On 21 February 2019 the Tax Working Group (the Group), released its Final Report called “The Future of Tax”. Although the report covers far more ground than the taxation of capital gains, it is this aspect that has excited the most interest amongst the public. The Coalition Government has undertaken to take a “measured response” to the report and to make further announcements in April on any measures to be adopted.
The report’s central recommendation to significantly broaden the income tax base from capital gains has attracted widespread resistance from property and business owners, but does not seem to have attracted obvious support from younger and poorer voters. In addition any legislation will require the support of New Zealand First. Unfortunately for the Labour Party, Winston Peters is on record as a strong opponent of capital gains taxes (CGT). He has said a CGT doesn’t work in other countries and won’t work here.
It is therefore very likely that the Coalition Government will promote legislation that is significantly watered down from the majority recommendations contained in the report.
According to the Group’s press release, “All members of the Group agree that more income from capital gains should be taxed from the sale of residential rental properties. The majority of us on the Group by a margin of 8 – 3, support going further and broadening that approach to include all land and building, business assets, intangible property and shares”
It seems likely that the Coalition Government will adopt measures that reflect the minority views of members of the Group – that additional capital gains taxes will be restricted to residential rental property and potentially holiday homes. It is timely therefore to examine the reasons advanced by the minority members for eschewing the broader approach to taxing capital gains recommended by the majority of the Group.
These are paraphrased below:
The tax system should not impede experimentation and innovation
The minority members were concerned that the proposed additional taxes on the domestic capital deployed to fund new activity will have a negative impact on New Zealand’s productivity.
The underlying rationale for this thinking appears to be that New Zealand already suffers from low savings and accordingly has low levels of productivity. A disproportionate amount of savings is already deployed in the residential property market rather than in productive assets and businesses. The proposed additional taxes will likely exacerbate this problem especially given the Terms of Reference for the Group exclude consideration of capital gain on the family home.
The application of capital gains taxes to other asset classes is complex
The minority members support the view that more income from capital gains should be taxed from the sale of residential rental properties.
In forming this view they cite advice from officials that the taxable income from such properties is low compared with total returns from this asset class. They say that much of the additional income expected from this asset class could be achieved with some modifications by extending current rules, including the bright line test.
However they state that “As additional asset classes are included in the capital gains tax system, the issues become more complex and there is an increasing need for exemptions and exceptions which are intended to reduce lock-in impacts and compliance costs, but can cause the reverse”.
As one illustration, they cite the need to value business assets such as Goodwill on the starting date or so called Valuation Date on introduction of the regime. Valuing these assets is likely to impose high compliance costs on businesses and pose unacceptable fiscal risk to the government. This risk relates to over-stated opening valuations and therefore potential for paper losses to arise on disposal of the asset. In order to control for this risk it is proposed that losses from assets valued on a method other than an arms length price, be ring-fenced and not allowed to be offset against income from other asset classes. In turn this measure to protect the integrity of the tax base, has the potential to cause collateral damage by reducing investment driven experimentation and innovation.
Taxing both business gains and gains from shareholding in the business, can create double taxation.
Under current law a New Zealand company and its kiwi shareholders are effectively taxed only once on the income earned by the company. The company derives income in its own capacity and pays tax on that income. At some point it distributes some or all of its income to its shareholders together with imputation credits representing the tax paid by the company. These imputation credits are used to offset the shareholders’ own tax liability from receipt of the income.
In the case of realized gains at the company level (under the proposals this also will now include realized gains from the sale of assets such as intellectual property), the gain will be taxed at the company level. In addition it is to be expected that the value of the shares will increase in line with the after tax gain in the company.
Under the proposals all shareholders who sell their shares will be exposed to tax on the gain in the share price. If the company has chosen not to distribute its profits (perhaps because it wishes to reinvest in its growth), there will be no imputation credit relief for the shareholder and the realised gain will have been double taxed.
A similar situation occurs where the company has unrealized gains, for example in a patent, which is reflected in its share price. If the shares are sold the gain will be taxed at the shareholder level and taxed again (double taxed), at the company level when/if the patent is sold.
These examples illustrate the potential ‘lock-in” problems that arise. Businesses and/or shareholders defer sales of assets and/or shareholdings to avoid a capital gains tax. However this deferment may result in the business holding onto mature assets that would otherwise have been upgraded, and/or shareholders holding onto ownership interests rather than transferring their interests to new more vigorous owners.
