Australian Capital Gain Tax Discount: Principle, Tax Policy and Alternatives

by

Dr. Cheaseth Seng

Officialin

Cabinet of H.E. Deputy Prime Minister, Minister in charge of Council of Ministers

Kingdom of CambodiaAssociate Dean, Faculty of Business and Economics

Pannasatra University of Cambodia

1. Introduction

Capital gain tax (CGT) is a part of Australian income tax system and came into force on the 20th of September 1985. The taxable capital gain is the net capital gain of all capital assets held by the taxpayers. Capital assets are assets that defined by CGT legislation as to subject CGT. Thus not all capital assets are subjected to CGT. The taxpayers need calculate capital gains or losses of each of their capital assets held to determine their taxable capital gain. There is no separate CGT liability, as the taxable capital gain is included in the taxpayers’ taxable income and assessed based on personal marginal tax rate (ATO Website 1).

The current CGT legislation, which included recommendations from the Ralph Review reforms of business taxation, provides three methods to calculate capital gain and one method to calculate capital loss (ATO, 2008; Kenny, 2005). The capital loss is calculated by subtracting the purchase cost of the capital asset and associated costs from capital proceed from the asset. The three methods allowed for computing capital gain are indexation method, discount method and the ‘other’ method. The three methods are used in different situations (capital event and timing). The discount method was introduced under the recommendation of the Ralph Review and driven by tax policy objectives (Kenny, 2005). There are conflicting views of the merit of its introduction. The majority of the attentions are focused on whether it achieves the intended objectives or not and that it induces some distortions to economic behaviours (Kenny, 2005).

The current paper has three objectives. First, it introduces the three methods used to determine capital gain. Example illustration will be given for each method. Second, the paper discusses, in detail, the tax policy reasons for the introduction of the discount method. The outcome of this normative analysis is used to determine the tax policy that subjected to the conflicting views. Lastly, the paper suggests alternative courses of action to frame the CGT discount provision and thus attempting to solve the problems identified. The underlying reasons for the alternative methods will be provided. This paper is structured accordingly.

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2. General Rule

The general rule used to compute capital gain is subtracting capital proceeds from the sales or dispose i.e. change of ownership of capital asset by its cost base. The cost base of an asset consists of five elements, namely money paid or property given for the asset, incidental costs of acquiring the asset or of the CGT event1, cost of owning the asset, capital costs to increase or preserve the value of the asset and capital costs of preserving or defending the title or rights to the asset (ATO Website 2). The indexation method allows the taxpayer to increase each element of the cost base, except for the third element, by an indexation factor. The indexation factor is calculated by dividing the consumer price index (CPI) for the quarter the CGT event occurs with the CPI for quarter when expenditure incurred. This option is given to taxpayers when the CGT event happened to asset acquired before 11.45am on 21 September 1999 and the asset is owned for at least 12 months. The general formula and illustration of the indexation method is provided in Exhibit 1.

Exhibit 1: Indexation method

Source: ATO (2008)

1 CGT event describes the sales or transfer of ownership of the capital assets.

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Indexation formulae:1. CGT event occurs on or after 11.45am on 21 September 1999

Indexation factor = Consumer price index (CPI) for quarter ending 30.9.99 / CPI for quarter which expenditure was incurredCPI is frozen on the 30.9.99 upon the introduction of the Discount method

2. CGT event occurs before 11.45am on 21 September 1999

Indexation factor = CPI for quarter when CGT event happened / CPI for quarter in which expenditure incurred

Example illustration:Val bought a property for $150,000 under a contract dated 24 June 1991. The contract provided for the payment of a deposit of $15,000 on that date, with the balance of $135,000 to be paid on settlement on 5 August 1991. She paid stamp duty of $5,000 on 20 July 1991, she received an account for solicitor’s fees of $2,000, which she paid as part of the settlement process. She sold the property on 15 October 2001 (the day the contracts were exchanged) for $215,000. She incurred costs of $1,500 in solicitor’s fees and $4,000 in agent’s commission.

