Hon Dr Michael Cullen Minister of Finance

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1 Hon Dr Michael Cullen Minister of Finance Pro-business tax cuts: background information Fairer rules on taxing investment income New rules will make the taxation of income from investment through managed funds more consistent and fairer to investors. They will apply to widely held unit trusts, registered superannuation schemes, group investment funds and other pooled investment vehicles to be known as "collective investment vehicles". The changes will reduce inconsistency in the taxation of investment income and remove the main tax disincentives to investing through managed funds. The government will also consult on proposals to reduce the extent to which offshore investment in shares is taxed differently, depending on where and how the investment is made. All the proposals will be detailed in a government discussion document to be released next month. In most cases income in managed funds will "flow through" to investors and will be taxed at their correct tax rate (not a flat 33 per cent rate). The complex differences between superannuation schemes, unit trusts, group investment funds and other entities performing a similar savings function will be removed. Funds will be able to make tax-free capital gains on domestic shares in the same way as individual investors do now. There will be no distinction between tax-favoured passive funds and taxpenalised active funds. Tax on offshore investment in shares will not be dependent on which country the investment is made in. Flow-through and domestic investment The new rules for managed funds will apply from 1 April 2007 and will be optional. Instead of funds themselves paying tax on the income, they will withhold tax on behalf of each investor, at the investor s correct tax rate. This is known as flow-through treatment. Funds will then pay the tax to Inland Revenue in the same way as banks pay withholding tax on the interest

2 paid to depositors. This approach has real advantages for investors on a 21 per cent tax rate, whose investment income will be taxed correctly at 21 per cent and without their having to provide any cash to fund the tax. The tax withheld at the fund level will be treated as final withholding tax. This will ensure that the earning of fund income will not: o automatically trigger the need for the investor to file a tax return; o affect social policy programmes delivered through the tax system (such as family assistance). An approach for dealing with tax losses in a "flow-through" environment will be presented in the discussion document, and the government will explicitly seek feedback on the proposed approach. If the fund income cannot be allocated to specific investors in the fund, the income will continue to be taxed at the managed fund level at a flat 33 per cent tax rate. Profits from sales of domestic shares that investors earn through a qualifying fund will not generally be taxed. This will make the tax treatment consistent with the treatment of share profits from direct investment. Certain gains from the sale of New Zealand shares that would be taxed if they had been earned by an individual direct investor will continue to be taxed if they are earned via a collective investment vehicle: for example, schemes that have been entered into to exploit the boundary between debt and equity. A proposed approach to achieving this will be presented in the discussion document, and the government will explicitly seek feedback on the proposal. Example At the beginning of the tax year Mike invests $1,000 into a defined contribution superannuation fund that invests in domestic shares. At the same time he provides his tax rate of 21% to the managed fund. The fund earns $100,000 for its 100 investors for the tax year made up of $50,000 ($40,000 + $10,000 imputation credits) in dividends and $50,000 from profits on the sale of shares. The $50,000 sale profits are not taxed. The $50,000 of dividends is taxable to the fund s investors. Mike s share of the taxable dividends is $500 ($400 + $100 imputation credits). The tax payable by the fund on his behalf is $500 X 21% = $105. The fund can use Mike s share of the imputation credits of $100 to offset his tax, leaving $5 of tax to pay. The fund pays the $5 to Inland Revenue and adjusts Mike s investment in the fund to reflect the tax payment. (Under current law, the superannuation fund would probably pay tax on the entire $100,000 that it earns for its investors at 33%.) Portfolio investment into foreign shares The current distinction between investments in grey list countries (Australia, the United States, the United Kingdom, Japan, Germany, Canada and Norway) and investments in other countries that are more

3 heavily taxed under the FIF rules will be removed. This will remove a disincentive for New Zealanders to invest in high growth economies such as those in Asia. This will not result in the current foreign investment fund rules applying to all offshore investments. Instead the government will outline proposed new rules in the discussion document. These proposed new rules will reduce the extent to which offshore investments in shares are taxed differently. The proposals will balance revenue, economic and compliance concerns. The proposed changes will be detailed in a forthcoming discussion document that will invite further consultation on the operation of the new rules. Once enacted, the changes are planned to come into force from 1 April 2007.

4 Reducing tax costs for international recruitment A temporary tax exemption on foreign income will be made available to people who come to work here, whether they are foreigners or New Zealanders who have been non-resident for tax purposes for ten years. Tax on offshore income is an important issue for highly skilled people who are in demand internationally and for the businesses that recruit them from overseas, which often end up bearing the "tax costs" themselves in the form of higher pay. The new exemption will thus remove a tax barrier to New Zealand gaining the skilled people it needs. New and returning residents can apply for a certificate of exemption if they have not been tax-resident for at least ten tax years. New employees will be exempted from tax for five years on all foreign income except dividends, interest, employment income and business income relating to services. Those who come, or return, to New Zealand who are not in employment will receive the same exemption for three years. The exemption will be available to people only once. Example A New Zealander who has worked in France for fifteen years owns $70,000 worth of shares in French companies and pays tax in France on the dividends she receives. Under current New Zealand law, if she returns to work in New Zealand her shareholding will be treated as foreign investment funds. She will have to pay New Zealand tax on the value of the shares as it accrues, regardless of how much has been distributed. The new exemption will mean that only distributions from the shares will be taxed in New Zealand during the period of exemption. The new exemption is included in the Taxation (Depreciation, Payment Dates Alignment, FBT, and Miscellaneous Provisions) Bill introduced today. Once enacted, the exemption will apply to people arriving in New Zealand from 1 April 2006.

5 Updated tax rules for securities lending The tax rules on securities lending transactions will be updated to bring them into line with the rules relating to other commercial transactions and with those of countries such as Australia. The reform will remove tax barriers to securities lending transactions and make New Zealand more attractive to international investment. It will also introduce new rules to prevent the use of securities lending for tax avoidance. Securities lending involves the lending of shares to another party for a fee. It allows brokers to transact in shares in which they have a shortfall and provides a relatively risk-free way for larger holders of shares to increase their overall returns. Internationally, securities lending plays an important role in facilitating market liquidity. "Qualifying transactions" involving the lending of equities will be taxed on their economic substance rather than legal form, meaning the lender will be treated as the owner of the shares over the period of the transaction. New anti-avoidance rules will apply to arrangements where a party, unable to use imputation credits, lends the relevant securities to a resident party who can use the credits. Example of taxing transactions on their economic substance A broker, anticipating a drop in the share price of NZ Limited, enters into a contract to sell NZ Limited shares to a third party for $6.00 a share. The broker does not hold any NZ Limited shares so enters into a securities lending agreement to "borrow" the shares required from an institutional investor. Legally, the borrowed shares are sold by the institutional investor to the broker, who then goes into the market at the end of the month to buy replacement shares (at $5 per share) to return to the institutional investor. Instead of being taxed on any realised gain on sale of the shares, the institutional investor is treated as holding the shares for the entire period and receives a taxable lending fee as additional income. The broker is able to enter into an additional sale and makes a profit of $1 per share less the lending fee. The market benefits from additional transactions and increased liquidity. The new rules are included in the taxation bill introduced today. Once enacted, they will apply for income years and transactions beginning on or after enactment. The associated anti-avoidance measures will apply from the date of enactment.

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