New Zealand's International Tax Reform

The role of the international tax changes within the business tax reform package is to help increase our international connections. It is crucial for New Zealand to participate more in the global economy.

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Roundtable breakfast meeting with NZ Institute of Chartered Accountants (UK Division). New Zealand House, London. 8.00AM Thursday, 27 September 2007


It is a pleasure to discuss New Zealand's international tax reform with you. This has been a landmark year for tax reform in New Zealand. We introduced the largest package of business tax measures in twenty years.

The international tax changes are an important component of the package. In some ways, they are the component I am most excited about. A number of businesses told us international tax reform was a higher priority for them than a reduction in the company tax rate when we consulted on the changes.

The government's vision for our economy is for a high-skill, high-value and innovative economy, well-connected to global markets.

Reforms we made this year to business tax are carefully designed to help realise our vision. The package overall was aimed at lifting New Zealand's productivity and innovation. The role of the international tax changes within the package is to help increase our international connections. It is crucial for New Zealand to participate more in the global economy.

But first, before I get into the details of the package, let me explain the backdrop.

Overall our economy is in good health.

We have experienced the longest economic expansion in 30 years.

Average growth rates since 1999 have been over three per cent - faster than the average of developed countries, faster than Europe, Japan, the US and here in the UK. Since 1999 the New Zealand economy has grown around 24 per cent larger.

More Kiwis than ever are in jobs. Our unemployment rate is one of the lowest in the world.

We consistently rate highly in international comparisons of our openness and competitiveness and of the ease of doing business in New Zealand. Last year we ranked only a sliver behind Singapore at the top of the World Bank Cost of Doing Business Report.

Business has enjoyed good years as a result of our growth. According to company tax returns, profit growth averaged over 20 per cent a year in 2003, 2004 and 2005 (those are the most recent years for which data is available.) By comparison the average for the previous eight years - which is about as long as we have comparable data for - was profit growth of five to seven per cent.

This is a satisfying overall health check. The immediate future gives pause for excitement too.

Though the economy has slowed a little this year, in line with Budget forecasts, there are reasons to be confident about the future.

According to the ANZ Bank Commodity Price Index, world dairy prices rose by 120 per cent in the last year. New Zealand's multinational dairy company Fonterra lifted its forecast payout to $6.40 per kilogram of milk solids - that is 43 per cent higher than the previous season. It will be a very strong economic stimulus.

Naturally an economy running at full capacity will show signs of strain, and we are seeing these in a number of ways:

. The current account deficit is about eight and a half per cent of GDP.

. Inflationary pressure is persisting in the non-tradeables sector.

. Household debt to income levels are well above their historic averages.

These issues are not critical, but the prudent thing for our economy is to address the imbalances.

The wisdom of taking a conservative fiscal approach has been highlighted even further in recent weeks by the global credit squeeze.

The shake-up was triggered by so-called sub-prime mortgages in the US, where some lenders found out they had been a little easy with the availability of credit in recent years.

This led to a wider re-pricing of risk, which is no bad thing. It is perfectly healthy for markets to move away from what has been very high-risk activity in recent years to something approaching normality. But the growth of the derivatives industry has done such a good job of spreading risk, it is not entirely clear who is left holding which risks, creating some financial "mist". Though the mist is beginning to clear, there will still be some uncertainty and volatility in the short term.

There are some positives to take out of recent events too. The international financial system is in much better shape to cope than it was 10 years ago. And we saw major central banks assisting liquidity where need be.

Back in New Zealand, we don't have the same sub-prime mortgage problems - our banking system is sound. The riskier end of our financial sector is finance companies, where we have seen some troubles in the past year. But they make up a much smaller portion of the overall system than sub-prime mortgages do in the United States and there is no indication of the same sort of systemic issue. Of course, that is no comfort to those who have lost savings, and I do feel for those who have. The New Zealand government is proposing changes such as mandatory credit ratings to help make the risk/return profile of investments more apparent to investors in the future.

One of the most obvious impacts in New Zealand of a reduced appetite for risk was a sharp drop in the exchange rate. A lower dollar (and continued high interest rates) could re-orientate growth towards exports and away from domestic demand.

The global financial developments have emphasised the virtue of several key components of New Zealand's economic strategy:

. First, our strong fiscal strategy.

. And second, our strategy to increase savings and to increase the rate at which our economy can grow.

The government's strategy to lock-in continued economic success for New Zealand is to maintain the foundation of a strong fiscal position.

Second, we are trying to change the mix of growth away from domestic demand toward investment in productivity growth.

