The Tax Working Group has released its Interim Report on the Future of Tax. Amongst a number of other matters, the Interim Report describes two alternative methods for the implementation of a capital gains tax in New Zealand, which will be the subject of further consideration over the coming months.
The terms of reference for the Tax Working Group include scope for the consideration of a capital gains tax on land and other capital assets, with the express exclusion of the family home. The Interim Report describes two areas of potential complexity and interest concerning the introduction of a capital gains tax, both of which will be the subject of further consideration by the Tax Working Group before the Final Report is released in February 2019. The first concerns how to tax capital gains, and the second considers the issues that such taxation would raise in relation to KiwiSaver and portfolio investment entities ("PIEs").
Two alternative methods for taxing capital gains
The Interim Report describes two alternative ways of taxing capital gains.
The first is the traditional capital gains taxation model which brings to tax the actual return on the disposal (or deemed disposal on certain trigger events) of an asset. The other is to tax an imputed risk-free return on capital assets, similar in principle to the existing fair dividend rate method for taxing certain foreign equities. As well as the family home exclusion, the Interim Report indicates that personal property (boats, cars and household durables) will be excluded from the scope of the tax as evidence suggests they generally decline in value. Further, higher value jewellery, fine art and other collectibles are proposed to be excluded for reasons of simplicity and compliance cost reduction. The tax base for individuals would therefore largely comprise land and shares, while for businesses it would include business assets and premises (including farms).
The consideration of the latter option is, at this stage, high level. The proposal is not new – the 2001 McLeod review had previously recommended this option for further consideration, and it formed the basis of one of the taxation policies of The Opportunities Party in the 2017 general election.
Broadly, the risk-free return method would involve the calculation of the total income generated by an asset by applying a risk-free nominal rate of return. The amount calculated would then be taxed at the taxpayer’s marginal rate (with the income that is actually earned from the asset ignored for tax purposes). The main advantages of this method include the absence of a ‘lock-in’ effect, its simplicity and the certainty of cash flows for the government. Difficulties associated with this method are acknowledged, in particular issues relating to the establishment of market values for certain asset classes, as well as issues with public perception and the ability to actually pay the tax without having realised gains on sale. Under this method, expenses associated with earnings from the asset would be ignored for tax purposes, as the method would replace the existing taxation of income from the asset – such as rental income. Although discussion of this method in the Interim Report is limited, we should expect further thinking around the possibility of taxing capital income on this basis before the release of the Final Report.
Whichever approach is adopted, gains will be taxed at the taxpayer’s marginal rate on traditional income.
Issues with KiwiSaver and PIEs
A further area of interest relates to the application of any proposed capital gains tax to KiwiSaver and PIEs.
The Report notes that there are features of the multi-rate PIE ("MRPIE") regime (the form of most KiwiSaver schemes) that should not be disturbed by the new rules, including the imposition of one level of tax and the imposition of tax at portfolio investor rates. In the absence of specific exclusions, a capital gains tax would affect MRPIEs investing in property and/or Australasian shares, as gains from the sale of these assets would become taxable. This is because it is proposed that in relation to interests in Australian listed companies not subject to the foreign investment fund regime, realised gains and losses should simply be taxed in the same way as is proposed for other assets.
The issue arises for MRPIEs partly due to the open-ended nature of the funds and partly due to the tax benefits they provide. A key example of this complexity concerns the need to allocate realised gains and losses to investors taking into account the movement in value during the time that the relevant investor was actually involved in the MRPIE. This would require detailed record-keeping on the part of the MRPIE, and various adjustments for gains and losses already recognised due to redemptions.
A further point to note is the effect for investors of a capital gains tax imposed on a realisation basis – that is, the discrepancy between pre-tax and post-tax investment proceeds could be greater. It is recognised in the Interim Report that further consideration will need to be given to the interaction between the treatment of capital income and trade-offs around retirement savings.
Other design features
Other points addressed in relation to the design of a potential capital gains tax include the following:
An outline of principles used to define the concept of the family home for the purposes of its exclusion from the tax base. This includes suggestion that this exemption is only available to taxpayers that are resident in New Zealand for tax purposes under a double tax agreement.
An indication that where a property moves in/out of the tax base there will be a deemed sale for market value at the point that it becomes an excluded home (such that a taxable gain arises at this point), or where it ceases to be an excluded home (such that a cost price is established), as applicable.
The Tax Working Group has proposed that if New Zealand introduces a capital gains tax, it should be imposed on a realisation rather than an accrual basis in most cases. It is not currently intended that the tax will account for inflation on the bases that there is no inflation adjustment for any other forms of income, and the lack of inflation adjustment should be counteracted by the deferral of tax.
The potential for roll-over relief to defer taxation on realisations of capital assets in certain circumstances. While the Tax Working Group is still developing roll-over relief principles, current thinking is that such relief should be provided where there is a change in ownership of the asset in a legal, but not realistic, sense. Two examples include where there has been no change in ownership in substance (such as where the change in legal ownership reflects the fact that a recipient partner always had an ownership interest in the property), or where there has been a change in ownership that has not given rise to a gain to the vendor (for example, where land is compulsorily acquired). The breadth of the application of these principles is still being considered.
In terms of transitional rules, the Tax Working Group favours a "valuation day" approach, as opposed to the application of the tax only to assets acquired after a certain day (as was the case for Australia). While representing a significant administrative burden, a valuation date approach has the benefit of disincentivising taxpayers from continuing to hold their pre-capital gains tax enactment property in order to take advantage of the transitional rules.
There is clearly a lot of water to go under the bridge to develop core design features of what a capital gains tax might look like in New Zealand. The Interim Report is leaving many design features open for debate through public submission. What is apparent already is the significant complexity that would be involved in such a tax to ensure equitable outcomes across the tax base in a way that does not upset existing and well-functioning regimes that have already adopted policy positions based on the tradition income/capital distinction.
That complexity will no doubt influence whether there is political appetite to pursue a capital gains tax beyond any recommendations in the Final Report.
If you would like to discuss The Tax Working Group’s Interim Report and its potential relevance to you or your business, please contact the lawyers featured or your usual Bell Gully adviser.