This is a basic overview of the main building blocks of the CGT system.

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1 INFORMATION GUIDE Re: Capital Gains Tax: General topics Date: 5 March 2018 This is a basic overview of the main building blocks of the CGT system. CGT and the income tax system 1. CGT is essentially a tax upon gains from the realisation of property where the realisation is not an aspect of the carrying on of a business. 1 It is about bringing capital receipts into the income tax system. It does this by tacking on net capital gains to our concept of assessable income. 2. Australia levies its income tax on the concept of assessable income, which is made up of; Ordinary income, like money from employment, investment, business; and Statutory income, being a made-up idea of the tax law. 3. The point of statutory income is to bring amounts into the tax net that our common sense (or ordinary usages ) would not normally think of as income. It is just another example of how the tax law has been allowed to create its own legal world, existing in another dimension warped and twisted around everything else. 4. For example, if you buy a bond for $10 and sell it later for $15 you usually would not think of the $5 you made as being income. Hold on right there! says the ATO. We have just brought in section 26BB which says that gain is income after all! : (2) Where a taxpayer disposes of a traditional security or a traditional security of a taxpayer is redeemed, the amount of any gain on the disposal or redemption shall be included in the assessable income of the taxpayer of the year of income in which the disposal or redemption takes place. 5. This situation has been repeated many times throughout the tax law where the Commissioner has managed to convince Parliament that all sorts of amounts which are clearly not income, should be taxed as income anyway: Certain allowances; Recoupments (i.e. money received when you previously deducted as losses); Work-in-progress; Withdrawn amounts from farm management deposits; and Franking credits. 6. These amounts are all statutory income. A long list of amounts that have been caught this way is set out at section 10-5 of the ITAA 1997 (as a Guide). 7. The general reasons for deeming these amounts to be income are to prevent mischief, to create consistent outcomes, and to make administration easier. 1 Asprey Report (1975), page 414. Phone andreyev.com.au Liability limited by a Scheme approved under the Professional Standards Legislation Legal practitioners employed by Andreyev (Sydney) Pty Ltd A.B.N and Andreyev (Adelaide) Pty Ltd A.B.N are members of the Scheme

2 8. The most significant type of statutory income is net capital gains which brings us to the CGT system (which is nested inside the income tax law). 9. The CGT has been implemented in quite an interesting way. The income tax system works by saying that everything ends up being a CGT asset unless it is specifically carved out. It lays in wait below all the other income tax provisions to catch any money that tries to get away. Nearly every dollar will fall into the CGT bucket, unless it has already been caught earlier by the normal income tax provisions. 10. In this way, you can think of the income tax system as a series of overlapping circles, with CGT as the foundation. 11. For example, trading stock is dealt with in special income provisions at Division 70, but otherwise would probably fall into the CGT net. The same goes for depreciable assets which have their own special regime in Division 40 which would also fall into the CGT if they were not dealt with already at a higher level. 12. This is all a result of the vast definition of CGT assets which has been created i.e. any kind or property or a legal or equitable right that is not property The CGT system has been purposely designed this way. It has been used to tax gains you make on selling capital assets, but it has also been remoulded several times to be a general purpose way of catching things the rest of the income tax system had trouble with. 14. The normal income tax provisions are given priority through the anti-overlap provision of section , which says that we will compare your income tax and your CGT and make you pay whichever is higher: (1) A capital gain you make from a CGT event is reduced if, because of the event, a provision of this Act (outside of this Part) includes an amount (for any income year) in: your assessable income or exempt income; or if you are a partner in a partnership, the assessable income or exempt income of the partnership. 15. People usually prefer to pay CGT instead of normal income tax, because the CGT has the (usually) 50% CGT discount available. The downside of CGT is that it is taxed on a realisation basis (instead of an accruals basis), so you can end up with massive tax liability from a single event. This is why the CGT is such a big sting for people. Accruals basis CGT would be preferred, but it is impossible to do. 2 Section ITAA Andreyev Page 2

