Regulatory impact statement

An objective in developing tax laws is to ensure that costs associated with the functioning of the tax system are minimised. This objective must necessarily be balanced by the need to protect the tax base, to treat taxpayers fairly, and to ensure an efficient system.

International tax review: introducing an active income exemption

Executive summary

We propose to reform the taxation of international investments by New Zealanders, to remove impediments to offshore expansion of New Zealand businesses. This will involve a move away from the current system of comprehensive accrual taxation of controlled foreign companies (CFCs) and foreign dividends, to an exemption from accrual taxation for active income of CFCs and an exemption from income tax of foreign dividends. This will allow CFCs engaged in active businesses to compete on a similar footing to other businesses in the same jurisdiction. Measures will be necessary to protect the tax base.

The proposed policy is preferred to the status quo because it removes impediments to overseas expansion by New Zealand businesses. Compliance costs are reduced or maintained in many cases, and the policy has been designed to limit increases in other cases. There should be an overall simplification of the tax legislation because some complex mechanisms will be removed.

We have consulted extensively on the proposed policy and the final policy incorporates a number of important changes suggested by submitters.

Adequacy statement

The Regulatory Impact Analysis Unit (RIAU) in the Ministry of Economic Development (MED), has reviewed this Regulatory Impact Statement, and considers that the statement is adequate according to the Regulatory Impact Analysis adequacy criteria.

Status quo and problem

International equity investments by New Zealanders are currently taxed comprehensively on an accrual basis. The income of controlled foreign companies (CFCs) is attributed back to New Zealand shareholders who pay tax on that income (unless the CFC is resident in one of eight “grey list” countries). Dividends received from overseas are also taxed, with an effective credit for tax previously paid on an accrual basis.

This system of taxation, which involves a number of complex mechanisms (such as attribution rules, credits for foreign tax paid, dividend withholding payments, branch equivalent tax accounts, underlying foreign tax credits, conduit relief tax credits) promotes so-called capital export neutrality (CEN). CEN means that a New Zealander should be indifferent, after accounting for tax, between investing in a New Zealand business or a foreign business if they have the same pre-tax rate of return.

Unfortunately, other countries do not tax most income of CFCs in such a comprehensive manner, so that New Zealander businesses face additional tax costs relative to their competitors in overseas markets. Other countries exempt the income of CFCs that are active businesses—businesses engaged in activities such as manufacturing or selling goods or providing services—from accrual taxation. This, in contrast to CEN, promotes Capital Import Neutrality (CIN). CIN means that a CFC faces the same effective tax rate as its competitors in the same jurisdiction. New Zealand’s current preference for CEN and other countries’ preference for CIN are a barrier to the offshore expansion of New Zealand businesses and can create an incentive for New Zealand businesses to migrate to other countries as an alternative to expanding from a New Zealand base.

Objective

The aim is to remove a barrier to offshore expansion by New Zealand businesses by reforming the taxation of international investments by New Zealanders, while minimising compliance costs and preserving the tax base.

Alternative options

A single overall option has been considered (see the preferred option below) involving an exemption from accrual taxation for active income of CFCs and an exemption from income tax for foreign dividends. This is preferred to the status quo because it puts New Zealand businesses expanding into foreign jurisdictions on a similar footing, in relation to tax, to their competitors in those countries, reduces compliance costs for active businesses in many jurisdictions, and substantially limits increases in others. It also does not involve excessive fiscal cost (foregone tax revenue).

At a more detailed level, there are a number of design options.

Transaction vs. entity approach

The government could adopt 1 of 2 approaches to attributing the income of a CFC to its resident shareholders:

• The transactional approach examines each item of income derived by a CFC to determine whether it produces passive income or active income. Accordingly, different income streams of the CFC attract different treatment depending upon their category.

• The entity approach looks at whether the company is active or passive. Once categorised, then all of the income of the company is taxed in the corresponding manner, regardless of the nature of the income derived.

The transactional approach is more accurate in taxing only passive income. In contrast, under an entity approach the entity is either taxed on all its income or none, with the former being disadvantageous to firms with a mix of active and passive business and the latter allowing some deferral of tax. The transactional approach potentially involves higher compliance costs. For example, if the CFC has paid tax in the foreign jurisdiction on all its income, those foreign taxes would need to be allocated between the active and passive income under the transactional approach. The compliance costs of transaction-based approach may be reduced significantly without sacrificing a great deal of accuracy by providing an exemption at an entity level where passive income is a small proportion of gross income (this is essentially a hybrid approach). The preferred approach (see below) allows businesses that derive less than 5% of their income from passive sources, which we expect to be most active businesses, to be entirely exempt.

Active business test design

An active business test is included in the policy. CFCs that satisfy the active business test (less than 5% of their gross income is derived from passive transactions) will effectively not be taxed on accrual in New Zealand.

Having the 5% threshold will lower compliance and administrative costs as long as it is easy to apply, since firms that meet it do not need to calculate tax on an accrual basis. We have allowed the use of existing financial accounts to calculate the ratio, to make the test easy to apply. There are some adjustments required but these are kept to a minimum. Firms have the option of using audited financial accounts that comply with International Financial Reporting Standards (IFRS) or New Zealand equivalents to those standards. Nearly all New Zealand companies, with the exception of small entities, will be required to comply with these standards anyway for financial reporting purposes, and where they own CFCs they will need to consolidate those CFCs into their accounts. This means the necessary data should be available at low cost. Some smaller companies will also be able use existing New Zealand Financial Reporting Standards until a government review of reporting requirements for these entities is complete. Companies who are not required to comply with IFRS, or who cannot derive the required information from them, can use tax rules to calculate the ratio. This will be relatively costly if the businesses involve complex transactions, but we expect a only small minority of (mostly) larger firms to be in the situation where they have complex transactions and cannot use the other methods based on accounting standards.

Choosing the level of the threshold involves a trade-off of compliance costs against ability to defer tax. A higher threshold means a lower compliance cost, since more businesses will qualify for the active business exemption, but it also allows firms to defer significant amounts of tax (a higher amount of passive income is not taxed on accrual).

Distinguishing active and passive income

The general approach of many countries is to define passive income positively, with active income defined by default as any income falling outside the passive income definition.

The challenge of using a positive definition of passive income is that any item which is inherently passive but is omitted from the list will not be passive income for the purposes of the CFC rules, and will therefore be exempt from attribution.

The alternative, a positive definition of active income, may provide legislators with less control and certainty over the scope of the active income exemption than would occur under a positive definition of passive income. That is because even a small amount of “activity” associated with an inherently passive transaction would bring the transaction within the active income net.

On balance, the government considers it preferable to define passive income positively.

The definition of passive income can be either narrow or broad. A narrower definition lessens the likelihood that genuinely active business will be misclassified as passive, but also allows more scope for tax on passive income to be deferred.

“Base company income”, which classifies certain sales or service income as passive income, is included in passive income in other jurisdictions. This is to prevent the interposition of CFCs in transactions to avoid domestic tax. This does involve a compliance cost, since certain sales need to be identified and tracked.

Interest allocation

If active CFC income is not taxed on an accrual, there may be incentives for New Zealand owners to move debt held by CFCs into New Zealand entities. Depending on the tax status of the CFC in its own jurisdiction, this could allow tax on New Zealand income to be temporarily or permanently deferred.

Interest allocation rules deny interest deductions where an unusually high proportion of a New Zealand entity is funded by debt. This limits the extent to which New Zealanders can exploit tax deferral by moving debt from CFCs into a New Zealand entity.

Interest allocation rules have a cost for firms in that the ratio of debt to assets may need to be calculated, and interest deductions may be denied. However, de minimis thresholds can be used to make this cost apply only in unusual circumstances.

It is argued that interest allocation rules are unnecessary because of New Zealand’s imputation framework, which encourages New Zealand companies to pay tax in New Zealand. However, there is still scope for domestic income tax to be deferred. Australia also has both interest allocation rules and an imputation framework.

Grey list exemption

CFCs in 8 “grey list” countries are exempt from tax on accrual under current rules. It is proposed to abolish the grey list with the exception of Australia.

The abolition of the grey list, and its effective replacement with an active business exemption, will mean that active CFCs will not be taxed on accrual in any jurisdiction. This is a significant advantage for those outside the current grey list countries (see costs and benefits below for an estimate of the number of such firms). The abolition of the list will reduce the scope for deferral of passive income.

The abolition of the list has a cost for firms currently in grey list countries (again, see costs and benefits below). For the majority of these businesses, that cost is just the cost of applying the active business test, which is small, but for some it will involve attribution. Balanced against this, the Australian exemption is likely to prevent cost for most smaller entities (Australia is anecdotally the first port of call for most smaller businesses) and most businesses not in grey list countries will now qualify for the active business exemption.

Dividend exemption

Under the current rules, dividends from CFCs and non-portfolio foreign investment funds are taxed, but a credit is provided where the income has already been taxed on accrual. Under the preferred approach, such dividends will be exempt from taxation.

Exemption of dividends will prevent double-taxation of income without the need for complex apportionment accounts for companies, currently known as branch equivalent tax accounts and dividend withholding payment accounts.

However, there will be continued taxation where the dividend is from a fixed rate share or is deductible to the CFC. This extends the current treatment and is required to prevent the loss of domestic tax revenue. In practice, the dividend will be treated as an interest payment with a deduction provided to the CFC for its payment, to prevent double-taxation. The proposed taxation of the dividend will impose compliance costs. Companies will need to check that, if a dividend has been paid, it is deductible to the CFC or paid on a fixed rate share. Given the low frequency of dividend payments (typically once a year or less), the relative simplicity of checking deductibility or the form of the underlying equity instrument, and the rarity of fixed rate shares and deductible dividend payments, these costs are not expected to be significant.

As an alternative to exempting most dividends and treating others as if they were taxable payments of interest, it would be possible to continue to tax the portion of dividends that is derived from passive income, and to provide credit for any passive income taxed on accrual. This is not the favoured approach because it would require complex mechanisms to track tax paid on passive income and to apportion dividends between active and passive income.

Preferred option

The preferred option is to exempt from tax the income derived from active business of a CFC, and to exempt ordinary foreign dividends received by New Zealand companies from income tax.

Passive income of a CFC, being certain interest, rent, royalty, or dividend income, and income from services performed in New Zealand, will continue to be taxable to the New Zealand owner of the CFC on an accrual basis.

Passive income has been narrowly defined. For example, there are exclusions from the definition of passive income for transactions between CFCs in the same jurisdiction, for rental income from property situated in the same jurisdiction, and for certain royalty income, even though these are typically passive sources of income. The preferred option also limits “base company income” to only services performed in New Zealand. In our view this targets schemes that would defer tax with minimal impact genuine transactions. It would be unusual for a CFC of a New Zealand resident to perform services in New Zealand. The narrow definition of passive income increases the likelihood that businesses will qualify for the active business exemption and the consequent reduction in compliance costs.

