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Submission No. 246 Back to full list of submissions
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16 April 1999

 

The Secretary
Review of Business Taxation
Dr Alan Preston
Department of Treasury
Parkes Place
CANBERRA ACT 2600

 

Dear Dr Preston

SUBMISSION TO REVIEW OF BUSINESS TAXATION
SUBJECT: CAPITAL GAINS TAX REFORM

Please find enclosed a submission dealing with capital gains tax reform.

I can be contacted on 0409-004-233 if you need to discuss further this submission.

Yours sincerely

 

DAVID G STEVENS
Director
DGS Consulting Group Pty Ltd

 

REVIEW OF BUSINESS TAXATION

SUBMISSION ON CAPITAL GAINS TAX REFORM

EXECUTIVE SUMMARY

The focus of this submission is on the reform of capital gains tax as referred to in Chapter 11 of the Review of Business Taxation’s (RBT) A Platform for Consultation (APC).

Summary of key elements of this proposal:

  • Abolish future indexation for all taxpayers, from date of effect;
  • Abolish averaging for individuals, although continue to permit the use of the tax free threshold where capital gains and other income are less than the threshold;
  • Tax net capital gains – after allowing for net deductions - at a rate of 17 or 18% (other than those below the tax free threshold which would continue to be free of personal income tax); and
  • Clawback net income deductions related to capital gains (i.e. negative gearing) at the individual’s marginal tax rate before applying the 17% flat capital gains tax.

This final measure is both an integrity and equity measure to limit tax exploitation of the flat rate for other than genuine net gains. It is acknowledged that it adds an element of complexity to an otherwise very simple and transparent proposal that is designed to achieve international competitiveness in an area of taxation where Australia is clearly uncompetitive despite the highly mobile and global nature of capital.

Reform of capital gains tax to promote savings, investment and business commencements and expansion is probably the most significant area of taxation reform necessary. In a global capital environment where as a nation we continue to rely on foreign savings and are a small, albeit competitive and open, economy we must have a capital gains tax regime that is not just alright, but needs to be close to world’s best practice. This is essential if we are to compete for capital with bigger and more central markets such as the United States and the United Kingdom - both of which offer significantly more competitive capital gains tax regimes.

KEY AREA OF REFORM

I commend the Review of Business Taxation (RBT) for its attention to this very important area of business taxation reform. As the RBT’s International Perspective information paper illustrated and APC acknowledges, Australia’s capital gains tax regime is complex, uncompetitive and in some cases subject to exploitation in a manner detrimental to efficient and effective allocation of resources and promotion of savings and creation and expansion of new businesses.

Given the RBT’s previous views and the broad body of opinion calling for meaningful reform in this area, this submission does not propose to revisit the discussion in Chapter 11 of APC. Other than stating that it is premised on the key areas of economic activity that require more competitive capital gains tax treatment including:

  1. venture and development capital for expanding growing, but usually not listed, businesses
  2. start-up or ‘business angels’ capital, which is crucial for turning ideas or family arrangements into genuine business opportunities
  3. employee share ownership and participation schemes that are common overseas for joining employee and employer interests together so as to enhance industrial relations, productivity, stakeholder and performance criteria
  4. scrip-for-scrip takeover, reorganisations or de-constructions, where the underlying economic interest does not change but the legal form may
  5. a generally lower, internationally competitive, rate of capital gains tax such that international and domestic capital can be encouraged to channel investments and savings into Australian assets and businesses, without requiring higher rates of return to justify their risk profiles

Measures to reform capital gains tax need to adequately address all of these areas.

OPTIONS FOR REFORM

Chapter 11 of APC includes a number of specific options for capital gains tax (CGT) reform.

Those options are all effectively premised on the assumption that indexation and averaging are abolished from a specified future date. If indexation and averaging are abolished then a number of those options would need to be selected in order to ensure overall CGT does not rise. Chapter 39, table 39.2 acknowledges this and proposes a mixture of measures to achieve roughly revenue neutral reform within capital gains tax. While this may be one way of looking at ‘revenue neutrality’ I submit that ‘revenue neutrality’ should be able to be viewed broadly, i.e. including all business tax reform measures, and the RBT may wish to consider an overall lower CGT revenue position.

