What happens if you fail to disclose FIFs?

Tax Alert - February 2023

By Hester Geel & Kirsty Hallett

Late last year Inland Revenue issued a draft QWBA statement for consultation and discussion clarifying when a taxpayer must use a default calculation methodology to calculate income in accordance with the Foreign Investment Fund (“FIF”) rules. Many people may have overlooked this statement in the rush to close out 2022. That said, if the draft statement applies to you, you’re highly unlikely to be reading tax interpretations.

Taxpayers who are not correctly filing tax returns may not know what a FIF is, let alone what FIF income is. A FIF is an offshore equity investment, such as into a foreign company, unit trust, managed fund, or exchanged traded fund (ETF) and can include some superannuation schemes and life insurance policies. Inland Revenue provides guidance on FIF investments here.

The methods for calculating FIF income are prescriptive and in most cases choices are limited. However, natural persons and certain trustees are able to choose whether to apply the comparative value method (“CV”) or the default Fair Dividend Rate (“FDR”) method annually, allowing taxpayers to choose the most beneficial method for calculating income from their Foreign Investment Funds.

A taxpayer chooses which method they are applying for an income tax year by including any FIF income arising under that method in their income tax return.

Where a taxpayer fails to choose a method, the default method must be applied. In most cases, this will be the FDR method which deems 5% of the market value of the taxpayers’ attributable interests in FIFs at the beginning of the income tax year to be taxable income (with an adjustment for quick sales), or where no market value is available, the cost method. Neither of these methods take into account the actual movement in the market value of the income tax year which in many cases will be less than 5%.

Draft QWBA

So, what does the statement cover? Draft Questions We’ve Been Asked PUB00443 “Foreign investment fund (FIF) default calculation method” explains that a person who has failed to declare FIF income in an on-time tax return does not have a choice of calculation methods and must use a default method to calculate FIF income if they later file a voluntary disclosure, or file a late tax return.

Inland Revenue will treat a taxpayer as failing to have chosen a method if they:

  • File their return by the due date but do not include the relevant FIF income; or
  • Do not file their return by the due date for filing.

However, there is no apparent reference in the legislation to a timeframe for making an election as to which FIF calculation method to apply and is a change in interpretation, at least from our experience with Inland Revenue. In the past, we have been dealing with voluntary disclosures or late filings we have seen the use of the comparative value method accepted, despite not meeting the relevant timeframes prescribed above. However, we understand that this is not always the experience for all taxpayers, with divergent interpretations existing within Inland Revenue.

We understand from initial discussions with Inland Revenue that the basis for their interpretation is premised on the wording of section EX 44 of the Income Tax Act 2007 which states that a taxpayer chooses the FIF method to use by completing “their return of income accordingly”; with a return of income not completed correctly if it is not filed on time.

What is the rationale for this position? Our thoughts:

The draft interpretation put forward by Inland Revenue has raised a number of concerns and is inconsistent with our experience in dealing with Inland Revenue which has prompted us to consider why Inland Revenue is proposing this change now.

  • While it is possible Inland Revenue is simply wishing to ensure there is a consistent practice being applied within Inland Revenue, the timing of the statement and direction of the interpretation could also be indicative of the potential for an increase in future targeted review activity. We know that individual tax compliance is a specific focus area for Inland Revenue and with the increased information available to Inland Revenue through cross-border data sharing, the scale of potential non-compliance could be coming to fruition. In its most recent Annual Report, Inland Revenue noted that its compliance focus on offshore income had resulted in contact being made with almost 7,000 taxpayers with the consequence being voluntary disclosures totalling $100 million in omitted income.
  • The draft interpretation raises a number of concerns when we consider some real-life scenarios, as this approach is excessively harsh for taxpayers, especially where they have tried to comply and not wilfully ignored their tax obligations. It is also unfair to taxpayers who submitted one day late.

    This proposed interpretation eliminates the choice of methods for all taxpayers including those who are making efforts to voluntarily comply with their obligations, not just ones who may not be making any efforts to comply. As the rules currently stand, any default assessments issued by Inland Revenue would be issued applying the default methods.
  • Inland Revenue is mindful that this approach may impact voluntary compliance and taxpayers’ willingness to comply. Taxpayers who have been non-compliant with their FIF obligations and face a large tax bill under the FDR method may choose not to voluntarily correct past mistakes, instead leaving it to Inland Revenue to detect the issue. However, this approach may only have a short shelf-life, as Inland Revenue utilise the information collated through automatic exchange agreements to proactively contact taxpayers to remind them of their tax obligations based on the information they hold (these are known as “nudge letters”).
  • Should Inland Revenue proceed with this interpretation additional guidance will be required by Inland Revenue as to the evidentiary support required to be retained by taxpayers in situations where the CV method has been applied and no income arises. As the election to use the CV method is made by including the FIF income in the taxpayer's income tax return (or in cases where FIF income is nil, by returning no FIF income), Inland Revenue will not be able to determine whether a taxpayer has omitted to return FIF income or has elected the CV method simply by reviewing the taxpayer's income tax return submission. In most cases, no other FIF disclosures are required to be made to indicate that a method has been selected. Care will need to be taken by Taxpayers to avoid an unfavourable interpretation down the track in the event Inland Revenue undertake any review activity.

We think there are arguments that the interpretation adopted in the draft statement are incorrect, and we will be making a submission to Inland Revenue about this. Submissions close on 10 February 2023 with a final statement anticipated to be released in the first half of this year.

Please contact your usual Deloitte adviser if you would like to discuss this issue, including how we can assist with FIF calculations.

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