Key points
- We don’t know yet which measures suggested by the Tax Working Group will be adopted by the Government. There is still a lot of water to go under the bridge.
- The proposed capital gains tax makes investing in New Zealand and Australian share markets less attractive, yet there is no proposed change to the tax regime for other share markets.
- While managed funds like KiwiSaver will be required to calculate their tax bill every day and continue paying tax each year, direct investors holding the exact same shares will not face a capital gains tax bill until they dispose of the shares.
- The proposed regime will dampen demand and liquidity in New Zealand’s capital markets. Three reasons for this are:
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- overseas shares receive favourable tax treatment compared to Australasian shares;
- direct investors are incentivised to hold shares for longer, hold foreign shares over domestic shares and invest in their family home; and
- investors in unlisted companies receive preferential tax treatment over investors in pooled investment schemes.
Key Developments
The eagerly-awaited final report from the Tax Working Group (TWG) was released in February. Since then there has been a high level of discussion, or hysteria as Sir Michael Cullen put it, in various quarters around the implications of each recommendation. To add further complexity to the matter, the exact form the recommendations may take are wide and varied. For these reasons, we are hopeful the Coalition Government’s response to the TWG’s final report will provide clarity around what recommendations will be put to the electorate and perhaps answer some currently unanswered questions. Our implied preference is that the Government focus on the common ground between the dissenting TWG members and the TWG recommendations around taxation of rental properties and exclude proposals to adopt a capital gains tax on New Zealand shares. In this report we explore some key questions we have had from our clients.
What will the impact be for investors in managed funds?
There has been much made of the impact of the proposed capital gains tax on managed funds (including KiwiSaver). As a starting point, the only certainty is that a capital gains tax on Australasian shares will increase taxes on an unrealised basis for every managed fund and KiwiSaver fund which has an allocation to Australasian shares. For example, an investor who put $10,000 in the New Zealand share market in a managed fund ten years ago, then put in an additional $5000 per year would have savings around $19,000[1] lower today under the TWG recommendations.
What will the net impact be on KiwiSaver investors?
The complicating factor for KiwiSaver investors is that the capital gains will almost certainly be offset for lower income investors. An “illustrative set of options” put forward by the TWG include a reduction or exemption in employer superannuation contribution tax, a parental benefit, a higher member tax credit and a reduction in the two lower Portfolio Investor Rates (PIR). Until we know exactly which of the “illustrative options” the Coalition Government proceeds with, people will try in vain to calculate which KiwiSaver members may be better off.
While our earlier example uses New Zealand shares, the reality is that, while there are some KiwiSaver funds which invest solely in Australasian shares, the impact on investors will depend on the level in which their KiwiSaver or managed fund invests into New Zealand and Australian share markets (in our experience a “Balanced” Fund has around 25% in Australasian shares and listed property).
Are we disincentivising people to invest in New Zealand?
While the TWG has recommended a capital gains tax on Australasian shares, there is no recommended change to the taxation of overseas shares, which will continue to be taxed using the Fair Dividend Rate (FDR) method that assumes a return of 5% p.a. In fact, the TWG recommended lowering the 5% FDR reflecting a reduction in recent years in dividend yields and interest rates. A lowering of the FDR will create an even greater incentive to invest overseas. To put this in perspective, the New Zealand share market has returned 10.1% p.a. since 1900[2] and since the turn of this century, which includes two significant crises (the Tech bubble and Global Financial Crisis), the return has been 8.6% p.a.[3], far in excess of the 5%.
Let’s again think of the investor starting with $10,000 and putting in $5,000 per year. Let’s assume the investor has a choice of investing in either Australasian or global shares. We will assume that both Australasian and global shares returned 8% p.a. on average in the next 20 to 30 years, a reasonable assumption given the numbers discussed earlier. What will the investor’s net position be over the next 20- and 30-year periods?[4]
Under the TWG recommendations, investors in Australasian shares will be significantly worse off after tax compared to investors investing in global shares despite getting the same pre-tax return. Of course, the severity of the numbers gets worse if you use historical numbers (which are typically above the more conservative 8% return we have used). The longer the time period, the larger the impact on returns due to compounding. We think 20- and 30-year examples are sensible given share market investors have a longer-term objective. With this perspective, investors, consultants, advisers and investment managers are likely to allocate away from New Zealand’s capital markets.
