In this Counsel we discuss the recently enacted regime for the taxation of “portfolio investment entities” – essentially, superannuation funds, unit trusts and certain listed entities. The regime is part of the Government’s KiwiSaver initiative. A recent survey suggests there is little public understanding of KiwiSaver. However, the tax changes are significant, particularly for investors on 19.5% and 39% tax rates, and for investment via funds into New Zealand shares and real property. It will be important for investors to review their portfolios in light of the changes.
On 1 October 2007, the new portfolio investment entity (PIE) tax regime will come into effect. The Government’s purpose in enacting the regime is to ensure that tax issues are not an impediment to New Zealanders saving for their retirement via its flagship KiwiSaver initiative. However, it has a much more far-reaching effect. PIE tax treatment is available (on an elective basis) to a wide range of investment vehicles, not just retirement or investment funds. It is relevant to foreign investors as well as to New Zealand investors. In some cases, the tax changes it provides for are very significant.
In this Counsel we focus on the different types of entities that can qualify for the PIE tax regime, and on what the requirements of the regime are. We also summarise the tax treatment of PIEs and their investors, and make some predictions about the likely effect of the regime on the shape of the New Zealand investment environment.
Principal components of the regime
The PIE regime has three key elements.
- A PIE has tax exemption for gains on sale of shares in New Zealand companies, and in Australian companies which are listed under the ASX market rules.
- Rather than eliminating double taxation of income through the imputation system (as currently occurs with companies or unit trusts) or by taxing the entity and exempting distributions (as currently occurs with superannuation funds), the PIE regime generally adopts a hybrid approach.
- Income earned by a PIE and attributable to a New Zealand resident investor who is not a natural person is taxable to the investor at the time it is earned by the PIE (i.e. whether or not distributed).
- Income earned by a PIE and attributable to a New Zealand resident natural person investor is taxable to the PIE, but at more or less the investor’s marginal tax rate, with a cap of 33%.
- Income earned by a PIE and attributable to a non-resident or an electing trustee is taxable to the PIE at 33%.There are exceptions to this approach for PIEs which are listed companies and certain defined benefit superannuation schemes.
- It excludes from taxable income all distributions from a PIE, other than certain dividends from a listed company PIE.
Who can be a PIE
PIE status is available to New Zealand resident:
- companies (including unit trusts)
- superannuation funds
- group investment funds (GIFs).
The PIE cannot issue units which stream particular forms of income from the PIE’s assets, e.g. which give capital gain to holders of one class of interest, and dividends to another.
The further requirements that must be met depend upon whether the PIE is seeking to qualify as a:
- portfolio tax rate entity. This category will generally apply to superannuation schemes and open-ended funds
- portfolio listed company. This category will be applicable to listed property vehicles and listed investment companies such as Kingfish
- portfolio defined benefit fund.
Generally, in order to be a PIE an entity must have a spread of owners. This reflects the purpose of the regime, which is to remove tax barriers to pooled investment. These requirements can be met by the entity itself, or by virtue of its having a widely held owner. The drafting is complex and difficult to summarise. The essence of the requirements is as follows.
An entity will qualify as a PIE if, for every class of interests it issues (other than classes representing less than 10% of the entity by value), it has either:
- 20 or more holders who are not associated; or a holder who is:
- another PIE; or
- a foreign investment vehicle. This is essentially a foreign vehicle which otherwise meets the PIE requirements as to the nature of its investors and its investments; or
- a life insurer; or
- the New Zealand Superannuation Fund, the ACC or the Earthquake Commission.
An entity will not qualify as a PIE unless each holder who is not in the last four categories set out above holds (along with its associates) not more than 20% of the interests in the class.
These rules are relaxed for an entity which is seeking to qualify for the PIE regime by being a portfolio listed company (PLC), but such an entity must have only one class of shares, which must be traded on a recognised exchange in New Zealand.
Neither the investor spread nor the investor size requirement applies to unit trusts which meet the requirements for being “qualifying unit trusts” under the Income Tax Act 2004. These are already subject to their own set of “widely held” rules.
Again reflecting the investment orientation of the regime, in order for an entity to be a PIE:
- 90% or more of its assets by value must be land, financial arrangements (broadly, debt instruments and financial derivatives such as swaps), excepted financial arrangements (which includes shares) or rights or options over such assets; and
- 90% or more of its income must be derived from such property;
- any shares held must either give the PIE a voting interest in the issuer of less than 20%, or must (together with any other 20%-plus shareholdings) comprise less than 10% of the PIE’s investments. This limit can be exceeded in some cases, including for an interest in:
- another PIE
- a foreign investment vehicle
- a “portfolio land company”. The exception for portfolio land companies is intended to allow real estate syndication vehicles (whether or not listed) to operate as PIEs.
Investor return adjustment requirement
The investor return adjustment requirement applies only to portfolio tax rate entities. The purpose of it is to ensure that the PIE allocates its tax burden between investors so as to reflect the tax rate advised to it by the investor – i.e. 0%, 19.5% or 33%. The PIE can reflect this rate either by adjusting the investor’s interest (for example, by cancelling some units held by unit holders on the 19.5% tax rate and more units held by investors on the 33% tax rate) or by adjusting the distributions paid to the investor.
