The global economy is seeing New Zealand (NZ) taxpayers invest in overseas companies. However, many people acquire foreign investments without understanding how they will be taxed. Taxpayers that purchase shares in a foreign company should ensure they are familiar with the Foreign Investment Fund (FIF) rules.
The FIF regime was introduced to prevent NZ taxpayers using offshore entities to avoid or defer their NZ tax obligations. The rules apply when less than 10% of the shares in a foreign company are held, or units of less than 10% in an overseas unit trust. Dividends/income received from such investments are not directly taxable. Instead, taxable FIF income is attributed to the taxpayer based on a number of calculation methods. This means that taxable FIF income can arise even if the investment does not generate a real cash return, and this is where uninformed taxpayers can be caught out.
The default calculation method is the fair dividend rate (FDR) method, which deems taxable income to arise based on 5% of the market value of an investment at the start of the financial year. Dividends received during the year are ignored. A quirk of this method means that no taxable income is derived during the tax year an investment is acquired, due to the nil value at the start of the year. Conversely, income is deemed to arise during the year an investment is sold. Complex adjustments apply when an investment is purchased and sold within the same year.
The FDR method provides certainty, and where returns on an investment exceed 5%, the excess return is effectively tax free. However, for a taxpayer with an underperforming investment, which may have fallen in value and paid no dividends, deemed income at 5% adds salt to the wound.
To deal with this scenario an alternative calculation method, the comparative value (CV) method, determines taxable FIF income based on the change in value of the investment during each tax year, with an adjustment for realised dividends and capital gains. This can result in lower taxable income than the FDR method when the return on an investment is below 5%.
In addition to FDR and CV there are other calculation methods available. Furthermore, whilst individuals and some trusts can freely switch between FDR and CV each income year to gain the best tax outcome, there is no such option for companies who are generally required to continue using the FDR method once it has been selected.
Australian listed shares are generally exempt from the FIF rules and are taxed in the same way as NZ investments, such that dividends are taxable when received and capital gains are tax free. However, the devil is in the detail and this exemption does not apply to all Australian shares, hence each investment must be considered separately.
Given the complexity of the regime, if you are evaluating an overseas investment, please do so with full knowledge of the appropriate tax rules, to avoid unexpected tax costs.