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Cullen wealth tax creeps back on to menu

By Shoeshine

Friday 1st August 2003

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Whatever happened to the risk-free return method (RFRM) of taxing investments?

Those who take an interest in these things will recall a splurge of publicity around March last year when the "wealth tax" reared its head after being raised in the McLeod review of the tax system.

Finance Minister Michael Cullen declared his "interest" in RFRM and his further comments were eagerly awaited in the May 2002 budget.

But not a word. Rumour had it ­ and Shoeshine doesn't vouch for this story ­ that Prime Minister Helen Clark immediately identified the potential for election-losing scare stories in the gutter press and told Cullen to put a sock in it.

No mention in this year's Budget either. "I wouldn't describe it as dead," Cullen told enquirers, "but I wouldn't describe it as kicking either."

Cullen-watchers now report the minister's interest is on the rise. PricewaterhouseCoopers' John Shewan told last week's FPIA conference he expected RFRM to be introduced within 18 months.

The first port of call in this process will be a government "issues paper" due out in October. The paper is expected to comment on RFRM and to examine other means of dealing with the distortions caused by the current messy regime for taxing foreign investments.

First up for a good clobbering are the so-called "circular" investment schemes that have been creeping in since November 1998.

Inland Revenue has long been aware of these but Cullen, gossip has it, has not. When he heard about them he apparently hit the roof.

The IRD is normally too busy to worry about such things as long as their promoters keep them low-key and they are used only by a small number of investors.

But circular investment schemes have been burgeoning lately. Fund manager ING, Doug Somers-Edgar's Money Managers, St Laurence Group, and Frank Russell all market funds with an element of circularity.

It works like this.

Investors' money is paid into Australian-based unit trusts, which pay no income tax in New Zealand, just a 2% "approved issuer levy."

The fund can hold investments anywhere it chooses but pays tax to the Australian government only on capital gains and income derived from Australian investments, if it holds any.

Circularity occurs when one of these trusts receives New Zealand investors' money, shifts it through an offshore trust and then invests back in New Zealand.

The New Zealand-derived returns can be paid out to the local investors in the form of annual issues of bonus units, which attract no tax when they are sold provided the individual taxpayers' investment buying and selling activities aren't frequent enough for the IRD to class them as traders.

This sort of scheme, and similar tax advantages of investment in British listed investment trusts, are perfectly legal and are symptomatic of the unwieldy, complicated, and distortionary FIF (foreign investment fund) tax regime despised by financial planners, tax advisers and Cullen equally.

The RFRM regime Cullen reportedly favours will certainly be a lot simpler but it looks likely to be just as distortionary.

And the potential for regulatory creep into the rest of the tax system is positively terrifying.

RFRM taxation works by applying a "risk-free rate" of tax ­ the McLeod report recommended the inflation-adjusted one-year government bond rate ­ to the capital value of the assets falling under the regime.

So the tax payable each year on a holding in an Australian unit trust would be calculated as the value of the units at the beginning of the year, multiplied by the RFRM, multiplied by the investor's tax rate.

When McLeod reported on RFRM it envisaged it being applied to all assets wherever they are held but Cullen's "interest" was in a regime applying only to offshore investments.

That would be distortionary enough.

To avoid double taxation investors would be discouraged from investing in foreign companies that pay dividends because they'd be double-taxed, once by the foreign government on dividend income and again in New Zealand through RFRM.

Investing in fast-growth companies that don't pay dividends would also be penalised because the RFRM tax bill would rise each year but the investment would bring in no income with which to pay it.

The incentive would be to invest in domestic shares. As New Zealand accounts for less than 1% of world equity markets that would produce unsound investment decisions.

But the real trouble is justifying applying it only to foreign investments, thereby denying RFRM its real logic.

Applying it domestically could be disastrous.

Retired people, for instance, living on minimal income could find themselves hit with annual tax bills on investments that exceed the income derived from those investments, driving them further into the asset-rich, income-poor trap.

Taking RFRM to its logical conclusion would mean applying it to people's homes, from which most derive no income at all.

Clark and Cullen last year rushed to assure voters that would never happen.

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