Inland Revenue unveils its weapon against Australian unit trusts

By Michael Coote

Friday 21st May 2004

Recent times have found Australian unit trusts (AUTs) in the wars in Godzone.

Their travails have taken another twist, with Inland Revenue's tax change proposals for them finally announced.

The government has attached a proposed interim solution in the form of a supplementary order paper to the rather obscurely entitled Taxation (Annual Rates, Venture Capital and Miscellaneous Provisions) Bill.

Some history: Australian unit trusts (AUTs) have been under the taxman's microscope for some time now.

Additionally, Revenue Minister Michael Cullen took public umbrage at "circular" AUTs. Such structures raise money in New Zealand, circulate it offshore and reinvest it back here.

Ordinarily, New Zealand residents would pay tax on the interest derived from these New Zealand-domiciled investments but the AUT structure permits returns to be rolled up into the fund and paid out as tax-free bonus units. The Kiwi investor gets the best of all possible tax worlds: returns on New Zealand investment without tax to pay.

Dr Cullen singled out government stock as an example but there are circular AUTs that are heavily involved in the likes of funding local finance companies, mezzanine property development lending and debt factoring.

It is difficult to know how much money is tied up in this circularity because some suppliers of circular AUTs are secretive about their activities but back-of-an-envelope calculations would suggest about a billion dollars. All that money is working tax-free for investors.

Tendentiously, Dr Cullen spoke of a "loophole" as allowing this circularity to take place, whereas what was happening was an aggressive application of existing tax rules that permitted AUTs to distribute returns to New Zealanders as tax-free bonus units.

On its website in a posting dated May 17, 2004, the IRD reiterates its boss's terminology where it states, "Parliament's Finance and Expenditure Committee has set a 4 June deadline for submissions on legislation proposed in Supplementary Order Paper 210, tabled on 12 May. The proposed legislation closes a loophole in the dividend tax rules that allows investments in certain unit trusts to be tax-free."

Ironically, some years back the IRD even gave a binding ruling to at least one circular AUT that contained a high percentage of New Zealand fixed interest, and therefore Dr Cullen's department was hardly caught napping by the circularity issue.

If there was a loophole, what was the IRD doing condoning it with a binding ruling?

What is more, the taxman already had a potential remedy in establishing whether circular AUTs were controlled from within New Zealand, as some undoubtedly are in using the AUT structure as screen to operate finance businesses over here that are funded tax-free by mums and dads.

Be that as it may, the IRD has come up with a proposal that whacks all AUTs, or more correctly, all New Zealand resident investors in those AUTs that distribute by way of tax-free bonus units.

The tax-free status of such units will effectively be abolished by deeming them to be dividends. The bonus units will be taxable at the investor's marginal tax rate.

The gross amount of the bonus unit distribution will be taxable upon receipt and will not carry imputation credits because it is technically derived from overseas.

Submissions to the select committee will be interesting in terms of what comes out of the funds management industry.

At one level, the industry might try to limit the scope of the amendment, perhaps just to cover circular AUTs, but the IRD is coming at all AUTs from the principle of protecting the revenue base and will be concerned to stop proliferation of them and consequent erosion of the tax base. So not much hope there, one would imagine.

Another issue of contention is when the tax change should apply from. Some fund managers would argue for it applying retrospectively, others for it to start from date of royal assent, and others still for April 1, 2005, the starting date for the 2006 tax year. Best guesses have the bill enacted into legislation by October this year.

For taxpayers all this may be a bit moot. AUTs must distribute all foreign-sourced income by June 30, the end of the Australian financial year, or face taxation at the highest marginal rate.

So the next year-end distribution date that would most likely be affected by the proposed change is that of June 30, 2005.

The capital account taxpayer the mums and dads investing modest sums retail will receive that money in New Zealand's 2006 tax year and not have to pay the tax until February 7, 2007, unless they have an exemption and can delay until April 7 of that year.

Provisional taxpayers are in a different boat and would need tax advice. As the tax change is billed as an interim measure, it may be that resolution of questions such as proposed uniform application of the risk-free rate of return method (RFRM) of investment taxation, or some variant, may supercede the interim regime before long.

If there was a loophole, what was the IRD doing condoning it with a binding ruling?

Comments from our readers

No comments yet