On the eve of the Australian Federal Election the government, with the support of the Greens, has proposed significant changes to superannuation laws, particularly affecting unrealized capital gains. The Government’s proposal aims to include a uniquely new and novel tax on “unrealized capital gains” in superannuation accounts with balances over $3m.
Unrealized capital gain refers to the amount by which an asset has increased in value within the financial year but has not been crystalized or realised. In other words, the gain is entirely theoretical or hypothetical since the investor has not received any cash or other benefit to reflect that theoretical capital gain. In fact, that gain may never be realized if the asset subsequently declines in value after the tax has been paid.
Backlash to Proposal
Just to be clear, no other country in the world taxes unrealised gains in the manner that is being proposed by the current Government.
This is a stunning proposal that has a range of very significant consequences which have the potential to dramatically adversely affect not only the Australian financial markets but the potential wealth of all Australians. It will also reflect as a material sovereign risk issue for potential offshore investors.
A Trojan Horse?
Let’s cut to the chase, implementing this radical proposal initially through the superannuation regime is a trojan horse aimed at acclimatising people to the notion that taxing unrealized capital gains is a legitimate and perfectly acceptable taxation policy. It is not, rather it is a bit like taxing the pay rise you hope you will get before you actually get it.
Once that aim has been achieved it will surely be rolled out across the entire tax system so that all unrealised gains on all assets including shares (both listed and unlisted) and property will be taxed each and every year irrespective of whether those gains were ever realised. To make matters worse, in the case of a subsequent capital loss the taxpayer will not receive a cash tax refund to compensate for the cash tax actually paid the previous year but rather a tax loss carry forward, which presumably will be available to offset any future gains (if any).
Let me posit an example.
A super fund has invested $1,000 in blue chip ASX listed shares and $500 in speculative unlisted start-ups and has $500 in cash. Through good luck or good fortune at the end of the relevant financial year the listed shares have gone up 10% and are now valued at $1,100. The speculative unlisted start-ups, which are highly illiquid and may have restrictions on on-sale, have been spectacularly successful and are now valued at $5,000.
The super fund taxpayer has made a theoretical unrealised gain of $4,600. If you assume a 30% marginal tax rate, the taxpayer will have to pay $1,380 tax. In order to meet that tax liability, the super fund would have to sell all the listed shares and draw upon most of the available cash to meet the tax obligation. That will leave the super fund with $220 cash and the investment in the unlisted start-up.
Fast forward 12 months and the start-ups have unfortunately flown too close to the sun and flamed out, leaving the super fund with only $220 in the bank and a tax loss carry forward of presumably $5,000. The problem is that that tax loss will likely never be able to be utilized because the super fund only has $220 left in it!
There are any number of permutations and combinations of the above example, but the message is clear, in the future it will become impossible to hold higher risk or illiquid assets in a super fund because there will be too much risk on the rest of the liquid assets of the fund associated with meeting the tax obligations on the unrealised gains on the illiquid assets. The same applies if the trojan horse theory is correct and the unrealised capital gains tax is rolled out into the non-superannuation environment, then it will become virtually impossible to hold higher risk illiquid assets in any investment vehicle because of the tax liability risk.
Even more concerning is how will existing super funds with significant unrealised accrued gains which cannot be realised be treated and will there be appropriate “grandfathering“ provisions. For example, what of the negatively geared property investor who has bought an investment property in the super fund 6 years ago and who is cash strapped but sitting on very substantial unrealized capital gains because of the recent boom in property prices? I guess the super fund will just have to sell it (or other superfund assets), at any price, to pay the tax.
One of the very significant consequences of this proposal which seems to have been overlooked is the fact that it will inevitably encourage short termism when it comes to investment horizons and decision making. Each year every investor with unrealised gains will essentially be forced to sell assets to pay tax, which will lead to a rolling 12 month investment cycle, which is not healthy.
Another significant flow on effect of taxing unrealised gains will be the impact on the availability of capital for start-ups in particular, but also illiquid not tradable assets in general, especially if there is any degree of volatility attaching to their potential value or restriction on their on-sale.
Even ordinarily liquid ASX listed securities maybe caught up in the net where, for example, a shareholder is required by the ASX to accept an escrow period of potentially up to two years before the shares can be sold, all while the shareholder will be required to pay tax on any capital gains not yet realized.
Another perfectly foreseeable outcome of this proposal is the mass withdrawal of money out of superannuation, especially SMSFs, so that their balance is below the proposed $3m threshold. When you couple this with the potential shrinkage in available capital t will be a miracle if there is any risk capital available to anyone.
As a final example, consider farmers who have to fund their own retirement. Many do it by putting their farm into a self-managed super fund. When they retire, they might lease out the farm to earn income, sometimes to their children who then inherit the property when their parents die. Under the federal government’s proposed changes, however, farmers with more than $3 million in their super fund will have to pay capital gains tax if their farm goes up in value even though it has not been sold. For many farmers, if they are cash poor, that could mean they may have to sell their farm to pay the tax bill, but if the farm value goes down the next year, they won’t get a tax refund and will no longer own the farm.
The US Experience
Under the Biden presidency a plan was raised that aimed to reduce the federal deficit by $3 trillion over the next decade. The proposal sought to address the wealth inequality in the United States, where the ultra-rich often pay a disproportionately low percentage of their wealth in taxes compared to ordinary Americans. Households with a net wealth over a proposed threshold would be required to pay a minimum effective tax rate of 20% on an expanded measure of income that includes unrealized capital gains.
For example, the proposal would have likely forced Elon Musk to sell billions of dollars worth of Tesla shares to meet the tax on his large unrealised capital gains that have accrued on his shareholding in Tesla, which would have had a materially detrimental effect on the Tesla share price. The same would have applied to many other US tech billionaires eg Zuckerberg, Gates, Bezos with the flow on effect to their respective companies. Not surprisingly, the plan faced such pushback that it was shelved.
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