With the election only a few days away, many of our clients have expressed confusion about the potential impact of a Shorten Labor Government. We’ve taken the time to explain some of Labor’s key tax reform proposals; identifying who will be the winners and losers, plus some of the potentially impactful reform proposals that have slipped under the radar.
Lost in the Middle?
As advisers we are constantly exposed to a broad range of political views and opinions. Rather than trying to impose our own views, we see our role as helping clients better understand the mechanics and implications of policy, in the hope this will allow them to better develop their own attitudes and opinions.
Whilst there are always ‘rusted on’ Liberal and Labor supporters, our conversations in recent months have suggested that there may be more people in the ‘undecided camp’ than in elections gone by.
Many clients seem genuinely confused as to the technical implications of a change of government. In this era of slogan style politics, it seems nobody takes the time to explain the detail.
For these ‘undecided people’ the problem seems to have been exacerbated by the shifting of politics away from the middle. Whereas in the Rudd and Turnbull eras the policy differences between the major parties were minor, recent times have seen Labor shift to the Left and the Coalition be forcibly moved to the right by its right faction.
These undecided voters represent a growing cohort who are often socially progressive (e.g. support gay marriage, accept the science of climate and tend to be non-religious), while also being strong economic conservatives (believing that markets allocate capital better than governments and that smaller government is generally better than bigger).
These people are at a loss as to whom to give their vote. A vote for either party presenting too big a compromise to their conscience.
On one side we have a Coalition government that is likely to provide more of the same, while on the other we have a Labor opposition intent and making radical changes in order to implement an ideological agenda.
We haven’t discussed Coalition tax policy at length here because their position is largely to maintain the status quo – while Labor want to change rather a lot, so the Labor tax policy platform is the focus of our discussion today.
What is clear is that Labor’s tax reforms have been designed to substantially reduce the number of avenues available to affluent Australians for tax planning. Or in Chris Bowen’s language “close tax loopholes”.
Whereas the use of self-managed super funds and discretionary family trusts is currently widespread, under a Labor government the benefits of these structures will be substantially reduced – thereby encouraging many to wind up those entities and move to simpler, more conventional super funds and company structures.
It is important to note that none of Labor’s tax reforms are supported by the Coalition. Thus, for any of the tax reforms we are about to discuss to get up, Labor would firstly need to win the election, and secondly, get their proposals through both the lower and upper houses. The closer the election outcome, the more challenging this is likely to be.
Key Tax Reforms being proposed by the Labor Party:
- Excess imputation credits non-refundable from 01/07/2019.
- Reduction of the CGT discount from 50% to 25% for assets acquired after 01/01/2020
- Removal of negative gearing on investment properties other than ‘new housing’ purchased after 01/01/2020;
- Introduction of a minimum 30% tax rate for discretionary family trust distributions from 01/07/2019;
- Reduction in the income threshold from $250K to $200k for the additional 15% tax on concessional superannuation contributions;
- Non-concessional contribution cap reduced from $100,000 pa to $75,000 pa
In the articles that follow, we endeavour to explain each of these reforms in turn, so feel free to scroll to the ones that interest.
Franking Credits Non-Refundable (Imputation)
To understand the proposed changes to franking credits, it is first important to understand how the dividend imputation system works and how it was conceived. Dividend imputation was introduced so that company profits were not taxed twice. Without imputation, profits earned by a company are taxed both in the hands of the company itself and then again in the hands of the shareholder when they receive a dividend.
For example, if we consider ‘Company A’ which has just one shareholder and earns a profit of $100. The company pays tax on its profit at the corporate tax rate of say 30%. So, the company’s profit after tax is $70. The company then pays all its $70 profit as a dividend to its sole shareholder. The dividend is then subject to personal income tax in the hands of the shareholder. If we assume the marginal tax rate of the shareholder is 47%, then the $70 dividend is reduced to around $37 after personal income tax is paid. So in total the tax office has collected around $63 tax on income of $100.
The architects of imputation felt that taxing the same source of income twice was ‘double dipping’, so the imputation system was designed to provide the shareholder with a credit for the tax that had already been paid at the company level.
With imputation in force the example above plays out quite differently. 30% tax is paid on the $100 profit at the company level, but the shareholder gets a credit for that and they only pay ‘top-up tax’ if their marginal tax rate is higher than 30%.
