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Foreign superannuation schemes - Proposed changes a step in the right direction

Author: Ian Fay and Kirsty Hallett

On 24 July 2012, the Inland Revenue released an Officials’ issues paper entitled ‘Taxation of Foreign Superannuation’ seeking feedback on proposed changes to simplify the tax treatment of foreign pensions and superannuation schemes.  The proposed changes are to apply with effect from the 2012 income tax year (i.e. from 1 April 2011).

The issues paper proposes a new regime where taxpayers would only need to consider whether they have New Zealand tax to pay on their superannuation when they receive a pension payment or lump sum, or when superannuation entitlements are transferred to another scheme.  The Foreign Investment Fund (“FIF”) rules would no longer apply.

The proposed rules also address a number of implementation and transitional matters including:

  • withdrawals and transfers of foreign superannuation made between 1 January 2000 and 31 March 2011; and
  • Taxpayers who have declared income in respect of the foreign superannuation scheme under the FIF rules for the 2011 or earlier income tax year.  Under the proposed rules these taxpayers would continue to apply the FIF rules and would not be subject to the new regime.

The proposed changes will have a significant impact on the way foreign pensions are taxed going forward.

The Need for Change

The current rules for taxing interests in foreign superannuation schemes are complex.  They require the consideration of the FIF regime, the trust regime and the dividend rules.  Depending on the legal form of each investment, taxpayers with an interest in a foreign superannuation scheme can end up applying significantly different tax treatment to their interests.    

Given the complexity of the rules there is a lack of awareness and confusion regarding how the rules apply resulting in a significant degree of non-compliance and inconsistent application of the rules.

How will the New Regime Work?

Under the proposed new rules, an individual with a foreign pension scheme will only be liable for New Zealand tax on receipt of a pension payment or lump sum payment from the scheme, or when the superannuation is transferred to another scheme.  That is, going forward the FIF rules will no longer apply to tax individuals on an accrued or deemed income basis; rather individuals would be taxed on a receipts basis which would help to align cash flow with the resulting income tax liability.

More specifically:

  • Taxpayers who receive a pension payment would be taxed at their individual marginal tax rate (ranging from 10.5% to 33% depending on their income profile).  This aligns the treatment going forward with the treatment many taxpayers have adopted in practice in the absence of professional advice.

  • A lump sum withdrawal or a transfer to another scheme would be taxed depending on how long the taxpayer has been in New Zealand before the withdrawal or transfer.  This is called the inclusion rate approach.  Under the proposed regime only a portion of the lump sum would be included as taxable income in an individual’s return and income tax would be calculated on the income at the individual’s marginal income tax rate. The remainder would not be taxable in New Zealand. 

    The portion of the lump sum which is included as income in a taxpayer’s return is directly linked to the period the individual has been a New Zealand tax resident prior to receiving the sum.  The proportion of the lump sum to be included as taxable income would range from 0% (where the sum is received during the first two years of New Zealand tax residency" [1] to 100% (where the transfer is made after being tax resident in New Zealand for 25 years or longer).

    It is proposed that the inclusion rate will apply to the amount of the lump sum distribution/receipt after deducting the value of contributions made while the individual is New Zealand tax resident, provided the contributions have been subject to New Zealand income tax.

  • The transitional resident rules would continue to apply as they currently do and as such transitional residents will retain a 4 year window to withdraw their funds/ transfer them to another scheme without incurring a New Zealand tax liability on the receipt of the funds/value of the transfer.

One aspect of the proposed rules which Officials acknowledge requires further consideration is in respect of the tax treatment of transfers from a foreign superannuation scheme to another scheme or annuity.  The rules as currently drafted impose a New Zealand tax liability under the inclusion rate approach at the time the funds are transferred/distributed from the scheme.  However, many schemes have restrictions in place around the transfer to ensure that the full value of the sum being transferred must be deposited into another scheme and locked-in on similar terms until retirement.  As such it will not be possible for many taxpayers to access the cash to meet the resulting tax liability which may give rise to cash flow issues for taxpayers. 

Views on this aspect are particularly welcomed by Officials.  Options could include placing an obligation on the fund the lump sum is transferred into to meet the liability, although this may not meet the lock-in requirements of the country from which the funds are transferred, or deferring the liability until the funds are accessible. 

Our Views
As a general comment we consider the proposed changes are a move in the right direction and should address a number of the issues/difficulties we currently see with applying the FIF rules to foreign superannuation schemes.  In particular where a pension or lump sum is received the proposed regime better aligns cash flows and foreign tax credits with the resulting tax liability which should ease some cash flow difficulties taxpayers can experience under the current regime.

The proposed rules certainly simplify the tax treatment of foreign superannuation schemes considerably.  Having said that, do they go too far?

While we do like the simplicity of the inclusion rate approach, which as currently proposed applies to “brackets” of years as opposed to requiring taxpayers to apply a formula to work out how much income should be included in their return based on the specific period of their residency (e.g. calculated on a days or monthly basis), it is likely to create distortions and tax planning opportunities for those financially aware.  For example, it may be more beneficial to transfer funds on the last day of a bracket to take advantage of the lower inclusion rate than the first day of the bracket. 

In addition, where taxpayers receive a pension it is taxed in full on receipt.  There is currently no mechanism proposed to recognise the capital contribution to the scheme.  For example a New Zealand resident continues to contribute to the foreign superannuation scheme during the period of their employment in New Zealand.  These contributions are made from after-tax earnings.  Upon retirement the taxpayer receives an annual pension and will once again pay tax on this pension at their marginal income tax rate.  This pension will include a distribution of capital contributions (i.e. the individual’s contributions to the scheme along with the investment gains).  Given this, we would like to see an option introduced to ensure taxpayers are only taxed on investment gains.  This calculation could be done at the time of receipt to ensure consistency in the timing of the application of the rules across all taxpayers.