3 Building blocks of CGT 16. The CGT is a complex system, and uses a web of different definitions to do this process: Look at whether something has happened to trigger CGT; Figure out how much the relevant thing was worth at the start and compare it to how much it is worth now; Calculate the change in value and see if you have made or lost money; and Charge CGT against any money that you have made by lumping it onto your income for the year. 17. These are the building blocks of the CGT: CGT assets; CGT events; Capital proceeds; Cost bases; and CGT general discount. 18. We will go through these concepts in some detail below. Understanding these will give you a general idea of what the CGT is doing, and how it works in legislation. 19. There are also more complex aspects to the CGT (which we will not cover in this Part of the memo): Main residence exemption; Roll-overs; Deceased estates; Small business concessions; and Value shifting. The CGT starting point 20. Everything in the CGT provisions are about boiling things down to a net capital gain figure (i.e. your gross capital gains less your capital losses) to lump on to your assessable income for the year. Section 102-5(1) states: Your assessable income includes your net capital gain (if any) for the income year 21. So the general exercise is to follow the steps to work out whatever your net capital gain may be. 22. The ITAA 1997 follows a practice of setting out (non-binding) diagrams and tables to summarise this sort of thing, which are sometimes called Method Statements. The most famous Method Statement is the one about your net capital gain calculation. Andreyev Page 3

4 23. It is worth setting out the CGT Method Statement in detail: Step 1. Reduce the capital gains you made during the income year by the capital losses (if any) you made during the income year. Note 1: You choose the order in which you reduce your capital gains. You have a net capital loss for the income year if your capital losses exceed your capital gains: see section Note 2: Some provisions of this Act (such as Divisions 104 and 118) permit or require you to disregard certain capital gains or losses when working out your net capital gain. Subdivision 152-B permits you, in some circumstances, to disregard a capital gain on an asset you held for at least 15 years. Step 2. Apply any previously unapplied net capital losses from earlier income years to reduce the amounts (if any) remaining after the reduction of capital gains under step 1 (including any capital gains not reduced under that step because the capital losses were less than the total of your capital gains). Note 1: Section explains how to apply net capital losses [i.e. you apply your net capital losses in the order you made them.] Note 2: You choose the order in which you reduce the amounts. Step 3. Reduce by the discount percentage each amount of a discount capital gain remaining after step 2 (if any). Note: Only some entities can have discount capital gains, and only if they have capital gains from CGT assets acquired at least a year before making the gains. See Division 115. Step 4. If any of your capital gains (whether or not they are discount capital gains) qualify for any of the small business concessions in Subdivisions 152-C, 152-D and 152-E, apply those concessions to each capital gain as provided for in those Subdivisions. Note 1: The basic conditions for getting these concessions are in Subdivision 152-A. Note 2: Subdivision 152-C does not apply to CGT events J2, J5 and J6. In addition, Subdivision 152-E does not apply to CGT events J5 and J6. Step 5. Add up the amounts of capital gains (if any) remaining after step 4. The sum is your net capital gain for the income year. 24. Essentially, the Method Statement is following this process: Compare your capital gains and losses for this year to get your net amount; Apply previous years capital losses (i.e. those carried forward ) Apply the general CGT discount (to each gain it can be applied to); and Finally, apply any of the small business concessions that are available. Andreyev Page 4

5 25. This process will give you your net capital gain for the year. Your net capital gain is then added to your income and taxed at your tax rate: 26. It quickly becomes clear that to calculate your capital gains and capital losses (which are fed into the Method Statement), you need to refer to CGT assets, CGT events, capital proceeds, and cost bases. CGT assets 27. We have already mentioned that CGT assets have been very widely defined as any kind or property or a legal or equitable right that is not property 3 including specifically: (f) Land and buildings; Shares in a company and units in a unit trust; Options; Debts owed to you; A right to enforce a contractual obligation; and Foreign currency. 28. Each CGT event generally relies on a CGT asset to trigger capital gains. In practice, because of the wide definition of CGT assets, it makes sense to assume that CGT applies to nearly everything. However, there are these two classes of assets which are specifically excluded or exempt from CGT (even if they would normally fit within the definition of CGT assets): Pre-CGT assets Pre-CGT assets; and General exemptions. 29. The CGT was brought in with the political compromise that only assets acquired after its introduction are subject to the tax. This created an entire class of assets called pre-cgt assets, which create massive distortions and anxiety today as they become more and more valuable for the tax they escape. 30. Essentially, an asset that was acquired before 20 September 1985 is a pre-cgt asset. If the asset is ever subject to a CGT event most commonly if it is sold or transferred (i.e. disposal) then the asset will lose its pre-cgt status and fall into the CGT net. 3 Section ITAA Andreyev Page 5

