New Overseas Tax Rules - Worked sample problem

[Snoopy]

I thought it might be informative if I presented my sample problem in graphical form. It is telling to compare the original discussion document proposal with the draft legislative proposal.



There are a couple of points worth clarifying that are not entirely obvious from the diagram.

The 'total tax dollars' is the total tax dollar liability incurred over the five year period over which the shares are held. To get this total, we add the total tax downpayments made for years FY2001 to FY2005 to the residual income tax due in the final year only - FY2005.

It is rather interesting to observe that the tax positions are significantly different between the two proposals in the first two years. Yet towards the end of the five year period the tax bar mountains take on a surprisingly similar shape. At first I thought that I must have made a mistake. Looking at the numbers, the tax due after five years under the proposed legislation is 95% of that due under the draconian discussion document proposal! That's odd when I was expecting nearer a 15% difference (due to the capital gains tax component being reduced from 100% of gains to 85% of gains), not a 5% difference!

However, on reflection I don't think I have made an error. The rather unexpected small difference is because the 'downpayment of tax' is reduced under the proposed legislation. Perversely because the downpayment required is reduced, more money is left in the hands of the taxpayer. The taxpayer then uses that extra money not only to produce more capital gain for themselves, but -by association- more capital gains tax for the government! It is quite probable that if this example was extended further out in the future, then the reduced up front tax take will result in *more* total tax income for the government, even though the capital gains tax rate has been reduced!

Finally I have added to both graphs some thin horizontal blue bars. These represent the amount of tax payable under an alternative tax regime where 'earnings per share' or 'eps' (as opposed to 'dividends per share' or 'dps' under the current legislation) are taxed. The inclusion of an eps tax system for comparison is noteworthy. Because it provides a benchmark against the amount of tax the same company would pay if it were NZ domiciled and paid out 100% of earnings as dividends. Notice that the blue lines of 'eps tax' are above the actual blue overseas tax downpayments in all cases. That means both overseas capital gains tax proposals require substantial *less* tax to be paid up front than if eps tax were adopted. Ultimately though, when the overseas investment is cashed up there is a substantial tax wash up bill, represented by the brown bar, that is not present with an eps tax system.

If you regard the eps tax system as a proxy equivalent for investing in New Zealand shares, you can see that the proposed capital gains will result in a tax bill some 40% higher. That doesn't mean the taxpayer will be better off investing in NZ though - if the growth profile for the overseas company you choose to invest in is 40% higher than any NZ equivalent company.

SNOOPY

[duncan macgregor]

Welldone SNOOPY, It all means nothing to me however. I believe in investing only on the home market. Why should i invest overseas when the country that I live in is screaming out for development. I have no problem with exchange rates, I fully understand my tax obligations. If it all hits the fan my money is safely in the local bank in five min flat. If you want to invest in a country overseas, then add that to your risk. To spreadeagle your investments all over the world tells me an investor is incapable of working systems out to give them more than a decent return in NZ. Reading the posts on this subject tells me that most of you dont have a clue what is going on with tax obligations. Work out your buy and sell systems, then you can forget all that garbage with overseas investments. macdunk

[Deev8]

quote:Originally posted by Snoopy

Do you agree or disagree?

Finally got back to this after going away for a couple of days, and basically having reworked my way through the example I do agree with your interpretation.

quote:Originally posted by Snoopy

Deev8, something has happened to your arithmetic here.

By my calculator

-$NZ13.69 - $NZ682.53 = -$NZ696.22

Or am I misinterpreting what you are trying to do?

That was an arithmetic error ... and one that's difficult to understand. So moving quickly ahead ...

My basic mistake was in assuming that taxable amount for the year would be calculated as 5% of the value of the investment at the start of the year. The fact that no dividends were received and the investment made a capital loss (even when the sum carried forward from the previous year is considered) means that no tax is payable that year. And assuming that the loss isn't set-off against other liabilities a loss of NZD 13.69 is carried forward to the next year.

It was a simple mistake with a one-share portfolio, which I believe illustrates the possible pit-falls when we have to do this in reality.

[Deev8]

quote:Originally posted by Snoopy


The specific words that caught my attention were:

"any negative “available to tax“ amount would be available as a loss in proportion to the ratio of the realisation to the market value of the pool at the time."

That's why I only carried forward the -$NZ13.69 as the loss to be carried forward beyond FY2003. -$NZ13.69 is the equivalent of the 'available to tax' (although I don't like that term) amount in the investment income discussion document. No mention is made in the reference paragraph of the equivalent NZ$682.53 'downpayment' proxy taxable income amount.

This is my own interpretation of the literature out there. I still could be wrong.

I believe that you are correct, or at least, having re-read the document I agree with your interpretation ... but we could both be wrong. A lot of detail needs to be clarified before April 2007.

[Snoopy]

*The PWC proposal*

Price Waterhouse Coopers, via Chairman John Shewan, has presented to the parliamentary select committee a rival proposal to the Cullen/Dunne unreleased capital gains tax. This proposal has received favourable consideration by the parliamentary select committee. They have asked for the submission to be developed in more detail.

The proposal is relatively simple in concept:
The investor pays tax on the maximum of

i/ the overseas dividends received only OR
ii/ 3% of the averaged value of the investment at the beginning and end of the current financial year.

