Classic Texts in Australian and International Taxation Law

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29. Chapter 23 Capital Gains Tax

23.1. In this chapter the Committee turns to the difficult and controversial topic of the taxation of capital gains, one on which it has received a great many submissions. Its discussion is in six sections. The first three examine the case for the general taxation of such gains by special provisions to that end. In section IV proposals are made for the amendment of certain provisions of the Income Tax Assessment Act relating to capital and income. Section V notes the possibility of special treatment of certain types of gain from the sale of land. The conclusions are summarised in Section VI. Certain reservations to the conclusions reached are appended.

23.2. Since the preparation of the Committee's preliminary report, which drew attention to the complexities of this type of tax and the need to prepare and circulate explanatory material, the Government has announced proposals for a capital gains tax which will operate in respect of assets disposed of after 17 September 1974. To date these proposals are available in outline form only, and the legislation to give effect to them has yet to be introduced into Parliament. As a consequence, the full details of the new tax are not available and many taxpayers are in a state of uncertainty as to the tax implications of transactions entered into after 17 September 1974. This is particularly so in the case of deceased estates, the administration of which in many cases cannot proceed until liability for capital gains tax can be ascertained.

23.3. The Committee believes that such a new and complex tax should not be introduced in this fashion. In view of the uncertainties created by the Budget announcement and the fact that the tax will represent a new dimension in the Australian tax structure, the form and details of the tax should be exposed to critical public discussion and comment before the enactment of legislation and certainly before the tax takes effect.

23.4. The other significant development in this area since the preparation of the preliminary report has been the almost unprecedented and rapid acceleration in the rate of inflation being experienced in Australia.

23.5. Accordingly, the Committee recommends that the plans for introduction of the tax with effect from 17 September 1974 be abandoned. Instead, a Green Paper setting out the details of the proposed tax should be published as is now the practice with new taxes introduced in the United Kingdom. This will provide the means for public discussion and enable potential problem areas to be examined before rather than after the enactment of legislation. Only after allowing considerable time for such critical examination of the proposed tax should legislation be introduced. In particular, the Green Paper envisaged should examine the difficulties caused by inflation in the context of a capital gains tax and should traverse all possible approaches to dealing with the problem.

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23.6. It appears from the details so far available of the 1974–75 Budget proposals for capital gains tax that the broad outline of the proposed tax is similar to the Committee's recommendations in its preliminary report; but there are a number of significant areas of divergence. Attention will be drawn throughout this chapter to areas where the Committee's recommendations differ from the Government's proposals in the outline of the tax so far announced.

I. The General Issue

23.7. A capital gains tax is essentially a tax upon gains from the realisation of property where the realisation is not an aspect of the carrying on of a business or the carrying out of a business deal. At present, subject to the Budget proposals, such gains are not taxed in Australia unless they come within sections 26 (a) or 26AAA of the Act (see paragraphs 23.73–23.74). Where such a gain is taxed it is taxed as ordinary income of the taxpayer. A capital gains tax seeks to tax gains that at present escape levy.

23.8. A tax on capital gains is levied today by a number of countries including Canada, France, West Germany, Japan, the Netherlands, the United Kingdom and the United States. In addition Ireland has recently announced its intention of introducing such a tax. Thus most countries comparable with Australia in terms of social background and economic development have the tax and, while this in itself is not a justification for its introduction in Australia, it is an indication that Australia is somewhat out of the mainstream of current thought and practice on this matter.

23.9. The general arguments for and against a capital gains tax can be set out succinctly by testing the tax by the three main criteria of equity, simplicity and efficiency employed in earlier chapters.

23.10. It is a tax which, in any administrable form, must be complex and difficult, and produce some anomalies and inequities of its own. There is no doubt whatever that any revenue it raises could be more cheaply and easily raised in other ways. By the criterion of simplicity it fails.

23.11. The arguments over its consequences for the efficient use of resources are somewhat less easy to assess. In a number of submissions received by the Committee its deleterious effect upon the investment of risk-capital is referred to. But the deterrent effect of a tax on realised gains would be matched by the encouraging effect of an allowance of losses in capital gains assessments, and the Committee doubts whether there is much substance in this argument. The converse argument has also been put that in the absence of a capital gains tax there will be excessive investment in assets which, though they yield relatively little taxable income, are especially likely to appreciate in capital value. There may be truth in this proposition. If so, it is possible that a capital gains tax might deflect investible funds from this area into areas where more risk has to be accepted. On balance, while recognising that a capital gains tax, by the complexity of the calculations it inevitably involves, must be troublesome to investors, the Committee believes that there is a case for it on efficiency grounds.

23.12. It is on grounds of equity that, in the Committee's view, the arguments for a capital gains tax may reasonably be held to be so strong as to overwhelm the admittedly strong case against it on grounds of simplicity.

23.13. The fundamental argument here is that in a taxation system in which ability to pay is a primary test of liability, capital gains, whether accrued or realised, constitute an increase in ability to pay in so much the same way as receipts of wages,

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salaries, interest, dividends and rents as to make it inequitable for them not to be brought to tax. Failure to tax them gives rise to inequity of both the kinds earlier distinguished:

(a) Horizontal inequity occurs because individuals in similar economic circumstances are treated unequally in that those who derive their accretions to market power in the form of non-taxable capital gains pay less tax than those deriving more conventional income.
(b) Vertical inequity occurs between individuals in dissimilar economic circumstances in that the failure to tax capital gains will usually favour those who are more well-to-do rather than those who are less, since the former own more capital per head than the latter and are more likely to make investments that realise capital gains.

23.14. Before the validity of this central proposition is examined, two points need to be made:

(a) The impracticability of taxing capital gains as they accrue is universally recognised: the tax can only attempt to deal with realised gains. Where these gains are in effect the receipts at one moment of several years of accrued gains, to tax them, under a progressive tax system, as if they were one year's income would be inequitable. This is the phenomenon of ‘bunching’ and its treatment requires special consideration.
(b) In inflationary conditions a part, and possibly a large part, of capital gains will be ‘purely monetary’ rather than ‘real’. Though this is a complication that to some extent also affects other categories of income, it is essential to make allowances for it in the taxation of capital gains.

23.15. While these points are, in the Committee's view, sufficient to make it wrong wholly to equate all realised gains with ordinary income, they are peripheral to the question of whether they should be regarded as income at all.

23.16. It is sometimes argued that their present non-taxation is anomalous primarily because many of them are virtually certain, as for example in the case of urban land and works of art. This, pushed to extremes, would not make a very satisfactory case. For if both buyers and sellers were equally well informed, the non-taxation of appreciation would already have been reflected in the relative current prices of the assets so that over time their future returns net of tax to their holders would be the same. Hence the introduction of a capital gains tax would principally create a crop of capital losses among holders of such assets as land, and a parallel crop of capital gains among owners of assets the main yield of which was in taxable income form. The substantive situation here is, however, that no market is ever ideally well informed and that, in relation to such assets as land and works of art, capital gains are mainly achieved by those buyers who have a better knowledge than sellers of market trends. Thus their gains are rightly judged akin to income because most are the fruit of skill and effort.

23.17. The corresponding case against taxing capital gains is sometimes made by suggesting that they are too uncertain, too irregular to be treated as income and should for that reason be left with the non-taxable status now accorded to ‘windfalls’. The temporal irregularity of some realised capital gains has already been conceded as a valid argument for special treatment in a progressive taxation system. But in the Committee's view the other considerations are not persuasive. Uncertainty attaches in greater or less degree to all income, and intermittent earnings are properly brought to

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tax at present. However, pure windfall gains and payment of compensation for physical injuries and injury to reputation should be exempt from taxation. This favourable treatment is in the former case due partly to public tolerance towards good luck but in the latter to the administrative difficulties in bringing the income element in such receipts within the income base.

23.18. The Committee does not believe that the purposes of a capital gains tax can be adequately served by any other taxes. The land taxes currently levied by all State governments do not seem to be adaptable: they only tax one of many vehicles for these gains and they tax the whole value of land and not changes in it. Estate duties impose a tax at only rare intervals and do not impinge on capital gains devoted to consumption during lifetime. A wealth tax would tax them but only incidentally; however, for reasons explained in Chapter 26, this tax is not recommended.

