There are common misconceptions in relation to how portfolio shareholdings in foreign companies are treated for tax purposes.
One misconception is that if either the profits of the foreign company or the dividends it pays have been subject to tax overseas then New Zealand (NZ) tax does not apply. Another is that if the foreign company does not pay a dividend at all, then there should be no income to disclose, and hence no tax to pay.
However, unless a specific exemption applies, income might be deemed to arise under the foreign investment fund (“FIF”) regime – this regime gives rise to annual New Zealand income tax obligations, regardless of whether a cash return is received.
The FIF regime was originally introduced in 1993 alongside other international tax regimes to prevent New Zealand tax residents from avoiding or deferring New Zealand income tax by establishing foreign entities in jurisdictions with lower tax rates.
Under the regime, a person is required to determine their annual FIF income using one of the prescribed methods. For foreign companies which are traded on a recognised stock exchange and an annual market value is readily available, the applicable FIF methods are the Fair Dividend Rate (FDR) method, and the Comparative Value (CV) method.
The FDR method deems a shareholder to derive income equal to 5% of the opening market value of the shares (irrespective of the amount of dividends received), with an adjustment for any purchases and sales made within the same year. The CV method calculates income based on the change in the value of the shares plus dividends received. Where the CV method results in a loss for the year, in most circumstances the loss is not claimable and hence would be limited to $0. A person subject to the FIF regime is required to apply the FDR or CV method to their entire portfolio – i.e. they cannot choose FDR for one investment and CV for another.
Where the market value of a foreign company is only obtainable by way of independent valuation, the cost method is commonly used – this deems 5% of the opening cost base to be taxable FIF income, and the cost base itself is increased by 5% each year.
Generally, once chosen, a calculation method must continue to be applied in later income years, unless a change of method is permitted – for example, a natural person or family trust is able to change between the FDR and CV method on an annual basis. Further, the cost base under the cost method can be “reset” every five years by an independent valuation – this is useful if the investment has appreciated by less than 5% each year. Usually, any foreign tax withheld is available as a foreign tax credit to offset the tax liability on the FIF income.
There are exclusions from having to apply the FIF rules, for example, where the investment is in an ASX-listed company or for specific investors, where the cost of the interest is less than $50k. Although, if the FIF regime does not apply, dividends received will still be taxable under ‘ordinary rules’.
Due to the kiwi love affair with land, investing in rental properties is often favored over share investments. However, with the increase of the bright-line period for some residential property to 10 years, disallowing interest deductions and ring-fencing residential rental losses, investing in shares has become comparatively more attractive than it used to be. But don’t get tripped up by not understanding the rules that apply to foreign share investments.