The wholesale funds figures don’t capture all of Kiwi investments, of course: for example, another $40-odd billion resides in retail funds and $31 billion in directly-held assets described by the RBNZ as ‘individually managed accounts’ (IMA), which is mostly controlled by stock-broking firms.
But even at the retail fund level global equities ($12.2 billion) outweighs the local share exposure of $10.7 billion. While there is no data on the IMA asset allocation, international equities undoubtedly represent a reasonable chunk of that $31 billion invested.
Overall, then, New Zealanders could easily have at least $50 billion invested in global shares via various routes. Those international equities investments may end up largely at the same destinations but which route you choose can have enormous consequences for the return trip.
This ain’t no holiday: unpacking global equity rules
Retail investors, in particular, have a complex series of scenarios to consider when planning their offshore equity adventures – and almost all of the complication is due to tax.
Under NZ’s quirky tax regime, retail investors in international shares have a few options at their disposal. Perhaps the most simple approach – a package tour, if you like – is to invest in a global equities fund structured as a portfolio investment entity (PIE).
PIE funds are obliged to deduct tax from offshore shares under the straightforward formula set down by the Fair Dividend Regime (FDR) rules. Essentially, FDR applies your PIE prescribed investor rate (PIR) – which ranges from 0 to 28 per cent depending on marginal tax brackets – to a deemed annual return of 5 per cent for global equities. In years where the actual return from international shares is more than 5 per cent, FDR investors get a tax break; the corollary sees FDR investors overpaying tax when their actual return from global equities returns drops below 5 per cent in any given annual period.
In theory, over the long term FDR tax windfalls and over-payments should balance out.
However, many Kiwis choose to invest directly in international shares, a definition that also includes offshore-based funds such as Australian Unit Trusts (AUTs). For example, many InvestNow clients have exposure to global equities through AUTs such as the popular Vanguard funds.
Unlike through PIEs, New Zealanders investing directly in international shares can choose between two different tax treatments offered under the Foreign Investment Fund (FIF) rules: either FDR or the so-called Cumulative Value (CV) method, which taxes actual total returns on global equities.
The only catch is that investors must apply the same methodology to all their FIF holdings in the same tax year. Whether investors elect to use FDR or CV in any particular annual period will likely be determined by how their global equity returns sit in relation to the 5 per cent threshold.
Assuming returns of 5 per cent or more, under FDR someone on the highest marginal tax rate would pay a maximum 1.65 per cent of the value of their global equity portfolio as tax in any year: based on multiplying the tax rate of 33 per cent by the deemed return of 5 per cent.
The CV method would clearly be less desirable when the returns for FIF global shares are over 5 per cent but it provides a better outcome below that threshold – especially if returns go negative. In a negative return environment, using the CV method would mean a person would have no FIF tax to pay, which improves their lot in life that year by 1.65 per cent (assuming they are on the top marginal tax rate).
Why de minimis might not be best for the rest of us
If FIF, FDR and CV hasn’t set your head spinning yet, the global equities tax rules have one more trick to trip up unwary investors. The tax regime includes another set of calculations for those who hold less than $50,000 in international shares – labeled as ‘de minimis’ investors.
De minimis investors simply pay tax on the dividends they receive from their FIF investments. From memory, the government of the day (led by then minister of finance Dr Michael Cullen) wanted to make it easier for smaller investors to complete their tax returns, plus provide a sniff of a tax benefit over their more wealthy counterparts.
The de minimis method is particularly attractive where an investor is holding FIF funds or investments that pay low dividends each year, with the balance of the return coming from capital gains. And typically most global share funds – or even directly-held offshore equities – would fall into this low-dividend category, and put de minimis investors ahead of the game.
But there is a nuance at play in the NZ market that de minimis investors need to consider carefully. Specifically, the many investors who access international equities through AUTs (such as the Vanguard, Russell Investments, Morphic and India Avenue funds on InvestNow) have another layer of tax to factor into their calculations.
Under Australian tax rules, AUTs must pay out all income they receive, including realised capital gains, with the latter creating a conundrum for de minimis investors.
Ultimately, within a managed fund like an AUT all capital gains will be realised either as a result of changes in the investment strategy or composition of the portfolio. Capital gains will also be realised as investors enter and leave AUT funds. The upshot is over time all AUT returns will end up as income and, for de minimis investors, subject to tax.
Accordingly it is likely that de minimis investors in AUTs could end up paying more tax than those who operate under the normal FDR or CV methodologies.
If global equity returns are negative, of course, de minimis investors do pay more tax than their CVusing counterparts, who, you may recall, will be tax-free under that scenario.
De minimis investors, however, can escape this potential tax-trap by simply opting into the FIF world: albeit that they must then continue to use that methodology for the next 4 years.
We strongly recommend people don’t make this election without considering their own personal situation, and seeking expert advice. Nonetheless, from an administrative perspective the switch from de minimis to FIF shouldn’t create too much issue for investors as both methods require them to fill out tax returns.
From a high-level perspective, where people are using Australian unit trusts the FIF methodology should usually win out over the de minimis approach. But, as I warned earlier, personal tax situations can be complex and may require specialist advice, particularly when a change is under consideration.
InvestNow offers both FIF and PIE international equity fund options to cater to those diverse range of client needs; we believe investors should be able to travel offshore as they like it.