23.19. Hence the Committee concludes that the taxation of capital gains should be introduced in Australia at an appropriate time, and in the next section examines the main provisions new legislation should contain. It is not feasible to do more than set out a broad outline of the coverage and mode of a tax on capital gains that appears suitable for Australian conditions. In particular, certain matters such as the jurisdictional base of the tax and the treatment of lease transactions and part-disposals of assets are not considered here. The Committee has, in general, not attempted to deal with aspects of the tax beyond those covered in the preliminary report and the proposals announced by the Government.

23.20. Complex legislation would be required and much explanatory material would need to be prepared and circulated. The pamphlet giving general information about capital gains tax, issued in the United Kingdom by the Board of Inland Revenue, runs to 112 pages. In preparing the summary suggestions that follow, the Committee has studied with considerable interest the provisions relating to the similar tax introduced in the United Kingdom in 1965 and Canada in 1971.

II. The Method of Taxing

23.21. As already noted, despite the theoretical merit in taxing capital gains as they accrue, the tax can only feasibly be levied upon realisation. To tax gains on an accruals basis would lead to unacceptable problems in the periodical valuation of assets and would generate severe liquidity difficulties for taxpayers. Furthermore, assets fluctuate in value and an asset that eventually gives rise to no gain may nonetheless have given rise to payments and refunds of tax during the period of ownership. Deferring the tax until realisation does, however, have a number of undesirable consequences. It can cause what is known as ‘lock-in’ whereby the taxpayer, unwilling to pay any tax before he has to, defers realising an asset for as long as possible. Moreover, the asset-holder may, by judiciously arranging to realise his gains and losses in the years in which they will secure him maximum tax advantage, be placed in a more favourable position than other taxpayers who are not able to adjust their income between years. Nonetheless the Committee recommends that the tax be levied only upon the occasion of the realisation of the asset, or upon certain occasions (discussed below) on which there is a notional or, as it is usually termed, deemed realisation.

23.22. The role of inflation in generating illusory capital gains cannot be ignored. Inflation is the factor which leads to the greatest difficulty in devising an equitable and workable capital gains tax. It was suggested in several of the submissions to the Committee that the problems associated with levying capital gains tax in inflationary conditions can be obviated by applying a suitable index to the cost price of an asset to

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allow for inflation over the period between purchase and sale, thus separating out the purely inflationary element of the gain. The idea is attractive, but there are two important objections:

(a) Indexation of assets will distort the measurement of gains and losses unless indexation is also applied to reduce the real value of monetary liabilities. Indeed, in the extreme example of a person who purchases an asset entirely with borrowed funds and the asset increases in value at a rate less than the rate of inflation, the application of an index will produce a capital loss whereas in reality there has been a considerable gain because the debt has declined in real terms. The application of an index to all liabilities as well as to all assets was considered by the Committee but rejected as impracticable.
(b) The choice of an appropriate index presents great problems and its application would involve much administrative labour.

After considering at length various forms of indexation, the Committee has come to the conclusion that such a device cannot be recommended as a general solution to the problem posed by inflation. The merits and defects of indexation should however be accorded further study, particularly in the light of the level of inflation currently being experienced in Australia.

23.23. An alternative method of allowing for inflation in the inclusion of a variable proportion of the gain in assessable income, the proportion to be included declining the longer the asset has been held. This will, in general, not make the desired correction for inflation and will usually give the opposite result to that sought. Consider, for instance, an asset purchased for $1,000 which increases in money value at a constant annual rate of 10 per cent during a period when inflation is running at 5 per cent a year. As Table 23.A shows, the net gain (after the cost price has been adjusted for inflation) becomes an increasing proportion of the nominal gain as the period of holding increases. Where an asset has increased in value at exactly the same rate as the rate of inflation, thus giving rise to a gain in money terms but no gain in real terms, the effect of the declining-proportion method would be to impose a capital levy by taxing a gain that has not in reality occurred. The rate of capital levy would not necessarily decrease as the proportion of the nominal gain that was taxed decreased but it might rise before eventually declining to zero. Where an asset has increased in value at a rate less than that of inflation, giving rise to a gain in money terms but a loss in real terms, the declining-proportion method would again impose a capital levy in addition to the capital loss sustained through inflation. As in the preceding case the rate of capital levy would eventually decline to zero, though it might rise for a time before it starts to fall.

TABLE 23.A: INFLATION AND CAPITAL GAINS: PERIOD OF HOLDING

Period of holding Years	Sale price	Nominal gain	Net gain(a)	Net gain as percentage of nominal gain
	$	$	$	Per cent
1	1,100	100	50	50.0
5	1,611	611	335	54.8
10	2,594	1,594	965	60.5
20	6,727	5,727	4,074	71.1
50	117,391	116,391	105,924	91.0
^note

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23.24. A point in favour of the declining-proportion method of taxing capital gains is that it is less harsh than some other methods in the case of assets which have generated either real losses or no real gains, but as a general method of allowing for inflation it has no merit. In addition there would be unacceptable difficulties in devising an equitable and workable method of dealing with capital losses.

23.25. Broadly, there are two main systems in use in those countries that levy capital gains tax: the flat-rate method, which imposes a fixed rate of tax on the gain, and the proportional-inclusion method, which includes a proportion of the gain in the taxpayer's income. The former is employed in the United Kingdom while Canada has adopted the latter.

23.26. A flat-rate capital gains tax has many atractions. It is simple, certain and easily understood. Because it is divorced from the income tax system there is no incentive for the taxpayer to realise capital gains in years when his other income is low, whereas this incentive does exist with the proportional-inclusion method. For the same reason there is no way in which the tax can be minimised by diverting capital gains to other members of the taxpayer's family. It avoids the problem of bunching of gains in one income year, particularly bunching arising from a provision for deemed realisation at death, and the necessity for provisions to mitigate this. It is a simple and effective method of taxing capital gains made by non-residents; and it can be argued that it is a more neutral method of taxing gains made by companies and certain types of trusts as against gains made by individual taxpayers. In addition, since the assessment of the tax would be separate from the assessment of income tax it would be easier to calculate its revenue yield and the issue of an assessment for capital gains tax would not be delayed pending the issue of the normal tax assessment.

23.27. On the other hand, it has the drawback of lack of progressivity. If the rate of tax were set at, say, 30 per cent, then a low-income taxpayer who makes a small capital gain would pay more tax than if the gain had simply been added to his other income and taxed accordingly, while the high-income taxpayer would pay less. This inequity is recognised to some extent in the United Kingdom legislation which gives the taxpayer the option, subject to certain limitations, of including half the gain in his income. With such an option, however, much of the simplicity of this method is lost. More importantly, the tax will normally be progressive over a narrower income range than in the case of personal income tax.

23.28. After considering the alternatives, the Committee has come to the conclusion that the less unsatisfactory method is the second of those mentioned: to tax a fixed proportion of the gain by including it in income, subject to the arrangements described in paragraph 23.35–23.37 for spreading the taxable gain over a period of years. It is recognised that the use of a fixed proportion for determining the taxable elements of all capital gains is open to a number of objections. In particular it will be overly harsh in those cases where gains are largely or entirely due to inflation; and it will be excessively lenient in those cases where very large gains have been made in relation to the amount of inflation that has taken place during the period of ownership of the asset, more especially when the ownership was financed from borrowed funds. Nonetheless the Committee believes it to be an approach that should prove satisfactory in the majority of cases, and it has the advantage of ease of understanding and administration.

