Are we Pai on* Pie?

*adj. be pai on. NZ informal: to be keen on [from Maori pai ana]

New tax legislation may not be near the top of many people’s list of things to read. However, for anyone tired of “fiendish” level Sudoku puzzles, the portfolio investment entity (PIE) regime in the Taxation (Annual Rates, Savings Investment, and Miscellaneous Provisions) Bill (Bill) offers an alternative intellectual challenge.

The shape the PIE regime has taken is not altogether what one might have expected prior to reading the Bill and from the debate surrounding the “QCIV” tax proposals which preceded it.

In this edition of SuperScoop, we attempt to unravel the following mysteries:

1. what a PIE is;
2. how a PIE will calculate its tax liability; and
3. how a PIE’s members will be treated for tax purposes.

Transitional and other practical implementation issues will be dealt with in a future SuperScoop edition.

The combination of time pressures and abundant complexity means there will inevitably be a considerable amount of change between this first reading version of the Bill and the Bill as reported back from the Finance and Expenditure Committee. Hopefully, IRD and Treasury officials will be permitted by the Committee to discuss submissions during the Committee’s deliberations. Allowing such discussion will undoubtedly improve the quality of the reported back Bill, which is important given the very limited ability to make changes after that stage.

The closing date for submissions on the Bill is 7 July.

Overview

Qualification criteria

The requirements for an entity to qualify as a PIE, though lengthy, are fairly much as expected. They appear to be generally workable, but further thought will need to be given to how some of the requirements apply in the context of superannuation schemes, and schemes with daily unit pricing.

Because some of the requirements operate on a class-by-class basis, PIEs offering a number of different units or share classes out of one entity will need to think carefully about the risk of a qualification failure in one class causing a qualification failure for all classes. PIEs will also need to make quarterly or more frequent adjustments to investors’ interests to take account of the different rates of tax imposed on the PIE with respect to different investors’ incomes, and will need to report to all investors on a quarterly basis.

Taxation of the PIE

The calculation by a PIE of its income is complex. The PIE pays tax on the income attributable to its individual and non-resident owners, at a rate of either 19.5% or 33%. In order to calculate the amount attributable to these owners, and to pay tax at the correct rate, the PIE must calculate its income (and pay tax) at least quarterly, and must track its owners on a daily basis. As drafted, the Bill also requires the PIE to separately calculate income and credits from each of its investments.

The exclusion from taxable income for gains on sale of New Zealand and certain Australian shares is welcome, but the Bill contains some problematic restrictions on this exclusion.

Taxation of investors

For individuals and non-residents, investment in a PIE should not impose significant tax compliance costs. In many cases the income earned will receive a favourable tax rate compared to direct investment, though investment through a PIE could give rise to tax inefficiencies. The principal tax “cost” of investment through a PIE is that the $50,000 cost de minimis exception from the foreign investment fund (FIF) regime only applies to direct investment by individuals and is therefore unavailable to investors through PIEs.

For companies and trusts, investment through a PIE will give rise to a similar tax cost as if they had invested directly.

This SuperScoop reflects our first impressions of a complex piece of legislation. Feedback is welcomed.

What is a PIE for?

It bears repeating that the purposes of the PIE regime are two-fold:

• to specify a type of collective investment vehicle on which the Government is prepared to confer the same tax-free capital gains treatment on sales of NZ and certain Australian shares as is claimed by most natural persons; and
• to allow such a vehicle (whether or not it actually invests in NZ shares) to be taxed in broad terms as a “pass-through vehicle”, whereby the income attributable to each member is taxed at the member’s marginal rate. In fact, the PIE regime is intended to allow income to be taxed in many cases at a rate lower than the member’s marginal rate.

Both of these aims are considered important in encouraging individuals to put their money into NZ-based savings vehicles such as KiwiSaver.

Achieving the capital gains treatment appears to have been relatively simple. Achieving (or rather, approximating) the pass-through treatment has evidently been very much more difficult.

What is a PIE?

For present purposes, there are ten significant requirements that must be met before an entity is eligible to be treated as a PIE:

1) Type of entity
The Bill states that only a company, group investment fund or superannuation fund may be a PIE. Life insurers are excluded. Of course, company for tax purposes includes a unit trust, so these entities may also become PIEs.

