New Zealand Budget Report

May 2002

Prepared by the CCH Tax Editors, in association with

and

The Treasurer and Minister of Finance, the Hon Dr Michael Cullen, presented the 2002 Budget Statement to Parliament on 23 May 2002. This CCH Budget Report has been prepared with the assistance of specialist practitioners from Ernst & Young and Bell Gully. It covers announcements of interest to tax practitioners and the business community.

Ernst & Young is one of New Zealand?s leading professional services firms, offering clients a full range of services in taxation, assurance, corporate finance, real estate and business partnering. Ernst & Young has focused tax groups which provide specialist tax advice and assistance to the corporate and entrepreneurial sectors based on the strengths of both their local expertise and the support of the global Ernst & Young network.

Bell Gully is a leading New Zealand corporate law firm with extensive commercial, corporate, finance, banking, taxation, litigation and commercial property experience. Bell Gully's tax division is one of the largest corporate tax divisions in a New Zealand law firm and advises on all aspects of New Zealand taxation including a substantial tax litigation and indirect tax practice.

2002 Budget overview

With a projected operating balance of $2.3 billion for the 2002/03 fiscal year, the Government considers it has met concerns expressed after the last election that expenditure management might be a problem.

The Budget statement has several main themes. One is the continuation of effectively targeted government support for business operating in the socalled 'knowledge economy'. Today's announcements are expected to further the growth and innovation strategy announced in February 2002.

Allied to this is the increased funding for tertiary education, designed to provide improved research initiatives and better links with business, to the benefit of both. Finally, there is a significant increase in expenditure on health.

The emphasis on innovation is boosted by the creation of a new investment promotion agency, Investment New Zealand, and a Strategic Investment Fund.

The investment promotion effort in Asia is to be stepped up while additional resources are directed to the United States and Australia.

Tax matters receive mention but are largely proceeding on their own path under the generic tax policy process. Structural reforms to the tax system recommended by the final report of the Tax Review 2001 (the McLeod Committee) remain in limbo, in particular the proposal for application of the risk-free return method to offshore equity investment by New Zealand residents. Funding for the reduction of tax compliance costs for small businesses remains a priority.

Other Budget items include the contribution of $1.2 billion into the New Zealand Superannuation Fund, $61 million extra funding for early childhood education, a five-year allocation for a meningococcal vaccine strategy, extra amounts for police and an increase in funding over 10 years for the upgrading of Department of Conservation facilities.

Growth rates sustained for now

Ministerial statement

"Budget 2002 forecasts solid, sustained growth over the current year and the two following, averaging 3 percent. ..."

"There is now a broad consensus that there is a need to lift that sustainable growth rate, in the first instance to somewhere around the 4 percent mark if we are to see a long-term rise in our standard of living relative to the rest of the developed world. There is far less consensus about the means to achieve that lift in performance."

Editorial comment

The Minister points out the absolute standard of living of average New Zealanders has improved over the past 50 years. However, long-term underperformance means New Zealand has drifted down the OECD income rankings. While there may be no reason to panic, there is clearly cause for concern given that the Budget does not spell out a prescription for significantly improving New Zealand's ranking.

Tax burden refuted

Ministerial statement

"... there is little evidence to support what are sometimes portrayed as the key reasons for that [growth rate] underperformance and therefore the guides to its improvement.

The most frequently asserted of these is the contention that New Zealand is highly taxed by developed country standards."

Editorial comment

The Minister says the comparative tax rate structures of countries are misrepresented by those who claim New Zealand is a highly taxed developed country. Furthermore, he argues that the significant cuts in personal and corporate tax rates in the 1980s and 1990s did not lift the sustainable growth rate. Overall, the Minister is unconvinced of the merits of significant tax cuts.

Tax simplification continues

Ministerial statement

"For many small businesses, the compliance costs of tax are the biggest bugbear because they do not earn enough to incur big tax bills but have to plough through a lot of paperwork to establish that. And tax design tends to focus on the dynamics of the large corporate, often at the expense of the smaller enterprise."

Editorial comment

The Government's tax simplification endeavours are mainly focused on small to medium-sized enterprises. This is unfinished business and more radical measures are under consideration. Clarification of the tax treatment of research and development expenditure and interest deductions has assisted larger corporates.