6 31. This reset of status can be avoided if a roll-over applies. When a reset happens, it is important to be clear what new cost base the asset will acquire, on which any future capital gain may be calculated. There are limited circumstances when shares that are pre-cgt may be subject to CGT on disposal (CGT event K6). 32. In practice, it is important to know when an asset may be a pre-cgt asset, because taxpayers will be particularly concerned not to lose this status lightly. General exemptions 33. Division 118 sets out that the following amounts or assets will be specifically exempt from CGT: (f) (g) (h) (i) (j) (k) (l) Cars and motor cycles; Valour decorations (i.e. medals); Collectibles of $500 or less; Personal use assets of $10,000 or less (i.e. furniture and appliances etc.); Assets used to produce exempt income; Super lump sums; Depreciating assets; Trading stock; Compensation and damages; Family breakdown settlements; Transfers to special disability trusts; and Losses made by exempt entities (i.e. charities etc.). 34. Note that these amounts are generally subject to their own regimes and taxed already. 35. CGT does not apply to personal use assets because they generally decrease in value anyway, and applying CGT to them would require a level of complexity and recordkeeping that would be crazy. 36. The other important exemption is your main residence (which we will not discuss here in any detail). Collectibles 37. There is a subsystem of the CGT regime for collectibles which are defined as: Artwork, jewellery, an antique, or a coin or medallion; A rare folio, manuscript or book; or A postage stamp or first day cover, that is used or kept mainly for your (or your associate s) personal use or enjoyment The definition of collectibles also includes an interest, a debt or option or right in any of the above things. 5 4 Section (2) ITAA Section (3) ITAA Andreyev Page 6

7 39. Generally speaking, if you acquired collectibles for $500, or if they were valued at less than $500 when you acquired them, then any capital gain will be disregarded. 40. If you have a few collectibles that are a set, and would ordinarily disposed of as a set, then the $500 threshold will be applied to the set and not to the individual items. This is an anti-avoidance measure. The main point of this subsystem is to say that capital losses on collectibles are quarantined from your other CGT assets [s (4) ITAA 1997]: If some or all of a capital loss from a collectable cannot be applied in an income year, the unapplied amount can be applied in the next income year for which your capital gains from collectables exceed your capital losses (if any) from collectables. 41. This is because people invest in collectibles in a more speculative manner, which more often lead to losses. This is also because of the difficulties with valuing collectibles in the first place, and the potential for large changes or engineering mischief about these collectibles. 42. Now that we are clear about CGT assets and how they are defined, we are ready to look at CGT events. CGT events 43. Section says: You can make a capital gain or capital loss if and only if a CGT event happens. The gain or loss is made at the time of the event. 44. In other words, nothing happens without a CGT event happening. The CGT event itself triggers any capital gain or loss which we then feed into the Method Statement to get our net capital gain amount and pay tax. 45. The concept of a CGT event was introduced in 1998 to replace the old structure of needing an acquisition and disposal to trigger CGT. Instead, now we have specific CGT events which trigger capital gains or losses in many different situations. 46. Some of these CGT events are weird and not intuitive, but they have been created over time to patch perceived holes in the income tax system (whether they make sense or not). They are all set out in a table in section ITAA There are many other CGT events, which cover the following categories: CGT Event A1 CGT Event B1 CGT Events C1, C2, C3 CGT Events D1, D2, D3, D4 Disposals of assets Using and enjoyment of assets before title passes End of CGT assets Creation of CGT assets CGT Events E1, E2, E3, E4, E5, E6, E7, E8, E9, E10 CGT Events F1, F2, F3, F4, F5 CGT Events G1, G3 CGT Events H1, H2 Trusts Leases Shares Special capital receipts Andreyev Page 7

