This section provides a basic overview of the Australian income taxation system and a basic explanation of how individuals, companies, trust and super funds are taxed and how the main types of investment income, interest, rents and dividends are taxed.
History of taxation
Income tax was first levied by the colonies in 1884. Rates were low and enforcement was weak. The agrarian economic base, the tyrannies of distance, poor personal and governmental record-keeping and a strong dose of general indifference all meant that compliance was a perpetual problem. At Federation, the new states (no longer colonies) retained control of taxation. The Federal government was still weak and remote and had little need for a universal income tax. This changed in the war years and in 1915 the Federal government introduced an income tax to finance the war effort. For some time, a two-tier system operated, with income tax levied by the Federal government and by each of the state governments (administered by the states). Each state had separate rules with rates and definitions differing considerably. Compliance remained poor, a realistic reflection of the society and economy of the time.
Gradually, the Federal government assumed full control of income tax and compliance levels improved. This assumption was achieved by setting Federal income tax rates high, creating priority for the payment of Federal income tax and making state grants dependent on the states not using their income tax powers. In 1942, again as a wartime measure, the process was completed. The major step came in 1936 with the introduction of the Income Tax Assessment Act 1936 (Cth) (‘the 1936 Tax Act’). This Act still operates, although few in the House in 1936 would recognise it today. Its function is now shared with a twin Act, the Income Tax Assessment Act 1997 (Cth) (‘the 1997 Tax Act’). Both sets of legislation must be considered today, along with a dizzying array of related legislation.
The Federal government derives its taxation powers from the Constitution. Sub-section 51(ii) includes a power to tax “but so as not to discriminate between states or parts of states”. Interestingly, taxation bills cannot originate in the Senate and the Senate has no power to amend taxation bills. If the Senate wishes to alter a proposed bill once it has been passed by the House of Representatives, it can only refer the bill back to the House with a request for change, but cannot change it per se. Of course, political realities mean there can be all sorts of political ploys and plays, usually involving other unrelated Acts not being passed without the House first agreeing to the Senate’s request for changes to a tax Act.
The taxation laws are administered by the Commissioner of Taxation and the Australian Taxation Office (ATO). The ATO is based in Canberra and has offices in each capital city, and in some regional cities, each of which is headed by a deputy commissioner. The administration of the taxation laws includes the collection of income tax from individuals, companies, super funds and certain other entities. The ATO is also responsible for collecting instalments of income tax from employers and for the administration of related taxation laws such as the fringe benefits tax (FBT) laws and the goods and services tax (GST) laws. From 2000 on, under the euphemistically titled ‘New Taxation System’ these taxes are all collected via the quarterly Business Activity Statement (BAS) and Instalment Activity Statement (IAS) systems. The ATO also has certain other roles, such as the administration and enforcement of laws applying to self-managed super funds.
Taxation of investment income
There are many ways of classifying investments. One way is to break them down into their fundamental qualities. When this is done, three main types of investment assets emerge: cash (including bank deposits and similar facilities); property; and shares. Everything else (for example, managed funds) is a variation or combination of these three basic investment types. This means there are three main types of investment income – interest; rent; and dividends. These investment types can also produce capital gains. In this unit, we focus on the taxation of interest, rent and dividends.
Interest is the reward an investor receives for allowing another person the use of the investor’s money for a period of time. It is normally calculated as a percentage of the amount lent over the period of the loan. Interest is included in assessable income under general concepts of income, subject to a number of special statutory extensions. Interest is generally taxed on a receipts basis, not a due and payable basis. This means, for example, that interest that is due under a private loan, but which has not yet been paid at 30 June 2015, is not included in the taxpayer’s assessable income for that year. Similarly, interest which is paid on, say, 1 July 2015 but which has been earned over the previous 6 months is included in the taxpayer’s assessable income for the year ending 30 June 2016, even though it relates to the year ending 30 June 2015.
Over the years, there have been many attempts to treat interest as capital gains, which are generally taxed on a more favourable basis than interest. Special rules apply to make sure that purported gains on the expiration of the terms of financial securities are treated as interest for taxation purposes, no matter what their character under the general law or for other purposes. A common question arises where income is held in a joint bank account: In whose hands is it taxed – the person who deposited it, or jointly on a 50/50 basis? The normal answer is jointly and, usually this is on a 50/50 basis unless different proportions can be shown to apply.
