Using the “Cost Method” for FIF’s

If you have a little bit to do with foreign investment fund (FIF) calculations, then the latest Inland Revenue (IR) draft interpretation statement (IS) may be just what you are looking for if you have ever been uncertain as to whether or not you’re entitled to use the “cost method”—one of the five available methods for calculating the amount of FIF income for an attributing interest.

The draft IS is titled “Income tax—Using the cost method to determine foreign investment fund (FIF) income,” and as a 16-page document, it's quite a quick and easy read, I must say. However, like a lot of Revenue publications I’ve found recently, I still seem to come away with unanswered questions.

So, a few key points:

• The “cost method” is really there as an alternative to the fair dividend rate (FDR)/comparative value (CV) methods, both of which require the use of market values. So, if your FIF is a listed share, it's very unlikely that you will be able to use the “cost method.” Correspondingly, therefore, if your FIF is an unlisted share, the method will likely be available to you.
• The “core” interpretative issue, in my view, is whether “the market value of the FIF is not readily available at the start of the income year.” There is some level of comment in the IS on the meaning of this phrase. For example, a market valuation that an unlisted foreign company prepares internally for commercial purposes can satisfy the definition of market value. Still, equally, the mention of an approximate market value by the company in its investor communications could also satisfy the test. However, what about a scenario where the investor becomes “aware,” through means other than a more formal investor communication, that the approximate value of their interest has significantly increased since acquired. At what point is it prudent for the investor to revert to using FDR/CV based on this knowledge, even though it’s perhaps knowledge not in the public (other investors have shared the same insight) domain yet? I suspect it’s one of those judgment calls—how large is the value gap, how many others are likely to be aware of this “market value”, and how material is the risk that the Revenue could equally get its hands on the intel?
• In certain circumstances, you can only access the “cost method” by obtaining a truly independent valuation. This will be in the case where some exemption previously applied to the FIF—you were a transitional tax resident, you qualified for the $50,000 de minimis rule etc. In this regard, the IS provides guidance on what the Revenue considers the term “independent valuation” means.
• As with FDR, FIF income under the “cost method” for the income year during which you acquire the FIF?will usually be zero since the FIF was not owned on April 1st. For each subsequent income year, FIF income is calculated as 1.05 x preceding opening (an assumption that the value of the FIF will have grown by 5% over the course of the income year) plus the average cost of any new interest acquired during the income year. And there is also a quick sales adjustment for any interest bought and sold in the same income year.

The IS concludes with a useful flowchart that can help you determine eligibility to use the “cost method,” and there are a number of examples throughout the document to illustrate its commentary.

If you would like to make a submission on the draft, closing date is 29th November 2024.

This article from the 'A Week in Review' newsletter was originally published on Monday, August 5th 2024. If you have any questions or would like a second opinion on any national or international tax issues, please get in touch with me at [email protected].

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