8 CGT Events I1, I2 CGT Events J1, J2, J3, J4, J5, J6 CGT Events K1, K2, K3, K4, K5, K6, K7, K8, K9, K10, K11, K12 CGT Events L1, L2, L3, L4, L5, L6, L8 End of Australian residency Reversals of roll-overs Other CGT events Consolidated groups 48. You must apply the CGT event which is most applicable to the thing that has happened. The numbering of the events tries to follow a logical order, but this has nothing to do with the priority in which they should be applied. 49. For example, CGT event A1 will apply when there has been the disposal of an asset, but CGT event E7 will apply in the more specific event when a trustee disposes of a CGT asset to you (as a beneficiary) to satisfy an interest you have in the trust s capital. 50. Each CGT event has its own section of the ITAA 1997, which sets out the specific rules for each of these questions: When the CGT event actually happens? Who is said to be making the gain or loss from the CGT event? When you make a capital gain from the CGT event (i.e. how is the asset s cost base to be used to calculate a gain or loss)? 51. Setting out these details is particularly important when you are dealing with CGT events which are more abstract. 52. For example, where a right is created under CGT Event D1 by a leaving employee not to compete, then the CGT is payable by the leaving employee (i.e. the person who created the right), with any gain calculated from value they received to provide the covenant. 53. Common CGT events are: CGT event A1: disposal of CGT asset; CGT event C1: loss or destruction of CGT asset; CGT event D1: creation of rights; and CGT event C2: cancellation or ending of rights. 54. Some of these CGT events exist simply to allow you to claim a capital loss you may have suffered such as CGT event C1. Without these, you would not be able to plug your capital losses into the CGT system. CGT event A1 55. CGT event A1 is by far the most common CGT event that applies. What causes the event? 56. Section says that CGT event A1 happens if you dispose of a CGT asset, which is defined in the following way: Andreyev Page 8

9 (2) You dispose of a CGT asset if a change of ownership occurs from you to another entity, whether because of some act or event or by operation of law. However, a change of ownership does not occur if you stop being the legal owner of the asset but continue to be its beneficial owner. 57. In other words, there must be a change of ownership. A severance of joint tenancy to tenants-in-common is not a disposal; neither is transfer out of a bare trust to the beneficiary. When does the event happen? 58. The provisions for CGT event A1 then make clear exactly when the event/trigger takes place. These timing things are something you need to be particularly careful about. The most simple CGT event A1 is a good example of this, because the provisions say the relevant trigger time is: When you enter into the contract for disposal; or If there is no contract when the change in ownership occurs. 59. This means that you have made a capital gain as soon as you execute the contract of sale regardless of whenever settlement takes place! This is not necessarily what you would expect, especially since legal ownership of the property does not actually pass until settlement. 60. As a result, anyone who enters into a long-term contract for sale should make sure they can afford the CGT that will become liable that income year. If not, they should ask for a larger deposit than normal to pay for it. What amount gives us the capital gain or loss? 61. It is important to carefully look at how the capital gain or loss is to be calculated, because this is not the same for every CGT event. 62. The provisions then set out that: (4) You make a capital gain if the capital proceeds from the disposal are more than the asset's cost base. You make a capital loss if those capital proceeds are less than the asset's reduced cost base. 63. This means we need to refer to the concepts of capital proceeds and cost bases which we will do below. Other CGT events 64. There are many CGT events. 6 It may be worth setting some of them out to give you an idea of the sorts of things they cover. 65. There are different CGT events which happen for options: CGT event D2: granting an option; and CGT event C3: expiry of option (without exercise). 66. There are range of CGT events that occur for trusts: CGT event E1: creating a trust over a CGT asset; 6 See Division 104 ITAA Andreyev Page 9

