There was no comment in the Retirement Commissioner’s 2016 Reviewon tax matters (accessible here).
Tax Working Group’s report
Since the 2016 review, the government established the Tax Working Group (TWG) to look at the issues of tax fairness and capital gains tax in particular. As part of the TWG’s recommendations it suggested an offset of part of the tax revenue raised by a capital gains tax with additional tax subsidies/concessions for retirement income, particularly targeted at the lower-paid. We have already commented on that evidence-free recommendation in section 9 (On tax subsidies for saving).
The government responded on the proposed capital gains tax as follows:
“The Government is not adopting any of the recommendations on capital gains taxation and has agreed no further work is necessary on that aspect of the report.”[2]
The government did not eliminate introducing some of the other recommendations of the TWG. It stated:
“The final report covered all aspects of the tax system, and a number of the recommendations will now be considered for inclusion in the Government’s Tax Policy Work Programme,”
Those recommendations could include the KiwiSaver-related changes we discuss in section 9.
The main income tax issues for saving vehicles
The following summarise the main issues that New Zealand faces on income tax associated with ‘collective investment vehicles’ (CIVs):
(a) Different categories of CIV pay different rates of tax;
(b) Different tax regimes apply to different types of asset;
(c) Tax applies to investments differently for CIVs when compared to individual savers.
We think the Retirement Commissioner should have considered the implications of this fragmented and inconsistent approach to the tax treatment of investment income. Instead, there was no mention of this issue in the 2016 Review.
The Tax Working Group, on the other hand, did touch on the way CIVs are treated for tax purposes. It stated:
“The current rules offer a relatively consistent tax treatment of investors, irrespective of the entity through which investments are made.”[3]
For the reasons explained in this section, that statement is wrong both as between individual investors and CIVs as a group and also as between different types of CIV. New Zealand’s tax system deserved better than this superficial summary.
Our 2010 Working Paper
In 2010, we reviewed the income tax regime of CIVs and the relationship between ‘income’ and the income-tested welfare benefits. In essence, nothing has materially changed so what follows summarises our findings of nine years ago.
Until 2000, New Zealand had a relatively simple tax treatment of CIVs where the CIV’s income was taxed at the top personal rate of tax (33%) that was also the corporate tax rate and the rate that applied to trusts. Under the TTE regime (see section 9 – On tax subsidies for saving), members’ contributions to CIVs that were workplace superannuation schemes were made out of the employee’s after-tax income (the employer’s contributions were also taxed at 33%) and withdrawals were treated as tax-paid capital.
An Inland Revenue 2005 Discussion Document[4]stated:
“…it is important that the tax rules for investment income operate efficiently and that investors’ decisions are not distorted by different tax treatments for income from investments that are similar in nature……
“The proposals outlined in this discussion document aim to resolve these inconsistencies and the distorting effect they have on investor decision-making.”
The results of the review sparked by the Discussion Document were the 2007 introduction of Portfolio Investment Entities’ (PIEs) and the Fair Dividend Return (FDR) approach to the tax treatment of overseas investments. However, as our 2010 Working Paper concluded, “It is clear that the tax regime is complex and distortionary and this seems at odds with the reasons for the 2007 changes.”
There are now, broadly, three types of CIV or pooled investment vehicle:
A unit trust type of product where the return is passed through to the investor and taxable income is taxed at the investor’s own marginal tax rate.
A superannuation scheme type of product. These can be a PIE where tax is calculated within the scheme at the investor’s Prescribed Investor Rate (PIR) that mimics, on a favoured basis, the investor’s marginal rate but doesn’t tax all income. Returns are ultimately distributed to investors as tax-paid capital. A superannuation scheme does not have to be a PIE – in this case, tax is still calculated within the scheme on a ‘final basis’ but at a standard 28% for the scheme as a whole[5].
A non-superannuation scheme (which may be a unit trust) that is a PIE and that also taxes the income at the investor’s PIR.
Separately, the FDR regime taxes overseas equities owned by trusts (and direct equity investments) other than certain Australian shares on a deemed income basis. Under this regime, regardless of the investor’s actual returns, taxable income is assumed to be 5% of the asset’s opening value on 1 April in the tax year for an individual and some CIVs, though most CIVs are now taxed on 5% of the average daily value. For some individuals, the basis of tax can be set at the lower of the FIF (foreign investment fund) regime and the FDR regime. This can see some individuals, at their choice (each year), pay no tax when the markets are negative while other investors still pay tax on the deemed 5% income[6].
