Tax Policy Political Battleground of 2019 - Capital Gains Tax

Author: Carl Valentine

The Capital Gains Tax (CGT) discount has been in place in its current form since 1999 and operates such that individuals pay tax at their marginal rate on only 50% of the capital gains they derive (after first deducting capital losses) where they have held the relevant asset for at least one year. Under the current discount arrangements, the highest effective tax rate an individual can pay on a discountable capital gain is 23.5% (i.e., 47% x 50%).

The Federal Opposition proposes to prospectively reduce the general CGT discount for assets acquired on or after 1 January 2020 from 50% to 25%. This has the potential to impact many people, with the ATO recording that over 320,000 individuals claimed the 50% discount in their 2017 income tax returns.

Changes proposed by the Opposition mean that individuals will pay tax on 75% of the capital gains they derive from the sale of assets they acquire on or after 1 January 2020 and hold for at least one year. Assets held prior to that date, and “small business assets” acquired after that date, would still qualify for the current 50% CGT discount. Under the proposed discount arrangements, the highest effective tax rate an individual would pay on a discountable capital gain is 35.25% (i.e., 47% x 75%).

The “small business assets” could be a reference to the existing small business CGT concessions, however there is currently no further detail as to what constitutes a “small business asset” or how the retention of the 50% CGT discount for such assets will be achieved. This carve out from the proposed changes has the potential to be extremely complex to administer for both taxpayers and the ATO, especially when one considers there are already a number of different criteria to determine what is a small business for different income tax provisions.

Companies are not eligible for the CGT discount. Interestingly, even without the CGT discount, the highest rate of tax a company would pay on a capital gain is 30% (and for eligible smaller companies that rate is now 27.5% and is scheduled to decrease to 25% - albeit a passive investment focussed company would likely remain at the 30% tax rate). The lower effective rate of tax on capital gains derived by companies could see them increase in popularity as investment vehicles or as beneficiaries of trusts that derive capital gains and then distribute them (although, this would likely only be the case where the company re-invested its earnings or was in a position to distribute its profits to an individual with a marginal tax rate lower than the company’s tax rate and thereby managing the top-up tax cost otherwise payable).

If the Opposition’s proposals are introduced, only individuals with a marginal tax rate of 32.5% or less will have a lower effective tax rate on discountable capital gains than a company with a tax rate of 25% (however, as noted above the potential for top-up tax on distributed company profits needs to be considered here too).   

The effective tax rates under the current and proposed CGT discount regimes are summarised as follows for a range of actual or notional marginal individual tax rates and company tax rates:

* The above company tax rates reflect the tax rate on company profit or the total overall tax rate on distributed profits where profits are distributed to a shareholder with a marginal tax rate lower than that of the company (should the Opposition implement its proposed changes to deny a refund of surplus imputation credits the company tax rate becomes the minimum rate of tax payable on distributed profits). Where profits are distributed to a shareholder with a higher marginal tax rate than the effective tax rate on distributed profits, including those arising from capital gains, reflects the shareholder’s marginal tax rate and could be as high as 47%. 

If introduced, the Opposition’s proposed changes would create another special class of assets that taxpayers and their advisors must track for CGT purposes. In broad terms those classes are:

In addition, it should be kept in mind that there are some other very specific asset classes that already need to be separately track for CGT purposes, including those acquired: 

• pre-20 Aug 1991: non-capital costs of ownership are excluded from cost base;
• pre-13 May 1997: capital works deductions are included in cost base; and
• pre-21 Sept 1999: indexation still included in cost base for companies and for other entities if elected.

While only time will tell how the Opposition’s proposed changes will be legislated, and thus only then that the full range of potential consequences can be understood and properly planned for, some areas that will need to be considered by affected entities may include:

• Timing of transactions is an obvious consideration around the proposed change in the CGT discount with taxpayers effectively incentivised to acquire assets on or prior to 31 December 2019 should the Opposition implement the proposed changes as those assets then become 50% CGT discount assets and, all other things being equal, will generate a higher after tax rate of return than a 25% CGT discount asset would in identical circumstances. Vendors of CGT assets are likely to be indifferent to the changes unless they can realise a better price for contracts concluded on or prior to 31 December 2019 than those concluded after that date. This could distort prices, especially for listed investments, in the lead up to 31 December 2019.
• There are likely to be complex rules detailing how an asset may transition from a pre-CGT or 50% CGT discount asset to a 25% CGT discount asset (likely to be built on the current rules detailing the transition from a pre-CGT asset to a post-CGT asset) or potentially from a 25% CGT discount asset to a 50% CGT discount asset in the case of “small business assets”. Those rules will need to be factored into many areas including, but not limited to, estate planning, family succession planning, business continuity planning and investment structuring choices.
• Interaction between the 25% CGT discount and other CGT provisions, including, but again not limited to, the small business CGT concessions (the lower general discount will leave a larger residual gain to be dealt with under those concessions subject to gaining a better understand of how the 50% CGT discount will continue to apply to “small business assets”).
• Investment behaviours could change given that 50% CGT discount assets will implicitly have a higher after-tax value than 25% CGT discount assets and hence there could be lessened propensity to dispose of 50% CGT discount assets where the investor would then be investing in 25% CGT discount assets.
• Subject to how the proposed changes are implemented in law, trust deeds may need to be reviewed to consider if the change in the rate of the CGT discount gives rise to the need to amend trust deeds (e.g., the definition of Income).
• The Opposition has also proposed a new regime that would see Trusts taxed at 30% (this is the subject of a separate article in this series). It is not currently clear how the CGT discount regime (at the 50% or proposed 25% rate) will interact with a 30% tax rate on trust income and if discountable gains can still be distributed to beneficiaries of a trust or if, like companies, trusts and their beneficiaries will lose the ability to utilise the CGT discount.

No changes are proposed to the CGT discount available to superannuation funds and hence it will remain at one third (such that superannuation funds pay 15% tax on two thirds of the capital gains they derive and attributable to accumulation accounts which equates to an effective tax rate of 10% of the capital gains derived).

It should also be kept in mind that the proposed changes to the CGT discount are but one of a suite of measures, including eliminating negative gearing on assets acquired on or after 1 January 2020 (aside from investments in new residential housing) and the denial of refund for surplus imputation credits from 1 July 2019. Together, these policy changes will have a more magnified impact on taxpayers than any one of these changes in isolation would have.

Please note: The Opposition’s taxation policy announcements are relatively low on detail and require legislative change for them to be implemented. The final form of any taxation changes will of course be dependent on the outcome of the May 2019 Federal Election and the composition of both the House of Representatives and the Senate. The above comments are general in nature and do not constitute financial advice in any form. You should consult with your specialist advisor for advice on these matters specific to your circumstances.