Foreign Investment Funds tax regime creating a financial barrier?

For many, 7 May will pass without note, however for a group of New Zealanders who hold foreign shares, this date will be looming large as their third provisional tax date. This is when they (and others) will need to work out if they have any additional tax to pay for their 2024 income tax year to avoid Inland Revenue interest charges.

This date is particularly relevant for these individuals due to New Zealand’s current taxation of interests in foreign investment funds (“FIFs”) (such as foreign shares) which drives a cash tax obligation in situations where there is no income generated to fund it. Provisional tax, which requires a down payment of the year’s tax liability in three instalments, can be difficult enough to manage when there is an actual income but for those individuals who are taxed on “deemed income” with no expectation of any cashflow to match, this is particularly challenging.

Take the common example of a Kiwi entrepreneur who has spent time living and working in the US, UK, or Asia in the tech industry. On return to New Zealand these individuals often have continued connections to their offshore start-ups. These types of unlisted companies can have high valuations “on paper”, especially to support capital raising during their growth phase, but often with no liquidity or income stream for the foreseeable future. Very few will become unicorns, the vast majority will not.

Rebecca Armour

Partner - Consulting

KPMG in New Zealand

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Darshana Elwela

Principal - Tax

KPMG in New Zealand

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Observations

With the fall in the New Zealand dollar against several major foreign currencies in the tax year to 31 March 2024, the paper gain for many may be more pronounced this year.

Under New Zealand’s tax settings for FIFs, owning such shares can result in an annual tax bill based on 5% of the valuation of that investment. The ability for returning expats and “new” New Zealanders to continue to invest in these opportunities is often dependent upon their ability to fund the tax through other sources. If the investment comes to nothing because the start-up fails, which is unfortunately quite common, there is no avenue for the recovery of what can often be tens of thousands of dollars in tax paid over the years of the investment under New Zealand’s FIF tax rules.

This issue could easily be dismissed as a burden of the “wealthy”, however the FIF tax regime applies to any New Zealander whose total portfolio of offshore shares (excluding certain listed Australian stocks) has a cost exceeding $50,000. This threshold hasn’t been revised since inception of the rules. These rules can have the effect of discouraging investment particularly in innovative, interesting, and diverse overseas companies.

The lack of reference to cash-flows, such as dividends, or proceeds from sale of the shares, as the taxing point in the FIF tax settings means New Zealand stands apart from most other OECD countries in its approach to taxation of such investments.

As a result, the FIF tax settings can create a significant financial barrier to highly skilled New Zealanders returning, and new migrants moving, to New Zealand. For those individuals already here, who have options about where to live and work, it can lead to them leaving, or looking to leave New Zealand, to avoid prohibitive tax bills on paper gains.

Because of the way the NZ FIF tax rules operate, versus most of the rest of the world, there is also a risk of double taxation. This is particularly the case if a foreign country exercises taxing rights at the time the investment is realised. The United States is one country where this issue arises, as it taxes citizens and green card holders on their capital gains (regardless of their tax residence). This issue can also arise where a New Zealand tax resident moves to a new country before disposing of their offshore shares.

It is worth noting that current FIF tax rules were introduced to ensure that New Zealanders could not avoid or defer the taxation of income in New Zealand, by investing in offshore companies. At that time there was a concern that simply taxing dividends from offshore investments was not effective because many foreign companies had a policy of paying low or no dividends. However, the solution of taxing a notional 5% “fair dividend” from these investments raises a number of practical issues, particularly where the companies are unlisted, meaning valuations are difficult if not impossible to come by, and there is no cash flow to pay the tax on deemed income.

There are many reasons why a review of the FIF tax regime and how it impacts individuals would make sense, not least the global competition for skills and talent. Greater alignment of New Zealand’s international tax rules with cashflows, including on realisation of an investment, would in our view be a better approach to ensuring that New Zealanders are fairly taxed while ensuring they are not practically limited in the types of investments they can hold. This is likely to assist in making New Zealand a more attractive destination for those who have acquired investments while working overseas but are wary of returning or relocating because of how those investments will be taxe