An increase in CGT would, if nothing else, send the wrong signal in terms of the direction of reform in this area – unless the increase in revenue was driven by dynamic or efficiency benefits arising from the reforms. Indeed, an increase in CGT would likely reduce international competitiveness in this key area and therefore be contrary to one of the key principles of the RBT.

While any of the major options for reform in Chapter 11, except perhaps the $1000 threshold that does not even make up for the loss of averaging in most cases, would be likely to be better than the present arrangements they all involve an element of selectivity and arbitrariness. As such they will all have more limited beneficial impacts. For example, a phasing down CGT regime encourages longer term investment over short term. On what basis should the tax system make that value judgement? Is an investment in a high-risk new start-up business sold within 12 months any less deserving of CGT relief than a long term holding in a low risk blue-chip share? Should someone who has the ability to manipulate their taxable income year by year (which is one of the exploitations of averaging) be entitled to a lower CGT rate on that basis?

If the desire of the RBT is a tax system to provide a very dynamic economy, then the CGT regime should minimise any selective, distortionary or arbitrary benefits between either different investors or investments.

PROPOSAL FOR REFORM

While Chapter 11 includes a number of specific options, paragraph 11.42 also suggests that other options may be considered. This proposal is therefore a response to that section, page 293, on Alternatives for lowering CGT rates.

The proposal itself is:

  1. Abolish future indexation and averaging;
  2. Tax net capital gains at a single rate (preferably equal to the 17% lowest marginal tax rate from 1 July 2000) of 17% or 18%;
  3. Allow net capital gains to be tax free where an individual has any unused tax free threshold (or Low Income Earner Rebate and Aged Persons Rebate), i.e. they get one threshold if it is not already used for other income;
  4. Tax any net deductions (negative gearing) at the taxpayer’s marginal tax rate, before applying the single CGT rate to the balance;
  5. Maintain capital losses being quarantined only against capital gains;
  6. Introduce a broadly defined scrip-for-scrip rollover provision; and
  7. Retain a small business goodwill concession.

The focus of the remainder of this submission is items 1 to 4 above. However, items 6 and 7 are important elements of a comprehensive CGT reform and are included here for completeness. This submission endorses the inclusion of them in any final CGT reform proposals. Especially acknowledging the considerable benefits of scrip-for-scrip rollover relief for removing legal ‘obstacles’ where no economic change occurs and the special small business concession in recognition of the important role it plays, that could be penalised by any withdrawal.

This proposal has been designed to meet the RBT’s national objectives for reform as spelt out in the Overview of A Strong Foundation, namely:

  • optimising economic growth and international competitiveness;
  • ensuring equity (horizontal and vertical); and
  • facilitating simplification, including clarity, certainty, uniformity, consistency, adaptability and ease of compliance.

PURPOSE

The purpose of this proposal is to enhance the capital gains tax treatment of all the areas identified above, and capital gains more universally. It is therefore a measure aimed squarely at meeting the primary objective of reform – economic growth and international competitiveness.

It is not targeted at any specific industry, type of investment, class of investor, period of investment or value of investment. It is deliberately beneficial to all forms of capital gains, be they shares, business interests, property, or any other form.

The reason it is universal rather than targeted is because any targeting will always involve a degree of arbitrary selection, thereby failing the uniformity, consistency, simplicity and adaptability requirements.

It has, however, included the provision to ‘clawback’ the value of net deductions or negative gearing to enhance its fairness and deny high income earners to ability to convert revenue income into capital income by gearing or other tax planning. This feature will particularly reduce the attractiveness of negative gearing, for example in property, where it is on non-commercial or economic grounds. This measure is an equity one, which while in some ways compromising simplicity, does not negate the overall simplicity of design and economic benefits of the proposal (see below for further discussion of compliance options).

