House of Representatives

Income Tax Assessment Amendment (Capital Gains) Bill 1986

Income Tax Assessment Amendment (Capital Gains) Act 1986

Second Reading Speech

by The Treasurer, The Hon. Paul Keating, MP

Capital Gains Tax

This legislation will enact a fundamental reform to the Australian Taxation System.

It will make the tax system much fairer by smashing the basis of much of the rampant tax avoidance that occurred under our predecessors.

And it will make the tax system much more efficient by encouraging investment that will generate growth and jobs.

For years a debate on this issue has dragged on in this country - a debate which unfortunately has too often been characterised by misinformation and hysteria rather than rational discussion.

This government invited discussion on a Capital Gains Tax at the National Taxation Summit in July 1985.

We listened carefully to the views of the Australian people as expressed at that meeting, and the design of the tax reflects those views.

Capital Gains contribute to taxable capacity no less than wages and salaries, interest and dividends, and business trading profits. It has been particularly inequitable that those who receive their income primarily or wholly in forms such as wages and salaries have been taxed more heavily than those who have been able to arrange for much or all of their income to be taken in the form of Capital Gains.

The absence of a Capital Gains Tax has also undermined the intended progressivity of the tax system since the distribution of the ownership of capital is more heavily concentrated among the higher income groups.

In addition, it has been at the core of many tax avoidance arrangements involving the conversion or dressing up of income as Capital Gains. The introduction of a Capital Gains Tax therefore strikes at one of the foundations of tax avoidance in Australia, and makes a crucial contribution oe the government's efforts to stamp out tax avoidance practices.

The lack of a Capital Gains Tax has also distorted investment choices towards less productive uses. Decisions to invest have been determined, not only by the overall yield of a project, but also by the composition of that yield as between Tax Free Capital Gains and Assessable Income.

This has produced an inappropriate pattern of investment, preventing Australia from achieving the best possible economic growth rate. Australia is a capital scarce nation - the last thing it should be doing is providing incorrect signals to the market as to how to allocate that capital.

By ameliorating this distortion, the Capital Gains Tax will help to improve the overall productiveness with which capital is invested in Australia, improving our international competitiveness and lifting our economic growth rate. The design of the Capital Gains Tax introduced by this Bill follows that announced in my 19 September 1985 Statement on tax reform, as expanded upon in press releases which I issued on 28 November 1985 and 20 March 1986.

I now turn to the main features of the Bill.

Plan of the Tax

The tax will apply only to Capital Gains realised on assets acquired after 19 September 1985. Accordingly, assets acquired by taxpayers on or prior to that date will be exempt from the tax when disposed of by them. This will substantially reduce the immediate impact of the tax and allow the community a lengthy period in which to adjust to its application.

Except where assets are acquired and disposed of within 12 months, the tax will apply only to real Capital Gains realised on the disposal of assets - that is to any gain remaining after removing the purely inflationary element. To achieve this, the cost base of assets will be regularly indexed according to the movement in the consumer price index over the time from when the expenditure was incurred to the date of disposal.

This means that an asset which increases in value at no more than the rate of inflation will bear no Capital Gains Tax. Assets whose value increases at more than the rate of inflation will be taxed only on that part of the gain which exceeds the inflation rate.

Any real Capital Gain realised on an asset will be included in assessable income in the year of receipt and subject to income tax, but will receive the benefit of averaging. Under the system of averaging adopted, a Capital Gain realised in any year will be notionally spread over 5 years for purposes of determining the rate of income tax applicable to the whole of the gain in that year.

Currently gains on assets are taxed if they fall within either Section 25A or Section 26AAA of the Income Tax Assessment Act. The former section will cease to apply for assets acquired after 19 September 1985 but Section 26AAA, which deals with gains on assets bought and sold within twelve months, will continue to apply, where relevant.

Consistent with the equity and anti-avoidance objectives of the tax, gains on the foreign assets of Australian residents, as well as gains on their Australian assets, are to be included in the Capital Gains Tax Base. However, relief from double taxation will be provided for any foreign tax levied on gains on foreign assets subject to the tax.

