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The capital gains tax main residence exemption, affordable housing and caps

CGT beginnings

With wage and salary earners taxable on virtually every dollar they earn from their work, sources from the Asprey Report (1975) through to the tax summit of 1985 identified the lack of a capital gains tax as a tax regressive unfairness in the Australian income tax system which then relied on a narrower tax base. Before the CGT, gains on investments made by their owners escaped income tax and allowed already wealthier people to step up their wealth untaxed where less wealthy typically working people who paid their taxes could not.

Still it would have been near unthinkable for the Hawke Keating government of 1985 to have introduced the capital gains tax, which then was a partisan political and controversial proposal, into the Australian income tax system without CGT relief on the family home following the tax summit.

In those days a greater proportion of working people and middle Australia owned their own homes. So the exemption now legislated as the CGT main residence (MR) exemption in Division 118 of the Income Tax Assessment Act (ITAA) 1997, then not thought especially regressive, was a political price the government then had to pay to have a constituency-supported capital gains tax in the Australian income tax mix at all.

The uncontained housing tax exemption

But the breadth of the CGT MR exemption has made the CGT MR exemption itself regressive.

The CGT MR exemption is unlimited and especially generous when compared to CGT relief given in other countries.

The CGT MR exemption has these characteristics:

  • generally, where there is no income-earning use of a home and a taxpayer is or is taken to have occupied the home as their main residence while he or she has owned it, any capital gain on the home is fully exempted from the Australian CGT;
  • there is no qualifying length of ownership period to wait before the CGT MR exemption can be applied to exempt CGT on sale of an Australian home – the owner can live there for a month, rent the property out for five years, go overseas, come back and sell the (former) home and claim the full exemption – see section 118-145 of the ITAA 1997; and
  • a taxpayer can turnover any number of homes and keep claiming the exemption from CGT on every successive capital gain. In other words there are no limits on the amount of, or numbers of tax free step ups in, wealth a taxpayer can achieve with no taxation by selling each of their successive and possibly more expensive homes.

This has made Australian home ownership an incomparably attractive investment for tax reasons. This frustrates wider social housing objectives such as opportunity and ability for the populace to securely house themselves when they cannot afford to compete in the housing market especially as long term renting in Australia is not so secure either.

Sources of unaffordable housing

The CGT MR exemption has indisputably contributed to unaffordible housing both as a tax shelter, as a driver of demand for real estate and as an improver of the financial case to own an expensive home. To what extent is not for a tax lawyer, who is no econometrician, to judge. The CGT MR exemption may not even be the greatest contributor to unaffordable housing in Australia. Housing markets around the world are elevated due to the abundance of money injected into major economies by quantitative easing. But in Australia add:

  • dark money laundered through Australian real estate attributable to persisting slack regulation of money flows into Australia, including continuing failure by government to commence the 2007 AML/CTF measures to expand the range of oversight of AUSTRAC to non-financial businesses and professions including the legal, accounting and real estate professions: see my 2017 blog – Sluggish anti-money laundering reform in Australia https://wp.me/p6T4vg-6J and The Lucky Laundry by Nathan Lynch https://cutt.ly/JCwVAyK;
  • housing financialisation; and
  • light and regressive taxation of housing in Australia;

to the reasons why Australian residential property prices have reached the unaffordable levels they have.

The wrong culprit

Light taxation has been widely canvassed in the media as a contributor to unaffordable housing but journalists and commentators frequently focus on the 50% CGT discount for investors and negative gearing as the tax system causes of unaffordable housing unfortunately ignoring the CGT MR exemption or even the various land tax exemptions that Australian state and territory governments extend which shelter owner-occupied homes from state taxation too.

The 50% CGT discount was an inexplicable 1999 adjustment to sound original design of the CGT in 1986. It replaced the indexation of cost (base) which was to ensure an investor paid tax only on a real capital gain after adjusting for inflation but at ordinary income tax rates so the CGT could work fairly and progressively as designed. The 50% CGT discount instead effectively and regressively reduced the income tax rate on investment capital gains made by property investors, as it turned out, during a period of negligible inflation which the 50% discount was meant to overtly but more crudely counter. Now inflation is back so a nuanced policy response may be to scrap the 50% CGT discount and to revert back to the 1986 indexation of cost which should never have been altered in the first place.