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23.29. The choice of the proportion of the gain to be included in taxable income is not one that can be made without reference to the actual level of inflation being experienced. It should not be regarded as fixed and immutable and should be varied if there is a significant increase or decrease in rates of inflation. For illustrative purposes only, this chapter assumes the inclusion of one-half of a capital gain in income and with capital losses being dealt with in accordance with the recommendations in paragraph 23.71. It is recognised that adjustment to the proportion to be included is a very blunt instrument for dealing with variations in the rate of inflation, but it will at least operate in the right direction. It is to be noted in this respect that the Government's proposals for the introduction of a capital gains tax involve the inclusion of half the gain in income; but the rationale for this has not been made public and in particular there has been no statement as to whether or not this half-inclusion is designed as an implicit allowance for inflation. The Committee believes that half-inclusion in circumstances where inflation is at an annual rate approaching 20 per cent is altogether too harsh. If capital gains tax is to be introduced in such circumstances, the amount of the gain to be included in income should be considerably less than half— possibly even less than a quarter.

23.30. The Committee is conscious of the fact that proposing an allowance for inflation in regard to capital gains raises questions as to similar allowances in regard to income gains, particularly when trading stock and fixed assets subject to depreciation are involved. There is also a question of the fairness of treating the whole of any interest on fixed-money return investments as income. These questions are considered in Chapters 8 and 9.

III. Specific Issues

Transitional Provisions

23.31. Only capital gains arising after the introduction of the tax should be liable to tax. The Committee however rejects the view that only gains on assets acquired after the introduction of the tax should be liable. Such an approach would be inequitable and would have a very powerful lock-in effect for existing owners of appreciating assets.

23.32. To ensure that only capital gains arising after the date selected for commencement of the tax are subject to levy, and also that a deduction is given for losses incurred after that date, it is necessary to lay down a procedure for valuing all assets (other than those exempted from the tax) at the commencement date, usually referred to as ‘valuation day’. Furthermore, to reduce the scope for investors to rearrange their affairs so as to benefit from advance notice of the date from which the tax will commence, it is proposed that the valuation day be selected and announced after the decision to introduce the tax has been publicised and after the date selected as valuation day has passed. This should be the case even if the recommendation as to the deferment of introduction of the tax and publication of the Green Paper is adopted. This procedure was followed in Canada, apparently with success.

23.33. The major transitional problem is fixing the value of all assets (other than assets the gains from which are exempt from tax) at the valuation date. In the United Kingdom and Canada specific provisions were introduced to reduce to a minimum the occasions when special valuations by independent or government valuers would be required. The transitional provisions in the 1974–75 Budget proposals have drawn on the United Kingdom and Canadian experience. While there are numerous aspects

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of the transitional provisions not yet announced, the Committee is in general agreement with the principles which it appears are to apply, with the one exception referred to in the next paragraph.

23.34. One method of determining a gain or loss, called the ‘valuation method’, involves comparing the proceeds from the disposal of an asset with the value on a particular day—17 September 1974 in the Budget proposals. The method, as proposed, will apply subject to an over-riding rule that no taxable gain or allowable loss may exceed the difference between the proceeds of the disposal of the asset and its cost. This rule is fair if, for example, the taxpayer can establish that an asset sold in 1975 for $21,000 was purchased early in 1974 for $20,000 although its value on 17 September 1974 was $18,000. The rule limits the gain to $1,000. The rule is unfair where an asset is sold in 1975 for $21,000 and its value on 17 September 1974 was $25,000, as the Commissioner will be obliged to deny the loss to the taxpayer until the taxpayer can establish that the cost of the asset was in excess of $21,000. The ‘cost’ may include some expenditure incurred by the taxpayer and of which he now has no record. The Committee considers that the rule should be limited to gains and not be extended to losses.

Bunching and Spreading

23.35. Since capital gains will usually have accrued over a period of years, it is considered excessively harsh to tax the gain as if it were ordinary income by simply adding half the gain to the other income of the taxpayer in the year of receipt of the gain. With a progressive tax structure this would often mean that the taxpayer would move into a higher tax bracket and the gain be taxed at a higher rate than if it had been subject to tax as it accrued. There are several ways of mitigating such bunching. These include averaging the gain and reopening past assessments, spreading the gain over the period of ownership, and spreading all gains over a fixed period. The Committee recommends that the third method be used and that all gains be spread over a fixed term of years, say five. It is recognised that the choice of an arbitrary period will be generous in the case of assets held for shorter periods and harsh in the case of assets held for longer periods. Nonetheless these inequities are outweighed by the advantages of a fixed period as far as ease of understanding and administration are concerned.

23.36. As an example of how spreading over a five-year period will work, consider three taxpayers A, B and C who earn taxable income (other than capital gains) of $25,000, $15,000 and $5,000 respectively. Assume that in the income year in question each taxpayer sells an asset at an actual gain of $40,000, thus producing a taxable gain of $20,000 (i.e. half the actual gain). Instead of simply adding this $20,000 to the taxpayer's other taxable income, it is divided by five and $4,000 is added to give taxable incomes of $29,000, $19,000 and $9,000 respectively. The additional tax attributable in each case to the addition of the $4,000 is then calculated and multiplied by five to give the total additional tax payable in respect of the capital gain. The results are summarised in Table 23.B on the basis of 1974–75 tax rates.

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TABLE 23.B: SPREADING OF CAPITAL GAINS

	Taxpayer A	Taxpayer B	Taxpayer C
	$	$	$
(1) Taxable income (before capital gain)	25,000	15,000	5,000
(2) Tax payable on (1)	11,620	5,470	680
(3) Taxable income plus one-fifth of taxable gain	29,000	19,000	9,000
(4) Tax payable on (3)	14,180	7,820	2,300
(5) Difference between (4) and (2)	2,560	2,350	1,670
(6) Tax payable on taxable gain: 5 × (5)	12,800	11,750	8,100
(7) Total tax payable: (2) + (6)	24,420	17,220	8,780
(8) Rate of tax on gain: (6) as percentage of $40,000	32	29.4	20.3
(9) Marginal tax rate on top bracket of income including taxable gain (per cent)	64	60	48

23.37. By way of comparison, the tax payable by the three taxpayers if the whole $20,000 of taxable gain were treated as ordinary income is shown in Table 23.C. It can be seen, by comparing line 8 of Table 23.B with line 4 of Table 23.C, that spreading makes little difference to the tax liability of someone who already has a high taxable income; however, the difference is quite marked for anybody on a lower taxable income.

TABLE 23.C: NON-SPREADING OF CAPITAL GAINS

	Taxpayer A	Taxpayer B	Taxpayer C
	$	$	$
(1) Taxable income (before capital gain)	25,000	15,000	5,000
(2) Taxable income plus taxable gain	45,000	35,000	25,000
(3) Tax payable on (2)	24,570	18,020	11,620
(4) Rate of tax on gain (per cent)	32.4	31.6	27.4

23.38. The Committee notes that the Budget proposals for a capital gains tax contain no reference to any form of spreading provisions. While such provisions involve a degree of administrative complexity, they are well justified. The differential effect of spreading provisions on high- and low-income earners in particular is to be noted: the absence of such provisions operates harshly in the case of low-income taxpayers who may realise one or perhaps two large capital gains during their lifetimes. Many taxpayers, especially those of fairly modest means, may not realise any capital gains during life but may have substantial accrued gains at death which will be brought to tax as notionally realised. The absence of spreading provisions is particularly harsh in these circumstances.

Determination of Amount of Gain

23.39. It is recommended that to determine the amount of the gain there should be deducted from the proceeds of sale of the asset:

(a) The cost of the asset, including all costs directly incurred in the purchase such as stamp duty, legal costs and agent's commission. This will apply in the case of assets purchased after the date of introduction of the tax, while to those already owned by the taxpayer at that date the provisions outlined in paragraphs 23.31–23.34 will apply.
(b) Expenditure incurred in enhancing the value of the asset or preserving the taxpayer's title to it. This would usually include the cost of improvements and

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additions but not expenditure that has been previously allowed as a deduction for income tax purposes. In particular, expenditure related to the use or enjoyment of the asset would not form part of the cost base nor would outgoings such as repairs or interest which have been allowed as a deduction for income tax purposes.
(c) Costs directly incurred in the sale of the asset, such as stamp duty, legal costs and agent's commission.

The actual capital gain thus determined then will be halved to give the taxable gain.