To reduce compliance costs, companies with a small amount of passive income in relation to their active income will be treated as having wholly active income. This is achieved by an “active business test”, which calculates passive income as a percentage of gross income. The calculation may be undertaken using audited financial accounts that comply with international financial reporting standards or existing New Zealand financial reporting standards, or by using tax rules. Where the ratio of passive income to gross income is less than 5%, the business will be treated as active.

The 5% ratio allows a significant proportion of firms’ assets to be generating passive income (we estimate 25–30% for a typical business, which is likely to be well above the actual ratio for most active businesses); 5% is also the value used in Australia and US. Choosing a value of more than 5% risks undermining the accuracy of the transactional approach.

With the change in the tax system and the active business exemption, the need for the existing “grey list” exemption (which exempts CFCs in 8 countries from the need to attribute income) is much reduced and the list is effectively removed. However, the “grey list” exemption is retained for CFCs in Australia because many smaller entities have CFCs in Australia and even the relatively small burden of the “active business test” might be challenging for them.

A number of other mechanisms are also being removed. There is no further need for branch equivalent tax accounts for companies, for dividend withholding payments or for underlying foreign tax credits, and a much reduced need for conduit tax relief account. All will be removed.

Some anti-avoidance rules are required as part of the proposed reforms, to ensure the level of tax revenue is broadly maintained, although there is a fiscal cost of the active business exemption.

Interest allocation rules will be introduced, which prevent a New Zealand company shifting debt from CFCs that are exempt from tax, to New Zealand where they can obtain deductions for interest payments. Interest allocation rules will only apply where the debt to assets ratio exceeds 75% (a commercially unwise ratio in many circumstances) and where there are significant interest deductions. In practice, we expect relatively few genuine arrangements will be anywhere near these thresholds. An “on-lending” concession, in which a New Zealand company can borrow and on-lend to a CFC and not have this counted as debt for the purposes of the interest allocation rules, is also provided to help New Zealand entities remain within the threshold.

A further anti-avoidance measure is that the exemption from tax of foreign dividends will be restricted to dividends on ordinary shares and will not apply to dividends that are a deductible expense of the CFC or payable on fixed rate shares.

Benefits

Tax burden: benefit for some companies and benefit overall

The active business exemption puts New Zealand businesses expanding into foreign jurisdictions on a similar footing, in relation to tax, to their competitors in those countries. There will be no accrual taxation of CFCs that are active businesses. The fiscal cost of the active business exemption, excluding administrative costs ($12.5 million in 2008–09, $50 million in subsequent years) is indicative of the expected reduction in tax payable by New Zealand CFCs and their parent companies.

Compliance burden

Compliance costs for New Zealand residents with CFCs outside the 8 “grey list” countries will be significantly reduced, provided those CFCs are mainly engaged in active business. These residents currently need to pay tax on CFC income on an accrual basis, which requires calculating the CFC income under New Zealand tax principles. Under the proposed rules, there is no requirement to pay tax on the income of active CFCs, and so the only compliance cost is verifying that the CFC qualifies for the active business exemption. The test for an active business has been designed so that existing financial accounts can be used for this purpose in most circumstances, with only a small number of adjustments required. We estimate that approximately 50% of the 846 CFCs for which tax records were submitted in the 2005 year were in jurisdictions not on the grey list.

Some complex mechanisms, such as branch equivalent tax accounts for companies and dividend withholding payments, will be removed from the legislation. This will reduce the costs of understanding the rules for taxpayers, particularly for those taxpayers who do not employ tax agents.

Costs

Tax burden (cost for some companies)

A minority of CFCs—those currently in “grey list” countries other than Australia and not engaged primarily in active business—will be taxed on passive income on an accrual basis under the preferred policy, whereas this is not required at present. Of 846 CFCs known to exist in 2005, approximately 20% were in “grey list” countries other than Australia, although the number is likely to be under-reported. There is no information available about the proportion of these firms that were not engaged primarily in an active business, or the amount of tax that would have been paid if accrual taxation of passive income had been required.

New Zealand residents with high levels of debt may be denied some interest deductions under the preferred policy, leading to an increased domestic tax liability. If the New Zealand group (combined New Zealand entities) has a debt to asset ratio of more than 75%, deductions for interest paid on debt above 75% of assets may be denied. In most cases, a 75% debt to asset ratio is not a prudent level and it is expected to be rare in practice for active businesses to exceed this. The proportion of New Zealand residents with CFCs who have a debt to asset ratio exceeding 75% is not currently available, but is expected to be small. Where debt is on-lent by the New Zealand group to a CFC, this does not count towards the total, which further reduces the numbers affected, as do exclusions where total interest deductions are less than $250,000 or where the New Zealand company holds 90% or more of its assets in New Zealand.

Compliance burden

All companies with CFCs or who receive foreign dividends will need to understand the new rules, update their internal practices, and understand new tax forms and tax reporting requirements. This is a “one-off” cost rather than an ongoing cost. In many cases, the direct cost to firms will be reduced because they will employ tax agents, who continuously monitor changing tax laws and can efficiently apply their knowledge to the affairs of many taxpayers.

New Zealand residents with CFCs in “grey list” countries other than Australia will experience a limited increase in compliance costs, because they will have to check that those CFCs meet the active business test and, in the minority of cases where they do not, calculate the amount of income tax to pay on attributed CFC income. As noted above, we estimate that approximately 20% of the 846 CFCs that reported in 2005 are in this category. As noted previously, existing financial accounts can be used for this purpose in most circumstances, reducing the time required to make the calculation. New Zealand residents with Australian CFCs (approximately 30% of CFCs, although again likely to be under-reported) will experience no change in compliance costs because a “grey list” exemption is being retained for that country.

A minority of New Zealand residents will experience some increase in compliance costs as a result of the interest allocation rules (see the comments on interest allocation in the section on the tax burden above). The ratio of debt to assets will need to be calculated. The interest allocation rules have a parallel in the thin capitalisation rules for non-resident controlled New Zealand taxpayers so that the calculations required are not a novel concept—some taxpayers (and/or advisors) will already have experience in complying with the rules and doing the calculations.

Stock of regulation

The proposed policy will require legislation. This will be added to the Income Tax Act 2007 (amendments to related legislation may also be required). Some complex legislation will be redundant as a result of the policy and will be repealed and a consequent simplification of the Act is expected. However, an overall increase in the volume of legislation is expected.

Consultation

A series of discussion documents were published (December 2006, October 2007, December 2007) inviting submissions on the international tax review process. 50 submissions were received on the December 2006 document, 24 on the October 2007 document and 9 on the December 2007 document.

The submissions were received from a range of accounting and legal firms, larger companies, professional bodies, and other businesses.

Numerous meetings with submitters were also conducted to discuss concerns raised and potential options for reducing those concerns.

The Government announced a series of in-principle decisions on the core policy framework in May 2007. The central proposals were:

• an exemption for owners of controlled foreign companies (CFCs) from the requirement to pay tax on income of the CFCs on an accrual basis, provided the CFCs are engaged in earning mainly active income from operations as opposed to passive income such as interest, rents or royalties (to reduce compliance costs there is a test for an “active business”); and

• an exemption from income tax of ordinary foreign dividends received by New Zealand companies.

Related to this were a number of other key proposals, including:

• removal of the “grey list” (owners of CFCs in “grey list” countries are not required to pay tax on income of the CFCs on an accrual basis);

• the application of interest allocation rules to outbound investment (limiting the interest deductions available to a New Zealand company when the New Zealand company carries a significantly greater percentage of debt than the CFCs it owns do); and

• the repeal of mechanisms which will no longer be as necessary because of the active business income and foreign dividend exemptions, including branch equivalent tax accounts, dividend withholding payments, underlying foreign tax credits and conduit tax relief credits.

Consultation responses welcomed the proposed exemptions for active income and foreign dividends. Submitters also seemed comfortable with the design of the active business test and the proposed boundary between active and passive income, albeit that a number of detailed issues were raised.

There was criticism of the aspects of the package designed to prevent erosion of tax revenue, particularly the limitation of the dividend exemption to ordinary (as opposed to fixed-rate) dividends, repeal of the grey list and the extension of interest allocation rules. We consider these measures to be essential for the protection of the domestic tax base, particularly given that neither offshore active income nor most foreign dividends will be subject to New Zealand tax under the new rules. However, and in response to submissions, we have changed the policy so that the existing grey list exemption for CFCs in Australia will continue to apply. This will help substantially in limiting the impact of the reforms on small and medium-sized enterprises (SMEs), for which Australia is usually the first point of offshore expansion.

There was also criticism of the decision to remove conduit tax relief credits. Conduit relief is designed to relieve taxation of income derived by a CFC and paid by the New Zealand owner of the CFC to a foreign shareholder. With the active income and foreign dividend exemptions, conduit relief is only necessary in relation to passive income, and in that case there are significant risks to the tax base (in the past the use of conduit tax relief has led to significant erosion of the New Zealand tax base), so we consider the removal of conduit relief to be justifiable.

Other changes made in response to submissions included:

• Allowing the active business test to be calculated using existing financial reporting requirements rather than New Zealand International Financial Reporting Standards, for those small and medium sized firms that are temporarily exempt from complying with New Zealand IFRS while the government reviews reporting requirements for smaller entities.

• Excluding related-party royalties from passive income of a CFC where the property to which the royalty applies is substantially developed by the CFC (this relaxes the original proposal that all royalties received by a CFC from related parties in other jurisdictions be treated as passive income).

• Narrowing proposed “base company rules”, which classify certain income that appears active in character as passive income. These rules now apply only where a CFC performs services in New Zealand, rather than to any service performed outside the CFC’s jurisdiction.

• Introducing temporary rules for insurance companies to ensure they can take advantage of the active business test until a more comprehensive solution is found.

As part of a second phase of the international tax review, the government has also announced that it will consider other matters raised in submissions:

• the extension of the active income exemption to financial institutions (including insurance companies);

• a relieving mechanism for NRWT on dividends paid to non-residents if those dividends represent a distribution of foreign income.

Life insurance

Executive summary

The current taxation rules applying to life insurance business no longer reflect the market for which they were designed resulting in life insurance companies unintentionally being tax preferred compared to other companies because their tax liabilities do not adequately reflect their profitability.

Some life insurance products have also been excluded from the recent tax changes to the taxation of portfolio investment entities (PIEs). Under these rules, collective investment vehicles that satisfy certain legislative criteria are not taxed on realised gains made on New Zealand and listed Australian equity investments. Qualifying PIE entities pay tax on investment income based on the tax rates of their investors (capped to 30%).

