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Inland Revenue

Tax Policy

Chapter 2 – Policy framework

   Ways of earning income
   Taxes on Non-residents
   Taxes on residents
Taxation of residents in practice
   The CFC regime
   The FIF regime
Directions for reform


The international tax policy outlined in this paper is a key element of the Government’s fiscal and economic plans.

The Government’s objective is to shift the New Zealand economy from a slow-growth to a high-growth track.

To grow, New Zealand needs investment. Much of the funding required to finance that investment will come from overseas.

A credible fiscal plan is one of the necessary conditions for achieving long-term growth. The 1991 Budget sets out a clear plan to bring Government expenditure and revenue into a sustainable fiscal position.

To maintain that fiscal position, the tax system must continue to be able to raise revenue effectively. However, the Government needs to consider more than just the revenue raising potential of various taxes.

Taxes on residents’ offshore incomes should be designed to ensure that capital flows to where it will produce the highest yield for all New Zealanders. If this is done effectively, the taxes should raise revenue directly and inhibit residents from locating their income outside of New Zealand to knowingly or unknowingly take advantage of lower or less effective tax structures elsewhere.

Taxes on non-residents should be designed to raise revenue without raising interest rates or barriers to the foreign funding for investment that New Zealand needs to grow and without risking serious erosion of the New Zealand tax base. New Zealand needs to be an attractive destination for quality investment: investment that will improve the New Zealand skills base, raise productivity and encourage an outward-looking business focus.


New Zealand’s international tax regime encompasses:

  • domestic laws defining New Zealand residence
  • domestic laws defining New Zealand-source income
  • taxes on the foreign-source income of New Zealand residents
  • taxes on the New Zealand-source income of non-residents
  • double tax agreements (DTAs) with other countries.

The two key questions discussed in this paper are:

  • How should New Zealand tax non-residents who earn income in New Zealand?
  • How should New Zealand tax residents who earn foreign-source income?

Of special significance is the taxation of income both resident and non-resident individuals earn through separate legal entities like companies.

Ways of earning income

Individuals can earn income directly or indirectly through a company or other legal entity.

Direct income includes dividends from companies, interest from bank accounts and wages and salaries.

New Zealand taxes direct foreign-source income of residents in much the same way as such income earned domestically, although New Zealand often gives a credit for any taxes paid to foreign governments.

For example, interest earned from a bank account in a foreign country is taxable in the hands of a New Zealand resident in the same way as interest from local banks is taxed. However, New Zealand would provide a credit for any NRWT paid to the foreign government in question.

Likewise, New Zealand taxes the income that non-residents earn directly in New Zealand.

For example, it applies non-resident withholding tax on interest, royalties and dividends paid to non-residents.

Income earned indirectly through separate legal entities poses special taxation problems. This is because, legally, an individual and a company they own are not the same. Therefore, income earned by a company is not usually regarded as income earned by the individual.

The individual shareholder, however, does expect to ultimately benefit from the income earned by the company. They can receive this benefit through either the payment of dividends by the company or by selling shares in the company.

Domestically, the company tax is used to ensure that individuals cannot escape tax by earning income through companies.

New Zealand’s imputation credit system allows residents to claim credits for New Zealand company tax against personal income taxes on dividends where that company is a New Zealand-resident company. The combination of company tax, personal income tax, and the imputation system ensures that resident shareholders are taxed on both the retained and distributed income that they earn through resident companies.

New Zealand cannot, however, apply its company tax to income earned through overseas companies or funds owned by its residents. To the extent that it seeks to tax this income, New Zealand must tax individuals themselves on the income they earn through such vehicles.


Developing international tax policy depends on understanding the inter-relationships between international taxation, domestic taxation and the domestic economy.

Taxes on non-residents

This section presents an analysis of the taxation of non-residents. The examples given are stylised to bring out the key points. Specific directions for change to specific parts of the current taxation regime are discussed in Chapter 3.

The taxes that New Zealand imposes on non-residents earning income in New Zealand can, while raising revenue, increase the cost of capital (including domestic interest rates) to all New Zealand businesses.

This is because New Zealand has an open economy and is largely a price taker in world capital markets.