Treatment of Companies

23.40. The Committee recommends that in general the treatment of capital gains realised by companies should be the same as for individual taxpayers: a proportion of the gain should be included in income. The Committee notes that the Budget proposals envisage the taxation of capital gains made by companies at a flat rate of 33½ per cent. The effect is the same as the inclusion in income of, approximately, three-quarters of the gain. The logic of this approach is difficult to discern and the reasons for treating companies in a significantly different fashion to individual taxpayers is not clear. If a proportion of a capital gain is to be regarded as income there is no reason why, in effect, different proportions should be deemed to be income depending upon whether the recipient of the gain is an individual or a corporate entity. The Committee thus disagrees with the Budget proposal. Further problems do, however, arise in considering the appropriate tax treatment of capital gains made by companies. These gains will ultimately be distributed to shareholders and the liability of the shareholders to tax on such distributions must be considered.

23.41. Several different approaches are possible, but the Committee favours, at least at the outset, the simple one of regarding half the gain as income of the company and the other half as a non-income receipt. The half regarded as income will be treated as such for all purposes, and thus it will enter the calculation of a sufficient distribution for purposes of undistributed profits tax when the company is a private one. If the amount treated as a non-income receipt in the hands of the company is the subject of a dividend it will, to this extent, be included in the income of the shareholder. There will, in the result, be some failure to carry through to the shareholder the quality of capital gain which the gain had in the hands of the company. However, if the system of imputation credit on the Canadian model as proposed by the Committee in Chapter 16 is adopted, the shareholder will be entitled to credit in respect of the whole of the dividend, both that part of it representing the amount of the gain taxed to the company and that part representing the amount not taxed. There will, in the result, be some correction of the over-taxation of the gain. If, however, Australia comes to adopt the method of advance corporation tax used in the United Kingdom, which restricts the imputation credit by reference to the amount of tax paid by the company, special provisions will be necessary to give some recognition to the quality of capital gain in the receipt by the shareholder. Thus, one-half of a capital gain derived by the company and treated as not being income might be held in a separate account, and a distribution from that account given favourable treatment in the hands of the shareholder. Canada, in relation to such distributions by private companies, gives an exemption from tax.

23.42. The introduction of a capital gains tax will require a reconsideration of section 47 of the Act. That section deems distributions on the liquidation of a company to be dividends to the extent that they represent income derived by the company. While

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the section remains, there will be two elements that have to be distinguished in distributions on liquidation. To the extent that they represent income derived by the company, they will be dividends taxable as such to the shareholders with whatever imputation credit is allowed. For the rest, they will be proceeds of realisation of shares.

23.43. In the United States and the United Kingdom receipts by a shareholder in the liquidation of a company are in general treated as the proceeds of realisation of his shares, which may give rise to a capital gain or a capital loss depending on whether the proceeds exceed or are less than the cost to the shareholder of his shares. This approach has the advantage on the score of simplicity. Section 47 gives rise to some perplexing problems of interpretation and application. If a significant amount of imputation credit comes to be given, the section might be repealed. The present advantage of section 47 to the Revenue in terms of the amount of tax collected would be diminished by the availability of an imputation credit. If a substantial imputation credit is given, and section 47 remains, the advantage to the Revenue will disappear.

23.44. Income may be derived by a company in the course of liquidation, for example from the disposal of trading stock. If section 47 is repealed, there should be provision whereby the liquidator may pay a dividend out of such income or out of income accumulated in periods prior to liquidation which will qualify for imputation credit. In a parallel fashion it could be provided that capital profits generated in the course of a liquidation by the disposal of fixed assets might also be the subject of a dividend. However, if such disposal is simply not recognised for capital gains tax purposes it will be possible to avoid two impositions of tax: there will be no tax to the liquidator. The United States law does not recognise the realisation of a capital asset in liquidation for purposes of taxing company capital gains, though assets distributed in specie are deemed to have been received by shareholders at their market values for purposes of determining the capital gains tax liabilities of shareholders on the deemed realisations of their shares. However, the United States law has not been proof against tax avoidance: if that example is followed, protective provisions will be necessary.

Treatment of Trusts

23.45. As in the case of capital gains derived by companies, the Committee sees no reason for treating capital gains derived by a trust estate in a markedly different manner from the treatment of capital gains derived by an individual. The same proportion of the gains should be included in the income of the trust estate as would be the case with a capital gain realised by an individual taxpayer. However, particular problems arise in apportioning the liability of the tax on a capital gain between the beneficiaries entitled to the income from the trust estate and those who will ultimately be entitled to the capital of the estate. Capital gains will not generally be income according to trust law principles and, unless the terms of the instrument creating the trust estate direct otherwise, will not be available to those beneficiaries entitled to income: they will become accretions of the capital of the trust estate and will enure ultimately to those beneficiaries who take the capital. This being so, it would be unfair as a general rule to impose a tax liability on the income beneficiaries. On the other hand, the identity of the capital beneficiaries is often unknown at the time the capital gain is realised and it is thus impossible to levy the tax directly on them. Accordingly, the Committee recommends that as a general principle the tax be levied on the trustee. It will then be for the trustee to apportion the liability between income and capital beneficiaries in accordance with general principles of trust law and with the terms of the instrument creating the trust.

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23.46. The determination of an appropriate rate of tax will pose difficulties. In Chapter 15 (paragraph 15.34) a special rate of tax of less than 50 per cent is recommended to apply where income is taxed to the trustee because income for tax purposes exceeds income calculated in accordance with trust law. In the Committee's view, it is appropriate to apply this special rate to the half of capital gains taxed to the trustee, except where a lower rate is determined in accordance with paragraph 23.47 or a lower rate is applicable to income taxed to the trustee in accordance with paragraphs 15.33–15.35 (which refer to estates in the course of administration or certain trusts whose income is being accumulated for minor children).

23.47. Where a beneficiary is absolutely entitled to both income and corpus, or the present entitlement of an income beneficiary includes the capital gain, and the beneficiary so elects, the rate of tax should be determined on the basis that half the gain has been added to and is subject to tax as the top slice of the income of the beneficiary. This exception will cover the case where the beneficiary is an infant who is entitled to both income and corpus and the case of a bare trust. It will apply where the trust instrument defines trust income in a way that will include capital gains.

23.48. The transfer of an asset by the trustee to a beneficiary should be treated as a deemed realisation of the asset for purposes of capital gains tax. There should also be a deemed realisation on any occasion when a fraction of the trust assets falls to be included in the estate of a deceased person or is deemed to be disposed of for gift duty purposes. And there should be a deemed realisation on the expiration of each period of twenty-five years referred to in paragraph 24.A42.

23.49. Because of the complexities involved, the Committee does not propose that there should be carry-back of capital losses suffered by a trust. Nor should there be any application of capital losses against income of a trust. Generally, unrecouped capital losses will cease to be available on the termination of a trust. To this there should be one exception. Where a beneficiary who, at the time of the loss, was absolutely entitled to income and corpus receives the corpus of the trust, any unabsorbed capital losses of the trust should be transferred to him.

23.50. Except in one situation, income losses should not be applied against capital gains. The exception proposed is where there are income losses unabsorbed at the termination of a trust. These losses should be applicable against capital gains that arise in the winding up of the trust and the transfer of assets to beneficiaries.

Treatment of Gifts

23.51. Where the taxpayer disposes of an asset by way of a gift or sale at less than market value, he should be deemed to have disposed of the asset at market value and should be liable to taxation on the notional capital gain arising from a deemed disposal at that value. Not to so treat gifts and sales at an undervalue would be to provide a means of avoiding capital gains tax or indefinitely deferring it. There may of course be liquidity difficulties for a taxpayer in meeting the tax arising from the gift of an asset where the notional capital gain is large. However, this would be a factor to be taken into account by the taxpayer in deciding whether or not to make a gift and is in any case essentially no different to the position with regard to a liability for gift duty. Though the primary liability of the tax would be upon the donor, it may be necessary to impose a secondary liability upon the donee. It is noted that the Budget proposals envisage that gift or sale at an undervalue will be treated for capital gains tax purposes as a disposition at full market value. The liability of the donor for capital gains tax should be deducted from the value of the gift in computing his liability for gift

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duty; the effect would be to give a lifetime gift treatment comparable with that of a bequest.

