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Frank Newman

Capital Gains Tax pitfalls and false prophets

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Over the last few weeks various economists and tax experts have been trying to predict the economic effects of Labour’s capital gains tax (CGT) proposal. What the experts do agree on is the best tax is one that is simple, has a broad base and few exemptions and incentives. A “good” tax should:

Reflect taxpayer’s ability to pay. (For this reason most taxes are levied when income is earned or realised, not on the change in notional values.)

Generate income for the government much greater than its cost to administer. (Hence the abolition of gift duty from 1 October this year.)

Have a low compliance cost to the taxpayer and be convenient to pay (e.g. income tax and GST).

Be hard for taxpayers to avoid. In other words, have few exemptions for lawyers and accountants to exploit, and

Not create distortions in economic behaviour.

When measured against these criteria Labour’s CGT proposal has been given the thumbs down, not because a capital gains tax as such is necessarily a bad idea in theory, but because it is unworkable in practice. In essence Labour’s CGT would tax:

Investment property.

Commercial property.


Assets in trust, when sold.

Rural property.

Inherited assets, when sold.

Farms, including non-family dwellings, machinery, stock.

The sale of intellectual property.

Gifts, other than inheritances.

The assets that would not be taxed are:

Family homes.

Collectibles; such as cars, jewellery, art.

Retirement savings like KiwiSaver.

Term deposits.

Small business exemption up to $250,000.

Lottery and gambling winnings.

Christchurch residential homes would be exempt for five years.

Maori land.

When Labour’s Finance spokesperson, David Cunliffe, was asked why the family home was exempt he replied that to include it was “politically unacceptable”.

Let’s be upfront about it – Labour’s CGT is a political strategy more than it is an economic policy. Anyone who has been around politicians for more than five minutes would not be surprised by that. What is surprising is that Labour thinks their CGT will improve their electoral chances, and the number of commentators who don’t see the CGT in its political context. Unfortunately the NZ economy has for many decades been tainted by politicians putting their own agendas above what’s best for the economy, and Labour’s CGT is a fine example of that.

Not surprisingly Labour does not want to talk about the detail behind their policy – “The key point for us is not to be dragged down into the detail on the CGT. The public don’t care and we get boring”, says Labour strategist and MP Trevor Mallard.

This probably explains why whenever they are asked a tough question the party faithful reply: “An Expert Panel will be established to deal with issues that are technical in nature and involve areas where a high degree of specialised knowledge is required before a final decision can be reached.”

Detail is important – it’s like the fine print on a contract – it’s the detail that actually matters because that’s where the fish-hooks are. Here are some of the issues Labour does not want to discuss in detail:

Exempting the family home will create what is called the “mansion effect”. Money flows into the area of lowest tax – which will be family homes. Less will go into shares and investment property. Someone with a spare $50,000 or so will instead put an extension on their home, knowing that when they retire they can sell their home and buy something smaller and cheaper and make what they expect to be a tidy tax free gain.

Some property investors may do likewise. Instead of pumping cash into their rental properties and putting up with the endless hassles of dealing with tenants, they will sell up and put all of the capital into a mansion so they can enjoy their capital and reap a tax free gain when they sell. Others will become recidivist home buyers and sellers. Buy, live in it for a while, sell and buy something better, sell and buy something better and so on.

As a consequence, a large amount of unproductive money will be invested in oversized homes and less money will be put in rental properties. Rents will rise and the taxpayer will have to provide more state houses instead of private landlords. Art collections would also be exempt so we could expect art to fill the cavernous vacant spaces of these over-sized mansions.

All assets subject to the CGT would have to be valued as at a specified (“V”) date. I recently completed an exercise valuing a two-bedroom unit in Whangarei. Three valuations were obtained. The values were: $192,000, $215,000 and $220,000. A $28,000 spread is significant, and this was a very basic very typical unit. Imagine the difficulties if the property is unique. Inevitably there will be all sorts of rackets and disputes involving valuations.