Val’s capital gain calculated using indexation method

Deposit X (multiply) indexation factor$15,000 x (123.4 / 106.0 = 1.164) = $17,460Balance X indexation factor$135,000 x (123.4 / 106.6 = 1.158) = $156,330Stamp duty X indexation factor$5,000 x (123.4 / 106.6 = 1.158) = $5,790Solicitor’s fees for purchase of property$2,000 x (123.4 /106.6 = 1.158) = $2,316Solicitor’s fees for sale of property(indexation does not apply) = $1,500Agents commission (indexation does not apply) = $4,000Cost base (total) $ 187,396Capital proceeds $ 215,000Capital gain $ 27,604

The ‘other’ method is the simplest methods of the three. This method applies the general rule (mentioned above) to determine capital gain. This method is the only method available to taxpayers when the capital asset under consideration owned less than twelve months or with CGT events that do not involve an asset. Exhibit 2 provides example illustration of the ‘other’ method.

Exhibit 2: ‘Other’ method

Source: ATO (2008)

Lastly, the discount method is available to individual, trust and complying superannuation entity when the CGT event happened after 11.45am on 21 September 1999. The taxpayers need to own the asset for at least 12 months and opt not to use the indexation method. The discount method is generally not applicable to company and excluded certain CGT events. The CGT events that excluded from the discount method are D1, D2 D3, E9, F1, F2, F5, H2, J2 or J32. The discount percentage is 50% for individuals and trusts and 33.33% for complying superannuation entities. Exhibit 3 provides illustration of the discount method at works.

Exhibit 3: Discount method

2 Refer to Appendix 1 of Guide to Capital Gain Tax 2008 for detail of each CGT event

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Marie-Anne bought a property for $150,000 under a contract dated 24 June 2002. The contract provided for the payment of a deposit of $15,000 on that date, with the balance of $135,000 to be paid on settlement on 5 August 2002. Marie-Anne paid stamp duty of $5,000 on 20 July 2002. On 5 August 2002, she received an account for solicitor’s fees of $2,000 which she paid as part of the settlement process. Contracts for the sale of the property for $215,000 were exchanged on 15 October 2002. Marie-Anne incurred costs $1,500 in solicitor fees and $4,000 agent’s commission.

Deposit = $15,000Balance = $135,000Stamp duty = $5,000Solicitor fees for purchase = $2,000Solicitor fee for sales = $1,500Agents commission = $4,000Cost base $ 162,000Capital proceeds $ 215,000Capital gain $ 52,000

Val bought a property for $150,000 under a contract dated 24 June 1991. The contract provided for the payment of a deposit of $15,000 on that date, with the balance of $135,000 to be paid on settlement on 5 August 1991. She paid stamp duty of $5,000 on 20 July 1991, she received an account for solicitor’s fees of $2,000, which she paid as part of the settlement process. She sold the property on 15 October 2001 (the day the contracts were exchanged) for $215,000. She incurred costs of $1,500 in solicitor’s fees and $4,000 in agent’s commission.Deposit = $15,000Balance = $135,000Stamp duty = $5,000Solicitors fees for purchase = $2,000Solicitors fees for sales = $1,500Agents commission = $4,000Cost base (total) $ 162,000Capital proceeds $ 215,500Capital gain $ 52,000Less 50% discount ($ 26,250)Net capital gain $ 26,250

Source: ATO (2008)

3. Taxation Principles

The merit of an income tax system is generally assessed based on tax principles. The common tax principles used to assess an income tax system or part of includes, inter alia, equity, robust, effectiveness, flexibility, economic efficiency and simplicity. The introduction of the discount method was mainly driven by economic efficiency tax principle (Kenny, 2005; REIA; SAECCI, 1999; ACCI, 2007). This tax principle concerns with the impact of tax system on economic behaviours. It contends that a tax system should have neutral characteristic i.e. no distortion impact on or alter economic behaviours. For example, a company income tax system should not alter investors’ behaviours to or from investing in company structure of organisation.