Treatment of Unrealised Gains at Death

23.52. As a general principle the Committee recommends that a taxpayer should be deemed to have realised his assets at death for the purpose of determining capital gains or losses and the taxable portion of any gain treated as if it were income of the taxpayer in the year of death. Not to do so would be to create severe inequities between the individual who dies shortly after realising his gains and the individual who dies before realising them. It would also create a severe lock-in effect for the elderly investor who would be reluctant to sell assets and incur a tax that he would not incur were he to hold the assets until death. It has been suggested that an alternative to a deemed realisation on death is to have a carry-over of the deceased's cost-basis to the beneficiary for the purpose of determining the latter's capital gains tax liability on ultimate disposal, but this might result in an indefinite deferment of tax. The deceased should be deemed to have disposed of his assets, and the beneficiaries be deemed to have acquired them, at their fair market value as determined for estate duty purposes.

23.53. While the Committee recommends that there should be a deemed realisation on death, it recognises that this may give rise to practical difficulties in the case of an estate consisting largely of non-liquid assets such as rural property or shares in a private company. In many other instances, too, when associated with the need to find moneys to pay estate duty (which would be reduced by virtue of the fact that the liability for capital gains tax diminishes the net value of the estate), the imposition of capital gains tax on the deemed realisation may impose a liquidity strain on an estate. Some provisions are necessary to mitigate this hardship and the capital gains exemption recommended in paragraph 23.55 is one such step. As a further measure it is recommended that, in the case of an estate holding a high proportion of its assets in non-liquid items, the capital gains tax liability arising at death should be assessed in the normal way but the payment should be deferred for a specified period or until the realisation of the items, subject to interest at a reasonable rate. As an alternative, provision could be made for payment of the capital gains tax over an extended period, again with interest: a maximum of seven years might be fair.

23.54. The Budget proposals make no reference to any concessional treatment of capital gains deemed to be realised at death. In the Committee's view the liquidity strain that would be imposed on many estates by the combined effect of capital gains tax and estate duty would be so significant as to require relief. This will particularly be so in the case of those estates consisting largely of small businesses or rural property.

Exemption on Retirement, Death or Disablement

23.55. It is important that there be a concession, available on the death of the taxpayer, to give some relief to the estate from what might be a heavy liability to capital gains tax arising from the deemed realisation at death. It is also reasonable that there be some relief to the taxpayer who, as a result of retirement or permanent incapacity, will be realising capital gains after he ceases to be employed or retires from his business or profession. Accordingly, it is proposed that there should be an exemption from capital gains tax of a specified amount of gains realised after attaining the age of 65 or upon permanent incapacity or deemed to be realised at death. The amount should be revised at regular intervals in the light of the rate of inflation: a figure of not less than $40,000 might be appropriate under present circumstances. In the case of gains

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deemed to be realised at death, the exemption will apply no matter what relationship the beneficiaries bear to the deceased, but in the majority of cases it could be anticipated that the exemption will ensure to the benefit of the deceased's spouse and children. The total amount of exemption will be limited and, to the extent that it has been used during the deceased's life, it will not be available on death.

23.56. The Budget proposals do not envisage any exemption from capital gains tax in respect of gains realised after retirement or deemed to be realised at death. This is unduly harsh, particularly in view of the fact that many taxpayers, especially those in the lower income brackets, may not realise any gains during their lifetime but may have accrued gains at death. The liability for capital gains tax on the whole of such accrued gains is likely to impose liquidity strains on the estate, with concomitant hardship for dependants.

Treatment of Taxpayer's Principal Residence

23.57. The taxpayer's principal residence should be considered in a different light to his other assets, particularly in a society such as ours where home ownership is so highly valued and encouraged. A home is regarded as more than simply an investment and it must be remembered that any capital gain on a home will usually be in a sense illusory since the taxpayer will normally have to use all the proceeds of sale to purchase another house of comparable size, comfort and location. To tax the gain would have serious effects on the mobility of the work force. A person might be unwilling to accept a job in another city if the gain on the sale of his house is to be taxed, thus reducing the amount available for purchase of a new house and forcing him to accept a house of a lower standard than the one he has left. In addition, the administrative problems of levying tax upon the gains on the taxpayer's principal residence would be unacceptable. Apart from the task of valuing all houses on the date of commencement of the tax, there would be a continuing problem of determining the costbase of the house. All expenditures on repairs, alterations and extensions would need to be accounted for and dissected into those that enhanced the value of the property (and would thus be taken into account in determining the cost-base and hence the gain) and those that were related only to the use or enjoyment of the property. In addition, homes are commonly owned for very long periods, and records of expenditure on the taxpayer's home are likely to be scanty or non-existent.

23.58. The Committee accepts that it would be possible to adopt provisions giving a ‘roll-over’ (explained in paragraph 23.69) instead of an exemption or confining the proposed exemption to houses below a certain value. If either alternative were adopted, the tendency for resources to be diverted into overlarge houses would be corrected. The former alternative would, if anything, increase the administrative problems. Under the second alternative the administrative problems would be less: only a small number of houses need be outside the exemption. The administrative difficulties would nonetheless still be considerable.

23.59. Accordingly, the Committee recommends that capital gains on the taxpayer's principal residence should in general be exempt from tax. But there is a need to ensure that this exemption is not abused and the Committee favours limiting the exemption to the house together with a reasonable amount of the land on which it is situated. It is recommended that the amount of land qualifying for exemption should be such amount as is reasonably necessary for the enjoyment of the house having regard to its location. The appropriate limits might be:

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(a) in the case of land zoned residential, industrial or commercial: two-tenths of a hectare (approximately half an acre) or such greater area not exceeding four-tenths of a hectare (approximately one acre) as may be reasonably necessary for the enjoyment of the house;
(b) in the case of rural land: one hectare (approximately two-and-a-half acres).

The Committee recognises that any arbitrary limits such as these will produce inequities and anomalies. Four-tenths of a hectare of land in a densely populated inner city suburb may be an excessive amount of land to exempt, whereas a similar amount on the outskirts of a country town may be unreasonably small. Nonetheless the advantages of certainty in this matter outweigh the possible inequities. Where the amount of land on which the principal residence is situated exceeds the exempt amount, the gain would have to be apportioned between the house and exempt amount on the one hand, and the remainder of the land on the other and the latter will be subject to tax. This would give rise to some administrative difficulties and disputes but these should not be numerous having regard to the fact that the vast majority of homes are situated on areas of land below the suggested exemption level.

23.60. The Budget proposals envisage an exemption of the taxpayer's principal residence together with such area of surrounding land (not exceeding four-tenths of a hectare) as may be reasonably necessary for enjoyment of the house.

Exemption of Small Gains

23.61. For ease of administration it is necessary to have some provisions for exempting small gains from tax. While it would be desirable to express this in the form of an exemption for gains not exceeding a certain amount in any one year, overseas experience indicates that such an approach is not satisfactory since it necessitates the computation of the actual gain in order to determine whether or not the exemption applies. For this reason the Committee recommends that an alternative method be adopted and that the exemption apply to the gains arising from the sale in any one year of assets where the total proceeds of sale do not exceed a certain figure, say $1,000. Although this may involve some inequity in that the exempted gain could be $1 or $999, it is felt that in practice the inequities will be slight and will be greatly outweighed by the administrative simplicity of the recommendation.

23.62. The Budget proposals contained no general provisions exempting small gains from capital gains tax. Having regard to the administrative difficulty for both taxpayer and revenue authorities involved in assessing tax on small capital gains, the wisdom of this is questionable. The Committee has been particularly impressed by evidence from the United Kingdom on the difficulties involved in assessing small capital gains and believes that the loss of equity involved in the provisions suggested in the previous paragraph is small compared with the gains in simplicity and ease of administration.

Exemption of Certain Assets

23.63. Gains and losses on certain items of personal use such as motor vehicles and household furniture should be disregarded for capital gains tax purposes. Such items will in general depreciate rather than appreciate over time and if brought within the net of capital gains tax would for that reason lead to capital losses. For those few items such as antique furniture and jewellery that may appreciate, the problems in determining the cost of assets which may have been purchased many years before ultimate disposition would often be extremely difficult.

