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Taxation (savings investment and miscellaneous provisions) Act 2006 and Taxation (annual rates of income tax 2006-07) Act 2006: Tax rules for portfolio investment entities

Tax rules for portfolio investment entities

Sections CB 4B, CP 1, CX 44C, CX 44D, DB 17(1) and (2), DB 43B, subpart HL, IE 1(2BB), KD 1(1)(e)(viii), KI 1, LB 2(2C), LC 1(1B) and (1C), LD 3(1B) and (1C), LD 8(1B) and (1C), LD 10, LD 11, ME 1(2)(k), MG 2(1), MJ 1(1), OB 1 and Schedule 1 of the Income Tax Act 2004; sections 28B, 31B, 33(1), 36AB, 38(1B), 57B and 139AA(1)(ab) of the Tax Administration Act 1994; section 53(2) of the Companies Act 1993; sections 4 and 72B of the Public Trust Act 2001; sections 2, 5(4A) and 5(4B) of the Securities Act 1978; sections 2 and 42E of the Trustees Act 1956; sections 2 and 33B of the Trustee Companies Act 1967; and sections 2 and 12A of the Unit Trust Act 1960

From 1 October 2007, entities that meet the definition of a "portfolio investment entity" will be able to elect into new tax rules under which they will not be taxable on gains on shares in New Zealand and certain Australian companies. Portfolio investment entities will also generally pay tax on investment income based on the tax rates of their investors (capped at 33%), rather than at a flat rate. Income earned via a portfolio investment entity will not affect investors' entitlements to family assistance (under Working for Families) or their student loan repayment and child support obligations.

Background

The new tax rules for portfolio investment entities have arisen from proposals in the Taxation of investment income discussion document (released in 2005) to alleviate a number of long-standing problems with the taxation of collective investment vehicles (CIVs).

The first problem the new rules address is the difference in tax treatment when people invest directly in New Zealand shares and when they invest in such shares via a New Zealand CIV. Someone who invests in New Zealand shares directly is taxed on dividends only because the investment is likely to be held on capital account. Gains of a capital nature are typically not taxable as New Zealand does not have a general capital gains tax. However under the old rules, an equivalent investment via a CIV would typically have been taxed on dividends as well as any realised New Zealand share gains. This occurred because CIVs are generally in the business of trading in shares making any income from this business taxable. The new tax rules put investment in New Zealand (and certain Australian) shares through CIVs that elect to become portfolio investment entities on a similar tax footing to individuals investing directly in Australasian shares. Similarly, the new offshore tax rules for portfolio investment (with less than 10 percent interests) in offshore companies will result in greater consistency of treatment between investments in such companies through CIVs and directly. The new rules for offshore portfolio investment in shares are discussed separately in this Tax Information Bulletin.

The new rules also address the problem of investors in collective investment vehicles having their investment income taxed at a higher rate than their marginal tax rate. For example, superannuation funds are taxed at 33% on their income, although a substantial number of investors in such funds may have a lower marginal tax rate (say, 19.5%). This has created a significant tax disincentive for lower income savers to use managed funds. Under the new rules, lower income savers investing in entities that elect to become portfolio investment entities will be taxed at their correct tax rate - 19.5%. The investment income of higher income savers will continue to be taxed at 33% to ensure that these investors continue to have an incentive to save via portfolio investment entities.

The new tax rules for portfolio investment entities are integral to the government's KiwiSaver initiative as they remove a number of tax disincentives to saving via managed funds.

The government has announced that certain remedial amendments will be included in a tax bill to be introduced in May this year. The commentary below relates to the portfolio investment entity tax rules enacted in December 2006.

Key features

The new portfolio investment entity tax rules are contained principally in new subpart HL of the Income Tax Act 2004 but should be read in conjunction with the relevant definitions in section OB 1. Sections HL 1 and HL outline the scheme and purpose of the subpart. There are three main types of portfolio investment entity:

  • portfolio tax rate entities;
  • portfolio listed companies; and
  • portfolio defined benefit funds.

The portfolio tax rate entity is the main type of portfolio investment entity.

To become a portfolio investment entity, an entity must meet a number of eligibility criteria (contained in section HL 3). These include the requirements that:

  • the entity must be a company, superannuation fund or group investment fund (and not a life insurer) (section HL 3(7)));
  • the entity must be resident for tax purposes in New Zealand (section HL 3(8));
  • investors' interests in the entity must give investors the same rights to all types of investment proceeds (with the exception of Category B income) (section HL 3(9)); and
  • the entity must not have ceased to be a portfolio investment entity for a period of less than five years (section HL 3(10)).

An entity must also meet a number of other eligibility requirements (contained in sections HL 6, HL 9 and HL 10). The main requirements are:

  • the investor membership requirement, which generally requires a portfolio investor class of a portfolio investment entity to have at least 20 nonassociated persons as investors (section HL 6);
  • the investor interest size requirement, which generally requires an investor in a portfolio investor class to hold no more than a 0 percent interest in the class (section HL 9);
  • the investment type and income type requirements, which generally require a portfolio investment entity to have 90 percent or more of its investments by value in the form of land, financial arrangements and excepted financial arrangements, and derive 90 percent or more of its income from such investments with that income being in the form of dividends, financial arrangement income, rent from land, proceeds from disposing of property and FIF income (sections HL 10(1) and (2)); and
  • the entity shareholding investment requirement, which requires a portfolio investment entity (and a portfolio investor class) to hold voting interests of less than 20 percent in any underlying companies invested into (section HL 10(3)).

(Note: There are a number of exemptions from the requirements contained in sections HL 6, HL 9 and HL 10.)

Portfolio tax rate entities must also make adjustments to investors' interests in the entity to reflect the effect of tax paid at investors' elected tax rates. This is called the "investor return adjustment requirement" and is contained in section HL 7.

There are rules that deal with breaches of the portfolio investment entity eligibility criteria. These criteria are contained in section HL 4.

The rules for electing and ceasing to be a portfolio investment entity and the consequences of each are contained in sections HL 11 to HL 14. An entity can elect to become a portfolio investment entity from 1 April 2007 by giving notice to the Commissioner of Inland Revenue. An election is effective from 1 October 2007 at the earliest. On becoming a portfolio investment entity, section HL 12(3) deems a disposal and re-acquisition at market value of New Zealand and certain Australian shares held by the entity. Any tax liability relating to this event is payable equally over three years. An entity can cease to be a portfolio investment entity by giving notice to the Commissioner.

Sections HL 15 to 23 and HL 27 to 30 deal with the obligations and requirements (including calculation mechanisms) for entities that elect to become portfolio tax rate entities. Portfolio tax rate entities must allocate income to investors and calculate and pay tax on this income based on the tax rates elected by their investors.

The entity must elect a portfolio allocation period (the period over which income, expenses, losses and credits are allocated) and a portfolio calculation period (the period over which tax is calculated, generally involving one or more allocation periods) under section HL 15.

The tax liability for a portfolio tax rate entity for a portfolio calculation period is calculated under section HL 20. It is the sum of the liabilities calculated for each investor in the entity and for each class the investor has an interest in, for each allocation period.

Portfolio tax rate entities that choose a portfolio calculation period of a quarter must pay the amount of any portfolio entity tax liability within one month of the end of the portfolio calculation period, under section HL 21. These entities are not subject to the provisional tax rules. A portfolio tax rate entity that pays tax under section HL 1 does not need to pay tax based on the tax rate of an exiting investor if, broadly, the tax liability of the entity associated with that investor in the period is equal to or greater than the value of the investor's interest remaining in the entity (defined as a "portfolio investor exit period"). The exiting investor must instead pay tax on that income at the end of the year.

Alternatively, portfolio tax rate entities can elect to pay provisional tax under section HL 22. These entities have a portfolio calculation period of a year. Any provisional tax paid is available as a credit against the entity's portfolio entity tax liability calculated at the end of the year under the mechanism in section HL 20.

Portfolio tax rate entities that choose a portfolio calculation period of a day must pay tax when investors exit the entity, under section HL 23. These entities are required to pay tax relating to exiting investors within one month of the end of the exit period. For investors who remain in the entity, the portfolio entity tax liability is payable within one month of the end of the tax year.

Investors in portfolio tax rate entities must elect a tax rate (called a portfolio investor rate) based on their prescribed investor rate. The prescribed investor rate for natural persons is either 19.5% or 33%. Investors in portfolio investment entities may elect a 19.5% rate only if their total income (other than portfolio investment entity investment income) in either of the previous two years is $38,000 or less. An investor must elect the 33% tax rate if their combined portfolio investment entity and non-portfolio investment entity income in both of the previous years is greater than $60,000. The prescribed investor rate for all other resident investors is 0%, unless a person is a resident trustee who elects a prescribed investor rate of 33%.