This requirement does not apply to portfolio listed companies or portfolio defined benefit schemes, since both of these entities simply pay tax at 33% on all of their income. However, a portfolio listed company is required to attach imputation credits to dividends paid to the extent such credits are available. This allows shareholders on a 19.5% tax rate to get the benefit of excess credits (but not holders on a 0% tax rate).
Making the election
An election to become a PIE can be made any time after 1 April 2007, though it will not be effective before 1 October 2007. Subject to the 1 October start date, an election can be effective up to 30 days before it is received.
For existing entities, becoming a PIE will give rise to a number of transitional issues. These include the fact that the PIE must have a balance date of 31 March, that it must recognise for tax purposes any unrealised gains and losses on its New Zealand and Australian listed shares (if held on revenue account) prior to going into the regime, and that its tax payment dates will change. Various concessions are made in the legislation which are aimed at smoothing these transitional issues. If the entity has tax losses, these continue to be carried forward, and used against future PIE tax liabilities.
An existing entity which intends to qualify as a PIE can also elect to defer the application of the new foreign investment fund rules to their non-New Zealand holdings, by notifying the Commissioner before 1 April 2007.
Losing PIE status
Generally, if an entity breaches any one of the PIE requirements applicable to it, it will cease to be a PIE from the first day of the following quarter. However, in the case of the investment-in and investment-out requirements, the legislation permits PIE status to continue if the relevant requirement:
- is cured by the last day of the quarter following the quarter in which the breach occurred and, if it would not have occurred but for an event or circumstance within the PIE’s own control, is insignificant. An example of a breach which might not be within the PIE’s control would be a breach of the investment-in requirements. A breach of the investment-out requirements is more likely to be within its control; or
- is during the initial six months of the entity’s becoming a PIE, or is no more than three months before announcement to owners of a decision to wind up the PIE within the following 12 months.
PIE status can also be surrendered by electing out of the regime.
Tax treatment of different types of PIEs and their investors
The PIE regime offers a number of different tax payment systems. A full description of these is beyond the scope of this Counsel, but the broad outlines are as follows.
Portfolio listed companies continue to be taxed as if they were not PIEs, except for the exemption from tax for gains on sale of New Zealand and Australian listed shares. They maintain an imputation credit account, and any losses are carried forward to be used against income in future years.
There is a significant change for their shareholders, which is the taxation of dividends. Unimputed dividends are excluded from income. Imputed dividends are also excluded for a New Zealand resident, unless the person elects to include them in their tax return. The only persons who would generally do so are natural persons on a 19.5% tax rate, who would be able to reduce the tax on their other income.
This benefit has clearly been recognised in relation to listed property trusts, whose units have experienced a significant increase in value with the enactment of the PIE legislation. As a result of accelerated tax depreciation deductions, property trusts are often in a position where their distributable cash-flow is considerably higher than their taxable income. Under the current tax regime, distribution of the untaxed cash flow is an unimputed dividend which gives rise to additional tax to the shareholders, at their marginal tax rate. This will not be the case for property trusts which elect into the PIE regime.
Portfolio defined benefit funds
Other than with respect to the exemption for tax on sale of New Zealand and Australian listed equities, the tax treatment of defined benefit funds which elect to be PIEs will not change significantly. These funds will continue to pay tax at 33%. Distributions from such funds are already tax-free to investors.
Portfolio tax rate entities (e.g. unit trusts and defined contribution superannuation schemes)
Any entity which wishes to be a PIE and is not either listed on a New Zealand exchange or a portfolio defined benefit fund, will have to pay tax as a PTRE. A PTRE can choose to pay tax under one of three different tax regimes.
The core elements of PTRE taxation are as follows:
- prima facie the entity pays tax on its income (subject to the New Zealand and Australian listed equities exclusion) at 33%;
- this rate can be reduced to the extent that the entity’s income is allocated to investors who notify the entity that they are entitled to a lower rate. Investors eligible for a lower rate are New Zealand residents who:
- are natural persons who, in either of the two previous tax years, earned less than $38,000 taxable income (which excludes their income from PIEs) and less than $60,000 of taxable income plus their share of PIE income. For these investors, the lower rate is 19.5%
- are companies, trusts, superannuation funds or other PIEs. For these investors, the lower rate is 0%, and these investors are referred to as zero rate investors.