The 17% rate has been selected, admittedly arbitrarily, to try to match the lowest tax rate proposed in A New Tax System and to closely correlate with a revenue neutral outcome. Obviously, the lower it is the more beneficial the proposal, but equally the higher the likely cost.

COST

The cost of the proposal is, I have been lead to understand, roughly revenue neutral. It has been designed on that basis.

The clawback of negative gearing would be revenue positive and has not been factored in. While the dynamic and other economic benefits from higher realisations and investment would also be likely to lead to additional revenue, some of which may be able to be returned by way of a lower single CGT rate. These two additional revenue gains have not been factored in.

If the lower CGT rate is extended to all entities, there may be some additional cost, which has not been included, but may be financed from the revenue gains above.

ELIGIBILITY

The single CGT rate would be available to all individuals.

The single rate should at the very least be available to trusts as part of the measures proposed on page 114 of A New Tax System. This treatment would provide some offset to trusts for the loss of indexation and averaging for their beneficiaries. As per the proposals on page 114, the value of this tax preference should be flowed through to the beneficiaries.

If Collective Investment Vehicles maintain flow through, the a 17% CGT rate flow through would be a significant benefit, in particular, for addressing the concerns of overseas venture capital and mutual funds who have expressed considerable concern about Australia’s high CGT rates acting as a major impediment to investment in Australia.

On consistency, uniformity, equity and optimising economic growth grounds it should also be extended to other entities. However, in the case of other entities the tax preference would be taxed on distribution, in much the same way as indexation or pre-CGT exemption is lost when paid out as an unfranked dividend.

ADMINISTRATION

The measures would have effect from the date of announcement. Any foreshadowing of such a major future CGT change could have considerable behaviour effects, that will otherwise not occur if the date of announcement is the date of effect. This approach is common practice where tax changes may result in major behaviour change.

The proposal includes the clawback of net deductions to limit abuse and address equity concerns about negative gearing. This element adds a complexity that would otherwise not be necessary if these concerns were not addressed. In addressing these concerns the overall integrity of the proposal is enhanced even if simplicity is partly reduced. Having said that, for most taxpayers this will not be an issue, unless they are negatively geared. And for many entities capital items are taxed on revenue account as an integral part of their business income, e.g. where they trade.

There are two ways in which the net deductions claw back could operate (assuming negative gearing is not otherwise addressed). The first approach, which would best be used where there are a small number of assets (e.g. less than 10) would be to require tracing of net deductions. Assets are already traced for cost base, indexation, and non-deductible costs. Also income, including net income, is ordinarily allocated to assets to determine returns, valuations, etc.

The second approach, which has considerable compliance benefits, would be allow grouping of income from investments against deductions from investments to arrive at a net income figure. Where it is negative it would be traced against the assets. The identification of this number could be similar to that for the Savings Rebate, excluding superannuation contributions. Such a global of grouped approach would be consistent with any move to provide a generalised deduction arrangement, especially for interest expenses.

A further modification of the two approaches for entities would be to treat the net deduction against general income and acknowledge that on distribution the tax preference will be clawed back under DCT or RDWT anyway. As the deduction would be at 30% (assuming a 30% entity tax rate) and the distribution taxed at the same 30% the net deduction is clawed back. This approach is no different to that which applied now for the inflation slice on existing capital gains, where deductions have been claimed.

SUMMARY

A proposal to radically alter CGT in such a way as to create enormous incentive for investment by, and for, all sectors of the economy will generate economic growth, employment, new businesses and revenue.

It will reward risk taking and attract capital to Australia.

By introducing a world best practice CGT regime – noting world best practice is in fact no CGT – Australia will greatly enhance its opportunities for the future.

This non-targeted, universal, low rate CGT proposal has the potential to provide those benefits and meet the criteria the RBT has established for business tax review.

I look forward to any opportunity to discuss further this measure.