10 Sep 2009
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