The taxation of unrealised profits is a current reality and a Trojan Horse.
Before the Federal Election, the Albanese government had legislation on the books to tax unrealised profits within superannuation funds.
There has been much commentary in the last two weeks. One might say there has been a growing chorus from unlikely quarters about the destructive nature of the policy behind the legislation.
The unrealised economic gain policy is that an accretion in the economic value of an asset is available for assessment each year.
This economic policy is counterintuitive, as it is not productive as it disincentivises the building of wealth.
Under this policy, the owner of a forest plantation, hardwood or softwood, will have an annual asset that grows, literally increasing its value. And under the wide-ranging unrealised gains for assessable income policy, the plantation owner will pay income tax. Anyone who purchases timber to cure it naturally over several years would face the same issue of adding to their gross income to determine assessable income.
Under the proposed legislation to hit superannuation funds, anyone with a plantation currently in a self-managed superannuation fund will pay 15% on the unrealised gain (accretion) in the value of the plantation AND the land on which the plantation is growing.
Supporters of the Treasury Laws Amendment (Better Targeted Superannuation Concessions) Bill will rush to argue this will not happen. That this is only for superannuation funds with more than $3M in assets, and the tax is only 15%.
That’s correct, but have you heard of the story of the Trojan Horse? The City of Troy represents Australian society, the economy, and all of us.
There are several observations that can be made.
- The taxation of unrealised profits has been in place since 2001.
The Income Tax Assessment Act 1997 already taxes unrealised profits or book gains. It has been in force for 25 years, starting at the beginning of the 21st century.
It is known as TOFA, which stands for the taxation of financial arrangements. At the end of the accounting period, usually 30 June, the ‘market value’ of a financial arrangement is ‘marked’. When a ‘mark’ value is at the end of a previous financial arrangement, it is compared with a value up or down. Both values are unrealised, just book value, but the difference is considered to determine assessable income for the income tax year.
A financial arrangement can be a share, a hybrid, a unit in a unit trust and any other financial instrument that meets the Income Tax Assessment Act 1997 definition. The ATO website sells this statutory regime for gains to constitute assessable income in this way.
TOFA provides a principles-based framework for taxing gains and losses from financial arrangements based on their economic substance rather than legal form. Gains and losses from financial arrangements are generally included in assessable income or allowed as a deduction on revenue accounts.
TOFA aims to:
- Minimise the extent to which the tax treatment of gains and losses from financial arrangements distorts trading, financing and investment decisions, risk-taking and management.
- more closely align the tax and commercial recognition of gains and losses
- Minimise compliance costs.
The interesting issue is how many institutions with assets in financial instruments have elected to be assessed using TOFA. I’m unsure how you find out without asking a question in the Senate of the ATO or Treasury. Banks retain financial instruments as part of their compliance with banking regulations. This information is not in the public domain, but would be interesting in the current public discussion.
The unrealised economic gain policy is that an accretion in the economic value of an asset is available for assessment each year.
It is interesting to note that John Howard was Prime Minister in 2001 when Parliament passed this legislation. Commonwealth Treasury had been working on this legislation for at least the past decade, including the Hawke-Keating years.
When the legislation was passed, Ted Evans was the Treasury Secretary, but he was followed by Dr. Ken Henry. The TOFA Rules did not start until March 2009; he was the Treasury Secretary until 2011. Legislation was in the TPFA regime in 2003 and 2009.
Yet Dr Henry has recently stated that the policy behind taxing unrealised gains is not good policy. The issue that is the sleeper here is that there was no public-wide discussion at this time on how the TOFA legislation radically altered the principles of the income tax regime within Australia, which, to that time, had been taxation only of realised gains.
- Taxation of realised gains
It has been a matter of good policy in the principles of income tax that an income tax system taxes gains made or realised. The assessment period is a regular interval of time, traditionally a year.
The policy is that the sovereign State can only take a portion of the accretion of wealth made over the assessment period. What is interesting is that this accretion has been seen as a material increase in wealth, and it was expressed in its fungible State as the value of money. What the Commonwealth Treasury has done is altered policy so that accretion is the economic value, the book value not the actual monetary gain.
This a radical change. Some might argue for revolutionary change.