In nearly all cases, the FDR regime will either over-tax or under-tax the investor’s actual income, measured against the investor’s marginal tax rate and also creates potential liquidity issues as tax is based on deemed income, not income actually received.
Contributions by an employer to a ‘workplace superannuation scheme’[7]or a superannuation scheme or a KiwiSaver scheme, are subject to a complex ‘Employer Contribution Withholding Tax’ (ESCT) if the employer has chosen the multi-rate approach that mimics the employee’s marginal tax rate for the last tax year but includes the contributions paid as ‘income’. Contributions by employers to other types of schemes are subject to Fringe Benefit Tax.
Different combinations of direct and indirect investment will produce different overall tax consequences.
Overseas investments – ownership basis affects tax treatment
Our 2010 Working Paper analysed the practical implications of the 2007 changes by looking at the different ways a New Zealand saver could invest in overseas shares or bonds. We concluded that:
For an overseas share (we used BHP Billiton as an example of an Australian share), there were at least 11 different ways a New Zealand investor can invest in overseas shares and seven potentially different after-tax returns even though the pre-tax return was the same in each case. However, even the four that had similar tax treatments could vary between themselves (and with others) depending on the relationship between timings of dividends and market values relative to the 1 April fixing of market values under the FDR regime. Even currency management options can affect the optimal tax structure.
For an overseas bond, there are 13 possible ownership choices with 13 potentially different after-tax returns for the same pre-tax return. The ‘best’ answer for a New Zealand investor will depend on the investor’s marginal tax rate, effective marginal tax rate and issues such as costs, convenience etc. For most, owning overseas bonds through a PIE or registered superannuation/workplace savings scheme that invests in an Australian or overseas unit trust that includes currency hedging bought overseas will probably be optimal.
Tax treatment of CIV’s income and distributions
The way in which a CIV’s income and distributions are taxed also varies by category. Whether returns are ‘income’ within the CIV depends on the CIV’s classification (registered superannuation scheme, unregistered superannuation scheme, unit trust, PIE, ‘group investment fund’, family trust or even an ordinary bank account).
Also, the PIE tax calculations for an individual member are complex as the PIR depends on the total of the PIE’s income attributable to the member and the member’s taxable income in one of the two preceding complete tax years (the lower year). The member must advise the PIE’s manager what the correct PIR for each year should be. The effect of the calculations means that when an investor enters the workforce they can often keep their lower 10.5% PIR rate for two years irrespective of how much income they earn. Likewise, when an employee earning above $48,000 a year retires and their only income is NZS, they retain their 28% PIR rate for at least a year even though their correct tax rate is likely to be 17.5%. These distortions change people’s behaviour and how they invest, solely for tax reasons.
Interaction with state benefits
The definition of ‘income’ matters not just for tax but also for an individual’s entitlements to a number of state-provided benefits or obligations that depend in some way on ‘income’. These include the Family Tax Credit (FTC), In-work Tax Credit (IWTC), Minimum Family Tax Credit, Parental Tax credit (together referred to as ‘Working for Families’), the Independent Earner Tax Credit (IETC), Student Loan payments and allowances, Child Support payments and income-tested welfare benefits such as Sole Parent Support, Job-seeker Support and the Accommodation Supplement.
In all these cases, the ‘income’ that counts is taxable income[8]. Non-taxable benefits or benefits that are subject to either Employer Superannuation Contribution Tax (ESCT) or Fringe Benefit Tax (such as the private use of a car, low interest loan, etc.) are not counted. Neither are the tax credits (FTC, IWTC, IETC etc.).
‘Income’ within a scheme (and not effectively distributed) is unlikely to be included and that seems illogical.
Summary of the 2007 changes
There is a variety of ways in which assets and income can be ‘sheltered’ from direct connection with the economic owners of that income. Income derived through the various tax-based vehicles is not always aggregated for either income tax or for the application of income-tested payments.
