Category Archives: Investment income

Other capital taxes – what are the options?

Last Thursday I had the very great pleasure of talking about tax to smart young people – here and here – at the Social Change Collective alongside Marjan van den Belt and Max Rashbrooke.

One of the questions was if not CGT and we wanted to tax capital more – what are the options? Answered it on the night but as the sharing individual I am I thought I’d do it for you all too.

This version might even be more coherent. Fingers crossed.

To me the options seem to be:

  • Net equity tax or risk free rate of return method (rfrm)
  • Wealth tax
  • Alternative minimum tax
  • Land tax

Net equity tax / risk free rate of return method

Susan St John is proposing the net equity tax – or risk free rate of return method for residential property.

This means a notional rate comparable to that a risk free rate of return – say 5 year bank term deposit – is applied to the equity held in residential property. This amount then becomes the income that is subject to tax.

For example if a property has a value of $1million – land $800k building $200k – but has a mortgage of $600k – it has net equity of $400k.

If a rate of return of say 3% is applied to the equity of $400k this will generate taxable income of $12,000. This $12k would then be taxed at the tax rate that applies to that particular taxpayer. Say 33% if top rate individual or trust. 28% if a company.

This $12k would replace any existing taxable income from that asset. That is rent would no longer be taxable and so there would be no associated deductions allowed.

As Susan is only proposing that it apply to residential property there would be no particular problems with getting a valuation to work out ‘net equity’ as land is regularly valued.

There could be issues if the debt that is attached to a property funded other investments and not the property itself. However there are lots of issues with debt and how it is allocated generally – I don’t think that is a deal breaker here.

There are also the issues that I raised in my comments on the officials note. For landlords who are currently charging below market rent this may incentivise rent increases. It may also further disincentivise landlords maintaining their properties as there is no tax benefit for doing so.

However that is more the place of regulation rather than tax.

Interim conclusion: Some technical issues with debt allocation and possible adverse behavioural effects by landlords but quite doable. No issues with valuation.

Wealth tax

Max Rashbrooke is proposing a wealth tax on all wealth.

An annual tax of a small percentage of the value of wealth held. As per the previous example – assuming no other wealth was held by the taxpayer – a small percentage – say 1/2% would apply to the $400k and an extra $2000 wealth tax would be payable on top of any other existing taxation.

Unlike net equity tax, this is not a proxy or an alternative calculation of taxable income for income tax to apply to. It is an additional tax on a different base in the same way GST is.

And just like GST it is a form of double tax. Consumption – and GST – is made from tax paid income. That is the same income is taxed twice. It is a feature. The beauty of GST is can also ensure one level of tax is paid when income wasn’t taxed in first place. Say if an untaxed capital gain.

Wealth taxes are similar. If tax has been paid at every level we would get:

  • 1) Original wealth coming from unconsumed tax paid income (current situation) A
  • 2) Investment return on wealth taxed (current situation) B
  • 3) Total wealth A plus B subject to wealth tax (new situation with wealth tax)
  • 4) Wealth if consumed – subject to GST (current situation)
  • For some asset classes such as bank deposits – or possibly foreign shares – this is absolutely the deal as there is no part of the income that is untaxed. In those cases wealth tax seems a bit like over kill/taxation.

    For other classes such as shares, investment in small businesses and unleveraged residential rental property where some part of the return is taxed but there is still an element of untaxed capital gain – depending on the rate of tax – a wealth tax absolutely has merit.

    For serial entrepreneurship or land banking where the whole return is a capital gain – in a world without the capital gain taxed – this is an absolutely bang on approach.

    Assuming this can be got through – maybe with different rates for different types of wealth although that will then bring in issues of debt allocation – the most significant issue will be that of valuation.

    This is particularly the case with valuing goodwill in unlisted businesses. To have to value every year would make the valuation industry very rich.

    Now I know it is possible for the tax administration to come up with some rules of thumb but having been upclose and personal in the Michael Cullen/Troy Bowker spat on exactly this issue – it is definitely a practical thing that will slow this option down.

    Interim conclusion: Need to clarify conceptual basis for including asset classes already fully taxed. Valuation issues likely to be a significant hurdle in practice. But could work.

    Alternative minimum tax

    Geoff Simmons and TOP are proposing an alternative minimum tax on all wealth. A bit like Susan’s proposal but instead of the rate being applied to residential property it would apply to all the wealth of a taxpayer.

