Problem Question 1a i) In this question the important phrase is “compensation” and is an important concept in taxation law that can be used to research the relevant legislation and cases in this area. Generally, a compensation receipt takes on the character of the item it replaces and this is known as the replacement principle. FCT v Dixon (1952) 86 CLR 540. Consequently where there is a nexus between ordinary income and the amount being compensated any compensation amount will in itself be considered ordinary income and assessable under s 6-5 of ITAA 1997.
If the compensation amount that replaces income is made in lump sum instalments does not alter its character where the payment is income in nature.
In both FCT v Dixon and C of T (Victoria) v Phillips the payments were periodical. However, the receipt of compensation or damages as a lump sum will not alter its assess ability where the lump sum payment is for loss of income only or a portion of the lump sum payment is identifiable as income. Determination TD 93/58.
In conclusion the receipt is assessable income and the case law and precedent supports the principle that a receipt that is a product of employment or a reward for services will be considered assessable income or more specifically ordinary income. ii) Distinction between payment for services and giving up a capital right can have consequences for the taxpayer as generally if someone is paid for giving up ordinary income it will take on the character of ordinary income. Conversely, if a taxpayer is paid for giving up a capital right it will generally be considered capital.
In the case of Bennett v FCT (1947) 75 CLR 480 the taxpayer was employed as a managing director of a company he effectively controlled. His original contract was terminated and subsequently relinquished certain rights that he had held previously. The taxpayer was compensated for the loss.
The court held that the payments were not for loss of income, but were capital in nature for the removal of those rights.
In Higgs v Olivier (1952) Ch 311 the court held that as the agreement for compensation was separate to his employment contract it was not payment for his exertion as an actor but for giving up a right to earn income which was capital in nature.
In FCT v Woite (1982) 13 ATR 579 the taxpayer was a footballer that received compensation for an agreement not to play with a certain club in Victoria. The court held that the payment was capital in nature and was not ordinary income from his profession as a footballer. In conclusion Clara’s receipt of $15,000 constitutes capital as supported by case law and precedent determined by the courts judgement that receipts paid for giving up valuable capital rights was capital also.
1b) Division 152 provides very generous tax concessions for small business entities. Provided certain conditions are met, the capital gains tax (CGT) for small business may be completely eliminated or reduced by one or more of the small business concessions available.
Importantly there is no statutory limit to the amount of capital gain that can be eligible for the concessions and therefore no limit to the amount of capital gain that can be eliminated or reduced.
There are four (4) main concessions available to a small business entity;
152 B the fifteen year exemption allows the gain arising from an active CGT asset to be disregarded provided it has been owned for fifteen years.
152 C the active asset reduction concession allows a capital gain to be reduced by 50% in addition to the general CGT discount that is available.
152 D the retirement exemption means a small business can disregard up to $500k of a capital gain from a CGT event that is applicable to any of its CGT assets.
152 E the small business asset rollover relief means a small business can defer making of a capital gain from a CGT event occurring to one or more of its active assets
To qualify the criteria is set out in subdivision 152-A where the entity must be a small business or a partner in a small business partnership and the value of the assets that the small business or its related entities own must not exceed $6m.
In order to qualify for the small business concessions the taxpayer must meet the criteria as a small business entity s.152-10(1)(c)(i) or the taxpayer satisfies the $6m net asset value test s.152- 15ITAA97.
The $6m net asset test effectively imposes a ceiling on the whole of the net assets of $6m.
The taxpayer who owns the CGT asset
Entities connected with the taxpayer
Affiliates and their connected entities The net value of the CGT assets is equal to the market value less debt, annual leave, long service leave, unearned income and any tax liabilities. Other items to be included in the calculations are cash, bank accounts, trading stock and motor vehicles.
There are also certain exemptions from the $6m net asset test which include;
Personal use assets
Main residence
Super Fund The assets Tanya owned including sale proceeds
Sale of business ie land, shop and garage $900k
Sofa $15k
Non- compete contract $150k
Subtotal of sale $1,065m
Additional assets owned at time of business sale;
Car ($30k)
House Owner Occupied ($1.4m)
Rental property ($550k -$50k debt) $500k
Shares Invist P/L 65% ownership= full amount $975k
CBA Shares $600k
Subtotal of assets held $645m
Total assets $1,710m
The total amount of net assets attributable to Tanya as the taxpayer is $1,710m which is less than the $6m limit imposed under s.152-15 as a gateway to access the concessions.
The non-compete proceeds of $150k is considered a CGT event as it is inherently connected with a CGT asset (ie the business) of the taxpayer. Importantly the creation of this contractual right, s104- 35 is not available under the 12 month general 50% discount rule under s115-25(3). However, the small business CGT concession rules will apply to all the capital proceeds.
There are however, a number of other pre-conditions and access conditions that Tanya must step through to determine if the small business concessions are available to her. The taxpayer will also be considered a small business entity if it is an individual, partnership, company or trust and is carrying on a business and has a turnover in the current year of less than $2m. This turnover test also extends to previous years and the actual year that the CGT event occurred.