The economic efficiency objectives of the discount method include encouraging savings, investment and economic growth, reducing the lock in effect of CGT and equity financing (Kenny, 2005). Each of these objectives will be discussed in turn. First, CGT is considered as ‘a wedge between current and future consumption’ (p.25, Kenny, 2005). This is because the realisation of capital assets is subjected to CGT. The greater the percentage of income tax shared of taxpayers’ taxable income is the less that left for saving. Therefore, CGT distorts economic behaviours and bias toward saving. As the result a preferential treatment of CGT, such as reducing the capital gain by 50% (individual and trust) or 33.33% (qualified superannuation funds) would increase disposable income available for saving. The example illustrations above indicate that in comparison to other methods i.e. indexation and the ‘other’ methods the capital gain computed under the discount method is the lowest of the three. The increase in disposable income is expected to have positive relationship with saving and in turn reduce the extent of economic distortion. In addition, saving was the government’s objective at time of legislating Ralph Review’s recommendations. The Treasurer indicated that ‘with more saving we can finance more out of investment to growth the economy faster’ (cited in Kenny, 2005). The American Council of Capital Formation (ACCF) (1999) and Kenny (2005) provide that level of saving is linked to capital investment and in turn linked with economic growth. Figure 1 provides the

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chain of effect of using the discount method to calculate CGT taxable capital gains and economic growth.

Figure 1: Chain effect of Savings

Source: Kenney (2005)

The argument of the positive link between increase in disposable income or higher rate of return of investing in capital assets, saving and economic growth is debatable. This is because empirical studies on the affect of reducing tax rate on savings indicate that savings are not very responsive to higher rate of return (Kay and King, 1990; Gann, 1980; Gordano, 1986; Kenny, 2005). In addition, the characteristics of Australia’s capital assets and their incomes suggest the same weak link. Kenny (2005) provides four capital assets related reasons to illustrate the weak relationship between higher rate of return and saving. Firstly, capital gain is only 31% of reported capital income. Hence, increase rate of return by discounting capital gain will have little impact on total capital income and in turn saving. Second, the incomes produce by capital assets are mainly in the forms of dividends, interest and rent instead of capital gain. In other words, realisation of capital assets is not the major source of capital income. Third, saving is insensitive to rate of return when saving is done for precautionary or liquidity purpose. Lastly, CGT preferential treatment would not greatly impact on tax exempt bodies or low taxed superannuation fund.

Turning to empirical studies, Kay and King (1990), in their study of the affect of changes in real interest rate in the UK in 1970s and 1980s, assert that savings are not very responsive to the rate of return. Gann (1980) and Gordano (1986) also found the same weak relationship between higher rate of return and saving. Their studies were focused on US context and the changes in income tax rates.

Lastly, there are indications that savings does not have a clear link with economic growth. Schmidt (2003) examines the long-term and short-term relationship between Australia’s savings, investment rates and economic growth provided changes in level of saving have no impact on national investment and economic growth. Chaudhri and Wilson (2000) also found savings have no impact on economic growth. They find the level of savings is neither necessary nor a necessary requirement for economic growth.

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In conclusion, the saving, investment and economic growth reasons lend little support in introducing the discount method to calculate CGT. The CGT discount method has little impact on saving and economic growth.

The second objective of the discount method is to reduce the lock in effect of CGT. The lock in effect of CGT arises when investors are unwilling to realise their capital assets in response to new information. The investors are reluctant to change their portfolio investment even if others profitable investment opportunity arises. This is because realising their assets will subject to CGT. Thus the investor is said to have locked in with current investment portfolio. Therefore, CGT induces misallocation of capital assets among industries and firms. In addition, there are claims that CGT alters ‘the mix of financial assets that firms supply, the ratio of debt to equity and the allocation of risk bearing in the economy’ (p. 35, Kenny, 2005). In other words, CGT distorts investment behaviours. The introduction of the discount method would reduce this lock in effect. The CGT discount gives investors (individual, trust and qualified superannuation firms) some relieve of their CGT, which in turn encourage realisation of their capital assets when others profitable opportunity arises.

Similar to the saving, investment and economic growth objective, the lock in effect objective is not a strong argument for introducing the discount method. There are several counter arguments as follow. First, the Australian Stock Exchange (ASX) provides that majority of share investors sell their shares quickly in response to poor company performance (cited in Kenny, 2005). In addition, these investors are comprised of lower taxed superannuation funds and foreign investors (Australian Prudential Regulation Authority, 2003) which are not greatly affected by CGT. The low taxed superannuation funds face little CGT liability and the foreign investors are excluded from CGT discount. Furthermore, investors with large portfolio of assets will have both capital losses and gains. The capital loss will offset the capital gains. In sum, the lock in effect is not a major issue for Australian share market.