Third, we have put in place structural incentives to save rather than increase demand through debt. We introduced KiwiSaver as a landmark workplace retirement savings scheme.

And, finally, this year the government introduced the most comprehensive package of business tax reform in twenty years.

The business tax package invested $3.4 billion into the economy.

The only way to increase our real prosperity in the long term is to increase our productivity. High productivity is a matter of getting a lot of things right - from our skills and investment in knowledge and innovation, to capital markets and global connections.

The tax environment has a crucial influence on many of these.

The business tax reforms will help our businesses to grow and compete in the global economy. The headline corporate rate was cut, and the tax treatment of savings vehicles brought into line. Market development assistance and skills training were expanded in the package.

The proposed tax exemption for active income from a controlled foreign company will also bring New Zealand into line with international norms.

New Zealand needs to prepare for a global economy that is becoming increasingly borderless. We need to be able to attract and retain capital and our businesses need to be able to compete effectively in foreign markets.

The international tax changes help to boost our competitiveness as a place in which globally connected firms can locate and expand.

The introduction of a tax exemption for active income of a controlled foreign company is a major policy change.

It means the offshore active income of New Zealand business will no longer be taxed as it is earned. It will, instead, be exempt from New Zealand tax.

A simple "active business" test will be developed to exempt all controlled foreign companies will less than five per cent passive income - no matter where they do business. The test replaces the current so-called "grey-list" exemption, which applies to eight countries.

Even if a controlled foreign company does not meet the active business test, only its passive income will be taxed back in New Zealand.

The international tax reform package fits within the government's agenda to transform the base of our economy. With an increasingly borderless global economy, New Zealand needs to be able to attract and retain our businesses and compete effectively in foreign markets.

Before the package was introduced, New Zealand companies operating in foreign countries effectively competed at a disadvantage. It is no wonder we don't have enough of them trying!

We had a philosophically pure tax system. Our controlled foreign company - or CFC - rules taxed offshore income more comprehensively than other countries. The problem was, where we led, no one else followed. Other jurisdictions generally exempt active income earned offshore or defer tax until that income is returned as dividends. That put our competitors at a tax advantage over kiwi companies. New Zealand companies faced an additional tax not faced by firms based in comparable countries.

It put us at a particular disadvantage against Australia, which has an extensive active income exemption in its controlled foreign company rules.

The legislation putting the new rules in place should be introduced early next year, to take effect from the 2009/10 tax year.

The framework for an active/passive income distinction was announced earlier this year in the Budget. An exemption from taxation in New Zealand will apply to:

. active foreign income from CFCs

. ordinary dividends from CFCs

. passive income of CFCs if that passive income is less than five per cent of the CFC's offshore income.

The new rules will also include limited base company rules. In addition, interest allocation rules will be introduced to limit deductions for debt in New Zealand for outbound investment (most likely a safe harbour rule of 75 per cent) These rules protect from shifting income out of New Zealand where the transfer pricing rules do not provide adequate protection.

It is worth noting that the government has benefited from extensive feedback from business in honing the reforms. This consultation has been critical in developing a set of rules which will have minimal impact on how New Zealand companies operate on a global basis.

Rising productivity depends on innovation, and innovation comes from much more than simply tax rules.

Crucially, it also comes from research and development. That is why the business tax reform package included the tax credit of 15 per cent of allowable research and development expenditure. It will encourage more businesses to invest in more R&D.

The case for locating greater R&D in New Zealand is now more compelling. International companies will now look much more positively at New Zealand, weighing up our existing clusters of R&D and world class universities where they can leverage off academic research.

The more international R&D we encourage to relocate, the better it will be too for home grown research and development. A greater pool of R&D should improve the rewards from research and help to retain our brightest researchers.

There is no doubt our new regime is far more generous than many other countries, including our close rival and friend, Australia. After the Business Tax Reform package was announced, business newspaper the Australian Financial Review began its story by saying,

"New Zealand is luring businesses across the Tasman..."

A senior tax partner quoted in the paper's story said:

"There are companies which in the past have relocated R&D facilities from New Zealand to Australia. This may well reverse that trend."

To sum up our business tax package, the paper said:

"R&D investment could flow back across the Tasman."

I am confident that changes in the tax environment this year will help to prepare New Zealand to be a dynamic, well-connected, knowledge-led economy.

It is combined with smart, active policies to unleash the potential of our enterprises, and deep investment in skills and infrastructure. The tertiary education sector is being reformed to make it more responsive to the needs of our industries and KiwiSaver has been introduced to increase our low household savings rate.

Overall, this makes a compelling package of measures that positions New Zealand very well for the increasingly globalised international economy.