The Treasury

Global Navigation

Personal tools

7.3  The effect on investment decisions

Because capital gains are often taxed in practice, the operation of the capital-revenue boundary will have an important influence on the decision making of some savers.[39] The boundary between what is defined as taxable income and what is defined as untaxed capital gain can be uncertain ex ante, which can have significant effects that savers might find difficult to plan for. The difference on a rate of return calculation from taxation at zero for untaxed capital gains or (ultimately) 39 percent for taxable income demonstrates the significance of this boundary.

Individual persons buying shares would not ordinarily be taxed on the gains from selling those shares. A business selling an asset would not normally be taxed on the proceeds from the sale of that asset. Both would be subject to the same tests defining whether a capital gain is classified as income and is thus taxable. In the context of financial transactions, an individual is less likely in practice to face scrutiny because lower dollar values are generally at stake and because for many companies it will in practice be much easier to determine if trading in shares is integral to the business of that company. Because the boundary is indistinct, an individual may be able to obtain some capital gains without resulting in taxation, even though they would be taxable if conducted by some companies. A financial intermediary for whom buying and selling assets such as shares is an integral function will generally be classified as having generated income on revenue account which is taxable. As a result, it is quite possible that while the tests applying to firms and to individuals are the same, in general practice the same transaction made directly by an individual or indirectly through a financial intermediary will attract significantly different tax treatments.

Further, an individual’s transaction through an intermediary will take on the character of that intermediary for tax purposes. It will be the intermediary’s business practices that determine whether gains from an investment are taxable income, which in some cases will produce a different result than if an individual were to buy and sell an asset directly. Because an individual may be able to make a purchase and sale of an asset without being taxed, whereas an intermediary would be taxed on the same transaction, and because transactions through an intermediary result in that transaction being defined as taxable because the intermediary is taxable, the practical effect of New Zealand’s tax system is a distortion away from the use of intermediaries by lenders/savers and toward investments made directly, or structured in such a way as to appear to be direct.

Transactions through New Zealand financial intermediaries are able to earn untaxed capital gains through passive index tracking funds, on the basis that the purpose of trades made by these funds is to match the composition of the relevant index, rather than for the purpose of resale at a profit. Inland Revenue has provided binding rulings to taxpayers on this subject, providing a degree of certainty to investors but distorting investment behaviour toward passive index tracking funds.[40]

Not all direct transactions by individuals that result in capital gains are defined as non taxable. Of particular note is the fact that the tax system intends to tax capital gains earned by “traders” and other individuals who essentially conduct the business services of a financial intermediary for their own benefit. Likewise firms that would not consider themselves to be in business as a financial intermediary are still subject to several tests that may result in certain capital gains being taxable as income (the most relevant tests for this discussion can broadly be referred to as a business test and a purpose test as previously noted). These tests are based on two main criteria. The first criterion is whether a transaction was made for the purpose of generating profit from resale (this would result in gains being taxable), which might be determined by the length of time the asset was held or by whether it generated a revenue flow such as a taxable dividend (in which case only the dividend not the capital gain would be taxable). The second criterion relates to the sophistication of the trading activity, to the level of attention paid to transactions, to the number of trades conducted and to whether these factors imply that the taxpayer is actually a professional “trader” and should thus be treated as being in the business of generating capital gains (in which case those gains, and potentially other gains as well, would be taxable).[41]

The practical effect of these tests is to encourage a saver, who is unsure as to whether capital gains from their purchase and sale of assets would be taxable, to make marginal investments in larger and more established firms and in passive tracking funds. Lenders would be biased toward these types of investment for several reasons. First, dividends are more likely to be paid frequently in larger and more stable firms and so it would be easier to demonstrate that holdings in such firms were made with the purpose of obtaining those dividends rather than to obtain a capital gain on the sale of shares. Second, an investment in an established firm may be easier to leave unchanged for a longer period of time to avoid gains from the eventual sale being taxable. Third, a portfolio of smaller or riskier firms may require a higher level of attention by an investor, which could be taken to be active management and could result in gains from any sale being taxable (even if gains result from the sale of assets that are performing poorly relative to the market). The cumulative effect of these factors would suggest that a saver, who is concerned that gains from the sale of their assets would be taxable, would choose to make longer-term investments in larger and safer firms or in passive index tracking funds.