Second, Burman (1999) contends that the discount method could create a reverse lock in effect for investors. This situation arises where an investor is better off to realise their assets and face CGT and acquire a more profitable (highly appreciated assets) than waiting for the discount relieve.

Third, the CGT discount may induce a further lock in effect. This is because investors need to hold their assets for at least 12 months to get the discount relieve. This requirement affects free operation the market and in turn further induces distortion to economic behaviours. In this context, the discount method does not achieve its intended objective.

Lastly, Krever and Brooks (1990), in their study of the effect of New Zealand CGT, point out a number of situations where lock in effect will not apply to investors. The situations include where the investors have no choice but to sell the assets for business consideration or through forced disposals. In addition, assets with short lives like leases, patents and mineral deposit are not affected by lock in effect. Their short lives force the investors to sell the assets. Lastly, CGT exempt assets attract no lock in effect either. Thus, the discount method is not relevant to these situations.

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Once again, there are arguments for both for and against the introduction of the discount method and merit of the driving tax principle, namely the economic efficiency tax principle. The lock in effect issue is seemed to have insignificant effect on share market and the discount method induces further lock in effect and economic distortion.

The last objective of the discount method chosen for discussion in this paper is equity financing. The argument for discounting capital gain is that it would encourage risk taking, equity financing, entrepreneurial activity and new business start ups (ACCF, 1999; Reynolds, 1999; Kenny, 2005). Discounting capital gain will lower CGT rate and in turn decrease the cost of capital for business. This would be beneficial for businesses that rely on equity financing. Such businesses include small growth companies that have insufficient retained earnings and limited borrowing capacity.This equity financing argument is another weak one. As previously mentioned major contributors to equity market are low taxed superannuation funds and foreign investors. The cut in CGT rate have little impact on their after tax rate of return. In addition, CGT discount applies to all types of assets, namely productive and unproductive ones. This makes the CGT discount a poor choice to encourage entrepreneurship.

Overall, the economic efficiency objectives of introducing the discount method to calculate capital gain are insufficient and somewhat weak. The objective that the discount method reduces the problem of economic distortion toward saving, investment and economic growth behaviours faces many criticisms. This is because there is a weak relationship between CGT discount and savings. The equity financing objective is also faced with the similar criticisms. For the lock in effect objective, the discount method has little impact on reducing the lock in effect as it is not a major issue in the market. Moreover, the discount method induces further lock in effect as investors need to hold their assets for at least twelve months to receive the discount relieves. This distorts the free market operation and in turn economic efficiency of CGT. As the result a change to the discount method is required, especially regarding to the lock in effect matter.

4. Proposed Change

The majority of current proposals for changes toward CGT are focused, once again, on economic efficiency (ACCI, 2007; SAECCI, 1999; REIA). The proposals focus on CGT rate and holding period. The Australian Chamber of Commerce and Industry (ACCI) (2007), the Real Estate Institute of Australia and South Australian Employers’ Chamber of Commerce and Industry (1999) are all proposing a ‘stepped rate’ method. The method is considered to ‘significantly reduce the burden of tax on capital gains and encouraging increased investment’ (p. 8, ACCI, 2007). Table 1 provides the ACCI proposed ‘step rate’ method.

Table 1: Capital gain tax scheduleTime asset held Proportion of Gains Subjected to TaxLess than 1 year 100%

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1 – 2 years 50% (25% small business active asset exemption)2 – 5 years 25%5 – 10 years 10%More than 10 years 0%Source: ACCI, 2007

This ‘step rate’ method provides relieves to taxpayers and meets some of the objectives discussed above. However, in term of lock in effect, it still induces further lock in effect and if an investors would like to get the full exemption of CGT, a 10 years holding period is required. The distortion to free market operation is still present.

An alternative to the ‘step rate’ method is to allow for CGT discount immediately with no waiting period. This way it eliminates the lock in effect and not induces any distortion to free market operation. In addition, it serves the original purpose of introducing the CGT discount. This method does however attract conversion of income into capital. According to Evan (1999), this proposed method provides incentive to taxpayers to convert their income into capital in order to receive concessional CGT rates. Nevertheless, the issue of converting income into capital is also present with the original and ‘step rate’ methods (Evan, 1999). Reynolds (1999) provides that the introduction of CGT concession rates has revenue elasticity of – 1.7 in the first two years and – 0.9 in the five years.

