Terry Baucher says the lack of a capital gains tax makes tax policy illogical, and unfair to those priced out of the housing market

By Terry Baucher*

Are the opponents of a comprehensive capital gains tax (CGT) really just NIMBYs in another guise?

At times it’s hard to escape the suspicion that the vociferous opposition to CGT from the likes of the New Zealand Property Investors Federation appears to be more motivated by the self-interest of protecting untaxed capital gains than any concerns about introducing a complex new tax.

The current tax rules around capital gains are a mess.

As the IRD’s Policy Advice Division advised the 2009 VUW Tax Working Group (TWG), the tax treatment of capital gains is “inconsistent… lacks an overall coherence and creates uncertainty”.

This might be great for tax consultants, but hardly fair for taxpayers in general.

In theory, the existing rules tax sales of any asset or property acquired with a purpose or intent of sale.

This, as opponents of a CGT have been quick to argue, means a change in law isn’t needed.

However, defining “intent” gives plenty of wriggle room for well organised and advised persons.

By contrast, there are several major asset classes where capital gains are automatically subject to taxation regardless of the investor’s intent. 

One such case is the Financial Arrangements regime (also known as the Accrual Rules). The Accrual Rules have been around since 1986 and like the Foreign Investment Fund (FIF) rules are another part of the Income Tax Act best approached with a stiff drink in hand. 

The Accrual Rules cover financial instruments such as bonds (both in New Zealand and overseas), bank deposits and mortgages.

The rules tax all income and any gains, including foreign exchange gains, arising from the investment over the period the financial arrangement is held. 

The Accrual Rules regularly spring unpleasant surprises on the unknowing.

I will elaborate on just how unpleasant these can be in my next column.  For the moment the following example will serve as a taste.

A couple selling their former family home in the UK which was rented out after they migrated to New Zealand, should not be taxed on any capital gain. However, if the mortgage over the property was Sterling denominated, then the Accrual Rules would tax any exchange gain.

Conceivably, the taxable foreign exchange gain on the mortgage could exceed the non-taxable capital gain on the property.

The end result is that one class of gain is taxed, but another is not even though both gains relate to the same asset. It is a clear example of the current tax system’s “incoherence”. 

I have written previously about the FIF regime which applies to shares and other investments such as foreign superannuation schemes and life insurance policies in countries outside Australia and New Zealand.

As most people are probably aware, under the FIF regime the lesser of a 5% “fair dividend rate” of the investment’s market value at the start of the tax year, or the actual income and gains for the year is deemed to be income. This applies even if the FIF income is more than the actual cash return.

The current FIF rules are intended to “levy a reasonable level of tax on offshore share investments”.

Officials argued that investors were choosing to invest in lower yielding equities outside Australia and New Zealand. By doing so they minimised their taxable dividend income but still derived the same overall economic gain through share price appreciation. The new FIF rules countered this practice by expecting a return similar to the typical dividend yield of Australian and New Zealand shares.

The TWG estimated the total value of residential property investment at $200 billion. If the FIF regime 5% fair dividend rate was applied to residential property investment this should result in approximately $10 billion of taxable income per annum.  In fact, according to figures supplied by the IRD to the New Zealand Property Investors Federation the net taxable income from residential property for the year ended 31^st March 2013 was $1.5 billion.

This is barely 1% of the estimated value of residential property.

This immediately begs the question that If investing in low yielding but capital appreciating foreign shares is considered unacceptable, why doesn’t the same logic apply to residential property?

Are residential property investors really paying their fair share of tax?

Viewed in this context the arguments against CGT appear to be a form of NIMBYism – don’t tax my capital gains. That's understandable from the viewpoint of those currently enjoying tax free capital gains, but illogical as a basis for a coherent tax policy. 

Ultimately, introducing a CGT boils down to two issues of fairness: firstly, from a tax policy perspective it is neither fair nor logical to exclude from comprehensive taxation such a significant asset class as residential investment property. 

The other issue about fairness relates to the current housing affordability issue. As one participant at a recent conference on the design of a CGT remarked, when people feel they have been priced out of the housing market they cannot be expected to also accept as fair that the capital gains of those who own property should be tax free. That is a long term recipe for social stress.

After tomorrow New Zealand may have decided to follow the majority of the OECD by electing a government which will introduce a comprehensive CGT.

Regardless of the Election result, it is a debate which will continue.

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*Terry Baucher is an Auckland-based tax specialist and head of Baucher Consulting. You can contact him here »