2) Residence
The entity must be resident in NZ (and not resident in another jurisdiction under a double tax agreement).

3) Income interest requirement
A PIE cannot give investors rights to only certain types of income from an underlying investment. For example, it may not issue a unit which gives a right to dividends on a share and another unit which gives a right to gains on sale of the share. This requirement does not prevent the issue of units which differ in other ways.

4) Independent management
Generally, no investor in a PIE, and no person associated with an investor, can have the power to influence the PIE to make, or dispose of, an investment. This requirement seems problematic and may need some modification to allow for commonplace superannuation arrangements.

In particular, it should be clarified that offering a member investment choice facility, whereby scheme members can effectively influence the scheme’s investment strategy by directing the trustee to invest in certain types of assets, will not fall foul of this requirement. In addition, the consequences of having member trustees, or member directors of a sponsoring employer (where the employer for example appoints trustees, or must consent to deed amendments, and can wind up the scheme), need to be thought through. This may be a point on which submissions could be made.

There is an exception for investors who are themselves PIEs (or equivalent foreign entities).

5) Number/nature of investors
The PIE must have:

• 20 or more members. For this purpose associated persons are counted as one person (and a very broad test of association applies); or
• a member who is a PIE; or
• a foreign member which is equivalent to a PIE (referred to as a foreign investment vehicle).

If the PIE issues a number of different classes of units, this requirement must be met for each class individually. If the test is failed with respect to any class, then the entity ceases to be a PIE with respect to all of the classes of units issued. This is probably not desirable, though it would be complex to draft rules for an entity which is in part taxable as a PIE and in part not.

Because superannuation schemes typically do not issue units but do in many cases offer member investment choice facilities, the concept of investment “classes” does not sit comfortably in a superannuation context. It seems a scheme which offers, for example, balanced, growth and conservative investment choices will probably be regarded as having “classes”. However, the definition of “portfolio investor class” is not straightforward and its application may depend on how the investment choice facility is structured.

6) Size of investors
There is no limit on the proportion of a PIE which can be held by another PIE or a foreign investment vehicle. However, if the investor is:

• a NZ resident unit trust, group investment fund, NZ resident life insurer or superannuation fund, then the investor must hold 20% or less of the total value of the PIE’s assets;
• anyone else, then the investor and their associates must hold 10% or less of the total value of the PIE’s assets.

Again this requirement applies separately to each class of interests, and must be met for each of them.

7) Type of investments
90% or more of the PIE’s assets must be used, or be available to be used, to invest in income-producing property, share, debt or derivative investments or things similar to shares, loans or derivatives. This requirement is intended to exclude from PIE status entities which are businesses providing goods and services, rather than in the business of providing a vehicle for savings and investment. This requirement applies at the level of the PIE only, and does not look at the assets attributable to a particular class of interest.

8) Investment value limit for equity investment
If the PIE holds more than 25% of the value of one or more companies, then the total value of that investment must not exceed 10% of the total value of the PIE’s assets. This limit seems to be intended to apply to share investments, but as drafted could include a debt investment as well. This should probably be clarified. This 10% requirement must also be met for the investments attributable to each class of interest. This requirement does not apply to investments in other PIEs or in foreign investment vehicles.

9) Repurchase requirement where equity investments exceed 10%
The nature of this requirement is not clear. However, its effect seems to be that if, for a continuous period of five years or more:

• the PIE holds shares in one or more companies (other than a PIE or foreign investment vehicle) which are at least 10% of the market value of the company; and
• such shares make up at least 10% of the value of the investments attributable to a given class of interests,

then the PIE must make an offer to all investors in that class to repurchase all of their units or shares at market value.

10) Investor interest adjustment requirement
Aspects of this requirement are discussed in more detail below. It requires that at the end of each quarter (or more frequently if the PIE elects) the PIE must adjust each investor’s interest to reflect the effect of the investor’s portfolio investor rate (i.e. the rate of tax applied to the income attributable to that investor’s interest). This requirement would generally require the PIE to issue bonus units to taxpayers with rates lower than 33%, or to compulsorily redeem units held by taxpayers with rates higher than 0%.

In the case of a superannuation scheme that is not unitised, the interest adjustment requirement would seem to require a quarterly adjustment to the earnings rate attributable to each member’s scheme account.

