Shares, Tax and YOU!!!

  1. Yak
    13,672 Posts.
    Not my work but a very useful read indeed:

    Gimme shelter
    Author: Tony Rumble
    Date: May, 2002
    Publication: Shares (subscribe)
    Tax, like art, is often thought to be one of those ephemeral things where beauty is in the eye of the beholder. The reality is not so obscure: although there is certainly huge (and often hidden) complexity in taxation, there are some clear and well-established rules about taxes and investments that should always be remembered:

    Tax deductions for interest expenses are the natural by-product of an income tax system, and so long as the investment that is bought with borrowed money produces income, the tax deductions are properly available to the investor.
    Franking credits represent tax already paid by the company the shareholder has invested in, and dividends received with franking attached are a well-established means of generating what is in effect tax-free income.
    It is natural to seek to maximise investment returns and to minimise risk, and using a financial product as a convenient way of obtaining this investment profile is normally a prudent and legitimate investment approach.

    It is worth recalling the words of caution in last month's article: although using many share-based structured products as simple tax-effective investments is within the tax rules, artificial or contrived products with no clear commercial benefits are frowned upon by the Australian Taxation Office. Investors should look for investment products that are accompanied by clear and positive tax opinions, covering the obvious issues such as deductibility of any interest payments, franking credits, capital gains tax and anti-avoidance rules.

    Tax office product rulings are normally irrelevant for share-based structured products and are not normally sought or obtained for financial products, since these rulings are primarily designed for speculative products where the tax office is simply expressing its view on the factual basis of the scheme. (Is the project properly funded so as to allow the promoter to carry it out sufficiently well, to at least allow the prospect of income being generated in later years?)

    For example, product rulings look at agricultural project economics to see if there is sufficient water and cash to water, grow and maintain plantations. In contrast, share-based structured products, which have real dividend income flowing from them, will typically not involve the type of speculation product rulings are designed to deal with.

    In the first part of this article (in last month's edition of Leverage) we looked at the basic tax rules relating to equity and derivative investments, as well as the new tax rules that allow for refunds where an investor has excess franking credits. We also looked at specific tax benefits available to structured equity products such as instalment warrants. This month we discuss the new tax rules for discount capital gains taxes, and describe in detail the growing range of tax anti-avoidance rules that operate in this area.

    Discount CGT rules

    Capital gains taxes are a strong impediment to long-term wealth creation, and as a result they are gradually being reduced in major Western economies. One of the most popular and progressive reforms introduced by the Government following the recommendations of the Ralph review of business taxation was the huge reduction in CGT rates for assets held for more than 12 months.

    Under these new rules, individuals and trusts now pay CGT on only half the profit made on the sale of an asset, while superannuation funds pay CGT on two-thirds of profits. Of course, these rules only apply where the taxpayer is subject to CGT in the first place: for example, share traders who pay ordinary income tax (and not CGT) will not be able to use the discount CGT rules. In practice, typical share investors and superannuation funds are eligible for discount CGT treatment.

    The basic operation of the CGT rules is that a capital gain will arise if the net proceeds from the disposal of the asset exceed its cost base, which is basically the cash amount paid to acquire the asset. If the net proceeds are less than the cost base then a capital loss will arise. Before the introduction of discount CGT, asset prices were adjusted to reflect inflation, but this CGT indexation has been removed for assets bought after the rules were introduced.

    For taxpayers who acquired assets at or before 11:45am on September 21, 1999, and have held them for 12 months or more before disposal, the capital gain on disposal may be calculated by:
    The cost base indexed to September 30, 1999; or
    The CGT discount method.

    For taxpayers who acquired assets after 11:45am on September 21, the capital gain on disposal must be calculated using the CGT discount method, and indexation will not apply.

    Under the CGT discount method, individuals (including beneficiaries of trusts) are required to include in their assessable income half of the nominal gain realised on disposal of an asset that has been held for more than 12 months. The trustee of a superannuation fund is required to include in assessable income two-thirds of the nominal gain realised on disposal of an asset that has been held for more than 12 months.

    It is easy to calculate CGT for simple assets like shares that have been bought and sold after 12 months. Financial products such as instalments are also easy to analyse by recalling that they are simply investments in the underlying shares, with borrowed money being used to finance the investment. In the case of instalments, for CGT purposes the underlying share is taken to be purchased at the date of investment in the instalment.

    For example, an investor who acquired an instalment over a share for $5 and paid a final instalment of $5 (excluding any interest) would have a CGT cost base for that share of $10. If the instalment is held for more than 12 months, the share the investor receives on paying the final instalment is eligible for discount CGT treatment. In this example, if the investor disposes of the share for $16, assuming there are no incidental costs of disposal, the nominal gain is $6. If the investor sells the instalment prior to maturity, once again the investor will be eligible for discount CGT treatment, as long as it has been held for at least 12 months.

    Superannuation fund: If the CGT discount method is used, the discount is one-third of nominal gains. Therefore the superannuation fund investor would be taxed on a discount capital gain of $4.

    Individual: If the CGT discount method is used, there is a 50 per cent nominal gain, so the individual investor would be taxed on a discount capital gain of $3.

    Company: A company is not entitled to the discount capital gain, hence the company investor would be taxed on a capital gain of $6.

    Anti-avoidance rules

    Australia's anti-avoidance tax laws range from rules targeting special situations to the general provisions of Part IVA. Part IVA has been the subject of a wave of media and tax office hype that has clouded its operation. The idea of Part IVA is that it applies to situations where there is no real prospect of commercial gain or to transactions that are artificial or contrived and have no prospect of gain.