10 CGT event E2: transferring a CGT asset to a trust; CGT event E3: converting a trust into a unit trust; and CGT event E5: beneficiary becoming absolutely entitled to trust asset. 67. There are CGT events which relate to leases: CGT event F1: granting a lease; CGT event F3: lessor pays lessee to get lease changed; CGT event F4: lessee receives payment to change lease; and CGT event F5: lessor receives payment to change lease. 68. Significant CGT events happen when you leave Australia behind: CGT event I1: individual or company stops being an Australian resident; and CGT event I2: trust ceases to be a resident trust or CGT purposes. 69. There are several CGT events which apply in relation to CGT roll-overs and their reversal (like CGT event J5), as well as several that deal with the consolidation regime (CGT events L1 to L8). 70. The strangest one is CGT event H2 which is essentially a residual or waste basket category that applies when an act, transaction or event occurs in relation to a CGT asset that you own and it has not otherwise resulted in an adjustment being made to the asset s cost base It is important to be familiar with the vast array of CGT events that exist, because these are what will give rise to the sting. 72. Once the CGT event happens, we need to refer to the rules about capital proceeds to figure out any capital gain or loss that we have made. Capital proceeds 73. Your capital proceeds are ultimately what will determine (less costs) how much capital gains you have made. Essentially, your capital proceeds are compared to your cost base to get your capital gain. However, there are several rules and modifications to how we calculate capital proceeds, which are designed to stop mischief and uncertainty. 74. Going back to CGT event A1, those provisions set out that you make a capital gain if the capital proceeds from the disposal are more than the asset s cost base The general rules define that your capital proceeds will be the total of: The money you have received, or are entitled to receive, in respect of the event happening; and The market value of any other property you have received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event). 7 Section (1) ITAA Section (4) ITAA Andreyev Page 10

11 76. In most cases, you will receive a purchase price and this will be your capital proceeds from the sale. However, we include the value of any other property to stop any mischief caused by arrangements to be paid in non-cash ways. 77. There are six modifications that play with this general rule in certain circumstances: (f) Modification 1 - Market value substitution rule: which generally substitutes a market value consideration for your capital proceeds where: 9 (i) (ii) There are no proceeds; The proceeds cannot be valued; or (iii) The consideration provided is more or less than full market value, and the parties did not deal with each other on arm s length terms; Modification 2 - Apportionment rule: which operates to divide proceeds received across several CGT assets on a reasonably attributable basis; 10 Modification 3 - Non-receipt rule: which applies to reduce your capital proceeds where you are not likely to receive some or all the proceeds, not because of anything that you or your associate have done, and you took all reasonable steps to get the unpaid amount; 11 Modification 4 Repaid rule: which applies to reduce your capital proceeds by any amount of the proceeds you repay, or compensation you pay that can be reasonably regarded as a repayment of the proceeds; 12 Modification 5 Assumption of liability rule: which applies to increase the capital proceeds if they acquire the asset from you and take on a liability by way of security over the asset; 13 Modification 6 Misappropriate rule: which applies to reduce your capital proceeds if your employee or agent misappropriates the proceeds (i.e. theft, embezzlement, larceny etc.), less any amount you recover from them later There is a lot of complexity created around these provisions. For example, not all the modifications apply to every CGT event. The market substitution rule does not apply to CGT event C1 (loss or destruction of asset) where no capital proceeds are received Essentially, you can think of your capital proceeds being the purchase price you receive. 80. We now must look at the last major mechanical definition, which is the idea of cost bases. 9 Section ITAA Section ITAA Section ITAA Section ITAA Section ITAA Section ITAA Section ITAA Andreyev Page 11

12 Cost bases 81. As we have covered, the goal of the CGT is to lump your net capital gain into your income for the year. You calculate your net capital gain by feeding all your capital gains and capital losses into the Method Statement. 82. You are meant to figure out your capital gains and capital losses for every CGT event that happened that year, and you calculate each capital gain or loss ultimately by comparing your capital proceeds to your cost base for the relevant asset. 83. This all means that the underlying machinery is cost base vs capital proceeds. 84. Essentially, your cost base is the value of the asset when you first bought/acquired it. In a sense, this will just be the actual cash purchase price you originally paid. 85. However, it was not long before the Commonwealth decide it would allow a range of other costs on your capital assets to also be incorporated into your cost base. 86. As a result, the cost base of any CGT asset is now comprised of five elements: 16 First element: total of: (i) (ii) What you spend to acquire the asset; and The market value of any other property you gave to acquire it; Second element: incidental costs (such as stamp duty, and conveyancing fees); Third element: costs of maintain the land, land tax costs etc.; Fourth element: capital expenditure to increase or preserve asset s value; and Fifth element: capital expenditure incurred to preserve or defend your title in the asset (i.e. cost of fighting in court). 87. In most case, the first element will make up the vast majority of any cost base. However, it is important to understand how the cost base is divided up in this way, because the other elements can be used to significantly reduce the CGT you end up paying. Remember: the higher cost base means the lower capital gain (and tax). 88. There are some modification rules for costs bases, similar to those for capital proceeds. 17 For example, if you subdivide your land then the cost base rules will operate to say that you initial cost base is split among the new subdivided land. 89. We now know enough to calculate a capital gain or loss. However, the last major building block is the CGT discount. CGT general discount 90. The Method Statement is used to calculate your net capital gain this way: Step 1: calculate all your capital gains and capital losses for the current year; Step 2: apply any net capital losses you have from previous years; Step 3: reduce by the discount percentage each amount of a discount capital gain remaining after step 2; and Step 4: apply any small business concessions under Division Section ITAA See Division 112 ITAA Andreyev Page 12