While Tanya owned and ran the store, annual turnover was between $2.8m and $2.9m. In addition Tanya collected $15,000pa rent in connection with a garage on her business property. Tanya clearly does not meet this element of the criteria which is considered an alternative to the $6m test and therefore will not restrict access to the concessions in this case.
In summary the s152-A prerequisites described above and including the CGT event has happened s.152-10(1)(a) in relation to a CGT asset s.108-5 and the disposal s.104-10(2) has resulted in a capital gain.
We have established that Tanya does qualify to make the capital gain as a small business entity; however, we now need to establish if the assets giving rise to the gain are considered active assets.
The small business concessions apply only where a taxpayer disposes of active assets which can be tangible or intangible but must be owned by the taxpayer. There are four limbs to consider and test if a CGT asset is an “active asset” s.152-15;
If you own the asset ( tangible or intangible) and it is used in the course or held ready for use in carrying on a business
If the asset is held by by an affiliate or a connected entity
If at the time you own it and it is inherently connected to the business
Shares or trusts interests may get CGT relief depending on strict criteria
The types of assets that are excluded from being active assets are loans, debentures, bonds, futures etc.
Finally after satisfying these pre conditions we have established that Tanya can access the small business concessions.
The business and associated property was purchased and established at its earliest point in August 2007 and sold in March 2015 being held for a period of less than 8 years. The business was sold when Tanya is 51 years of age and she has purchased another business so is not anticipating retirement any time soon.
This means that Tanya will not qualify for the 15 year small business CGT concession rule which provides a total exemption for any capital gain on the disposal of a CGT asset owned for at least 15 years where the taxpayer is 55 years or older and retiring is permanently anticipated.
The retirement concession will also be out of reach for Tanya because the sale of the assets is not connected with any retirement plans. However, if she did contemplate retirement the retirement concession would allow the entire capital gain connected with the asset to be disregarded up to a lifetime limit of $500k. However, given Tanya is less than 55 years of age the proceeds would need to be paid into a complying superannuation fund.
There is, however, a 50% active asset capital gains reduction available to Tanya. The 50% reduction allows a qualifying taxpayer to reduce the amount of its capital gain by 50%. Importantly the 50% reduction may be used after the capital gain has already been reduced by the general 50% discount percentage, giving a total discount of 75%.
Further, the gain may also be reduced for Tanya by the small business rollover concession. If a taxpayer chooses a roll over, all or part of the capital gain is not included in the taxpayers assessable income until circumstances change. Tanya may defer paying tax on a capital gain made from a CGT event in relation to her small business if she acquires a replacement active asset and elects to obtain rollover. Importantly the rollover relief may be applied after the CGT general discount and active asset reduction. Remembering, the types of assets that are excluded from being active assets are loans, debentures, bonds, futures etc.
In April 2015 Tanya purchased a corporation called TLC P/L for $400,000. The company’s assets are $100k in Bonds which do not qualify as an active asset and a restaurant for $300k which would qualify as an active asset under the roll over relief concession. Calculations to establish capital gains tax applicable to Tanya; August 2007 purchase land s.110-25(2) ($115k) Purchase includes stamp duty costs s.110-35 ($5k) February 2008 built shop premises s.110-25(5) ($280k)
Total cost base ($400k)
March 2015 Sold business incorporating land shop & garage $900k
March 2015 sale of non-compete contract $150k
Total capital gain $650k
July 2008 purchased sofa ($20k)
March 2015 sold sofa $15k
Total capital loss ($5k)
Net capital gain $645k
Therefore; Applying 50% general discount
($645k-$150k) = $495,000k – (50% x $495,000k) = $247,500
Add back ROT contract proceeds
$247,500 + $150,000 = $397,500
Applying 50% active asset reduction
$397,500k – (50% x $397,500k) = $198,750
Applying rollover concession and assuming the first and second elements of the cost base of the business’ replacement assets total $300k, this amount can be disregarded under the rollover and all of the capital gains can be disregarded and deferred.
Effectively the capital gain is deferred automatically for two years and can be deferred indefinitely.
Problem 2 i) There is much debate around the lack of housing affordability and more particularly the distortion on the housing markets that may be attributable to the current set of Federal and State based tax arrangements.
Stamp duty Stamp duty is levied by State Governments on the transfer of land. Stamp duties are an important source of revenue for State Governments. However, stamp duties can
Land tax Land taxes are a tax paid periodically by land owners.
Capital gains When a property is sold by an investor the difference between the prices at which it was bought and the prices at which it is sold is known as a capital gain for tax purposes. Capital gains are currently taxed at a discount of 50 per cent if the property has been held for one year or more.
Many housing experts and economists consider that this discount combined with rules surrounding the deductibility of investment property losses raise issues around housing affordability and macroeconomic instability.
Negative gearing Investors in property often negatively gear their investment.
ii) The setting of tax policy is important because if it is not designed well it has the potential to distort decision making, potentially leading to adverse social and economic outcomes. Depending on its design, taxation policy may improve or hinder housing affordability, through its effect on the incentives of the buyers, renters, sellers and investors.