When requirements must be met

The first four of these ten requirements must be met at all times. The last six are tested on the last day of each quarter. They do not have to be met for the first two quarters during which an entity is a PIE. However, once an entity is a PIE, it will not have the benefit of this grace period for any new classes of interests which it issues. This may be a point on which submissions are desirable.

A failure to meet any of the last six requirements will be ignored if:

• it is corrected by the end of the next quarter (the Commentary on the Bill suggests that this should be the end of the next quarter but one); or
• it is due to factors outside the control of the PIE.

The latter test is particularly unclear. The Commentary suggests that it would apply if the value of investments falls – for example if a PIE holds 30% of the shares in a given company, and as a result of the fall in the value of other investments, those shares become worth more than 10% of the total value of the portfolio. However, it could be argued with some force that this breach is due to factors within the control of the PIE, and that therefore a “by reason of market value fluctuations” type of qualifier should apply instead or in the alternative (by analogy with such qualifiers in many Trustees’ Statements of Investment Policy and Objectives).

Election

The PIE regime is elective rather than mandatory. Elections made during the 2007/8 tax year are effective from the beginning of the next quarter. Elections made subsequently are effective at the beginning of the next tax year.

However, anyone wishing to become a Default KiwiSaver Scheme must, in terms of the Key Requirements set out by the Ministry of Economic Development, opt into the PIE regime for their default investment product and other non-default investment products included in the Default Scheme.

Default KiwiSaver Schemes – Request for Proposal

The MED has just released the Request for Proposal document for providers wanting to be considered for appointment as Default KiwiSaver Schemes. We will be issuing another edition of SuperScoop detailing those requirements shortly. Providers should note that they need to register their intention to apply by 6 June. Completed applications must be in by 7 July.

Taxation of PIE

General

In its regime for taxing the income of a PIE, the legislation takes off on a tangent which is both novel and almost unfathomable. The reason behind this is largely the desire to avoid imposing an income tax return filing obligation on natural persons. This could perhaps have been dealt with by treating the PIE as a withholding agent for the investors. However, the legislation does not take this approach, instead imposing tax directly on the PIE with respect to those investors.

Key points to be aware of in terms of the taxation of the PIE itself are:

• the usual income tax calculations for a company or trust are abandoned, and instead the PIE pays “portfolio investment entity tax” (PIET);
• PIET is calculated and payable for each portfolio entity period (i.e. each quarter or shorter period elected by the PIE). The payment must be made within a month of the end of the period;
• the PIET tax rate is effectively a weighted average of the rates applicable to each investor in the PIE on each day of a given period, so the rate will vary between PIEs and between periods depending on the composition of the investors in the PIE;
• the rates are:

1. for non-individual NZ residents (essentially companies and trusts, and including PIEs) 0%, on the basis that these entities will pay tax on income derived through the PIE themselves;
2. for non-residents, and resident individuals with income and attributable PIE income of more than $48,000, 33%;
3. for other resident individuals, 19.5%;

• PIET is not calculated by applying the tax rate to a global net income figure. Instead PIET is an aggregate figure, determined by taking each investment separately and applying the PIET tax rate to the net income from that investment. Under the Bill as drafted, investments which produce a net loss are not included in the calculation of income subject to PIET. This is in all likelihood an error which will be corrected;
• the role of tax credits in calculating PIET is not at all clear from the Bill;
• losses and excess credits are not carried forward by the PIE but are attributed to the investors, as discussed in more detail below. There is an exception for pre-PIE losses and certain real-estate losses.

It is regrettable that more effort has not been made in the Bill to conform the calculation of PIE income to a core provisions approach. That approach has been developed very carefully, is robust and is well understood.

Unallocated assets

To the extent that no investor holds an interest in an asset, the asset is treated as being held by an investor in the 33% default class. This will be the case, for instance:

where a superannuation scheme holds assets unallocated to particular members; or
in the case of a defined benefit scheme, where members do not have any defined right to the proceeds of any of the assets of the scheme.

It seems that the intention of the legislation is that all of the assets of a defined benefit scheme will be treated as effectively unallocated (by virtue of the definition of “portfolio investor interest fraction”).