Interest offset accounts deserve special mention. Interest offset accounts involve the interest otherwise payable on a bank deposit balance not being paid to the depositor and instead being offset against the interest paid on another separate loan from the same institution. The usual advantage to the depositor is that he or she is giving up assessable interest income in return for a reduced non-deductible interest cost (assuming the loan is used for private purposes, such as a family home). The advantage to the institution is that it has a happy customer and possibly a customer it would not otherwise have. Also, it pays out a slightly lower interest rate, meaning that it makes more profit.
In strict theory, these arrangements may seem to run afoul of a special tax rule that says income is derived by a person even though the person directs that it not be paid to them but instead be paid to some other person or applied to some other purpose. These arrangements also seem to run afoul of the general anti-tax avoidance rules. However, the ATO accepts that interest offset arrangements are effective. This means that they are an excellent way to derive otherwise assessable interest income: the arrangement is tantamount to deriving tax-free interest income.
Interest on amounts held in children’s bank accounts also deserves special mention. In this case, the ATO has ruled in Taxation ruling no. IT 2486 that the interest is taxed in the hands of a parent where the facts show that the deposit really belongs to the parent and the ATO will “rely on all arguments available to it” to treat the interest as being derived by the parent and not the child.
Rent is the reward paid to an owner of an asset (other than a bank deposit or similar facility) for allowing another person to use the asset for a period of time. Rent is usually thought of as a concept applying to real estate, however, it also applies to other types of assets such as plants and equipment. Rent is included in assessable income under the ordinary concepts of income. Like interest, rent is usually assessed on a receipts basis. This means, for example, if a tenant pays the rent late and it is not received by a landlord until, say, 1 July 2016, the landlord includes the rent in their assessable income computation in the year ending 30 June 2017, notwithstanding that it relates to, or was earned, in the year ending 30 June 2016. Where property is jointly owned, the rent is usually treated as accruing to the owners in their ownership proportions.
Interestingly, where a person rents out part of their home to boarders, the ATO has ruled that the payments received are not assessable income whether as rent or otherwise, and should be treated as reductions in non-deductible domestic costs: Income tax ruling no. IT 2167. This ruling appears to be aimed at preventing owners from claiming deductions such as interest and depreciation against the rental income.
Receipts similar to rent (but which are not rent) such as premiums received for the grant, surrender or assignment of a lease are either treated as income in the landlord’s hands under general concepts of income or treated as taxable capital gains.
‘Dividends’ are defined broadly for tax purposes to include any distribution made by a company to a shareholder whether in money or in other property including shares in that company or another company and any amount credited to the shareholder as shareholder. Therefore, a dividend is a much wider concept than a distribution of profit from a company and includes virtually any benefit paid, credited or distributed to a shareholder from a company. Dividends are assessable income under ordinary concepts, but they are also specifically included in assessable income under Section 44 of the 1936 Act.
In the private company environment, there can be difficult questions as to when a dividend is actually derived by shareholders for taxation purposes; however, these questions are not important from the point of view of an investor, who almost always focuses on listed public company dividends. Here, the various dividend advices and statements will make it very clear when and in what tax year the dividend was paid to shareholders.
For many years, company profits were taxed twice in Australia, once in the hands of the company when they were derived and once again in the hands of shareholders when and if they were paid out as dividends. There was no imputation of tax already paid by the company on those profits when they were paid out to the shareholders. This meant there were very high effective rates of income tax on company profits. The 1985 reform of the Australian taxation system identified this as a major inefficiency and, consequently, recommended a change to a partial imputation system of taxing company profits. This system started in 1987 and has now been extended to a full imputation system of taxing company profits. This system relies on a complex system of record-keeping to track income tax paid by companies and to allow their shareholders to claim a credit for that tax i.e. an imputation credit or a so-called ‘franking credit’ when they include those dividends in their assessable income computations.
The basic logistics of taxing franked dividends are as follows:
- The company pays tax on its taxable income at the company tax rate (currently 30%) and records this tax as a credit in a notional account called a ‘franking account’
- When the company pays a dividend, it determines the extent to which the dividend is paid out of taxed profits, debits its franking account and advises its shareholders via a written dividend statement of the amount of the cash dividend and the attached franking credit
- The shareholder includes both the cash dividend and the attached franking credit in their assessable income computation; and
- The shareholder claims a tax offset in their tax payable computation, equal to the value of the imputation credit; this tax offset, unlike most tax offsets, can generate a refund of tax.