Investors in portfolio tax rate entities have portfolio investor allocated income or losses under section HL 4. Section CX 44D provides that the amount of any portfolio investor allocated income is treated as excluded income to natural person investors who elect a portfolio investor rate that is no lower than their prescribed investor rate. This means that investors do not need to include portfolio investor allocated income in their tax return, so that income allocated by portfolio tax rate entities does not affect entitlements to family assistance (under Working for Families) or student loan and child support repayment obligations.

Portfolio investor allocated income is not considered excluded income for zero-rated portfolio investors (and certain exiting investors in entities paying tax under section HL 21). This income must be included in the investor's tax return. Under section HL 25, these investors are allowed a deduction for the amount of any portfolio investor allocated losses under section DB 43B.

Portfolio investor allocated losses relating to non-zero rated investors under sections HL 21 and HL 23 are available as a rebate to the entity under section HL 26. The rebate is allowed under section KI 1.

Any tax credits received by a portfolio tax rate entity must first be used against the portfolio entity tax liability of the entity, under section HL 27. Any excess tax credits, other than foreign tax credits, are allowed as either a rebate to the entity under section KI 1 or to the investor, in the case of zero-rated portfolio investors. Foreign tax credits are not rebated and must be used in the income year in which they are derived.

Portfolio tax rate entities electing under section HL 22 to pay provisional tax must carry forward any losses that are not able to be utilised (such losses are not available as a rebate).

Sections HL 28 and HL 30 outline the rules for portfolio entity formation losses (which are losses generated in a period before an entity becomes a portfolio investment entity) and portfolio class land losses (which arise where a portfolio investor class of an entity owns predominantly land).

Section HL 31 outlines the rules and obligations for becoming a portfolio investor proxy. These entities, typically custodians and nominees, must perform the responsibilities under subpart HL (for example, the allocation of income, payment of tax, and filing of returns) as if they were a portfolio investment entity.

Under section CX 44C, gains on the disposal of shares in New Zealand-resident companies and Australian-resident companies listed on an approved index of the Australian Stock Exchange by portfolio investment entities are not taxed.

Returns-filing requirements for portfolio investment entities and other information requirements are provided in sections 28B, 31B, 36AB and 57B of the Tax Administration Act 1994.

Application date

An entity can apply to the Commissioner of Inland Revenue to become a portfolio investment entity from 1 April 2007. The earliest date a portfolio investment entity can apply the new tax rules is 1 October 2007.

Detailed analysis

Subpart HL

The new portfolio investment entity tax rules are contained principally in new subpart HL of the Income Tax Act 2004. A number of changes to the bill as introduced were made at the Finance and Expenditure Committee stage of the bill. This included the re-ordering and re-structuring of a number of provisions in new subpart HL.

New section HL 1 - intended effect

New section HL 1 sets out the intended effects of the new rules for portfolio tax rate entities which are portfolio investment entities, and investors in portfolio tax rate entities. The intended effect of the rules is that a portfolio tax rate entity uses funds supplied by investors to make investments of a specified nature. The entity has a tax liability relating to the income from these investments that is calculated using the tax rate elected by each investor (their "portfolio investor rate"). This resembles the liability that would arise if the investors had made the investments separately. The entity must distribute the income to investors, after deducting the appropriate tax liability. Investors in a portfolio tax rate entity that have elected a correct portfolio investor rate greater than zero have no tax liability on the income allocated to them by the entity. Importantly, the economic return that the investor receives, allowing for tax, would resemble the return from investing directly. The intention is that the income derived by the entity, and the tax thereon are, in economic substance, to be considered as income and tax of the investor.

New section HL 2 - scheme and purpose

New section HL sets out the scheme and purpose of the portfolio investment entity tax rules. It provides a roadmap to navigate through subpart HL.

New section HL 3 - eligibility requirements

New section HL 3 sets out the eligibility requirements to be a portfolio investment entity. It is important to note that a portfolio investment entity is defined in section OB 1 to mean: a portfolio tax rate entity, a portfolio listed company or a portfolio defined benefit fund. A portfolio listed company is defined in section OB 1 as a company that is listed on a recognised exchange in New Zealand and which has become and is a portfolio investment entity. A portfolio defined benefit fund is also defined in section OB 1 as a defined benefit fund that has become, and is, a portfolio investment entity that does not allocate income to investors. A defined benefit fund is defined as a superannuation scheme, registered under the Superannuation Schemes Act 1989, that must comply with section 15(1)(a) of that Act.

A portfolio tax rate entity is a company, superannuation fund or group investment fund which has become, and is, a portfolio investment entity and is not a company listed on a recognised exchange in New Zealand or a portfolio defined benefit fund. Such entities must allocate income to investors and calculate and pay tax on this income based on the tax rates elected by their investors. Portfolio listed companies and portfolio defined benefit funds, in contrast, do not allocate income to their investors. These entities pay tax at a flat 33% tax rate.

To be a portfolio investment entity generally, the entity must meet the form and business requirement, residence requirement and entity history requirement under sections HL 3(7), 3(8) and 3(10), respectively. The form and business requirement is that the entity must be a company, superannuation fund or group investment fund and not be a life insurer. The residence requirement is that the entity must be a resident for tax purposes in New Zealand (including under a double tax agreement). The entity history requirement is that the entity must not have ceased to be a portfolio investment entity for a period of less than five years, before the relevant election. This requirement is designed to prevent the portfolio investment entity rules from being used to gain unintended tax benefits.

An entity that elects to be a portfolio tax rate entity or a portfolio listed company must meet the income interest requirement under section HL 3(9). The income interest requirement is that each investor's interest ("portfolio investor interest") in the entity must give the same rights in relation to the proceeds from the investments of the entity as those of other investors. This is to prevent a portfolio tax rate entity streaming different types of income to investors in the entity depending on the individual tax status of the investor. An example of this would be providing tax-free Australasian capital gains to investors that have elected a portfolio investor rate of 33% while providing imputed dividends to investors with a 19.5% elected rate. There is an exception to the income interest requirement when income is Category B income (income derived by certain group investment funds).

In addition to the general eligibility criteria, portfolio investment entities must also meet the further eligibility requirements contained in sections HL 6, HL 9 and HL 10 which are discussed below.

New section HL 4 - failure to meet eligibility requirements

Under section HL 4, an entity would generally cease to be eligible as a portfolio investment entity if it fails to meet one or more of the eligibility requirements contained in section HL 3, at any time. A portfolio investment entity must comply with the general eligibility criteria in sections HL 3(7), 3(8) and 3(10) at all times during the year. In addition, portfolio tax rate entities and portfolio listed companies must comply with sections HL 7 and HL 8 respectively.

However, in the case of the further eligibility requirements contained in sections HL 6, HL 9 and HL 10, an entity can temporarily breach these requirements, if the breach is fixed within a specified timeframe and the breach is significant and is the result of an event or circumstance outside the control of the entity. The rules governing "temporary" breaches of the further eligibility criteria are found in section HL 4(2).

Under section HL 4(2)(b), a breach of the further eligibility requirements imposed by sections HL 6, HL 9 or HL 10 must be corrected by the end of the quarter following the end of the quarter in which the entity first failed to meet one of these requirements. This would allow an entity a maximum of six months to correct a failure to meet one of the relevant further eligibility criteria.

Section HL 4(2) also contains rules to accommodate breaches of sections HL 6, HL 9 and HL 10 when an entity is starting up as a portfolio tax rate entity and winding down. In both cases, an entity has a maximum period of 12 months before failure to meet one or more of the further eligibility criteria triggers cessation of portfolio investment entity status.

The requirement for the breach to be as a result of a circumstance or event outside the control of the entity is to ensure that these rules are not triggered as a result of a deliberate failure to meet the eligibility criteria under sections HL 6, HL 9 and HL 10. Examples of circumstances beyond the control of the entity are:

  • when an investor in an entity that is subject to the investor interest size requirement in section HL 9 temporarily holds a portfolio investor interest of more than 20 percent because of other investors exiting the entity;
  • when a "portfolio investor class" of an entity does not meet the investor membership requirement under section HL 6 because a number of investors have exited it; or
  • when an entity holds less than 90 percent of its assets in the types of financial asset investments outlined under section HL 10 as a result of a reduction in the value of the entity's financial asset investments compared with the other assets it holds.

The requirement for the breach to be "significant" is mainly to ensure that minor breaches resulting from human or other error do not trigger the breach rules (a breach resulting from human error is arguably within the control of the entity).

Portfolio investment entities should monitor compliance with the further eligibility criteria outlined in sections HL 6, HL 9 and HL 10 on a quarterly basis.

