CAPITAL GAINS TAXATION
A capital gain arises if the realisable value of an asset (something providing economic benefits beyond the current year) is more than the holder of the asset paid for it. Jim pays $1000 for an asset and if Jim could sell the asset for say $1100 the following year he has made a $100 capital gain over the year. If Jim could sell the asset for $1210 the year after that (perhaps because it is one year closer to the asset's first production of saleable product or because land forming part of the asset increases in value), a further capital gain of $110 has been made. These annual gains totalling $210, 'accrued' year by year while Jim continues to hold the asset, would be 'realised' should Jim actually sell the asset.
Similarly, a capital gain arises if the amount the holder of a liability (something imposing economic obligations beyond the current year) would be able to pay others to assume the liability is less than the holder's original up-front obligation. If Jim borrowed $1000 of fixed interest long term debt but because of rising interest rates would be able to pay someone just $900 the following year to take over the debt's fixed repayment obligations, Jim would have accrued a $100 capital gain on the debt over the year - a gain that would be realised if he actually did the deal.
Jim would accrue (and potentially realise) capital losses, rather than capital gains, if after acquisition the value of his asset fell or the value of his liability rose.
Capital gains (and losses) associated with investment activity are invariably treated very differently within the one country's income tax law - with the type of treatment often depending on such things as the type of asset/liability involved, the type of taxpayer involved and the holding period of the asset/liability. This variety of treatment adds to complexity, creates boundary lines that are difficult to administer and causes varying degrees of taxpayer confusion:
In the absence of a general CGT regime, a country's income tax laws will invariably be focussed on those capital gains that can be construed as forming regular 'income'.
CASE AGAINST PARTIAL TAXATION OF CAPITAL GAINSIf realised capital gains are only partly included in tax assessments just because the associated CGT assets are held for more than a year, pressure naturally arises for less and less of realised capital gain to be included in tax assessments the longer assets are held. Some simply argue that the capital gains tax impost should be reduced the the longer the holding of assets because capital gains are different from 'income'? Against this simplistic notion, however:
Much effort is put into determining annual depreciation allowances for accrued capital losses on a multitude of depreciating tangible assets. Similar effort could see accrued gains (as the mirror image of accrued losses on depreciable assets) incorporated into the tax base for the relatively few types of assets likely to increase in value - namely, property and shares and other financial assets. In particular, for accrued capital gains on land, direct annual valuation would often be possible as would comparisons with actual recent sales of similar properties. Annual estimates of property values are often already required for government land taxes. In relation to financial assets, market values of ownership interests in listed entities (like companies and trusts) would be known year by year. Good estimates of market value of ownership interests in unlisted entities would often be possible. For other financial assets/liabilities, value is known or good estimates of value can often be obtained from associated cash flows.
Taxing capital gains on accrual across the board - that is, gains subject to general CGT regimes and gains traditionally classed as regular income - opens up the exciting prospect of collapsing the confusing array of ways that capital gains are treated. Taxpayers' intentions when buying an asset, and the associated 'revenue account' versus 'capital account' distinction, would be irrelevant as would the time the asset was held. Gains and losses accrued year by year could all immediately be added to or subtracted from assessable income. The benchmark tax treatment would be achieved.
No doubt governments and their advisers continue to baulk at seeking to tax accrued gains across the board on the basis of arguments like taxpayers do not have the cash to pay taxes on accrued gains or the final sale value of assets like property or shares is not known up front. Nevertheless, even removing the common partial taxation of realised gains on CGT assets so that the full gain realised on sale was included in tax assessments would remove complexity and move the tax treatment closer to the ideal benchmark. The time taxpayers held assets would be irrelevant to tax treatment. Taxing on a realisations, rather than an accruals, basis would still be concessional relative to the benchmark and would therefore impose broader distortions in the flow of investment funds - as illustrated by the 42% effective tax rate of the appreciating asset in Figure 52, reflecting its 5.8% after-tax return relative to the 5.3% after-tax return available to the taxpayer (on a 47% tax rate) from financial markets. But greater simplicity and less confusion would be involved with benefits for both tax administration and compliance.