This means that ultimately the amount of income tax paid on the company’s profits depends on the income tax profiles of its shareholders. If all of a company’s shareholders faced the 47% marginal tax rate, then all of its income would ultimately be taxed at that rate. If all of a company’s shareholders faced a nil tax rate, for example because there were super funds paying allocated pensions, then all of its income would be ultimately taxed at 0%. This means that income derived through companies, like income derived through trusts, is ultimately taxed in the same way as it would have been had it been derived directly by the underlying owners i.e. the shareholders or unit holders, as the case may be.
This means that the level playing field identified as a major policy goal in the 1985 reform of the Australian taxation system has largely been achieved. This, and particularly the removal of the structural tax bias against companies through the imputation system, is recognised as a major factor fuelling Australia’s economic growth and, in particular, the strong growth in share market values since 1985.
Large investment trusts
Large investment trusts (managed funds) invest in cash deposits (and similar facilities), properties and shares. This means that they derive interest, rent and dividends from holding investments, and capital gains as the value of those investments increases. ‘Net income’ is the phrase used to describe the equivalent of taxable income for trusts i.e. assessable income less allowable deductions. The trust’s beneficiaries or unit holders are said to be ‘presently entitled’ to a share of net income, usually in proportion to the number of units that they hold.
The character of the trust’s net income in the trustees’ hands determines its character in the hands of the unit holders. This is called the ‘flow through’ or the ‘attribution’ principle. This means that if the trust’s net income is made up of, say, 50% cash franked dividends, 30% rent, 10% interest and 10% capital gains, then a unit holder receiving a distribution of $1,000 technically derives $500 rent, $300 franked dividends, $100 interest and $100 capital gains. Under special rules designed for trusts, the benefit of any franking credits, the benefit of any tax deferred amounts connected to depreciation and building allowances, and the benefit of any capital gains discounts flow through or are attributed to the unit holders. This way the trust’s net income is ultimately taxed in the same way as it would have been had it been derived directly by the unit holders. In practice, the details of the income distribution are made very clear to unit holders in the distribution advice statements provided by trusts to their unit holders.
Taxation of capital gains
For many years, capital gains were rarely taxed in Australia. This was because Australia has an income tax system and capital gains are not considered income under the ordinary concepts of income. Therefore the income tax laws did not automatically apply to capital gains. There were two limited statutory exceptions to this proposition. The first was a special rule for assets bought and sold within 12 months and the second was a special rule for assets bought and sold as part of a profit-making scheme or undertaking. This gave rise to obvious social inequities. Taxpayers who improved their wealth through investing for capital gains did not pay tax, but taxpayers who improved their wealth through employment, running businesses or investing for income did pay tax. It also gave rise to economic inefficiencies because the allocation of scarce resources became skewed towards assets expected to appreciate in value, such as residential property, rather than the assets that were expected to generate the best before-tax returns.
These inequities and inefficiencies were considered in detail in the 1985 reform of the Australian taxation system and this culminated in an announcement on 19 September 1985 that assets acquired after that date would be subject to a comprehensive capital gains tax (CGT) regime. This regime first saw the light of day in 1987 when a new Part IVA was introduced into the 1936 Act. Part IVA has since been extended, amended and simplified so that many of the original concepts and limits no longer apply. Now, almost every transaction involving an asset (‘asset’ being very widely defined and including things that most people would not regard as being an asset) must be considered for CGT implications.
Investments are assets. Therefore anyone interested in understanding the investment process must understand the CGT regime. Many books have been written on CGT and many more will, most certainly, be written in the future. Many tax professionals dedicate virtually their entire working lives to understanding how the CGT rules work. In 99% of cases, the CGT rules are actually quite simple. If an investor acquires an asset and disposes of it at a profit, that profit, or part of it, is included in the investor’s taxable income computation and tax payable computation. That is a simple enough proposition. Like most things, it is the other 1% of cases that produce virtually all the complications. To understand CGT and not become confused by all the weird and wonderful extended definitions, exceptions and deeming rules, one is well advised to focus on the 99% of cases that are simple and bear in mind that another 1% are complicated and require detailed consideration. If you do this, you are well on the road to understanding this important part of investment law. The discussion that follows focuses on the 99% of simple cases, not the 1% of complicated cases. But the complications will be noted where appropriate.