    The simplest way to think about Part IVA is to remember it applies to situations where the taxpayer's dominant purpose is to generate a tax benefit. Where the investment is in shares or simple financial products like instalments, with real dividend income flowing from them, it is clear the dominant purpose is to generate that income (and ultimately profit from sale of the asset). In this case, tax benefits such as deductions for interest expenses will normally be secondary to income-producing purpose, and Part IVA will not apply.

    Part IVA in detail

    The general anti-avoidance provisions of Part IVA deal with the generation of deductions and the non-inclusion of amounts in assessable income of a taxpayer. Part IVA will apply to investments where a taxpayer enters into a scheme or transaction with the dominant purpose of obtaining a tax benefit.

    Tax benefit is defined as either:

    (a) An amount not being included in assessable income where that amount would otherwise have reasonably been expected to be included in assessable income in the absence of the scheme; or
    (b) A deduction being allowed by virtue of entering into the scheme, which might reasonably have been expected to have not otherwise been allowable.

    Part IVA sets out the matters relevant to determining of the dominant purpose of a scheme. The main ones are:

    (1) The way in which the scheme was entered into;
    (2) The form and substance of the scheme;
    (3) The time at which the scheme was entered into and the length of the arrangement;
    (4) The tax benefits flowing from entering into the scheme; and
    (5) Any change in the financial position of the taxpayer or a person associated with the taxpayer.

    For practical purposes, investments where there is a real financial cost to the investor and that generate income are usually outside the scope of Part IVA.

    Tax shelter rules

    Following exhaustive appraisal by the review of business taxation, the basic concept of negative gearing remains intact as a core principle of our tax system. Negative gearing is simply the reality that expenses involved in the acquisition of income-producing assets are tax-deductible because the income from the asset is taxable. In typical cases, expenses incurred for investments will be less than the resulting income, at least in the early years of the investment. The problem for the tax office is that in some cases income may only arise well after expenses have been incurred (or in some cases no income arises).

    In recent years, there has been a flood of anti-avoidance rules introduced to deal with speculative investments. Many of these target deductions claimed for interest on borrowings used to fund investment in speculative agricultural or film schemes. In many cases these schemes do not produce income unless some future event occurs, such as the film making money at the box office or the agricultural commodity achieving sales prices above today's levels.

    Most of these anti-avoidance rules are aimed at investments for which upfront deductions are claimed with no real prospect of income arising from the investment. To deal with this problem, two new rules have been introduced, commonly described as the "tax shelter" and "non-commercial loss" rules.

    The tax shelter rules may operate, in some circumstances, to deny borrowers an immediate deduction for prepaid interest. The prerequisite for the tax shelter rules to operate is that an investment is made (for which a deduction is sought) in a scheme where someone other than the investor is responsible for the management of the investment. The classic scenario targeted by these rules is an agricultural scheme where the practical management cannot be carried out by the investor, simply because the agricultural activity is physically carried out at some distance from the residence of the investor. In contrast, the tax shelter rules will normally not apply to simple structured equity products such as margin lending or instalments.

    Where the tax shelter rule applies, the tax deduction must be apportioned over the term to which the interest relates.

    The tax shelter rules also require for their application that the allowable deductions for the expenditure year (such as interest prepayments) in respect of the investment exceed the assessable income for the expenditure year attributable to the investment. The tax shelter rules specifically do not apply where the expense in question is a prepayment of interest incurred on money borrowed to acquire listed shares.

    Where interest is prepaid by instalment investors, provided the period for which the interest is prepaid is no longer than 12 months and where the tax shelter provisions do not apply, the timing of the interest deduction should not be adversely affected and the interest should be deductible when paid.

    Non-commercial losses

    Recently enacted legislation prevents losses of individuals from "non-commercial" business activities being offset against other assessable income. The targets of these rules are typically hobby farms and rural schemes. The provisions do not apply to passive investments such as shares or instalments unless they are part of share trading. In such cases, the non-commercial losses provision will not affect the deductibility of the interest prepayment made on the acquisition of an instalment or on a margin loan.

    Where there is a continuous large-scale activity in the buying and selling of shares by an investor, the non-commercial losses rules may apply as it may be considered that the investor conducts a business of buying and selling shares. Ordinary share investors, including superannuation funds, are not considered to be share traders and are outside the scope of the non-commercial loss rules.

    Franking credit rules

    In the 1997 budget, Treasurer Peter Costello introduced measures requiring investors to hold shares or share-based products for at least 45 days to qualify for franking credits attached to dividends on the shares. These rules also included an addition to the general anti-avoidance rule in Part IVA to apply to arrangements where one of the purposes is to obtain a tax advantage in relation to franking credits.

    These rules use a different concept to the dominant purpose test in Part IVA, but for practical purposes, where an investor in a share or structured product has the opportunity to profit from the investment, they will not apply. And since most investors ordinarily look to generate a profit, for most simple products there should be no concern.

    Know what to look for

    Understanding the application of these tax rules is a matter of knowing what to look for when you make the investment. Share-based investments with regular dividend flow are safer from a tax perspective than other products with no certain income. If the investment involves borrowing money, make sure there is a clear and understandable tax opinion that covers the issues of tax deductibility and Part IVA. Where the investment produces income in the current tax year, this issue is simple to resolve. If there are dividends flowing from the investment, check that the tax opinion confirms you are entitled to retain any franking credits on them. You should also check on the CGT result of the investment and ensure that you keep good records of the date and price you paid for the investment.

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