The Labour Party, during the 2017 election, promoted a policy platform around tax reform, focussing on perceived fairness. Following a negative public reaction, especially to the spectre of a Capital Gains Tax (CGT), they promised no new taxes in their first term, but rather to go to the polls in 2020 with a fully legislated tax reform to be effective 1 April 2021.
History now shows that Labour were able to form a coalition Government with NZ First (with support from the Greens), so they were bound to a pathway of following through on their tax reform promise. The Tax Working Group (TWG) was formed under Sir Michael Cullen’s chairmanship to review the tax system, especially through this lens of fairness (perception that wealthy taxpayers were not being taxed on the same degree of economic income as others). However, the mandate was carefully limited to exclude certain aspects, like an inheritance tax and a capital gains tax on an individual’s main home.
The TWG issued its draft report in late 2018, but it was light on details and offered a range of potential options, which may be considered in the Final Report released to the public on 21st February 2019. The Government has had this report for a couple of weeks to formulate a response to it. It is a complicated matter best summarised by the TWG – “The Government does not face a binary choice regarding whether or not to extend capital gains taxation. There is a spectrum of choices for the coverage of assets, and the inclusion of each asset class will come with its own costs and benefits.” Initial comments from Government indicate a measured approach will be taken, albeit within a compressed timeframe.
Why Are We Debating This Again?
It does seem that we have had these discussions before and there have been several equivalents of the TWG in the past. However, there are two main drivers – perceived fairness of the current tax system in terms of the divide between low and upper wealth groups (with a common view that the wealthy pay proportionately not enough tax as the effective tax system, ignoring welfare payments, is flat in terms of international standards), and the mismatch of tax rules across income and asset classes (which can create economic or investment bias, plus potentially impact on Government fiscal revenue as more people retire to live off capital versus wages).
Whether the fairness argument actually stacks up once the welfare system’s transfer payments (e.g. Working for Families) are considered, as it has been suggested that many New Zealanders pay no or negative net taxes, is for the economists to debate. Fairness is a qualitative measure determined in the eyes of each individual and undoubtedly is influenced by their personal situations. Overall fairness is a balancing act.
One of the main proposals is extending the definition of income to include the sales of certain capital assets including shares, land (not family home), goodwill and other previously excluded assets. “This would involve a realisation-based tax that is applied to capital gains on a broad range of assets, at full rates, with no allowance for inflation.”
So is the main proposal a CGT?
Unlike what exists in many jurisdictions around the world, this proposal is NOT for the introduction of a CGT, per se. CGT is normally a separate tax regime/set of rules, that applies separately to income tax, and often has its own much lower rate of tax (as compared to the top marginal income tax rate).
The TWG’s main proposal is a recasting/extending of the definition of income under the existing income tax legislation so that income includes the proceeds of selling practically every main asset class except the family home. This means we move from only those in the business of selling these types of assets, or speculators, being caught, to ALL taxpayers being caught. A tax deduction will be allowed for the costs, or deemed cost, of the asset being sold. The key is that the net income earned from the sale of these assets is taxed at the taxpayer’s marginal income tax rate, up to 33% (as opposed to a lower, special CGT rate like 15%).
Most CGTs are a disposition-based tax, that is, a disposal is required to trigger a tax consequence. A disposal will occur no only when an asset is sold, but also on the owner’s death, a relationship property transfer and business reorganisations.
What Assets are Caught?
It is probably easier to list those not caught, being the family home (although the definition of this will cause some challenges), personal assets like jewellery, boats, artwork, and cars (if the taxpayer is not a trader in such things). Effectively all other physical (e.g. land) and intangible assets (e.g. business goodwill, intellectual property) are captured, including any secondary private homes such as holiday homes.
Disposition vs Accruals Basis?
Foreign shares and financial arrangements will retain existing accruals based regimes whereby “deemed” gains are taxed on an annual basis, but for other assets a “disposal” based regime will apply, effective from 1 April 2021. This means that as at that date, all assets need to have a market value ascribed to them. For listed shares and the likes where there are established markets, that is a simple task, but for other assets, Valuation Day may involve significant compliance costs, albeit there is a recommended 5-year timeframe to do this. Business goodwill and intangible assets are inherently difficult to value without a market transaction.
What is uncertain is how investors will respond to a different approach for NZ based shares (disposal basis, ringfenced losses) and foreign based shares (accruals based, with only 5% of their value subject to tax rather than the entire gain in value), as some commentators have suggested that there could be a movement of capital offshore as a consequence.
What about Losses?