    But unlike Susan’s option, instead of the rfrm number becoming the taxable income figure it would be compared to the taxable income that arises under the current tax rules. Tax would then be payable on the higher of the two numbers.

    So in our example above if the property was the only source of wealth and currently returned no taxable income, then the $12,000 would be taxed at whatever the appropriate tax scale is.

    However by including all wealth this option suffers from the same valuation issues as a wealth tax.

    But because it calculates an alternative minimum income level, rather than an additional or alternative tax, there is no issue of double or triple taxation. Its aim is to simply ensure the income that level of wealth should (or is on an imputed basis) be generating is subject to tax at normal rates.

    Interim conclusion: Conceptually the most coherent of all the options but significant issues with valuation. Could work though.

    Land tax

    This would involve an annual tax of a small percentage of the value of land held. Like a wealth tax it would be a separate and additional tax but unlike a wealth tax it is levied on the value of the land – in this case $800k – with no reference to the debt borrowed to purchase it.

    By focussing on land it doesn’t have the valuation issues that a wealth tax or an alternative minimum tax does. Also there are no issues with allocating debt.

    It does, however, seem arbitrary to pick on one asset class only. But as this is the asset class that is currently undertaxed by reference to the level of capital gains earned (1)- such an argument doesn’t stress me.

    It is, though, the current tax base of local authorities so if central government were to move into their tax base, local authorities’ arguments for a portion of GST could become more compelling.

    Interim conclusion: Conceptually the least coherent of all the options. Minimal practical issues. Could definitely work.

    The key difference between all these options is that a land or wealth tax is an additional tax separate to income tax. Net equity or alternative minimum taxes, however, are still within the income tax system but trying to get a better measure of taxable income than the status quo.

    But they have many more things in common.

    Similarities between the options

    Thresholds

    I think all options will need some form of threshold before they apply. No one – thank goodness – is keen on a family home exclusion. But all have additional complexity and compliance cost so something like $500k threshold for an individual could take out personal assets including a home (and maybe KiwiSaver) for most people. This would then mean the taxes could focus on the top end of the income and/or wealth scale.

    May not have cash to pay the tax

    None of these options are realisation based. That is they apply irrespective of whether any cash – or income other than imputed income – has been generated from the assets or wealth. Now I know that Susan St John explicitly doesn’t care about that as she feels then the property should be sold if that is a problem for the owner. I am guessing that is also the view of TOP as it is only cash poor pensioners that can get any deferral.

    I get why economists might not care about this and/or see it as a design feature to encourage more efficient use of assets but not sure that is how the general public would see it. Even with a threshold.

    As an example the Tax Working Group only considered rfrm on residential rental properties as it was only that group that would have the cash to pay it.

    Impact on Māori collectively owned assets

    Māori currently own a tiny fraction of the land they did at the time of the signing of Te Tiriti. And the settlements they have received were only 2% or so of the value they lost through crown action. (2)

    Now the deal with the settlements was that they were to be full and final and that there are no special tax rules. But any tax isn’t linked to cash income earned and targets their assets or wealth, even if not the basis of a potential contemporary Waitangi Tribunal case, will be considered more bad faith action from the Crown.

    As a woke Wellington snowflake I would have no problem exempting assets held collectively under a Māori Authority. Not for tax policy reasons but as a way of preventing further injustice. But as the equivalent noise showed with capital gains, this would not be a universal view.

    Would raise shed loads of money

    Rfrm on residential rental property only was found to raise a $1 billion (3) a year more than the current taxation of residential rental property. This was even when the extension of the brightline test to 5 years and loss ringfencing was allowed for. That was with a rate of 3.5% which was the 5 year bank term deposit rate at the time of the report.

    $1 billion. Every year.

    Let that sink in.

    Final conclusion on all options

    So all options even with quite modest rates could raise seriously useful dosh for the Government.

    But this money wouldn’t come from thin air. Like capital gains it comes from people of means. A section of whom – much like with capital gains – are well organised, connected and resourced.

    So I am not holding my breath for any of these being adopted by a major party any time soon. No matter their merit.

    Andrea


    (1) Paragraph 60.

    (2) For readers interested in more background. Here is the officials paper on the subject for TWG and here is mine as I didn’t feel officials went far enough.

    (3) Paragraph 41

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    PIEs, timebar and tax fairness

    My lovely young friends had a great time with their guest post last week and were delighted with the reception they received. Including getting picked up by interest.co.nz – something they like to point out I have never managed.

