Current issues in Taxation: Address to Institute of Chartered Accountants Special Interest Group

Introduction
When I worked for the Ministry of Foreign Affairs we had a saying that "what I can tell you is not interesting, and what is interesting I can't tell you". With that theme in mind I can tell you that there is a great deal happening in the Revenue portfolio currently, not all of which is appropriate to discuss now. However, I hope that today I can steer a course between these two extremes.

My senior colleague Dr Cullen spoke to a wider ICANZ group last week and did some scene setting regarding revenue flows and the broader economic context. I will recap on this then cover tax simplification, banking and taxation on housing.

Some of my comments today will reflect the remarks made by Dr Cullen. However, in some areas I will provide additional information.

Clearly, the overall picture has been one of strong economic growth with the first half of 2004 stronger than forecast by Treasury and others. Economic growth for the year to June was 4.4 per cent. The domestic economy, especially private consumption, continues to be the driver of growth and residential and business investment. The small business section grew 4.6 per cent for the same period. Growth in private consumption eased in the June quarter, but consumption overall remained at a high level.
The momentum in the domestic sector of the economy is likely to maintain growth at a higher rate than forecast in the Budget Update over the remainder of 2004. However, activity is still likely to slow from its recent rate as a result of higher interest rates, increased oil prices and a slowdown in the housing market, with expected growth of 2.5 per cent in the year to March 2006. This would only be a mild slowdown and reflects the momentum in the domestic economy and the fact that the negative factors are expected to be relatively mild.

International oil prices have reached record levels in nominal terms recently as a result of strong demand and disruptions to supply. While prices may have increased to a higher underlying level, the recent spikes have been caused by temporary supply factors and so are not expected to persist. New Zealand has benefited from the strong world demand for a range of goods and services, even though this has boosted oil prices. But persistent higher oil prices will lead to lower world growth, lower export returns for New Zealand and higher import prices.
These economic fundamentals mean that we are well placed to react to the changing world economy and fluctuating prices.

Taxation growth has reflected the strong performance of the New Zealand economy. In the year to June 2004, tax receipts grew by $2.8 billion, or 7.1 per cent. Most of this growth came from source deductions, company tax, and goods and services tax.

Source deductions receipts grew by $1.4 billion, or 8.9 per cent, reflecting a very strong labour market, with over three per cent growth in both employment and wages for the year to June 2004. Net company tax receipts grew by nearly $900 million, or 17 per cent, well in excess of operating surplus, which at Budget time was estimated to grow by 1.6 per cent for the March 2004 year. Also goods and services tax grew by $700 million, or eight per cent, driven by increased consumer spending and residential investment.

So, overall the picture is very positive.

The Crown financial statements for the year ended 30 June 2004 recorded an operating balance surplus of $7.4 billion (5.3 per cent of GDP) and an OBERAC (Operating Balance Excluding Revaluations and Accounting Changes) of $6.6 billion (4.7 per cent of GDP).

I am sure Dr Cullen would encourage me to reiterate that he does not have enormous piles of cash sitting around in a bank account. This is because:

• $1.3 billion was used on capital purchases such as new machines for hospitals, building new roads and prisons;
• $1.7 billion was used for loans – such as those made to students and District Health Boards;
• $1.9 billion was put aside to save for future New Zealand Superannuation costs;
• $1.2 billion represents the non-cash element of the OBERAC such as surpluses retained by SOEs and Crown entities, which they can use for future investment.

Once these have all been accounted for, the Crown’s cash surplus for the year was $520 million.

The solid performance on the revenue side for a number of years has enabled the government to fund increases in health, education and infrastructure spending, as well as the ‘Working for Families’ package announced in the last Budget. This investment in our society is not only socially good but also necessary to keep us as an attractive destination for highly skilled migration.

Healthy revenue has enabled us to make this investment while maintaining a sound fiscal position. That means we are better placed to withstand any external economic downturn because we can put aside funds to help cover the future costs of our aging population. Providing for known future pressures, investing in the country’s infrastructure and building a sound fiscal position demonstrates the government’s sound planning for the future.

