7  New Zealand’s taxation of capital and the effect on the financial system

This section discusses the effects of the New Zealand tax system on the financial system. It first reviews the taxation of capital gains and then outlines how New Zealand’s tax system, which classifies some capital gains as taxable income while exempting others, acts to distort the investment patterns toward direct investments in larger and less risky firms or toward passive indexing tracking funds. The information asymmetry framework is then used to assess the potential impact of these distortions on investment decisions and economic growth.

7.1  Development of the current capital-revenue boundary in New Zealand tax policy

New Zealand considers itself to be a country without a capital gains tax (CGT), with the common assumption being that gains from the sale of assets that have appreciated in value are not taxable.[31] In practice a significant amount of capital gain in New Zealand is classified as taxable income, and the difference between what gains are or even should be taxable is a contested issue. As a result, the question of whether to adopt a comprehensive capital gains tax is a beehive that is prodded every so often in New Zealand. In each instance, after the buzzing has died down, New Zealand has remained “CGT-free”.

While a comprehensive capital gains tax may or may not be optimal tax policy (a separate issue with a substantial dedicated literature), a country without a capital gains tax does not escape the need to police the difficult boundary issue as to whether a particular sum received should be classified as income or capital (Oliver 2000). These boundary issues arise because of the substantial return to reclassifying income streams (taxed at marginal tax rates) as capital gains (untaxed). Indeed, New Zealand currently faces many of the challenges associated with capital gains taxes because of the practical operation of the capital-revenue boundary which polices against this type of reclassification. As a result, the debate on a capital gains tax has remained a staple of New Zealand tax policy.[32] Underneath this unresolved debate remains an approach to taxing capital with serious deficiencies that are likely to affect the country’s growth potential.

The boundary between capital and revenue is a core element of the New Zealand tax system.[33] It seems straightforward to suggest that proceeds from the sale of capital items are generally untaxed, while sums obtained on the revenue side of the boundary are defined as income and so are typically taxed at full marginal rates. In practice the boundary generates widespread uncertainty.[34]

The history of New Zealand tax law related to capital gains may seem odd to some. While New Zealand’s income tax legislation provides inclusive guidance, it does not define the central term “income”. Judges, when faced with the question of what constitutes income,have borrowed concepts from trust law, which predates income tax law and is inherited by New Zealand’s historical connection with the United Kingdom. The purpose of these trust law concepts is to “differentiate the interests of the life tenant (entitled to income) from the interests of the remainderman (entitled to capital and so to the realisation of capital assets of the trust)” (Royal Commission on Social Policy 1988: 450).

The jurisprudence which has evolved from these concepts has created a definition of income focusing on particular tests, such as whether a sum received is more in the character of a flow (income) or of a one-off payment (capital), and it is tied to analogies such as that of the tree (capital) and the fruit (income). These have been, and will continue to be useful tools to guide difficult judgements before the courts. With respect to the financial system however (for savers and those managing the funds of savers in particular), judicial and policy interpretations of the capital-revenue boundary have generated a substantial degree of uncertainty. The inability to clearly understand the outcome of transactions is likely to provide an additional hurdle to effective contracts. Attempts to generate definitive guidance for superannuation funds and others by reference to test cases have met with limited success.[35]

This situation is not particularly unique in the evolution of the capital-revenue boundary in New Zealand. A decision by the courts that a particular transaction represents capital means that it is untaxed in New Zealand, while similar decisions by courts overseas may simply determine what rate of tax should apply. Policy concerns have dictated that legislation at times clarify or shape this boundary where reliance on existing case law alone does not provide a satisfactory outcome. With respect to taxation of the financial system, the task is to determine what tax policy is attempting to achieve, what costs arise from the current approach and whether legislative change is the best remedy. An analysis of the current system’s workings and its underlying logic is a necessary first step.

