Brian Fallow: Taxing time for the lawmakers

The danger of a widely unpopular and fiendishly complicated capital gains tax on overseas equity investments has been averted.

It is democracy in action. It is a beautiful thing. But a new risk has taken its place: legislate in haste, repent at leisure.

The unprecedented number of overwhelmingly negative submissions on the overseas provisions of the tax bill gave the Labour members of the finance and expenditure select committee, and Doug Woolerton in the case of New Zealand First, a resoundingly clear message to transmit to their party leaders.

United Future's leader Peter Dunne, as Minister of Revenue, was clearly getting the same message. Even with the carve-outs and rollover provisions that had already been made, a tax on unrealised capital gains was not acceptable.

It was too bitter a pill even with a thick sugar coating in the form of investor-friendly changes to the treatment of investment in New Zealand and Australian shares via managed funds.

It is refreshing to see the select committee process go beyond tweaking, fine-tuning and limiting itself to the workability of legislation, rather than its broad policy design.

But in the case of tax law there are two important reasons why its role is normally that limited one. One is that under the tortuous generic tax policy process the broad principles and policy design have been extensively consulted on discussed before the legislation is even drafted.

In this case there were discussion documents in 2003 and 2005, not to mention Craig Stobo's review.

The Plan B option now favoured by the Government, which it is calling the fair dividend method, did not come out of the blue.

It resembles the standard return rule method which was the subject of a 40-page chapter of the 2003 discussion document, and which in turn derived from the risk-free return method advocated more broadly by the McLeod review in 2001.

The 2003 version, by the way, envisaged a rate of 4 per cent applied to the asset's value at the start of the year "which, broadly, reflects a reasonable dividend yield on an equivalent domestic investment".

The latest version has bumped the rate up to 5 per cent. But for individual investors holding shares directly, that is the maximum that will be taxable. Allowing for years in which shares underperform or fall in value, the select committee has been given to understand that the average effective rate is likely to be closer to 3 per cent.

The other major reason the select committee is usually confined to the devil-in- the-detail of tax law changes is that such changes have revenue implications.

Including the taxpayer-friendly local changes, the overhaul of the investment tax regime is estimated to have a fiscal cost of $140 million, up from the $110 million cost of the capital gains tax version. That is a lot of hip replacements and school computers.

And it probably means that Finance Minister Michael Cullen would not be too keen on the most straightforward way of proceeding from here.

That would be to delete the international provisions from the current tax bill. It would allow the rest of it to be reported back to the House by the due date of November 24.

The fair dividend return method for overseas portfolio investments could then be included in the next tax bill, which would give officials time to carefully draft the provisions, and interested parties to reflect and make submissions on them, because six weeks is not a lot of time to draw up a tax regime that will be around for years and whose defences will immediately be subject to attack by cunning tax planners.

The problem with delay, from a finance minister's point of view, is it amounts to licking off the sugar coating and spitting out the pill. People will happily pocket the tax relief locally and baulk at any later moves to tighten up the overseas regime.

Indeed people are already finding fault with the fair dividend return method, even with only the broad brush strokes of a press statement to go on.

Fund managers complain that whereas individual investors will pay tax on less than 5 per cent of the opening value of the share portfolio at the start of the year if their return (including dividends) is less than 5 per cent, and none if they make a loss, managed funds are pinged for 5 per cent regardless.

One of the objects of the exercise is to level the playing field between direct and intermediate investment. It fails that test.

But on the other hand - and at least Cullen and Dunne were candid about this - this limits the fiscal cost.

Another potential problem relates to gains or losses that arise from the gyrations of the exchange rate rather than the underlying performance of the overseas asset in its local currency.

And there is a risk that what are in substance flows of debt finance are routed through overseas "equity" vehicles to reduce tax.

In an interim report back to the House last week the select committee said, with dry understatement, it appreciated that the technical details of the fair dividend rate proposal needed further development.

Its chairman, Shane Jones, said officials had been asked to "put some flesh on the bones" of the proposal, and that while the committee had "yet to lock in the best process going forward, there is an expectation it will involve some additional submissions".

But time is short. Parliament's standing orders require the bill to be reported back within six months of being sent to the select committee, in this case November 24. Extensions are possible but require the unanimous agreement of the House. In any case there are time pressures arising from the introduction of the KiwiSaver workplace savings regime on July 1 next year.

The fund managers to whom these savings are to be entrusted would no doubt like the new tax regime to be enacted by then.

But they might prefer living with the existing rules a little longer to being stuck with new ones which discriminate against them in favour of direct share ownership.

There is also the issue of the exemption which was to be extended to GPG (and any other company exactly like it). The two ministers have dumped that issue in the lap of the select committee as well, implying that the deal they struck with GPG director Tony Gibbs might not be a done deal after all.

A distinctly unimpressed Gibbs has written to the ministers saying the basis for the exemption remains exactly as it was in May: it gives GPG the opportunity to consider shifting its headquarters to New Zealand following the forthcoming review of the controlled foreign company regime.

Tax officials advising the committee will be burning a lot of midnight oil over the next few weeks. But if they had come up in the first place with a regime that did not treat the rest of the world as one big tax haven they might have saved themselves, and many other people, a lot of time and trouble.