TAX SIMPLIFIICATION
Einstein once said "the hardest thing in the world to understand is income tax". Were he still with us I could assure Mr Einstein that simplifying income tax is harder still, but we are working on it.

Late last year IRD undertook quantitative and qualitative research to identify exactly what were the major concerns for small to medium-sized enterprises in particular. The message that was received back was clear, the number one problem was tax compliance, and within that provisional tax payments not aligned to cash flow.

Following that work, Dr Cullen and I outlined a range of tax simplification initiatives. Some were relatively straightforward, like a discount for early tax payment for self-employed persons in their first year of business, which is now before Parliament. This is designed to avoid the problems of a large tax bill in the second year. Other tax simplification proposals are more ambitious and will affect a far greater number of taxpayers.

It is important that tax simplification means just that. There is little point in introducing measures that make life easier for some taxpayers while simultaneously making life more difficult for others. Therein lies the difficulty of tax simplification initiatives. Taxpayers are an extremely diverse group and what suits one group of businesses many not suit another.

There are two key proposals, which I believe will make paying tax and managing cash-flows significantly easier for businesses. These are aligning provisional tax payments and using GST as a basis for estimating provisional tax. The research identified that timing of provisional tax payments are causing financial problems for some taxpayers. While more payments may suit some firms, it may make difficulties for others.

The issues are fundamental to business operations but equally important is it affects how the IRD operates. For both groups it is important that the results are practical, achievable and consistent with the overall aims of tax simplification. Officials and key groups have been working closely to ensure those objectives are satisfied and are close to a solution which will satisfy all parties.

Another proposal is that the government encourage the use of payroll intermediaries by way of a subsidy. This government has allocated $45 million to reduce the payroll functions of small to medium enterprises. Currently employers have to deal with number of government departments, namely IRD but also ACC, Statistics and others to a lesser degree. It is important that processes are developed so that businesses can rely on these intermediaries to administer their payroll functions in a reliable and competent manner. I am currently considering a number of options to achieve these aims.

Tax simplification is an ongoing process. Once the current round of measures has been implemented I am confident that further consultation and proposals can be considered.

Recently I released a discussion document on limited tax amnesties. We have all (or know someone who has) been offered the "cashie" job from a business or individual. Some firms are brazen. I heard of an IRD official who had the cash price written on the back of their IRD business card.

At the heart of the amnesties proposal lies some serious issues. Tax evasion, in the form of cash jobs, can become the norm in some areas. Honest firms, who take their responsibilities seriously, have to compete against those who gain an unfair advantage by not paying tax. Some can be forced out of business altogether. Consumers are worse off as their rights are compromised by the illegality of the transaction. They are also unlikely to complain of poor service if they accepted a "cashie".

The amnesty proposal is designed to provide a pathway for businesses to legitimatise their operations. For those who think they can continue to avoid their responsibilities, they will face increased audit processes and the possibility of tax liabilities and penalties.

The limited amnesties proposal will not be a magic bullet for this type of behaviour. However, along with increased audit activity in target industries as well as an ongoing programme of compliance and enforcement by IRD, I believe that inroads can be made in this area.

The government is currently considering feedback on the amnesties discussion document and will make a judgement on whether to proceed with a trial amnesty after having carefully considered that feedback.

PROVISONAL TAX
An important part of government revenues comes from provisional tax. Mostly businesses and individuals pay provisional tax and last year contributed $9 billion dollars, which represent 20 per cent of the total tax revenue.

From a government perspective it represents a large portion of tax revenue. Therefore it is important that this revenue arrives in a reliable and consistent manner.

From a taxpayer's perspective, provisional tax is always going to be more problematic to assess than other taxes. Some firms are required to make payments on estimates of income. In the fickle world of business, it is difficult to get these estimates completely right.

This government has undertaken two initiatives that will lessen some of problems in making provisional tax payments.