One design feature of the Capital Gains tax requiring elaboration is its application to non-residents. Consistent with the principle that non-residents are subject to income tax on their Australian source income, the government has decided that non-residents are to be taxed on a substantial range of Capital Gains.

Broadly, the following assets owned by non-residents are to be included within the Capital Gains Tax Base:

any asset used in carrying on a trade or business in Australia;
land and buildings, and specified interests in land, situated in Australia;
shares in Australian resident public companies or units in resident unit trusts, where the non-resident or his or her associates had at least a 10 per cent interest in the company or unit trust; and
shares in Australian resident private companies and interests in resident partnerships and trusts.

Because of the 10 per cent threshold test applying in relation to shares held in Australian public companies, it can be expected that the tax generally will not apply to purely portfolio holdings of Australian shares by non-residents.

Where arrangements apply for the crediting of Australian Capital Gains Tax against the non-resident's liability in his country of residence, the total tax burden will increase only to the extent, if any, that the rate of Australian tax exceeds that in the foreign country. This point is important to bear in mind when assessing the implications of the tax for the attractiveness of new foreign investment in Australia.

Where crediting arrangements apply, failure to tax non-residents on their Australian source Capital Gains generally simply results in us giving up revenue for the benefit of foreign treasuries.

An important general design feature of the tax is that the death of an asset holder will not be taken to give rise to a realisation of his or her assets for capital gains tax purposes.

An exception applies where the beneficiary receiving the assets is exempt from income and capital gains tax to ensuei that any gain accruing over the period that the deceased held the assets does not disappear entirely from the tax base.

With certain exceptions - broadly, personal use assets and assets subject to income tax depreciation and balancing adjustments - nominal capital losses on the disposal of assets will be able to be offset against capital gains of the current or subsequent years.

In calculating a gain or loss, any capital expenditures associated with the acquisition, improvement or disposal of an asset will be taken into account.

Exemptions and Rollovers

Honourable members will recall some exclusions from the tax that have been announced previously. The most important exemption relates to gains on the taxpayer's principal residence.

Also exempt is 20 per cent of the otherwise taxable capital gains on the sale of business goodwill wholly created by a taxpayer, where the net value of the taxpayer's business interests is less than one million dollars. Other exemptions include gains made by bodies exempt from income tax, the proceeds of life insurance and superannuation policies, gains on certain motor vehicles, and gains on most kinds of personal use assets whose disposal value is less than $5,000.

Rollovers - that is, deferral of capital gains tax liability - are to be allowed for asset ownership changes associated with specified types of business reorganisations where no change occurs in the underlying ownership of the asset concerned or where the underlying assets against which the taxpayer has a claim do not change.

The specific situations provided for include, for example, transfers of assets between companies in the same group, provided the companies share 100 per cent common ownership.

The Government has considered the view that more general rollover relief should be available for business reorganisations on the argument that not to do so could inhibit desirable business behaviour.

It has rejected this argument on equity grounds. Taken to its logical conclusion it is virtually akin to saying that it is only the capital gains of individuals not operating businesses which should be subject to the tax.

Rollovers are also provided for certain involuntary asset disposals. These include the compulsory acquisition of assets by a Government body and the theft or destruction of assets, where replacement assets are acquired within a stipulated period. In addition, in order to avoid the possibility of undue financial hardship, rollovers will apply for asset transfers between spouses incident to the breakdown of legal marriages.

The Bill also generally provides for the continuation of capital gains tax exempt status where an asset acquired prior to 20 September 1985 is transferred in circumstances where it would have qualified for a rollover if acquired after that date.

Additional Matters

The Bill will give effect to the Government's decision to treat as new assets subject to capital gains tax major capital improvements made after 19 September 1985 to assets acquired on or before that date. A major capital improvement will be taken to have occurred where the indexed cost base of the improvements at the year of disposal exceeds both an indexed specified value - $50,000 for the year ending 30 June 1986 - and 5 per cent of the asset's disposal value.

To leave such major improvements outside of the capital gains tax base would significantly distort investment decisions as between the improvement of existing assets and the purchase of new assets.

The Bill also provides for the capital gains tax treatment of trusts to parallel their income tax treatment.