The discontinuities between different parts of the CIV regime, the illogical tax treatment of contributions and investment income and the artificial distinctions between directly and indirectly earned income mean, inevitably, that the 2007 rules will be subject to change as advisers test the boundaries. As is usually the case, wealthier taxpayers will benefit the most as they rearrange their affairs to their best tax-advantage. They should capture the KiwiSaver-related concessions and invest the rest either in a PIE or in a superannuation scheme that invests in a PIE. They should not invest directly.
Along the way, the tax system seems to have lost the natural meaning of ‘income’. In a progressive tax regime, how much total ‘income’ an individual receives matters to the system’s integrity. ‘Investment income’ needs, potentially, to have no clear connection with the member’s economic capacity to pay tax. If this basic principle had been set aside for practical considerations, that might have been justifiable. Regrettably, that was not the case.
As the 2009 Tax Working Group put it:
“The tax system lacks coherence, integrity and fairness: Differences in tax rates and the treatment of entities provide opportunities to divert income and reduce tax liability. This disparity means investment decisions can be about minimising tax rather than the best business investment. For individuals, the tax burden is disproportionately borne by PAYE taxpayers since many with wealth can restructure their affairs through trusts and companies to shelter income from taxes or to enable people to receive social support.”[9]
A ‘first principles’ approach
Our 2010 Working Paper proposed the recognition of a number of key points:
(a) Principle 1: Tax should not be the driver.
For an investor in a CIV, it should not matter, from a tax perspective, what that CIV is called or under which legislation that CIV is regulated. In principle, individual investors should be treated similarly for tax purposes in superannuation schemes, PIEs, unit trusts, group investment funds, life insurance funds or companies.
(b) Principle 2:Place of origin should not matter.
For New Zealand tax purposes, it should not matter to an individual investor in which country the CIV is resident. Within reason, international CIVs should be treated similarly for New Zealand tax purposes to New Zealand-based CIVs. How the overseas CIV is treated in its local jurisdiction need not affect its New Zealand status when an investor calculates income tax[10].
(c) Principle 3:The individual’s circumstances are important.
Again, within reason, the tax the investor pays on the CIV’s return should be close to the normal tax the investor would have paid had the investment been held directly. As the original 2005 Discussion Document stated, the investor should choose a CIV for reasons other than tax – for example, for convenience, cost, diversification, liquidity, management skills etc.
These principles may need tempering if the cost of collecting the ‘correct’ amount of tax were uneconomic. Any replacement compromise should, however, recognise the principles and the costs of change.
The three principles form a suggested ‘gold standard’ against which any proposals should be measured. The old tax regime that governed the different types of CIV violated all three principles. Regrettably, the current regime is not much better in some respects and is worse in others.
Income should be ‘income’ and should be taxed and benefit-tested accordingly[11]. The current regime does not come close to that objective.
While the tax treatment of CIVs is normally a compromise between principles and practicality, compromise of principle should apply only if there is a combined effect of simplification and increased net returns to investors with no significant loss of tax revenue. Changes in recent years have failed to achieve these objectives and have left a complex patchwork of compromises and significant discontinuities between the income tax and welfare systems.
CIVs should be encouraged and their continued development should be seen as a contribution to a successful financial services industry. They should not be tax-favoured. The current ‘proxy-rate’ system of taxing CIV members needs reform. As we said in our 2010 Working Paper:
“No member of a CIV presently pays the appropriate tax on their full income (both directly and indirectly earned) under New Zealand’s progressive tax regime. That distortion is potentially magnified when the tax system is set alongside the income-related aspects of our welfare system…” (page 34)
We suggest that the combination of income tax, income support and the treatment of CIVs leaves an unsatisfactory gap that now needs to be filled.
It is not possible to distinguish, in policy substance, between:
income tax (where the state takes money);
income-support (where the state gives back some of that money in different ways to people it decides need that support) and
income-testing (where the state takes back part or all of the income support).
Those three strands should go to make up the single environment of defining and calculating 'income'. Only in that context can the significance of CIV-derived income be measured, and the problems identified and addressed. The reason that CIVs are adding to the inconsistencies derives from the ‘silo approach’ to tax policy that has treated some CIVs in isolation[12]. That approach must change. The introduction of PIE status also introduces a complication and a distortion. Superannuation schemes and unit trusts can choose to be ‘PIE’ or ‘not PIE’. Again, this seems to offend basic tax principles as it lets investors make decisions purely for better tax outcomes.