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23.64. The Budget proposals envisage that items of personal-use property originally costing less than $500 will be deemed to have cost $500 for the purpose of assessing any gain on disposition; and where the proceeds of disposition are less than $500 they will be taken to $500, thus limiting the taxable loss to the excess of cost over $500. In addition, under the Budget proposals certain specified personal-use items such as jewellery, coins and works of art will be treated in the same manner as non-personal-use property to the extent that all gains will be subject to capital gains tax but losses will be available to be offset against gains on similar property. The Committee is in general agreement with the philosophy underlying the Budget proposals: personal-use property which normally deteriorates through use should be disregarded for capital gains tax purposes, but property which is as much for investment as for personal use and which may thus appreciate in value over time should not be exempted. Nonetheless there are considerable difficulties in drawing a clear dividing line between the two types of personal-use property. The Committee therefore recommends that while such property as jewellery should be subject to the tax, furniture, even though it may be antique furniture, should be altogether exempt. Furthermore, attention is drawn to the fact that the application of the $500 rule referred to above is likely to give rise to considerable dispute and administrative difficulties in the case of items such as stamps and coins which may be disposed of in sets.

Life Assurance Policies

23.65. The general tax treatment of life assurance is considered in Chapter 21. The Budget proposals envisage the exemption from capital gains tax of the amount payable under a life assurance policy or any part of such amount, which is in line with the Committee's own thinking.

Superannuation Rights

23.66. The tax treatment of superannuation is also considered in detail in Chapter 21. The Committee is in agreement with the Budget proposals that superannuation receipts should not come within the ambit of capital gains tax.

Depreciable Assets

23.67. Where assets on which depreciation has been allowed for income tax purposes are sold at a price greater than the original cost of such assets, the excess should be regarded as a capital gain. It is to be noted, however, that the practical application of capital gains tax in the area of depreciable property on which a surplus arises on sale will usually be mitigated by the roll-over provisions referred to in paragraph 23.69. Where the asset is sold for less than the written-down value, the deficit will, as now, be treated as an income loss.

Intangible Assets

23.68. The Committee can see no good reason why, in general, the disposal of intangible assets such as goodwill, patents and trade-marks should be treated any differently, for purposes of capital gains tax, than tangible property.

Roll-over for Certain Assets

23.69. In certain circumstances where an asset is disposed of and the proceeds are invested in a similar asset, or where the disposal of one asset and acquisition of another involves merely a change in legal form but not a material change in the substance of what is owned, the new asset should be regarded as a continuation of the old

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with the cost-basis of the latter being carried over. This is known as a ‘roll-over’, and provisions of this nature are commonly found in capital gains tax legislation as a means of reducing the undesirable aspect of lock-in. The Committee recommends that roll-over provisions should apply in the following cases:

(a) The disposal and replacement of certain business assets (such as plant, machinery and buildings) within specified periods and the expropriation, loss or destruction of such assets followed by a replacement with assets of a similar nature. A suggested period in which the replacement must take place is one year for plant and two years for buildings.
(b) The transfer of assets to a company in which the equity shares are wholly owned by a taxpayer. A proportionate roll-over should be allowed where the taxpayer takes up more than a nominal proportion of the equity shares.
(c) The transfer of assets to a partnership in which the vendor is a partner, to the extent that the vendor acquires an interest in the capital of the partnership.
(d) The distribution of assets upon the dissolution of a partnership.
(e) Certain types of company mergers and reconstructions.
(f) The liquidation by a company of a wholly-owned subsidiary.

23.70. The Budget proposals envisage the availability of roll-over provisions in circumstances yet to be precisely defined but which accord in broad outline with the recommendations of the Committee.

Treatment of Losses

23.71. One of the distinguishing features of capital gains in comparison with other income is that the taxpayer will usually be able to choose the time at which he realises his gains and losses. If half the gains were included as income and half the losses allowed as a deduction from income, there would be a considerable incentive for taxpayers to realise their unprofitable investments, thus obtaining a deduction, and retain their profitable ones, thus deferring the tax on their gains: in short, a taxpayer would realise his losses and ‘hoard’ his gains. Such an approach cannot be countenanced and the Committee recommends that in general capital losses should be taken into account only as an offset to capital gains. However, special provisions should be made for capital losses unrecouped at death, for small capital losses (on administrative grounds) and for the carrying back of capital losses by re-opening past assessments of capital gains, the allowable capital loss being assumed, in line with the treatment of a capital gain, to be half the actual loss. Accordingly, it is recommended that:

(a) There should be a limited carry-back of allowable capital losses, the extent of the carry-back to be the same as that recommended by the Committee for income losses.
(b) Allowable capital losses should be permitted to be carried forward indefinitely as an offset to future taxable capital gains.
(c) A limited allowance of, say, $1,000 of allowable capital loss (i.e. up to $2,000 of actual capital loss) should be permitted to be offset against other income.
(d) Special provisions will be needed to counter artificial losses and sale-and-buy-back transactions.

The order of application of allowable capital losses should be:

firstly against taxable capital gains of the same income year;

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secondly against taxable capital gains made during the period allowed for carry-back;

thirdly as to (say) $1,000 of allowable capital loss (i.e. $2,000 actual capital loss) against other income;

any excess to be carried forward with the first (say) $1,000 of the excess allowable capital loss available as an offset to other income in the next year.

Where a taxpayer dies with unrecouped or unrealised capital losses, the allowable capital loss should be applied:

firstly against taxable capital gains made in the income year of death and gains deemed to be realised at death;

secondly against taxable capital gains made during the period allowed for carry-back;

thirdly against any other income (without limit) of the income year of death or the preceding income year.

23.72. The treatment of capital losses proposed in the Budget diverges quite considerably from the recommendations of the Committee. In general the Budget proposals appear to be harsher than the Committee's recommendations in that they allow no general carry-back of capital losses (other than a three year carry-back at death) and there is no provision for offset of any part of a capital loss against other income.

IV. The Distinction Between Capital and Income

23.73. If the Committee's recommendations with regard to the introduction of a capital gains tax were to be adopted, the recurrent disputes between the Revenue and the taxpayer attendant upon the realisation of various forms of property would be diminished in number. The present conflict in the rival contentions, on the one hand, that the profit is a taxable income-profit and, on the other, that the profit is a nontaxable capital profit, should be reduced for the reason that the difference in the amount of tax exigible in any transaction will be considerably less than under the ‘all-or-nothing’ approach which must result under the legislation in its present form. The problem of distinguishing between capital and income will continue to exist since, with the presence in the system of a capital gains tax, a capital-profit and an income-profit will be brought to tax in ways producing different monetary consequences. That problem is one which has always defied easy solution because the criteria for distinguishing between the two types of profit can, according to circumstances, encompass such a wide variety of matters which may be relevant to its determination that no universally infallible touchstone is possible. Hence, the fact that the Act does not contain any comprehensive definitions of capital, income, gross income or assessable income should occasion no surprise.

Section 26(a)

23.74. An attempt was made in 1930 to achieve a greater degree of certainty in this area by the enactment of provisions now represented by section 26 (a) which includes as assessable income of the taxpayer:

‘(a) profit arising from the sale by the taxpayer of any property acquired by him for the purpose of profit making by sale, or from the carrying on or carrying out of any profit-making undertaking or scheme.’

