Paul Mersi and Mark Russell: 2020 vision delivers a rude tax shock

Imagine it is 2020. Wally and Wilma have been retired for a year, living a comfortable but not extravagant life after working hard to own their home and acquire a nest egg of investments.

However, they have just been rung by their accountant. He has told them that tax has whittled away all of the gains on their investments - in fact they are paying a marginal rate of 100 per cent. They have had their investments since 2007, the year the Government changed the taxation of overseas investments. The only good news from their accountant is that it could have been worse.

Wally and Wilma are dumbfounded - surely this couldn't happen. They recall that back in 2006 the Government said investors would be taxed on their income at their own marginal rate - 19.5 per cent, 33 per cent or 39 per cent - not 100 per cent.

They were told they would be taxed on no more than 5 per cent of the value of their assets a year - Wally even has a clipping from July 2006 quoting then Finance Minister Michael Cullen as saying the tax would generally only be about 2 per cent a year on income from the investments (39 per cent of 5 per cent of gains) - go figure.

Back to the present. Under the proposed regime (contained in a tax bill being considered by Parliament's finance and expenditure select committee), ridiculous tax rates can apply to the income of any investor. The "mark-to-market" approach underpinning the new rules at present applies only to a few types of investments but it is set to be imposed on virtually all foreign equity and managed fund investments from April 2007.

This means tax is payable where there are mark-to-market gains, but in the years where investments fall in value you don't get a refund of past tax paid - you just generate a tax loss which can be used in current or future years.

The catch is, if you are an investor with no other income in these later years then you can never use this loss. This is clearly a pretty big risk for retired people.

So what happened to the investments of Wally and Wilma? In 2010, they put their savings of $200,000 into an Australian-based "global equities" unit trust. Over the years (while they were working), the value of their investment grew by $100,000, which was nice. They were taxed under the new international portfolio investment regime and paid $33,000 tax on that gain (39 per cent of 85 per cent of each year's gains).

However, in the year after they retired, the New Zealand dollar went up and foreign sharemarkets went down, meaning the value of their investment dropped from $300,000 to $233,000.

They sold these investments in 2020 (to switch their savings into bank deposits) and their accountant has told them that although they will have a combined tax loss in that year of almost $67,000, they cannot get back any of the tax paid previously, and the loss is of no use as they have no other income.

The result? Wally and Wilma made a net gain of $33,000, and paid tax of $33,000, an effective tax rate of 100 per cent.

To add to their misery, Wally and Wilma have been told that even if they have taxable income of $67,000 over the next few years (say if their investment increases in value), the tax losses will only save them tax at 19.5 per cent.

These bizarre results can certainly arise at the moment for stakes in foreign investment funds (and even foreign currency accounts with local banks), and will arise in the future for most overseas equity investments under the Government's proposals.

But does it have to be this way? No - and there are two solutions. Unfortunately, neither appears to appeal to the Government or officials.

* The investment could be taxed on a "cash-realisation" basis, rather than mark-to-market. Gains and losses would simply be taxed when the investments were cashed up.

* Unusable losses could be "carried back" to previous years to release refunds of tax previously paid. This is allowed now for certain foreign equity investments. It means losses are unable to be offset against other income but can be carried back to previous years against income from the same investments. Loss carry-back regimes exist in the United Kingdom, United States, Canada, France, the Netherlands and elsewhere.

Why the apparent reluctance of the Government to allow taxpayers to carry back tax losses? It cannot be because of equity concerns, in fact loss carry-back is only fair in a tax regime which is increasingly calculating taxable income by reference to unrealised market value movements in investments.

It can't be because the Government is worried about the certainty of its tax revenues in any given year, can it? Surely it cannot be reluctance by the IRD to process tax returns which require them to open files for previous years and check that gains had arisen and tax was paid?

Perhaps it isn't being offered because the Government is concerned about tax becoming too complicated for investors who may not be able to cope with the additional burden of calculating loss carry-backs. Thanks, but no thanks.

The advent of the financial arrangement accrual rules revolutionised the taxation of debt-type investments in the mid-1980s, just as the impending changes are set to do to the taxation of overseas portfolio investments.

Introducing a tax on most forms of investment rooted in mark-to-market means it is time for other aspects of the tax system to be modernised and adjusted to cope.

A little flexibility to allow carry-back tax losses will not guarantee investors avoid suffering the same fate as Wally and Wilma - they may still pay tax out of all proportion to the income they make over a few years. What it will do is reduce the likelihood of it happening, a matter that should concern people whose primary (or only) source of income is from investments, such as retired people.

This is not just an issue for people on the rich list. Anyone who invests in a KiwiSaver scheme from next year, and who has little or no other taxable income, may be forced to pay tax where they make little or no net gain over the years from the investment.

Alternatively, they will probably be paying tax at ridiculously high marginal rates. It is just not acceptable.

As the tax proposals have developed over the past two years we have constantly recommended some form of a loss carry-back, with little success. We hope the select committee emphasises the need for equity and fairness in the New Zealand tax system when it considers the 3600 submissions before it.