An advantage of this tax proposal, the way it is pitched, is that the ultimate tax liability is between 1 to 2 percent of the capital value of the shares. Even in low dividend yielding economies, such as the US, many shares do pay dividends at these levels. For that reason alone this PWC scheme is better balanced (more ‘cashflow affordable’). So how would the PWC proposal work in practice?

(continued)

SNOOPY

[Snoopy]

Not all details of how this proposed tax would work have been tabled. That means I need to make some assumptions about how it would work in practice. In the first year of share ownership we shall use the ‘buy in price’ as the ‘year beginning opening price’, and reduce the capital to be taxed by the brokerage spent acquiring the shares. We shall also assume that the tax is levied in local (NZ) currency. IOW exchange rate movements are taken into account.

Mathematically this new Price Waterhouse Coopers proposed DRWT (Dividend Relieved Wealth Tax), can be expressed as follows.

A is the market value of the unit holding at the end of the income year.
A1 is the aggregate of all gains (e.g. capital returns) derived from holding or disposing of the interest during the income year (excluding dividends)
B is the market value of the unit-holding at beginning of the income year; and
B1 is the total expenditure incurred by the holder during the income year including cash issues, and any cost incurred acquiring or increasing the holding.
D is the sum of dividends received during the income year

Deemed Taxable Income = max [0.03x½{(A+A1)+(B-B1)}, D]

Before anyone celebrates too much the possible dumping of the Cullen-Dunne proposal, I think it is useful to run through what would happen to our sample investor, the one who holds those YUM shares in the United States. Let’s see how ‘Ms Investor’ (we shall call her ‘I’) fares under this new DRWT (Dividend Relieved Wealth Tax). The words ‘Wealth tax’ don’t sound all that attractive do they? But that is exactly what this tax proposal is.

(continued)

SNOOPY

[Snoopy]

Problem Part 1 (DRWT September 2006 proposal)

Let's assume 'I' bought 100 shares (we'll keep everything in round numbers) in December 2000 for $US34.655 dollars per share at an exchange rate of $NZ1= US42.32c. Brokerage was $US51.99. The shares paid no dividend in the time ‘I’ held them up until 31st March 2001, at which time the share price had increased to $US38.19. Furthermore the exchange rate changed to $NZ1= US42.19c. How much tax would ‘I’ pay on these shares for FY2001?

Using 0.03x½{(A+A1)+(B-B1)}:

0.03 x ½{(3819/0.4219 + 0) + (3465.5/0.4232 - 51.99/0.4232)} = $NZ256.77

Now, 'Deemed Assessable Income' is the maximum of the dividend received (nil) and $NZ256.77 (as just calculated). That means the tax payable, based on a 33% tax rate is:

0.33 x $NZ256.77= $84.73

(continued)

SNOOPY

[Snoopy]

Problem Part 2 (DRWT September 2006 proposal)


It is now the end of FY2002. ‘Yum Restaurants International’ paid no dividends during the entire year. ‘I’ didn't buy or sell any shares during the year and the share price improved to $US58.78 based on an exchange rate (at 31st March 2002) of $NZ1= US43.06c. How much tax would ‘I’ pay for FY2002?

Using our formula: 0.03x½{(A+A1)+(B-B1)}

0.03x½{(5878/0.4306+ 0) + (3819/0.4219 - 0)}= $NZ340.53

Again there is no dividend paid, so the deemed assessable income is $NZ340.53 by default

Assuming a 33% tax rate, the tax payable is 0.33x $NZ340.53= $NZ112.38.

(continued)

SNOOPY

[Snoopy]

Problem Part 3 (DRWT September 2006 proposal)

We have now rolled forwards to FY2003, and Mr. Market has thrown in a couple of curved balls. On 30th September 2002 there was a 1:1 share split. As at 31st March 2003 the YUM share price was $US24.33 and the exchange rate on that date was $NZ1 = 55.12c. But instead of owning 100 shares 'I' now own 200 (due to the share split). Once again no dividend was paid during the year.

The estimate of tax to pay based on deemed assessable income is based on a fixed multiple of the capital ‘I’ has (averaged between the start of the year, and the end of the year), *no matter what the actual performance of the share price during the year*.

Using our formula: 0.03x½{(A+A1)+(B-B1)}

0.03 x½[( 100x58.78/0.4306 )+( 200x$24.33/0.5512 )] = $NZ337.18

Assuming a 33% tax rate the tax to pay would be: 0.33 x $NZ337.18=$NZ111.27

Note that for this financial year the tax due is not only cash flow negative (always the case when a company doesn’t pay a dividend), but there is also tax to pay even though ‘I’ has made a loss on the investment of $4,822.71 for the year. What is more the tax payable on the loss cannot be recovered even if subsequently this company goes broke. That is a bitter pill to take.

(continued)

SNOOPY

[Snoopy]

Problem Part 4 (DRWT September 2006 proposal)


It is now the end of FY2004. Again ‘I’ hasn’t bought or sold any shares and no dividends have been paid. The share price is now $US37.99 and the exchange rate is $1US= 65.75c. What is the tax liability for ‘I’ in FY2004?

As at 31st March 2003 (start of the financial year) the ‘Yum Restaurants International’ share price was $US24.33 and the exchange rate on that date was $NZ1 = 55.12c.

Using our formula: 0.03x½{(A+A1)+(B-B1)}

0.03x½{(200x24.33)/0.5512 + (200x37.99)/0.6575 } = $NZ305.76

Assuming a tax rate of 33% the tax to be paid is:

0.33x $NZ305.76= $NZ100.90.


SNOOPY (to be continued)