Potential Options for a CGT

There are two options available for when capital gains would be taxed: accrual based and realisation based.

Accrual based taxation

An accrual based capital gains tax taxes the gain in an asset’s value over a certain period, with the tax payable at the end of this period (typically annually). Under accrual taxation, the tax liability arises regardless of whether the asset is disposed of. Declines in an asset’s value would be treated as a deductible loss and immediately offset against other income or carried forward. There are both positive and negative aspects to accrual based capital gains taxation.[1]

The key advantages of accrual-based taxation include:

  • a substantial increase in average tax revenues;
  • an increase in the overall progressivity of the income tax; and
  • neutrality with respect to investment decisions if applied to all assets at the same rate as other forms of income.

The key disadvantages of accrual-based taxation include:

  • the creation of liquidity problems for shareholders and other capital holders who accrue substantial gains without realising cash;
  • problems with the regular valuation of assets; and
  • greater revenue volatility for the government due to market fluctuations.

Realisation based taxation

In reality, no country has accrual-based capital gains tax, despite its efficiency advantages. Instead, most countries follow a realisation-based capital gains tax. This tax taxes the gain in an asset’s value when that asset is sold.

The key advantages of realisation-based taxation include:

  • ability of taxpayers to fund the tax liability;
  • existence of a sale price for determining the gain or loss;
  • relative simplicity of the concept for taxpayers; and
  • relatively lower revenue volatility than a tax on accrual basis.

The key disadvantages of realisation-based taxation include:

  • incentives to defer the sale of appreciating assets and bring forward the sale of depreciating assets; and
  • the need to ring fence capital losses to prevent sheltering of ordinary income.

As mentioned above, when to implement the CGT is only the first part of the question. Having decided which type of tax to implement, several design questions begin to emerge. Based on research, 5 key issues have been isolated, considered and analysed, based on the Australian example. These are summarised in box 2. [2]

Box 2: Design issues for the implementation of a capital gains tax.

  1. 1.       Accrual or realisation: When the capital gains would be taxed.
  2. 2.       Primary residence: Many countries exempt a person’s primary residence from a tax or tax it at a concessional rate. This can bias investment decisions and undermine the integrity and revenue of a CGT.
  3. 3.       Gains from inflation: A CGT must take into account how to treat gains from inflation. There is the possibility of indexing capital gains to inflation, but this can come at the cost of increased complexity and compliance costs.
  4. 4.      Death: Policy makers need to assess whether, and if so, how, capital gains would be implemented upon death and possible emigration from New Zealand.
  5. 5.       How to transition: The transition from no CGT to a CGT involves the difficult question of how to transition. The transition can be done in three ways:
    1. Gains and losses from assets acquired after the date of introduction (‘grandfathering);
    2. Only gains and losses accumulated after introduction date from assets held on or after the date of introduction (‘valuation day’); alternatively, treat the initial valuation as the higher of the market value on the date of valuation or the original cost; or
    3. Apply a valuation day to those assets that are easy to value and grandfather.

 


[1] Accumulated from: Leonard E. Burman and David I. White, “Taxing Capital Gains in New Zealand: Assessment and Recommendations,” http://www.victoria.ac.nz/sacl/cagtr/twg/Publications/3-taxing-capital-gains-burman_white.pdf (accessed 25 August, 2011), 17; Inland Revenue Department and New Zealand Treasury, “The Taxation of Capital Gains Background Paper for Session 3 of the Victoria University of Wellington Tax Working Group,” 4; BERL, “Headline Estimates of Fiscal Revenue from Capital Gains Tax,” http://www.ownourfuture.co.nz/static/assets/BERL%20report.pdf (accessed 28 August, 2011).

[2] Accumulated from: Leonard E. Burman and David I. White, “Taxing Capital Gains in New Zealand: Assessment and Recommendations,”17; Inland Revenue Department and New Zealand Treasury, “The Taxation of Capital Gains Background Paper for Session 3 of the Victoria University of Wellington Tax Working Group,” 4; BERL, “Headline Estimates of Fiscal Revenue from Capital Gains Tax.”