It is also worth noting that most New Zealand retirement savings vehicles and particularly KiwiSaver schemes are Portfolio Investment Entities, and as such taxpayers pay tax on investment gains within the schemes at a maximum rate of 28%.  Consideration should be given to capping the rate at which individuals pay tax on distributions/receipts from foreign superannuation schemes to better align the treatment with New Zealand schemes and other investment vehicles. 

Transitional Matters – Fraught with Issues
It is clear Officials have approached their review of the regime with one main goal clearly in mind -   Simplicity.  However, there are a number of implementation and transitional issues with the proposals that need to be addressed prior to the new rules being introduced. 

Grand-parenting of the FIF Rules
As the rules are currently proposed, where people have complied with the FIF rules during the 2011 income tax year or an earlier year and have disclosed FIF income in their income tax returns, Officials' view is that it is not appropriate to require these people to pay additional tax on the receipt of the income (i.e. when the lump sum or pension is received).  As such these taxpayers are required to continue to apply the FIF rules to their foreign superannuation schemes going forward and the new regime will not apply.   This may leave taxpayers who have complied with their obligations in the past worse off as compared to taxpayers in similar circumstances who have previously ignored or been unaware of their obligations (discussed further below).  It would seem Officials have made an implicit assumption that these taxpayers will all be better off continuing to calculate income in accordance with the FIF rules on an annual basis.  We do not share this view.

We appreciate that Officials are trying to keep the rules simple and do not wish to introduce complexity unnecessarily however we are strongly of the view that these taxpayers should have the option to apply the new regime going forward, with some recognition of the tax already paid by complying with the FIF rules to date. 

Amnesty for past non-compliers
Officials are aware that a number of taxpayers have withdrawn funds from a foreign superannuation scheme and have not declared the income resulting from the transaction in their income tax return. 

As part of the proposed rules, Officials are proposing a grace period until 1 April 2014 for taxpayers who have withdrawn funds from a foreign superannuation scheme during the period 1 January 2000 to 31 March 2011 and not complied with their obligations to disclose the transactions to Inland Revenue and pay the requisite tax.  These taxpayers will have the option to either apply an inclusion rate of 15% (regardless of the length of time the individual has been tax resident in New Zealand) or to apply the rules which applied at the time. 

Where an individual chooses to apply the inclusion rate methodology no interest or penalties will be imposed.  If a taxpayer chooses to apply the rules which applied at the time the distribution was received Inland Revenue will have discretion to remit penalties on a case by case basis. 

This is not the right policy outcome and amendments are required to these rules to address the current situation.  Many taxpayers who are currently under the FIF regime would welcome the new rules and would rather be taxed on a receipts basis. 

Officials state that the purpose of this proposal is to “ensure that all people are treated fairly, including those who have paid the appropriate amount of tax, and as well as ensuring that new migrants who may not have been aware of the rules at the time they withdrew their superannuation are not unfairly disadvantaged”.  Given the intent behind the proposal is fairness we would like to see Officials amend the proposal to apply no use of money interest or shortfall penalties where a tax payer makes disclosure and not limit the non-application of penalties to taxpayers who choose the inclusion rate option.

Retrospective Application of New Rules
The retrospective application of the proposed new rules causes concern and not only because it is incredibly poor from a policy perspective to apply a rule change retrospectively.

Some taxpayers may have made a decision to transfer funds to New Zealand post 1 April 2011 unaware of the proposed rule change and the impact this may have on how the receipt of the funds will be taxed.  If they had known about the rule change they may not have made a decision to transfer but instead, given the removal of the FIF rules and the application of the inclusion rate approach, left the funds overseas.  Taxpayers are entitled to make an informed decision having regard to the tax consequences.  For this reason we would like to see the proposed rules apply from 1 April 2013 or, at the very least, from the day the Official’s paper was released.

Transfers to a NZ fund
One area of uncertainty of the proposed rules is in respect of which transactions will give rise to a New Zealand tax liability.  Specifically, it is clear that a transfer from a foreign superannuation scheme to a New Zealand fund will be taxable under the inclusion rate method.  However the issues paper does not expand on whether transfers from one foreign scheme to another foreign scheme or transfers to purchase a foreign annuity would trigger a New Zealand tax liability.  Generally annuities are taxable on a receipts basis and as such to the extent a transfer to purchase an annuity is taxable under the inclusion rate method double taxation may arise. 

We await further details from Officials regarding the implementation of the rules in this regard.

Concluding Remarks
The proposed rules certainly simplify the tax treatment considerably and are a move in the right direction.  In saying that, there are some aspects of the transitional rules for people who have previously returned income in their New Zealand returns under the FIF rules which we would like to see amended. 

In our opinion there is a need to introduce some flexibility into the rules to allow taxpayers who have respected the rules in the past the ability to apply the new rules and likewise to allow taxpayers the ability to undertake more complex calculations to ensure they are not paying tax on capital already contributed should they choose to take the time to understand the rules.

It is also clear that further consideration needs to be given to how the transfer of funds from a foreign superannuation scheme, either to a New Zealand scheme, a foreign scheme or to purchase an annuity should be taxed, as the current proposals result in significant double taxation or taxation without cash available to meet the liability. 

Implementing some relatively straightforward amendments would in our view make the proposed rules much more robust and would address many of the concerns we currently have without over complicating the rules.   

Comments regarding the proposed changes and particularly in relation to the transitional rules are invited.  Submissions are due by 3 September 2012.   

For more guidance or to discuss the above proposal in further detail please contact your usual Deloitte advisor.

[1] This ignores the application of the transitional residency which provides a 48 month exemption where certain criteria are met.

Tax Alert August 2012 contents:

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