No adjustment will be made for inflation. As a result most of the taxable gains will be “illusory”. Inflation this year is expected to be 5.5%. Let’s say that results in the value of an investment property rising from say $300,000 to $316,500. At Labour’s 15% CGT rate the tax payable on sale would be $2,475 even though the “real” inflation adjusted value of the property has not changed. What’s fair about that? The more inflation the government creates, the greater the tax it will collect. That’s perverse.

Although all capital gains on the sale of investment property would be taxed Labour would retain the existing “intention” test (detailed shortly) so those who buy with the intention of selling would still be taxed at their marginal rate as though it were income. That would actually add to the confusion that already exists. Most countries with a CGT do not mix income and capital gains in this way.

These are just some of the problems with Labour’s CGT and have been widely discussed over many decades by various expert panels. For example, in 2001 the McLeod Committee concluded, “We do not consider that New Zealand should adopt a general realisations-based capital gains tax. We do not believe that such a tax would make our tax system fairer and more efficient, nor do we believe that it would lower tax avoidance or raise substantial revenue that could be used to reduce rates. Instead, such a tax would increase the complexity and costs of our system.”

One of the ironies in the debate is the lack of attention given to the fact that New Zealand already has a capital gains tax regime. Unfortunately its application is far from clear and therefore not widely understood.

Put very simply, a taxpayer is liable for income tax on capital gains if they deal or trade in an asset, or if they bought the investment with the intention of resale at a profit. If, on the other hand, they made the investment with the intention of providing a taxable income stream then capital profits, should any arise, would not be taxed.

Let’s take a hypothetical example of a young entrepreneur who sees how well ebay has done overseas and decides to replicate the service here in New Zealand. Let’s assume he has also seen how IT entrepreneurs in the US start-up then sell businesses and become fabulously and famously wealthy in the process. “Why not here?”, he thinks and enters into the venture with the intention of building the business and selling a few years down the track. He does so, with the help of some passive investors, and a few years later they pocket many hundreds of millions of dollars. Given those intentions, the capital gain would be treated as income, and income tax would be payable.

If on the other hand that entrepreneur says they started the business with the intention of holding for the long-term to reap the benefits of the substantial annual income BUT THEY JUST HAPPEND to sell it a few years later for a very large sum to a very willing buyer, then the gain on sale would not be taxed.

Intention, of course, is a state of mind. Only our young entrepreneur knows what his intention was when the investment was made but in tax law it is the IRD, not the taxpayer, who has the say on this matter. The IRD will attempt to determine intention by looking at the circumstances surrounding a transaction, and it is for the taxpayer to prove otherwise should they disagree with the IRD’s assessment.

Had the IRD determined that our young and now very wealthy IT entrepreneur intended to sell (perhaps from evidence of their past investment habits, how much equity they had in the business, whether they drew profits, the correspondence surrounding the transaction, and so on) then tax would be payable. Conceivably the young entrepreneur could say, “It is soooo unfair that I did not pay tax on the gain, so I hereby declare it was my intention to resell at a profit and therefore I would pay tax on my gain”. Usually taxpayers are not that obliging.

It is fair to say that many investors have conveniently not taken a lot of notice of this rule and blindly assumed gains to be non-taxable. Many property investors now know differently given that over the last few years the IRD has actively “reminded” them of their obligations and collected many hundreds of millions of dollars in additional tax revenue as a result.

Unfortunately the IRD tends to send these reminders to investors AFTER a boom has past. It would be more appropriate to do so during a boom, when investors would be in a better position to pay.

There is no doubt the current law regarding the taxation of gains on the resale of an asset should be clarified and simplified, if only because that lack of clarity puts the taxpayer at risk of an unexpected and potentially ruinous tax liability.

Labour, unfortunately, takes us further away from the clarity required, and worst of all has put politics before prosperity. Removing GST from fruit and vegetables is another example of a policy promoting what sounds good rather than what

will work in practice. While retailers may initially reduce prices to reflect the absence of GST (and when all eyes are on them to do so) there is no guarantee that over time the retail price would not increase to its former price point.

Perhaps our Labour MPs really are tax experts and know a lot more than those with a high degree of specialised knowledge who have already looked at and rejected a CGT. I don’t think so. If this country is to reverse the slow economic decline we need to wise up to the fact that the heavy handed interventions of our politicians are a dead weight on our economic future.