Don't Let Tax Be the One That Got Away

Every year I go fishing with mates who are successful investment advisers.  After a few cold refreshments we seem to fall into the same old fight about tax. 

They argue tax isn’t something they really think about in structuring their clients’ portfolios and that they focus simply on selecting the best possible investments assets.  This is the proverbial red rag to the bull!  I find myself going red in the gills as I explain that structural considerations like tax is often where the biggest, most repeatable gains sit!  In addition to investing in great assets, steps like making sure fees are tax deductible, that every available tax credit is used, getting the right assets in the right names, and choosing funds that could save up to 40% in tax absolute dollar terms, is a sure-fire way to maximise wealth through time.   

Aurellan was built by our founders to manage our own families’ intergenerational portfolios, and the thinking in this series reflects how we invest practical, honest, and grounded in what we do with our own money. This article talks about how, in my own household, we utilise PIE Funds for family members who have low levels of taxable income, which is something we implement because the numbers and dollars are compelling, the PIE tax rules are straightforward, and the benefit recurs every single year.

The spouse who isn’t in paid work, while absolutely killing it financially

Let’s address the elephant in the room straight away. When I say a spouse “who isn’t in paid work,” I’m not casting aspersions. I am not suggesting they are somehow faulty, or that they spend their days horizontal on the couch watching reality television. I simply mean they have no taxable employment income, which as it turns out, makes them one of the most tax-efficient investors in the country. So, while you’re grinding through another Monday, your non-working spouse may be quietly building wealth at a tax rate your accountant can only dream about.

A quick primer on PIE tax

Portfolio Investment Entities (PIEs) are New Zealand managed funds that pay tax on behalf of their investors using each person’s Prescribed Investor Rate (PIR). The lowest available PIR is 10.5%, and qualifying for it requires meeting two tests. Firstly, a person’s taxable income from employment, rental, and other ordinary sources must be under $15,600 per annum, and secondly their combined taxable income plus PIE income must remain under $53,500 per annum. Both tests are assessed based on either of the two prior income years, so a temporary spike in income does not necessarily disqualify an investor from the 10.5% rate.

A spouse or partner with no other taxable income will sail through both tests with ease. Most importantly, it means their entire $53,500 annual allowance can be filled with PIE investment income, all taxed at just 10.5%. Better still, unlike interest or rental income, PIE returns cannot be reassessed upward at year end. PIE tax is a final tax, meaning there is nothing more to pay. Zip, zero, nada.

Pleasingly, this PIE tax opportunity isn’t restricted to just those on a 10.5% tax rate, as people on 17.5% tax rated can earn up to $78,100 including their PIE income, provided the “normal” income component of this remains under $53,500. 

Also, be sure to read our article “The investment hack Sir Michael Cullen probably never meant to give us”, as that strategy creates no taxable income, so is perfectly complimentary to the opportunity set out below.  

Global shares and the FDR advantage

PIE funds that invest in global equities are taxed under the Fair Dividend Rate (FDR) method. FDR is beautifully simple, reflecting that regardless of what the fund actually earns, the taxable income is deemed to be exactly 5% of the value of the investment over the course of the year. For PIE funds, this is typically calculated daily, which means that if an investor withdraws partway through the year, the fund knows precisely how much tax has accrued to that point. If global markets return 15% that year, the investor is still only taxed on 5%. The other 10% is entirely tax-free.

For a 10.5% PIR investor, the effective tax on the underlying investment is just 0.525% per annum (5% x 10.5%). That is an extraordinarily low tax cost for a growth-oriented investment, and it would be lower again if we considered the tax deductibility of fund fees and the ability to offset credits for offshore withholding taxes, but we will keep things simple for now.

So, let’s work backwards from the $53,500 PIE income threshold. If a spouse has no other income, their entire allowance can be used for PIE income. Under FDR, $53,500 of deemed taxable income corresponds to an investment of $1,070,000 in a global share PIE fund (5% x $1,070,000 = $53,500). In practice, however, it pays to leave a small buffer below the threshold, meaning a sensible target investment amount might be around $1,050,000, generating deemed FDR income of $52,500 per annum and keeping the investor comfortably inside the 10.5% PIR limits.

The good news is that staying within the threshold is straightforward to manage. Because FDR income is based on 5% of the value of the portfolio, it is very predictable. There are no surprise dividends or variable distributions to catch an investor off guard. A quick check to make sure the portfolio value mainly stays below $1,070,000 during the year is all that is needed to confirm the investor remains within their $53,500 allowance. If the portfolio has grown above $1,070,000 through strong market performance, a modest withdrawal or rebalance will bring it back into range.

New Zealand equities and the imputation credit sweetener

PIE funds investing in New Zealand equities work differently. There is no FDR deemed return, and instead the fund is taxed on actual dividends received from its NZ company holdings. Crucially, capital gains on the sale of NZ equities are specifically exempt from tax in a PIE fund, So, if a NZ equity PIE fund generates strong capital growth, that growth flows through to investors completely free of tax. Note that investors hold NZ equities directly don’t enjoy the same surety about not getting clobbered for capital gains tax which you can read about in this article The shark already has teeth.

