NZ’s Foreign Investment Fund (FIF) Regime: A Mess That Needs Fixing for Savers’ Sake.

Précis: Given the steep fall in overseas equity markets over 2023, and likely to continue with then flat markets for some years, many investors caught in New Zealand’s FIF regime, pending when they invested, may be paying more tax than on the total capital appreciation of their holdings plus dividend stream: that is more than if caught in a true capital gains tax such as in US, UK or Australia. Given the importance of savings, policy makers need to urgently fix this hotch-potch regime.

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‘The only source of the generation of additional capital goods is saving. If all the goods produced are consumed, no new capital comes into being.’

Ludwig von Mises: The Anti-Capitalistic Mentality.

‘Capital is not a free gift of god or nature. It is the outcome of a provident restriction of consumption on the part of man. It is created and increased by saving, and maintained by the abstention from dissaving.

Ludwig von Mises: The Anti-Capitalistic Mentality.

Ludwig von Mises was the first to clearly inject into economic thought the analysis that saving – not spending – is the engine of economic growth; all the more perplexing, therefore, how badly our tax system – that’s governments both Labour and National – treat savings in New Zealand.

I believe there should be no taxation of investment income, defined as interest and dividends – I’m leaving rental properties outside this piece - and no capital gains tax on equities/bonds (or if there is, then we should have a company tax rate of 0% - but that’s another blog post). The aim of bolstering savings by letting savers compound the tax that is otherwise taken from them and building their retirement nest eggs so much more quickly, at a policy level, should then be to wean New Zealand off paying a subsistence state pension which yet remains one of our biggest spends. Of course in our Orwellian sized tax and surveillance state – tax and surveillance are inseparable - sic 2023 either of these notions sadly is fantasy, so this post is only about that mess, and a mess left for far too long, which is New Zealand’s Foreign Investment Fund regime (FIF) as it will operate over the next few years or possibly even decade to the disadvantage of savers. With an election looming this year, opposition parties big and small should have policy on fixing this: it’s important. Even better if this policy was part of a reset of the way we tax investment income period.

If you are a saver with a wisely structured portfolio including overseas shares, you need to read and understand this. Governments get away with too much skulduggery in esoteric areas of tax law that seem above our heads in complexity, and the boredom involved to figure it out, but this affects your ability to retire, and your standard of living in retirement.

There’s a saying – I think - you should have most of your investments in the currency you’re going to retire in. Sounds good unless you’re Venezuelan or live in a pimple sized market like New Zealand, with really only three sectors on our NZX to invest into: a few big industrials, utilities and real estate, and remembering your currency is a minnow in world trade. Also a pimple sized hence fragile economy: imagine a 8 Richter scale earthquake along the Alpine fault – we’re overdue – pending where along the fault but taking out Christchurch again, or at least severally damaging it (the West Coast of the South Island is gone into the sea along with my home in Marlborough) & Wellington at the same time: that’s a king hit to our economy; overseas investments will in that case protect your ability to retire at all. So it makes sense to invest in overseas markets both for opportunities of sheer scale, and for sectors that don’t exist  such as sizeable multi-various tech or health sectors: space even (if you want to invest in New Zealand’s only space company, Rocket Lab, you can only do so via buying shares on the Nasdaq).

But I’m not a financial planner, and this is not about where to invest: this is about the nonsensical way overseas shares outside the NZX and ASX are treated under our tax system. New Zealand’s Foreign Investment Fund (FIF) regime, Michael Cullen’s shambolic policy legacy, for the last decade of freakishly good equity returns from the central banks stimulunatic zero interest rate policy setting, has given investors a neutral to in many cases advantageous treatment over a straight out tax on ‘actual’ dividend income and a capital gains tax on overseas shareholdings which FIF attempts to approximate, (noting for now NZX and most ASX held shares are not subject to the FIF regime or any form of capital gains tax, unless you are a share trader). However, the point of this blog post is that all changes now:  given the financial year just gone, the first year in perhaps a decade and a half when investors will be sitting on losses on their overseas investment income, many of them large, and given the hyper valuations shares, especially growth shares, ended up on, there may well be a decade coming of sub-standard returns wherein the FIF regime is going to substantially disadvantage savers: especially for investors who only came into the regime in the latter years, but I will also show for many investors who have been in the regime for last ten years and more. This will mean investors will be longer coming out of their losses, and will effectively mean they will be paying tax on their overseas shares despite they are in losses overall because they will be paying tax as they recoup those losses, not on actual gains over cost of investment. Indeed, I think – and will try to prove – many (not all) investors in the FIF for the last ten years will be paying more tax under FIF rules than a straight out capital gains tax implemented fairly as in overseas jurisdictions where capital gain taxes apply: that is, will pay more tax on overseas investments than the capital gain they’ve had on those shares plus dividends. That is not on:  all opposition parties fighting this year’s election need to promise backdated legislation when they win government in 2023 to fix the problems with FIF in these markets that exist now. Because von Mises is right; savings are the engine of our economy, and savings allow individuals dignity and freedom to retire free of the state.