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This enactment has proved to be unpredictable in its application and a most potent source of disagreement and litigation between taxpayers and the Commissioner. Until recently its first limb had been thought to involve a subjective test: what was the taxpayer's dominant purpose at the moment of acquiring the asset? The second limb, however, had been thought to involve an objective test as to whether or not the taxpayer was ‘carrying on or carrying out a profit-making undertaking or scheme.’ The second limb thus involved an examination of whether or not the undertaking or scheme was essentially of a business nature, whereas the first limb simply involved an inquiry as to the purpose of the taxpayer at the time of acquisition of the asset. These long-held interpretations of the somewhat differing requirements of the two limbs of the section have now been shown to be incorrect by a recent decision of the High Court. It appears that the first limb as well as the second limb requires that some ‘business purpose’ be shown before the section will have any application. The section is thus considerably narrower in scope than had been thought, and in the Committee's view this narrowing of the section means that it now adds nothing to the determination of income for the purposes of the Act. In other words its operation is merely declaratory, adding no more to the section than section 25 has already provided. Furthermore, the High Court's decision has placed further constraints on the operation of section 26 (a) by requiring that there be a complete identity between the property acquired and the property disposed of. This means that the section may have no operation in cases such as the exercise of an option and subsequent profitable resale. The Committee can see no good reason for retaining the section and recommends that to avoid any further uncertainty it be repealed.

Section 26AAA

23.75. Section 26AAA was inserted into the Act in 1973 and by the introduction of a time-limit seeks to remove some of the difficulties inherent in section 26 (a) by including in the assessable income of the taxpayer any profit arising from the sale of property (other than the taxpayer's home realised as a result of a change in his place of employment or business) within twelve months of its purchase. In the absence of a capital gains tax of the type referred to above, it achieves a measure of certainty in that, in effect, it is a short-term capital gains tax. However, where property is held for more than twelve months after its acquisition, the taxpayer and the Commissioner are then faced with the problems which section 26 (a) creates. In practice a great many land transactions, and probably a number of other property sales, will fall outside the ambit of the section. The section also does not take into account any deductions for losses incurred when property is sold within twelve months; nor does it make any provision for the cases where through some unexpected hardship the taxpayer is forced to realise his property, especially his residence, within the time-limit. The Committee does not favour a short-term capital gains tax by reason of the complexities such a method of taxation involves, in particular in conjunction with the general capital gains tax the Committee has proposed. Having regard to the wider application of the capital gains tax recommended above, the Committee also recommends the repeal of section 26AAA.

Replacement of Sections 26 (a) and 26AAA upon their Repeal

23.76. Firstly, it will be convenient to point out that the Committee's recommended capital gains tax will cover the ground presently marked out by section 26AAA. Secondly, with regard to section 26 (a), it is apparent that no definitions or principles can be framed to provide either a universal or, short of that, a satisfactory solution for the problem of distinguishing between capital and income and between business income

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and non-business receipts. The distinctions between these concepts will of necessity remain areas of difficulty. The Committee is, however, of the opinion that consideration should be given to strengthening the broad sweep of section 25 without in any way detracting from its generality as a substantive enactment. This objective could be attained by giving to the decision-making tribunals directory emphasis of the fact that a business transaction can just as easily be constituted by a single act or operation or by one performed apart from the taxpayer's usual occupation, as a series of repetitive acts. This proposal, expressed as being without restriction of the generality of section 25, would neither add to nor detract from its actual scope and operation and would have an application equally to transactions resulting in a profit as to those in which a loss occurred. The well-known ‘badges of trade’ would still be the major considerations to which recourse would usually be had. However, the effect of the proposal would be that a declaratory warning would be contained in the section that the absence of one of those ‘badges’, which is so often relied upon to deny the business element in an isolated transaction, i.e. the frequency of similar transactions, cannot always be successfully relied upon. The repeal of section 26 (a) would necessitate the repeal of the similar verbiage in the definition of ‘income from personal exertion’ in section 6 (1) and also the repeal of section 52.

23.77. The Budget proposals specifically state that capital gains tax will not apply to transactions caught for income tax under section 25 or under sections 26 (a) or 26AAA upon the assumption that these two latter sections are to be retained against the Committee's recommendation.

V. Development Gains Tax

23.78. Certain types of gains on land have characteristics distinguishing them from gains on other assets. Three main varieties of gain can occur with land:

(a) Gains from carrying on a business in land dealing or development. These are essentially the same as any other business activity, with the land forming the trading stock of the enterprise and the gains, as now, normally being taxed as income. (It should be noted that the Committee's recommendations in paragraph 23.76 will ensure that such profits are taxed as income even if the transaction is an isolated one.)
(b) Gains arising from the realisation of the land by its owner where there has been no change of permitted use. These gains would emanate from inflation or from the normal operation of rising market demand when a commodity is in fixed supply. Such gains would normally be taxed as capital gains.
(c) Gains arising from the actions of public authorities in permitting change of use of the land together with any gains arising from associated or consequential development carried out upon that land. These mainly take the form of gains upon the re-zoning of land or the granting of development approval for a large project and gains resulting from subsequent sub-divisional or other development operations.

23.79. The third category of gains has one main characteristic distinguishing it from other capital gains. The change-of-use gains are made possible, not by the efforts of the individual, but by the planning decisions of public authorities. As such, they should enure more to the benefit of the whole community than they do now or would

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do under a capital gains tax of the kind proposed. Where the actions of the community give rise to a sudden increase in land values, as in the case of population growth leading to the re-zoning as residential of outer suburban or rural land, the community has a right to a greater share in such increases. The taxation system should if possible be brought to bear on such gains by taxing them more severely than if they were ordinary capital gains.

23.80. A tax on the gains arising from the disposal or deemed disposal of land with development potential was foreshadowed by the Conservative Government in the United Kingdom in late 1973 and a Bill to give effect to this was then introduced by the present United Kingdom Labour Government in the early part of 1974 and enacted as a part of the Finance Act 1974. This Act was extremely complicated in its provisions and application and was subject to considerable debate and criticism. The Australian Government's Budget proposals for taxing land gains of this type appear to be a somewhat simplified version of the United Kingdom provisions. However, it is understood that the United Kingdom Government will now not be giving effect to the recent legislation but intends instead to introduce a special development land tax. Details of this latest proposal are not yet available.

23.81. The Committee has been unable to undertake a full study of the ramifications and difficulties of the various systems for taxing the increment in land value attributable to changes in the permitted use of land. While the equity arguments for a tax of some sort on these gains in addition to a capital gains tax are impressive, any such tax must undoubtedly be extremely complex, difficult to administer and productive of some inequities and anomalies. Accordingly, the Committee makes no recommendations in this area but suggests that any proposals for such a tax should be subject to the widest possible public debate before their introduction.

VI. Conclusion

23.82. In conclusion it may be helpful to give a broad summary of the analysis of this chapter:

(a) On grounds of equity there is a very strong case for taxing capital gains, and there is a case too on economic efficiency grounds. A tax on capital gains should therefore form a part of the Australian tax structure. However, the introduction of such a new and complex tax is a matter requiring careful thought and considerable public discussion. Furthermore, the introduction of such a tax at a time when inflation is running at an annual rate approaching 20 per cent must result in the taxation of ‘paper’ gains in many cases.
(b) Accordingly the 1974–75 Budget proposals to introduce a capital gains tax with effect from 17 September 1974 should be withdrawn. A Green Paper on the United Kingdom model should be published to provide adequate opportunity for critical analysis and debate before any legislation is introduced and before the tax goes into operation.
(c) Further study needs to be given to the most appropriate way of allowing for the impact of inflation in the context of a capital gains tax. Whilst the Committee rejects the indexation of gains as impracticable under normal conditions, it recognises that this device has some merit in conditions of very high inflation and is worthy of further examination. If a capital gains tax is to be introduced which adopts the proportional inclusion method recommended

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by the Committee, then the proportion of the gain to be included in income should be considerably less than half during periods of high inflation.
(d) The tax should apply only to gains accruing and realised after the introduction of the tax and the family home should be exempt.
(e) Continued efforts are needed to achieve a workable system of distinguishing between income gains and capital gains.
(f) The possibility of treating development gains more severely than other capital gains requires close consideration, but the attendant complexity of any such separate tax on development gains must be borne in mind.

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Reservation to Chapter 23: Capital Gains Tax

My first reservation relates to one of the Committee's reasons—the prevailing high rate of inflation—for recommending that the introduction of a capital gains tax should be deferred. I have a second reservation about the steps proposed by the Committee to clarify the distinction between an income gain and a capital gain.

In paragraphs 23.4 and 23.5, and in 23.84 the Committee recommends that the introduction of a capital gains tax should be deferred. One reason given is that the public have not been sufficiently informed of the details of the tax which has been announced. With this reason I agree. Another reason given is the prevailing high rate of inflation. With this I disagree.

