Chapter 3 - Objectives of the Reform Measures
3.1 Introduction
3.2 The Issues at a Glance
3.3 Deficiencies in Existing Law
3.4 Objectives of Reform
3.5 Context of Reform
3.6 Impact of the Measures
3.7 Conclusion
3.1 Introduction
The purpose of this chapter is to briefly outline the deficiencies in New Zealand's existing international tax provisions and their consequences; the objectives for the reform of those provisions; why the reform proposals set out in this consultative document have been adopted and why they are more comprehensive than those proposed in the June 1987 Budget; and to address issues relating to the likely impact of the reforms.
3.2 The Issues at a Glance
The taxation of income earned by residents through offshore entities is manifestly in need of reform. New Zealand's existing international tax provisions are unable to counter the deferral or outright avoidance of New Zealand tax. The following observations sum up the problems.
There is blatant erosion of the tax base. Many large companies and wealthy individuals resident in New Zealand are avoiding and deferring New Zealand tax through a variety of offshore transactions. Such practices have become easy and routine.
The cost to New Zealand of tax abuse is high and growing. As the level of deferral and avoidance has become more widespread and the techniques more sophisticated, the New Zealand tax base has been seriously eroded. Such erosion amounts annually to hundreds of millions of dollars in forgone tax revenue - which must be raised from other sources.
Offshore investment is taxed more favourably than domestic investment. The exploitation of opportunities to defer or avoid New Zealand tax has resulted in investment being directed offshore rather than to more productive uses in New Zealand. Tax considerations are driving investment decisions. Consequently, the best use is not being made of New Zealand's scarce resources.
The cost is pervasive and ultimately borne by other New Zealanders. The fiscal and economic cost of the deferral and avoidance of New Zealand tax reduces the economic and social well-being of the nation. In this sense, the tax system imposes a greater burden on the community than is necessary. The impact is adverse for jobs, growth and living standards.
International tax avoidance is unfair. The ability of some taxpayers to defer or avoid New Zealand tax undermines perceptions about fairness and puts at risk the voluntary compliance of taxpayers on which the integrity of the tax system rests.
Desirable domestic reform is obstructed. A tax system that is vulnerable to international tax deferral and avoidance reduces the prospects for domestic tax reform. In particular, lower and more uniform rates of income tax are possible only if all taxpayers bear their fair share of tax.
3.3 Deficiencies in Existing Law
The fundamental deficiency in the tax system, which is at the heart of the issues identified above, is the lack of neutrality. In principle, residents are subject to New Zealand tax on their income derived from all sources - that is, their worldwide income. In practice, however, foreign income derived by residents is often not subject to New Zealand tax. Whether it is depends on whether the income is realised directly or realised indirectly through the use of interposed entities such as companies or trusts, and on whether it is earned in a country that levies high or low income taxes.
For example, residents of New Zealand may conduct business outside New Zealand through branches or separately incorporated subsidiaries. Branches are not considered to be separate entities and income derived by a foreign branch is included in the resident taxpayer's assessable income as it is realised by the branch. However, because a company is considered to be a legal and taxable entity separate from its shareholders, income derived by a non-resident company does not constitute income of the New Zealand shareholders until they receive dividends. Thus, New Zealand resident individuals and companies can defer New Zealand tax on foreign income simply by earning such income through a non-resident company. Moreover, resident companies may avoid New Zealand tax entirely because the dividends they receive from non-resident companies are exempt.
If the foreign taxes are lower than those in New Zealand, taxpayers can enjoy tax deferral advantages by realising income through a non-resident company or trust instead of directly. The income will not be taxed in New Zealand until repatriated and will not be taxed even then in the case of dividends received by a resident company.
The deferral or avoidance of New Zealand tax on foreign income earned through non-resident companies and trusts is unacceptable. It constitutes an incentive for foreign investment by New Zealand residents in countries with tax rates lower than those of New Zealand. It encourages the diversion of New Zealand income to non-resident companies and trusts. It benefits mainly large companies and wealthy individuals. More generally, it undermines the integrity of the tax system by permitting the New Zealand tax base to be easily eroded.