13 91. We need to look at Step 3, and these concepts of the discount percentage and discount capital gains. Why do we have it? 92. One of major concerns of the Asprey Committee (which recommended the CGT in 1974) was to make sure people are only taxed on real capital gains and not simply gains that have occurred because inflation has increased prices. 93. Inflation is essentially the increase of goods and services that happens over time. The Consumer Pricing Index or CPI is one method by which we measure inflation. Source: It was clear that the CGT needed to have some method to take into account inflation. 95. One solution we used to have was indexation of your asset s cost base, effectively to keep it in line with inflation. However, indexation was abolished by the Howard Government in 1999, and indexation can only be claimed on assets acquired before 11:45am on 21 September Indexation was replaced instead with the CGT general discount, for all CGT events that occur after 21 September The CGT general discount was meant to be a rough and ready solution to the inflation problem, by providing discounts of 33% to 50% of any capital gain you make (provided you held the asset at least 12 months). Requirements to claim the discount 97. You can claim the CGT general discount if you meet these requirements: 18 You are an eligible taxpayer i.e. individuals, trusts and super funds; The CGT event happens after 21 September 1999; The capital gain has not been calculated using cost base indexation; The CGT asset involved has been held for at least 12 months; 18 Section ITAA Andreyev Page 13

14 (f) The CGT event must not be an ineligible CGT event (such as D1: creating contractual rights or D2: granting options, but there are others); and The integrity measures do not otherwise deny the discount. 98. These requirements are generally straightforward. There are special rules about acquisition times (against which we test your 12 month holding period) which can operate to deny the discount in relation to certain roll-overs. 99. One sting to be aware of is that you cannot claim the discount on any CGT event relating to a CGT asset that gives rise to a capital gain as a result of an agreement entered into within 12 months of acquiring the CGT asset. 19 This is the case, even if the relevant CGT event only happens after 12 months of acquisition. This is an integrity measure to avoid people using options to cause mischief with the discount There are several rules which deal with the streaming of the CGT general discount through to beneficiaries contained in subdivision 115-C ITAA Discount percentage 101. The amount of the discount percentage depends on the type of entity: 50% for individuals and trusts; and 33⅓% for super funds Companies are completely excluded, and cannot claim the CGT general discount. Applying the discount 103. The CGT general discount is then applied to reduce each capital gain that you make, and we only look at the left over amount to calculate your taxable net capital gain For example, if you (as an individual) make a $400,000 capital gain, then you can apply the CGT general discount to reduce this to $200,000. This means that only the reduced $200,000 amount will be applied to your assessable income this year, and you are only taxed on this amount. This is despite the fact that you have actually received $400,000 in total (which is made up of $200,000 discounted capital gain, and $200,000 disregarded capital gain). Summary 105. The CGT is essentially about charging income tax on the money you make when selling capital assets though several other CGT events capture other things The main concept is your net capital gain which gets added to your assessable income for the income year. You calculate your net capital gain by adding up every capital gain and capital loss you have through the year each of these being calculated through comparing: your cost base (essentially what you paid for it) and capital proceeds (essentially what you sold it for) After you add together all your capital gains and capital losses, you can then claim the CGT general discount to reduce this further, and only this reduced amount goes towards you net capital gain and is taxed. ANDREYEV LAWYERS 19 Section ITAA Andreyev Page 14