7.2  Foundations and operation of the current capital-revenue boundary

The case law on the capital-revenue boundary has developed to assist decisions before the courts on a range of issues, the origin being a question of the ultimate ownership of the assets of a trust. On their own, the tests and analogies evolving from case law are not robust enough to in all cases definitively determine the approach by which a government should base its tax treatment of capital gains. Parsons(1986) expressed this notion best:

“A principle of trust law that would direct that in the circumstances an item should be allocated to the remainderman, because this was the presumed intention of the creator of the trust, seems a strange basis for a conclusion that the item is not one in which the State should share through a tax.”[36]

Tax legislation based on the legal approach to the distinction between capital and income immediately faces a tension with the conception of comprehensive income held by economists, which includes changes in net wealth broadly defined.[37] In practice, comprehensive income can not fully be taxed, with practical considerations requiring on balance decisions to be made to account for the imperfect real world in which tax systems operate. This is often the crux of the argument for supporters of a capital gains tax, who believe that the challenges associated with implementing and administering a capital gains tax are an acceptable trade off for a move closer to the taxation of comprehensive economic income. There may be another way to approach this issue if economics can provide guidance to the way New Zealand approaches the capital-revenue boundary, beyond suggesting the imposition of a capital gains tax (again, a question on which this paper is agnostic). In a country that has decided not to adopt a capital gains tax, reference to economics is still valuable in assessing the objectives and impact of the current capital-revenue boundary, in providing a basis to motivate change and in evaluating proposals for change. While it is beyond the scope of this paper to develop a detailed economic basis for the reform of taxation in this area, the Appendix attempts to reconcile the New Zealand decision not to tax comprehensive income via a capital gains tax with an economic view of the function of financial intermediaries that may allow a simpler and more direct approach to their taxation in New Zealand.

International case law as well as decisions by New Zealand courts influence the definition of income, but over time New Zealand tax legislation has deviated from the interpretations of the courts where the impact of those decisions would be incongruent with the remainder of the New Zealand tax system or where broad application would be too economically or fiscally costly. These moves have defined certain realisations, which might otherwise be defined as capital, to be income. Examples of legislative extension to the judicially defined boundary are the classification as income of the following: gains from assets acquired with the purpose of resale, gains from certain transactions in land, gains from redundancy payments and gains from restrictive covenants.

This evolution has been undertaken without guidance from a professed economic theory, which is not surprising in a country without an explicit capital gains tax when considering the comprehensive definition of income held by economists. Changes have instead been driven by practical concerns in protecting the tax base from erosion. New Zealand tax law has responded to specific incidents involving tax avoidance behaviour and an underlying concern that the absence of a capital gains tax would result in the creation of effectively untaxed occupations. There has been a particular concern about the opportunity to recharacterise what would otherwise be labour income as capital gain.[38]

If capital gains were completely untaxed a government may be concerned that occupations such as share trading or property development, the income from which would primarily be the result of the purchase and resale of otherwise capital assets, would entirely escape tax. This would create an incentive for persons to leave other employment and to participate in such an occupation, even if they were marginally less productive in doing so.

The other motivation for expanding which capital gains are deemed to be taxable income results from observed behaviour designed to minimise tax by exploiting the capital-revenue boundary. While there have been a number of such concerns, these can generally be illustrated by example. One example is payment associated with a restrictive covenant (a payment made in respect of a contract which restricts one party’s ability to perform services, commonly restricting work for a competitor firm, etc). Such payments are held by the courts to be capital, but in practice Inland Revenue expressed concern that the ability to inflate such payments to include the value of services performed was substantial, resulting in such payments being classified as taxable income. Such arrangements could effectively transform an otherwise taxable revenue flow to an untaxed capital gain. There have been several high profile and costly tax avoidance schemes in New Zealand’s history that have essentially attempted to take otherwise assessable income and transform that income into capital gain.

While in practice there are several tests to which judges might refer when assessing whether a receipt is income on revenue account or a non taxable capital gain, with respect to investment by savers (direct or intermediated), these tests can be boiled down to two overriding tests. These are the business test and the purpose test, both of which define the conditions in which a gain might be classified as taxable income. The business test classifies as income those capital receipts that are an integral part of the business of the taxpayer and the purpose test classifies the gains from the sale of an asset as income if that asset was purchased with the purpose of resale. These rules essentially separate “traders” from “mum and dad” style savers, and active investment managers from passive index tracking funds.

Obviously there are many guidelines that underlie these two broad tests. While examples are provided in the next section, case law in this area suggests caution before trying to be too explicit, as “(i)t is not easy to state in plain clear words any infallible test by which this question may in all cases be resolved” [CIR v City Motor Services 1969 NZLR 1010].