In contrast to the CGT MR exemption, the 50% CGT discount has a waiting period, 12 months – see section 115-25 of the ITAA 1997, which is not much, and is limited to 50% as a highest discount to individuals. Like the CGT MR exemption, availability is not limited or capped to those who qualify and this is a boon to investors in the property market although major investors and developers need to be tax wary that their property investment activity is not treated by the Commissioner of Taxation as a business of profit-making by sale with the consequences that:

  • proceeds of sale of investment in housing become taxable as ordinary income;
  • thus CGT relief, such as the 50% CGT discount, is unavailable – see section 118-20 of the Income Tax Assessment Act (ITAA) 1997; and
  • their activities become an enterprise where they must charge the goods and services tax (GST) to buyers for reasons set out in Miscellaneous Taxation Ruling MT 2006/1.

Tax relief saving for a home?

The CGT MR exemption is of no benefit to someone who is saving for a home, but does not have a home yet, whom one would think would be the focus of a real and progressive tax exemption to house. Capital gains made on investments by someone saving for a home are not exempt from tax, and get no better than the 50% CGT discount I have maligned in this post, which is odd when it is understood the tax system gives already housed wealthier citizens, who may turnover a series of homes of increasing value and for increasing gains, full tax relief on each gain made on their homes through the CGT MR exemption.

For the CGT MR exemption to be fairer, and to discourage home buyers from taking on higher mortgages to get into the housing market where ruin may be more likely than gain, could the CGT MR exemption extend to capital gains made by persons who are saving for a home or who are yet to own home on portfolio assets set aside to buy a home they hold in the interim? Clearly the former First Home Saver’s Account scheme, which was an utter failure and repealed in 2014, was not ambitious enough and was a false move to help those accumulating what they need to buy a home.

A cap on the CGT main residence exemption?

A limit or cap could be put on the CGT MR exemption that a taxpayer can use to exempt capital gains on his or her home during their lifetime. This would take heat out of the housing market.

An arguably generous lifetime cap of $A 1 million would still bring in substantial additional CGT revenue that could fund social and universal housing and reduce the CGT MR exemption rort by those who take large or multiple full exemptions on their turnover of increasingly expensive homes. The CGT system already uses a lifetime limit in the small business CGT retirement exemption rules in Subdivision 152-D of the ITAA 1997 and caps now limit contributions that can be put into tax concessional superannuation on tax fairness and equity grounds.

A home turnover limitation?

In many countries in Europe a holding period of less than five years can cause capital gains on assets including the family home to be taxable. Tax relief cuts in where an asset is held for longer. Are their approaches something Australia should also consider when looking at tax exemptions and concessions for housing?

Challenge

There is no doubt changes that really improve Australian housing affordability and address inequitable and fiscally disastrous untethered tax exemptions will be politically fraught especially when there are so many interests vested in the present tax system who may lose with change. In the bigger picture lightly taxed property gains and unquarantined negative gearing deductions can be seen as scourges when proper taxation, orthodox monetary policy and extended oversight of criminal money flows could be used to re-balance the housing investment market with the social housing needs of Australia’s citizens.

Foreign purchaser stamp duty and land tax surcharges – design faults & unit trusts

DesignFault

Advent of the state foreign person property surcharges

Foreign person surcharges have applied on New South Wales, Victoria, Queensland, Tasmania, Western Australia and Australian Capital Territory property taxes following Commonwealth action to have the Foreign Investment Review Board more closely monitor the acquisition and holding of Australian real estate by foreign interests: see our July 2016 blog post:

Australia is now tracking & surcharging foreign buyers of land

https://wp.me/p6T4vg-56

NSW surcharges and current rates

In NSW, surcharges imposed since 2016 are:

(a)          a surcharge purchaser duty (currently 8% of the market value of the property) on the acquisition of residential property in NSW (Chapter 2A of the Duties Act (NSW) 1997 [DA]); and

(b)          a surcharge land tax (currently 2% of the unimproved value of the land) for  residential property in NSW owned as at 31 December each year (section 5A of the Land Tax Act (NSW) 1956).

