One size fits all

By MARK FRYER

Taxes, like death, are one of those things that most of us would rather not contemplate until absolutely necessary.

That may help explain why the final report of a major review of the tax system, released 10 days ago, vanished from the news so promptly.

That and the fact that the Government moved quickly to dismiss any of the review's suggestions which might have frightened the voters, like raising GST or taxing the family home.

But the tax review chaired by accountant Rob McLeod could still mean a profound change for investors, if the Government follows up on its suggestion to change the way in which many investments are taxed.

If this does happen, it won't happen overnight, so there's no need to rush out and rearrange your portfolio just yet.

But the review committee's suggestions would mean major changes in the way investments are taxed and would alter the relative attractiveness of various forms of investment.

The review committee, which was given the task of thoroughly appraising the country's tax system, spent about a year and almost $1 million gathering submissions, publishing a paper outlining the main issues, gathering even more submissions, then producing a final report.

That report recommended, among many other things, some changes to bring a little consistency to the way various forms of investment are taxed.

That's hard to disagree with; the differences in the way in which many investments are taxed now defies logic.

An example: if you buy $1000 worth of shares and the price doubles, you've just made yourself a $1000 profit, absolutely tax free (unless you're in the habit of doing such things, or Inland Revenue can show you bought the shares with the purpose of re-selling them for a capital gain).

But if you instead put your $1000 into a unit trust, which buys the same shares and makes the same gain, the trust will have to pay 33 per cent tax on that $1000 profit, meaning only $670 for you.

Same shares, same gain, but a completely different tax treatment and a completely different return to you, the investor, depending on whether you invest directly or through a managed fund.

Example number two: you buy two shares, one of which rewards you with a 10 per cent dividend, the other of which pays no dividend but rises in price by 10 per cent. The dividend is taxable, because it's income. The price rise is not taxable, because that's a capital gain and - subject to some exceptions - New Zealand has no capital gains tax.

Example number three: put your money into a "passive" managed fund - one that blindly follows a particular index rather than trying to pick winners - and any capital gains are yours to keep.

But if you choose an "active" fund, the manager has to pay tax on any capital gains.

Those sorts of inconsistencies make choosing an investment much more complicated than it should be. Instead of just looking for something which will provide the highest return, you also need to ask how that return is going to be taxed.

Or, as the McLeod committee's final report says, "A particular concern is the extent to which savings decisions seem to be dominated by tax considerations ... "

The committee's response was to suggest a new way of taxing some investments.

Forget about the distinction between income and capital gains, it suggests, and ask a simple question: how much was the investment worth at the start of the tax year?

Then assume the investment earns a certain return over the year, knock off a bit for inflation and multiply what's left by the taxpayer's individual tax rate.

Hang on a minute, assume the investment earned a certain amount? That's the idea; the committee suggests that investments taxed in this way should be assumed to earn something called the "risk-free return", which is the return you would get by investing in Government stock.

So, if Government stock is returning 6 per cent, and inflation for the year ahead is expected to be 2 per cent, your investments would be assumed to earn 4 per cent.

If you have $10,000 invested and you're on the 39 per cent tax bracket, your tax bill will be $10,000 times 4 per cent times 39 per cent, which equals $156.

This approach might not be a bad deal if your investments earn more than 4 per cent, since anything above the risk-free rate is effectively tax-free.

However, it's not such a great deal if your investments earn less than the risk-free rate.

Therein lies one of the pitfalls. Under such a system investments would be taxed regardless of how well they performed.

This could be a problem with investments that didn't provide much in the way of income.

International share trusts, for example, often produce next to no income even if they make good capital gains, so investors would have to pay their annual tax bill out of other income, or by selling a few of their units every year.

And even if your investments lose value, under such a system you'd still be expected to pay tax - adding insult to injury.

Because of this problem, the McLeod committee said special rules might be needed to provide relief for cash-strapped taxpayers.

There would also have to be a way of dealing with investments which are only held for part of the tax year.

Despite those sorts of complications, such a system would have some advantages:

* While no one likes a new tax, this one would at least be much less complex than one of the alternatives - a fully fledged capital gains tax. The committee did look at a general capital gains tax but decided it would make the tax system more costly and complicated, without achieving a great deal.

* The suggested approach would also be more consistent than the present mish-mash of tax rules.

* The fact that it would be inflation-adjusted would be a plus. At present, those investments which are taxable are taxed on all their returns, including the inflation component.

* Choosing the right investment should become easier. Investors would be able to concentrate on looking for the best returns, at an acceptable risk, without having to worry about how that return will be taxed.

* The suggested system would also be fair, in the sense that two people with the same amount invested would face the same tax bill.

* The risk-free-return approach could even be seen as something of a tax concession, given that most investments are likely to earn more than the return on Government stock.

For most of us, though, whether such a change is good news or bad boils down to where we already have our money.

If it's in investments which now suffer from a relatively high tax burden - super schemes, for example, or locally based active unit trusts - it should mean lower taxes.

But it will be bad news for anyone who has sought out investments which pay no or little tax under the current rules, such as passive funds.

The $64,000 question now is, will the Government adopt the committee's suggestions and, if so, what sort of investments will be taxed this way?

For now, the idea has been referred to the Treasury and Inland Revenue for more work - in contrast to a number of the committee's recommendations which the Government rejected out of hand.

The McLeod committee recommended that the risk-free-return method should apply to "savings and investment entities", which would include things such as unit trusts, group investment funds and some life insurance and superannuation schemes.

It also suggests applying the tax to investments in overseas investment funds listed on sharemarkets, as well as overseas unit trusts.

The committee doesn't recommend applying the risk-free-return tax system to other investments until it proves itself in practice.

However, there is no reason this approach could not be applied more widely; in its earlier issues paper the committee recommended using it for direct shareholdings and - most infamously - housing.

The Institute of Chartered Accountants said in its submission to the committee that the risk-free-return method of taxing investments would go a long way towards removing some of the inconsistencies in the present system, although it also had major reservations about such a change.

Accountants PricewaterhouseCoopers supported the suggested system - subject to a lot more work - as long as it was not not applied to a taxpayer's principal home and as long any extra tax paid was used to reduce other taxes.

However, it also noted that with tax changes, "the devil is in the details."

* Contact Personal Finance Editor Mark Fryer at: Business Herald, PO Box 32, Auckland. Phone: (09) 373-6400 ext 8833. Fax: (09) 373-6423. e-mail: mark_fryer@herald.co.nz.