New section HL 5 - definition of a foreign investment vehicle

New section HL 5 outlines the definition of a foreign investment vehicle. This section outlines the types of foreign-resident entities that can invest in portfolio investment entities. In turn, the section outlines which foreign-resident entities a portfolio investment entity may invest in, without causing the portfolio investment entity to breach the various eligibility requirements under sections HL 6, HL 9 and HL 10.

A foreign investment vehicle is defined under section HL 5 as an entity that is not resident in New Zealand, is a company or superannuation scheme, and would meet a number of the further eligibility criteria to be a portfolio investment entity under sections HL 6, HL 9 and HL 10. In effect, a foreign investment vehicle is an entity that, if it were New Zealand tax-resident, would be eligible to be a portfolio investment entity. That is, it is a widely-held vehicle that holds portfolio investments in underlying companies.

Consequently, under section HL 6, a portfolio investment entity would meet the investor membership requirement if it has a foreign investment vehicle as an investor. Similarly, a foreign investment vehicle can hold up to 100 percent of a portfolio investment entity without breaching the investor interest size requirement in section HL 9. Under section HL 10, a portfolio investment entity can hold up to 100 percent of a foreign investment vehicle without breaching the entity shareholding investment requirement.

New section HL 6 - investor membership requirements

New section HL 6 contains the investor membership requirements for a portfolio investment entity and each portfolio investor class of the entity. Subsection (1) of this section contains the requirements for an entity that is not a company listed on a recognised exchange in New Zealand.

Portfolio investor class

The further eligibility requirements in sections HL 6, HL 9 and HL 10 apply in the context of a portfolio investor class of a portfolio investment entity. A portfolio investment entity, other than a portfolio-listed company, can have multiple portfolio investor classes, such as a separate class for different investment options. However, for the entity to qualify as a portfolio investment entity, each portfolio investor class of the entity must meet the relevant further eligibility criteria in sections HL 6, HL 9 and HL 10. A portfolio investor class is defined in section OB 1 as one or more investors in an entity, where each investor has an entitlement to the proceeds from the investments of the entity, the investments are the same for all investors, and each investor's interest in the investments are in similar proportion (that is, they differ by less than 2.5 percent of the average value) to other investors.

Under section HL 6(1), an entity - or, if the entity has more than one portfolio investor class, each portfolio investor class of the entity - must have at least 0 persons as investors, treating all interests held by persons that are associated (as defined under section OD 8(3)) as one person. Under section HL 6(4) only persons holding an interest of 5 percent or more are counted as associates. This is to prevent portfolio investment entities from having to keep track of associated parties that hold small interests. An interest held by a portfolio investor proxy (as defined in section HL 31) is treated as an investment by one person.

Exceptions to the investor membership requirement (sections HL 6(1)(b) to (j), 6(3) and 6(4))

A portfolio investor class does not need to meet the investor membership requirement if the class has at least one investor that is a portfolio investment entity or is a foreign investment vehicle, an entity that is eligible to become a portfolio investment entity but does not elect to do so, or if it is a life insurance company. There are also exceptions to the investor membership requirement if the class has, as an investor, either the New Zealand Superannuation Fund, the Accident Compensation Corporation (or Crown entity or subsidiary) or the Earthquake Commission.

Boutique portfolio investor classes can have fewer than 20 persons as investors in certain circumstances. To qualify, the entity holding the portfolio investor class must have at least one other portfolio investor class which meets the investor membership requirement No investor in the boutique class (other than the manager or trustee of the entity) can control the investment decisions of that class and the interests of investors in all boutique classes of the entity must total less than 10 percent of the total value of interests in the entity. This exception to the investor membership requirement is designed to ensure that umbrella funds offering investors boutique investment options alongside more mainstream products are not denied access to the new rules.

An entity electing to be a portfolio investment entity also does not need to meet the investor membership requirement if the entity, if treated as a unit trust, would meet one or more of paragraphs (a) and (c) to (e) of the qualifying unit trust definition in section OB 1. The investor membership requirement would also not need to be met if the entity is a superannuation fund that is established under the proposal for restructuring of the National Provident Fund required by the National Provident Fund Restructuring Act 1990 or a fund established by the Government Superannuation Fund Act 1956.

Investor membership requirement for a listed company (section HL 6(2))

The investor membership requirement for an entity that is a company listed on a recognised exchange in New Zealand is that the entity must not have more than one portfolio investor class. Such companies are, by definition, widely held as a result of the listing requirements in New Zealand. Therefore, no further investor membership requirements are required.

New section HL 7 - investor return adjustment requirements

When an entity elects to be a portfolio tax rate entity, the entity is required to make adjustments to reflect the effect of tax paid by the portfolio tax rate entity or any rebate that is available to the entity. The investor return adjustment requirement is designed to provide investors on marginal tax rates lower than 33% the benefit of these rates on their allocated income (portfolio investor allocated income) or loss (portfolio investor allocated loss).

An entity can choose between two methods for making the adjustment. The first is to adjust members' interests in the entity. These adjustments must be made within two months of the end of a quarter or the tax year, depending on the tax calculation period elected by the entity under section HL 15. In the case of portfolio tax rate entities that elect to pay provisional tax under section HL 22, the adjustment must be made within three months of the end of the tax year. Alternatively, the investor return adjustment could be made to the amount of any distribution paid to an investor. Portfolio tax rate entities have a choice of the method of the adjustment under sub-section (4).

The investor return adjustment requirement does not apply if an entity elects to become a portfolio listed company or a portfolio defined benefit fund. This is because, unlike portfolio tax rate entities, portfolio listed companies and portfolio defined benefit funds would not calculate their tax liability based on the tax rates elected by investors.

Changes to other Acts to give effect to the investor return adjustment requirement

As a consequence of the investor return adjustment requirement, amendments have been made to the following Acts to enable adjustments to be made without significant compliance and operational complications:

  • Companies Act 1993
  • Public Trust Act 2001
  • Securities Act 1978
  • Trustee Act 1956
  • Trustee Companies Act 1967
  • Unit Trusts Act 1960.

New section HL 8 - imputation credit distribution requirement

The imputation credit distribution requirement only applies to entities that elect to become portfolio listed companies. Portfolio listed companies will continue to pay tax as a company. As a result, under section HL 8, portfolio listed companies must maintain an imputation credit account. Any distributions made by these entities must carry imputation credits to the extent permitted by imputation credits available as determined by the directors of the entity.

Distributions from portfolio listed companies to shareholders (section CX 44D(3))

Fully imputed distributions to shareholders from a portfolio listed company are considered excluded income unless an investor specifically includes the distribution as income in their tax return (section CX 44D(3)(a)). If the investor elects to do so, the imputation credits would be able to be used to offset any tax liability on the distribution. Investors on a marginal tax rate lower than 33% may chose to treat the distribution as taxable income and use any excess imputation credits against other taxable income. Under section CX 44D(3)(b), the amount of any distributions that are not fully imputed are also considered excluded income to the shareholder. This is to ensure that income that has not been taxed at the portfolio listed company level (for example, capital gains from the sale of shares in a New Zealand company) can be distributed to investors without the investor paying tax on that income.

New section HL 9 - investor interest size requirement

New section HL 9 contains the investor interest size requirement for a portfolio investment entity. Under the investor interest size requirement, no single investor (or group of associated investors) in a portfolio investment entity or, where applicable, a portfolio investor class, can hold more than 20 percent of the underlying investments of the entity or class. As with the investor membership requirement, section HL 9(6) specifies that only persons holding portfolio investor interests of 5 percent or more are counted as associates for the purposes of determining whether the investor interest size requirement has been breached.

Exceptions to the investor interest size requirement (sections HL 9(2), 9(3), 9(4) and 9(6))

An investor in a portfolio investment entity can hold more than 20 percent of the entity or, if applicable, the portfolio investor class if the investor is a portfolio investment entity, a foreign investment vehicle or an entity that is eligible to become a portfolio investment entity but does not elect to be. There is no investor interest size requirement for an entity that is a life insurer, the New Zealand Superannuation Fund, the Accident Compensation Corporation (or Crown entity subsidiary) or the Earthquake Commission.

An entity electing to be a portfolio investment entity does not need to meet the investor interest size requirement provided the entity, if treated as a unit trust, would meet one or more of paragraphs (a) and (c) to (e) of the qualifying unit trust definition. This safe harbour also applies to a superannuation fund that is established under the proposal for restructuring the National Provident Fund required by the National Provident Fund Restructuring Act 1990 or a fund established by the Government Superannuation Fund Act 1956. The reason for this safe harbour is that these entities are themselves widely held.