Changes in the bill will ensure that life insurance business is taxed on a basis that is close to actual profits. Life insurers will also be able to use the PIE rules to ensure that life products are taxed in a manner similar to other savings products.

Adequacy statement

The Regulatory Impact Analysis Unit has reviewed the RIS and considers the RIS is adequate according to the adequacy criteria. The RIAU notes that it was not possible to obtain quantitative estimates of the level of costs (including impact on overall premium prices and compliance costs) and impact on the demand for life insurance as part of a formal quantitative cost-benefit analysis. It understands, however, that such quantitative estimates were not able to be produced because of industry and market structure issues and the impact of the transitional rules.

Status quo and problem

The current rules, which were enacted in 1990, tax life insurers on a two-tier basis. The life office base (LOB), taxes the income earned for the benefit of both shareholders and policyholders of the life insurer as a whole and consists of investment income less expenses, and underwriting income. Underwriting income comprises mortality profit, discontinuance profit, and premium loading, determined by a formula set out in tax legislation, which is intended to reflect the income from the provision of risk services.

Income accruing to policyholders is taxed to the life insurer on a proxy basis under the policyholder base (PHB). Income is calculated by a formula to arrive at the before-tax amount necessary to provide the after-tax benefit implicit in the policy. Tax paid on the LOB generates imputation credits that can then be used to meet the PHB liability.

Problems presented by the current rules include:

• Individuals who save through life insurance products face a higher tax burden than other savers who invest directly or through managed funds that become portfolio investment entities (PIEs). In connection with the tax exemption under the PIE rules for investment gains in Australasian equities, it is estimated that policyholders are in aggregate over taxed by about $21 million each year. This effect may distort consumer decisions about the type of saving vehicle they use and place participating life polices at a competitive disadvantage.

• Term insurance, which is now a major part of life insurance business but which was a minor part when the 1990 rules were enacted, is undertaxed. The premium loading formula (which was not designed with term insurance products in mind) anomalously results in profitable term insurance business generating artificial tax losses with, in many cases, a higher accounting profit resulting in a larger tax loss. Accounting profit is measured using generally accepted accounting principles and involves matching income from premiums against claims and expenses for the relevant income year. It has been estimated by some in the life insurance industry that the level of undertaxation is about $75 million each year. These tax benefits were unintended and cannot be justified on tax policy grounds.

To the extent that tax preferences are received by life insurers, this can distort the decisions by consumers and investors in terms of their choice of saving product or investment compared to other businesses and entities that are required to pay tax on their profits. Similar concerns exist in relation to the overtaxation of policyholder investment gains in Australasian equities.

Objectives

Life insurance companies should be subject to tax under the same general framework that all other businesses in New Zealand are subject to tax. The life tax rules therefore need to ensure that tax paid by life insurers corresponds to their profitability and, in the case of savings products, incorporate them, where relevant and feasible, into the PIE rules. Unit-linked life policies can currently benefit from some of the reliefs provided under the PIE rules and the objective is to ensure that non-unit linked life policies are not tax disadvantaged relative to other equivalent investment vehicles that are subject to the PIE rules.

Any reform of the taxation rules applying to life insurance must therefore encompass both the shareholder and policyholder bases in an integrated and coherent manner.

Alternative options

The review of the taxation of life insurance analysed a range of options, including the status quo, for their consistency with New Zealand’s tax policy environment—for example, whether the option could be fully integrated within the dividend imputation system, loss carry forward rules and the measurement of taxable income under the Income Tax Act generally.

The options were also measured, where practical, for their consistency with generally accepted accounting practice and actuarial standards.

Option 1: technical changes

Isolated technical changes to current legislation were considered, such as increasing the premium loading to better approximate the profits made by life insurers. These changes were considered too arbitrary and would create winners and losers on an artificial basis. There is no accurate, objective basis on which to determine an appropriate premium loading that covers all life products and all life insurers.

Incorporating savings products in the PIE rules without addressing the term insurance issue is inappropriate as it would exacerbate the undertaxation of life insurance income. It would also mean that life insurance tax would develop in an ad hoc and arbitrary fashion and would further add to the complexity of the tax rules.

These ad hoc measures were considered to be inconsistent with New Zealand’s tax policy environment as they could not provide a coherent or integrated platform and would not meet the desired objectives.

Option 2: adopt the practices and tax treatment used in other jurisdictions

The taxation rules for life insurance that are applicable in other jurisdictions were examined, and while certain features from various countries were influential in the design of the preferred option (particularly, some aspects of the Australian rules), New Zealand’s unique tax policy and commercial environment precluded a wholesale adoption of a foreign model.

Option 3: “premium taxation”

Under a typical structure, the tax is applied to the total of the insurer’s premium revenue with certain alterations. In this way it is similar to a levy, as opposed to income tax. Usually, but not always, the life insurer is responsible for tax payments.

While premium taxation would be simple to administer for Inland Revenue and compliance by insurers would be relatively straightforward, there are less desirable features:

• It is regressive in that it burdens lower-income purchasers of life insurance more than higher income persons, as unit costs for small policies (which are typically bought by the former) are higher than for larger policies.

• Higher premium forms of life insurance will be subject to a greater level of tax, irrespective of the profitability associated with that product.

• It discriminates against those who must pay higher insurance premiums owing to their age, health or other difficulties and again imposes a tax burden that does not necessarily correspond to the profit earned by the life insurer in connection with the life product sold.

• As the tax must be paid irrespective of life insurer profitability, it does not adequately take into account costs incurred.

• It is a direct tax on life savings products that is not applicable to other savings products and would therefore distort consumer choice.

This alternative was not considered appropriate for tax policy reasons and would not achieve the desired objectives.

Option 4: “economic basis”

One life insurer suggested life insurance should be taxed on an “economic” equivalence basis incorporating taxation of the policyholder. This would entail taxing insurance claims paid to policyholders while making premiums paid tax deductible. This is not consistent with New Zealand’s tax policy that, except for certain income protection insurance, life insurance claims are not income to the policyholder.

Further, the insurer has suggested that a life insurer would deduct the premiums and recognise the claims as a “proxy” of the policyholders. Effectively, its tax loss would be greater than that produced under the current rules as there would be no taxation of underwriting income. It therefore would perpetuate the anomalous tax treatment of term insurance.

For these reasons, this option is not considered appropriate and would not achieve the desired objectives. The option is likely to retain or increase the tax preferences for life insurers. It is difficult to estimate to what extent the option would affect premiums.

Preferred option

Under the preferred option, life insurer income will be allocated on the basis of actuarial principles between income earned on behalf of shareholders (the shareholder base) and income earned on behalf of policyholders (policyholder income).

The shareholder base will comprise risk profits, fees, share of participating profits, and investment income on shareholder funds, and other income accruing to the life company. It will be taxed at the company rate, and be generally subject to ordinary rules for companies, including those for losses and memorandum account balances.

The policyholder base will comprise investment income less expenses, including the policyholders' share of net investment income from participating policies, allocated between shareholder and policyholder incomes according to the life insurer’s rules.

The PIE exclusion of realised New Zealand and listed Australian equity gains will be extended to policyholders in all life insurance savings products, which will then be taxed at the 30% tax rate. However, life insurers can elect to attribute income in investment-linked products to policyholders at their individual PIE rates (19.5% or 30%). While policyholders will need to maintain certain memorandum accounts and carry forward unutilised tax losses, these will not be subject to member continuity rules.

The new rules will apply from the insurer’s first income year beginning on or after 1 April 2009. Policies sold before 1 April 2009 will be grandfathered for up to 5 years. However, if a policy is single premium, level premium, or guaranteed premium, it could be grandfathered for the life of the policy or for the period for which the premium is guaranteed.

The preferred option corrects the underwriting anomaly in the current rules, by taxing the life insurer on its actual profits and extends certain PIE tax base benefits to all policyholder income. It also ensures that life insurers are progressively taxed, as determined by the natural expiry of life products sold before 1 April 2009, on the basis of earned profits as required by any other business taxpayer.

The correct taxation of underwriting income will be fiscally positive, but the impact will be gradual due to the transition rules. The PIE benefits, which are not subject to any transition, will incur an offsetting fiscal cost. The initial annual net fiscal position on application of the new rules will be a loss, followed by a close to break even result. There is an estimated small fiscal benefit in the third year, increasing as more term insurance policies become subject to the new rules.

The overall fiscal effect is eventually expected to be positive, taking into account the proposed transition, and the net effect will depend on the extent to which life insurers adapt products that respond to the new taxation rules.

Impact on premiums

It is not possible to determine how premiums may change as a result of the reforms. This is because it is not known where the incidence of the tax benefit of the current under taxation of life insurance rests. In particular, different life insurance businesses operate under different structures, many within wider financial service provider groups, and cross-subsidisation of products and business lines could occur.

Premiums payable for life insurance vary between insurers and are influenced by many factors, not the least being the type of life product purchased, the health of the policyholder and the insurers costs (including commissions and tax). The degree to which tax influences increases in the premiums paid by policyholders cannot be measured with certainty as this will depend on a wide range of risk variables including the insured’s income, lifestyle, and age.

Any change from the status quo may result in an increase in life premiums to the extent that the tax cost is directly passed on to policyholders. The industry has asserted that any change from the status quo could result in premiums increasing, on an all things being equal basis, by 1 % to 30%. The calculations supporting the industry’s analysis were not provided, and given the competitive market for life products such increases would seem to be at the extreme end of the scale.

The demand for life insurance, like any other product, is sensitive to price and the industry is concerned that any change to the current tax preferences will have a corresponding effect on life insurance premiums and could result in a reduction in the demand for life policies. It is, however, impossible to estimate the extent, if any, that the tax preference allowed under the status quo has influenced the pricing and take up of life insurance in New Zealand. International research suggests that while life insurance premium prices are a factor in demand, other important factors such as income, age, education, and dependants are more influential. There is no compelling evidence to suggest that tax preferences alone influence demand.

The transition rules provided for under the preferred option are designed to reduce the impact of the new rules on premium prices. It is expected that the changes to the taxation rules under the preferred option will mean that there should be minimal reason, taxation effects alone, to increase premiums on most existing term life insurance policies until at least 2014–15.

The transition should apply to almost all existing term life insurance policies sold before 1 April 2009 whose premiums are determined annually. Premiums for these policies, which represent the majority of term products sold, are typically calculated by taking into account the age of the policyholder and general economic and health factors. These policies will be grandparented until the insurer’s 2014–15 income year. Restrictions will apply, however, to prevent new policies from being attached to current policies that are subject to the transitional provisions.

