Capital gains tax - what we know about how it would work

Thursday, 10 January 2019

Sir Michael Cullen forecast in 2018 that it might then be 'now or never' for a capital gains tax.

The Tax Working Group expects to hand over its final report to the Government by the end of next week, a month earlier than first expected.

It is understood the working group has held its last meeting and the report is now basically complete. The report will contain a plan to extend the taxation of capital gains, and to hand back the money that would raise through cuts to other taxes.

Whether its recommendations are enacted will then be a matter for politicians and voters, with an ocean of water still to go under the bridge.

But chairman Sir Michael Cullen revealed in November that 'a clear majority' of the 10-person working group had reached an agreement on a central package around the extension of capital income taxation – in other words, a capital gains tax.

* Capital gains tax gets tick from most Tax Working Group members

* Capital gains tax would increase house prices, modelling suggests**

More than that, at a conference hosted by Victoria University in November, several members of the working group revealed most of the key details about how they envisage the tax would work.

So what do we now know?

The basics

Profits from the sale of assets and investments such as rental properties and shares would be taxed alongside their other 'income' at people's marginal income tax rate.

Broadly-speaking capital gains on the 'family home' would not be taxed, and nor would any gains on the likes of artworks – which could increase their relative appeal as investments.

Former Inland Revenue deputy commission Robin Oliver, who sits on the working group, has warned that defining the 'family home' is not always as easy as it might appear.

But the important rule for most people is that for the purposes of taxation, they would only be allowed to have one of them.

Foreign citizens may need to be tax resident in New Zealand to claim a tax exemption on a family home here.

Auckland University professor Craig Elliffe says not reducing capital gains tax to take inflation into account would be fair as well as 'consistent'.

Russell McVeagh tax boss Brendan Brown believes politics might also dictate some concessions for owners of hundreds of thousands of small businesses, if they sold their firms for a profit.

He notes Finance Minister Grant Robertson and Revenue Minister Stuart Nash wrote to Cullen in September asking the TWG to consider whether 'a tax-free threshold' might be appropriate when businesses were sold.

But the TWG hasn't signalled whether it is keen on that particular idea.

How would the tax be spent?

The Tax Working Group (TWG) has suggested that a broad tax on capital gains might raise $290 million in its first year, rising to $2.7b in 2026, and just under $6b in 2031. But it acknowledges that is just a guess.

It has been instructed by the Government to come up with a 'tax-revenue neutral' plan to overhaul the tax system and to consider inequality. So what Inland Revenue gained through taxing capital gains would be given back elsewhere to a broader pool of taxpayers.

Sir Michael Cullen says tax would mostly be due when profits were 'realised' but there would be some exceptions.

TWG member and Council of Trade Unions economist Bill Rosenberg has strongly hinted that the trade off could be either a tax-free threshold of $7000 under which people would pay no income tax, or that the lowest rate of tax on income under $14,000 would be halved from 10.5 per cent to 5.25 per cent.

Rosenberg says those changes would be more 'redistributive' than alternatives such as cutting GST.

It is important to note that even if the Government handed back all the capital gains tax it received by cutting the lower rates of income tax, the Government would still come out better off financially overall, because that rebalancing would result in it paying out fewer benefits.

Many benefits such as Working for Families and accommodation supplements are tied to people's after-tax income.

When might changes come in?

Assuming Labour agreed to implement the TWG report and coalition partner NZ First played ball, Cullen believes legislation could be passed by July next year. A capital gains tax could then take effect from April 2021, after the next election.

In most cases, tax would then only apply 'on realisation', when people sold an asset at a profit, rather than 'accruing' each year on investors' paper gains. But Cullen has said there will be exceptions.

For example, the TWG's current preference is for mutual funds to pay tax each year on the paper gains they made from holding Australian and New Zealand shares, possibly at a discounted rate.

Valuation day

One of the biggest decisions the TWG has had to make is whether people would only pay tax on assets they bought after April 2021, or whether tax would apply on assets they already owned when the change came in.

Since it published its interim report, it has decided people should be taxed on assets they already owned, but only on the gains that they make after April 2021 – the so-called 'valuation day' approach.

Baches would be subject to capital gains tax but artworks would not.

That means if people bought shares in a company or an investment property in 2015 and then sold them in 2025, they would pay tax on any increase in value from April 1, 2021.

TWG member and PwC tax expert Geof Nightingale says the major reason for that is that if it took the alternative 'grandparenting' approach, then it would take years for a capital gains tax to bring in much revenue.

Grandparenting would provide a big incentive for people to hang on to the likes of houses and shares that they owned before the change took effect, for no good reason other than to minimise tax.

But EY tax expert Paul Dunne says a final decision might well come down to politics, noting Australia changed tack and adopted grandparenting against the advice of experts.

'You do wonder given the timeframes and the challenges of getting quality legislation whether we might see something similar where you might see grandparenting for a while.'

Rough and ready

The idea that everyone might have to value assets they owned on April 1, 2021 has generated a lot of controversy. Some assets such as shares in listed companies and investment property could be easy to value (for example from rateable values), but others such as small business might not be.

The TWG has promised to recommend a practical approach. Cullen says it is proposing investors have up to five years to value some assets.

'We will be quite clear in the report that we have done so far that Inland Revenue shouldn't be pressing to get the last dollar out of the system by its introduction.'

But even allowing for a 'rough and ready' approach, the challenges here run deep. Dunne says it tends to be assumed that a tax on capital gains will only apply to 'discreet assets' that don't morph over time.

But what if a company that existed before 2021 sold off part of a division to another business at a profit 10 years later?

He takes as a hypothetical example a situation in which Spark decided in future to sell off its mobile business. How would the original value of its 'goodwill' be valued given that it is not now broken out separately in its accounts?

'We will be doing valuation in some way, shape or form with hindsight using 'best endeavours' and looking back at what those assets in combination would have been worth at the time,' he forecasts.

Read to roll over?

A policy choice on which the TWG appears to have made progress is over 'rollover relief'.

Rollover relief let investors defer paying tax on capital gains when they reinvest profits.

Cullen says the TWG will recommend such relief be 'narrow', though Nightingale says the TWG has 'reluctantly accepted' rollover relief would apply on death – so, for example, an investment property could be passed on to a family member without triggering a tax bill on inheritance.

Nightingale says that in theory capital losses should not be ring-fenced – so if investors make a loss they should be able to offset that against a capital gain on which they would otherwise pay tax.

But the more Inland Revenue allowed rollover relief, the more it would need to ring-fence capital losses to 'protect the integrity of the system'.

What about inflation?

There is bad news for investors here. The TWG will recommend investors pay tax on all their notional capital gains – just as savers currently need to pay tax on all their interest income – even if much of that has been eaten away by inflation.

Aside from ensuring consistency, Auckland University professor and TWG member Craig Elliffe argues that is actually fair.

That is because a capital gains tax is a 'deferred tax', not one that people pay every year, and the benefit that investors get from only paying tax when their profit is realised through a sale can be quite substantial, he argues.

*comments on this article have been closed