Investor interest size requirement for portfolio listed companies (sections HL 9(3) and 9(5))

An investor in a portfolio listed company is generally not allowed to hold a portfolio investor interest of more than 20 percent. However, under section HL 9(5), an investor in a portfolio listed company is allowed to hold an interest of more than 20 percent, but no more than 40 percent, in the company if the investor held the interest in the entity beginning on 17 May 2006 and continued to hold the interest after 30 September 2007. This exception to the general investor interest size requirement deals with the problem of investors with large "legacy" investments in listed investment companies that elect to become portfolio listed companies.

New section HL 10 - investment type, income type and entity shareholding investment requirements

Under the investment type requirement in section HL 10(1), a portfolio investment entity must have 90 percent or more of its assets by value invested in deriving income from land, financial arrangements, excepted financial arrangements or a right or option relating to such property.

Similarly, under the income type requirement in section HL 10(2), 90 percent or more of the income derived by a portfolio investment entity must be income derived from an interest in land, financial arrangements, excepted financial arrangements or a right or option relating to such property. A further requirement is that the income must be passive in nature and consist of dividends, income taxed under the financial arrangement rules, rent from an interest in land, proceeds from the disposal of property listed in section HL 10(1), or foreign investment fund income.

Under the entity shareholding investment requirement in section HL 10(3), a portfolio investment entity must hold less than 20 percent ownership interests (denoted by voting interests) in companies (including unit trusts) that it invests into. The entity shareholding requirement applies on a portfolio investor class basis - the class shareholding investment requirement under section HL 10(5) - if a portfolio investment entity has more than one portfolio investor class. Taken together these rules are designed to ensure that the main purpose of a portfolio investment entity is portfolio investment.

Exceptions to the entity shareholding investment requirement (sections HL 10(3)(b), 10(4) and 10(5)(b))

An entity can hold more than a 0 percent interest in a company if the market value of all voting interests in companies of more than 0 percent comprise less than 10 percent of the total market value of the entity's investments. There is a similar exception to the class shareholding investment requirement under section HL 10(5). These exceptions are designed to provide portfolio investment entities with some investment flexibility and recognise that an entity can have as its main function portfolio investment even though it has a limited number of non-portfolio investments.

There are further exceptions to the entity shareholding requirement if the interest is in:

  • another portfolio investment entity;
  • an entity that could be a portfolio investment entity but does not elect in;
  • a foreign investment vehicle;
  • a life insurance company; or
  • a company that predominantly owns land (defined as a portfolio land company).

A portfolio investment entity can invest up to 100 percent in these entities.

New section HL 11 - becoming and ceasing to be a portfolio investment entity

An entity can elect to be a portfolio investment entity under section HL 11 by giving a notice in the prescribed form to the Commissioner of Inland Revenue at any time after 1 April 2007. A notice of election is effective from the later of either:

  • 1 October 2007 (the application date of the portfolio investment entity tax rules);
  • the date the entity is formed (in the case of a new entity);
  • the date nominated in the notice to the Commissioner; or
  • a date 30 days before the notice is received.

Similarly, an entity can cease to be a portfolio investment entity under section HL 11 by providing a notice in the prescribed form to the Commissioner. A cancellation is effective from the later of the date on which the entity became a portfolio investment entity, the date nominated in the notice, or the date the notice is received.

New section HL 12 - requirements on becoming a portfolio investment entity

An entity that makes an election under section HL 11 becomes a portfolio investment entity unless it cancels the election within 1 months of the date of election or fails to meet one or more of the general eligibility criteria in section HL 3 (other than breaches that can be fixed and are fixed within the conditions specified in section HL 4(2)).

If an entity with a non-standard income year chooses to become a portfolio tax rate entity and elects to pay tax under sections HL 21 or HL 23, then the entity has a transitional income year (under section 39 of the Tax Administration Act 1994). The income year starts on the date that the election to become a portfolio tax rate entity became effective and ends on the following 31 March.

All portfolio tax rate entities that pay tax under sections HL 21 and HL 23 must have standard balance dates. That is, they must operate on a tax year basis. This is reiterated under section 38(1B) of the Tax Administration Act 1994, which prevents section HL 21 and HL 23 entities from electing a non-standard balance date. The standard balance date requirement does not apply to portfolio tax rate entities that elect to pay tax as provisional taxpayers under section HL 22, or to portfolio listed companies or portfolio defined benefit funds.

On becoming a portfolio investment entity, section HL 12(3) deems the entity to dispose and re-acquire any shares held in New Zealand and certain Australianresident listed companies (as defined under section CX 44C(1)(a) and (b)) at their market value on the day before the election is effective. The deemed disposition and re-acquisition does not apply in the case of an investment in a company that is a portfolio investment entity or an entity that will become a portfolio investment entity within six months. This is designed to prevent double taxation. The investee company would also be subject to a deemed disposal and re-acquisition of shares subject to the section CX 44C exclusion.

New section HL 13 - transitional tax rules

Any tax liability arising from the effect of the election on the length of the entity's income year under section HL 12 or the deemed disposal and re-acquisition under section HL 1 can be spread evenly between the year in which the entity became a portfolio investment entity and the following two years under section HL 13(2). For the purposes of any transitional tax liability, the provisional tax rules, tax penalties rules and use-of-money interest rules do not apply (section HL 13(1)).

New section HL 14 - requirements on ceasing to be a portfolio investment entity

An entity ceases to be a portfolio investment entity if it cancels the election to be a portfolio investment entity under section HL 11 or becomes ineligible to be a portfolio investment entity under section HL 4. The cessation of portfolio investment entity status is effective from the date on which the cancellation of portfolio investment entity status is effective or the first day after the end of the quarter in which the entity ceased to be a portfolio investment entity under section HL 4. For example, an entity that is no longer eligible to be a portfolio investment entity, through the operation of section HL 4, on 27 May 2007, would cease to be a portfolio investment entity on 1 July 2007 in accordance with section HL 14(2)(b).

Once an entity has ceased to be a portfolio investment entity the entity is treated as having disposed and reacquired of any shares in New Zealand and Australian-resident listed companies, as defined under section CX 44C(1)(a) and (b), at their market value. These shares would no longer be subject to the protection of section CX 44C(1) on gains from sale. Instead, the normal capital/revenue boundary would apply to any future sales.

The disposal and re-acquisition of shares is treated as being to and from another person at the market value of the shares on the date the entity ceased to be a portfolio investment entity (section HL 14(3)). This provision ensures that shares previously subject to the Australasian share exemption re-enter the tax base at their market value on the date the entity ceases to be a portfolio investment entity in accordance with section HL 14(2).

Calculation and payment of tax for portfolio investment entities

The requirements to calculate and pay tax vary depending on the type of portfolio investment entity.

Portfolio tax rate entities would generally pay tax four times a year, under section HL 21. There are exceptions to this general rule in the case of portfolio tax rate entities that elect to pay tax when investors exit (under section HL 23) and in the case of portfolio tax rate entities that elect to remain provisional taxpayers (under section HL 22). Sections HL 15 to 23 and HL 27 to 30 deal with the calculation and payment of tax for portfolio tax rate entities. Portfolio listed companies and portfolio defined benefit funds continue to pay tax, broadly, under current rules.

New section HL 15 - the periods relevant to the calculation of tax for portfolio tax rate entities

A portfolio tax rate entity must first elect a portfolio calculation period and portfolio allocation period under section HL 15. This determines the periods over which income (and expenses, losses and tax credits) are allocated and tax is calculated.

The portfolio allocation period is the period over which a portfolio tax rate entity allocates its taxable income or loss, under section HL 19. The portfolio calculation period consists of one or more portfolio allocation periods and represents the period over which the entity must calculate its portfolio entity tax liability or rebate, under section HL 20, on taxable income or loss allocated to each portfolio allocation period under section HL 19. A portfolio tax rate entity therefore cannot elect a portfolio allocation period that is greater than the entity's portfolio calculation period.

An entity can choose different portfolio allocation periods and portfolio calculation periods, depending on the type of portfolio tax rate entity they elect to become. The default portfolio allocation period for a portfolio tax rate entity is a day. Alternatively, a portfolio tax rate entity may choose a portfolio allocation period of a month, quarter, or income year by giving notice to the Commissioner before the start of the relevant tax year or when the entity first chooses to become a portfolio tax rate entity.

The default portfolio calculation period for a portfolio tax rate entity is a quarter. A portfolio tax rate entity can choose a portfolio calculation period of a day or income year (for entities electing under section HL 22 to pay provisional tax) by giving notice to the Commissioner - again, before the start of a tax year or when the entity first chooses to become a portfolio tax rate entity.

Special rules for portfolio tax rate entities that elect to pay provisional tax (sections HL 15(2)(c) and 15(3)(c))

A portfolio tax rate entity that elects to pay provisional tax under section HL has a portfolio calculation period of an income year. Such an entity can, however, choose a portfolio allocation period of a day, a month a quarter or income year. A portfolio tax rate entity that elects to pay provisional tax under section HL must notify the Commissioner of their portfolio calculation period and portfolio allocation period when they make the election under section HL 22.