The FIF regime is absurdly complex in the details – internecine complexity itself a fault with our tax system – so let’s look at a simplified example of how FIF works (don’t come at me with but this or but that; I’m having to simplify and this piece is already two long for most attention spans). Assuming you individually directly hold more than $50,000 of overseas shares at cost, or via share funds – and that’s a piffling amount these days – then you’re caught in the FIF regime. Note, Kiwisaver funds are generally PIE structures so don’t contribute to your FIF cost base for this exemption. Although there is no threshold exemption if you hold your overseas share investments in a company. 

For our worked example, say you owned $50,000 of Tesla at start of the just finished 2023 financial year. That share ended the year (roughly) 50% down, thus by 31 March your $50,000 investment was only worth $25,000.

You have two main options for taxation of this investment under FIF: fair dividend rate (FDR) or comparative value (CV). There are three other options, but in reality it is these two people use (and the only ones I’ve seen financial planning firms issue with their summaries). The workings get complicated because individuals - not companies - can pick and choose between the two main methods used to calculate FIF income, so I’ll start with explaining the two options separately as if you can’t change between them; then I’ll show you how the choice to change from year to year gave you an ‘out’ while overseas share returns have been good over last decade up until 2023, but leave you in an undesirable position as you climb out of last year’s losses, and the losses that may continue through this year in an extended bear market to fix the excesses of our zero interest rate markets.

The FIF Regime: Fair Dividend Rate (FDR).

The a-priori problem I have with FDR is it is not connected to real returns but imputed, that’s fictional, returns – on a base level whenever you deny reality in any sphere you’re in trouble. FDR seems to be an attempt to capture a capital gain on growth type shares that don’t pay dividends by imputing a 5% return(dividend) on all your overseas shares at the start of the year at their market value on that day, whether the companies paid dividends or not. Again, over last ten years many of these growth shares were earning double digit returns in capital appreciation, so in absence of a straight our capital gains tax, the 5% imputed return was probably to your advantage; same for income styled shares if you held those that paid a better than 5% dividend yield.

Tesla is a mega-tech growth company which doesn’t pay a dividend, however, if you choose FDR for calculating your 2023 FIF income you’re going to pay tax on a 5% dividend even though you’ll never bank one. And despite Tesla is 50% down, you would still pay tax on a 5% dividend based on the opening value you held. Thus, 5% of $50k is $2,500, assume a personal tax rate of 33% then although you’ve lost $25,000 on your investment- half of it - and you received no dividend, Mr Cullen’s withered hand still reaches out from the grave and will take tax of $825 from you.

Which would be crazy: so you’re not going to choose that. At least you’re not going to use this unless you were unfortunate to run your investments in a company as companies have to use FDR. Given the losses you’re probably sitting on, for 2023 most of you will chose Comparative Value (CV).

The FIF Regime: Comparative Value (CV):

Had you been stuck with this option, that is, when entering the FIF regime you had to, say, choose one method and stick with it, no swapping between CV and FDR, you would now be getting right royally screwed had you chosen CV across the course of your investing life.

The calculations for CV can only be done on a spreadsheet or specialised software; if you have a financial planner they’ll send you the calculations in about a 16 page book on how to try and file your tax return which you’ll never understand so you’ll simply give to your accountant (hence you’ve never understood how this regime works).

Essentially, CV places a capital gains tax on your overseas share holdings, meaning you’re at the disadvantage of holding NZX or ASX shares which – unless you’re a trader – do not have a capital gains tax – and indeed you’re at the disadvantage of every other asset class in New Zealand (it’s no wonder so much NZ investment is distorted and ends up in property).

So under CV you pay tax on a capital gain on your overseas shares, not payable on other asset classes: not fair, but you’ve made a gain still. There are, however, two further problems with CV.

Many overseas jurisdictions, including Australia, UK and USA, have a capital gains tax on shares, but you only calculate and pay the tax in the period you physically sell shares: so you’ve got the cash to pay the tax with. Under FIF, however, you calculate the capital gain and pay tax on sales but also on holdings, the gain you made by holding a share for a year, not just when you sell an investment: so you don’t necessarily have the cash for the tax, just as with FDR you have a tax on dividend income you may never have received: so you have to pay the tax out of your other income or by selling down investments to fund it. That’s problem number one. Although as bad as that is, if you had been stuck with this option across the life of your investment there would have been a much bigger problem (that will still come into play over the next few years of markets running with bears more than bulls).