    They were really keen to post this week on the digital services tax discussion document which they think is awesome. But I need to have a little chat to them before they do.

    We also had a chat about whether the Andrea Tax Party is really a goer. Much like Alfred Ngaro we have concluded it all seems a bit hard. Also the move from thinking about things to politics hasn’t been the smoothest for TOP. So as the evidence led people that we are, we have decided to conserve our emotional energy and not fall out over boring constitutional issues.

    I’ll stay as your correspondent and my young friends will come back from time to time when they can fit it in between their three jobs and studying. They are also checking out Organise Aotearoa who recently put up this sign in Auckland and seem to be to the left of Tax Justice Aotearoa.

    As well as the digital services tax proposal – which I’ll save for my (briefed) young friends – the other tax story this week was how thanks to the Department upgrading its computer system it has found a number of people – 450,000 – haven’t been paying enough tax on their PIE investments. And while that is the case the Department has said that it won’t chase this tax on any past years.

    Behind this story are two interesting – to me anyway – tax concepts.

    Portfolio investment entities (PIEs)

    These are a Michael Cullen special and came in at the same time as KiwiSaver. Before their introduction all managed funds were taxed at the trust rate of 33% and were taxed on any gains they made on shares sales – because they were in business.

    Alongside all this was passive investment or index funds who had managed to convince Inland Revenue that because they only sold because they had to, those gains weren’t taxable.

    Individual investors weren’t taxed on their capital gains and otherwise they were taxed at less than 33% if they had taxable income below the 33% threshold. This was particularly the case for retired investors.

    The status quo did though give a minor tax benefit to high income people who were otherwise paying tax at 39%.

    So it was all a bit of a hot mess.

    Added into the equation was that, unlike now, the Department’s computer wasn’t up to much so all policy was based on ‘keeping people out of the system’.

    So where the PIE stuff landed was income of the fund would be broken up in terms of who owned it and taxed at the rate of the owners. Except for the high earners – as their alternative was a unit trust taxed at the company rate – the top rate was capped at the company rate.

    Low income people were now taxed at their own rate rather than the trust rate and high income people kept their low level tax benefit.

    Happiness all round.

    But it all depended on the individual investor telling the fund what the correct rate was and boy did the funds send out lots of reminders. I got totally sick of them.

    Particularly when not filling them out meant you got taxed at 28% which was the top rate anyway.

    So the people getting caught out this week would have once told the fund to tax them at a lower rate. It wouldn’t have happened by accident.

    Although it is entirely possible they were on a lower rate at the time – because they had losses or something – and then ‘forgot’ to update it. Such people though would probably had a tax agent who would normally pick this stuff up. So not these people,

    The caught people I would suggest are people, without tax agents, who accidentally or intentionally chose the wrong rate at the time or are PAYE earners whose income has increased over time and didn’t think to tell their fund.

    But really only a tax audit would tell the difference between the two groups even if the effect is the same.

    Time Bar

    The other thing this week has shone light on is something known in the tax community as timebar (2).

    It is a balance between the Government’s right to the correct amount of revenue and taxpayer’s ability to live their lives not worrying about a future tax audit. The deal is that if you have filed your tax return and provided all the necessary information – but you are wrong in the Government’s favour – Inland Revenue can only go back and increase your tax for four years.

    If you haven’t filed and/or provided the necessary information – usually in cases of tax evasion – game on. The Department has no time constraints.

    But the thing is none of this is an obligation on Inland Revenue. It is a right but not an obligation.

    Under the Care and Management provisions (1) – the Commissioner must only collect the highest net revenue over time factoring in compliance costs and the resources available to her.

    And so on that basis – I must presume – she has decided to not go back and collect tax for the last three years underpaid PIE income. In the same way he – as it was then – decided to only pursue two years of tax avoidance that arose from the Penny and Hooper tax avoidance cases.

    Now I am sure this is completely above board legally in much the same way as the use of current accounts or the non-taxation of capital gains.

    But with a tax fairness lens, it makes discussions with my young friends quite tricky.

    They only have their personal labour which, to them, is taxed higher than I was at the same age. They don’t have capital and see this recent story as another way the tax system is slanted against them.

    So I am not sure we have seen the last of the motorway signs.

    Andrea


    (1) Section 6A(3)

    (2) Section 108

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