Frank Newman: When a capital gain is income

The interim report recently published by the government's Tax Working Group had a handy summary of the current law regarding taxing gains in the value of investment assets. Here are the relevant extracts from their report.

Gains on the sale of land are taxable if the land was bought with a purpose or intention of resale, even if resale was not the only or dominant purpose or intention of the purchase. Capital losses are generally not deductible unless a gain on the sale of the property would be taxable.

The bright-line test for residential property sales serves as a proxy for ‘purpose of disposal’ by taxing the sale of any residential property within five years of purchase, subject to some exceptions. The most important exception is that the family home is excluded from the test but this exclusion can only be used twice in a two-year period, and owner-occupiers with a regular pattern of buying and selling residential property will be treated as having a trading intention and therefore be taxed on their gains.

Land affected by changes to zoning, consents, or other specified changes may be taxed on the sale, if the sale is within ten years of acquisition. If at least 20% of the gain on disposal can be attributed to the change, the whole gain is taxable, but the taxable amount is reduced by 10% for each year the taxpayer has owned the land.

Land disposals may be taxed if an undertaking or scheme involving more than minor development or (sub)division of the land was commenced within ten years of the land being acquired. Land disposals may also be taxed if there has been an undertaking or scheme of division or development of the land that involves significant expenditure on specified works, subject to a number of exclusions.

Gains on shares are only taxable if they have been acquired for the dominant purpose of disposal, or in the course of a person’s share dealing business. Otherwise the shares are said to be held 'on capital account' and gains are not taxable. In practice, it can be difficult to determine the dominant purpose of an acquisition. Although most people acquire shares with a view to selling them at some later time for a profit, this fact is insufficient by itself to satisfy the ‘dominant purpose’ test.

Gains on NZ and Australian shares held by portfolio investment entities (PIEs) are not taxable. This treatment is a response to the fact that gains on shares held by individuals are in practice rarely taxable.

The fair dividend rate (FDR) method is generally used to tax portfolio investments in foreign shares (other than in Australian listed companies). Shares are taxed on a 5% deemed (assumed) return, based on the opening value of the shares in each year. FDR is intended to raise revenue, while reducing the bias against foreign equity investment through managed funds.

While the final report from the Tax Working Group is not due until February, the interim report makes it pretty clear that a "capital gains tax" will be introduced. Technically, a purist could argue it is not be a capital gains tax because there will be no separate tax category for capital gains, but in practice it will be a capital gains tax. The proposal is that the definition of "income" will be widened to include gains arising from the sale of investment assets.

That means, a capital gain would be added to a taxpayers other income (from wages, interest, dividends, rental income, etc) and taxed at the taxpayers "marginal tax rate" - the rate of tax they pay on the last dollar of earnings. We have what's called a "progressive" income tax system so the marginal tax rate rises with a person's income, with the top marginal tax rate being 33 cents in the dollar when an individual earns more than $70k.

Given “capital gains” tend to arise after holding an asset over many years and tend to be one-off transactions rather than a continuous income stream, they are likely to be taxed at the highest marginal tax rates - which is 33% for individuals and most trusts (Maori trusts have a lower rate of 17.5%) and 28% for companies. This is significantly more than the flat 15% that Labour suggested when it first proposed a capital gains tax.

The other significant issue that is glossed over by the Tax Working Group is the inflationary effect. They have rejected submissions to discount capital gains for inflation. As a result, a significant proportion of the tax liability arising from capital gains will be inflationary rather than real gains. 

The Tax Working Group and politicians have made a big deal about having a tax system that is fair. Fairness is a matter of opinion, not fact. Once people have had time to reflect on the proposals, I think many will come to the view that the capital gains tax recommended by the Tax Working Group falls well short of fair.

The Tax Working Group has invited submission on their proposals. They can be emailed to submissions@taxworkinggroup.govt.nz by 1 November 2018.  

Frank Newman, an investment analyst and former councillor on the Whangarei District Council, writes a weekly article for Property Plus.