For most investors, owning a healthy allocation of international shares is a wise investment decision. Offshore markets provide access to sectors not well represented in the NZ market (technology and pharmaceutical companies are good examples), offer geographic diversity, and exposure to high growth economies (particularly via emerging markets).
Owning international shares is usually via investment funds – NZ based or overseas based – or could be via direct holdings in international companies (which in terms of this blog post, are treated in the same way as overseas based investment funds).
Interestingly and worryingly, international investments are taxed differently depending on whether the investment is with a NZ based provider (many KiwiSaver funds would be good examples of this), or with an overseas based foreign investment fund – also known as a FIF.
With a NZ based fund the international holdings are taxed via a mechanism called the Fair Dividend Rate (FDR). Under FDR, you pay tax on 5% of the value of your international shares at the start of that tax year. This is regardless of whether your international shares have increased or decreased in value over the course of the tax year. Why is there an FDR regime at all? It was introduced to account for the fact that international companies tend to reinvest their profits more than NZ companies (which pay more taxable dividends).
FDR is a swings and roundabouts approach. Say your international shares increase by 20% in one year – under FDR you will still only pay tax on 5% of the start of year value … nice! But if your international shares decrease by 20% in a year, you will still pay tax on 5% of the start of year value … ouch!
However, things are different if you are invested internationally via a FIF (Foreign Investment Fund). Rules for FIFs give you two options for paying tax. Either the FDR approach described above, or you can use the Comparative Value approach that compares the value of your shares at the start and end of the tax year, and you pay tax on the difference. Under FIF rules you get to choose which tax method (FDR or Comparative Value) is most beneficial – ie results in the least tax payable. In negative years, where the value of your international shares has fallen, under FIF you can choose the Comparative Value method for that year, and effectively pay no tax.
So … if you managed to follow the above, you will see foreign funds have a distinct tax advantage over NZ based funds in years where the value of the international shares declines (in fact the advantage is present for year on year declines, and for gains of up to 5%).
This different tax treatment is sub-optimal, and unfair for NZ based funds. But until this situation changes, from a tax perspective only, it is preferable to hold international shares via foreign-based funds (or direct investments in overseas companies).
Of course, there are other considerations beyond tax. For example most NZ based funds will calculate and pay the tax on international holdings on your behalf, versus possibly having to work it out yourself for foreign investment funds. And many NZ based funds will hedge their international holdings against currency movements (which can be either advantageous or disadvantageous, depending on whether the NZ$ rises or falls).
PS. Tax of course is nothing if not complex. There are a few nuances which I haven’t included here as I want to keep this blog post readable! If in doubt, please consult a tax specialist.