Tax on offshore investments awaits

Ministerial statement

"The third area of the tax system which requires attention to assist economic transformation are those aspects of the international tax regime and related matters which may encourage investment and skilled migration. Therecommendations of the McLeod Committee in this area are under intensive study.

Possible avenues for exploration are the introduction of a time-limited exemption for overseas earnings for new migrants and the application of the risk-free return method to the broad area of offshore equity investment on capital account outside a business context.

No decisions have yet been taken in these respects and given the complexity and likely controversial nature of any changes in the international tax regime, a further round of consultation with the private sector will be undertaken."

Editorial comment

The Budget papers contain some further comments on this topic. The papers note that the Government is considering application of the risk-free return method to tax "equity investments on capital account outside a business context. A number of details of the proposal need to be further developed ... [and] it is not expected to be implemented before 2003/04."

In the months leading up to the Budget the Minister of Finance had said that he expected to announce on Budget day an "in principle" decision to adopt the risk-free return method, subject to endorsement by the electorate in the forthcoming general election. The comments on Budget day do not seem to go that far. They say only that further consultation with the private sector will be undertaken.

Nonetheless, that "in principle" decision seems to have been taken. The further explanations indicate that the Government's attention is on the details and that a likely introduction date of 1 April 2004 has been identified.

In light of this looming change it is worthwhile exploring the concept further.

The first aspect concerns the scope of the proposal. The Budget announcement clearly indicates that the risk-free return method is likely to be limited in its application to non-business investors. This will necessarily exclude taxable entities such as professionally managed funds and larger superannuation schemes. Within the net, however, will be the passive tracking funds and of course private investors.

Investors subject to the risk-free return method will apparently be exposed to the regime on all of their equity investments situated offshore. There will no longer be a distinction between grey list investments and others. The consequence will be that, for fiscal purposes, an investment in a company such as BHP, AMP or one of the 30 stocks in the Dow Jones Industrial Average will be treated exactly the same as an investment in a company resident in a well-known tax haven such as Liechtenstein.

Confining the scope of the regime to equity investments will have the consequence of excluding investments in land. This may have the possibly unintended consequence of providing a boost to the Gold Coast apartment market.

The Budget papers do not explain the concept of the risk-free return method. This does not relieve the uncertainty and confusion about the meaning of the concept. In some quarters the risk-free return method is viewed as being similar in concept to the deemed rate of return currently operative under the foreign investment fund regime. A brief explanation will illustrate that that is not the case.

Broadly, there are a number of steps involved in dentifying the amount of taxable income that will be exposed by the risk-free return method. These begin with the risk-free rate of return itself and the measurement day. When the McLeod report was published a risk-free rate of return of 4% was circulated along with a measurement day of 1 April in each income year.

The next steps are to quantify the net value of equity investments on measurement day. The McLeod report envisaged that that would be the market value of the investments less any borrowings raised to purchase them. The risk-free rate of return of a suggested 4% would be applied to the market value to expose an amount of taxable income that would become subject to income tax at the investor?s marginal rate.

The risk-free return method would be applied in each income year. There would be no allowance for any reduction in value of the taxable assets from one income year to the next. Nor would any interest costs be deductible. Furthermore, dividends would not be taxable.

This outline may indicate the contrast with the current deemed rate of return method. Under the risk-free return method it is the capital invested that becomes the base for calculation of taxable income. For example, $100 invested in foreign shares on measurement day will provide the base for calculation. By contrast the deemed rate of return method seeks to impute a notional return on the capital invested. For example, for the 2001/ 02 income year the Government imputes a return of an incredible 10.46% (despite the widespread depreciation in world equity markets) on the cost of a qualifying investment.

In operation the risk-free return method functions as a wealth tax. It is misleading to term it a risk-free return method since that is only the means of identifying the deemed taxable income on net value. A number of European countries have adopted wealth taxes but typically these are taxes of last resort for the extremely wealthy. It is likely that few, if any, countries adopt the proposed model of extremes of a wealth tax on some equity investments and the non-taxation of capital gains on some other equity investments.