(Surcharges)

The foreign trusts that aren’t foreign problem

Discretionary trusts with all or predominantly Australian participants and entitled beneficiaries can nevertheless be caught as foreign trusts that must pay the Surcharges. Liability for the Surcharges is based or grounded on sub-section 18(3) of the Foreign Acquisitions and Takeovers Act (C’th) 1975 (FATA): Sub-section 18(3) provides:

For the purposes of this Act, if, under the terms of a trust, a trustee has a power or discretion to distribute the income or property of the trust to one or more beneficiaries, each beneficiary is taken to hold a beneficial interest in the maximum percentage of income or property of the trust that the trustee may distribute to that beneficiary.

sub-section 18(3) of the Foreign Acquisitions and Takeovers Act (C’th) 1975

If the income or property (capital) that could be distributed to a foreign beneficiary of a trust is 20% or more of income in a year or property of the trust, the trust is foreign for FATA and Surcharge purposes. An ameliorating aspect of the Surcharges legislation is that:

  • Australian citizens who are non-residents of Australia; and
  • some New Zealand citizens with certain Australian visas;

who are foreign persons under the wide sweep of sub-section 18(3) of the FATA are excluded from being foreign persons for NSW Surcharges purposes: see sub-section 104J(2) of the DA.

The lengthy transition

Even for those not averse to the idea that foreign individual and foreign trust investors should pay higher property dues the implementation of the Surcharges in NSW has been agonising. Even now, in 2020, four years after liabilities for Surcharges were first imposed under the DA and the LTA the State Revenue Legislation Further Amendment Act (NSW) 2020 (“SRLFAA”) is still needed to phase in the Surcharges, and transitional relief from them, as they apply to trusts.

As well as imposing the wide sweep of what the FATA treats as foreign, the SRLFAA:

  • imposes impugnable trust deed requirements on discretionary trusts (see below); and
  • extends transitional arrangements that were set to end on earlier dates in versions of Revenue Ruling G010 from Revenue NSW and the State Revenue Legislation Further Amendment Bill (NSW) 2019.

Trust deed requirements on discretionary trusts

Where a trust is a discretionary trust for Surcharge purposes then the SRLFAA requires that the terms of the trust must be amended by 31 December 2020 so:

(a) no potential beneficiary of the trust is or can be a foreign person [the no foreign beneficiary requirement]; and
(b) the terms of the trust cannot be amended in a manner so a foreign person could become a beneficiary [the no amendment requirement];

and then only does the discretionary trust, even a discretionary trust that:

  • has no foreign participants or beneficiaries; and
  • thus is not foreign after the FATA wide sweep and sub-section 104J(2) of the DA are considered;

(a Local DT) escape treatment as a foreign trust for Surcharge purposes.

Why the no amendment requirement?

The object of the no amendment requirement is to impose the Surcharges based on the contingency or possibility only that a Local DT may come to have a foreign beneficiary in the future. The position of Revenue NSW is understood to be that Revenue NSW does not have the compliance resources to monitor Local DTs for foreign beneficiaries into the future on an ongoing basis.

Although nearly all discretionary trust deeds contain some kind of variation power, a design fault of such resource-saving requirements viz.:

  • the “irrevocable” requirement of Revenue NSW in paragraph 6 of Revenue Ruling DUT 037 concerning sub-section 54(3) of the DA concerning concessional duty on changes of trustee; and
  • the no amendment requirement now in the SRLFAA;

is that the variation power in many or most trust deeds of trusts in NSW may not permit modification of the variation power to satisfy either of these requirements.

