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This commentary is written by independent finance journalist James Dunn. The title is Tax time brings investors lots to think about

It was first published on Friday 1 June 2012

And is read by Michael Mullins

Please remember that advice in this podcast represents a general view. It is recommended that you seek specific financial advice, before making investment decisions. The views expressed are those of James Dunn, not necessarily those of Vanguard.

Investors should all have a sign displayed prominently over their desks, stating clearly something along the lines of “Tax Considerations Should Never Drive Investment Decisions,” but there is a flipside to that, which is that tax is something of which investors should always be mindful.

Tax minimisation – as opposed to tax evasion, of course – is a perfectly legitimate goal when structuring your financial affairs.

As the calendar clicks over toward 30 June, many investors will be starting to think about this.

The capital gains tax regime (CGT) gives investors a lot of flexibility in using capital losses to minimise tax legitimately. Firstly, investors can sell under-performing shares to crystallise a capital loss and use the losses to offset capital gains.

Investors are entitled to a 50 per cent capital gains tax discount on profits provided the shares they sold had been owned for more than 12 months. So when using a capital loss to offset a capital gain, it makes sense to use it to offset a capital gain on a stock that has been owned for less than 12 months – where you pay CGT at the full rate – rather than the discounted CGT rate. That way, you get the full value of the loss offset.

In this respect, it is handy that losses made in one asset class can be offset against gains in another. For example, investors who crystallise share market losses made between 1 July last year and 30 June this year can offset them against capital gains made on selling an investment property, or other asset during the same 12-month period.  

A common mistake, however, is to sell loss-making shares before 30 June to crystallise a handy tax loss, thinking that you will buy them back on 1 July.  The Australian Taxation Office (ATO) has cracked down on this practice, which it calls a “wash sale”. If the ATO thinks a loss has been incurred to obtain a tax benefit, it is likely to deny the loss.

Unfortunately, if the shares have gone really badly – for example, entered liquidation or administration, and the shares are frozen at the last sale price – the loss can’t be offset against a gain until the liquidator or administrator declares the shares worthless. This may take some time.

CGT also comes into play in managed fund investments.

A managed fund generates both income from the dividends received from the stocks in the portfolio and capital growth from the sale of shares: at the end of the financial year, the trust has to pay out all of its realised capital gains and net income, both of which are taxed in the hands of the investor.

How the income is taxed depends on the individual investor’s marginal tax rate. But while the realised capital gains are also taxed at each investor’s marginal tax rate, how they are derived has a big part to play in the overall tax liability.

To minimise the level of realised capital gains being distributed by a fund, the manager of the fund must ensure that as much as possible, shares they sell have been owned for more than 12 months, and are thus eligible for the discounted CGT rate (half the investor’s marginal tax rate).

The process is called ‘tax-lot selling’, where the manager (or any investor) selects parcels of shares to be sold, so that as far as possible, the sales qualify for the discounted CGT rate. Tax-lot selling also enables the manager to get the full value of the loss offset by choosing to apply a capital loss to a capital gain on a stock they’ve held for less than 12 months.

For a self-managed super fund (SMSF), the discount for holding stocks for greater than 12 months is only one-third, from 15 per cent to 10 per cent. But the super fund makes up for that in the gains from the franking credit refund, which is enormous.

All of this becomes academic when the SMSF moves to pension phase; that is, you can choose to have your fund pay you a pension. In this case, the assets are held in the fund’s ‘pension account’ which means they are being used solely for the purpose of paying out a pension.

In this case, 30 June comes and goes without a hitch, because there is no tax on the income or capital gains from the assets. Even better, the franked dividends can be refunded fully by the ATO – increasing the effective yield on the dividends significantly, and making dividend income highly attractive to SMSFs.

 But the SMSF doesn’t escape the 30 June period completely worry-free: the fund still has to beware of excess contributions tax, levied if individual members contribute more than the $25,000 in concessionally taxed contributions allowed each year.

Contributions that overshoot the concessional cap are taxed at 31.5 per cent, in addition to the 15 per cent standard contributions tax – pushing the tax take to 46.5 per cent. But contributions that overshoot the concessional and non-concessional caps in a financial year are taxed at 46.5 per cent, bringing the possible tax slug to 93 per cent.

Remember, in the government’s Budget delivered in May, the contributions tax on workers earning more than $300,000 was lifted from 15 per cent to 30 per cent. This move is expected to affect about 128,000 people.

And that concludes the column

Tax time brings investors lots to think about

from independent finance journalist James Dunn on behalf of Vanguard Investments Australia

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Please remember that advice in this podcast represents a general view. It is recommended that you seek specific financial advice, before making investment decisions. The views expressed are those of James Dunn, not necessarily those of Vanguard.