3.4 Objectives of Reform
The two major objectives guiding the Government's reform of the tax system are efficiency and equity. The best way to improve the efficiency and equity of New Zealand's tax system is to broaden the tax base and lower income tax rates. A comprehensive base with lower and more uniform rates will encourage investment decisions to be based on commercial rather than tax considerations. It will remove artificial incentives for taxpayers to invest offshore. Lower rates will serve to encourage all types of investment, business and income-earning activity. Lower tax rates are possible only if the tax base is broadened and avoidance is curtailed.
New Zealand's international tax regime should generally reflect the same principles of efficiency and equity embodied in the domestic tax system. In particular, the taxation of foreign income should reinforce the taxation of domestic-source income and prevent the erosion of the domestic tax base by international tax avoidance. Reform of New Zealand's international tax regime therefore requires measures which will ensure that all New Zealand residents are subject to tax on their worldwide income as it is earned.
More particularly, the objectives of the reform proposals contained in this consultative document are to ensure, as far as possible, that:
a foreign income derived by New Zealand residents is subject to New Zealand tax as it is earned, whether earned directly or indirectly through a non-resident company or trust;
b the bias in the existing tax system, which encourages foreign investment by New Zealand residents in countries with lower tax rates than those of New Zealand, is removed;
c opportunities for international tax avoidance, which erode the New Zealand tax base and undermine the New Zealand tax system, are eliminated;
d appropriate relief is provided for foreign taxes on foreign income earned by New Zealand residents;
e the complexity of the tax law and the attendant compliance and administrative costs are kept to the minimum necessary to ensure the effectiveness of the measures; and
f the reform proposals are compatible with the existing domestic tax system and with the thrust of future domestic reforms.
3.5 Context of Reform
The thrust of the reform proposals in this consultative document is the elimination of the avoidance and deferral of New Zealand tax on all foreign income derived by residents of New Zealand through non-resident companies and trusts. Consequently, these reforms differ in some important respects from those originally proposed.
The proposals outlined in the 18 June 1987 Budget were essentially anti-avoidance rules. They were directed primarily at the use of trusts and companies established in tax havens to earn passive investment income and limited types of business income. They applied only to non-resident companies controlled by, and trusts settled by, residents of New Zealand.
The proposals were modelled on anti-tax haven measures currently in effect in several capital-exporting countries. Such measures may be effective in limiting the use of tax haven companies and trusts to defer and avoid domestic tax, but they are narrow in scope, arbitrary and complex. They deal only with the worst forms of tax avoidance. They do not deal with the fundamental problem of the deferral of domestic tax on foreign income earned through non-resident companies and trusts.
The Government has decided a broadening of the tax base with respect to foreign income is required to permit cuts in the rates of income tax applicable to both individuals and companies. Accordingly, the task is to eliminate the avoidance and deferral of New Zealand tax on foreign income earned by residents of New Zealand through non-resident companies or trusts. Where a New Zealand resident has an interest in a non-resident company and can provide sufficient information about the company, the resident's share of the foreign income will be taxed as if it were derived from a foreign branch. Where the resident is unable to provide sufficient information, New Zealand tax will be levied annually on the change in value of the interest. A similar approach will be adopted with respect to non-resident trusts to which New Zealand residents contribute property. Further, there will be several consequential changes to the tax treatment of dividends received by New Zealand residents from non-resident companies and distributions received by New Zealand resident beneficiaries from non-resident trusts.
This approach has several advantages over the more limited anti-avoidance approach adopted by some countries. For example, under the measures proposed in this document it will be unnecessary to determine when a non-resident company is controlled by New Zealand residents; to distinguish between tainted and other income; or to determine whether a non-resident company is resident in a tax haven.
The new approach will significantly limit opportunities for international tax avoidance and protect the domestic tax base. Since the foreign income of non-resident companies will be subject to New Zealand tax currently, there will be little reason for New Zealand residents to divert income (whether in the form of transfer pricing, fees for services, royalties or interest) from New Zealand to a non-resident company.
Under the reform proposals, if a New Zealand resident has an interest in a non-resident company or trust, in many cases that interest will be treated, in effect, as if it were a foreign branch. Since the tax treatment of foreign branches is relatively straightforward, the reform proposals are simple in concept and should not involve undue legislative complexity. The alternative basis for taxing foreign income, the comparative-value basis, will require such interests to be valued each year.