Exclusion for gain on sale of NZ and Australian shares

The Bill excludes from the assessable income of a PIE income from disposing of a share in (i) any NZ resident company or (ii) any Australian resident and ASX listed company. The effect of excluding these amounts from income, rather than exempting them, is that expenses incurred in earning the income are deductible on the same basis as if the income were assessable.

However, this exclusion does not apply if:

• the share is a fixed rate redeemable share (broadly speaking). This exclusion is presumably aimed at preventing a PIE avoiding comprehensive taxation of debt under the financial arrangement rules by substituting for debt investment a share with similar returns; or
• a dividend on the share is declared before the disposal and paid afterwards (i.e. the share is sold cum div); or
• the PIE is assured, under an arrangement with another person, of having a gain on the disposal of the share; or
• within 30 days of the sale, the company declares a dividend and the PIE acquires an identical share in the company to that sold.

The second and third of these exclusions are highly problematic. In respect of the second, it seems illogical to remove the exemption for tax on capital gains (which may be very significant) because of the existence of a dividend, which will usually be comparatively modest in size.

The third exclusion is overly broad. For example, an agreement to sell a share for a specified price, once it is entered into, means the PIE is assured, under an arrangement with the purchaser, of having a gain on the disposal of the share. This should not prevent the exclusion of the proceeds from tax.

A further interesting issue is how these exclusions fit with the newly legislated share lending regime.

Other foreign shares (except Guinness Peat Group)

Pursuant to the new foreign investment fund (FIF) regime, the PIE will be taxable on 85% of the gains from other foreign shares, whether or not such gains are realized. A number of methods are possible. Regardless of which is chosen, funds will presumably continue to provide for tax on sale of such equities in their unit pricing or earnings rate calculations.

GPG shares

Readers will be aware of the proposed 5 year exception from the FIF regime for GPG shares. Although exempt from the FIF regime, these shares have not come into the exclusion which applies to shares in NZ and certain Australian companies. The result is that for most PIEs, 100% of the gain on sale of their GPG shares will under the proposed exception be taxable, but only when those shares are sold. Ironically, this will presumably give rise to a greater accounting provision for tax due to increase in the value of GPG shares than would be the case for an equivalent gain in value on other foreign shares.

Losses

A PIE will not carry forward or group any net loss it may have (with the exception of losses arising for periods before the PIE qualifies as a PIE). Rather, the net loss will give rise to either a rebate or a deduction of tax for the investors in the PIE, as set out below.

Issue

Because the PIET is calculated by applying the weighted average daily rate to income calculated for the entire period, it seems to give rise to an issue for PIEs providing daily unit pricing. For example, suppose a PIE’s only income for a quarter is a $100 unimputed dividend, received on day 5. For the first 10 days of the quarter, all of the PIE’s investors have elected the 19.5% rate. On day 11, all of these investors exit, but they are replaced by investors subscribing an equal amount of money, all of whom are on a 33% tax rate. For the rest of the quarter, all of the investors in the PIE are on this rate.

The exiting investors will presumably expect to receive an aggregate $80.50 with respect to the cash from the dividend, i.e. the pre-tax amount less their tax rate. Assume that the PIE prices the units accordingly. On that basis, the new 33% investors will pay $80.50 for the right to the cash from the dividend. However, as a result of their investment, the amount of tax paid on the dividend will be $31.83, reflecting their ownership of the PIE for 89% of the quarter. This means they will pay $80.50 for a return of only $61.87.

Taxation of investors

PIE investors will be taxed in the same way regardless of whether they invest in a unit trust, a superannuation scheme, a GIF or a company. While the result in some cases may be the same as under the current regimes, in many cases there will be significant differences.

The taxation of a PIE investor depends on whether the PIE income attributable to them is subject to PIET at the 0% tax rate (which applies generally to resident charities, trusts and companies) or a rate higher than 0% (applying generally to natural person investors and non-residents). The general principle is that an investor on a 0% rate is taxable on their share of the PIE’s net income, whereas other investors are not taxed because the tax has already been paid at the appropriate rate by the PIE. However, even in the case of 0% investors, the PIE tax regime is not a tax pass-through regime in the sense of, for instance, the partnership tax regime. The 0% investors do not treat themselves as deriving directly a portion of the gross amounts derived by the PIE, or as incurring directly its items of expenditure. Rather they are taxed on a defined single item, which is “portfolio investor attributed income or loss”.