This will mean, for example, that where a beneficiary in a private trust or a unitholder in a public unit trust is presently entitled to a capital gain made by the trust, it will be taxed in the beneficiary's or unitholder's hands. Where this is not the case, it will be taxed in the trustee's hands.

Capital gains tax will also apply to units held in untc trusts, where the units were acquired after 19 September 1985.

Leases and leasehold improvements are to be treated as assets subject to capital gains tax.

Special provisions are to apply where a leasehold interest in land is converted to freehold after 19 September 1985. Where the lease was acquired after that date, capital gains tax is not to apply until the freehold is disposed of.

Where the lease was acquired on or before that date, and had a term of at least 99 years, the tax will not apply to the disposal of either the leasehold or freehold interest. Where the term was less than 99 years, the tax will only apply to any real gain accruing on the land from the time of its conversion to freehold.

Also subject to capital gains tax will be payments for the surrender of various rights. An example would be payments under restrictive covenants whereby the recipient undertakes not to use specified assets or to trade only with the other party to the agreement.

Such rights are assets and gains made on their disposal are to be included within the capital gains tax base where they are not already subject to income tax.

The basic design features of the capital gains tax will apply to mining exploration and production rights. Their application is further explained in a press release being issued this evening.

The Bill contains a number of specific anti-avoidance provisions. The general anti-avoidance provision of the Income Tax Assessment Act, Part IVA, will also, of course, have application. The tax will be assessed annually as part of the normal Income Tax Assessment process and the existine Income Tax penalty provisions will apply for breaches of the law in the capital gains tax area.

Finally, I would emphasise that, in designing the capital gains tax, the government has taken great care to ensure that it will not impact unfairly.

The restriction of the tax to assets acquired after 19 September 1985, the exemption for the principal residence, the concessional treatment of personal use assets including motor vehicles, and the non-taxation of inflationary gains, mean that, for most taxpayers, the tax will have little or no impact.

Groups such as farmers and small businessmen who have expressed concern that a capital gains tax would be unduly harsh and lead to the break up or sale of the family farm or business upon their death have no foundation for such concern.

The exemption for pre-20 September 1985 assets means that there will be no tax liability for farmers and small businessmen in respect of their asset holdings as at 19 September 1985.

Further, the exemption for the principal residence and reasonable curtilage, the tax-free transfer of assets upon death and full indexation of gains for inflation, will mean that the vast majority of those who acquire farms or small businesses after that date are unlikely to face a substantial liability when they dispose of their assets. The availability of averaging provides further protection to taxpayers.

Employee Share Acquisition Schemes

As a consequence of the introduction of the capital gains tax, amendments are also to be made to those provisions of the Income Tax Law that relate to the taxing of benefits associated with shares and share rights acquired under employee share acquisition schemes.

Under the existing law, shares acquired under such schemes and subject to conditions or restrictions on disposal are taken to have been acquired when those conditions or restrictions cease to apply.

The excess of the value of the shares at that time over their cost to the employee is subject to income tax. The result is that any unrealised nominal capital gain accrued between the date of issue and the date when the conditions or restrictions cease is subject to tax, as well as the "Fringe Benefit" element represented by the excess of the market value of the shares at their date of issue over their cost to the employee.

In relation to share rights, the present law subjects to tax - when the rights are either disposed of or are exercised to acquire shares - the excess of the sale price or the value of the shares, as the case may be, over their cost of acquisition to the employee.

Here also, an unrealised capital gain may be subject to income tax, in addition to any "Fringe Benefit" element.

In respect of shares or rights issued after 19 September 1985, the Bill will give taxpayers the option of being taxed on the benefit derived as calculated at the date of issue, rather than at the relevant later date.

Where that option is exercised by the taxpayer, the acquisition cost of the shares or rights for capital gains tax purposes will be taken to be their market value at the date of issue.

Financial Impact

The estimated net revenue gain from the introduction of the capital gains tax and modifications to the employee share benefit provisions is $5 million in 1987-88 and $25 million in the fifth year of operation of the capital gains tax.

This Bill marks another important step towards a fairer tax system. In revenue terms its direct yield is modest but it will make a significant contribution to protection of the income tax base.

A detailed explanatory memorandum is being made available shortly to Honourable Members

I commend the Bill to the House.