Nevertheless, taxing capital gains on realisation, rather than on accrual, inevitably imposes 'lock-in' effects and opens up arbitrage possibilities. The lock-in effect sees assets with gains being held longer and assets with losses being sold earlier than they would in the absence of tax - an effect that taxing capital gains upon accrual avoids because tax liability is then not affected by the period that assets are held. Auerbach (1991) proposes that such distortions of realisations-based capital gains taxation be addressed by designing the tax to be equivalent in effect to taxing gains as they accrue, even though tax would not be paid until disposal of assets. The general idea is for the tax on accrued gains of assets to be computed each year and then carried forward at an appropriate interest rate (reflecting the after-tax time value of money to the investor). The compounded tax liability would be paid on disposal of the assets. This design would also address arguments over lack of cash to pay taxes on accrued gains.
Despite the theoretical appeal of Auerbach's design, it would require all the work to be done in valuing assets each year but without tax being collected (though tax revenue would recover after a transitional period). It would also add complexity by requiring taxpayers to keep track of streams of compounding tax liabilities and its equivalence with accruals-based taxation would depend on governments' imposing a sufficiently high carry-forward interest rate (complexities associated with determining the ideal rate for investors aside). It could be that, for a government convinced of the advantages of taxing capital gains on accrual, actually taxing accrued gains when they arise each year has more appeal.
For assets whose capital gains a government does not wish to be taxed upon their accrual, the practical policy response is not to reduce tax on realised capital gains the longer those assets are held. That would exacerbate lock-in effects:
In contrast, as noted, taxing all rather than part of the capital gain realised on disposal of assets whose gains are not taxed on accrual would move the tax treatment closer to the ideal benchmark with reduced distortive effect. Thus, the price of the appreciating asset in Figure 52 might only increase from $1000 to $1098 with all its capital gain taxed on realisation (versus an increase to $2072 with no tax on capital gains, an increase to $1585 with half the realised capital gains taxed and no change in asset price with capital gains taxed upon accrual). Moreover, taxing all the realised capital gain meets the general objective of imposing tax once on all the economic income of investments, an objective that is particularly important when entities are included in the policy analysis. The single layer of tax applying in the context of an off-market share buyback - where the full amount of both realised capital gains and realised capital losses is included in the tax base - is a good illustration of the benefits of this objective. More generally, outcomes of investing via an entity or investing directly when the full capital gain is taxed upon realisation often give way to more distortive situations when only part of capital gains realised on asset disposal are taxed.
In summary, a practical long-term policy approach to the taxation of capital gains might entail:
As noted, typically, capital gains are classed as being either on 'revenue' account (ie the whole realised gain taxed as 'regular' income) or on 'capital' account (ie possibly only part of the realised gain taxed under a general CGT regime). Capital gains on 'revenue' and 'capital' account must be clearly distinguished from investment expenditures on 'revenue' and 'capital' account. The 'revenue' account label is accorded recurrent expenditure which attracts immediate write-off and the 'capital' account label accorded capital expenditure whose change in value over its period of use may be included in whole or part in tax assessments (eg via depreciation allowances or capital gains taxation arrangements). This 'revenue' versus 'capital' classification of expenditures, common in income tax systems, fits neatly within the framework of the ideal 'benchmark' income tax base:
Regardless of the degree to which gains or losses of assets/liabilities are accommodated on accrual within an income tax system, determining whether expenditure creates or adds to an asset, and therefore is capital expenditure, or is 'exhausted' in the current year is a central and unavoidable requirement of income taxation. In terms of cash flow analysis, for an investment to be considered viable, all expenditures over the life of the investment need to be sufficiently more than offset by revenues to result in a commercial rate of return. In practice, it is useful to think in terms of capital expenditures - expenditures on 'capital' account - that feed into the asset in question (like the $1000 up-front expenditure on Jim's orchard) needing to result in sufficient future net receipts (like those produced from Jim's orchard after 3-year's delay). As noted, those net receipts comprise annual gross receipts less recurrent expenditure (like selling costs and maintenance during production) - or expenditure on 'revenue' account - which is 'used up' in the year's production.
Thus, the distinction between capital or recurrent expenditure is a central one. In contrast, the distinction between, on the one hand, a realised capital gain which is to be included in assessable income in full - as regular income on 'revenue' account - and, on the other, a realised 'capital' account gain on a CGT asset to be included in part (or, potentially, in full) is an artificial construct borne out of the way most income tax laws developed historically, essentially starting from recurrent costs and revenues with change in value of assets (and liabilities) grafted on piecemeal over the years.
As noted, were all gains taxed on their accrual and the capital loss quarantining associated with realisation-based CGT regimes dropped, this artificial construct of classing capital gains as being on 'revenue' or 'capital' account would disappear.
