Snapshot of tax developments affecting banks in New Zealand
Banking on Tax, Issue 8
There has been some tinkering around the edges of banking taxation in New Zealand. These changes could be sold as wholesale changes, but the reality to date appears to be ‘business as usual’. We have provided a snapshot of some recent tax changes and challenges in New Zealand.
The most direct tax change for banking has been in the interest apportionment rules (i.e. thin capitalisation). As outlined in Banking on Tax #4 (July 2011, in the article entitled, “New Zealand banking thin capitalisation changes”), the minimum capital ratio has been increased from 4% to 6% of risk-weighted assets from 1 April 2012. Most locally incorporated banks won’t be affected by this as their ‘post-GFC’ capital strength is likely to be in excess of the increased minimum capital ratio. However, this change may affect New Zealand branches of non-New Zealand banks, particularly if those banks manage their branch capital in accordance with these ‘bright line’ tests.
The current thin capitalisation rules are aligned to a more traditional (and restrictive) definition of share capital than is contemplated under current regulatory definitions and Basel III. Unfortunately, there does not appear to be any current desire to align the thin capitalisation methodology with capital for regulatory purposes. Alignment is a recommendation of the industry which we agree with and suggest it should be considered as part of the industry’s response to understanding and working through the Basel III tax challenges.
Basel III is expected to apply to New Zealand banks from 1 January 2013, with a phased approach and in a form that has slight modifications from the New Zealand Reserve Bank.
From a tax perspective, the main area of interest is the definition of the new levels of capital. Deductible “core” tier one capital may no longer exist. The focus going forward is to understand how the new “additional tier one capital” and “tier two capital” hybrid instruments might work for the bank. There has been increased focus on overseas examples of certain instruments, often called ‘Cocos’ (contingent convertibles). Such instruments need to be carefully worked through, both from a tax and a regulatory perspective.
To qualify under Basel III, among other things, a ‘loss absorbing’ feature will need to be included in the terms of certain instruments. This is usually a ‘conversion into equity’ feature or a ‘write-off’ feature. The European banks and their regulators have debated these. A particular concern has been where that feature gives rise to a tax liability when triggered. The consequence being, that if it does, the deferred tax liability should be deducted from the amount of qualifying capital on issuance of the instrument. This same debate is likely to be significant in New Zealand as banks review and redesign their capital strategy. The arguments for and against this are complex. However, some would argue that in a stressed scenario, the bank will have significant losses and it is illogical to suggest that a deferred tax liability will become an actual tax liability. Today more than ever, tax is becoming a bigger piece of the capital jigsaw and banks will need to take care.
The New Zealand Reserve Bank has also set out grandfathering guidance for existing instruments, which will need to be worked through in detail.
Foreign investor portfolio investment entities
Foreign investor rules have been introduced into the New Zealand portfolio investment entity (PIE) regime, with effect from the 2012-13 income year. From a capital perspective, this will be relevant for those banks that have raised capital in the New Zealand market, or helped others to, using the PIE rules. However, these changes will also be relevant to banks more widely, potentially offering new product opportunities.
The aim of these changes is to reduce the disincentive for foreign investors investing in PIEs. For a PIE that only has non-New Zealand-sourced income, this regime will give rise to an effective tax rate of 0% for the foreign investor. For a PIE that has New Zealand-sourced income and is within the regime, the amount of tax that is suffered will depend on the type of income:
- 1.44% for financial arrangement income, being the approved issuer levy (AIL) rate of 2% after tax
- 15% or 30% for unimputed dividend income, depending on whether a double tax agreement would apply to the investor
- 0% for fully imputed dividend income or non-New Zealand-sourced income.
Few financial institutions appear to be embracing these changes yet. However, we expect that this will change as the industry and opportunities evolve.
0% approved issuer levy
Another welcome relaxation of barriers to foreign capital has been the expansion of the New Zealand AIL rules. AIL is a 2% levy on interest that is paid to a non-resident that isn’t associated with the payer. This was an incentive for foreign investment, as non-resident withholding tax on interest is reduced to 0% if AIL applies. This incentive has been extended further for certain ‘widely held’ securities, reducing the AIL rate from 2% to 0%, from 7 May 2012.
This change should be a more straightforward alternative to complicated offshore capital raisings to mitigate AIL and non-resident withholding tax. However, there are some limitations to qualifying which need to be carefully considered. One limitation is an inability to raise debt in a currency other than New Zealand dollar. Nonetheless, there may still be ways to achieve this with a good hedging strategy.
Custodian withholding tax
An issue has arisen for a number of institutions that perform a custodian role for non-resident shareholders of New Zealand companies. The issue is that if there is no system in place, the underlying company or share registry will not know whether the shares are held for a non-resident or a resident shareholder when calculating its withholding tax obligations in respect of dividends. There is a risk that the dividend payer will wrongly assume the New Zealand resident custodian is a New Zealand resident dividend recipient for tax purposes.
This can be an expensive lesson for custodians, as the withholding tax liability can fall on the custodian. It can be a real cost if the custodian has already paid the dividend on to the recipient, assuming that the company/registry has made the correct deductions.
The implications can also flow through to the New Zealand foreign investor tax credit (FITC) regime, which requires a dividend payer to pay a supplementary dividend in order to be able to access the regime. Where non-resident withholding tax is payable on the dividend and FITC is not accessed by the dividend payer, this will effectively result in double taxation for foreign investors.
Putting in place processes to manage this can be difficult. Where possible, we recommend proactively interacting with companies or registries around their dividend information date (or having a system to do this), and including this as part of your tax management plan as an area for rolling review and testing.