New section HL 16 - income not allocated, or allocated but not vested

New section HL 16 deals with income that is not able to be allocated to an investor by a portfolio tax rate entity and income that is able to be allocated to an investor but has not vested in the investor. Note: This section applies to portfolio tax rate entities only.

In the case of income that is not able to be allocated to an investor, the portfolio tax rate entity is treated as the investor for the purposes of calculating the entity's tax liability. This means that income relating to amounts such as reserve accounts or managers' holdings in portfolio tax rate entities would be taxed at 33%.

Some superannuation funds - for example, employerbased schemes that become portfolio tax rate entities may have members who have amounts contributed on their behalf that do not vest unless certain criteria are met. The intended effect of section HL 16(2) is that the tax rates of superannuation fund members should be used to tax income arising on unvested employer contributions, subject to the following conditions:

  • For the superannuation funds established before the bill was introduced on 17 May 2006, the vesting period has not been extended beyond the period in existence at that date.
  • Superannuation funds established after this bill's introduction must have vesting periods equal to or less than three years. For superannuation funds meeting this condition, the contributions made within the three-year period must vest in the employee within that period.

These conditions have been legislated to recognise the existence of established superannuation funds and vesting periods, and provide for new superannuation funds. The conditions associated with vesting periods have been designed to align with the intention of the portfolio investment entity rules that income will be taxed at the appropriate rate.

New section HL 17 - new investors treated as part of existing investor class

This section allows new members of a portfolio investor class of a portfolio tax rate entity to be treated as an existing member of that class. In the absence of this section the new investor may not be treated as being an investor in a portfolio investor class as they may temporarily hold interests in the underlying investments of the class that are different in proportion to those of other investors in the class. This difference may arise because the entity needs time to buy more of the underlying investments to make the investor's portfolio investor interests in the underlying investments similar in proportion to those of other investors in the class.

New section HL 18 - calculation of class net income or class net loss for portfolio tax rate entities

Section HL 18 outlines the formula for calculating the net income or loss for a portfolio investor class for each portfolio allocation period in a portfolio calculation period. It applies to a portfolio tax rate entity. A portfolio investor class has net income in a portfolio allocation period if the total amount of the entity's assessable income that is allocated to the class for the allocation period exceeds the total amount of the deductible expenditure that the entity allocates to the portfolio allocation period. A portfolio investor class has a net loss in an allocation period if total deductions for the class exceed assessable income for the class. It should be noted that under section EG 3, income and deductions of portfolio tax rate entities are allocated to the same periods as the entity allocates these amounts for the purpose of setting a unit price or, if the entity does not set a unit price, the amounts are allocated according to the entity's financial statements.

This calculation, along with the calculation under section HL 19, would be done at the end of a portfolio calculation period for each portfolio allocation period in the calculation period.

Example 1

PIE A has assessable income of $20,000 and expenses of $3,000 on day 1. On day 2, PIE A has a loss of $6,000 and expenses of $1,000. PIE A has class net income of $17,000 on day 1 and class net loss of $7,000 on day 2 (assuming PIE A elects an allocation period of a day and has a single portfolio investor class).

New section HL 19 - calculation of class taxable income or class taxable loss for portfolio tax rate entities

Section HL 19 outlines the formula for calculating the class taxable income or loss for a portfolio investor class for each portfolio allocation period in a portfolio calculation period. A portfolio investor class has taxable income in a portfolio allocation period if the amount of any net income (calculated under section HL 18) exceeds the amount of any "other loss used". "Other loss used" is defined as the total of portfolio entity formation losses and any portfolio class land loss that has not been used in any previous portfolio allocation period to reduce net income.

Portfolio entity formation losses are essentially losses that have been generated prior to the entity becoming a portfolio tax rate entity that have been carried into the new rules. They are defined more fully in section HL 28.

A portfolio class land loss arises when a portfolio investor class has investments that are predominantly in the form of land or in companies that hold land (defined as portfolio land companies). Where this class has a net loss for a portfolio allocation period under section HL 18, this loss can be carried forward as a portfolio class land loss for offset against net income of the class in future portfolio allocation periods. Portfolio class land losses are defined under section HL 30.

The amount of portfolio entity formation loss and portfolio class land loss which can be used in a portfolio allocation period is limited to the amount of net income calculated under section HL 18 for the class and the period.

A portfolio investor class of a portfolio tax rate entity has a taxable loss if the class has a net loss (under section HL 18).

New section HL 20 - calculation of portfolio entity tax liability or amount of rebate

Section HL 20 outlines the formula for calculating the tax liability for a portfolio tax rate entity for a calculation period or, when there is a loss, for the calculation period, the amount of the loss that can be rebated under section KI 1.

The tax liability or amount of the rebate for a portfolio tax rate entity is the total calculated under section HL 0 for all investors that have been in the entity during the period and have elected a tax rate (defined as a "portfolio investor rate") of greater than zero percent. Therefore, any "zero-rated portfolio investors" (as defined in section OB 1) and certain investors with a portfolio exit period (also defined in section OB 1) are not included in the tax calculation under section HL 0. Income or loss allocated by a portfolio tax rate entity to zero-rated portfolio investors and investors with a portfolio exit period (in the case of portfolio tax rate entities that elect to pay tax under section HL 21) is taxable or deductible respectively, directly for these investors. This is discussed in further detail below.

The "portfolio entity tax liability", or the amount of the rebate, is the total of the amounts calculated under section HL 20(4):

  • for each investor with a portfolio investor rate of greater than zero;
  • for each portfolio investor class the investor has an interest in;
  • for each day in a portfolio allocation period; and
  • each portfolio allocation period in a portfolio calculation period.

Therefore, the portfolio entity tax liability or the amount that is to be rebated is the sum of the separate tax calculations relating to each investor for each day of the calculation period.

When a portfolio tax rate entity chooses a portfolio allocation period greater than a day - for example, a quarter - the portfolio entity tax liability (or rebate) for the allocation period is spread evenly across each day in the allocation period, for each investor.

Example illustrates how a portfolio investment entity uses section HL 0 to calculate tax.

To avoid complexity, the following examples describe portfolio investment entities that would not meet either or both of the investor membership requirement in section HL 6 and the investor interest size requirement in section HL 9.

Example 2 - portfolio entity tax liability

PIE A (from Example 1) has five investors, each holding 20 percent of the entity. Investors A, C and D elect a tax rate of 19.5%. Investors B and E have a tax rate of 33%.

The portfolio entity tax liability is the sum of the tax liabilities for each individual investor for each portfolio allocation period in the relevant calculation period (assume PIE A's calculation period only encompasses day 1 and day 2).
Day 1 Investors on 19.5% (3) 33% (2)
0.2*($17,000)*0.195 = $663 0.2*($17,000)*0.33 = $1,122
1 1
Day 2 0.2*(-$7,000)*0.195 = -$273 0.2*(-$7,000)*0.33 = -$462
1 1
Portfolio entity tax liability (or amount of rebate (if negative)):

[($663*3 + $1,122*2) + (-$273*3 + -$462*2)] = $2,490 (portfolio entity tax liability)

 

Example 3 - rebate

PIE B has five investors, each holding 20 percent of the entity. Investors A, D, and E have a 33% tax rate and investors B and C elect a 19.5% tax rate (assume PIE B's calculation period only encompasses day 1 and day 2).

PIE B has net income of $15,000 on day 1 and a net loss of $20,000 on day 2. Under section HL 19, PIE B has portfolio class taxable income of $15,000 on day 1 and a portfolio class taxable loss of $20,000 on day 2. Under section HL 20:
Day 1 Investors on 19.5% (2) 33% (3)
0.2*($15,000)*0.195 = $585 0.2*($15,000)*0.33=$990
1 1
Day 2 0.2*(-$20,000)*0.195 = -$780 0.2*(-$20,000)*0.33 = -$1,320
1 1
Portfolio entity tax liability (or amount of rebate (if negative)): [($585*2 + $990*3) + -$780*2 + -$1,320*3)] = $4,140 - $5,520 = -$1,380). This is the amount that may be rebated under section KI 1.

Payment of tax by portfolio tax rate entities

Different types of portfolio tax rate entities have different rules for the payment of tax calculated under section HL 0 or the receipt of rebates.

New section HL 21 - portfolio tax rate entities that have a portfolio calculation period of a quarter

Section HL 1 outlines the rules for payment of tax by portfolio tax rate entities that have a portfolio calculation period of a quarter. These portfolio tax rate entities fall into the default category as a result of the portfolio calculation period of a quarter being the default option under section HL 15. It is anticipated that most entities in this category will have a portfolio allocation period of a day.