The transition will also apply to premiums paid for certain term insurance sold before 1 April 2009 which provide that the premium amount is fixed. These policies are grandparented and will not be subject to the preferred option.

If a life insurer, considers that the costs of grandparenting policies under the current old rules exceeds the benefits to policyholders, the life insurer can elect to have the new rules apply to those policies. Elections are irreversible.

The preferred option will immediately apply to policies taken out on and after 1 April 2009.

Impact on savings

To the extent that the tax treatment of policyholders under the status quo is a disincentive to saving using life insurance products compared to other savings products taxed under the PIE rules, the proposed changes should remove this disincentive. Subject to the life insurer electing into the PIE rules, participating polices will be treated on an equivalent basis as unit-linked life savings products and managed fund covered by the PIE rules.

Compliance costs

The preferred option, to the greatest extent possible, uses the current procedures and actuarial standards used by life insurers for financial reporting purposes when calculating income tax on risk-based life products. In the long-run this is expected to reduce tax compliance costs, by removing the requirements to make tax specific calculations in addition to accounting and actuarial calculations. Tax specific calculations for grandparented participating products will be required, but these will be the same as those currently undertaken (albeit for fewer policies).

Therefore many of the calculations required under the new rules, unlike those in the current rules, will already be required to be performed for financial accounting purposes using generally accepted accounting practice and actuarial standards, so the changes should not create additional tax compliance costs in this regard.

The proposed reform will, however, require life insurers to:

• understand the new rules;

• update their work programmes and spreadsheets;

• understand new tax forms and tax reporting requirements.

New products will also have to be priced on the basis of the rules.

The compliance costs associated with the preferred option were not identified as a particular concern by submissions, aside from those connected with re-pricing premiums for new life products sold on and after 1 April 2009 and implementing changes to ensure compliance with the PIE rules, such as paying tax on behalf of policyholders on the basis of their marginal tax rates. Submissions did not provide any estimates of levels compliance costs.

It has not been possible to quantify the level of compliance costs resulting solely from the proposed changes, as many of the proposed changes are similar to processes currently required for financial accounting purposes. However, the proposed changes are highly specialised and apply to a relatively small number of large businesses which are already expert in life insurance taxation and actuarial practice. Systems and processes set up at the start of the new rules may result in high initial costs for some insurers, but have low ongoing costs.

It is likely that the transitional rules for policies sold before 1 April 2009 will create on-going compliance costs arising from the need to have systems and procedures in place that identify that different taxation rules will apply. This cost is considered a necessary trade-off in order to reduce the impact of the preferred option on premiums paid for policies taken out before 1 April 2009. Life insurers will have the option of electing out of the transitional rules if they feel the benefit is not worth the cost of compliance.

As the PIE rules are elective, life insurers should only elect into the rules if they consider that the benefits to policyholders outweigh the costs.

There are no tax compliance requirements for policyholders.

Administration costs

The preferred option is not anticipated to create any new additional administration costs (besides those associated with the transition in terms of staff training, developing new forms and reporting systems) from those currently incurred by Inland Revenue. A specialist group with Inland Revenue’s audit and assurance function already exists that deals with taxation matters affecting life insurers.

Consultation

An officials’ paper, Life insurance tax reform: Officials’ paper No 1 – scope of the reform, released in September 2006 outlined the current taxation rules and their apparent inadequacies. The paper did not call for submissions but provided a framework for discussion with interested parties.

The product of these meetings helped form the content of a second officials’ paper, Life insurance tax reform: Suggestions for reform, in February 2007. Twenty-four submissions were received on this paper from a wide range of industry members, professionals, and industry associations. Submitters were subsequently met.

A working group with the Investment, Savings and Insurance Association (ISI) was formed to work on details of the new rules based on the model proposed. Officials also consulted with other professionals and insurers.

In December 2007 the government released discussion document, Taxation of the life insurance business: proposed new rules. Earlier drafts of the document were reviewed by a senior actuary from PricewaterhouseCoopers for technical accuracy and commercial practicality. Eighteen submissions were received. The preferred solution is based on the proposals in the discussion document modified, where considered appropriate, by the submissions and subsequent consultation.

The main concerns raised by submissions were about the proposed transitional rules, in particular the duration of the transitional period and the application date for the changes, and the treatment of annuities. Where relevant, concerns about the specific details associated with transition from the status quo to the proposed new rules have been addressed. An example is in the carry-forward of losses and recognition of reserves. The taxation treatment of annuities has been included in the tax policy work programme for further consideration.

Loyalty programmes and GST

Executive summary

Goods and Services Tax (GST) is charged on goods and services consumed in New Zealand. Since exported goods and services are consumed outside of New Zealand, as a general rule, exports of goods and services are zero-rated. Zero-rating allows supplier of goods and services not to charge GST, but still be able to claim input tax deductions.

There may be situations when supplies of what are normally considered zero-rated goods or services are essentially subject to GST at the normal rate. This could happen when a person, for example, redeems loyalty points obtained through certain arrangements subject to GST at the usual rate for a supply that should be zero-rated. This has led to GST being imposed on, for example, supplies of international travel, which is normally are zero-rated.

The proposed option is to amend the Goods and Services Tax Act 1985 (the GST Act) to allow certain loyalty programme operators to defer the imposition of GST until the redemption of the loyalty points to ensure that no GST is being paid on the provision of such supplies.

Adequacy statement

Inland Revenue has reviewed this Regulatory Impact Statement (RIS) and considers the disclosure of information is adequate and the level of analysis is appropriate given the likely impacts of the proposal. The Regulatory Impact Analysis Unit has not reviewed this RIS as the proposal under consideration does not significantly impact on economic growth.

Status quo and problem

As GST is based on the destination principle, in general, exported goods and services, including international travel, are zero-rated. The destination principle is a design feature of the GST system which seeks to prevent double taxation. International travel takes a consumer from New Zealand to an overseas destination. Since the service in question is ultimately consumed outside of New Zealand, it is treated as an export.

The zero-rating of exported supplies might not be achieved when the supplies are not acquired directly for a monetary consideration but are acquired in exchange for certain loyalty points. For example, an arrangement can be entered into by 2 parties, a loyalty programme operator and a loyalty points purchaser, whereby the loyalty point purchaser would pay consideration to the loyalty programme operator for crediting loyalty points to a customer. Since GST is a tax on transactions, such an arrangement should be taxed at the normal rate, when the loyalty programme operator issues the points to the customer. This is because the supply from the loyalty programme operator to a loyalty points purchaser is not of a supply of exported goods or services, but a supply of a service within New Zealand. Therefore, if the customer later redeems the loyalty points so acquired for what would normally be treated as a zero-rated supply, the first supply would still be subject to GST.

Objectives

The objective is to ensure that the GST liability on goods and services that should be zero-rated will not depend on whether the goods and services were acquired for a monetary consideration or by using loyalty points. There is no policy rationale in the same ultimate supply attracting a different GST treatment depending on the method by which it was acquired.

Alternative options

Status quo

Although the status quo could be retained by continuing to impose GST on loyalty points at the time they are issued, this is not the ideal option.

The purpose of loyalty points is to provide a method by which a customer can acquire a future reward from a loyalty programme operator. Loyalty points have no use unless they are redeemed for a reward. The fact that the customer might not know whether he or she will redeem airpoints and for what, does not change the reality that what the customer acquires is the promise of future goods or services. Imposing GST on such supplies even though they might be redeemed for zero-rated supplies, may distort prices charged for supplies and is inconsistent with tax policy objectives.

Where rights are acquired for the future provision of goods and services, the GST Act provides for a variety of outcomes for determining the basis and timing of taxation. For example, vouchers may be taxed on either issue or redemption based on practical considerations. In situations such as that under consideration, where it is not known whether and for what purpose redemption will occur, determining the tax treatment at the time of redemption, and not at the time of issue, would be appropriate.

Targeted zero-rating

One option proposed during consultation is to zero-rate the supply of points under an arrangement between a loyalty programme operator and a loyalty points purchaser, where and to the extent that those rights are redeemed for zero-rated goods and services.

Since this option requires the zero-rating to occur when points are being issued, the loyalty programme operator would have to use speculative estimations in order to apportion between loyalty points to be zero-rated and points to which the standard rate GST should apply. This is inconsistent with the accuracy required of a tax on transaction. Moreover, the GST Act does not apportion output tax in transactions where there is a single consideration and doing so would be inconsistent with policy. This option would also create additional compliance costs and administrative costs arising from the need to re-evaluate the GST apportioned on the issue of points in order to ensure that the ultimate GST liability was correct.

Voucher rules

The GST Act contains special voucher rules that may allow a taxpayer to impose GST on redemption in certain circumstances. Under the voucher rules the supply of a voucher can be recognised for GST purposes at the time the voucher is issued, or where it is not practical, GST may be recognised when the voucher is redeemed for goods and services.

The voucher rules have wide application. Therefore, making any amendments to the voucher rules to extend their application could have uncertain effects and costs, and thus should not be done without extensive consultation.

Preferred option

To ensure that the same ultimate supply does not attract a different GST treatment depending on whether the customer buys goods or services directly or acquires them by using loyalty points, it is proposed that GST on loyalty points sold under certain arrangements be deferred until the points are redeemed.

It is proposed that new rules are introduced for loyalty programme operators to apply where:

• 25% or more of the loyalty programme operator’s or its associated person’s business involves the provision of zero-rated goods or services.

• The operator or its associated person has a business activity outside the activity of operating a loyalty programme (the main business activity) and the loyalty points are able to be redeemed for rewards supplied by the operator or its associated person as part of the main business activity.

• The loyalty programme operator is able to identify, at the time of the redemption of loyalty points, whether or not GST has already been imposed on the points in question when they were issued or whether the GST liability was deferred until the redemption of points under proposed section.

If these conditions are satisfied, the loyalty programme operator will be able to choose to defer the GST liability in respect of transactions that would normally be subject to GST until the redemption of the loyalty points. The standard rate of GST would therefore only be imposed on redemption if the points were being exchanged for goods or services that would not normally be zero-rated.

If the loyalty programme operator decides against utilising the proposed rules, GST will be imposed as under the current rules.

Consultation

Air New Zealand was consulted, supports the proposed changes, and has no significant concerns with the preferred option.

Exported second-hand goods

Executive summary

Goods that are exported from New Zealand are generally not subject to GST. This treatment reflects the policy that exported goods are zero-rated, subject to the supply meeting certain statutory requirements.

An exception applies to the export of second-hand goods if the exporter has claimed an input tax deduction (sometimes referred to as an input tax credit) when the goods were acquired. This exception is an anti-avoidance measure that is designed to prevent arrangements that could create revenue leakage.

Exporters who deal with second-hand goods, such as scrap metal dealers, have commented that the current anti-avoidance rule is inconsistent with the wider objectives of GST, in that it imposes GST on exported goods.