'Income' for all purposes should be defined consistently, no matter how it has been earned.
Terms of reference for 2019 Review
There was no mention in the Terms of Reference for the Retirement Commissioner’s 2019 Review of the issues associated with the tax treatment of retirement savings.
We do not, therefore, expect the 2019 Review to address this issue. However, at some stage the following questions will need to be addressed.
Given that the tax regime is an important determinant of the net returns that New Zealanders saving for their retirement receive, it is disappointing that the terms of reference do not specifically address tax and the impact it has on retirement preparedness.
Questions New Zealand needs to discuss on income tax issues:
Should all CIVs be taxed similarly?
Should individuals pay income tax on all their ‘income’ whether that has been directly received (as with pay or interest income) or indirectly received (as with additions to their account within a CIV)?[13]
Should the Inland Revenue be calculating individuals’ tax (rather than employers and the managers of CIVs)?
Should all ‘income’ count when calculating income-tested welfare benefits?
If a CIV investor is tax-exempt (such as a charity) should any tax paid by a CIV be fully recoverable?
If the CIV investor has accumulated tax losses from earlier years or from the current year, should any CIV income be offset against such losses?
If an overseas CIV has paid any tax that can be attributable to an individual investor, should that tax be offset against any New Zealand tax liability on the same attributable income?
Rather than trying to define income exhaustively, should the Income Tax Act 2007 state some broad principles, specifying a list of considerations that the Commissioner of Inland Revenue should take into account when deciding what is ‘income’ and what is not?
Should the principles of ‘binding rulings’[14]be expanded to include a formal system of ‘practice notes’ that will give greater certainty of tax consequences and increased flexibility than the current court-based system?
[1]This section is based on our Working Paper 2010-1 for the Retirement Policy and Research Centre: Towards a more rational tax treatment of collective investment vehicles and their investors (accessible here).
[2]Govt responds to Tax Working Group repot, 17 April 2019, accessible here.
[3]The Future of Tax: Final Report Volume 1, Tax Working Group, February 2019 accessible here at page 28
[4]Taxation of investment income - The treatment of collective investment vehicles and offshore portfolio investments in shares(2005) Inland Revenue Department, accessible here.
[5]There is also a trust (such as a family trust) where undistributed income is taxed at 33%, the top personal marginal rate of tax.
[6]This ‘saver-choice’ facility seems directly at odds with the general principle stated above that investors’ decisions should be made for investment, rather than tax reasons.
[7]‘Workplace saving schemes’ are registered under the Financial Markets Conduct Act 2013
[8]Though sometimes capital receipts are deemed to be ‘income’ if they are received on a basis that will be applied for an “income-related purpose”: paragraphs (b) and (c) (“whether capital or not”); also paragraph f(xiv)(C) of the definition of ‘income’ in section 3(1) if the Social Security Act 1964 (accessible here) can include payments from a superannuation scheme.
[9]A Tax System for New Zealand’s Future (2009) Victoria University Tax Working Group, accessible here, at page 9.
[10]The relationship between ‘income’ earned overseas, any tax paid overseas, and the New Zealand tax regime will never be simple, especially where imputation credits are involved. The principle should be that New Zealand taxes the gross income and makes allowance for any tax already paid by the investor.
[11]The personal rates of tax are 10.5% on income to $14,000; 17.5% on income between $14,001 and $48,000; 30% on income between $48,001 and $70,000 and 33% on income over 33%. We think all ‘income’ whether directly or indirectly received should be taxed at these rates.
[12]We suspect that the ‘silo’ approach to the tax treatment of ‘income’ was a necessity, born of the Inland Revenue’s administration systems. The Inland Revenue effectively contracted-out the calculation of tax to PIEs and superannuation schemes as it could not cope with doing those calculations itself. We think that the Inland Revenue should be calculating tax, not each employer or manager of a collective investment vehicle. Only the Inland Revenue has all the information that is needed to calculate the correct amount of tax for an individual taxpayer under our progressive tax framework.
[13]Tax can still be calculated and paid by the CIV but as a down-payment on the saver’s final liability, in a manner similar to the imputation credits that can be added to a company’s dividend.
[14]See here for the Inland Revenue’s explanation of ‘binding rulings’.