As a wealth tax the risk-free return method creates a tax liability on income that has not been received. Indeed it may never be received, as victims of the ?tech wreck? of 2001 will confirm. This is likely to have serious implications for investors subject to the regime. In the likely event that dividends are insufficient to meet the tax the private investor will have to fund payment out of other sources. The private investor can be expected to become disillusioned with having to fund tax payments on offshore investments out of other sources. Because the passive fund has no resources beyond dividend income, financial difficulties can be expected.

The investor subject to the risk-free return method will always retain the option of pursuing offshore investments through a pooled investment arrangement. However, any such entity will almost certainly be in business and so be subject to income tax on realised gains. The investor may be tempted to revert to the domestic market to minimise taxation on investment returns.

These sorts of considerations suggest that a bias will develop against offshore investment. Funds that might otherwise have gone offshore will instead be placed in New Zealand equity and property markets, where the potential for tax-free capital gains will not erode returns. The risk-free return method potentially has significant implications for the New Zealand-based investment markets.

In the forthcoming debate on the risk-free return method it is to be hoped that there will be a clear justification of the reasons for the change. Discussion to date has typically centred on the apparent anomaly in the difference in treatment between grey list investments and other foreign investments. Unfortunately there is too little discussion on the grey list itself.

It is well known that the grey list comprises only six countries. Although not spelt out in legislation, the criteria for grey list admission centre on a country's tax system that has a controlled foreign company regime comparable in its rigour with similar New Zealand provisions. To some
observers it seems incredible that there could be only six other countries in the world with a controlled foreign company regime that matches the New Zealand one. The suspicion is that there has been a lack of administrative efficiency in pursuing expansion of the grey list. For example, the Government has been able to promulgate the Maebashi Dried Cocoon Exchange as an approved market for accrual rule purposes. It seems incredible, too, that the same attention to detail can produce only six countries of comparable respectability in the taxation of offshore
investments. Instead of introducing a punitive regime with the potential to function as a form of exchange control, there is merit in exploring the notion that the grey list should be put on a more sensible basis.

No tax breaks for new immigrants

Ministerial statement

"Officials have concluded that significantly lower rates of tax could not be restricted to new foreign direct investment except as a transitional measure. As a consequence, it seems unlikely that such a reduction would produce sufficient benefits to New Zealand to offset the welfare costs of raising revenue on other productive activity in New Zealand."

Editorial comment

The McLeod report had suggested that a new immigrant should not be subject to New Zealand income tax on offshore income for the first seven years of New Zealand residence. The idea essentially is rejected in the Budget.

Although the Budget speech does not say a final decision has been taken, the tenor of the Minister?s comments is that the McLeod suggestion has been rejected. It may be speculated that the underlying thinking is the difficulty of justifying on political grounds the granting of tax concessions to recent immigrants. The potential for resentment at a preference of that kind is obvious.

One aspect that is not explored is the possible impact of introduction of the risk-free return method on potential immigrants. Emphasis has been placed on attracting immigrants with a high calibre of business skills. Such migrants can be expected to have accumulated wealth and, furthermore, hold a desire to leave some of it in their home country. A natural reaction for a potential immigrant is likely to be a distinct lack of enthusiasm for New Zealand upon being informed that any equity investments left behind will be subject to a wealth tax. Australia, say, may appear to be a sunnier destination by comparison.

Small superannuation changes appear

Ministerial statement

"The second area of great interest to the Government is the taxation regime on superannuation. Considerable discussion has occurred on this matter.

It now seems clear that the largest amount of leverage over savings behaviour at reasonable fiscal cost is likely to be achieved in relation to employmentbased superannuation. As a first step, I am considering two options.

The first is to reduce the employers' specified superannuation contributions withholding tax for those earning under $38,000 to their statutory marginal tax rate. The alternative is to extend the present 6 percent concessional rate enjoyed by those earning over $60,000 a year to all income earners.

It is my intention that one or other of these changes will be introduced from 1 April 2004.

The Government is not considering upfront tax incentives. These are likely to have to be very large ? with fiscal costs running to many hundreds of millions of dollars a year ? before they have any desirable effect on overall savings. Their abolition in the mid-1980s represented sensible tax policy on both equity and efficiency grounds."