The real magic with a PIE fund, though, comes from the imputation credits. New Zealand companies pay corporate tax at 28% before distributing profits as dividends. When they pay those dividends, they attach imputation credits representing the tax already paid, meaning the income has in effect already been taxed at 28% before the investor sees it. The NZ share market is notable for its high level of fully imputed dividends. Most of our major listed companies distribute credits at or close to the full 28% rate.

Inside a PIE fund, imputation credits are applied against each investor’s individual tax liability, which is calculated daily and attributed at the investor level. For a 10.5% PIR investor, the arithmetic is striking. Since the credits represent tax already paid at 28%, they substantially exceed the investor’s 10.5% tax liability on the same income. The surplus is not lost, reflecting that each year, following 31 March, IRD refunds the excess to the PIE fund as cash, which is reinvested on the investor’s behalf as additional units. This means that on fully imputed dividend income, a 10.5% PIR investor will typically receive what amounts to a net tax refund (as explained above) rather than pay any tax at all. From a threshold perspective, the taxable income attributed by a NZ equity PIE is based on actual dividends received, which in recent years has typically been around 4% per annum for a diversified NZ share portfolio, rather than the 5% FDR deemed rate that applies to global equities. This means that the amount a 10.5% PIR investor can hold in a NZ equity PIE before approaching the $53,500 threshold is actually higher than for a global equity PIE, making it an even more capital-efficient structure for low-PIR investors.

The benefits described above only materialise, however, if the investment is held in the right name. As the next section shows, many New Zealand families are inadvertently giving these advantages away.

The family trust trap, plus the wrong spouse problem

Here is where things get sobering for many New Zealand families, and the problems come in a few different forms.  To understand this change let’s just focus on an investment in global equities.

The first form is where a family holds the same global equity PIE fund investments in a higher-income earning spouse’s name, or in a family trust with the income being treated as trustee income. In both cases the PIE FDR tax is capped at 28%, resulting in an effective rate of tax of 1.40% per annum (5% x 28%). This is more than 250% of the tax in absolute terms compared to when the same PIE fund asset is held in the lower-income spouse’s name.

Often this PIE-based approach is far more advantageous than the second, more complex scenario where families hold global share investments directly, for example in US-listed ETFs or directly held global shares. When these investments are subject to FDR tax and the deemed income is taxed as either trustee income or at the highest marginal tax rate, both of which are 39%, the effective tax rate becomes 1.95% per annum (5% x 39%).

The complexity in this case comes from a quirk in the tax rules where individuals and trusts owning directly held global equities can switch between the FDR method and what is called the Comparative Value method (often shortened to CV method), provided they use the same methodology for all their directly held global equities in any given year. The benefit of this is that in a year where an individual or trust experiences a negative return on their directly held global shares, they can choose to opt out of paying any FDR tax entirely.

While this appears advantageous at first glance, several other factors come into play in favour of a well-structured PIE global equity fund. For global equities these include the higher level of FDR tax that applies for trustee income and individuals on top tax rates, tax leakage from the non-deductibility of offshore fees, potential tax slippage relating to some non-resident withholding taxes in offshore funds and ETFs, plus the compliance costs of having to file a tax return with IRD. We will cover this in a separate article, which will show that these factors more than offset the benefit of paying no FDR tax in the occasional negative return year.

It is more than worth noting that where an individual invests less than $100,000 in directly held global shares and global ETFs, a de minimis threshold applies, meaning these investors only pay tax on dividends received rather than under FDR. This threshold does not apply to investments held inside a PIE fund.  The de minimis threshold throws up another super lucrative opportunity to create some real wealth, which I have covered in a separate article.

The table below shows the difference in tax cost between the different scenarios when the FDR method is being used in a situation where the investor has $1,050,000 invested in global equities.

On a $1,050,000 global share investment, the difference between the best and worst outcome is $14,962 every single year the FDR method is used, simply by choosing whose name the investment is held in, or whether a PIE fund is used.

Even a family trust or high-income earning spouse holding the same investment through a PIE fund, which is often assumed to be the most tax-efficient structure, is paying roughly two and a half times as much tax as a non-earning spouse on 10.5% when the FDR method is used. A direct holding outside a PIE is worse still in this scenario.

Why this matters for investors

The takeaway for investors (and their financial advisers) is clear. When reviewing a household investment structure, two questions should always be asked. Firstly, is the investment held inside a PIE? Secondly, is it held by the lowest-PIR investor in the household?

A “no” to either question often means money being paid away unnecessarily in extra tax.

Some simple tax optimisation steps at the household level represent one of the most reliable and accessible wealth creation tools available in New Zealand. These steps typically cost nothing to implement beyond a structural review and, where appropriate, ensuring that assets are held by the most appropriate individual or entity within the family circle. The numbers above show that the tax saving is not marginal. It is substantial, recurring, and entirely legal.

The spouse who “doesn’t work” may, in fact, be doing more for the household’s long-term financial position than anyone else at the table. Important Notice

Please note this article is provided for informational purposes only and is not intended to be tax advice.