The first is provisional tax pooling. This allows businesses to pool their provisional tax payments with those of other businesses, via commercial intermediaries. In the tax pooling process, underpayments by participating businesses can be offset by overpayments by those in the same pool, reducing the under-payers’ exposure to use-of-money interest. Overpayments will attract a higher rate of interest than a business would receive in dealing directly with Inland Revenue.

This has real advantages for businesses, in particular those with uncertain income.

One of my first speeches as a Minister was to launch Tax Management New Zealand. In that speech I said we will watch this new market with interest and expressed the intention of it being an open and competitive one.

On current figures, this seems to be the case. Currently about $800 million has been deposited into tax pooling accounts. Over time, as firms take advantage of the services on offer, I am sure that this will grow to eventually cover a significant portion of provisional payments.

The second initiative around provisional tax tackles the problem of firms required to make provisional payments that do not reflect their cashflow. This problem particularly affects small to medium businesses that do not have access to the capital required to cover tax payments.

As part of the tax simplification package, a proposal is being developed that will give firms the ability to use their GST return as a basis for provisional tax payments. If sales are slow then corresponding tax payments can be lowered. When business improves, then tax payments can increase.

I believe both these measures together will have a significant impact on reducing the hassle of paying provisional tax. I am also confident that the various tax simplification initiatives, currently in development, will be warmly welcomed by the business community when released.

Banking project
Much in the news of recent weeks has been the government’s announcement – and reactions to the announcement – that it is introducing new income tax thin capitalisation rules for foreign-owned banks, which constitute most of the banks in this country. As a major revenue protection measure designed to ensure banks pay enough tax in New Zealand, it is expected to result in them paying around $360 million more a year.

The problem became apparent about two or three years ago, when it was noted that banks’ growing profits, as reported, did not seem to be reflected in the amount of income tax they paid in New Zealand. Tax policy officials reviewed the tax laws applying to banks to see if they were sufficiently robust. They reported to the government that, indeed, there was a problem – banks were using debt to gain access to New Zealand interest deductions to reduce the part of their income that is subject to New Zealand tax.

They were using cross-border financing arrangements to generate income that was not subject to New Zealand tax, through the application of various features of our international tax rules. These outbound investments were generally funded by debt. It is estimated that banks have about $12 billion worth of outbound investment, which results in interest deductions of about $326 million a year. This is clearly where most of the problem lies.

On the inbound investment side, a lesser problem is that banks can substitute debt for equity in the financing of their New Zealand business through the use of holding companies and bank branches. This results in their New Zealand groups being thinly capitalised for tax purposes, relative to their businesses worldwide.

The government’s response is to introduce new rules specific to banks that will deny them interest deductions if they do not hold a level of capital equivalent to at least four per cent of their New Zealand banking assets, weighted for risk. If they want full interest deductions for tax purposes, they will also have to have enough capital in New Zealand to fully fund their offshore investments.

Requiring banks to carry this four per cent level of capital is consistent with similar Australian rules for banks. There are differences, however, between the two sets of rules. The differences arise primarily because of the need to have more robust rules operating in New Zealand, given the significant degree of foreign ownership of banks operating here.

I would like to note with appreciation the constructive process between officials and the major banks in working through this very important matter in a sensible way.

Once the new legislation is enacted, the situation will be closely monitored to make sure banks are paying tax appropriate to their New Zealand-sourced income and their worldwide operations.

Inland Revenue has received extra funding to enable it to monitor the application of the tax laws in a more timely fashion. In particular, I am advised that it will be able to monitor banks on a real-time basis rather than waiting for tax returns to be filed further down the track. This will help to ensure greater certainty for banks and the Revenue alike. The government and the public will watch closely to ensure that the banks' commitment to implementing the changes is honoured.