A vital goal for tax reform is to improve the affordability of housing. In a paper published in 2015 by the Australian Council of Social Service (ACOSS) it is claimed that Australia has among the most expensive housing in the world and from 2002-12, average prices rose by 92% for houses and 40% for flats while average rents rose by 76% for houses and 92% for flats.
The high cost of housing is caused by excess demand against a back drop of limited supply. Much of this demand according to ACOSS is driven by an explosion of rental property investment. From 2000 to 2013 lending for investment housing rose by 230% compared with a rise of 165% in lending for owner occupied housing. Investors are bidding up the price of existing homes without building enough new ones.
Tax statistics from (2011) suggests two thirds of individual rental property investors – 1.2 million people - reported tax-deductable ‘losses’ of $14 billion. The Capital Gains Tax discount cost the Federal Budget $5 billion and negative gearing arrangements added another $2 billion that year.
Negative gearing and Capital Gains Tax discounts for investors together encourage over-investment in existing properties and expensive inner city apartments which lifts housing prices and does little to promote construction of affordable housing:
Over half of individual taxpayers with geared rental housing investments are in the top 10% of personal taxpayers (earning over $100,000 in 2011) and 30% earned over $500,000.
Over 90% of investor borrowing is for existing rental properties, not new ones, so investors are bidding up home prices without adding much to the supply of housing.
These tax breaks encourage speculative investment with an eye to capital gains, not patient investment with an eye to rental yields.
They reinforce the bias in favour of housing investment by small investors with one or two properties, when we need more investment by institutions such as super funds to stabilise the rental property market and give tenants more secure tenure.
RBA (2014) Submission to Senate Economics Committee Affordable Housing inquiry commented that certain tax legislation can fuel speculative housing price booms that destabilise the economy and make it harder for the Reserve Bank to reduce interest rates when needed. With lending for investment properties rising by 150% in Sydney in the last three years, the Reserve Bank warns that investment housing bears close monitoring for signs of speculative excess. Last year APRA issued guidelines to curb excessive lending for rental property investment.
Tax receipts from stamp duties and land tax are also an important source of revenue for state governments. In the budget papers of the Victorian department of treasury and finance 2011 –’12 these taxes amounted to $5.3b or 35% of total tax revenue. Understandably there is reluctance by government to introduce reforms that threaten this revenue base.
Stamp duties when seen as a home ownership transaction tax can have adverse impacts on housing affordability because they simply raise the price of housing.
Land Tax duties are imposed on land held by investors and owner occupied land is exempt giving a financial advantage to home owners relative to landlords negating the desire of investors to hold land for private rental housing and contracting the supply of low cost housing for rent. The Henry tax review in 2009 believed the case for tax reform was strong enough in relation to stamp duties and land tax that two of its key recommendations were to abolish stamp duty on all property transactions and to more efficiently tax land in order to tax more valuable land at higher rates.
The argument for desirability of the Henry reforms notes that the educed stock increasing rent scenario perhaps does not take into account that owner occupied and investor housing is concessionally taxed to begin with compared to most alternative investments. Most of the investment prompted by the CGT discount and negative gearing benefits is in existing properties therefore housing supply is unlikely to be as responsive as argued.
The Grattan institute calculated that the cost of negative gearing concessions (compared with a regime in which deductions could only be claimed against income from the same investment) was $2b in 2011-12. The cost of the 50% discount on capital gains tax for individual investors was $5b.
This type of quarantining of expenses relating to investments in assets yielding capital gains so that they can only be deducted against income from the same class of investment exists in many countries around the world including the USA.
The investor tax breaks discussed thus far influence the profile of housing investors. They skew the profile of housing investors from institutions chasing rental returns to small investors chasing capital gains.
“The tax treatment of investor housing, in particular, tends to encourage leveraged and speculative investment. Since the Wallis enquiry, higher housing debt has been accompanied by lenders having a greater exposure to mortgages.”
The reserve bank has also weighed in on the argument for tax reform particularly in the area of negative gearing tax concessions. In the RBA submission to productivity commission 2003 it stated “The work undertaken in preparing this submission has highlighted a number of areas in which the taxation treatment in Australia is more favourable to investors than is the case in other countries. In particular, the following areas appear worthy of further consideration;
The ability to gear an investment property when there is little prospect of the property being cash flow positive for many years;
The benefit that investors receive by virtue of the fact that when property depreciation allowances are clawed back through capital gains tax, the rate of tax is lower than the rate applied when depreciation was allowed in the first place
The general treatment of property depreciation, including the ability to claim depreciation on loss making investments” In conclusion whether it be stamp duty and land taxes at the state and territory level, or capital gains and negative gearing arrangements at the Federal level, existing tax settings have the potential to influence demand and supply in the housing market and ultimately impact affordability. There is a strong case for tax reform within the existing investor housing taxation arrangements to achieve positive housing affordability outcomes that are desirable to government, economic and financial stability, social welfare, institutional investors and of course current and future private housing investors.
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