In those overseas jurisdictions that tax capital gains on share sales – not our Mickey Mouse FIF regime - they justly allow deductions, obviously, for share losses. But the FIF regime, incredibly, doesn’t: it taxes you on the capital gain but treats the loss as nil in your tax return that cannot be used against other income, or carried forward to offset future share profits.

Having trouble comprehending the damage to you here? The worked example:

This tax year you’ve lost $25,000 on your Tesla shares: so under CV for tax you’re going to pay nothing (so you will choose CV over fair dividend), however, the loss is treated as nil and can’t be offset against your other income nor carried forward to offset future share capital gains.

Go to year two. Your now $25,000 Tesla investment turns around and earns you a 100% profit (it’s not going to but bear with me): that’s $25,000 so by the end of year two you’re back to square: Tesla shares worth your original cost of $50,000. Well I’m afraid you would’ve still made a loss if trapped on this nonsensical CV: a big one.

The previous year’s $25,000 loss counted as nil and did not carry forward, thus year two you have to pay tax on your $25,000 gain.  That’ would’ve been tax of $8,250.00 when across your ownership of those shares you’ve made not one cent of gain.

And that’s where we get to the ability under FIF, for most of you reading this, natural persons not companies, to be able to switch in that year two over to FDR. But there’s still that problem with FDR: you’ve made no money across two years on your Tesla shares, however, year two you are going to have to pay tax as if Tesla had paid a 5% dividend, which it didn’t, and you’ve made no money at all.

The next decade is going to be the reverse – in my opinion – of the last decade, it will be a decade of much lower dividends for income (dividend paying) styled shares on lower earnings from a recessionary environment, and where you are simply recouping large losses from growth shares: thus on your dividend paying portfolio you will likely be paying tax on fictional bigger dividends than you will be receiving from them, worse, you will be paying tax on growth shares that will merely be recouping losses and if you’ve only entered the FIF regime in the last two or three years, you will be sitting on possibly large losses. Worse again you can’t split your treatment across growth shares as opposed to income (dividend paying) shares, you have to choose the same tax treatment across your whole basket of overseas shares, which is clumsier again.

If you were in markets for the last ten years perhaps this all balances out – or quite possibly not,  (I’ll comment on this soon) -  especially if you had a high exposure over that past period to the hyper-valuing growth stocks, but as overseas stocks slide from the heights those valuations reached, and moreover for all the people entering the FIF regime over the last two years and from now on, this is going to be  unjust and will materially affect the compounding of the country’s savings in total which is bad for our retirements and our economy.

Before getting to that a little postscript here also. It possibly will be worse for some of you. On 14 December 2022 IRD put out an answers to your questions: if you’re late filing your 2023 return, perhaps because the FIF regime is so complicated and random you can’t understand what your responsibilities are, then IRD state you have no choice between FDR and CV: you must use FDR. So in my example you would be stuck paying tax on a 5% dividend in Tesla  out of year one (2023 tax year) as you can’t choose the nil result from the loss under CV, despite they never paid a dividend while you lost $25,000 of your investment, then you would be taxed on a further 5% dividend year two as you merely recouped your loss: you will pay tax over two years on a share you’ve not made one cent on.

Note my Tesla example is not the exception to the rule regarding losses in these markets. There are big losses out of overseas (and NZ) equity markets over 2023 year, and I think despite the little recovery currently, there are further legs for markets to go down yet through this year, and we’re not going to get the exuberant rising markets that existed over last decade because they were based on the stimulunatic zero interest rate policies of central banks that will not happen again now the inflation those policies created is out of the bag. Interest rates are integrally related to the value of equities. Here’s the Tesla graph for last five years:

But here’s the five year graph for Cathie Woods’ now infamous ARK Innovation ETF:

That’s a roughly 72% fall from its peak value (some poor sods went in on that price point). There’s a lot of losses to be recouped and those in the FIF regime are thus going to be paying more tax than they would have been in a fair tax system, with a proper capital gains tax that allowed them to carry forward their 2023 losses to cancel out the recouping gains as people climb back above the breakeven line.

