Chapter 6 – Extension of tax credits to foreign direct investment

6.1 Introduction
6.2 Objective of the proposed extension of the FITC regime
6.3 Compliance costs of the extension
6.4 Fiscal costs of the extension
6.5 Implications for the branch profits tax
6.6 Conclusion

6.1 Introduction

This chapter covers:

• the objectives of extending the FITC to foreign direct investors;
• the fiscal cost of the extension; and
• the consequent change to the tax rate applying to branches of non-resident companies.

6.2 Objective of the proposed extension of the FITC regime

The FITC is a useful tool for reducing tax-related distortions in cross-border capital flows, consistent with the objectives in Chapter 2. This is because the FITC simultaneously:

• reduces the pre-tax rate of return required by foreign investors for them to place their capital in New Zealand;
• reduces the differential between the tax rates on foreign and domestic investment in New Zealand; and
• applies only where and to the extent that, the company actually pays New Zealand tax.

As mentioned in the Overview, at the time of the introduction of the FITC, the Government decided that it should initially apply only to foreign portfolio investors (that is, those owning less than 10% of a company). The Government said it would consider later whether the FITC regime should cover foreign direct investors.

The deferral was to allow time for further consideration of the complex economic and taxation issues surrounding foreign direct investment. For example, direct investors are more likely to be able to claim credits for company tax against their home tax liabilities, which could mean that levying both company tax and NRWT in New Zealand does not increase their final tax liabilities. Such investors may also be able to reduce their tax liabilities through measures such as thin-capitalisation and abusive transfer-pricing. The current proposal is to extend the FITC in tandem with the other reforms in this package.

Overall, the Government believes that extending the FITC to foreign direct investment now will reduce the total tax burden on such investment. This benefit will flow through to a reduced cost of capital for New Zealand firms, thereby lowering costs to businesses operating in New Zealand and increasing investment and employment.

Accordingly, the Government proposes to extend the FITC mechanism to foreign direct investment. This will involve a straightforward amendment to s.308A of the Act to remove references to portfolio investor status.

6.3 Compliance costs of the extension

Essentially, extending the FITC will have a neutral to positive effect on compliance costs for firms. Firms must already identify foreign investors for the purpose of withholding NRWT and foreign portfolio investors for the purpose of the existing FITC. If this proposal becomes law, firms would no longer have to separately identify direct investor shareholders (by the size of their shareholdings), thus saving that minimal compliance activity.

6.4 Fiscal costs of the extension

Extending the FITC would have a direct effect on tax revenue. The estimated additional annual revenue cost would be $60 - $70 million. Most of this reduction would be expected to flow through to businesses by way of reductions in their cost of capital. The resulting additional activity and profits generated from that activity would be expected to generate revenue, although it is not possible to determine the extent of the gain.

6.5 Implications for the branch profits tax

For DTA countries, the FITC will give portfolio and direct investors a maximum effective New Zealand tax rate of 33% on underlying company income. This is lower than the tax rate currently applying to branch operations of foreign companies.

Extending the FITC to foreign direct investors therefore also requires an adjustment to branch taxation. This is to restore equality in New Zealand taxation - the rationale for the current regime - between:

• the maximum rate for non-branch equity investment from DTA countries; and
• the single rate for branches.

When the FITC was introduced, it did not require any change to branch taxation because the branch structure is a substitute for direct, rather than portfolio, investment.

The Government therefore proposes to reduce the rate of tax on the New Zealand branch income of non-resident companies from 38% to 33%, coincident with the extension of the FITC. The estimated annual revenue loss is $5 million.

6.6 Conclusion

The Government proposes to:

• extend the FITC to cover all foreign investors; and
• correspondingly, reduce the tax rate on branch profits of non-resident companies from 38% to 33%.

This reform will involve simple technical changes to existing legislation, with minimal, if any, effects on compliance costs. It will benefit the New Zealand economy by increasing the attractiveness of New Zealand to foreign investors and reducing the cost of capital to New Zealand firms. This regime is consistent with the trend over the past decade toward eliminating differential tax treatments that are based on the type of investment or the nature of the investor.

The FITC mechanism also recognises that New Zealand is a small open economy, drawing on and investing in, a global economy. Any distortions the tax system introduces into interactions between New Zealand and the global economy can significantly affect New Zealand’s overall economic performance.

The extension of the FITC regime would apply from the date on which amending legislation is enacted, which is expected to be in the second half of 1995. It is proposed that the removal of the branch profits tax would take effect from the start of the 1996-97 income year.