Natural person and non-resident investors

Share of income
For these investors, their share of the income of the PIE for a given period is excluded income. This means that while they do not pay tax on it, for purposes of expense deductibility it is treated as having been earned by them. If the investor has net losses from other activities, there is no way to offset these losses against the person’s share of income from the PIE.

The exclusion does not apply if the investor has notified to the PIE a portfolio investor rate that is less than the correct rate. This should only occur if a person whose income (including share of PIE income) is more than $48,000 for the previous year, notifies the PIE that it should apply a 19.5% rate to the person. This could easily happen inadvertently. For example, a PIE investor who has properly elected a 19.5% rate in year 1 may find in year 2 that their income is above the $48,000 threshold. Unless the person notifies the PIE within the first quarter of year 3 that the 33% rate should apply, they will be taxable on their share of the PIE income for that first quarter.

There seem to be a number of problems with the legislation in this area.

• One would hope that where a person’s share of PIE income is not excluded due to a 19.5% rate being elected incorrectly, a credit would be allowed the investor for the tax paid by the PIE. This does not seem to have been provided for. The result is double taxation of the same income.
• If a person notifies a 33% tax rate to the PIE, and then finds that their income is below the $48,000 threshold, there is no provision allowing the extra tax paid to be refunded. This could be solved by removing the exclusion (as is done in the converse situation) and allowing the person to claim a tax credit.

Share of losses
If a PIE has a loss for a period, a non-resident or natural person investor’s share of this loss is converted to a rebate equal to the loss multiplied by the portfolio investor rate. For example, if an investor to whom the 19.5% rate applies has an attributed loss from a PIE of $500, this is converted into a rebate of $97.50. The purpose of allowing a rebate rather than a net loss is apparently to simplify the provision of the benefit of the loss to the investor. That is, it is simpler for the person to claim and receive a rebate (in fact, it is expected that the PIE will provide the necessary information to IRD so that IRD may do this automatically) than to have to file a tax return of all of their income, claiming an offset for their PIE attributed loss.

Excess credits
If a PIE has tax credits attributable to a natural person or non-resident investor which it cannot use (broadly because the credit arising from an investment attributable to the investor exceeds the PIET liability on the income from that investment attributable to the investor) the excess credits are treated by the investor as a rebates to which they are entitled. Presumably this is again on the basis of administrative simplicity.

The total rebate is limited to the total tax for which the investor is otherwise liable – i.e. the PIE rebate cannot give rise to a refund for more tax in a given year than is otherwise payable by the person. To the extent it cannot be used, the refund is lost. There does not seem any good reason for this. In principle, the rebate should either be refunded in cash (like other refundable credits) or be able to be carried forward to future periods, in the same way as excess imputation credits can now be carried forward by natural persons.

Distributions
Distributions from a PIE are excluded income, i.e. are not subject to tax. This means there will be no reason for a PIE to use manager buy-backs instead of direct redemption. Indeed, direct redemption will be preferable, as giving a higher level of certainty of tax treatment for the investor.

Superannuation benefits
The changes described above will not change the nature of superannuation benefits being tax free in members’ hands (subject of course to the possible imposition of FWT). It will mean, however, that scheme members will be treated as having earned a share of the income of the PIE, as described above. They will not be able to offset losses from other activities against this income but may be able to deduct expenses related to the deriving of that income if they have any. The existence of losses or excess credits in the PIE could generate rebates which can offset the income tax payable on that member’s other income, but cannot result in any benefits to be carried forward to future years.

Other investors

Share of income or loss
Other investors (i.e. NZ resident charities, companies and trusts) will be taxable on their portfolio investor attributed income, or entitled to deduct their portfolio investor attributed loss. These amounts will not include any gains or losses from the disposition by the PIE of shares in NZ resident or Australian listed and tax resident companies where the sale proceeds are excluded income to the PIE. This will be the case even if the investor is a share dealer who would be taxable on such sales if made directly.

If a loss exceeds the investor’s other income, it can be carried forward by the investor in the usual way.

Tax credits
Consistent with this approach, these investors will be attributed directly with their share of tax credits received by the PIE. The credits retain their character (e.g. as foreign withholding tax credits, resident withholding tax credits, etc).