These entities would not be required to pay provisional tax under subpart MB of the Income Tax Act. Instead, they are required, after each portfolio calculation period, to pay an amount of tax equal to the portfolio entity tax liability calculated under section HL 0 for the portfolio calculation period. The payment must be made within one month of the end of the portfolio calculation period. Similarly, when the entity has an amount calculated under section HL 20, for a portfolio calculation period that is able to be rebated under section KI 1, this amount would be rebated after the entity has filed their return for the period. This means any losses or excess tax credits relating to the portfolio calculation period that are able to be refunded would be dealt with quarterly.

On payment of tax or on receipt of a rebate, the portfolio tax rate entity would need to adjust each investor's portfolio investor interest or make a distribution under section HL 7, to reflect the investor's share of the entity's portfolio entity tax liability (or rebate). For a section HL 21 portfolio tax rate entity, this would be within two months of the end of the relevant calculation period.

Example 4

If PIE A (from Example 1) has a quarterly portfolio calculation period (and days 1 and 2 are the only allocation periods in the quarter), the portfolio entity tax liability of $2,490 (calculated in Example 2) would be payable within one month of the end of the quarter. Similarly, if PIE B (from Example 3) has a quarterly portfolio calculation period, it would be entitled to a rebate under section KI 1 after the end of the quarter.

Under the investor return adjustment requirement in section HL 7, each investor in PIE A (and PIE B) would need to have their portfolio investor interest or any distribution adjusted for the tax paid (or rebate received). This would have to occur within two months of the end of the relevant quarter. Assuming PIE A elects to adjust each investor's interest, investors A, C and D in PIE A would have their portfolio investor interest reduced by $390 and investors B and E would have their interest reduced by $660.
Exiting investors "zero-rated"

Investors who exit a portfolio tax rate entity that pays tax under section HL 21 part-way through a portfolio calculation period would be "zero-rated" by the entity. That is, the portfolio investment entity would pay tax on the exiting investor's share of the income earned during the period at zero percent.

A portfolio investor exit period is defined in section OB 1, in the context of section HL 21, as a period that starts at the beginning of a portfolio calculation period and ends five days after the end of the portfolio calculation period. The five-day grace period after the end of a portfolio calculation period is to accommodate investors who leave a section HL 1 portfolio tax rate entity just after the end of a calculation period, but before the entity has calculated the portfolio entity tax liability for the calculation period.

An investor has a portfolio investor exit period if the amount of the portfolio entity tax liability for the investor (calculated under section HL 20 as if the investor did not have an exit period) would equal or exceed the value of the investor's interest at the end of the exit period. This means that for an investor to be zero-rated, the investor's share of the tax liability for a portfolio calculation period must exceed any residual interest in the entity (in all classes of the entity) after they have made a withdrawal. If no portfolio investor exit period arises, the normal section HL 0 tax liability calculation would apply to the investor at the end of the quarter.

Example 5

PIE C has a portfolio calculation period of a quarter. Investor A reduces his interest in PIE C by $10,000 part-way through a portfolio calculation period. His residual interest in PIE C is $1,000. At the end of the portfolio calculation period, investor A's share of the portfolio entity tax liability for the portfolio calculation period is $1,250. Because investor A's share of the portfolio entity tax liability for the period is greater than his residual interest, there is a portfolio investor exit period. Consequently, PIE C can apply a zero percent tax rate for investor A for the purposes of section HL 20.
Cancellation of any residual portfolio investor interests (section HL 21(5))

Where an investor partially exits, a portfolio tax rate entity that makes payments of tax under section HL 21, and the level of the withdrawal is sufficient to trigger a portfolio investor exit period (and hence zero-rating), any residual portfolio investor interest in the entity must be cancelled and paid to Inland Revenue under subsection (5). This payment satisfies some of the investor's tax liability on income from the portfolio tax rate entity. While the investor will be required to include the amount of portfolio investor allocated income from the entity in relation to the portfolio investor exit period in their tax return, the amount of the investor's portfolio investor interest paid to the Commissioner under subsection (5) will be treated as a credit under section LD 11 against this tax liability.

A payment by the portfolio tax rate entity to the Commissioner under subsection (5) would also need to be made within one month of the end of the portfolio calculation period in which the portfolio investor exit period falls.

Example 6

As investor A in PIE C in Example 5 has a residual interest, under section HL 21(5), PIE C would be required to cancel this residual interest and pay this amount within one month of the end of the portfolio calculation period in satisfaction of investor A's share of the portfolio entity tax liability. The $1,000 paid by PIE C would be available as a credit in the investor's tax return.

New section HL 22 - portfolio tax rate entities that elect to pay provisional tax

Section HL enables portfolio tax rate entities that choose a portfolio calculation period of a year to continue to be subject to the provisional tax rules under subpart MB.

The actual income tax liability for these entities would still be calculated under section HL 0 at the end of the year, which allows investors' tax rates to be taken into account when calculating the entity's portfolio entity tax liability. This effectively results in the entity applying a blended average tax rate for the year. The investor return adjustment requirement under section HL 7 applies and would need to occur within three months of the end of the year.

The provisional tax paid by the entity during the year would be allowed as a credit against the entity's portfolio entity tax liability. As the provisional tax rules would operate, the entity may be subject to the use-of-money interest rules if the amount of provisional tax paid is less than (or exceeds) the portfolio entity tax liability calculated at the end of the year.

No rebate for losses and excess tax credits arising during a portfolio calculation period (sections IE 1(2BB), HL 26 and HL 27)

Unlike section HL 21 portfolio tax rate entities, entities that elect to pay provisional tax under HL would not receive rebates for losses and excess credits arising in the portfolio calculation period. Instead, under section IE 1(2BB), any amounts calculated under section HL 20 that would otherwise be rebated under section KI 1, are carried forward.

No "zero-rating" of exiting investors

Portfolio tax rate entities that elect to pay tax under section HL 22, would not be able to apply a zero-percent tax rate to the income earned by investors that exit the fund during the year. These entities would pay tax on all the income the entities earned during the year. Therefore, to cover the tax liability relating to exiting investors, these entities are likely to ensure that an appropriate amount is withheld from investors when they exit.

Example 7

PIE D elects to pay provisional tax under section HL . PIE D has a portfolio calculation period of an income year and elects a portfolio allocation period of a month. It makes provisional tax estimations of $333 for each of the provisional tax payment dates 1 to 3.

PIE D has two investors, investor A and investor B each holding 50 percent of PIE D. Investor A elects a tax rate of 19.5% and investor B elects a tax rate of 33%. Investor B exits PIE D completely, six months after the start of the tax year. On exit of investor B, the PIE pays investor B an amount, which includes assessable income of $1,500 (this is based on the PIE earning assessable income of $500 in each of the first six months). PIE D withholds tax of $495 on this amount. Investor C (with a tax rate of 33%) enters PIE D after investor B has exited. At the end of the year PIE D has taxable income of $6,000. Each investor's share of the portfolio entity tax liability is:
Investor A: 0.5*$6,000*0.195 = $585
Investor B: 0.5*$6,000*(6/12)*0.33 = $495
Investor C: 0.5*$6,000*(6/12)*0.33 = $495
(note: section HL 20 calculations have been simplified)

The portfolio entity tax liability for PIE D for the year is $1,575. This amount is the entity's final tax liability. The provisional tax payments totalling $1,000 are available as a credit against this liability. PIE D would therefore have a residual income tax liability of $575. This residual liability would be payable at the entity's terminal tax date.

PIE D must also carry out the investor return adjustment under section HL 7 within three months of the end of the income year for each investor still in the entity.

New section HL 23 - portfolio tax rate entities that pay tax when investors leave

Section HL 23 applies to portfolio tax rate entities that elect a portfolio allocation period and portfolio calculation period of a day under section HL 15. To be a section HL 23 portfolio tax rate entity, an entity must give notice in a prescribed form to the Commissioner of Inland Revenue at the time at which the entity selects its portfolio allocation and portfolio calculation periods under section HL 15.

Like entities that elect to pay tax under section HL 21, portfolio tax rate entities subject to section HL 23 would not be provisional taxpayers. However, unlike section HL 21 portfolio tax rate entities, these entities would pay tax (calculated under section HL 20) relating to all calculation periods in the tax year and for all investors remaining in the entity, within one month of the end of the tax year. Similarly, when the entity has an amount for a tax year under section HL 0 that is able to be rebated under section KI 1, this amount would be only rebated after the entity has filed its return for the year. The investor return adjustment under section HL 7 would also apply at the end of the tax year.

