Double jeopardy in tax plans

Investors caught by the planned new tax rules on overseas shareholdings could still have to pay tax even in years when they suffer losses.

The new rules apply to portfolios of shares in countries outside Australia and New Zealand above a $50,000 threshold. Eighty-five per cent of any unrealised capital gains is taxable, but under the 5 per cent cap rule the amount taxable in any year is limited to 5 per cent of the value of the share portfolio at the start of the year, unless the investor sells the shares and does not reinvest the proceeds in more shares which are subject to the rules.

Any taxable capital gain above the 5 per cent cap is carried forward.

PricewaterhouseCoopers tax partner Mark Russell said: "The commentary around the bill has very much focused on the deferral being permanent until you get your hands on the money - or die, in which case they write it off."

But the way the regime works, any taxable capital gain carried forward is treated as part of your income the following year and then the 5 per cent cap is applied again.

"Investors can and will be liable to tax on the deferred gains without selling any shares," Russell said. "This will happen in any year in which the investor's portfolio increases in value by less than 5 per cent and the investor has deferred gains from prior years.

"The most extreme scenario is that investors can have tax to pay in a year their portfolio declines in value, unless the decline in value exceeds the previously deferred [taxable gain]."

The revelation is likely to add to disquiet among some investors about the controversial tax proposal, which is currently being examined by Parliament's Finance and Expenditure Select Committee.

Russell said most people found the prospect of being taxed even in years when they made a loss surprising when it was explained to them.

"The first year when the market takes a big hit and they find they still have thousands of dollars of tax to pay in that year, I think they will be quite surprised."

There was also a limit on the "rollover relief" available which was not widely understood, he said.

Rollover relief allows an investor to defer tax on realised capital gains, provided the proceeds of selling the shares are reinvested in other shares, but only if they are also subject to the rules.

"Therefore an investor will not qualify for relief, or will get clawback of previously obtained relief, if they sell, say, UK or US shares and invest the proceeds in Australian listed shares that are exempt from the new rules."


HOW THE INVESTMENT TAX WORKS

How investors in foreign shares could have to pay tax even in years when their shares make a loss.

YEAR ONE
Investor starts year one with $100,000 in shares subject to the new investment tax rules (ie outside NZ or Australia).

It is a very good year for the market and by the end of it his shares are worth $150,000. There were no dividends and no shares were sold.

His capital gain is $50,000 of which 85 per cent or $42,500 is taxable.

But the 5 per cent cap applies. Only 5 per cent of the starting value of $100,000 is taxable that year, ie $5000. At 39c in the dollar he pays tax of $1950.

The other $37,500 of taxable capital gain ($42,500 minus $5000) is carried forward.

YEAR TWO
The market goes nowhere. At the end of the year his portfolio is still worth $150,000. Again there were no dividends and no shares sold.

Although there was no additional capital gain in year two, the $37,500 carried forward is treated as income that year.

Again the 5 per cent cap applies, but this time the starting value was $150,000 so the taxable amount that year is $7500. He pays $2925 in tax.

The taxable capital gain carried forward to year three has reduced, however, from $37,500 to $30,000.

YEAR THREE
The bears are out. The market value of the portfolio falls 15 per cent to $127,500.

The investor's capital loss of $22,500 comes off his carried-forward capital gain, reducing it to $7500.

He is still liable, however, for tax on 5 per cent of the starting value of $150,000, or $7500. He pays tax of $2925 again.

But at least he has no remaining unrealised capital gains to carry forward. Over the three years he has paid $7800 tax on a cumulative unrealised capital gain of $27,500.