Taxation and housing
Raising the tax treatment of housing is guaranteed to arouse heated interest.
By international standards, New Zealanders love investing in housing. New Zealand is at the upper end of the range for the percentage of home ownership rates in the OECD. Owning your own home is a time-honoured goal here, although there has been a gradual decline in home ownership rates in recent times.
On the other hand, there has been a dramatic increase in the number of taxpayers investing in rental housing, a trend for which there have been a number of possible explanations. Often quoted factors include that rental housing is an investment that is easily understood, people’s perceptions of greater certainty of long-term gains through property investment, and a lack of confidence in alternatives such as the share market and managed funds.
New Zealanders hold over $435 billion in total assets as measured in the last Household Saving Survey. The three most common types of assets held by New Zealanders were bank assets (91 per cent of economic units), motor vehicles (77 per cent) and the home they lived in (48 per cent). Homes made up the largest proportion of total asset value (37 per cent), followed by farms and businesses, which each made up nine per cent of the value of total assets.
The value of total debt held by New Zealanders, as estimated by the same survey, was nearly $72 billion. The most common debt type was credit card debt (46 per cent). This was followed by mortgage debt (29 per cent) and bank debt (24 per cent). In terms of value, the largest debt type held by New Zealanders was mortgage debt, which made up 81 per cent of the value of total debt, followed by bank debt at nine per cent.

The Tax Review 2001, chaired by Robert McLeod, raised the issue of whether a new tax should be imposed on owner-occupied housing. A similar suggestion had been raised a year earlier by the OECD.

In response to excited media reports linking the government to the Tax Review’s suggestion, Dr Cullen strongly rejected the idea of the government introducing such a tax. He has since reinforced that stance, saying the government does not support proposals to tax homes or introduce a comprehensive capital gains tax.

Although Zealand does not have a comprehensive capital gains tax, this does not mean that all capital gains go untaxed. In certain instances the gain in value of an asset is assessable for income tax.
Recent activity in and around the Queenstown and Wanaka regions suggests that many of the people buying up sections in new developments may not be aware of the tax implications if they on-sell the properties within a short time. If they are buying property purely to on-sell it and make a quick profit, they will be liable for tax on any profit made.
Depreciation review

Rental housing was one of the areas covered in the recent officials’ issues paper on suggestions for improving the operation of the tax depreciation rules. I’m told that the same officials have addressed this group on the details of the suggestions, so you will be familiar with the general thrust of the paper.

In relation to rental housing, the paper discussed a problem whereby some taxpayers are breaking a building into sub-components for tax purposes, claiming depreciation on the individual components and on the building. The practice of claiming building fit-out may be appropriate for commercial premises, where the internal layout of the building is often fitted out to the specific needs of the tenant, but its use in residential rental property appears to be hard to justify.

The use of the building fit-out category leaves the shell of the building, roof, load-bearing and external walls, foundations, floors and ceilings being depreciated at four per cent diminishing value.

There is a lack of hard data in New Zealand on how buildings actually depreciate, but studies for the United States have focused on how buildings as a whole depreciate and have suggested a depreciation range of two to four per cent. Thus a four per cent depreciation rate for buildings would already be on the high side of international estimates. It becomes more generous still as a rate of depreciation for the remaining shell if faster depreciating sub-components are split out and depreciated more rapidly. Officials have proposed two options to address this concern.

Both options include listing certain structural components (wiring, ducting and plumbing and internal walls) and treating them as part of the building. Option one goes on to allow separate depreciation of non-core chattels and fixtures where they are separately identifiable assets and are listed and separately accounted for.

Option two looks to reduce the compliance costs associated with option one. It suggests that owners can elect to depreciate non-core assets at the building rate, with there being greater scope for deducting expenses as repairs and maintenance.

Submissions have rolled in, and even though the closing date has come and gone, they continue to arrive daily. I’m told that so far they number over 300, and there has been a fair degree of comment on the low-value asset threshold and, of course, lots of comment in response to the paper’s suggestions on rental housing. The next step is for officials to analyse the submissions and report to the government with formal recommendations.

Conclusion
As you'll see there is plenty going on in the revenue portfolio. I want to thank you at ICANZ for your continual efforts in working closely with officials on tax policy. I consider the generic tax policy process to be a model that other government agencies could learn from and your contribution to that is invaluable.

Thank you.