The proposed change to the Goods and Services Tax Act 1985 (the GST Act) deals with this concern in a way that allows certain exported second-hand goods to be zero-rated but does not put the GST base at risk.

Adequacy statement

Inland Revenue has reviewed this Regulatory Impact Statement (RIS) and considers the disclosure of information is adequate and the level of analysis is appropriate given the likely impacts of the proposal. The Regulatory Impact Analysis Unit has not reviewed this RIS as the proposal under consideration does not significantly impact on economic growth.

Status quo and problem

In general, exported goods are zero-rated and this reflects the policy that goods and services consumed outside New Zealand should not be subject to GST. The general zero-rating rules that are applicable to exported goods require that:

• the goods are entered for export under the Customs and Excise Act 1996; and

• leave New Zealand within 28 days of the goods being supplied, as determined by the earlier event of the recipient paying for the goods or the supplier issuing an invoice.

An exception applies in connection with exported second-hand goods. If the exporter, or an associate of the exporter, has deducted input tax when acquiring the second-hand goods from an unregistered person, GST must be charged on the basis of the value of the second-hand goods when they were acquired. This rule is an anti-avoidance measure.

The purpose of imposing GST on the export is to reverse the original input tax deduction claimed. Any “added-value” that the supplier provides in connection with the second-hand goods may still be zero-rated. In other words, zero-rating is denied to the extent of the second-hand goods input tax deduction claimed by the exporter.

In the absence of GST applying at a standard rate to exported second-hand goods, it is possible that no GST would be collected but the government could suffer a revenue loss equal to the amount of the second-hand goods input tax deduction. In situations where GST does not apply to certain imported goods, such as artwork, antiques, and heirlooms, it is possible that the goods could be repeatedly imported to and exported from New Zealand to take advantage of the resulting input tax deductions.

The scrap metal industry is concerned that the current legislation forces them into a less competitive position than other New Zealand exporters and has a direct impact on their profitability.

Objectives

The objective is to ensure that the GST Act does not distort the export opportunities for second-hand goods that are consumed outside New Zealand but at the same time does not expose the GST base to leakage arising from transactions that repeatedly seek to exploit the deduction available on the purchase of second-hand goods.

Provided that GST has been paid at some stage during the lifecycle of the second-hand goods concerned, zero-rating should be allowed when they are exported.

Alternative options

Status quo

Other options have been considered, including the status quo. One reason for maintaining the status quo is the administrative and compliance cost concerns associated with tracing the exported goods once they leave New Zealand. However, in terms of the decision to proceed with legislative change following the approach from the scrap metal industry, the economic cost of not zero-rating exported goods is considered to exceed these concerns.

The economic costs identified with not zero-rating exported second-hand goods include the different tax treatment between exports of new goods compared to second-hand goods and the impact this could have on business decisions about whether or not to export scrap or similar waste products. The benefit received by the government in terms of protecting the GST base imposes economic costs on exporters of second-hand goods.

Because the problem affecting exporters of second-hand goods arises as a direct result of the GST Act, legislation is the only effective means for achieving the desired objective.

During consultation, 2 other legislative options were advanced by affected taxpayers for consideration. The following describes why these 2 options were not considered suitable.

Commissioner discretion

This option would give the Commissioner of Inland Revenue the power to identify specific second-hand goods which could be zero-rated.

The concern with this option is that it is inconsistent with taxpayer self assessment in that a taxpayer’s determination of their tax position would depend on the exercise of the Commissioner’s judgement. Consistency of application would also be a concern. This option was not considered suitable.

Change for scrap metal only

An alternative solution proposed that scrap metal, as defined in the Secondhand Dealers and Pawnbrokers Act 2004, be specifically zero-rated.

This option directly addressed the problem faced by scrap metal dealers and did not allow the type of goods that would be of concern from being zero-rated. However, its targeted application is problematic and there is little policy rationale for distinguishing between second-hand goods that are scrap metal and second-hand goods that are not scrap metal. For this reason, this option was not considered suitable.

Of the legislative options considered, including the preferred option, the identified costs and benefits were largely the same in terms of the systems necessary to support the decision to zero-rate the export.

Preferred option

Under the preferred option, GST-registered persons will be able to zero-rate exported second-hand goods if the following requirements are met:

• Consistent with the existing rules for zero-rating exported goods, the second-hand goods are entered for export, or will be entered for export as a condition of the supply, under the Customs and Excise Act 1996, and the supplier exports the goods within 28 days.

• The overseas recipient does not anticipate that the goods will be exported back to New Zealand by the recipient, or a person associated with the recipient, in substantially the same form in they were received. A written statement to this effect would be required at the time of supply. Affected taxpayers consider this requirement can be easily achieved as part of the purchase agreement.

To ensure that the change does not create a base maintenance risk, the current anti-avoidance rule will continue to have application if the exported goods are sold back to the exporter in substantially the same condition in which they were originally supplied.

To prevent the possibility of double taxation, the amended anti-avoidance provision would not apply if GST is collected by the New Zealand Customs Service should the goods return to New Zealand.

The benefit of the proposal is that the anti-avoidance provision is better directed at those arrangements that are of concern to the government and it also allows exported second-hand goods to be zero-rated. The export requirements imposed by the proposal to support the decision to zero-rate are a cost, but one that is generally borne by most exporters. The additional documentation requirements created by the proposal are considered necessary to balance the government’s need to protect the GST base against the benefit of zero-rating exported second-hand goods.

Consultation

KPMG, Macaulay Metals and the Scrap Metal Dealers Association were consulted. Those consulted support the proposed change and no significant concerns were identified with the preferred option.

Reducing tax compliance costs for SMEs—changes in certain tax thresholds

Executive summary

In Budget 2007, the government announced plans to look at measures aimed at reducing tax compliance costs for small and medium sized enterprises (SMEs). This included the release of a discussion document for public consultation.

The discussion document, entitled Reducing tax compliance costs for small and medium-sized enterprises set out the scope of the review and explained that the Government retains a continued interest in ensuring tax compliance costs are minimised as SMEs represent a large portion of the economy and they tend to bear a disproportionate tax compliance cost burden.

While the focus of the potential initiatives contained within the discussion document was on SMEs, where appropriate, measures applying to businesses more widely have also been considered. Submissions were sought on the discussion document to ensure that meaningful reductions in tax compliance costs are achieved.

The main recommendations and issues considered in the discussion document were in 2 parts. The first part, and the issues to which this particular regulatory impact statement relates, discussed increases to tax thresholds. The second part related to issues that would represent more fundamental departures from the standard tax rules, and which will require a longer consultation period.

Views were therefore initially sought on certain tax thresholds. After receiving submissions and undergoing some further consultation, changes to the following tax thresholds are proposed:

• pay as you earn (PAYE) once-a-month filing and payment;

• fringe benefit tax (FBT) annual return filing;

• provisional tax use of money interest safe harbour;

• goods and services tax (GST) registration;

• GST six-monthly return filing;

• those relating to accounting for financial arrangements; and

• low-value trading stock.

Adequacy statement

Inland Revenue and the Treasury have reviewed this Regulatory Impact Statement (RIS), and consider that it is adequate according to the Regulatory Impact Analysis adequacy criteria.

Status quo and problem

Compliance with tax laws can entail significant time and costs for many businesses. Compliance costs can arise because of the variety of tax compliance activities involved (for example, performing tax calculations, seeking advice, record-keeping, filing returns, and making tax payments) and the complexity of tax law and administrative procedures. These costs often have a disproportionate impact on SMEs, which make up approximately 96% of total businesses in our economy.

Minimising tax compliance costs is an important matter for all businesses. However, research suggests that while SMEs do not bear higher compliance costs than larger businesses in absolute terms, they do bear higher relative costs. Consequently, SMEs may bear a disproportionate burden of tax compliance costs. Higher relative costs can be a barrier to economic growth for a group that constitutes the majority of New Zealand businesses. By making it easier for business to comply with their tax obligations, valuable economic resources are freed up and re-directed towards more productive activities. This should also improve voluntary compliance in the sector.

Objectives

The purpose of the SME discussion document and associated review is to reduce tax compliance costs for businesses operating under New Zealand tax laws in order to assist productivity and competitiveness. The emphasis is on measures that may reduce these costs for SMEs. However, where appropriate and/or feasible, measures that might apply to businesses generally are also considered.

Officials sought submissions on a number of possible measures aimed at reducing or eliminating, where possible, the activities that give rise to significant tax compliance costs for SMEs. It also looks at streamlining certain other tax compliance activities, having regard to issues such as the security of tax revenues, fiscal costs, and administrative feasibility.

The first part of this review, and the initiatives to which this particular RIS relates, deal with the variety of monetary thresholds used in defining certain tax obligations faced by taxpayers. These thresholds set limits for certain rules, generally with the aim of reducing tax compliance costs for taxpayers that fall below those limits.

Thresholds can be changed by increasing the level at which they are set and by extending the types of taxpayers that may elect to use them. From a taxpayer’s perspective, changing a threshold may reduce compliance costs by reducing the number of tax returns that must be completed, by reducing the amount of information or the number of calculations required to complete each return, or by reducing the number of payments the taxpayer must make to Inland Revenue. The measures being proposed would reduce the number of interactions taxpayers have with Inland Revenue, and the amount of time taxpayers must spend on complying with tax rules.

Reducing the complexity of the tax rules means that taxpayers are less likely to require expert assistance, and are less likely to make errors. As well as reducing tangible costs, such as hours spent and expenditure on accounting fees, reducing the complexity of the tax rules can reduce the stress associated with completing tax requirements.

Alternative options

A range of threshold related options were considered, taking into account the number of businesses that fall within applicable thresholds, together with the need, where appropriate, to ensure that thresholds are kept in line with inflation.

Changes to the threshold for the change in use adjustment for GST were considered but, after taking into account the costs involved, submissions made, and the relative benefits likely to arise, these were not considered appropriate at this time. A GST registration threshold of $60,000 was also considered, but it was felt that a lower threshold was more appropriate to the maintenance of a GST system that applies at a low rate to a very broad range of goods and services.

Other non-threshold related options for reducing compliance costs for SMEs are also still being considered. These include:

• consideration of a single threshold for certain concessions;

• introducing a de minimis threshold under which legal expenses are fully deductible;

• introducing a de minimis threshold under which deductions for entertainment expenses are allowed in full;

• introducing a category of restricted private-use motor vehicles for SMEs for FBT purposes by setting the basis for valuing private use at 10% of cost (rather than the current 20%) and phasing out the exemption for work-related vehicles;

• simplifying record-keeping requirements for recording private use of motor vehicles for FBT purposes;

• simplifying GST invoice disclosure and other requirements; and

• introducing various tax administration initiatives, such as changing certain processes including correcting minor errors in subsequent returns, using the GST ratio to pay provisional tax, and reviewing the PAYE intermediary subsidy.