For example, consider foreigners deciding whether to invest $1,000 in domestic bonds issued by their own country or in New Zealand bonds. If they could earn $100 (i.e. 10%) from the domestic bonds before home taxes, they would, all other things being equal, require the same return after New Zealand taxes before they would buy the New Zealand bonds.

If New Zealand imposes a 15% tax on interest paid to foreigners, then New Zealand issuers of bonds would have to pay $117.65 to the foreigner to induce them to buy New Zealand bonds. That is, the before-tax interest rate paid to foreigners would be 11.765%, while the rate would be 10% after New Zealand taxes.

In other words, the post-New Zealand tax rate of interest the foreign lenders receive is the same, regardless of the tax New Zealand imposes. The tax is not in fact borne by the foreigner. It is borne entirely by the New Zealand borrower in the form of higher interest rates.

Moreover, because bond markets are open to both local savers and foreigners, the bond issuers would have to offer a return of 11.765% to all purchasers of the bonds. This would have the effect of raising all interest rates in New Zealand.

Accordingly, imposing a tax on foreigners, while raising revenue (in this example $17.65), also imposes an indirect cost on New Zealand residents in the form of higher interest rates, which will tend to lower investment and real wages.

A similar argument applies, with some qualifications, to the returns to equity capital. That is, applying a tax on dividends paid to non-residents would require New Zealand firms to pay higher dividends to their non-resident shareholders to compensate for the New Zealand tax.

Increasing productive investment is a key part of the Government’s economic strategy. Foreign capital can play a vital role in financing the productive investment that New Zealand needs to grow and prosper.

In general, therefore, New Zealand should reduce the taxes imposed on non-residents. This would benefit borrowers from domestic financial institutions as well as borrowers from overseas.

There is, however, one qualification to this general rule, which concerns the tax treatment non-residents receive from their home governments.

New Zealand’s double taxation treaties are intended to co-ordinate New Zealand’s tax system with those of its treaty partners. They can help to improve the economic impact of those tax systems and reduce tax compliance and administrative costs.

Tax treaties often involve a system of foreign tax credits. That is, in return for both parties agreeing to impose lower rates of NRWT, they agree to give a credit for each other’s NRWT against the taxes they impose on their own residents’ foreign-source income.

Such credits allow New Zealand to raise revenue from NRWT (albeit at a lower rate) without increasing the cost of capital.

This leads to the conclusion that New Zealand might wish to lower some taxes on non-residents, except in the context of bilateral arrangements to tax non-residents with an offsetting credit.

However, before this (or any) final decision can be made on the taxation of non-residents, it is necessary to explore the wider implications of such a decision.

Taxes on residents

There is a close link between the taxation of non-residents’ New Zealand-source income and the taxation of residents’ foreign-source income. Thus, the question of taxing residents on their foreign-source income needs to be considered in conjunction with the taxation of non-residents and decisions on the two integrated.

Economic costs would result and the domestic tax base would be eroded if residents were able to use the lower taxes levied on foreign investors to reduce their New Zealand tax liability[1].

Consider the example in the previous section of foreigners buying New Zealand bonds. Suppose that New Zealand chooses not to tax non-residents. In that case, a New Zealander could receive 10% before New Zealand tax on New Zealand bonds. After a 33% New Zealand income tax, the rate of return falls to 6.7%. However, there are a number of ways that a New Zealander could receive 10% rather than 6.7%.

First, they could become a ‘tax exile’ by ceasing to be a resident of New Zealand while still having New Zealand-source income. They would receive the same 10% return after New Zealand taxes as foreigners, for the same reasons. This is not a significant policy concern, as the costs of becoming a tax exile usually mean that this is not a viable proposition.

Secondly, they could remain a resident, but interpose a non-resident legal entity like a company or a trust that is not subject to New Zealand tax between themselves and the New Zealand source of their income. (This, in essence, is what ‘Island run-around’ tax avoidance schemes used to involve.[2]) The company would earn 10%, because it is a non-resident and, therefore, not subject to New Zealand tax. The person could defer paying New Zealand tax by accumulating the interest, tax free, in the company. Alternatively, they could repatriate the income tax-free, for example by way of a tax-exempt capital gain.