Tax payable on behalf of exiting investors (section HL 23(2))

Unlike a section HL 21 portfolio tax rate entity, investors who exit a portfolio tax rate entity that elects to pay tax under section HL 23 will not be zero-rated. Instead, the entity would need to pay the investor's share of the portfolio entity tax liability relating to a portfolio investor exit period to the Commissioner within one month from the end of the month in which the portfolio investor exit period ends. Therefore, investors who exit a section HL 23 portfolio tax rate entity during a tax year would not need to file a return for their portfolio investor allocated income for a portfolio investor exit period.

Example 8

PIE E elects to pay tax under section HL 23 by choosing a portfolio allocation period and portfolio calculation period of a day. PIE E has two investors: investor A (who holds 40 percent of PIE E) and investor B (who holds 60 percent of PIE E). Both investors elect a 33% tax rate. For simplicity, this example assumes only four portfolio allocation and portfolio calculation periods for the year. In portfolio allocation period 1, the entity has taxable income of $1,000, in period 2 a taxable loss of $500, in period 3, taxable income of $2,500 and in period 4, taxable income of $3,000.

Investor A exits PIE E completely at the end of period 3 and is replaced by investor C (who elects a tax rate of 19.5%). PIE E would need to calculate investor A's share of the portfolio entity tax liability for portfolio calculation periods 1 to 3 (the investor's portfolio investor exit period) and deduct this amount from the payment that is made to investor A:
Period 1: 0.4*($1,000)*0.33 = $132  
Period 2: 0.4*(-$500)*0.33 = -$66  
Period 3: 0.4*($2,500)*0.33 = $330  
The amount that is deducted - $396, would need to be paid to the Commissioner within one month of the month in which investor A's portfolio investor exit period ends.

For investors B and C, their share of the portfolio entity tax liability for the tax year, calculated below, would be payable within one month of the end of the tax year.
  Investor B     Investor C
Period 1: 0.6*($1,000)*0.33 = $198
-
Period 2: 0.6*(-$500)*0.33 = -$99
-
Period 3: 0.6*($2,500)*0.33 = $495
-
Period 4: 0.6*($3,000)*0.33 = $594
0.4*($3,000)*0.195
 
=$234
Total:   $1,188
$234

Section HL 24 - portfolio investor allocated income and loss

Sections HL 24 and HL 25 deal with the treatment of income or loss allocated to investors by portfolio tax rate entities. This is defined as portfolio investor allocated income or loss.

Election of a tax rate

Investors in portfolio tax rate entities can elect a tax rate in accordance with the definition of the prescribed investor rate in section OB 1. The prescribed investor rate for an investor in a portfolio tax rate entity is:

  • 0% in the case of an entity that is a charity (that is, an organisation or trust that derives exempt income under sections CW 34 and CW 35), a company, a superannuation fund, a trustee (other than a trustee that elects 33%), a portfolio investment entity, or a portfolio investor proxy (as defined in section OB 1). These investors are defined as "zero-rated portfolio investors";
  • 19.5% in the case of a natural person who, in either of the previous two income years, had taxable income of $38,000 or less (not including portfolio investor allocated income) and a total amount of $60,000 or less in taxable income plus portfolio investor allocated income; and
  • 33% in all other cases and for a trustee that elects this rate.

The rate elected by an investor is called the portfolio investor rate and is used by the portfolio tax rate entity to calculate the entity's tax relating to the investor and the period under section HL 0. A portfolio investor rate must be provided to a portfolio tax rate entity before the end of a portfolio calculation period. Under section 28B of the Tax Administration Act a person cannot provide a portfolio investor tax rate of 19.5% unless they provide their tax file number to the portfolio tax rate entity. If no portfolio investor rate is elected, the default rate of 33% applies.

An investor who exits a portfolio tax rate entity that makes payments of tax under section HL 21 has a portfolio investor rate of 0% if the investor has a portfolio investor exit period in the relevant calculation period.

Calculation of portfolio investor allocated income or loss (section HL 24(5))

Under section HL 24, the portfolio investor allocated income or loss for an investor is the total income or loss calculated under subsection (5) for that investor for each portfolio allocation period in a tax year the investor was present in the entity and each day of the portfolio allocation period, and each portfolio investor class to which the investor belongs. An investor's portfolio investor allocated income or loss mirrors the investor's share of the income on which the portfolio entity tax liability is calculated under section HL 20.

Excluded income in certain circumstances and not others (sections CP and, CX 44D)

Under section CP 1, the amount of any portfolio investor allocated income is treated as income of the investor in the year containing the relevant income-allocation periods. Section CX 44D provides that portfolio investor allocated income derived by an investor under section CP 1 is excluded income of the investor if:

  • the prescribed investor rate for the investor is more than 0%;
  • the investor has not chosen a portfolio investor rate that is less than the prescribed investor rate; and
  • the income is not allocated to a portfolio investor exit period, in the case of an exiting investor from a section HL 1 portfolio tax rate entity.

Under section CX 44D(2), any distribution from a portfolio tax rate entity to an investor is also treated as excluded income of the investor. In this context, a distribution would include an investor redeeming their units with the PIE. Excluded income does not need to be separately identified and returned.

As portfolio investor allocated income is excluded income for tax purposes, provided investors elect a portfolio investor rate that is no lower than their prescribed investor rate, the income does not affect entitlements to Working for Families' tax credits, or student loan repayment obligations or child support payment obligations.

Consequences if portfolio investor rate is lower than prescribed investor rate

If an investor elects a portfolio investor rate that is lower than the prescribed investor rate, then the portfolio investor allocated income is not considered as excluded income under section CX 44D(1)(b). Instead, the full amount of income becomes the investor's taxable income in the tax year in which it is allocated to the investor by the portfolio tax rate entity.

The taxpayer is allowed a credit under section LD 10 for any tax paid by the portfolio tax rate entity in relation to any portfolio investor allocated income that is no longer considered excluded income under section CX 44D.

However, even if portfolio investor allocated income is not considered excluded income as a result of section CX 44D(1)(b), the receipt of this income would not affect entitlements to family assistance (under Working for Families). This is because section KD 1 has been amended to exclude any amount of portfolio investor allocated income that is not considered excluded income as a result of section CX 44D(1)(b) from the calculation of net income for family assistance (under Working for Families) purposes.

Section Hl 25 - portfolio investor allocated loss for zero-rated portfolio investors and certain investors with portfolio investor exit periods

Section HL 25 outlines the treatment of portfolio investor allocated losses for investors that are zero-rated portfolio investors or those investors in section HL 1 portfolio tax rate entities that have a portfolio investor exit period. As a portfolio tax rate entity does not have a portfolio entity tax liability in relation to these investors, any portfolio investor allocated income is not considered excluded income under CX 44D. Therefore the investor must include this income in their tax return. Similarly, any portfolio investor allocated loss is allowed as a deduction to zero-rated portfolio investors and investors in section HL 1 portfolio tax rate entities with a portfolio investor exit period, under section DB 43B(1).

Reduction in amount of loss allowed as a deduction (section DB 43(2))

Section DB 43B(2) is designed to ensure that zero-rated portfolio investors in portfolio investment entities cannot claim tax deductions for losses that flow through to them from the portfolio investment entity if the investor has benefited from the portfolio investment entity using a formation loss against income earlier in the year.

Section Hl 26 - rebates to portfolio tax rate entities that pay tax under sections Hl 21 and HL 23

Section HL 26 provides that section HL 1 and section HL 23 portfolio tax rate entities can get rebates under section KI 1 in certain circumstances. The rebates are allowed for investors with portfolio investor rates above zero percent and investors in section HL 21 portfolio tax rate entities that do not have a portfolio investor exit period. Instead of these investors receiving a benefit for any losses or excess credits directly, it is the portfolio tax rate entity that would receive a rebate, of an amount that is calculated under section HL 20 (although this is subject to section KI 1). The entity would then be responsible for allocating each investor's share of the rebate by adjusting each investor's portfolio investor interest (or alternatively making a distribution) under section HL 7.

Reduction in amount of rebate allowed (section KI 1(2))

Section KI 1, which allows the rebate, is designed to reduce any amount calculated under section HL 0 by any portfolio entity formation losses used in the portfolio calculation period to which the rebate relates. This provision is intended to ensure that rebates can only arise if the entity has incurred a net loss for the calculation period.

Section Hl 27 - credits received by portfolio tax rate entities

Section HL 7 outlines the ability of portfolio tax rate entities (and certain investors in portfolio tax rate entities) to use tax credits to reduce their portfolio entity tax liability, obtain a refund of income tax or attach the credit to distributions. Section HL 7 does not apply in the case of portfolio tax rate entities that have elected to pay tax under section HL 22. As in the case of losses, section HL portfolio tax rate entities would be subject to normal income tax rules in relation to the use of any tax credits.