Distributions
As for other investors, distributions from a PIE to a 0% investor (including on redemption) are excluded income.

Information requirements
All PIE investors will require information from the PIE in order to comply with their tax obligations. Individuals will require the information to determine whether they are in the 19.5% or 33% tax rate. Companies and trusts will need it to determine their income and credits. One might have expected the Bill to include an addition to the Tax Administration Act imposing an information-providing requirement on a PIE, in the same way as, for example, a company paying a dividend must provide the shareholder with a dividend statement. However, it does not.

Conclusion

A cursory read of the Government’s 2005 Discussion Document Taxation of Investment Income, which first announced what has now become the PIE regime, would suggest that the regime was not likely to be simple. This promise has borne fruit. The shape of the PIE has been in particular influenced by the “no filing” regime for the bulk of wage and salary earners. The power to confer a lower tax rate on the earnings of its investors, and to shield them from abatements in social assistance, has brought with it further complexities. These pressures have combined to create in our tax environment an entity which is certainly fiscally unique, and may have consequences well beyond those intended by its creators.
Given the complexity of the rules in particular for taxation of the PIE’s income, many superannuation scheme trustees will be faced with a difficult decision as to whether to opt into the PIE regime or not. Now that the tax rate has been capped at 33%, the issue becomes whether trustees have a duty to minimise tax on behalf of lower income earning members, who will get the benefit of the 19.5% rate if their scheme becomes a PIE. There will inevitably be trade offs between the added complexity and these tax savings.

Defined benefit schemes will have their own issues to assess, as the “pass through” of income provisions will not apply to them. They will be able to become PIEs for the purpose of the exclusion from tax on realisation of New Zealand and Australian shares. However, all income will be taxed at the rate of 33%.

As many other superannuation schemes have an element of unallocated funding, it may be necessary in many instances to look closely at the nature of the scheme to assess whether there is sufficient linkage between the members and their entitlement to income allocations to bring the scheme within the requirements of the PIE regime, and in particular the statutory definitions. Income which is attributable to unallocated reserve funds or other unallocated funds would seem to be taxed at 33%.

Given the huge administrative changes that will need to be made in order to opt into the PIE regime, it seems that the start up date of 1 April 2007 is optimistic to say the least. Schemes are currently assessing how to adjust to the KiwiSaver regime, which also starts on that date. Given that there are likely to be further changes to both this Bill and the KiwiSaver Bill, it appears that this is to be an extremely busy year for superannuation schemes.

“Excessive salary sacrifice” amendments

The amendments contained in the Bill give effect to changes signalled in the issues paper Countering Extreme Salary Sacrifice: Ensuring that Employer Superannuation Contributions are Taxed Fairly prepared by the Inland Revenue Department in February 2006, and on which the public was invited to make submissions.

The proposed changes in the Bill are designed to close a tax loophole which some taxpayers have been exploiting by entering into so-called “extreme” salary sacrifice arrangements through registered superannuation schemes as a means of paying significantly less tax.

Proposed changes

The proposed changes in the Bill will minimise the possibility of the progressive withholding tax rates scale being used to gain significant tax advantages through “excessive” salary sacrifice.

The main change proposed is amending the progressive withholding tax scale so that the applicable rate is based on the aggregate of the employee’s salary/wages and employer superannuation contributions, instead of on salary/wages alone. To minimise the possibility of over-taxation, the withholding tax thresholds will increase by 15% in comparison to the usual income tax rate thresholds.

The effective date of the proposed changes is 1 April 2007. Based on the provisions in the current version of the Bill, the applicable withholding tax scale after 1 April 2007 will be as follows:

Salary plus superannuation contributions up to $10,925 -- 15%
Salary plus superannuation contributions from $10,926 to $43,700 -- 21%
Salary plus superannuation contributions over $43,700 -- 33%

As can be seen, the current 6% tax differential between the top marginal income tax rate of 39% and the standard withholding tax rate of 33% has been maintained in the Bill.

It is important to note that the changes are focussed on preventing undesirable behaviour pursuant to an existing major loophole. In our view, the amendments help to resolve rather than create propriety concerns about salary sacrifice. It will remain the case, after these amendments are enacted, that salary sacrifice for the purpose of genuine retirement saving is perfectly proper and permissible.

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