The proposed changes affecting investors if Labor are elected federally involve negative gearing constraints, less capital gains tax concessions and no longer refunding franking credits for those who don’t pay tax. Before we recap on the detail of the proposed Labor changes, let’s recall the background.
In 2010, the Henry Tax Review recommended winding back negative gearing. In December 2014, the Government’s Financial System Inquiry found borrowing was distorted by different tax treatments on savings that favoured borrowing in ‘growth’ assets when compared with deposits and fixed income investments. The issues highlighted included negative gearing and capital gains tax, franking credits on dividends and interest withholding tax.
Labor will limit negative gearing to new housing from 1st January 2020 – net losses from new housing investments would still be deductable against wages income. However, new investment in existing properties and shares could only be used to offset investment income tax liabilities but not against wages income. Losses could still be carried forward to offset a final capital gain on the investment. Existing investments would be unaffected.
Capital gains tax
Capital gains discount for all assets bought after 1st January 2020 would be halved. The capital gains tax discount for assets that are held longer than 12 months would reduce from 50% to 25%. Investments made before then are not affected. Superannuation investments are also unaffected, as is the CGT discount for small business assets.
To reduce tax minimisation by “income splitting”, Labor plans to impose 30% minimum tax on discretionary trust distributions to adult beneficiaries. High tax rates already apply to distributions to those under 18.
Franking credits on share dividends
To prevent double taxation, Keating introduced franking credits in 1988. In 2007/8, Costello extended this to refund imputation credits for those who did not pay tax. Company tax on profit that underlies dividend payments can now be passed through to cover personal income tax (or refunded to you if you don’t pay tax). These company tax credits passed on via dividends are called ‘franking credits’. From 1st July 2019, Labor would stop cash refunds for unused dividend imputation credits by those who pay no tax. Pensioners would be excluded from the proposed changes but superannuation pension accounts with Australian shares that pay franking credits would no longer be paid this as a refund. Tax on capital gains in accumulating superannuation is unaffected and franking credits can still be used for this.
What does it all mean?
Clamping down on negative gearing particularly affects property investors. Buying low and selling high is the main game with negative gearing but residential property prices are still declining. Without large capital gains, its only attraction is the savings discipline it imposes. We see many people who’ve borrowed for residential investing and net returns are usually underwhelming, especially if a partially rented holiday house. Superannuation strategies offer much better tax advantages.
But for retirees with significant capital in super pensions, losing franking credits could materially reduce their income (at least initially until markets adjust). Together with more heavily taxed capital growth, this could hit them particularly hard. For our clients, we are reviewing our Self Managed Super (SMSF) portfolio models to overcome this effect, in case the changes become law. This outcome will be reported separately to them.
Perceived unfairness in Labor’s plan to stop refunding imputation credits was a hot topic at the recent national SMSF conference about Self-managed Super. Refunding imputation refunds to those don’t pay tax may seem generous when tax revenue is scarce but it would remove retiree income and if it proceeds, it must be implemented fairly. Otherwise, it could unjustly distort our superannuation system.
Regardless, the change probably won’t raise as much tax revenue as claimed. Investors will either adjust their strategies or wait for the dust to settle into a milder result. Tax-free investors may decide to sell bank hybrids to those who can use the credits, since losing any franked component reduces hybrids’ appeal in a low interest world. They might also either sell their Australian shares for property or international equities, or even shift their Australian equity investments into industry super funds or large Wrap accounts.
Large Wrap accounts report on their tax as a single entity, so spare credits from the pension side can be offset against tax liabilities on the accumulation side. Industry super funds have smaller fund balances than most due to their predominance of members in the accumulating years. As both these report to the Tax Office as a single entity, they can combine their accumulation and pension tax obligations. So, pension member franking credits can be used to reduce the 15% tax for accumulator members.
However SMSFs are usually Mum and Dad funds, often both in pension mode. If super pensioners move from SMSFs into Industry super or larger Wraps, their larger pension balances could begin to swamp any tax sharing advantage from smaller balance accumulators.
Whichever way that investors adjust, savings to Federal Treasury may be nothing much. People and markets always rearrange their affairs to reduce negative impact. So another viable option is to save on adjustment costs and wait out the year or two it may take for this change to normalise.
Despite the unlikelihood of long lasting impact, Labor’s proposed changes must be seen as fair. The best way for this may be for all super funds to separately report pension and accumulation accounts for tax purposes. This prevents surplus pension account franking being traded across to accumulation and ensures all funds are treated equally. At present, the proposed change seems to unfairly favour industry funds over self-managed super. Dare we hope this was not intended?
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Disclaimer: All information in this article is intended to be general in nature for discussion purposes only. So you should not rely on it and seek personalised professional advice before making any decision.