Martin Riley responds to last week’s article opposing a selective capital gains tax exemptions

I read with great interest the article last week opposing the introduction of a selective capital gains tax – “CGT: How it works and why it doesn’t.”

However, I feel that it only tells half the story and some of the issues raised can be easily addressed if the tax is well structured and well thought out.

The article acknowledges that certain capital assets are already subject to income tax by virtue of the complex tax rules relating to certain land transactions.  However, it fails to acknowledge that CGT is also effectively charged on:

• capital gains arising from investment in overseas equities;
• capital held in foreign currency bank accounts; and
• overseas mortgages.

 

The first of these is, in my opinion, an insidious tax that assumes overseas equities will grow at a rate of 5%.  The rules are complex and can often impose a tax charge on investments that derive no income.  Taxpayers may therefore be forced to sell investments in order to pay the tax unless they can finance the tax from other resources.

The taxation of overseas mortgages may come as a surprise to many readers and is the result of the complex tax rules relating to ‘financial arrangements’.  These were introduced in 1987 and are perfectly justifiable in many cases when applied to complex financial transactions such as interest rate swaps.

However, they also apply to New Zealanders who hold rental properties overseas with an associated overseas mortgage.  In those cases, no tax is charged on the capital gain on disposal of the property but there is a tax charge on any exchange gain on redemption of the mortgage.

What this has meant in recent years is that many taxpayers with UK rental properties have had to pay significant amounts of tax on an asset that has fallen in value.

On the other hand, if the exchange rate had gone the other way, they would have received a tax ‘bonus’ from the government when their assets had risen in value.  This simply defies logic but the reason for this inequity is the absence of a comprehensive CGT.

Family home exemption

The authors suggest the family home exemption would create further problems for policymakers.  In my opinion, there should be no major problems.

The UK exemption for principal private residences allows one residence per person or per married couple.  It also allows the trustees of a trust to claim exemption where the property is the main residence of one of the beneficiaries.

While the UK exemption is not perfect it would provide answers to most of the questions posed.  In particular:

If a person or married couple (or de facto couple) only to properties that could each qualify as a main residence they can elect which property will be exempt residence for tax purposes.

On the death of an owner, the property would pass into the owner’s estate at market value – so CGT would not become a form of death duty, as the authors suggest might be the case.  Of course, if the executors of the estate then rent out the property then any further increase in value (from the date of death) would be taxable which, in my opinion, would be fair.

Small businesses and farms

Some opponents of a CGT suggest it will inhibit business growth but this should not be the case because if a business asset is sold then the capital gain can be rolled over into the cost of a replacement asset.

In other words, if I sell a factory and purchase a larger factory then there would be no CGT payable at that time if all of the sales proceeds were reinvested.  This allows businesses to expand quite happily without any tax issues. Tax would effectively be deferred until the business asset is sold without being replaced – or possibly at the point of downsizing when cash would be available to pay any tax due.

A similar relief could be introduced to allow businesses to be gifted within the family and these reliefs would obviously applied to the farming sector so there should be no major concerns for the farming community.

A form of ‘retirement relief’ could be introduced to allow a person over a certain age, say, $1 million of tax-free capital gains on the sale of the business.  The combined effect of rollover relief and retirement relief would allow expansion of the business over a number of years and then a final disposal either free of CGT or at a heavily discounted tax rate.

These reliefs are no doubt what some critics are opposed to but their aim is to allow businesses to grow – businesses that would employ more people and help to expand the economy directly.  If ‘being selective’ means small businesses can grow without being hindered by CGT then a small amount of complexity would, in my opinion, be worthwhile to achieve that objective.

Distortion to the economy

Finally, returning to last week’s article, the authors suggest a senior Inland Revenue policy analyst in 2000 could not find any distortions to the New Zealand economy created by a lack of CGT.

It seems to me that time has moved on and most rental properties would not be acquired without the possibility of a tax-free capital gain on disposal.  Certainly, the decision whether to invest would be marginal if it was based purely on rental yield.  If that’s not a distortion to the economy and I’m not sure what is.

Fairness issue

In my opinion we need a CGT not necessarily to reduce ‘speculation’ but for reasons of fairness and to correct distortions in the economy.  I accept that a selective CGT with exemptions will introduce a degree of complexity but, with some careful thought, that could be managed and, in return, we could scrap some of the complex legislation that we already have – which includes:

• the inequitable financial arrangements legislation applied to overseas mortgages;
• the insidious legislation relating to overseas equities; and
• the need to determine a taxpayer’s state of mind when purchasing a capital asset.

No doubt the introduction of a CGT would be a seismic shift in the taxation system.  It would be a once-in-a-lifetime experience for all involved.  However, I believe it is a question of when and not if.

One day the government will need to bite the bullet – the question voters need to decide on September 20 is whether it will be the next government.

Martin Riley is a director of Sterling Tax Services.  He is a New Zealand chartered accountant and UK chartered tax adviser based in Christchurch and advises on UK and New Zealand tax.