Lastly, Kenny (2005) suggests that the CGT discount should be abolished. According to the above discussions, the discount method has little impact on saving, investment and economic growth objectives as well as equity financing and lock in effect objectives. The abolition of the CGT discount thus eliminate the further distortion created. Moreover, it serves the original purpose of CGT, which is a form of wealth tax that aims to achieve vertical equity. Kenny (2005) provides majority of capital assets are held by small proportion of wealthy taxpayers. In addition, abolition of CGT discount eliminates the behaviours of converting income into capital as mentioned above.

5. Conclusion

In conclusion CGT is an essential part of Australian income tax system. It helps ensure equity treatment of the system. It is designed to prevent the conversion of income into capital. There are three methods allowed for calculating capital gains, namely the indexation, discount and the ‘other’ methods. The discount method was introduced based on Ralph Review recommendations and on economic efficiency tax objective. The arguments for its introduction were, however, quite weak and subjected to many criticisms, particularly, the reduction of lock in effect objective. The discount method induces a further lock in effect and distorts to free market operations instead of solving it. In light of this problem, there are several proposed of alternative courses of action. The proposed courses are ‘step rate’ discount method, immediate discount with no waiting period and the abolition of CGT discount overall. Each of these proposed methods has both up and down sides. The paper suggests the immediate discount method without waiting period. This is because this method reduces the lock in effect and distortion of free market operation. The incentive to convert income into capital embodied with this method is present with all other

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proposed methods. In addition, it meets most of the economic efficiency objectives that drive the introduction of the original discount method. Thus, it is the best alternative course of action.

Reference

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ACCF (American Council for Capital Formation), ‘Overcoming Barriers to US Economic Growth, International Competitiveness, and Retirement Security’ (1999) <www.accf.org/June99test.htm>, 16, M Feldstein (ed), Capital Taxation (1983)

ACCI (Australian Chamber of Commerce and Industry), (2007), ‘Capital gains tax needs reform’, Issue Paper

Australian Prudential Regulation Authority ‘ Superannuation Market Statistics’ (2003) < http://www.apra.gov.au/Statistics/Superannuation-Market-Statistics.cfm>.

ATO Website 1, ‘What is capital gains tax?, http://www.ato.gov.au/print.asp?doc=/content/36520.htm, Accessed on 19/04/2009

ATO Website 2, ‘What is the cost base?’, http://www.ato.gov.au/print.asp?doc=/content/36557.htm, Accessed on 19/04/2009 ATO (2008), ‘Guide to capital gain tax 2008’, ATO Australian Government

Burman, L. E. (1999), ‘The Labyrinth of Capital Gains Tax Policy, A Guide for the Perplexed’ Vol. 68.

Chaudhri, D. P. and Wilson, E. (2000) ‘Savings, Investment, Productivity and Economic Growth of Australia 1861–1990: Some Explorations’, Economic Record Vol. 76, No. 232, pp. 55–57.

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Gordano, R. M. A Wall Street economist, commented on E Steuerle’s paper ‘Effects on Financial Decision Making’ in J A Pechman (ed) Tax Reform and the United States Economy (1986) 67.

Kay, J. A. and King, M. A., The British Tax System 1990, 96.

Kenny, P., (2005), ‘Australia’s Capital Gains Tax Discount: More Certain, Equitable and Durable?’ Journal of the Australasian Tax Teacher Association, Vol 11, pp. 1-75

Krever, R. and Brooks, N. (1990), ‘A Capital Gains Tax for New Zealand’ Victoria University Press, Wellington, 43

REIA (Real Estate Institute of Australia), ‘REIA Proposal for Change to Capital Gain Tax’, http://www.reiaustralia.com.au/documents/REIA_Proposal_for_Change_to_Capital_Gains_Tax_15Sep05.pdf, Accessed on 22/04/2009

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Reynolds A., (1999), ‘Capital Gains Tax: Analysis of Reform Options for Australia’. A study commissioned by the Australian Stock Exchange for the Review of Business Taxation, <http://www.asx.com.au/shareholder/l3/MR160799_AS3.shtm>

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