Changing the scope or amending the terms of a trust amendment power

In Jenkins v. Ellett, Douglas J. of the Queensland Supreme Court stated the relevant law and learning about changing the variation power in a trust deed:

[15] The scope of powers of amendment of a trust deed is discussed in an illuminating fashion in Thomas on Powers (1st ed., 1998) at pp. 585-586, paras 14-31 to 14-32 in these terms:

“In all cases, the scope of the relevant power is determined by the construction of the words in which it is couched, in accordance with the surrounding context and also of such extrinsic evidence (if any) as may be properly admissible. A power of amendment or variation in a trust instrument ought not to be construed in a narrow or unreal way. It will have been created in order to provide flexibility, whether in relation to specific matters or more generally. Such a power ought, therefore, to be construed liberally so as to permit any amendment which is not prohibited by an express direction to the contrary or by some necessary implication, provided always that any such amendment does not derogate from the fundamental purposes for which the power was created ….It does not follow, of course, that the power of amendment itself can be amended in this way. Indeed, it is probably the case that there is an implied (albeit rebuttable) presumption, in the absence of an express direction to that effect, that a power of amendment (like any other kind of power) cannot be used to extend its own scope or amend its own terms. Moreover, a power of amendment is not likely to be held to extend to varying the trust in a way which would destroy its ‘substratum’. The underlying purpose for the furtherance of which the power was initially created or conferred will obviously be paramount.”

Jenkins v. Ellett [2007] QSC 154

In our experience a small minority of trusts in NSW have a variation power which expressly permits extension of its own scope or amendment of its own terms. That kind of extended power can raise its own set of difficulties which explains why these extended variation powers are not especially popular. It follows, as stated, that a substantial number of variations of the terms of discretionary trust deeds which the no amendment requirement imposes are prone, or likely, to be beyond the power conferred by the variation power of the trust and thus ineffective on a trust by trust reckoning.

discretionary trust for Surcharges purposes

In section 1 in the dictionary of the DA a discretionary trust is defined for DA and Surcharges purposes:

“discretionary trust” means a trust under which the vesting of the whole or any part of the capital of the trust estate, or the whole or any part of the income from that capital, or both–
(a) is required to be determined by a person either in respect of the identity of the beneficiaries, or the quantum of interest to be taken, or both, or
(b) will occur if a discretion conferred under the trust is not exercised, or
(c) has occurred but under which the whole or any part of that capital or the whole or any part of that income, or both, will be divested from the person or persons in whom it is vested if a discretion conferred under the trust is exercised.

section 1 of the dictionary of the Duties Act (NSW) 1997

More time to check for unexpected foreign trust treatment

With time extended to 31 December 2020 by the SRLFAA to amend trust deeds so a discretionary trust won’t be treated as a foreign person it is timely during the remainder of 2020 to also check the terms of residential land holding trusts that may not ordinarily be thought of as a discretionary trust.

A trust, including a unit trust, that contains powers in its terms which:

  • allow for a beneficiary to be selected by someone to take income or capital;
  • allow for the amount of income or capital a beneficiary is to take to be set by someone;
  • which can change the income or capital a beneficiary will take if the discretion is not exercised; or
  • which can divest a beneficiary of an interest in income or capital which they otherwise would take;

that brings the trust within a discretionary trust in section 1 of the dictionary of the DA needs to meet the no foreign beneficiary requirement and the no amendment requirement in the SRLFAA.

Hybrid trusts and other unit trusts

This definition brings in trusts known as hybrid trusts within this construct of discretionary trust. Shortly stated a hybrid trust is a tax aggressive structure where unit or interest holders have standing vested interests in income or capital of the trust but where, usually, the trustee has a supervening power or powers to divest those interests in income, capital or both in favour of other beneficiaries such as family or related companies or trusts controlled by the unit or interest holder with the standing interest.

Other unit trust arrangements can be treated as a DA discretionary trust even where the discretion is historical, redundant and income tax benign. For instance an older style standard unit trust may be set up by way of initial units and the trustee may be given a discretion in the trust deed not to distribute income or capital to initial unitholders once ordinary units in the trust are issued.

This discretion in the terms of a trust is enough for the unit trust to be treated as a discretionary trust so it would be prudent for the terms of the unit trust to be amended to remove the discretion if that can be done:

  • without resettling the trust; and
  • less onerously than amending the trust deed to comply with the no foreign beneficiary requirement and the no amendment requirement.