Does the FIF Tax Regime Apply to Me?
Perhaps the most significant tax nightmare for Americans living in New Zealand (NZ) is the foreign investment fund (FIF) income tax regime. FIF is a complex area of the NZ Inland Revenue Department (IRD) tax code. The purpose of this article is to cover the significant aspects of FIF that directly affect most Americans residing in NZ.
Native New Zealanders circumvent the FIF’s somewhat daunting IRD reporting requirements by investing in local funds, such as portfolio investment entity (PIE) funds1. Americans should avoid this option — or at least be extremely cautious when purchasing local NZ collective investments — as most local investment funds aren’t U.S. tax friendly. Americans residing in New Zealand should be aware of this adverse tax impact when investing in local funds and be cautious when joining online platforms that automatically calculate FIF tax liability. Online calculators aren’t designed to take into account the best method for an American’s specific cross-border investment needs and can often lead to less-than-optimal tax outcomes.
Note: This article doesn’t constitute tax or legal advice, and you should always seek the expertise of New Zealand tax lawyers or tax preparers.
What Is a Foreign Investment Fund (FIF)?
In the simplest terms, the Foreign Investment Fund (FIF) is an offshore investment that falls under one of the following: a foreign company (including a fund or unit trust), a foreign superannuation2 or life insurance products.
Because this could generate confusion, perhaps it would be easier to specify what the IRD excludes from the FIF tax regime:
- Bank accounts (including savings accounts, term deposits and CDs)
- Debt instruments, such as U.S. treasuries or individual bonds (keep in mind that a bond fund, such as a bond ETF, falls under FIF)
- Foreign real estate
- An income interest of 10% or more in a controlled foreign corporation (CFC)
- Income from foreign employment
- Being a beneficiary of a foreign trust
For most Americans, they read the above list and don’t see the terms “IRA” or “401k” and wring their hands in concern over the FIF income tax burdens they face. The good news is that the U.S.-NZ Double Income Tax Treaty does qualify these typical American pre-tax retirement accounts like the IRA and 401k as qualified “foreign superannuation” schemes eligible for a qualified exemption from the FIF income tax regime.
What Do the Terms FIF, FIF Income and FIF Tax Mean?
We often see that people use all these terms interchangeably, which generates confusion, so let’s break it down in the example below:
Let’s say John owns a U.S. ETF or a U.S. mutual fund. Therefore, John owns a foreign investment fund (FIF). Under FIF rules, John has an attributable interest in a FIF, and he must calculate its FIF income under one of the FIF methods imposed by the IRD. John chooses the fair dividend rate (FDR) method, and this method generates a total of $30,000 of FIF income. The FIF income gets added to John’s marginal income tax bracket in NZ every year, creating a much higher income tax liability, which is known as FIF tax.
Is There an Exemption to the FIF Tax Regime?3
There are a few exemptions to the FIF tax regime:
- Transitional residency exemption period: FIF doesn’t apply if you qualify as a transitional resident.
- De minimis exemption: A $50,000 ($100,000 joint) threshold exemption exists on the total cost of attributing interests. Thus, if you own a U.S. brokerage account that holds FIFs, as long as the cost basis doesn’t exceed $50,000 ($100,000 joint) at any time during the year, no FIF attributable interest will apply.
- Shares listed in the Australian Stock Exchange (ASX)
Which Methods Can Be Used to Calculate FIF Income?4
The methods that can be used to calculate FIF income are as follows:
- Fair dividend rate (FDR): This is an imputed income method. To apply it, the NZ taxpayer assumes the foreign investment funds yielded a dividend rate of a flat 5% appreciation annually. A word of caution — the default method, and sometimes the easiest method to calculate, is the FDR. For this reason, it’s not uncommon for taxpayers to just pay FIF income tax using the FDR method. This could be a costly mistake. You, or your New Zealand tax preparer, should run the numbers across all methods to see which generates the lowest tax liability. For example, in a bear market year you’d typically go with the CV method, whereas during a bull market year the FDR method would be preferable.
- Comparative value (CV): This is simply the closing market value at the end of the year minus the opening market value.
- Cost method (CM): This is just the FDR formula, but it can only be used if the FDR method can’t be calculated due to being unable to determine the opening market value of the shares at the beginning of the year (like with privately held non-tradeable shares, sometimes called “non-ordinary” shares).
- Deemed rate of return (DRR): This method can only be used on non-ordinary shares if the CV method is impractical (FDR isn’t allowed on non-ordinary shares).
- Attributable FIF income method: This method can only be used if the person owns a minimum of 10% income interest in a foreign company (CFC calculations are also much more complex and beyond the scope of this article).
As you’ve probably guessed, the two most frequently used methods for Americans who keep their liquid assets in a U.S. brokerage account are the FDR and CV methods. We analyze these two methods in more detail below. We also dive a bit deeper into the other terms listed above.