It is revolutionary not just because it is a major policy change but because it is economically a disincentive and destructive to a middle class with aspirations of wealth accumulation. This is a model where the distribution of wealth is through personal choice as the wealth is realised (after capital gains taxes.
Instead, the economic basis is of a central command economy. This means the State takes all wealth created through, whether through endeavour or inflation, for distribution. Now, supporters of the new tax will be protesting strongly at this analysis, but the issue here is not the bill but the policy structure behind it. The same analysis should have been raised before the TOFA legislation was introduced into Parliament. There was silence then as there is now on the fundamental policy issues.
The Howard Government, with Hon. Peter Costello as Treasurer, moved the drafting of income tax laws to the Commonwealth Treasury. The rationale was taxation laws are economic. That was another decision that had no public debate. It certainly was a very questionable piece of reform!
An economic approach to revenue issues is now a reality. Australia’s Future Tax System review, also known as the Henry Tax Review (as it was chaired by Dr Ken Henry), forwarded the Resource Super Profit Tax (RSPT). The Government adopted the RSPT as a major item from the Henry Review.
The RSPT was to be levied at 40% and applied to all extractive industries.
The tax, which was strongly opposed by the mining industry, was in policy one based on economic arguments. The argument was for a uniform resource rent tax based on distorted investment and production decisions. It was a tax based on economic arguments. The Henry Report section 6.1 is titled “Charging for non-renewable resources.”
- The practical stuff- the money!
It should be known to everyone in business or who is an employee that June 30 is tax time. On June 30, a profit and loss statement is effectively made for each taxpayer. A tax adjustment is made to this statement, taking gross income as income and permitting some expenses as deductions to arrive at assessable income, to which the tax rate is applied.
In this exercise, the income tax payable is fungible or tangible, meaning real, whether cash at the bank, cash drawings, or converted into inventory. For an employee, it is cash at the bank or money spent.
BUT THIS IS DIFFERENCE OF THIS NEW TAXATION POLICY.
In both a business and an employee under an accretion assessment based on economic gain, no cash is involved. The taxpayer has to have deep pockets if assets are experiencing accretion in value (wealth) and have not been realised.
The unrealised economic gain policy is that an accretion in the economic value of an asset is available for assessment each year.
Why the Federal Government is wrong.
The Federal Government says its superannuation bill will only hit the wealthy.
No.
The real implication here is the fundamental change to our Federal income taxation system. It will hit at the very basis of our Federal income taxation system and the type of society in which we live.
The difference, as mentioned above, is a person-based economy where individual choice is exercised and aspiration is rewarded to one where aspiration is quashed as there is no gain, and the economy moves to a command society.
When people say this legislation is a precursor to the taxation of other unrealised gains, they are correct.
- The first step is for the Federal Government to reintroduce the Treasury Laws Amendment (Better Targeted Superannuation Concessions) Bill again, as this is a new Parliament and Bills before the last one have lapsed. Parliament is not sitting until July. The Federal Finance Minister has said there has been enough debate and that the Federal Government has a mandate. The bill will be considered in proceedings. The predicted revenue is already hard-backed in the Federal Budget.
- Secondly, a superannuation fund can hold shares and property. Each of these asset classes will need to be valued at the date of the “arking.” This assists a bureaucracy that is ironing out all the wrinkles for the annual valuation of assets for income tax purposes.
- Thirdly, it will be easy to extend the income tac assessment of unrealised gains.
The hardest thing a Minister has to do in the Federal Parliament is introduce legislation. Why? There is a shortage of the number of days that the Parliament actually sits. But what is guaranteed each year is two Bills related to the Income Tax Assessment Acts—yes, there are two!
With governments spending loaned money as if there is no tomorrow, Treasuries will need to get new sources of revenue. The economic approach is the only easy pathway.
Negative gearing cessation was attempted by the Hawke Government. The attempt lasted a short time. But how about leaving negative gearing in place, but taxing the accretion in annual value? Now, that would be a gold mine. The Government could be generous and give each person one investment property. That will get the young renting investors off the hook, but hit the wealthy and keep the young voters on the side. Seems we have heard this all before!
Let us hope that the debate moves from personal interest to what is good policy and policy that will allow people to grow wealth and thrive, not the opposite.
