Chapter 7 - FIF interests of less than 20 percent
Summary of suggested changes
- A single set of rules will apply to all interests in FIFs of less than 20 percent.
- The accounting profits method will be repealed completely, and the branch equivalent method will not be available for FIF interests of less than 20 percent. (FIF interests of 20 percent or more will apply the active income exemption using a branch equivalent calculation.)
- The existing exemptions from the FIF rules for Australian companies listed on the ASX and certain venture capital investments made through grey list companies will be modified to apply to less than 20 percent interests in FIFs. Dividends paid from such FIFs will be subject to income tax.
- Portfolio shares that escape attribution under the $50,000 minimum threshold because they were inherited at nil value, will be subject to a deemed sale and reacquisition at market value.
7.1 The introduction of an active income exemption for CFCs and 20 percent or greater interests in FIFs provides the opportunity to look at the overall coherence of the rules covering investment by New Zealand residents in foreign entities. One of the main objectives of the reform is that the FIF rules should be easy for taxpayers and advisors to understand and operate.
Repeal of accounting profits and branch equivalent methods
7.2 There are currently six different methods for attributing income from FIF interests. These are:
- branch equivalent;
- accounting profits;
- comparative value;
- deemed rate of return;
- fair dividend rate; and
7.3 The active income exemption will replace the branch equivalent and accounting profits methods for FIF interests of 20 percent or more. The question that arises is whether either of these methods should be retained for FIF interests below 20 percent.
7.4 Most portfolio shareholders are focused on securing returns from an increase in share price or from dividend yields. In this context, the accounting profits and branch equivalent methods are not really appropriate as they are based on the company’s accounts rather than the shareholder’s investment return, and allow for losses.
7.5 Moreover, few taxpayers with interests of less than 20 percent use the branch equivalent or accounting profits methods for attribution. It seems that smaller shareholders have insufficient information to use the branch equivalent method and prefer not to use the accounting profits method even though accounts are frequently available.
Concessions for individuals
7.6 The rules currently applying to FIF interests of less than 10 percent distinguish between individuals and companies in certain respects, particularly the following.
- A $50,000 minimum threshold applies to an individual’s investments in foreign companies other than Australian-resident listed companies. If the original cost of these shares totals $50,000 or less, the FIF rules do not apply to the individual.
- Where an individual is using the fair dividend rate and the total return on their entire investment portfolio (dividends and capital gains) is less than 5 percent, then tax can be paid on the lower amount, with no tax payable when the total return is nil or negative. This outcome is achieved by allowing individuals (and family trusts) to switch freely between the fair dividend rate and comparative value methods in different income years.
7.7 It would be appropriate to extend these features to cover interests of less than 20 percent in a FIF.
Exemption for Australian companies listed on the Australian stock exchange
7.8 The existing FIF rules contain an exemption for a less than 10 percent income interest in an Australian company that is listed on the Australian stock exchange (ASX). It is suggested that this exemption be extended to cover less than 20 percent income interests in ASX-listed companies. This would ensure that a single set of rules applied to all interests in (non-CFC) FIFs of less than 20 percent.
Exemption for venture capital investment
7.9 The current rules covering FIF interests contain a special provision to cater for venture capital investments in New Zealand-resident start-up companies that migrate offshore to gain access to additional equity funding. The provision ensures that, provided certain conditions are met, New Zealand investors who acquired shares before the company migrated from New Zealand do not come within the FIF rules until the end of a 10-year exemption period.
7.10 A similar 10-year venture capital exemption applies to shares purchased in a grey list company that owns a New Zealand company. This variation is designed to cater for situations when shares in a grey list company are received in exchange for shares in a New Zealand-resident company.
7.11 The introduction of an active income exemption for 20 percent or greater interests in FIFs raises the question of whether the exemptions from the FIF rules for certain venture capital investments in the grey list in sections EX 36, EX 37 and EX 37B of the Income Tax Act 2007 should be limited to FIF interests of less than 20 percent. Ideally, these FIFs should be applying the active income exemption, as otherwise they could be used to shelter passive income. In most cases it should be reasonably practicable for investors with a 20 percent or greater interest in a venture capital FIF to access sufficient information to use the active income exemption. We are interested in feedback from the venture capital industry on this issue.
Taxation of dividends
7.12 As part of the earlier international tax changes, an exemption was introduced for most types of foreign dividends received by companies. However, as a general principle the foreign dividend exemption should not apply to dividends from an interest of less than 20 percent in a FIF that is not an attributing interest. Otherwise such investments would be more favourably taxed than attributing portfolio investments.
7.13 Accordingly, dividends from a less than 20 percent interest in a FIF (or a less than 10 percent interest in a CFC) described in sections EX 31 (Exemption for ASX-listed Australian companies), EX 32 (Exemption for Australian unit trusts with adequate turnover or distributions), EX 36, EX 37, EX 37B (Exemptions for certain venture capital investments made through grey list companies) or EX 39 (Terminating exemption for grey list company with numerous New Zealand shareholders) should be subject to tax when received by a company. All foreign dividends received by individuals are subject to income tax.
Inherited former grey-list portfolio investments
7.14 The treatment of portfolio interests (stakes of less than 10 percent) in FIFs changed from 1 April 2007. At that time, the grey list exemption for portfolio interests was repealed and it was intended those interests would be made subject to tax under – generally – the “fair dividend rate” rules. It has come to light that certain former grey list investments are still not subject to tax. Most commonly, this is because the investor has inherited the shares and claims they have a nil cost, which means they qualify for the $50,000 “de minimis” exemption from the FIF rules. It is not appropriate that these interests continue to be indefinitely exempt from tax. It is proposed that there will be a deemed sale and reacquisition of affected shares at market value. This amendment will have prospective effect.
Questions for submitters
When do small shareholders use the accounting profits and branch equivalent methods? Is there a strong case to keep these methods for FIF interests of less than 20 percent?
Are there other ways in which the FIF rules could be simplified?