Preferred option

The preferred option is to as the following changes:

• the threshold for PAYE once-a-month filing and payment to increase from $100,000 to $250,000 (based on annual PAYE deductions);

• the threshold for FBT annual return filing to increase from $100,000 to $250,000 (based on annual PAYE deductions);

• owner-employees of closely held businesses to file FBT returns annually, regardless of their annual PAYE deductions, when their FBT liability is for no more than 2 vehicles;

• the safe harbour threshold for provisional tax use of money interest (UOMI) to increase from $35,000 to $50,000 (based on annual residual income tax);

• the GST registration threshold to increase from $40,000 to $50,000 (based on annual GST turnover);

• the GST six-monthly return filing threshold to increase from $250,000 to $500,000 (based on annual turnover);

• non-individuals to be allowed to return income tax for financial arrangements on a cash accounting basis, and the threshold for straight line accounting to increase from $1.5 million to $1.85 million (based on the total level of financial arrangements); and

• the threshold for the exemption from adjustments for low value trading stock to increase from $5,000 to $10,000 (based on the value of trading stock).

The application date for these measures is 1 April 2009.

Consultation

Officials from Inland Revenue, the Treasury and the Ministry of Economic Development undertook preliminary consultation on the various options included in the discussion document. Those consulted included the Small Business Advisory Group, New Zealand Institute of Chartered Accountants, Business New Zealand, New Zealand Chambers of Commerce and Industry, and Tax Agents’ Institute of New Zealand. Various submissions on the issues in the discussion document were also received from interested parties.

Tax treatment of reimbursements and honoraria paid to volunteers

Executive summary

In the absence of explicit rules on the tax treatment of reimbursements paid to volunteers, a range of practices has developed, with the result that volunteers and organisations are confused about their tax obligations and are incurring unnecessary compliance costs. To address these problems the following key changes are proposed:

• Reimbursements that are based on actual costs incurred by a volunteer should be treated as exempt income with no limits. This would include reimbursements based on a reasonable estimate of expenses likely to be incurred by the volunteer; reimbursements in non-cash form such as petrol vouchers, and reimbursement of transport costs incurred in the course of volunteering, as well as transport costs incurred in getting to and from the place of volunteering.

• Honoraria will continue to be taxable but if an organisation pays honoraria including reimbursements to a volunteer, that organisation would be required to pay the reimbursements separately from honoraria if the volunteer is to gain the advantage of the exempt income treatment of the reimbursements.

Adequacy statement

Inland Revenue and the Treasury confirm that the Code of Good Regulatory Practice and the regulatory analysis requirements, including the consultation RIA requirements, have been complied with.

Status Quo and problem

New Zealand income tax law does not explicitly address the issue of the taxation of reimbursement payments to volunteers. However, under a strict interpretation, such payments are considered income and the relevant expenses deductible. That means the income should be stated and expenses claimed in the person’s income tax return.

A number of pragmatic approaches have, however, developed in respect of such payments when made to volunteers; from treating them as withholding payments and deducting tax at source, to ignoring them as if they were exempt income. The latter treatment assumes that the costs incurred equal the reimbursement received so that the net effect is no tax to pay. As a result of the lack of clarity and varied practices, volunteers and the organisations that use their services are confused and often anxious about their tax obligations, and are incurring unnecessary compliance costs.

Honoraria are withholding payments from which the payer, under current law, must deduct tax at the rate of 33 cents in the dollar. However, a practice has developed over time of payments that are characterised as honoraria sometimes including reimbursements along with a fee for service, or they may even be wholly reimbursement payments.

Since the tax deducted from honoraria is not a final tax, recipients must still file a tax return and claim any expenses incurred as a deduction before their tax position can be finalised.

Objectives

The objectives for reform of this area of tax law were to:

• determine the appropriate tax treatment of reimbursement payments made to volunteers;

• ensure that the law is clear and simple to apply;

• minimise, as much as possible, the compliance costs associated with return filing for volunteers and for the organisations for which they carry out their voluntary activities; and

• propose a basis on which payments to volunteers characterised as honoraria, which are actually reimbursements for costs incurred, can be removed from the withholding payments regime.

Alternative options

Setting a threshold up to which reimbursements would be treated as exempt income

Under this option, a threshold would be set that represents a “reasonable” amount for the reimbursement of any actual costs incurred. Reimbursement payments up to that level would be treated as exempt income and volunteers would not be required to include those payments in their income tax returns. Payments in excess of the threshold would have to be included in the volunteer’s income tax return and claimed expenses would have to be supported by documentary evidence of costs incurred before they would be allowed as a deduction.

This option would clarify the tax treatment. However, while a threshold would achieve the objective of minimising compliance costs for some individuals and organisations, it would not be effective for others. This was the view of almost three quarters of the submitters on the officials’ issues paper The tax treatment of honoraria and reimbursements paid to volunteers. It would also be difficult to justify a different tax treatment of payments that have similar features purely on the basis of their cumulative monetary value over a tax year.

Treating reimbursements not based on actual costs as exempt income up to a threshold

To mitigate the risks associated with reimbursements based on an estimation of costs that had been or would be incurred by volunteers the issues paper proposed that a cap could be imposed on that type of payment. However, this was not widely supported and would have been inequitable for volunteers when compared with the treatment of reimbursements paid to employees.

Claiming costs incurred as donations for the purposes of the donations rebate

Under this option, volunteers would be able to claim costs incurred in the course of volunteering, which have not been reimbursed, as donations for the purposes of the donations rebate. This option was suggested in some submissions on an earlier discussion document and is the approach taken in the USA. However, it was not supported by officials and not canvassed further in the issues paper because:

• it would increase compliance costs for both volunteers and their organisations;

• there would be an incentive for organisations not to reimburse their volunteers so the volunteers would continue to be “out of pocket” until they could claim their rebate after the end of the tax year; and

• volunteers who were reimbursed would not be relieved of tax filing obligations.

Honoraria to be tax-free up to a threshold of $1,000 per annum

Under this option, volunteers and organisations would be relieved of the compliance costs associated with return filing for honoraria payments until the total paid reached a threshold, which was proposed to be $1,000 per annum. A partial tax exemption for honoraria would have to be implemented on a per volunteer per organisation basis as an organisation would not know what withholding tax was being deducted by another organisation. This could have the effect of increasing the exemption available to individual volunteers to above $1,000 if they were receiving honoraria from more than 1 organisation and was regarded as an unacceptable revenue risk.

In addition, as for the option of a threshold for reimbursements, it would also be difficult to justify a different tax treatment of payments that have similar features purely on the basis of their cumulative monetary value over a tax year.

Withholding tax deducted from net honoraria paid to volunteers

Under this option the payer of an honorarium would be required, on an individual basis, to calculate the portion of an honorarium that represents expenses that have been, or will be, incurred. The payer would be required to deduct withholding tax only from the net amount.

This option would require payers to know in advance what expenses are likely to be incurred so they can correctly calculate the taxable portion of the honorarium, and the amount of withholding tax. This would significantly increase up-front compliance costs for payers of honoraria to volunteers. On the other hand, this option would be likely to eliminate compliance costs for some volunteer recipients of honoraria because they would no longer need to file an income tax return solely to claim a deduction for their expenses.

All except 1 of the submissions on the issues paper that commented on this option were opposed to the option, with most citing compliance costs as their main concern.

Preferred options

Reimbursements paid to volunteers

Our preferred option for the treatment of reimbursements paid to volunteers is that:

• Reimbursement payments that are based on actual costs incurred by volunteers should be treated as exempt income with no limits.

• If a paying organisation puts in place a process for making a reasonable estimate of the costs likely to be incurred by a volunteer in a given period, then payments made to the volunteer based on that estimate would also be treated as exempt income. This would include reimbursements in non-cash form such as petrol vouchers. The proposed treatment would also include reimbursement of transport costs incurred in the course of volunteering, as well as transport costs incurred in getting to and from the place of volunteering.

The proposed treatment would put volunteers in a no less advantageous position than employees.

Some concern was expressed about the risk that flat-rate reimbursements could be used to re-characterise payments that should be treated as income. The indications are that few, if any, organisations pay a regular flat rate reimbursement amount based on an estimation of actual or expected costs. It is to mitigate that risk that the payer of such reimbursements would be required to make, for a relevant period, a reasonable estimate of expenditure likely to be incurred by the volunteer for which reimbursement is payable. The estimated amount, when paid, would then be treated as exempt income similar to reimbursements based on actual costs.

It should also be a matter for the paying organisation to have in place adequate controls and records on which to base reimbursement payments that will satisfy audit requirements.

There is no evidence of what, if any, tax is currently collected in respect of pure reimbursement payments and the information gained through an independent survey is that almost invariably the costs incurred by volunteers far exceeded any reimbursement that they received. The estimated loss of future tax revenue would be outside the range of significant fiscal impacts.

The proposed treatment will almost entirely eliminate compliance costs in relation to reimbursement for volunteers and minimise compliance costs for the paying organisations.

Implementing the proposed changes will require amendments to the Income Tax Act 2007 and the Tax Administration Act 1994.

Honoraria paid to volunteers

We propose that honoraria should continue to be treated as taxable income and subject to withholding tax at source.

However, if an organisation pays honoraria including reimbursements to volunteers, that organisation would be required to pay the reimbursements separately from honoraria if the volunteers are to gain the advantage of the exempt income treatment of the reimbursements.

Under this option, volunteers would be able to receive the full value of the reimbursement of the costs they have incurred, rather than wait until they file a tax return at the end of the year.

The total revenue cost of the proposals relating to volunteer reimbursements and honoraria is estimated to be in the range of $2.3 million to $3.3 million. This is based on an estimation of the portion of the tax currently withheld from honoraria that represents tax on reimbursements and that would not be collected in future under these proposals. The total level of tax revenue collected through honoraria payments is estimated at $7 million per annum so this is the maximum exposure to the revenue base.

Consultation

The following agencies were consulted in the development of the issues paper and presentation of policy proposals to Ministers: The State Services Commission, the Office of the Community and Voluntary Sector, the Department of Internal Affairs, the Ministry of Education, Sport and Recreation New Zealand, Te Puni Kokiri, the Ministry of Social Development, and the Department of Labour.

The officials’ issues paper was published on the Inland Revenue Policy Advice Division’s website and widely promoted through key sector organisations.

The policy proposals were also informed by the findings of researchers from Victoria University of Wellington, School of Accounting and Commercial Law published in their report Tax and volunteering: empirical evidence to support recommendations to solve the current problems surrounding the tax treatment of volunteers’ reimbursements and honoraria in New Zealand.