Strictly speaking, CGT is a misnomer. There is no such thing as CGT. Technically speaking, Australia does not have a separate CGT in the same way as the UK, for example. Instead, “net capital gains” i.e. the sum of a taxpayer’s capital gains less the sum of the capital losses, are deemed to be assessable income for income tax purposes. Whether any tax is payable depends on the other variables in the taxable income and tax payable computations, mainly the amount of allowable deductions, the quantum of taxable income, its place in the progressive tax scales and the availability of any rebates and credits. Just because you make a capital gain does not mean that you will pay tax on it. Nevertheless CGT is a useful tag and everyone knows what it means, hence its conventional use.
The advantage of capital gains
Capital gains receive very favourable treatment pursuant to taxation law. Capital gains are only taxed if they are ‘realised’ i.e. the underlying asset is disposed of. An asset can go up in value year after year, increasing the owner’s net wealth with each increase, but there is no tax charge unless and until the asset is disposed of. Further, if the owner dies, death (which in a way is the ultimate disposal) is ignored for CGT purposes and there is still no tax charge unless and until the heirs choose to dispose of the asset. There is no disposal, even if the owner borrows against the asset and uses the cash for another purpose, rather than selling the asset for cash to enable that purpose to be completed. Similarly, there is no disposal if, for example, the owner allows the asset to be mortgaged or otherwise encumbered in connection with the purchase of another asset. Therefore, an asset that has gone up in value can be exploited as part of the owner’s overall financial strategy without being disposed of and, therefore, without crystallising a tax charge.
This is one of the reasons that many experts propound a long-term view of investing: as Warren Buffet says, the unrealised tax bill is, in effect, an interest-free loan from the government. Even if an asset is disposed of by an individual or a trust, provided it was held for more than 12 months, normally only half of the capital gain is taxed. This means that the effective tax rate on capital gains cannot be more than 24% (i.e. 50% of the top marginal tax rate of 48%). Therefore, a major part of an investment plan for anyone wanting to generate real wealth should be the accumulation of assets that are expected to go up in value and the enjoyment of the resultant capital gains without suffering a tax charge.
Investments in one’s own business often tend to be the best investments. The CGT rules provide particularly attractive results as they apply to gains on the sale of goodwill. This is due to the combination of the 50% discount factor, the active asset exemption and, sometimes, the super rollover rules. It is not uncommon for no tax to be paid on a capital gain on the sale of a business. Time spent building up a business can be time well spent when it comes to the sale day.
For most investors, a CGT problem is a nice problem to have and is much better than a capital-loss problem. Qualified listeners, when faced with an investor complaining of their CGT problem, should offer congratulations. Even if a problem remains after working through the various exemptions and concessions, sound tax planning usually allows the amount of tax ultimately payable to be reduced considerably. Registered tax agents can often be useful influences on the development of financial advice.
When does a capital gain or a capital loss arise
A capital gain or loss computation arises when a ‘CGT event’ occurs in respect of an asset. A CGT event normally involves a disposal of or some other dealing with a ‘CGT asset’. A CGT asset is broadly defined and includes any form of property and any legal or equitable right. From an investor’s perspective, a CGT asset includes real estate, shares, units in unit trusts, options, rights, foreign currency and similar assets.
The main CGT event affecting CGT assets is the disposal of an asset and this is referred to, helpfully, as ‘CGT event A1’. An asset is disposed of when a contract or agreement is entered into for the change in ownership of that asset. Normally, this is quite straightforward: a shareholder places a sell order through their sharebroker and the offer is accepted virtually immediately by another person acting through their sharebroker. The time of disposal is the date that the contract is signed. Therefore, in the case of a disposal of real estate, where the settlement date is typically 30, 60 or 90 days after signing the contract of sale, the land is disposed of on the date that the contract of sale is signed. Where the contract of sale is signed on, say, 1 June and settlement does not occur until the following financial year, say, on 31 July, the capital gain must be included in the vendor’s taxable income computations in the year ending 30 June. This is so even though the sale proceeds have not been received at that time.
In addition to this basic CGT situation, a number of less simple examples arise from time to time. Specialist taxation advice is required at such times.
A summary of CGT events can be found on the ATO website: Summary of capital gains tax events