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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