The Government recognises that no other country has to date eliminated the deferral of domestic tax on foreign income earned through non-resident companies and trusts as completely as these measures propose. Nevertheless, they are fully justifiable as part of the Government's broad tax reform initiatives to expand the tax base and lower income tax rates.
3.6 Impact of the Measures
In developing the proposed reforms, the Government has considered their effect on new investment, on New Zealand firms operating offshore, on foreign countries, and on the existing investment of residents.
3.6.1 New Investment
The key impact of the proposed measures on new investment will be to remove artificial incentives for taxpayers to invest in low-tax jurisdictions, and to restore incentives for investment to flow to areas where it will provide the greatest returns for the nation as a whole. This is consistent with directing New Zealand's resources to their most profitable uses.
At present, however, some offshore investment by residents has a lower pre-tax return than alternative investment in New Zealand. Such investment is made because it has a higher post-tax return as a result of the avoidance or deferral of New Zealand tax. This is clearly an undesirable effect of the current law which the proposed measures will remedy. A likely consequence is more productive investment by New Zealand residents, both domestically and offshore, and a relative increase in domestic investment by residents.
3.6.2 New Zealand Business Offshore
It is sometimes contended that New Zealand businesses offshore should not be required to pay as much tax as they would in New Zealand to enable them to compete more readily in foreign markets. This contention carries little weight. A resident taxpayer should not pay less New Zealand tax simply as a result of investing offshore in a particular legal form (ie a non-resident company or trust).
The implicit subsidy in the existing tax system for foreign investment in countries with tax rates lower than those of New Zealand is inefficient and inequitable. The proposed reforms will eliminate this aspect of our tax system.
Much offshore investment is not primarily tax-motivated. New Zealand companies are attracted to invest offshore for such reasons as proximity to markets, availability of natural resources, access to particular goods and services, and the like. The proposed measures will have little impact on these investments where they yield high pre-tax returns. The measures will, however, adversely affect offshore investments that have been made primarily for tax reasons.
3.6.3 Other Countries
Some countries may be adversely affected by New Zealand's moves to counter the avoidance and deferral of domestic tax by its residents. For example, if a foreign country provides significant corporate tax concessions in order to attract investment, those concessions may be less effective in eliciting investment from New Zealand as a result of the proposed reforms. Where foreign taxes are very low, reductions in the foreign tax of a company owned by New Zealand residents will simply be replaced by the domestic tax payable on such income according to the rules proposed in this document.
However, there will be some benefits for foreign countries arising from New Zealand's tax reforms. For example, the lowering of the New Zealand company tax rate will mean that the return which non-residents can obtain from investment in New Zealand will increase. The anti-avoidance measures will also make it more difficult for non-residents to enter into tax avoidance arrangements via New Zealand to exploit the tax systems of their own or other foreign countries.
3.6.4 Existing Investment
The effective date of the reform proposals for undistributed income is 1 April 1988, which provides taxpayers with a reasonable opportunity to reorganise their affairs if necessary. Although there may be costs for some investors who have entered into arrangements which cannot be altered, the Government has decided that no special relief can be justified. All tax policy changes create winners and losers, as do economic policy changes in general. New Zealand is currently undergoing a period of substantial and necessary economic adjustment. The long-term benefits of economic reform will be shared by all New Zealanders.
3.7 Conclusion
Significant reform of New Zealand's international tax provisions is urgently required. Such reform is a key element in the Government's overall programme of tax reform. In particular, the ability of the tax system to afford lower rates of income tax depends in large measure on a comprehensive tax base, and international tax reform is essential to ensure that all New Zealand residents pay tax on their worldwide income.
The measures proposed in this consultative document will strengthen New Zealand's international tax regime against widespread tax avoidance techniques and arrest the erosion of the domestic tax base. At the same time, the new measures will reduce the bias in the tax system in favour of foreign investment by New Zealand residents. The nature of the problems involved suggests, however, that results will not be achieved through any single set of initiatives. Rather, results will depend on a continuing reform of tax provisions on a broad front. The overriding concern must be to ensure that New Zealand's tax system adjusts as necessary, so that the nation secures the maximum benefit possible from international investment and income flows. The measures proposed in this document are compatible with this longer-term direction.