Arrangements such as this would have a limited effect on investment or employment in New Zealand. However, as they have in the past, they would lead to substantial erosion of the New Zealand tax base.

Finally, the person could remain a resident, but divest themselves of their New Zealand-based assets in favour of offshore assets which may be less productive from New Zealand’s viewpoint, but which are subject to lower New Zealand taxes. The incentive to do this would arise if the foreign-source income of residents is subject to a lower rate of New Zealand tax than domestic-source income.

Such divestiture of assets is undesirable for a number of reasons.

It results in New Zealanders undertaking investment which yields New Zealand a lower return even though it is more profitable for the individual concerned.

Although the investment that New Zealanders no longer undertake will be partially replaced by foreign investment, it is unlikely to be fully offset. This has an obvious impact on the associated jobs and real wages in New Zealand.

The New Zealand tax base would also shrink. The higher tax rates required to recover this tax base erosion will themselves have an adverse impact on investment and encourage further erosion of the base.

In short, not taxing residents on their offshore income has much the same effect as not taxing a particular sector of the domestic economy. That is, it produces investment decisions that are, either knowingly or unknowingly, made for tax rather than commercial reasons and can directly or indirectly reduce tax collections.

However, if the Government could put in place a robust regime for taxing residents on their foreign-source income, it can have low taxes on non-residents (with the lower interest rates and higher real wages that implies) without either risking erosion of the tax base by residents or inducing them to invest offshore.

Taxation of residents in practice

Low taxes on non-residents are important to the Government’s employment and growth objectives. However, pursuing that policy goal while exempting New Zealanders’ foreign-source income would have severe adverse economic and revenue impacts.

This means that foreign-source income should be taxed unless the compliance and administrative costs outweigh the economic and revenue effects of not doing so. At the same time, New Zealand’s experience suggests that taxing all such income is impractical.

In the New Zealand context, the most comprehensive way of taxing all foreign-source income would be to tax residents on all the income they earn directly offshore, to remove the ‘grey list’ and control tests from the CFC regime, and allow residents a deduction for foreign taxes when calculating their CFC income, rather than the current credit.[3]

It should be stressed that the Government is not advocating this extreme position.

Such a regime would be past the point where the benefits of taxation (in terms of revenue and business behaviour) are offset by compliance and administration costs.

The Government will not put in place tax structures where compliance and administration costs are larger than the benefits.

The key question in addressing the taxation of residents’ foreign-source income is the design and scope of the CFC and FIF regimes.

The key policy issues for these regimes are discussed below. Options to change the detailed design of the regimes are presented in Chapter 4.

The CFC regime

The desirable scope of the CFC regime involves judgements about the trade-off between compliance costs and the consequences of exempting some forms of income from tax.

If some income is exempt from tax, other types of income need to be taxed more heavily. Thus reducing taxes on the people who earn income through CFCs involves a higher tax burden on those who do not.

As discussed above, not taxing some sorts of income while taxing others will encourage people to earn the less heavily taxed income, even if that results in a lower yield to all New Zealanders.

Exempting income also increases the ability of taxpayers to avoid tax more generally by converting their income into the exempt form.

The operation of the ‘grey list’ in the CFC regime means that most offshore income is exempt from New Zealand tax and thus the regime does not impose any compliance costs on that income.[4] However, the CFC regime does prevent the worst forms of abuse. For example, ‘Island run-arounds’ are now very difficult, if not impossible, to implement effectively.

The Government considers that it will be necessary for a robust CFC regime to remain in place. It will consider easier ways of calculating CFC income for those to whom the regime does apply. Options are discussed in Chapter 4 below.

The FIF regime

A tax regime is required to protect the tax base from New Zealanders diverting their savings to overseas investment vehicles that they do not control. As noted above, this need becomes even greater if the Government has low effective taxes on non-residents.

The FIF regime is intended to serve this purpose.

The difficulty with all FIF-type regimes is the lack of control exercised by investors. This means that the method of calculating tax must not require detailed records of the fund’s underlying activities.

In New Zealand’s case, the method chosen was ‘comparative value’, which includes an element of taxation of accrued but unrealised (and potentially unrealisable) income.