It is true that inflation distorts the operation of a capital gains tax but it distorts the operation of other taxes as well, more especially income tax in relation to business income and interest income. Any thoroughgoing adjustment of the tax system to take account of inflation involves radical changes first in business and investment practices, and then in the tax law, so as to apply indexation in the calculation of gains and losses from transactions. Meanwhile it is only possible to provide mitigations which offer rough and ready relief in an inevitably discriminatory fashion. The Committee has proposed such relief in the form of the inclusion of only a fraction of capital gains in income. It has also proposed that there be some relief from the taxation of interest income, though relief which is much less significant than that contemplated in respect of capital gains.

The difficulties associated with adjusting gains and losses to take account of inflation may point to the conclusion that a capital gains tax should not be introduced at all and that one should move away from income tax to other taxes such as value-added tax, gift and estate duty and, perhaps, a wealth tax, where the difficulties associated with adjustments for inflation can be handled more easily. There is much to be said for such a view. But temporising about the introduction of a capital gains tax is a different matter.

The suggestion is made in paragraph 23.28 of the report that altering the fraction of capital gains to be included in income is a means of adjusting tax on capital gains to the prevailing level of inflation. It is said that it might be appropriate to introduce a capital gains tax now if only a small fraction of gains were to be included in income. The suggestion, in my view, has no merit. It is enough to draw attention to the implication that the fraction will be increased when the present period of high inflation has passed, and to the consequence that a taxpayer who held an asset during the period of high inflation, but realised the asset after it had passed, will be denied the special relief. If special relief to deal with a period of high inflation is contemplated, it could be provided by a limited indexation of costs of property held during the period. The special relief would of course be rough and ready—it should not be applied so as to give rise to a loss—and it would be subject to the criticism that it would give an advantage to a taxpayer who had acquired his asset with borrowed funds. But it will, at least, be directed to giving relief to those whose gains are illusory because of the inflation which prevailed while they held the assets.

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The Committee has recommended in paragraphs 23.75–23.79 that the specific provisions of the Act, sections 26 (a) and 26AAA, which are concerned with the distinction between an income gain and a capital gain, should be repealed. As I understand the recommendation, it is proposed that it should be left to the Courts to define the boundary line, subject only to an additional provision giving directory emphasis to the fact that a single act or operation or one performed apart from the taxpayer's usual occupation may give rise to an income gain. I would prefer a reform which would seek to strengthen the specific provisions. In my view the boundary line is more likely to be clarified by legislative prescription than by judicial precedent.

Section 26 (a) is admittedly unsatisfactory as at present drafted. Amendment to the first limb is called for to remove the emphasis on the subtleties of dominant motivation. The operation of the amended provision should be made to depend on the drawing of an objective inference from the actions of the taxpayer and other circumstances, that at the time of his acquisition of the property he had a purpose to profit by the realisation of the property. The inference will in most instances be drawn from the very limited current return in income or enjoyment from the property during the period it was held by the taxpayer, or from the short period it was held by him. Purposive acquisition will not be a condition of the application of the section. It will be applicable to a receipt under a gift inter vivos or by will. Those questions which presently arise when the taxpayer's purpose of profit-making at the time of acquisition cannot be identified with the part of the property he realised, can be avoided by the way the new provision is drafted. And the drafting should seek to overcome the tendency to bring refinements of property law to bear in determining whether the property realised was the property acquired and in the interpretation of the words acquisition and realisation.

Consideration might be given to extending the scope of the new provision so that it will be applicable when the inference is that for some period prior to disposal of the property that taxpayer had a purpose to realise it at a profit. He may have ceased current income-producing operations on the property some time prior to its sale. It would of course be necessary, in determining the amount of the profit, to value the property at the time when, according to the inference, the purpose arose.

I suggest that the second limb of section 26 (a) should be replaced by a new section which would include as income the profit derived from a business undertaking. Both this new section, and the section which will be constituted by the amended first limb, should be limited in their application so that they will not cover profits of transactions which are aspects of a continuing business. Such profits may be left to be dealt with by other provisions of the Act. The new section would provide that, in addition to any other circumstances which may indicate a business undertaking, regard should be had to the presence of a number of specified circumstances, any one of which may be held to be a sufficient indication. The circumstances so specified would be such as would be thought to justify treating a resulting profit as income. The list of indications might, for example, include the following:

(a) That the taxpayer made physical changes to property as a preliminary to its realisation.
(b) That property held by the taxpayer in one parcel was divided as a preliminary to, or in the course of, its realisation in several parcels.
(c) That the taxpayer secured an enlargement of his interest in property as a preliminary to the realisation of his interest.

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It is true that the phrase ‘business undertaking’ must qualify the force of any indication. But the indications must in turn affect the meaning of the phrase: the words must be read in their context. Hopefully, the new section would bring a greater measure of certainly to an area of tax law which has been characterised by divergences of judicial opinion.

In my opinion section 26AAA should be retained. The section makes a short period of holding—twelve months—conclusive that any profit is income. The sections replacing section 26 (a) will have limited application to share transactions. Section 26AAA provides, I believe, an acceptable way of drawing the distinction between income gains and capital gains arising from share transactions, when the taxpayer is not engaged in a continuing business involving such transactions. Within the limits of its operation it achieves certainty. The section may seem unfair where the taxpayer has been forced to realise property within the period: an exception, added to the one relating to the taxpayer's residence, would however cure this. The section has been criticised on the ground that it deters non-residents from entering into transactions on Australian stock exchanges: an exemption, if thought appropriate, would answer this criticism. The failure of the section to provide that a short period of holding is sufficient to give the right to a deduction of a loss is an element which, if it be unfair, cannot easily be cured. To allow such a deduction would convert the section into a short-term gains tax, since the application of the loss would have to be restricted. It may not, however, be unfair that a taxpayer who can choose to realise property outside the twelve months period, and thus prevent an income gain arising, should be denied a loss available against income gains when he chooses to realise within the period. A loss within the period will be deductible as a capital loss under the Committee's proposals.

Three collateral matters in relation to the sections to replace section 26 (a) merit some attention. Recent authority has made evident the need for a provision which will bring in as income a deemed profit when a transaction or undertaking otherwise within one of the sections has been commenced but has been terminated by a disposal of property otherwise than in carrying out the transaction or undertaking. The common illustration of such a termination is a gift of the property to a spouse or other associated person. An existing provision (section 36) of the Act will bring in a deemed profit when the property is stock in trade of a continuing business carried on by the taxpayer. But this is presumably inappropriate when the transaction or undertaking is not an aspect of a continuing business. There is a subsection (subsection (4) ) in section 26AAA which might be the model for the proposed provision. Consideration might be given to extending the operation of the proposed provision so that it will bring in a deemed profit on the death of the taxpayer.

A number of authorities, some of long standing, indicate the need for a provision by which shareholders and their closely-controlled company are to be treated as one: a realisation of shares may then be treated as a realisation by the shareholder of property of the company.

It is not by any means clear that a loss arising from an isolated transaction or undertaking will be deductible in the absence of an express provision. The meaning to be given to the word ‘loss’ in the general deduction section (section 51) is left obscure by judicial pronouncements. In my view section 52, which presently allows a deduction of a loss arising from a transaction within section 26 (a), should not be repealed. It should, however, be adapted so that it applies to a transaction or undertaking within the sections replacing section 26 (a).

R. W. Parsons

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31. Reservation to Chapter 23: Capital Gains Tax

My reservation to this chapter relates to the Committee's proposal in paragraph 23.58 that a tax on capital gains, when imposed, should be levied by a proportional inclusion method.

This proposal will add unnecessarily to the unavoidable complexities of a tax of this type and in my opinion the flat rate method to which reference is made in paragraphs 23.25, 23.26 and 23.27 is preferable. It would be altogether more simple, even with any modification incorporated to reduce the impact of tax on lower income taxpayers.

K. Wood

^note

The University of Sydney- Classic Texts in Australian and International Taxation Law