Tax Working Group faces complex CGT challenge
Members of the Government's Tax Working Group have outlined the challenges in NZ in pursuing a Capital Gains Tax. Bell Gully's Mathew McKay and Hayden Roberts report.
A Gapital Gains Tax has been hotly debated since the release of the Tax Working Group’s Interim Report on the Future of Tax.
That report didn’t offer any recommendation on such a tax, which will be the most keenly anticipated element of its final report in February next year.
What is becoming increasingly clear is just how challenging it would be to work through the mechanics of a Capital Gains Tax if the final report does endorse extending the taxation of capital.
Bell Gully recently hosted two members of the Tax Working Group, Joanne Hodge and Robin Oliver, who offered our clients insight into the issues being grappled with by the group.
Oliver spelled out exactly how daunting a task of implementing any Capital Gains Tax would be, in the timeframe required, if such a tax is recommended and pursued. The Government has said any significant decisions on tax changes will not take effect until the 2021 tax year, but a timeline released by the Labour Party indicates legislation would need to be introduced in September next year to be enacted by July 2020. That timing will allow the mandate to implement the changes to be tested in the next election.
He said he personally had been surprised at just how significant the issues are around introducing a comprehensive Capital Gains Tax. While the group had certainly recognised it would be a major tax reform, there are numerous examples of the implementation of such taxes elsewhere, notably in Australia and Canada.
Yet there is a key difference. Australia adopted a Capital Gains Tax in 1985, at the beginning of an extensive tax reform process. In New Zealand, there has already been 20 years of tax reform based on not having a Capital Gains Tax. The group will have just months to consider how to redesign a system that has emerged from those many years of reform. “The issues are fairly radical,” Oliver told our clients.
So, while the group has outlined a number of those issues, it hasn’t yet reached conclusions on all of them.
A close look at asset valuation, just one element required by a transition into a Capital Gains Tax system, captures the magnitude of the task. In Australia, if a taxpayer owned an asset before the adoption of the Australian CGT in 1985, they were not taxed on it. In Canada, and most other economies that feature CGTs, a particular date was established at which valuations were set. On balance, the Tax Working Group favoured the specific valuation date approach – being 1 April 2021 in order to meet Labour’s intended introduction date. At that date there would need to be a valuation of every asset in the country that is within scope of the CGT. To do so would be “challenging”, said Oliver.
The interim report itself describes two alternative ways to implement a CGT in New Zealand, pointing to key areas of complexity.
The first is a traditional CGT, which taxes the actual return on the sale of an asset. The second is the risk-free rate of return method, which 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 included in the taxpayer’s taxable income for the year and taxed at their marginal rate (with the income that is actually earned from the asset ignored for tax purposes). For example, say the risk-free rate was 2% and the taxpayer’s marginal rate 33%, the tax on the value of the asset each year would be 0.66% (on an asset worth $1 million, tax in that year would be $6,600).
The main advantages of a risk-free return method are that it is simple to apply, offers certainty of cash flows for the government, and does not cause a ‘lock-in’ effect (where assets can be held for longer than is economically efficient in order to avoid the tax at the point of sale). The difficulties under the method relate to the establishment of market values for certain asset types, and the taxpayer’s ability to actually pay the tax without having yet realised the gains from a sale.
Both the traditional capital gains method and the risk-free rate of return method have a number of things in common. Gains (or deemed gains) will be taxed at the taxpayer’s marginal income tax rate. The family home will be excluded, as will personal property such as boats, cars, household items, high value jewellery, art, and collectables. That means for individuals the tax would largely be levied on land and shares, while for businesses it would be directed at business assets and premises (including farms).
Regardless of the method, it is already apparent that there will need to be significant complexity in any such tax to ensure fair outcomes across the tax base, in a way that doesn’t upset existing, well-functioning regimes based on the historic distinction between income and capital in New Zealand’s tax system.
The report itself highlights this complexity in the application of a capital gains tax to KiwiSaver and Portfolio Investment Entities (PIEs). Most KiwiSaver schemes take the form of multi-rate PIEs (MRPIEs). While there are a number of features in the MRPIE tax regime the group would not want to see disturbed by any new rules, a CGT would affect MRPIEs that invest in property, or Australasian shares. An individual would be subject to a tax on those asset types, so it follows that the MRPIEs should similarly be taxed.
However, these are open-ended funds into which investors come and go. That means a fund would have to allocate gains and losses to an individual investor by taking into account the change in value during the time that investor was actually involved in the fund. It would require detailed record-keeping, as well as various adjustments for gains and losses already recognised due to redemptions from the fund. And while that’s not simple, it’s even more complex in reality. This is because units are issued and redeemed on a daily basis, MRPIEs often invest in other MRPIEs, and a retail KiwiSaver scheme may invest in a wholesale PIE that in turn invests in a specialist PIE.
The interim report highlights that the group will need to give further consideration to the choices and trade-offs around retirement savings in its final report.
Clearly there is a lot of work left in developing the core features of what a CGT might look like in New Zealand in a limited amount of time. Many of these features are now open to debate through public submission.
However, it may be the complexity of imposing a simple sounding tax on our established (and generally well regarded) tax systems that will ultimately determine the political appetite to pursue a CGT past the point of recommendation.
Mathew McKay is a partner, and Hayden Roberts, senior associate at Bell Gully, a Foundation Supporter of Newsroom.