Let’s talk about tax.

Or more particularly let’s talk about how New Zealand doesn’t tax capital gains.

There was a delightful expression I learnt as a junior official to describe situations which make absolutely no sense but are absolutely impossible to change – historic reasons.

So for historic reasons we

• Drive on the left
• Start school at 5
• Don’t compulsorily learn our second official language
• Build houses as one offs
• Treat renting as a short term activity
• Have a 3 year electoral cycle
• Imprison Maori at a disproportionate rate to Pakeha.

And in tax we don’t (theoretically) tax capital gains. In the late 80’s the government of the day did try but that was a step too far for the populace to accept.

There is a vague intellectual basis to the distinction between taxable and non-taxable returns from capital that doesn’t apply to returns from labour which are always taxable. Class oppression anyone? 

It comes from an American case – whose name escapes me – which set out that the fruit of the tree was taxable as income while the growth in the tree –  wasn’t. Of course both the apple and the bigger tree made its owner richer. In accounting changes in the balance sheet are generally income but in tax income – something wot comes in – was only the apple and under an income tax only the apple could be taxed. Continues to amaze me that more of the Monty Pythons weren’t lawyers.

Now in yoga the tree pose is a great pose for balance, focus and clarity of thought but a practice consisting of just the tree pose would be very unbalanced.

And here’s the thing. All this apple – tree stuff is fabulous until such time as the tree says: ‘You know what? Following a strategic review of our business model we need to make efficiencies in our supply chain. Therefore we should get out of apple production and fully focus on opportunities reflected in the ‘getting bigger’ market. We are deeply offended that the Commissioner could suggest that this was in any way related to the tax settings.’

So in the face of all this completely non-tax driven strategic behaviour successive governments – all of whom would never bring in a capital gains tax  – have brought in the following:

• Land rules for developers – returns on buying and selling land if a developer taxable
• Financial arrangement rules – tax tree like gains on financial instruments
• Dividend rules – distributions of capital gains to shareholders – other than on winding up – are taxed
• Foreign portfolio share rules – tax an imputed return
• Revenue account property – assets bought with the intention of resale (good luck on proving that Mrs Commissioner) are taxed when sold
• Taxed distributions from non-complying trusts
• Restraints of Trade and inducement payments are taxed
• Lease inducement payments are taxed
• Residential property sold within 2 years – aka the brightline test

The very major advantage to this approach is that when tree like returns are deemed to be apples, they are taxed fully at the receipient’s marginal rate. None of this  15% stuff which just reduces the incentive for the tree to get strategic rather than eliminates it.

But yeah even with all this fabulousness we still have holes in our base as a result of the residual apple-tree stuff. Aside from the whole appreciating Auckland residential property skewing intergenerational relations and exacerbating class boundries thing; sales of businesses and farms – even serial sales so long as they weren’t purchased with the intention of resale – are tree like returns and not subject to tax. 

And as an extra bit of icing, expenses incurred in building up the farm or business, so long as they met the general deductibilty tests, are not clawed back. Arguably the income from those businesses and farms are still subject to tax but only if the purchase price wasn’t heavily debt funded.

So yeah lefty friends while 15% taxation on realised capital gains wasn’t as good as full marginal rates – I see what you were doing there. Incremental improvement and all that. Half the income at marginal rates might interface better with the existing system though.

Now tax peeps yep it is also true that tree-like falls in value are also not deductible so that there is a degree of symmetry there. And that is absolutely the case when there is no control of the company. So yep the two years savings I invested in the sharemarket 85-87 and lost in October 87 was a non-deductible capital loss.

However if capital is put into a company; spent on legitimate business expenses that are tax deductible and ultimately lost; that loss can be grouped with other companies that have the same or similar (67%) shareholding. And if that company is a look through company it can be offset against the income of the shareholders.

So yeah 15% on realised gains would have been a good start. Shame no one can get elected on it.

Namaste