How’s the fit? Reducing the tax barrier for migrants and returning expats

By Joe Sothcott, Amy Sexton & Sam Mathews

The Government is focused on encouraging economic growth and is very focused on investment in the IT and technology sectors in New Zealand. One way to do this is to attract migrants and expats who are already working or investing in these sectors overseas to move to (or back to) New Zealand. As part of this focus the Policy team at Inland Revenue has published an officials’ issues paper Effect of the FIF rules on immigration: proposals for amendments. The proposals in the paper are a response to concerns of migrants and their advisors that the Foreign Investment Fund (FIF) rules may be a factor in discouraging non-residents who hold interests in foreign companies from coming to and staying in New Zealand.

But what are the FIF rules?

One of the aims of the international tax regime (which includes the Controlled Foreign Company (CFC) rules and the FIF rules) is to tax certain amounts of overseas income in New Zealand that is earned by New Zealand tax residents. The rules determine what is taxed in New Zealand, what amount is taxed and when it is taxed.

New Zealand tax residents (that are not transitional residents) are prima facie subject to the FIF rules if they have an interest (e.g. shares) in a foreign company, the interest is not enough to “control” the company (in which case the CFC rules would apply instead) and none of the “FIF exemptions” apply. There are a number of FIF exemptions, with the most common being where the cost of the shares is NZD50,000 or less, or where the foreign company is listed on the ASX (Australian Stock Exchange).

Taxpayers subject to the FIF rules have a number of different methods to calculate their FIF income, which is then included in their New Zealand tax return. The availability of a particular FIF method depends on the taxpayer and the nature of the FIF interest. The most common FIF methods are fair dividend rate (FDR), cost, and comparative value (CV).

Taxing deemed income vs actual dividends and gains

A commonly discussed issue with the FIF rules is that methods like FDR and cost calculate the tax on deemed income. Instead of taxing actual dividends received and any gains when the shares are sold, the FIF rules often require taxpayers to pay tax on this deemed income. As a tax liability can arise regardless of whether a dividend has been received or the shares have been sold, there can be cashflow problems for the taxpayer in paying the tax liability.

Deemed FIF income may also not reflect the reality of how the share’s value may have changed in the year. Under the FDR and cost methods, taxable income is calculated as 5% of either the market value at the beginning of the year (FDR) or the cost of acquiring the shares (cost, with the cost base uplifted by 5% every year). This deemed 5% income is supposed to be a “typical” share’s average annual return and approximate the taxable income that would arise if the taxpayer invested into a New Zealand company instead of the foreign company. Depending on actual dividends received and the actual movement in the value of the share, the deemed 5% return could either be favourable or unfavourable for taxpayers (or sometimes, just right!).

The main reason for taxing FIF interests in this way is that many foreign companies have no/low dividend yields (think US technology stocks) and without a capital gains tax no tax would otherwise be paid in New Zealand on the investment. Taxing a deemed return is a relatively unique way of taxing offshore investments, so the rules can be confusing for many potential migrants.

How the FIF rules can deter migrants

The FIF rules can create problems for some types of investments, particularly illiquid assets (investments that cannot be sold easily for cash, which is the case for many unlisted shares). Unlike listed shares, these investments cannot be sold easily to pay the tax on the deemed income.

Another common issue is that because the FIF rules impose tax on deemed income rather than when the investment has been sold (in some cases well before the sale), tax paid on FIF income in New Zealand may not be able to be used as a foreign tax credit to offset foreign taxes due on the actual sale of the investment (typically, overseas capital gain taxes), resulting in double taxation.

The third key issue is that a number of the FIF methods require a valuation of the shares when the taxpayer becomes a New Zealand tax resident and subject to the FIF rules. For publicly traded investments (like listed shares) this should be simple, but for other types of privately held investments this can be quite difficult, costly, or even impossible.

The potential options

To help reduce the tax barriers for migrants, Inland Revenue suggests two potential alternative FIF calculation methods for migrants that meet certain criteria:

Revenue account method – Taxing FIF interests on revenue account would mean that each year tax would only apply to dividends received and any actual gain in value of the investments when they are sold. It is suggested by Inland Revenue that this method would only apply to a migrant’s non-listed foreign shares at the time of migration to New Zealand, and the current FIF rules would apply to all other FIF interests held by the migrant.

Inland Revenue recognises that there is a risk that a migrant could still face double taxation on their FIF interests even after becoming a New Zealand tax resident and so there may be a case for this method to apply to all FIF interests (including those interest acquired after becoming a New Zealand tax resident).

Deferral method – A migrant’s FIF interests would be taxed upon sale (i.e. on realisation), based on a deemed 5% per annum increase in value from the date of their migration, with an additional interest charged to compensate Inland Revenue for the time value in money lost due to the deferral. This is similar to how withdrawals from foreign superannuation schemes are taxed.

Inland Revenue also recommends an “exit tax” for whichever option is chosen. This would be a tax on unrealised gains (increases in share value where the shares have not been sold) when a migrant ceases to be a New Zealand tax resident.

Deloitte perspective

We have lots of first-hand experience of the FIF rules putting off new migrants and returning New Zealanders, so we welcome the proposals in the issues paper as a step in the right direction. However, we think the proposed criteria to access the rules is unnecessarily restrictive and the rules as proposed may not be overly attractive to the target group. While we appreciate the need to consider any fiscal and integrity impacts, New Zealand needs to remove the barriers (of which the current FIF rules are just one) to attract these migrants and expats to New Zealand where they can have a positive impact on our economy and country.

In our experience there are also a number of other features of New Zealand’s tax system that can deter new migrants and expats, such as the financial arrangement rules (which generally tax certain investments on an accrued unrealised NZD basis), the CFC rules and mismatches in the way New Zealand treats an investment vs the foreign country (e.g. entities that are flow-through for tax purposes in the US such as limited liability companies and S Corporations, but are not flow-through for New Zealand tax purposes). Without some tweaks to these rules, in addition to the careful and appropriate design of the tweaks to the FIF rules proposed in the issues paper, there is a risk that the objective of attracting these people to live, work and invest in New Zealand will not be achieved.

Finally, we would welcome additional changes to the FIF rules that are mentioned in the issues paper, including increasing the current NZD50,000 FIF de minimis threshold referred to above (which has not been increased since 2000) and expanding access to the attributable FIF income method (which is the FIF method that applies the active income exemption to certain FIF interests). These changes would also help reduce the barriers for migrants and expats with interests in foreign companies.

The issues paper had a limited consultation period which has now closed so it will be interesting to see the results of this consultation in due course.

If you have any questions or would like to discuss how the international tax rules may apply to your overseas investments, please contact your usual Deloitte advisor.