Payroll giving scheme

Executive summary

In Budget 2007, the government announced plans to look at several measures aimed at laying the foundation for a stronger culture of charitable giving in New Zealand. Among those measures was the release of a discussion document on the implications of introducing a before-tax payroll giving scheme in New Zealand, for public consultation.

The discussion document entitled Payroll giving: providing a real-time benefit for charitable giving, considers 2 options for implementing a before-tax payroll giving in New Zealand, as well as possible measures for supporting employers to choose to offer payroll giving to their employees.

The preferred option (PAYE credit mechanism) would deliver an immediate tax benefit to the employee consistent with the current charitable rebate. This option has the added advantage in that it does not alter the level of an employee’s taxable income and therefore does not impact on the employee’s social policy entitlements and obligations that use taxable income as the basis of their calculations.

Adequacy statement

Inland Revenue and the Treasury have reviewed this Regulatory Impact Statement (RIS), and consider that the Statement is adequate according to the Regulatory Impact Analysis adequacy criteria.

Status quo and problem

In New Zealand, payroll giving is neither well known nor widely practised. Even so, a small number of employers have established payroll-giving relationships with individual donee organisations and with United Way. Donations are made from the after-tax pay of the employee. Many employers that currently offer a post-tax payroll-giving scheme are trans-Tasman employers. Individual donee organisations are also running, investigating, or developing payroll-giving programmes. A donee organisation is an entity or trust whose activities are not carried out for the private pecuniary profit of any individual and whose funds are applied principally for charitable, benevolent, philanthropic, or cultural purposes in New Zealand. For donee organisations, payroll giving is an efficient, low-cost way to raise funds and delivers the regular income support they need.

Under the current law, as long as they keep records, employees can claim the tax benefit of payroll donations at the end of the year through the current rebate process, like any other charitable donation.

The government is interested in exploring the merits of a before-tax payroll giving system. A before-tax payroll giving system enables employees to make regular financial contributions from their gross pay to philanthropic and charitable causes and receive an immediate tax benefit on their donations at each payday. Such a system would remove the need for employees to retain receipts and file end of year rebate claim forms. This type of scheme operates in the United Kingdom and Australia.

Objectives

The objective is to implement a before-tax payroll giving system that enables employees to make regular financial contributions from their gross pay to philanthropic and charitable causes and receive an immediate tax benefit on their donations at each payday. Such a system should not raise undue costs and should be easy to administer for employers who choose to offer payroll giving to their employees. Any system of payroll giving should be equitable.

It is envisaged that any before-tax payroll giving system would be voluntary for employers and employees and would operate alongside the current rebate process. Therefore, for employees who do not or are notable to give through payroll giving they can still claim tax relief on their charitable donations through the current rebate claim process.

Alternative options

The alternative option is the tax deduction mechanism. Under this option, payroll donations would be deducted from an employee’s gross pay each payday before the imposition of PAYE. This would essentially reduce the amount of the employee’s taxable income by the amount of the donation, and the employee would receive an immediate tax benefit as no tax would be paid on the donation amount.

This would mean that the tax value of charitable donations to donors would be determined by the employee’s marginal tax rate. For example, if the employee is on a 19.5% tax rate, then the tax benefit they would receive from the deduction would be 19.5% for every dollar donated to a donee organisation through payroll giving. A person on a 39% tax rate would receive a tax benefit of 39% for every dollar donated to a donee organisation. This delivers a different tax benefit to the current rebate system which is a flat rate of 33⅓% for all donors.

An employee’s social policy entitlements and obligations that use taxable income as the basis of their calculations would be affected by this option. Deducting the donation amount from the employee’s gross pay would, in effect, reduce his or her taxable income. For example, a reduction in an employee’s taxable income could result in a decrease in their child support liabilities and student loan repayments, and an increase in their Working for Families tax credit entitlements. In addition, the employee’s ACC earner premium would be reduced and the low income rebate would increase.

KiwiSaver employee contributions would also decrease as a result of donations made through payroll giving under this option. KiwiSaver employer contributions would likewise decrease.

The compliance costs associated with this option for employers would be minimal as they would only be required to deduct the donation amount from the employee’s gross pay. No extra information would be required to be collected through the employer monthly schedule, instead relevant information would be collected at the end of the year through an additional form. The extra form would contain information on the total amount of donations collected during the year through payroll giving.

Employees would not be required to retain donation receipts or file end of year rebate claim forms in order to claim the benefit of their charitable donations. Employees would also be able to receive the tax benefit of their payroll donations each payday.

Preferred option

The preferred option would require employers to calculate a PAYE credit of 33⅓% on the amount of the donation and would offset this amount against the PAYE calculated on the employee’s gross pay each payday.

Under this option, it is intended that all employees would receive a tax benefit of 33⅓% for every dollar donated to a donee organisation through payroll giving, irrespective of their marginal tax rate. This option would deliver an immediate tax benefit to the employee consistent with the current charitable rebate, without altering the level of their taxable income.

This option would have no impact on an employee’s current social policy entitlements and obligations that use taxable income as the basis of their calculation. Similarly, as the employee’s PAYE is still calculated on their pre-donation gross pay amount there would be no impact on the PAYE calculation, the ACC earner premium, and the low-income rebate would not be affected.

The compliance costs for employers would be greater under this option, compared with the tax deduction mechanism, as employers would have extra calculations to perform at each pay period and would need to supply the donation and/or PAYE credit amounts through the employer monthly schedule. Anecdotal evidence suggests that this would be relatively easy for employers with computerised payroll systems.

The compliance costs for employees under option 2 would depend on their level of giving. For most employees they would not be required to retain donation receipts or file end of year rebate claim forms in order to claim the benefit of their charitable donations. They would receive the tax benefit of their payroll donations each payday. However, under this option, it is possible that an employee might not receive the full benefit of their payroll donations on each payday. This would occur when the PAYE credit exceeds the PAYE amount calculated on the donor’s gross pay each pay day. For example, a donor earns $400 each payday and gives more than 50% of their pay to charity. In this instance, the PAYE credit would exceed the actual PAYE calculated. Similarly, for a donor earning $1,100 each payday, this problem would occur if the donor gave 76% of their pay to charity each payday. In order to address this problem, the donor could be permitted to make a claim for any unused portion of the PAYE credit at the end of the year. While this would ensure that the employee receives the full tax benefit of their charitable donations made through payroll giving, it would increase the compliance costs for the affected employees.

Consultation

The proposed system of payroll giving arose from the discussion document Payroll giving: providing a real-time benefit for charitable giving, which was issued for public comment in November 2007.

A total of 36 submissions were received from a wide range of people and organisations. These included individual donors, charities and other non-profit organisations, sector advisors, tax specialists, Crown entities, and overseas organisations involved in the non-profit sector. Most of the submissions were from umbrella organisations from the non-profit sector. ANZ National Bank Ltd, Business NZ, and the New Zealand Manufacturers and Exporters Association provided the “employer perspective” in submissions.

Feedback from consultation on the discussion document confirmed that there is strong support for the concept of a voluntary before-tax payroll giving system for New Zealand. Submissions considered that payroll giving would make it much easier for employees to make regular, voluntary contributions to their favourite charities, and would also provide charities with a low cost, on-going source of funding. Some businesses see the introduction of payroll giving as part of their corporate social responsibility work. However, there was serious concern for the potential compliance cost burden on employers.

In preparing the Cabinet submission the following departments were consulted: Department of Internal Affairs, the Ministry of Culture and Heritage, the Ministry of Economic Development, the Ministry of Maori Development, the Office of the Community and Voluntary Sector, Sport and Recreation New Zealand, and the Charities Commission.

Those consulted were generally supportive of the concept of payroll giving. Most of them preferred the alternative option for its simplicity and its potential ability to encourage higher income earners to give more.

Removal of section 13 of the KiwiSaver Act 2006

Executive summary

It is proposed that section 13 of the KiwiSaver Act be removed in order to:

• avoid repeated automatic enrolment of individuals transferring between schools in the state and state integrated schools sector;

• alleviate KiwiSaver administration issues faced by state and state-integrated schools and the Ministry of Education.

This change to the Act results in minor reconfiguration of business processes and reduces administrative processes and costs.

Adequacy statement

The Ministry of Education confirms that the principles of the Code of Good Regulatory Practice and the regulatory impact analysis requirements, including the consultation requirements, have been complied with. Formal review by the Regulatory Impact Assessment Unit of the Ministry of Economic Development has not been sought as the regulatory impact is considered to be of a minor nature and does not substantially alter existing arrangements. The changes deal with administrative procedures between departments, and do not impact on business, consumers, or the public.

Status quo and problem

The KiwiSaver Act 2006 (Act) section 13, currently establishes the Boards of Trustees for some 2500 state and state-integrated schools (schools) as the employer in terms of the Act. This results in repeated automatic enrolment of staff transferring between schools and consequential KiwiSaver administration workload.

Amendments to the Act that establish a single employer for staff in the state and state-integrated schools sector would avoid the repeated automatic enrolment of staff transferring between schools and reduce KiwiSaver administration workloads.

Objectives

The objective of the proposed changes is to remove the necessity to automatically enrol staff transferring between schools.

Alternative options

Option 1

Automatically enrol staff once as they enter the education sector for the first time. Automatic enrolment would not apply in the case of movement between schools. This can be achieved by removing section 13 from the Act and establishing the Ministry of Education as the designated single employer for KiwiSaver purposes.

Option 2

Split the employer status between Boards of Trustees and the Ministry of Education. This can be achieved by amending section 13 of the Act to provide for Boards of Trustees to be deemed the employer for auto-enrolment purposes, and the Ministry of Education deemed to be the employer for all other purposes of the Act.

Preferred option

Option 1, removal of section 13 from the Act, is the preferred option as it provides the least ambiguous and is most easily administered.

Removal of section 13 allows automatic enrolment within the state and state-integrated schools sector to function as it does in the wider employment community.

Implementation of the changes would be achieved in 3 stages:

• 1.Securing Cabinet approval to remove section 13 from the Act.

• 2.Make needed legislative changes in this bill.

• 3.Undertake targeted communications to ensure schools understand the purpose, nature, and extent of the changes.

Consultation

Officials from the Treasury, Inland Revenue, and Ministry of Education have jointly developed advice to Ministers.

Reforming the definitions of associated persons

Executive summary

The income tax associated persons definitions are mainly used in an anti-avoidance capacity to counter non-arm’s length transactions that could undermine the intent of our tax laws. There are a number of major weaknesses in the general associated persons definition and, in particular, the definition which applies for land sales. The legislative intent of the land sale tax rules is that property developers and their associates are generally taxed on all gains on property sold within 10 years of acquisition, and that they cannot claim to hold non-taxable investment portfolios. However, the definition of associated persons which applies to land sales contains some major loopholes which allow property developers to escape tax while still operating through closely connected entities.

