Most people spend far too much time worrying about tax. Even worse some investors base their investment decision on the tax benefits that they will receive. A sure fire way to lose money.
Tax is always something you should consider, but if you focus your efforts on making money and growing your assets you’ll pay some tax along the way and you’ll do fine in the end. You should take the sensible and legal steps available to reduce your tax, but don’t be obsessed by it.
Tax considerations should almost never influence your selection of investments. Take the popular forestry investments. You purchased a tax deductible investment in trees and claimed the tax deduction. When the trees are fully grown and harvest 10 years later you pay the tax. Unless of course the company goes broke in the meantime (Great Southern Plantations) in which case you lose all of your money.
Taxation should, have an influence on how you hold your investments:
1. in one name
2. in joint names,
3. in a trust
4. in a company
5. in a superannuation fund
The two main taxes which affect your investments are income tax and capital gains tax.
Individual income tax rates range from 0% (for people with income under $18,200) to 49% for anyone whose taxable income is over $180,000. “Taxable income” is the income on which you actually pay tax, after all of your deductions. Be aware that the tax thresholds can change from one year to the next.
Income from your investments is part of your taxable income. Interest income, for example, is simply added to your taxable income and subject to tax. Dividend income often comes with franking credits attached, as discussed in an earlier chapter.
Companies face a flat income tax rate of 30%. Franked dividends received by companies are subject to no tax. This is because tax at the company rate has already been paid by the company which delivers the dividend.
Superannuation funds pay 15% income tax. Note, however, that the screwy definition of income includes the contributions received, as well as income from any investments held by the fund. (Except that non concessional contributions are not subject to tax. These are discussed in a later chapter devoted to superannuation.) Also remember that super funds receive excess franking credits as cash refunds.
Account based pension funds pay nil income tax. These funds also receive excess franking credits as cash refunds.
The differences among these tax rates can have a big effect on how you hold your investments. These tax issues, combined with the other issues of asset protection and control (discussed in a later chapter) should be considered carefully when you decide exactly how you organise your investment structures.
Capital Gains Tax
The first thing to understand about capital gains tax (CGT) is that it only arises when you choose to sell an asset. If you buy shares and hold them forever, CGT doesn’t arise. It’s under your control.
CGT is payable when you make a gain on the sale of a capital asset. If you buy a parcel of shares for $10,000 and sell those same shares for $15,000, a gain of $5,000 arises. In the worst case, this can be treated as just more income, in which case it is taxed at your marginal rate.
Capital gains on assets held more than one year are taxed more gently. Half of your gain is excluded; so on the same transaction as above, you would ignore half of the gain and just add $2,500 to your taxable income. The other way of looking at it is that the maximum tax rate on long-term capital gains is half of 49% = 24.5%.
Companies are not allowed to use the discount method. They can use the indexed method, but the indexation of all assets is frozen at the value as at September 1999 and of course doesn’t apply to any asset acquired after that date.
Trusts simply pass through all of the characteristics of a gain: if it's a short term gain, you should distribute the gain to a beneficiary which either has an offsetting capital loss available or which will suffer the lowest tax liability on the gain. If the trust distributes a long term gain, the beneficiary can exclude part of the gain as if it had realised the gain directly.
Super funds can exclude one third of the capital gain, another way of looking at it is that the Superfund pays tax on capital gains at a rate of 10%. As Superfunds pay tax at a rate of 15% if you deduct one third or 5% you have a tax rate on capital gains of 10%. Account Based pension funds pay no tax on capital gains.
When an individual is dealing with capital gains be careful of Bracket Creep. Remember that realised capital gains can push you into a higher tax bracket. If your other taxable income is just less than $87,000, for example, you're still on the 32.5% marginal rate. If you realise a long-term $20,000 gain one year, you exclude half the gain and add the other half ($10,000) to your taxable income, bringing it up to $97,000. In this case the tax applicable to the extra $10,000 would be 37% plus the 2% Medicare levy, or $3,900.
All of these tax rules have an effect on where you place your investments and can have significant effects on how and when you sell certain assets. Please be careful, however, not to make too much out of the tax effects: if you pick assets which produce good income and good capital gains, you’ll do well. You will also pay some tax, but in the end the good results produced by your investments will overwhelm the tax damage.
The tax treatment of inherited shares depends on when they were originally bought.
Shares bought before 20 September 1985--No tax is payable when you take possession of the shares. Your cost base is the value of the shares on the day your benefactor died.
Shares bought on or after 20 September 1985--For these shares, you inherit your benefactor's cost base. It's exactly the same as if you personally had bought the shares on that date at that price.