There are implications to making New Zealand shares a comparatively less attractive investment proposition than global shares, the most obvious of all being a reduction of capital being provided to New Zealand businesses. In fact, a New Zealand business listing in the US will be a more enticing proposition to a New Zealand investor, than a New Zealand company listing in New Zealand.
The additional tax on New Zealand shares makes our domestic share market a less attractive proposition, therefore reducing demand (and liquidity) for New Zealand shares. Taxing direct share investments on a realisation basis creates an incentive for investors that retain New Zealand share market investments to buy and hold stocks to defer their tax bill, potentially creating a further drain on liquidity. The longer the time period shares are held for, the more benefit for long term direct investors. Conceivably, investors who do not need to sell their shares during their lifetime can elect to pass them on to the next generation. It is worth noting that direct investors will not be completely absolved of paying tax as they still will be required to pay tax on dividends and their tax rate could be as high as 33% compared to the PIE tax rate of 28%. An investor[5] investing directly in Australasian shares vs. a PIE fund can garner measurable benefits over the long term under the proposed CGT as shown below.
Funds are the most accessible, diversified and cost-effective form of investing for most New Zealanders and have a high level of disclosure and simplicity. We wonder why the TWG is proposing a tax system that complicates the savings decisions for individuals and reduces the advantages of pooled funds for investors?
Another challenge for New Zealand listed companies is that private companies’ capital gains are proposed on a realised basis, encouraging New Zealand listed companies to delist (or not list at all).
Ring-fencing losses, how can we make this work?
The TWG recommended that losses on Australasian shares are “ring-fenced” so losses cannot offset gains from other asset classes. The fiscal rationale for doing this is understandable, after all the government does not want to be in a position where they need to sign a large cheque to investors when the share market falls. However, we question how that would work in practice. Imagine a young couple who need to withdraw from their KiwiSaver to purchase a home after a market downturn. Would they get paid out their tax credit for their loss when withdrawing from KiwiSaver? What about a KiwiSaver member changing schemes? If the answer is yes, is it fair for other investors to subsidise them? If no, is it right to limit people’s accessibility and portability of funds?
TWG recommendations were not unanimous
Lastly, we note the findings of the TWG were not unanimous. A dissenting group produced their own report which is striking in agreeing on one key point. That is that there is potentially a case for extending capital gains taxes on residential rental properties where there is evidence that the taxable income from these assets is low compared to the total economic returns. They propose an extension and modification of current rules including the bright line test. Most significantly, the dissenters find no support for extending a capital gains tax to shares, businesses and property more generally, especially when exempting the family home. Many commentators, including the dissenting trio note that “the New Zealand Tax System has been justifiably commended internationally for being a simple and efficient system”. There are many other issues to tackle beyond those considered including the principal that capital gains on shares induces a double taxation on profits; and that taxation of nominal gains is partially a taxation of inflation.
The questions we raise in this paper highlight that many of the proposals are not simple and are therefore difficult to quantify. And while it hard to begrudge the goal of aiming for a “fairer” system, at this juncture it is not clear how the TWG proposals improve fairness. Our hope is that a “fairer” system does not come at the expense of the development of New Zealand’s capital markets. We are concerned that the proposals may significantly distort savings for retirement and lower investment, productivity, employment and economic growth. Our view is that the current proposals most likely will tilt savings into the family home and overseas investments. Local business may face significant headwinds if the TWG’s proposals are adopted as proposed.
[1] Investor has a 28% PIR rate
[2] Credit Suisse Global Investment Returns Yearbook 2018
[3] Composite of S&P/NZX50 and NZSE 40 index excluding imputation credits return from 1 January 2000 to 28 February 2019.
[4] Assumes net dividends are reinvested. Tax and returns calculated monthly and net gains are reinvested.
[5] An investor starting with $10,000 and investing $5,000 per annum. Assumed dividend rate of 3.5% p.a. and capital gain of 4.5% to give a total return of 8% p.a.
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