The FIF regime has a greater anti-avoidance focus and hence a narrower target than the CFC regime. The CFC regime applies to all companies outside the ‘grey list’, while the FIF regime is limited to those funds that have the most potential for tax avoidance and deferral.

While the Government considers that the basic form of the FIF regime should stay in place, the regime can and must be improved.

The comparative value method can result in a different tax treatment compared with domestic taxation of similar investments. This is because comparative value is only a proxy for the domestic company tax and personal income tax systems.

It may also tax returns not taxable under domestic rules, for example genuine unrealised capital gains. This could only be justified if no other practical alternative is available.

There are other difficulties with the FIF regime. The boundary of the FIF regime is often difficult to determine and, in some circumstances, the valuations required to calculate tax are almost impossible to obtain.

While some changes will be made to make the FIF regime easier to comply with, there must be in place a regime that adequately protects the New Zealand tax base.

Experience in New Zealand and overseas shows that countries without exchange controls will face accelerating erosion of the tax base if they do not have FIF-type regimes in place.

Details of the reforms of the FIF regime being considered are discussed in Chapter 4 below.

Directions for reform

The New Zealand Government has decided in principle that it will move to limit the taxes on income from capital it imposes on non-residents, while maintaining a comprehensive system for taxing residents on their world-wide income. In line with its general tax policy, it will seek to minimise the compliance costs of that regime.

Little change is envisaged in relation to the taxation of labour income.

In reaching this view, the Government has balanced the need to raise revenue, its desire to make New Zealand an attractive investment destination, its policy of securing low interest rates and the compliance costs that the various taxation options involve.

A strong revenue base is necessary for a sustainable fiscal position.

New Zealand needs foreign capital to finance the productive investment necessary for economic growth. Taxes on non-residents, while raising revenue, can increase the cost of financing investment by raising interest rates.

Low taxes on non-residents will both attract foreign capital to fund investment and contribute to low domestic interest rates.


1 The motive for behaviour that results in escaping New Zealand tax will normally be to achieve the best business deal. Because, other elements being equal, a reduction in taxation increases the return achieved, the investment with the lowest rate of tax will tend to be preferred. The individual may be entirely unaware of the tax implications. This is especially so with small savers. In this case, the relationship between the taxpayer’s motive and a reduced tax burden is indirect. In other cases, the taxpayer’s objective may be quite explicitly tax minimisation and the underlying investment may be largely unaffected, i.e. the taxpayer is motivated for some reason to invest in a project, and will do so in a way that reduces the level of tax incurred.

2 ‘Island run-arounds’ were tax avoidance schemes that developed in New Zealand in the period between the removal of exchange controls and the enactment of the Controlled Foreign Company (CFC) regime. Under a run-around, a New Zealand controlled company resident in a third country (often a Pacific island nation, hence the name) was interposed between a New Zealand resident and their New Zealand-source income. Because New Zealand did not tax the income that residents earned through non-resident companies, this allowed New Zealand residents to greatly reduce their lax liabilities. This experience was by no means unique to New Zealand. Similar schemes developed in other countries that removed exchange controls.

3 Allowing a deduction for foreign taxes treats such taxes like any other cost of business. Granting a credit implies that New Zealand should compensate taxpayers for foreign taxes paid. The deduction approach may be more appropriate from New Zealand’s point of view, since foreign taxes are a cost to the New Zealand economy as much as to the taxpayer - New Zealand does not benefit from the payment of foreign taxes. A credit provides no incentive for residents to reduce the level of foreign taxes, while a deduction does. If a deduction is allowed, reducing foreign taxes will increase returns to the investor after New Zealand taxes. If, however, a credit is allowed, reducing creditable taxes only results in an offsetting increase in New Zealand taxes. There is no increase in post-New Zealand tax returns to the investor. However, under its Double Taxation Agreements, New Zealand is obliged to grant a credit for certain foreign taxes.

4 The CFC regime does not apply to companies resident in Australia, the United Kingdom, the United States, France, Germany, Canada and Japan. The income New Zealanders earn through companies resident in these countries is only taxed by New Zealand when it is actually returned to New Zealand.