Foreign tax credits (sections HL 27(7)(a) and HL 27(10)(a))

Under section HL 27, foreign tax credits (known as subpart LC credits) can only be used to reduce a portfolio tax rate entity's portfolio entity tax liability under section HL 0. Any excess credits cannot be rebated under section KI 1. These provisions are intended to ensure a tax treatment for a portfolio investment entity's foreign tax credits that is broadly similar to the tax treatment of foreign tax credits of direct investors - taking into account that many portfolio investment entities will be doing tax calculations daily.

Other tax credits (sections HL 27(7)(b), HL 27(8), HL 27(9) and HL 27(11))

Other tax credits (not under subpart LC - such as imputation credits) must first be used to reduce a portfolio tax rate entity's portfolio entity tax liability. However, any excess credits are available to be rebated under section KI 1 in the case of investors other than zero-rated portfolio investors and investors with exit periods in section HL 21 entities (see section HL 27(11)(b)).

New section HL 28 - portfolio entity formation losses

Section HL 8 outlines what a portfolio entity formation loss is and how these losses can be used. A portfolio entity formation loss is defined as any net loss arising from a period ending on or before an entity becomes a portfolio investment entity that can be carried forward and used to reduce a portfolio investment entity's taxable income. A portfolio entity formation loss may therefore comprise investment losses incurred by the entity before it became a portfolio investment entity, that could not be used, or losses arising under the transitional rules in section HL 12(3).

Unlike losses that arise during a portfolio calculation period, portfolio entity formation losses cannot be rebated under section KI 1. They must be used up over time against the taxable income of the entity. Portfolio entity formation losses can be carried forward to subsequent income years.

The intent of section HL 28(3) is to provide new formation losses to an entity when rebates, credits, or deductions have been claimed under sections DB 43B, HL 7 and KI 1.

New sections HL 29 and HL 30 - portfolio class land losses

Certain restrictions on the use of losses apply in the case of portfolio investor classes whose investments are predominantly in the form of land. This class is effectively defined as one where, at the end of a calculation period, the interests of the class that are held in land or portfolio land companies (defined as companies whose assets comprise more than 90 percent in land or other land companies) comprise more than 50 percent of the value of the investments of the class.

Under sections HL 29 and HL 30, any tax losses relating to investment classes of a portfolio tax rate entity that predominantly invest in land or land companies would not be rebated. Instead, these losses would form a portfolio class land loss, which could be carried forward and offset against taxable income from the relevant class in future portfolio calculation periods. Portfolio class land losses cannot be offset against taxable income from other non- "land" classes.

New section HL 31 - portfolio investor proxies

On the basis of investor information held (or other circumstances), certain entities (such as custodians and nominees) may be in a better position to apply the responsibilities outlined under subpart HL than the portfolio investment entities themselves. In such scenarios, an entity that is eligible to perform responsibilities under the portfolio entity tax rules that would ordinarily be performed by the portfolio investment entity, may do so by becoming a portfolio investor proxy and applying section HL 31.

Under section HL 31(1), an entity is eligible to be a portfolio investor proxy for an investor in a portfolio investment entity in relation to a portfolio allocation period if the following conditions are met:

  • The portfolio investment entity is not a portfolio listed company (section HL 31(1)(a)).
  • The entity holds a portfolio investor interest for an investor in the portfolio investment entity (section HL 31(1)(b)).
  • The entity gives the portfolio investment entity a notice that the entity is holding the portfolio investor interest as a portfolio investor proxy (section HL 31(1)(c)(i)), together with any other information the Commissioner may require the entity to provide to the portfolio investment entity (section HL 31(1)(c)(ii)).

Section HL 31(2) clarifies the role of the entity once it becomes a portfolio investor proxy. The role is to carry out the responsibilities (detailed in section HL 31(3)) of the portfolio investor proxy in relation to amounts allocated to it as holder of the portfolio investor interest on behalf of the investor for the portfolio allocation period. The responsibilities detailed in section HL 31(3) must be carried out as if:

  • the entity which becomes a portfolio investor proxy were a portfolio investment entity (section HL 31(2)(a));
  • the portfolio investor interest held by the entity were an interest of the investor in the income of the entity (section HL 31(2)(b)); and
  • the portfolio investor allocated income, portfolio investor allocated loss, and distributions received by the entity for the investor (from the portfolio investment entity) were income or loss of the entity and the investor is entitled to these through their portfolio investor interest (section HL 31(2)(c)(i) and (ii)).

The responsibilities of a portfolio investor proxy in relation to amounts allocated to it from the portfolio investment entity are contained in section HL 31(3). These responsibilities are to:

  • allocate, to the investor, portfolio investor allocated income and portfolio investor allocated losses for the portfolio allocation period (section HL 31(3)(a));
  • distribute, to the investor, distributions and credits for the portfolio allocation period (section HL 31(3)(b));
  • pay income tax on portfolio investor allocated income for the portfolio allocation period (section HL 31(3)(c));
  • adjust the portfolio investor interest of the investor, or distributions to the investor, to reflect the effect of the investor's portfolio investor rate on the amount of distributions and payments above (section HL 31(3)(d));
  • provide the Commissioner with returns relating to the allocation, distributions, credits, and payments referred to above (section HL 31(3)(e)(i)); and
  • provide the Commissioner with any other information required (section HL 31(3)(e)(ii)).

Other provisions in the Income Tax Act 2004

New section CX 44C - exclusion for trading gains on australasian equities by portfolio investment entities

New section CX 44C provides the exclusion for portfolio investment entities on certain Australasian share-trading income.

Under section CX 44C, income derived by a portfolio investment entity from disposal of a share, where the share is in a New Zealand tax-resident company or by a company resident in Australia for tax purposes and listed on an approved index under the Australian Stock Exchange rules (explained more fully earlier in this bulletin), is excluded income of the portfolio investment entity.

As a consequential amendment, sections DB 17(1) and (2) have been amended to prevent portfolio investment entities from receiving a deduction for the cost of shares subject to section CX 44C, on disposal.

Dividends (section CB 4B)

Under section CB 4B, where a dividend is declared in respect of a share to which section CX 44C applies before the share is disposed of, but the dividend is paid after the disposal, the portfolio investment entity is considered to have derived the dividend as gross income. The amount of gross income is limited to the amount of any dividend that is not fully imputed for New Zealand tax purposes.

Tax Administration Act 1994 provisions

New section 31B - information to be provided by portfolio tax rate entities to investors

Section 31B(1) and (2) outlines the requirement for a portfolio tax rate entity to provide information which the Commissioner considers relevant to zero-rated portfolio investors and investors with portfolio investor exit periods. This information will be needed by these investors to comply with their tax obligations for any income or loss allocated to them by a portfolio tax rate entity.

Section 31B(3) requires a portfolio tax rate entity to provide all other investors with information the Commissioner considers relevant for each income year by 30 June after the end of the income year.

Section 31B(4) requires a portfolio tax rate entity to give a notice to each investor in the entity, at least once each income year, requesting that the investor provide the entity with the investor's prescribed investor rate.

New section 36AB - portfolio investment entities to file returns electronically

Section 36AB requires the Commissioner to prescribe the electronic format in which a tax return must be provided by a portfolio tax rate entity or a portfolio investor proxy.

New section 57B - returns to be filed and annual reconciliation statements to be provided by portfolio tax rate entities and portfolio investor proxies

Section 57B outlines the return filing requirements and payment obligations for portfolio tax rate entities and portfolio investor proxies.

Portfolio tax rate entities or portfolio investor proxies that pay tax under section HL 21 must file a return in a prescribed form at the end of each calculation period.

The entity must also pay an amount equal to the portfolio entity tax liability to the Commissioner along with each return of income.

Portfolio tax rate entities or portfolio investor proxies that pay tax under section HL 23 must file a return in a prescribed form:

  • for investors with a portfolio investor exit period by the end of the month following the month in which the portfolio investor exit period ended;
  • for investors who hold portfolio investor interests at the end of the tax year by the end of the month following the end of the tax year.

Portfolio tax rate entities that pay tax under section HL must perform the responsibilities of a provisional taxpayer under the provisional tax rules.

All portfolio tax rate entities and portfolio investor proxies must file an annual return in a prescribed form showing the income tax paid for the tax year and any other information the Commissioner considers necessary. The return must be filed by 30 June.

Consequential amendments

Consequential amendments have been made to:

  • section 139A(2)(a)(iii) to extend the late-filing penalties rules to returns filed under section 57B by portfolio tax rate entities and portfolio investor proxies; and
  • section 139AA(2) to apply the non-electronic filing penalty to portfolio tax rate entities and portfolio investor proxies that do not furnish returns in a prescribed electronic format.

 


Date published: 08 Nov 2006

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