Potential damage to New Zealand Capital Markets arising from the different treatment of gains from New Zealand shares and overseas shares and as between direct and indirect investment
As set out above, the Group proposes that capital gains earned by Kiwi investors on directly owned New Zealand shares will be taxed when realized. This will apply regardless of whether the Kiwi investor was a speculator in the shares or a passive investor. It will not however apply to foreign shareholders owning New Zealand shares.
Under the proposals, capital gains on most Australian shares and holders of smaller portfolios of non-Australasian shares costing less than NZ$50,000, will also now be taxed when the gain is realized.
Most overseas shareholdings directly owned by New Zealand investors are in the form of portfolio investments in listed companies with a high weighting to global blue chips. The vast majority of these portfolio shareholdings are for less than 10% of the company.
Under the proposals most portfolio interests in foreign companies other than Australasian shares and small portfolios as described above, will (or it is proposed will be), taxed using the Fair Dividend Rate (FDR) method. Under FDR, investors are taxed each year on 5% of the opening value of their portfolios regardless of the actual level of dividend or capital gain they earn in the year. The FDR method involves a form of capital gains tax because it is based on the value of the portfolio rather than the income earned from the portfolio.
The FDR method is already in place and is not affected by the proposals. Therefore the proposals involve a new capital gains tax on New Zealand shares, but no change to the current treatment of non-Australasian shares (other than for smaller portfolios). Investments in non-Australasian shares will become more attractive from a tax perspective, thereby incentivizing New Zealand investors to sell their New Zealand shares and invest overseas.
Imagine for example an investor on a 33% marginal tax rate who wants to invest in growth shares that he/she expects to cash up within 5 years. They have the choice of investing say $100,000 in Fisher & Paykel or Apple and forecast each share will gain 50% evenly over the five years i.e. gain $10,000 per annum.
The Chart below illustrates the difference in tax treatment of the capital gain:
In general the difference in approach between the taxation of New Zealand shares and international shares taxed under FDR may incentivise greater international share ownership by kiwi investors at the expense of the local market – this is particularly the case for investors with a short to medium term investment horizon and for those investors interested in capital growth.
The outcome is unfortunate from the viewpoint of capital deployment by kiwi investors in innovative New Zealand growth companies. Entrepreneurs’ will more likely look to foreigners (who will not be affected by this tax), to fund the growth in their businesses and this may have result in the loss of locally developed intellectual property.
The majority of New Zealand savers and investors hold shares in New Zealand and international shares indirectly through managed funds such as KiwiSaver Funds. These funds are classified for tax purposes as Portfolio Investment Entities or PIE funds. It is proposed that these funds will be taxed on their Australasian shares on an accrual basis i.e. on unrealized capital gains rather than when the gain is realized as permitted for direct investors as set out above. Clearly this causes a bias to hold New Zealand shares directly rather than indirectly via a managed fund.
However since most savers and investors lack the confidence, knowledge and skills to maintain their own portfolios they will continue to hold their New Zealand investments via managed funds despite the adverse tax treatment in the managed fund.
Fiscal Risks to the Government
In accordance with the Group’s Terms of Reference the proposals are intended to be revenue neutral to the government. The Group’s preferred approach is to allow New Zealanders to earn more at the lowest tax rate of 10.5%. This is admirable because it would reduce income inequality, benefit all full time workers and support those transitioning to work (i.e. from the beneficiary system).
However there are risks to the government from this approach, because it is replacing a stable cash-flow from full time workers, with an unpredictable and volatile cash-flow from taxing business assets and shares.
In addition the government must share any capital losses as well as any capital gains. Capital losses from a fall in say share markets or land prices or from an increase in business failures, will be absorbed in government revenues depending on the tax structure for the asset class. For example, taxpayers are permitted to offset losses against other income, alternatively losses can be carried forward into future years, or in some cases cashed out directly.
Due to this risk it will be more difficult for the Government to achieve revenue neutrality and it will likely be less generous on income tax cuts to allow for this uncertainty.
The minority members argue that the proposals mean “…the government simply assumes a proportion of investor risk and in return receives as tax revenue a proportion of investor gain. The government could assume the same risk and extra revenue by investing directly in the share market”
My Summary
So why doesn’t the government invest directly in the markets and capture for itself 100% of the revenue? …….Gosh???
As set out above there are already various forms of capital gains tax in our markets. Any new proposals adopted by the government will increase complexity and cause investors to review where they invest their capital.
If you are worried about the impact of capital gains on your financial affairs please call me.