The preferred option would involve changes to the income tax legislation to address these weaknesses in the associated persons definitions. The main changes would be:

• Addressing the weaknesses in the current definitions in relation to trusts. In particular, there would be new tests focussing on a trust’s settlor, that is, the person who provides the trust property.

• Having more robust rules aggregating the interests of associates, to prevent the tests for associating 2 companies and a company and an individual being circumvented by the fragmentation of interests among close associates.

• Having a tripartite test associating 2 persons if they are each associated with the same third person, thereby making the associated persons tests as a whole more difficult to circumvent.

The preferred option would also rationalise the current 4 income tax definitions of associated persons and other income tax definitions employing a similar concept.

Adequacy statement

Inland Revenue has reviewed this Regulatory Impact Statement (RIS), and considers that the statement is adequate according to the Regulatory Impact Analysis adequacy criteria.

Status quo and problem

New Zealand tax law often subjects transactions between associated persons to special scrutiny because these transactions can pose a substantial risk to the tax base. Transactions between associated persons may involve tax practices that undermine the intent of our tax laws because such transactions are more likely to be non-arm’s length than other transactions.

There are 4 separate definitions of “associated persons” which are used extensively in the Income Tax Act 2007 (the Act), often in an anti-avoidance capacity. There are also a number of other definitions, such as the “related persons” definition in the dividends rules, which employ a similar concept. To date, there has been no comprehensive review of the associated persons definitions to ensure that the Act has a coherent overall approach to defining “associated persons”.

The most important application of the associated persons definition in the Act is in the area of land sales. Parliament decided in 1973, when it enacted the current land sale tax rules, that land dealers, developers, and builders cannot generally hold land on capital account. This means that gains on land sold by these taxpayers within 10 years of acquisition are generally taxed. This legislative intent is clear from the parliamentary debates.

The land sale tax rules are buttressed by associated persons rules to prevent developers escaping tax by structuring ownership of their property through close associates.

There are major weaknesses in the current general associated persons definition and, in particular, the definition which applies for land sales. For example, a property developer may arrange for the trust, settled by the developer and under which the developer is a beneficiary, to acquire land. Under the current associated persons rules, the property developer is not associated with the trust so the trust is not automatically caught by the land sale provisions on the subsequent sale of the land. The policy intent would be that such arrangements are caught. However, due to weaknesses in the rules, they are not.

These weaknesses in the associated persons definitions affect the integrity of the tax system. Taxpayer confidence in the system is undermined if there is a perception that others are not paying their fair share of tax by taking advantage of such loopholes. This perception, in turn, may adversely affect taxpayer behaviour.

Objectives

The main objective is to close the loopholes in the Act’s definitions of associated persons and thereby promote key themes of the Government’s tax policy work programme, which are ensuring that the income tax system is robust and that it does not unduly distort investment behaviour. Another objective is to rationalise the various income tax definitions of associated persons and thereby make the tax law more coherent.

Alternative options

There are no alternative options to the preferred legislative option. Because the current income tax associated persons definitions are in legislation, legislative change is the only option available to achieve the desired policy objectives.

Preferred option

The preferred option involves a number of legislative changes to address the current weaknesses in the associated persons definitions. The main changes involve:

• Addressing the current weaknesses in the current definitions in relation to trusts. The new tests would focus on a trust’s settlor, that is, the person who provides the trust property.

• Having more robust rules aggregating the interests of associates to prevent the tests for associating 2 companies and a company and an individual being circumvented by the fragmentation of interests among close associates.

• Having a tripartite test associating 2 persons if they are each associated with the same person, thereby making the new associated persons tests more difficult to circumvent.

The preferred option would also involve rationalising the current 4 income tax definitions of associated persons and other income tax definitions employing a similar concept, such as the definition of “related persons” that is used in the dividend rules.

Consultation

Inland Revenue and Treasury officials released an issues paper on suggested changes to the definitions of associated persons in the Act in March this year. A total of 812 submissions were received on the issues paper – 657 of these were template letters. The focus of nearly all the submissions was on the impact of the proposals on land sales. Further discussions have been held with a range of submitters. The legislative changes under the preferred option include modifications arising from the consultation process which are designed, in particular, to prevent the changes applying more widely than intended.

Minor, remedial, or consequential matters

Compliance cost implications

Tax pooling

There are currently 4 tax pooling intermediaries. Some intermediaries may have to incur compliance costs in changing their processes to ensure they comply with the original intent of the tax pooling rules.

They will also have to incur compliance costs in providing for the transfer of funds from a tax pooling intermediary to another intermediary. However, this change will facilitate competition amongst intermediaries, so the benefits of the change will be considered by most to outweigh the compliance costs.

All tax pooling intermediaries will have to change their systems to enable taxpayers to access and use tax pooling funds for reassessments, voluntary disclosures, or resolution of disputes for all tax types. This change is supported by tax pooling intermediaries and that taxpayers will benefit from the changes. It is considered that the compliance costs faced by taxpayers will be outweighed by the benefits of the change.

Taxpayers who previously could not access tax pooling funds to pay tax outstanding as a result of a reassessment will now benefit from being able to do so for future assessments.

Migrant workers

There are not expected to be any additional compliance costs faced by employers who are currently complying with their PAYE obligations.

Migrant workers will benefit from having the correct tax deducted during the year and not having to file a tax return. Inland Revenue administrative systems will also be amended to make it easier for migrant workers to obtain an IRD number and to complete a tax code declaration.

General insurance

The proposed reform will require general insurers to understand the new rules and update work programmes and spreadsheets. However, these changes and their associated compliance costs are expected to be minor and apply to a relatively small number of large businesses which are already expert in general insurance taxation.

Banking continuity

There is not expected to be any additional compliance costs as a result of the recommended amendments.

Depreciation remedials and petroleum mining

The amendments ring-fencing petroleum mining expenditure incurred through a foreign branch may impact on New Zealand petroleum miners undertaking operations in other countries. Given the base maintenance concerns, the measure is warranted given the potential revenue risk.

The changes to the tax depreciation rules and to the remaining changes to the petroleum mining rules are considered to be of a minor or machinery nature. There is not expected to be any additional compliance costs as a result of the recommended amendments.

Emission trading scheme

Business’ compliance costs will increase as a result of the introduction of the emission trading scheme and the consequent need to acquire and surrender emission units. However, the tax proposals have been developed with a view to minimising compliance costs.

GST zero-rating

Zero-rating the supply of emission units has the lowest compliance costs of any of the alternatives considered, as it will be relatively straightforward for businesses to implement and does not require any attribution of GST input tax.

Income tax treatment

The additional compliance costs of the income tax proposals are not expected to be significant, particularly once markets develop and information on the market value of units becomes readily available. Two issues do arise. First, the tax treatment of the award of “free” units, which is that the income is recognised over time, is likely to be different from the accounting treatment. Unfortunately, the accounting standards bodies have not yet finally determined what the correct accounting treatment should be and a variety of approaches are being used internationally. Secondly, the very small number of taxpayers who have both forestry and non-forestry activities will need to apply 2 different sets of tax rules.

Administrative cost implications

Tax pooling

The administrative costs of changing and extending the provisional tax pooling regime are estimated to be: $510,000 in the 2008–09 financial year, with associated depreciation costs of $69,120 per annum in future years. All administrative costs associated with this initiative were considered by joint Ministers at the Budget bilateral on 13 February. A level of funding was approved for all Revenue initiatives including tax pooling. Funding for this initiative will be applied through Inland Revenue’s internal funding process.

Migrant workers

The administrative costs of implementing the changes in the 2008–09 financial year are estimated to be $310,000. There will be associated depreciation costs of $29,160 per annum in future years. The administrative costs for the 2008–09 financial year and future depreciation were considered by joint Ministers at the Budget bilateral on 13 February. A level of funding was approved for all Revenue initiatives including migrant workers. Funding for this initiative will be applied through Inland Revenue’s internal funding process. From the 2009–10 financial year onwards the non-depreciating costs will be met from within Inland Revenue’s baseline funding.

General insurance, banking continuity, petroleum mining, and depreciable land improvements

There is not expected to be any additional administrative costs associated with these proposals.

R&D remedial matters

Some minor reductions in administrative costs for Inland Revenue should result from these amendments.

Emission trading scheme

There will be some inevitable marginal increases in administrative costs as a result of the introduction of the emissions trading scheme. Administrative costs associated with this initiative will be funded through Inland Revenue's internal funding process.

Consultation

Tax pooling

In relation to the proposed changes to the provisional tax pooling regime, the Treasury, the New Zealand Institute of Chartered Accountants, Tax Management New Zealand, Electronic Tax Exchange Ltd, and Provisional Tax Finance Ltd have been consulted.

Migrant workers

The Department of Labour, the Treasury, and Horticulture New Zealand were consulted on this proposal.

General insurance

The Treasury and the body that represents the majority of the general insurance industry, the Insurance Council of New Zealand, were consulted on this proposal.

Banking continuity

The Treasury was consulted on this proposal.

Petroleum mining

The Treasury, the Ministry of Economic Development, and Crown Minerals were consulted on the proposed changes.

Depreciation remedials

The Treasury and the New Zealand Institute of Chartered Accountants have been consulted on these proposals.

KiwiSaver

Inland Revenue, the Treasury and the Ministry of Economic Development have been consulted on these proposals. Officials will consult with the superannuation industry in the development of the legislation.

Nuie joint ventures

Inland Revenue, the Treasury, the Ministry of Foreign Affairs and Trade, and the Department of the Prime Minister and Cabinet have been consulted on this proposal.

Amendments to the PIE rules for land-owning companies

Inland Revenue and the Treasury have been consulted on this proposal.

Research and development remedial matters

Inland Revenue, the Treasury, the Ministry of Science, Research and Technology, and the Corporate Taxpayers Group have been consulted on these proposals.

Emission trading scheme

Tax policy officials issued a paper titled Emissions Trading – Tax Issues in September 2007 which discussed both the potential GST and income tax treatment of emission units. A number of submissions on the proposals in that paper were received. Those submissions were considered in developing the proposals set out above.

Specific discussions have been held with the Institute of Chartered Accountants and some of the submitters.

The Treasury, Inland Revenue, and the Emissions Trading Group were consulted on the emissions trading proposals.

Application of the non-disclosure right to discovery

The Crown Law Office, the Ministry of Justice, the New Zealand Institute of Chartered Accountants, the New Zealand Law Society, Inland Revenue, and the Treasury were consulted on this proposal.