More than that: look at the ARKK graph, investors in that fund for the whole five years (and this goes for last eight years also, which I believe is the age of the fund) made that huge gain, paying tax on the FDR rate of 5% opening market value each year (they would not have chosen CV any of those years), however, every cent of those gains is now lost: investors are back to where they were five (and eight) years ago, but with no ability to claim those steep losses, merely able to flip to CV on the way down to pay no tax, and thus never able to be refunded the tax they paid on the way up. So a new investor that entered the FIF regime over 2023 is sitting on a loss they can’t use for tax, and will be paying tax under FDR (most likely, pending CV figures each year) as they recoup those losses before they ever get to make a gain. Existing investors in ARKK that were in the FIF regime all along have paid tax under FDR on the initial gains, but never get to claim the tax back when all those gains are given back.

That is not optimal and simply clumsy: under the FIF these savers will be paying tax on a greater gain than they earned via capital appreciation and dividend stream, because they can’t claim losses or carry forward. Given this if we have to tax investment in overseas shares – and why do we - then as an investor I’d rather simply have a logical capital gains tax meaning I pay tax on exactly my gain, no more no less, over the length of an investment, not this casino that FIF is.

No other country treats savers like this.

No matter what you think, I hope I have demonstrated what a hotch potch dogs breakfast this legislation is.

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My questions for policy makers because I think we need to go clean slate on taxing of investments and build policy from the ground up based on founding principles (that make sense):

Given the importance of savings to our economy and individual well-being in the form of independence in our retirements from an incompetent and overbearing state, as well as for the tax burden to that state of paying a universal pension, why are we paying tax on investment income – defined as equities and bonds – at all?

While we are taxed on investment income, why don’t we have a corporate tax rate of 0%?  (I’ll cover this on a future post).

Why do we have this difference in treatment between overseas shares per se, and NZX and ASX shares? It simply doesn’t make sense to me. Why have a mangled capital gains tax slash deemed income regime based on a floating abstract on one basket of shares or investments and not on another? All those savings ultimately come back and are spent in New Zealand. All the dividends paid in the meantime in overseas currency is converted to NZD and spent here … well most of it. And the argument it’s to encourage investment in NZ companies doesn’t hold as there is an exemption for most Australian companies, and given how just a couple of storms have shown how dangerous it is to have all your investment eggs in a country as tiny and fragile as New Zealand, then you’ll wisely have most of your money invested on the ASX anyway for its bigger and more diverse economy.

And finally, the New Zealand tax system has almost unenforceable rules that differentiate between share traders – regarding ASX and NZX shares in this instance – who are liable for tax on all gains, that is, a capital gains tax in which they can also claim losses – and those who buy and hold shares for long term gains/income and are only taxed on dividends. These rules approach farce, I think: do you know of any retail investor paying tax on trading shares? I think one of the most important features of a tax system is certainty: either tax every holder of shares on dividends only, or just bring in a capital gains tax for all shareholdings as exists in UK, USA and Australia.

But that all gets me back to why are we paying tax on investment income at all.

My note on the need for certainty hints at my next tax post which will be on the interest deduction limitation rule for landlords, policy direct from the mental asylum which is this Labour / Greens government.

Although more generally look at this mess which is our FIF regime. Successive governments since Cullen, including National, continue to do nothing to fix the issues above, and they can do that because most of you don’t understand this regime. But this loss environment with a likely slow recovery changes everything.

And when you see it put this starkly, what possible excuse can be given for not fixing this? Especially when there’s such an easy initial fix: if you’re going to tax capital gains, then you must allow deductions for capital losses, even if ring-fenced to carry forward against future share gains (such as for rental property now). Simply move to a US or Australian system where all overseas share sales - sales, not holding gains year on year - are taxable on profits or deductible on losses: capital gains and dividends  are taxed, but only after capital losses are deducted and capital losses carry forward if unused, as is the ordinary course of business: you pay tax on the exact profit and income you’ve earned, no more, no less, and when you have the cash to pay the tax from; you don’t end up paying tax on a fiction. That’s simple. That’s fair on everyone. Albeit I’m totally against this or any tax on investment income.

Which leads to the final question: how did a senior minister, his advisors and tax code drafters manage to make a law like this FIF regime? How did they possibly come up with the above nonsense over such a simple and fair solution? Did they work through the implications of the FIF in this current environment? How could later National governments not fix this? Now apply that to all our laws.

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Mark Hubbard, BA, BBS [Accountancy], (First Class Hons - Accountancy).

Note. Up until December 2021 I was affiliated with a national professional body, I’m not stating which as there are three and mine was just following Covid rules, no need to bad mouth, but when local members Covid passported me from regional meetings because I wisely chose not to take the Pfizer money-machine, in a fit ‘pique I resigned. I’m still in public practice whatever that means anymore, although I am retiring from clients as quickly as I can, a policy begun when my profession was forced to comply with our Soviet inspired AML legislation and I refused to comply meaning after protracted correspondence with the DIA I could not take on new clients. … for the record, I’m so much happier these days.

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