Do you think that the United States has complex tax rules? New Zealand has some to match, and the country’s system of taxing United States retirement accounts such as IRAs warrants the advice of an expert in this area – preferably prior to migrating to New Zealand.
Such accounts were exposed to New Zealand’s foreign investment fund (FIF) regime leading up to a rewrite of the rules in 2012-2013. Prior to the rewrite, this exposure has resulted in many new migrants to the country facing a New Zealand income tax liability their foreign retirement plan – even in the event that no distributions have been taken from the plan.
Pursuant to poor taxpayer compliance in relation to foreign retirement accounts Inland Revenue reviewed the rules for taxing ‘foreign superannuation schemes’ during 2012-2013.
From 1 April 2014 a new set of rules became effective, the aim of which was to simplify the legislation and encourage better compliance. Taxpayers who had declared FIF income on their foreign retirement accounts prior to the new rules coming into force on 1 April 2014 were able to continue with that method under grandfathering provisions.
Difficulties arose in interpreting New Zealand’s legislation resulted in IRAs being reported inconsistently after the removal of the greylist exemption from the FIF rules from 1 April 2007. Leading up to 1 April 2007, foreign superannuation schemes from grey-list countries[1] were exempt from the FIF rules.
Prior to the introduction of the Taxation (Annual Rates, Foreign Superannuation, and Remedial Matters) Act 2014, investments which met the definition of a ‘foreign superannuation scheme’[2], were taxable, in the absence of an exemption[3] on an accruals basis under the FIF rules.
This meant that the fund itself was subject to taxation on an accruals basis, under one of several methods available to the taxpayer to elect on an annual basis. This frequently leads to double taxation due to limitations on foreign tax credits for taxes paid in other countries – including taxes paid in the United States.
Upon removal of the greylist countries’ exemption from the FIF rules, taxpayers and their advisers faced significant uncertainty on how foreign retirement accounts should be treated for New Zealand tax purposes.
Consequently, some taxpayers reported FIF income under the FIF rules, other taxpayers reported withdrawals from their foreign retirement account on a cash basis, whilst other taxpayers simply did not report at all – often due to lack of knowledge of the rules.
Inland Revenue has acknowledged the difficulty facing taxpayers when it comes to applying New Zealand tax legislation to accounts such as IRAs, and has commented in the Tax Information Bulletin as follows:
“Sometimes savings in an individual’s retirement scheme can be used for purposes unrelated to retirement. For example, in the United States, individuals are able to establish a retirement account known as an Individual Retirement Account (IRA). An IRA is a savings account set up for the exclusive benefit of the individual or the individual’s beneficiaries. To discourage the use of IRAs for purposes other than retirement, a 10% penalty tax is imposed on any withdrawals made from the account before retirement. Some withdrawals can be made without penalty – for example, when withdrawals are made to meet higher education expenses, first home purchases or medical expenses, and in those circumstances, no penalty tax is imposed.
Nevertheless, IRAs are established mainly for the purpose of providing retirement benefits and therefore on the face of it, such accounts are likely to be foreign superannuation schemes for New Zealand tax purposes to which the revised rules mentioned above apply”. (Source: TIB Vol 26, No 4, May 2014).
To date, there has been no determination by Inland Revenue on the matter. Accordingly, taxpayers should treat United States Qualified Deferred Compensation Plans including IRAs as foreign superannuation schemes., applying either the FIF rules if the account is grandfathered, or the receipts-based approach.
The receipts-based approach requires the taxpayer to declare withdrawals from a foreign superannuation scheme only. That is to say that no accruals basis of taxation occurs and the fund is taxed on a cash basis as withdrawals occur.
On a cash basis, three potential outcomes arise which can result in taxable income. It is necessary to determine whether the withdrawal falls under the definition of a ‘lump sum withdrawal’ for New Zealand tax purposes, or a ‘pension’ – to which the income tax treaty in force between New Zealand and the United States.
It is important to take note that the distinction for New Zealand tax purposes between a ‘lump sum withdrawal’ and a ‘pension’ is a matter of judgement. Furthermore, Inland Revenue has a bias towards treating a distribution as a pension rather than a lump sum withdrawal, because 100% of a pension will be taxable rather than a percentage of the withdrawal only as explained below.
If classed as a lump sum withdrawal, the taxpayer has a choice of two methods under the receipts-based approach.
- The schedule method, which is the default method. The percentage of a withdrawal is taxable in New Zealand depending on the number of years of tax residence in New Zealand. 100% of a withdrawal will be taxable in New Zealand after 26 years’ tax residence in New Zealand.
- The formula method, an alternative method applicable to defined contribution schemes. This method taxes the actual investment gains that have accrued to the foreign superannuation scheme during the period of New Zealand tax residency.
If a withdrawal is treated as a pension, then Article 18(1)(a) of the income tax treaty allows New Zealand to tax the withdrawal. Article 18(1)(a) states that:
‘Pensions and other similar remuneration derived and beneficially owned by a resident of a Contracting State shall be taxable only in that State’.
Through the application of Article 18(1)(a), the Internal Revenue Service has granted the Inland Revenue Department sole taxing rights. This only applies in cases where the pension arises out of employment. Furthermore, the Inland Revenue Department has asserted that no credits for United States’ taxation paid on pension distributions to which Article 18(1)(a) applies are claimable in the New Zealand income tax return.
To conclude, there is far more to New Zealand tax implications for foreign retirement accounts than meets the eye. It, therefore, warrants the advice of an expert to minimize taxation liabilities in both countries, with a view to minimizing double taxation.
[1] The greylist countries include Australia, Canada, Germany, Japan, Norway, Spain, the United Kingdom and the United States.
[2] The term ‘foreign superannuation scheme’ is defined in Section Y of the 2007 Income Tax Act.
[3] Various opportunities exist for an exemption from taxation of foreign retirement accounts. Exemptions include the transitional resident exemption, the non-resident’s pension or annuity exemption and the four-year exemption period for foreign superannuation withdrawals.
This article provides general information, current at the time of publication. The information contained in this article does not constitute advice and should not be relied upon as such. Professional advice should be sought prior to actions being taken based on the information contained in this article.
NZ US Tax Specialists Ltd disclaims all responsibility and liability (including, without limitation, for any direct or indirect consequential costs, loss or damage or loss of profits) arising from anything done or omitted to be done by any party in reliance, whether wholly or partially, on any of the information. Any party that relies on the information does so at its own risk.