Fair Dividend Rate (FDR)
5% x Opening Market Value
This method generates an imputed income that assumes the foreign investment funds yielded a dividend rate of 5%. This dividend rate applies regardless of whether you realized any gains. This method can only be used if you can obtain the market value of the shares at the beginning of the tax year. The tax year in New Zealand goes from March 31 to April 1.
This method doesn’t account for dividends, and it doesn’t allow losses to be factored in.
You need to account for certain transactions during the tax year. These transactions are known as quick sale adjustments, and we’ll go over this in the next section. A quick sale adjustment is what adds significant complexity to the FDR method.
(5% x Opening Market Value) + Quick Sale Adjustment
For example, let’s say John owns the following stocks in his U.S. brokerage account:
Under FDR, John would have a FIF income of $52,125. Assuming John is in the 39% tax bracket, this would generate a FIF income tax of $20,329
Quick Sale Adjustment
The FDR ignores transactions (purchases/sales) that occur during the tax year as long as they are in different securities. In the example above, if John were to buy Microsoft (MSFT), that wouldn’t trigger a quick sale adjustment. However, if John were to buy and sell Apple (AAPL), that would trigger a quick sale.
To arrive at the quick sale adjustment, we need to calculate the actual gains and the peak holding adjustment and choose the lesser of the two:
Peak Holding Adjustment Method = 5% x Peak Holding Differential x Average Cost
Actual Gain = Proceeds of the Sale – (Average Cost x Number of Shares)
For example, let’s assume John bought and sold Apple throughout the tax year:
For the peak holding differential, you take the greatest number of shares held during the tax year (Sept. 20, 710 shares) and compare it to the number of shares both at the beginning of the year (500 shares) and the end of the year (590 shares). You then take the lowest number (710 minus 590 = 120).
Peak Holding Adjustment = 5% x 120 x 223 = 1,338
We then calculate the actual gain. We already have the proceeds from the sale (4,400 + 29,640), so we just have to calculate the average cost:
Average Cost (5,610 + 45,600) / (30 + 200) = 223
Actual Gain (4,400 + 29,640) – (140 x 223) = 2,869
Finally, we pick the lesser value of the actual gain vs. the peak holding adjustment (1,338)5, which leaves us with a total FIF income for Apple of 5% x 150,000 = 7,500 + 1,338 = 8,838 and a FIF income for all the positions combined of 53,463.
Comparative Value (CV)
As mentioned, this is simply the closing market value at the end of the year minus the opening market value.
The important thing to remember is that closing market value includes any realized gains, dividends/interest, and other attributable income received. The opening market value includes any additional costs:
CV = (Closing Market Value + Realized Gains + Dividends) – (Opening Market Value + Costs)
Using John’s example (see the table below), if the CV income were negative, the FIF income you can report is zero, as you can’t claim losses or offset them against other losses.
Cost Method (CM)
As mentioned, this is the same formula as FDR; however, this method can only be used when the opening market value can’t be determined, and an independent valuation is required.
Deemed Rate of Return (DRR)
Opening Market Value x Deemed Rate
As described earlier, this method can only be used for non-ordinary shares.3
Attributable FIF Income Method
Net Attributable FIF Income × Interest
As mentioned, this method can only be used if the person owns a minimum of 10% income interest in a foreign company.3
FDR vs. CV
In John’s example, we’d go with the CV method, as it generated the lowest FIF income.
Because these are the two main methods for most clients, before running any numbers, it should be evident that the FDR method would be preferable when the foreign funds have grown more than 5% during the taxable year. The downside of FDR, of course, is that you can’t account for losses, and any buy/sell of the existing investments needs to be calculated via quick sale adjustment.
On the other hand, CV is preferable when there has been a decrease in the market value of the funds. Keep in mind that you also can’t claim losses under CV. So if FIF income under CV is negative, you’d report it as zero.
Tax Planning
If you take just one thing from this article, it should be the intensive tax planning required for Americans residing in New Zealand. We aren’t referring to filing the tax forms. We’re talking about the tax planning involved in managing the accounts year after year. Also, it’s not as simple as moving the assets to New Zealand, as this isn’t an option for U.S. clients. Thus, it’s not about avoiding but rather efficiently managing the FIF income tax burden.
Given the complexity of FIF income tax reporting, there’s been extensive talk in NZ to reform the FIF tax and reporting regime. There are currently proposed changes, and the IRD is expected to make a ruling in the near future.
Tax Credits
The concept of FIF doesn’t exist in the U.S., so it’s not possible to claim FIF income tax against U.S. income or capital gains. Therefore, additional tax planning is required when it comes to tax credit optimization to minimize the impact of double taxation.
Trusts
This is beyond the scope of this article, but keep in mind that U.S. trusts are also subject to the FIF income tax regime.
For more information, don’t hesitate to contact Creative Planning, and you’ll be connected with one of our cross-border wealth managers.