- a zero rate investor is taxable on their share of the entity’s income as it is earned (unless they are a trustee who elects not to request the PIE to withhold at the lower rate), and also receives directly the benefit of losses and tax credits
- an investor who is not entitled to the zero rate is not taxable on their share of the entity’s income as earned, and receives no direct benefit from losses and tax credits. However, if the entity has a net tax loss or excess credits, then the investor’s share of the loss or excess will (in most cases) give rise to a rebate to the entity, which the entity must credit to the investor
- the entity must reflect the different tax rates which its members are subject to, either in the distributions it makes to them, or by adjusting their ownership interests. For example, a unit trust may make this adjustment by distributing gross income to its investors and periodically cancelling a number of the units held by investors who are not zero rated, in order to fund the unit trust’s own tax bill. An investor whose share of income is eligible for the 19.5% tax rate will have a lower proportion of their units cancelled than an investor whose income is subject to the 33% tax rate
- in most cases, the entity will not carry forward tax losses from one period to the next (since they will either have been attributed to zero rate investors, or have given rise to a rebate), with the exception of losses incurred before it became a PIE, and losses from portfolio land companies. In most cases these losses can be carried forward regardless of ownership changes
- no investors pay tax on distributions from the entity.
Within this general framework, PTREs face a minefield of elections and complex calculational requirements. Broadly speaking, a PTRE can either:
- pay tax on a provisional basis as it does currently, and reflect in an annual adjustment the different tax rates applying to each investor’s share of the entity’s income. Under this regime, losses are carried forward, rather than giving rise to a tax rebate. This method will be appropriate for a defined contribution superannuation scheme, but is unlikely to work for an open ended fund; or
- calculate income for each quarter as if it were a discrete income year, and pay tax on that income within a month of the end of that quarter (or claim a rebate if the entity has a loss or excess credits); or
- pay tax annually, except in relation to income attributable to investors who exit the entity during the year, in relation to which the tax must be paid within one month of the investor exiting.
The second and third approaches are designed in particular for open-ended funds. The key difference between them is how the entity deals with exiting investors. In the first case, the intention is that the exiting investor takes its share of income for the exit period gross of tax, and must pay the tax themselves. In the second case, the fund will pay the investor their income net of tax. However, the legislation in both cases requires amendment before it functions as intended.
There is no doubt that the PIE regime will have a significant impact on the design of New Zealand investment and savings products. While it will take some time for the regime to bed down in the commercial environment, the following list suggests some of the areas where this impact may be felt.
- Most open-ended unit trusts will convert to, or be formed as, PIEs. Even for those who do not invest in Australian or New Zealand equities, the benefit of the capped tax rate on earnings and the tax-free status of distributions will reduce the actual tax burden and the complexity of managing the tax exposure.
- The change to PIE status is likely to mean that unit pricing will be set on a gross-of-tax basis, i.e. the current practice of calculating unit prices net of a provision for tax expense will cease. The trust’s tax liability will arise solely on the income attributable to natural person and non-resident investors. It will be dealt by the trust in some way debiting the appropriate level of tax expense to the account of the investor. There are still some issues to be dealt with as regards the effect of pre-PIE losses on unit values, and on how to tax income attributable to investors who exit.
- New Zealand listed property trusts and companies will use the PIE regime and will become more attractive than currently, due to the capped tax rates and the ability to pass untaxed cash-flow out to investors (both domestic and foreign) free of tax. This cash flow may be operating cash flow sheltered from tax by depreciation deductions, or capital gains from sale of property or a property-owning company.
- The PIE regime may also encourage the growth of unlisted property trusts or companies. Provided they meet the investor-in requirements, investors in these entities can get the same benefits as investors in a listed trust or more (in the case of tax exempt investors, or investors in tax loss). However, unlike a partnership they cannot pass out losses to their investors.
- For similar reasons, PIEs may also be used as vehicles for syndicated forestry investments, in preference to the partnership structures which have been used. Again, the inability to pass out losses is a drawback when compared to partnerships.
- PIEs will be very attractive vehicles for investment into New Zealand and Australian listed equities, due to their special tax exemption. This feature may appeal not only to New Zealand residents but also to non-residents seeking to invest in these asset classes. Non-residents could become significant investors into PIEs.
- Conversely, non-New Zealand vehicles (e.g. Australian unit trusts) will be comparatively disadvantaged as vehicles for New Zealand residents to invest in New Zealand or Australian listed equities.
- Passive funds holding shares in New Zealand and Australian listed equities will lose their current tax advantage over active funds, and will have to rely on their pre-tax economics to remain competitive.
- Individuals with income over $60,000 pa will find PIEs attractive vehicles for investment from a tax perspective, especially leveraged investment.
- Foreign funds wishing to acquire real property in New Zealand directly (i.e. not through a collective entity) may find a PIE a useful vehicle. Provided the foreign fund qualifies as a “foreign investment vehicle”, the PIE will enable them to hold the property in a special purpose New Zealand legal entity (which may have commercial and foreign tax benefits) without imposing any additional level of New Zealand tax on distributions.
- Investment or savings vehicles who do not want to, or cannot, become PIEs themselves will nevertheless be almost compelled to hold their New Zealand and Australian listed share investments through PIEs (or passive funds). Examples of such institutions might be superannuation funds (whose distributions are not subject to tax regardless of the PIE regime) and life insurers (who are not eligible to be PIEs). Their Australasian equity investments could be either through wholesale PIEs or special purpose PIE subsidiaries.