Kiwis missing out from hole in our tax base

OPINION: How often do you hear governments say ‘we’re not sure if it will work, but we’ll give it a shot’?

Not a lot, Chalkie would say. Lack of evidence that a policy will produce the desired effect is generally its death knell, particularly if said government was not keen on it in the first place.

However, when it comes to corporate finance it appears this government is willing to experiment. To be specific, Chalkie is talking about cutting tax for foreign investors.

The relevant measure can be found in the Tax (International Investment and Remedial Matters) Act of 2012, if you stay awake long enough to read past the title.

Indeed, the issue is so obscure Chalkie would have remained in blissful ignorance if not for the helpful correspondence of a brainy Wellington businessman.

The tax cut in the Act allowed foreign investors to pay zero New Zealand tax on interest from New Zealand corporate bonds.

The idea was to stimulate the bond market and make it cheaper for local companies to borrow money by issuing bonds.

In an issues paper dated June 2009, government officials said: “Concerns have been raised from a number of commentators that current tax rules may be hindering the development of a domestic bond market. This issue has been raised in the context of the Jobs Summit and also in the Capital Market Development Taskforce.”

The solution, it seems, was to cut a fee called the approved issuer levy (AIL) from 2 per cent to zero on bonds sold to multiple investors, such as retail bonds listed on the NZX.

“[The cost of] AIL is one possible contributor to New Zealand’s relatively under-developed bond market,” said the paper, “and applying a zero rate of AIL on bonds may encourage borrowers to issue more bonds domestically.”

However, officials advised that “there is uncertainty about the extent to which this would lead to an increase in bond market activity.”

The government went ahead and did it anyway, estimating the money it lost would be about $5m a year.

And the effect? As far as the listed debt market is concerned there is no sign of the hoped-for stimulation.

In 2012, the year zero rating was introduced, there was $300m of debt raised on market, the lowest in six years. In 2013 there was $292m raised. So far this year the debt market has raised just $39m, according to NZX figures.

On its own, this looks like a failed instance of the constant tweaking that goes on in the arcane world of tax law, but Chalkie mentions it because it’s a useful introduction to the policy conundrum of the AIL.

The levy had its origins in the early 1990s.

A Treasury paper in June 1991 discussed reform of taxes on foreign investors. At the time the main measure was non-resident withholding tax (NRWT), which was charged on interest paid by local companies to foreign lenders.

In the year to March 1991 NRWT brought in $230m of tax revenue.

Under reciprocal tax treaties, those lenders would typically be able to claim credit for the NZ tax paid when totting up their domestic tax returns, so it didn’t reduce their returns from the loan.

The ones that couldn’t get credits would just dodge the tax.

But the problem as Treasury saw it was that lenders would sometimes add the cost of NRWT on to their loan, so it became an extra cost to the NZ borrower – and New Zealand was so reliant on foreign money that those rates effectively set the price for local borrowing too.

Back then Treasury estimated this added about 0.3 percentage points to interest costs, which was not much to worry about.

Unfortunately other countries were starting to restrict credits on NRWT and lenders were getting twitchy about dodging the tax as the IRD tightened up on avoidance, so the impost would increasingly fall on local companies and increase their cost of capital. Treasury thought the solution was for NZ borrowers to apply to the Inland Revenue for an exemption from NRWT in exchange for a fee, or levy.

This became the AIL, under which local borrowers pay a fee to the government of 2 per cent of the interest they pay on borrowing from overseas. The lender is then exempt from NRWT.

Last year the net revenue from AIL was $50m, which Chalkie estimates means an amount borrowed from overseas of more than $40 billion.

Which sectors are paying it is unclear because the IRD won’t release the information, however it will say that the financial sector paid $30m-odd, while the “other” sector paid about $20m.

The government also paid about $38m but that doesn’t count because it effectively pays itself.

Meanwhile, NRWT for 2013 was about $420m.

This means the NZ tax impost on borrowing from overseas was less than $500m.

Now, according to government financial statements the withholding tax on interest income paid to New Zealanders was $1.6b in the year to June 2013.

Given the large amount New Zealand borrows from overseas, Chalkie reckons these numbers imply New Zealanders are paying more tax on their lending to local entities than foreigners are.

This is particularly likely to be the case if the foreign lender is located in a tax haven. If you’re in the Caymans, say, the AIL means you pay no tax in New Zealand, while you also pay no tax in the Caymans.

It would be interesting to know how much of the lending supplied through the AIL regime comes from tax havens, but unfortunately the IRD says it does not collect this information.

In the end, Chalkie reckons what we have inadvertently created here with the AIL is a system that contributes to global corporate tax avoidance because it allows a wide range of entities to operate completely outside any tax system.

That this tax free status is intended to be widely available can be seen in the legislation itself, which makes specific provision for situations where the annual levy payment is less than $500.

At that level you could be talking about borrowing an amount suitable for a home mortgage, for example.

This is hardly the world of big corporate finance and managing the cost of capital for NZ Inc.

Last September the Revenue Minister, at the time Todd McClay, was cited in an IRD briefing paper as wondering why AIL was necessary given New Zealand’s high interest rates would give foreign lenders plenty of incentive to invest money here even without a tax break.

It’s a fair question. The IRD’s answer – that NZ borrowers may be higher risk because they’re relatively small and use a different currency – was in Chalkie’s view not a justification for creating complicated tax breaks available only to overseas entities.

After all, if this was really about lowering the cost of capital for NZ companies why not think about some sort of tax break for NZ investors?

Yes, there are no simple answers in tax policy, but creating huge loopholes for the benefit of international tax avoiders is surely not the best option.