Under the benchmark income tax treatment, capital losses in a year from investment activities would directly reduce taxpayers' assessable income in that year. Within general CGT provisions, typically and belatedly grafted onto existing 'income' tax laws to apply to specified asset types, a taxpayer's realised CGT losses can usually only reduce other CGT gains realised by the taxpayer. CGT losses can usually be carried forward indefinitely.
With typical CGT provisions not taxing gains of CGT assets when they accrue (and, in addition, often only partially taxing realised CGT gains), it is not surprising that realised CGT losses are usually required to be applied only against other CGT gains and not against 'regular' income from other sources. An interesting design question arises, however, in the common situation where less than the full realised CGT gain is taxed (say by excluding a percentage of the gain from tax or by excluding an inflationary 'slice' of the gain, comprising annual inflation applied to initial cost base). That design question is whether to apply CGT losses to CGT gains before or after the exclusion process is applied. The practical importance of the question is highlighted by taking the situation where a taxpayer in a particular year has realised a $100 CGT loss from one activity and has realised $200 of gross capital gains from other activities. Under each approach, the exclusion process involves either half capital gains being taxed or an indexed slice of $100 being excluded from the capital gains.
The potential for very different, and often distortive and unintended, outcomes from different design of CGT preferences can be avoided by at least taxing all the capital gain realised on the sale of CGT assets.
With an essentially nominal income tax system operating, there should be no question of going beyond CGT tax preferences in the form of taxing less than the full realised CGT gain through particular exclusion arrangements. For example, including only real gains and losses on CGT assets in the tax base (via additional annual deductions equal to start-year tax value of CGT assets times the annual inflation rate) would create considerable imbalance between the taxation of CGT assets and other assets taxed on a nominal basis. Any attempts at inflation-adjusting income should only be applied comprehensively not partially. In addition, this partial inflation adjustment would create the perverse situation where annual deductions would be allowed for the accrued loss in real value of CGT assets while gains on those assets might be taxed on realisation and then only partially.
CAPITAL GAINS WITH DEPRECIABLE ASSETS
Depreciating tangible assets usually attract annual tax depreciation as an estimated allowance for their annual accrued capital loss. Balancing adjustments on disposal of such an asset pick up any differences in the tax depreciation already allowed and the asset's loss in value over its period of use. Thus, long-accepted tax arrangements already deal with accrued capital losses of depreciable assets year by year. Nevertheless, two issues arise in relation to possible capital gains with such assets: applicability of CGT preferences on sale of depreciable assets; and CGT (and tax depreciation) arrangements for buildings (and structures) often treated as part of a composite asset including the associated land.
CGT preferences on sale of depreciable assets
Even though assets classed as depreciable are ultimately expected to decline to zero value, their value
might increase for a time and be reflected in a sale value higher than purchase price. If the full capital gain
realised on the sale of CGT assets were taxed, balancing adjustments for a depreciable asset sold for more than
purchase price would logically not only claw back all previously allowed tax depreciation but also include the realised
capital gain in assessable income. But if less than the full realised gain of CGT assets is taxed should that also be
the case with depreciable assets? Much complexity can avoided if the full capital gain realised on sale of depreciable assets is included in
tax balancing adjustments, regardless of the CGT treatment of CGT assets generally - as recommended in
Australia by the Review of Business Taxation (1999, pg 318). Instead of taxpayers having
to keep track of initial asset cost base plus costs of asset upgrades over the years of ownership, all that is required
on sale is the difference between start-year tax value and sale proceeds to add to or subtract from assessable income. Such simple treatment may also assist in achieving separation of buildings (and structures) from their
associated land for tax depreciation treatment consistent with other
depreciating tangible assets - by addressing concerns over tax revenue losses
were CGT preferences to apply to buildings with their typically long lives.
The general message for tax law design here is that the application of the principles underpinning the benchmark tax treatment of investments always requires the separate identification and valuation of individual assets and liabilities.
All annual accrued gains and losses on separately-identified assets and liabilities associated with investments feed into economic income on which people base their investment decisions. Taking a tax slice out of all economic income, including accrued gains, at the investor's tax rate would keep investment decision-making after tax in line with before-tax decisions.
Recognising that the general taxing of capital gains as they accrue is currently not generally acceptable, the following policy prescription sequence for capital gains taxation starts with changes whose implementation could be immediately achievable and ends with aspirational changes over the longer term leading to simpler, principle-based and less distortive income tax arrangements:
Version 1.2 © Copyright Wayne Mayo 2010