Tax Traps

Capital gains tax rules play an important part in accumulating wealth but investors often fail to understand the rules, which means the same mistakes keep cropping up to cause headaches. The Australian Taxation Office is running out of patience and says it wants the situation to improve, so investors had better get ready.
In the June edition of its TaxAgent newsletter, the tax office highlighted problem areas and warned tax agents that comprehensive records must be kept relating to capital gains, that capital losses should only be claimed against capital gains and that losses from capital gains must be deducted before applying the discount.

Life will be easier for you and your self-managed superannuation fund if you sort out three basic aspects of capital gains tax (CGT) treatment: discount rates, capital losses and income from property trusts.

Tax and superannuation consultant Dr Ed Koken says: "There is a lot of confusion about how CGT rules work in self-managed super funds, particularly with the discount rate, and some end up paying too much tax or too little." His comments are not surprising given the complexities built into the CGT law, the many changes that have occurred over the years and the different rules that apply to capital gains made by superannuation funds.

Unlike individuals, self-managed super funds don’t have pre-capital gains tax assets '” all assets that were owned by a fund on 30 June 1988 are treated as though they were acquired on that date and special rules apply to work out the original cost when the asset is sold.

Here, then, are the three most common areas where tax experts and the tax office say self-managed super funds get it wrong:

DISCOUNT PERCENTAGE

Where a self-managed fund disposes of an asset it has owned for more than a year, any gain can be reduced by a discount factor. But the discount is not the same percentage that applies to individuals. Some people believe, wrongly, that their self-managed fund can reduce the capital gain by a 50% discount (as applies to capital gains made by individuals), but this is not true; the discount for super funds is only 33.3%.

The tax rate on capital gains is often quoted as 10% as though there was a separate tax on capital gains. Although this may be the effective tax rate, CGT is not a separate tax and the taxable income of the self-managed fund, including the net capital gain, is all taxed at 15%.

The way CGT rules work is that there is no discount applied to a capital gain until it has been held for more than 12 months. Once an asset has been held for more than 12 months only two-thirds of the capital gain is reported as the fund’s net capital gain and so two-thirds of the net capital gain is taxed at 15%. This example shows you how these rules work.

A self-managed fund had the following CGT transactions during the income year:

• Bought shares for $600 and sold them nine months later for $950.
• Bought shares for $900 and sold them 14 months later for $1500.

The net capital gain for the year is $750 '” $350 from the first transaction, and $400 from the second.

CAPITAL LOSS

A superannuation fund’s net capital gain for a year is its total capital gains for the income year, less its capital losses and any concessions that apply. Some people take the discount off the capital gain first, then reduce the remaining amount by the capital loss.

However, CGT rules firstly reduce the total capital gain by any capital losses, and then take the discount from the remaining capital gains where applicable. You can choose which capital gain you reduce by the capital loss, and the most tax-effective way is to firstly apply the losses against capital gains that are not eligible for a discount, as shown below using the information from the previous example.

If the fund had engaged in a third transaction, of buying shares for $980 and selling them nine months later for $500, the loss there would be $480. The trustees should choose to offset the loss firstly against the $350 gain on the first transaction because there is no discount available, and then deduct the remaining $130 loss from the second transaction. This leaves $270 that is eligible for a one-third discount, so the net capital gain is $180.

PROPERTY TRUST INCOME

Property trusts are a popular investment for self-managed funds because they provide a way to invest in commercial property at a low cost and without the hassle of direct property ownership.

Usually part or all of the income received from a property trust is “tax-deferred” because it has arisen from deductions for building allowances, depreciation and other tax timing differences.

You may think that because you do not include tax-deferred amounts in your income in the year you receive them they are not taxable; however, tax-deferred does not mean tax-free. Each time you receive a tax-deferred amount, the cost base of the units is reduced and this results in a higher capital gain or a reduction in a capital loss when you eventually sell the units and work out any capital gain or loss.

If the total tax-deferred amounts are less than cost base of the units, then the cost base and reduced cost base of the units are reduced by those amounts. If they exceed the reduced cost base of the units but not the cost base, the reduced cost base of the unit is nil when the capital gain is calculated (ie. you cannot make a capital loss where tax-deferred income is more than the reduced cost base). However, if they exceed the cost base, the total capital gain is equal to that excess.

This is how the tax rules will apply to a self-managed fund. Say the fund invested $10,000 in a property trust three years ago and has sold the units for $11,410 in the current financial year. Further, $800 income has been received in each of the three years of ownership. The annual tax statements from the property trust showed that 40% of the income ($320) was assessable income in the year of receipt and the remaining 60% ($480) was a tax-deferred amount.

The fund should have included $320 in its assessable income each year. No tax has been paid on the remaining $480 in each of those years. This year the fund needs to calculate the reduced cost base of its units to calculate the net capital gain on those units. This is $8560, derived by subtracting three times the tax-deferred $480, or $1440, from the original $10,000 purchase price.

If the fund does not have any capital losses its net capital gain from the property trust is $1900, which is two-thirds of the margin between the reduced cost base of $8560 and the sale price of $11,410. The $1900 will be included in the fund’s assessable income.

CONCLUSION

As you can see, it is easy to underestimate the complexity of CGT rules and to get it wrong. Its better to be safe than sorry; where you are uncertain it is worth getting expert advice because if you overstate your capital gain you will pay too much tax, and if you understate it you with incur the wrath of the taxman!