While direct investors and financial intermediaries face uncertainty about the tax treatment of capital gains, financial intermediaries such as finance companies or unit trusts will face a further distortion. That is, because they are classified as companies, any distributions to savers using these entities will be treated as dividends and so will be fully taxable as income, even if those dividends represent underlying capital gains on investments. For example, an individual may be able to sell shares in company x for a tax free capital gain, whereas if that investment were held through an investment company or unit trust, when that gain was distributed to the saver, the distribution would be classified as a dividend paid to the saver and would thus become taxable income just like any other dividend. When a gain that is untaxed in the hands of an entity (such as a unit trust or company) becomes taxable upon distribution, the untaxed nature of the gain is said to be “clawed back”. The taxation of distributions by some intermediaries as dividends represents an unequal clawing back of the exemption on capital gains depending on whether a saver uses a financial intermediary or makes an underlying investment directly. The work of Benge and Robinson(1986)suggests that this type of differential claw back policy will distort savers’ and investors’ choices between different types of entity which implies that this approach sits uneasily with the remainder of New Zealand’s tax system.[42]

A bias against the use of intermediaries for equity finance compounds the incentive against providing external finance to smaller firms. This is because equity issued by smaller firms is likely to be less liquid and as a result, such an investment is more likely to require intermediation in some form, potentially at multiple levels. This result occurs because specialised intermediaries are generally required to pool investments in smaller firms before larger intermediaries can economically justify taking a position in that market segment. These practicalities further increase the likelihood of any gain being characterised as taxable because of the business of the interposing intermediaries.[43] The effect of the bias against intermediaries and its impact on economic growth is developed more fully below.

An additional investment distortion may arise from the current capital-revenue boundary if it affects shareholders’ ability to exercise their governance interests in firms. When providers of external finance attempt to exercise their governance interests, this may place them on the wrong side of the capital-revenue boundary and result in taxation.

A saver whose purchase of an asset was with the purpose of resale to realise gain from that sale will find any gain from that sale to be taxable. One could easily imagine a scenario in which a shareholder informed management of their dissatisfaction with management’s ability to put funds to most profitable uses, as demonstrated by growth in share value relative to industry rivals. If such a shareholder were to subsequently liquidate their position in that firm to take a position in a rival company, the shareholder’s previous communication with management could be taken to suggest that their purpose, (particularly of purchasing shares in the second company) was to obtain capital gain from resale.


  • [39]Savings and investment decisions are made for a number of reasons other than because of their tax impact.  This paper outlines the potential marginal impact on decisions that result from tax policy.  Across a number of taxpayers and over time the effects of such marginal impacts have the potential to be significant.
  • [40]While some will argue that investment in such funds is an appropriate investment strategy, it should be straightforward to suggest that investors ought to make that decision on the basis of relative returns and fee levels such that the superiority of one investment strategy or another is not a good defence for such a significant and unintentional tax wedge between those investments.
  • [41]For example, an otherwise passive investment fund that deviates from a passive strategy to make informed trades is likely to result in that fund being classified as actively rather than passively managed and all of the capital gains obtained by that fund are likely to be taxable as a result.  This is a point on which some uncertainty in case law remains.
  • [42]In response to Sir Roger Douglas’ announcement that the Government intended to introduce an imputation system, Benge and Robinson (1986) outlined how New Zealand should introduce such a system.  Their criticism of an unequal approach to clawback, as currently applies to some financial intermediaries, demonstrates one way in which the current tax treatment is at odds with the principles guiding the initial design of the imputation system.
  • [43]That is, unless ‘tax efficient’ structures allow savers using these vehicles to replicate a direct investment position.  While such arrangements may reduce tax payments, the overriding economic efficiency of these structures and the system which encourages them is in doubt.
Page top