The TWG recommends that capital losses be ring-fenced for portfolio investments in listed shares (other than when they are trading stock), associated party transactions, and losses from Valuation Day assets. The ability to claim a capital losses on privately used land (e.g. holiday homes) should be denied entirely. It also recommends that all other capital losses be treated in the same way as other tax losses, and taxpayers should generally be able to offset losses arising from the disposal of capital assets. The Valuation Day limitation is not as draconian as it could be, as denial of losses could have been proposed, as opposed to ringfencing. What is not as clear is what asset gains ringfenced losses will be able to be offset against in the future, but presumably it will be “capital assets” as defined.
The most emotive component of these proposals will undoubtedly be around the denial of any losses generated from holiday homes whereby any gains would be taxed. Holding costs are also non-deducible but improvements will be allowed as part of the “cost” base.
What is Rollover Relief?
rollover relief is where a disposition is ignored meaning any gain in disposal is not taxed and the purchaser effectively steps into the shoes of the seller (in terms of costs base, etc). The TWG recommends rollover treatment for certain life events (such as death and relationship separations), business reorganisations and small business reinvestment, however on a reasonably narrow basis. For example, initial recommendations are limited to spouses/de facto recipients, which would not appear to allow for rollover relief where the couple have held assets in trusts or companies. A possible surprise was the potential roll-over relief for small businesses (turnover under $5m) where they reinvest in similar assets within 12 months. This is a major concession. Intra-group reorganisations will also receive rollover relief, such as a sale of assets from a sole trader to a company owned by that person, where it can be concluded there is no underlying change in ownership.
Although not strictly rollover relief, there is also a recommended concession for small business sales upon retirement whereby the tax rate for the first $500,000 of capital gain (goodwill essentially) would be reduced from 33% to 28% (to mirror KiwiSaver outcomes).
Spreading the Burden or Lolly-Scramble?
Notwithstanding that the new regime will have a slow burn in terms of fiscal impact, it is signalled that it will, over time, generate significant tax revenue, which provides options around the mix of retention by Government to fund new budgetary items or replace potentially falling taxes on wages as age demographics change, or essentially redistributing/recycling the upside back to targeted groups such as low/middle income via moving income tax thresholds up and potentially refunding Employer Super Contribution Tax for those earning less than $48,000. Undoubtedly such will be dressed up in the form of “fairness,” but in effect it is politically also a means to an end to get popular support for the decided-upon proposals, but is equally dependent on the new rules funding such in due course.
Tax System and Environmental Matters?
The TWG acknowledged that tax has a role to play in respect to moderating environmental behaviours and ensuring negative externalities are at least partially funded by those who create and benefit from them. The report is light on detail but at a minimum acknowledges that the Emissions Trading Scheme and Waste Disposal Levy both need a rework. There was mention of taxing fertiliser to reduce usage. The logic seems consistent at first, but the impact on business will be somewhat dependent on whether they are price takers or price makers. The former will need to fully absorb additional costs. Interestingly, the Minister of the Environment has already professed a view that tax is not the best mechanism to effect such change.
There was also some discussion around taxing water rights, but this could not be contemplated in detail until disputes over ownership with Maori interests are resolved.
What else was Covered?
There were numerous recommendations around minor concessions for small business, mostly pertaining to automatic deduction thresholds and the likes. All of these should be welcomed as compliance cost savings, but there was also a strong signal that the TWG feels corporate structures are being used by small business to defer ultimate tax (28% corporate rate vs 33% top personal tax rate). Furthermore, they recommend positive changes around blackhole expenditure, a review of FBT, changes to provisional tax thresholds, and the introduction of taxpayer friendly disputes resolution services for smaller taxpayers. Another taxpayer friendly element was the suggestion that depreciation on buildings should be reintroduced, while the current tax loss rules may be reviewed to make them friendlier for early stage companies. The TWG has dismissed concessional tax rates for small business due to likely distortionary effects on taxpayer behaviour.
Where to from Here?
The report notes that the “Government could choose to extend the taxation of capital gains to some asset classes only. The Government also has options about how to stage the timing of introduction, whether to phase in asset classes, whether to grandparent some or all asset classes and whether to apply the deemed return method.” This is where the political rubber hits the electioneering road. Ministers Robertson and Nash have signalled that the Government will “take a measured approach” to determining their final policy view around what aspects will be adopted or otherwise. It is expected that the Government will release their full response in the form of a Discussion Document in April 2019 for consultation, but have recommitted to the timeline of having legislation in place before the next election; an ambitious target indeed.