Editorial comment

The Budget papers add that any new regime incorporating these proposals would not be implemented before the 2003/04 income year. Accordingly, the earliest implementation date becomes 1 April 2004.

These announcements are not unexpected. Earlier this month the Minister of Finance announced his rejection of the incorporation of incentives in the tax system to encourage private savings. By that the Minister meant that
no deduction or rebate would be granted for qualifying superannuation contributions. Instead the Minister favours the minor changes of:

• aligning the specified superannuation contribution withholding tax rate of 33% with the taxpayer?s marginal tax rate; or
  
  
• granting a reduction in the tax rate of 6% for superannuation contributions
  by a member with an annual income of less than $60,000.

The first of these proposals is not new. In 1998 it was known as ?TOLIS? and was incorporated in Bill form but failed to be enacted through lack of political support. One of the grounds for objection was the increased compliance costs that such a regime would entail. The concerns about compliance costs are unlikely to have abated since that earlier occasion. The Government has expressed sensitivity in general terms to the impact of measures on compliance costs and so it will be interesting to see how this proposal develops.

The underlying difficulty of both of these proposals is their potential limited impact. Both proposals refer to enhancing the attractiveness of employer sponsored superannuation schemes. However, the reality is that such schemes are an institution in decline. A number of factors, including in
particular the burden of compliance costs and the erosion of returns through the inability to prevent income tax on realised equity gains, have contributed to the steady decline in employer superannuation arrangements. It is also the case that a large part of the New Zealand workforce is engaged in small to medium-sized businesses that do not have the financial resources to sponsor an employer superannuation scheme. If enacted, either proposal seems to have the potential to confer only a small benefit on the limited number of employees who have access to an employer superannuation arrangement.

Trans-Tasman triangular tax relief

The Budget notes the agreement between the New Zealand and Australian Governments on the "pro rata allocation" method to relieve Australia & New Zealand triangular double taxation. The estimated fiscal cost is $10 million per year from the 2004/05 year onwards.

The risk-free return method of taxing offshore equity investments would make redundant the proposed triangular taxation relief for New Zealanders investing in Australian equities.

GST changes in 2004

The Budget notes the 2001 discussion document proposing that some imported services be subject to GST. It also notes the discussion document to be issued in 2002 proposing the zero-rating of GST on certain financial services supplied to registered businesses. Both measures will apply from 1 April 2004.

The net fiscal effect of these measures is expected to be $20 million per year.

Inland Revenue Department funding

The Budget notes that the Inland Revenue Department receives a total funding increase of $146 million over four years.

This funding will be utilised as follows:

• $98.8 million on Departmental tax base maintenance;
  
• $26 million on audit activities;
  
  
• $17 million on tax simplification for small and medium-sized enterprises; and
  
  
• $4.2 million on the new debt and hardship rules.
  

The increased enforcement budget is expected to generate a net fiscal gain of $317 million over four years.

Tax in dispute largely unchanged

The Budget reports that tax in dispute at 31 March 2002 stood at $134 million (down by $2 million from 31 December 2001). This refers to the outstanding debt from tax assessments subject to objections and legal action.

Industry New Zealand promotes investment

Ministerial statement

"The Government has decided to merge the Investment New Zealand arm of Trade New Zealand and Industry New Zealand?s Major Investment Service into a single world-class investment promotion agency operating under the wing of Industry New Zealand."

Editorial comment

This investment promotion agency will increase the effort put into attracting and securing major investments in New Zealand. Rather than offering large financial inducements it will harness local skills and advantages. The initial budget for the agency will be $14.5 million per year.

New Zealand Superannuation Fund contributions

Budget statement

"In the first three years of the Fund's operation the Government plans to build towards making the full capital contribution as calculated by the formula set out in the NZS Fund Act. This transition period will prevent undue pressure being placed on the fiscal position while structural surpluses are raised to the required levels."

Editorial comment

The required annual contribution to the Fund of $1.666 billion for the year ended 30 June 2003 is surpassed by the contributions of $0.6 billion and $1.2 billion for the years ended 30 June 2002 and 2003, respectively.

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