In this example, where our shareholder is on the 47% rate, the top up tax amount is the difference between the shareholder’s rate and the company tax rate. So, 47% -30% = 17%. So the shareholder pays an additional 17% x $100 = $17. The end result is that tax on the original profit amount is levied at the shareholder’s rate.
The original imputation system meant that imputation (franking) credits could be used to reduce an individual’s tax liability. However, much like other tax credits within the tax system, if someone didn’t have a tax liability, or the tax liability was smaller than the imputation credits, the imputation credits went unused.
In 2001, the dividend imputation system was amended to allow any excess imputation credits (i.e. those in excess of the tax liability) to be paid as a cash refund. This meant those people with a tax rate lower than the company tax rate (generally 30%), would receive a cash refund where they had no other tax liability.
The Labor opposition has proposed that the changes introduced in 2001 be reversed, meaning that the original imputation system would effectively be restored i.e. after 1 July 2019, any excess imputation credits would no longer be paid as a cash refund.
To ensure that the measure does not impact upon those receiving a government pension or allowance (including those receiving a full or part age pension, disability support pension, carer payment, parenting payment, Newstart or sickness allowance), Labor has announced a Pensioner Guarantee, meaning recipients will still receive any excess dividend imputation credits as a cash refund.
Labor sees this as a vital area of tax saving should it form government at the next federal election, with the current dividend imputation system forecast to cost more than $56 billion to the federal government over the next ten years.
Implications & Comment
Labor’s policy position has disenfranchised thousands of ‘self-funded retirees’ and particularly those who run their own Self-Managed Super Funds, are wholly in pension phase and have invested heavily in Australian shares. This cohort of people can be quite severely impacted as they are accustomed to receiving significant tax refunds of franking credits in their super funds. In some cases, these people stand to lose as much as 10% of their income.
This policy is interesting in that it hits the mid-affluent retirees whilst sparing high affluent retirees. Albeit it is worth noting that high affluent retirees with more than $1.6M in super were forced to shift balances above $1.6M from tax free pensions back into accumulation phase where they pay tax at 15% when the pension transfer cap was introduced by the Coalition in 2017.
Family Trusts, Imposing a Minimum 30% Tax Rate on Distributions
For me this policy has been the ‘sleeper’ of the campaign, largely flying ‘under the radar’. It hasn’t featured much in the public discourse, yet it stands to have a very significant impact on families and small businesses.
Perhaps the reason this policy has garnered so little attention is that the layperson (both in the media and the electorate) simply doesn’t understand how trusts work. Even those with trust of their own, often don’t fully understand how they work.
Compounding the misunderstanding is the widely-held view that only the very wealthy benefit from trusts. In truth thousands of low to middle income families use family trusts. Indeed, a report from the Australian Institute suggests family trusts have assets of more than $3 trillion and annual revenues of $350 billion. The same report showed that 21% of national income is funnelled through trusts.
It is unsurprising then that the Labor’s proposals to alter the way trust distributions are taxed stands to raise around $7.7 billion over four years and more than $28 billion over ten years.
Broadly speaking trusts can have the benefit of reducing tax, protecting assets and providing a mechanism for preserving wealth for future generations.
When a small business operates through a family trust, the family can spread the business profits among family members, thereby reducing the average rate of tax paid by the family group in aggregate.
The key to understanding the taxation of trusts is appreciating that trusts themselves don’t usually pay tax or retain their profits. Instead, a trust’s income and realised capital gains are distributed each year to its beneficiaries – meaning, profits are passed through the trust to family members and taxed as ordinary income in their hands.
Family trusts also have the added benefit of being able to vary the share of income that goes to the various family members from year to year to optimise the tax outcome.
For example, if a family’s small retail business generates operating profits of $200K and the business is run through a Family Trust, then the family can distribute the profits equally across its five family members (i.e. Mum, Dad and three adult children). This results in each family member receiving a trust distribution of $40,000. Assuming the family have no other source of income, each family member pays personal income tax of around $4,547, or $22,735 for the group. So, the average tax rate paid on business profit is around 11%.
If on the other hand the business was operated through a company, then the businesses profit would be taxed at the small business corporate tax rate of 27.5%. If we assume Labor’s changes to imputation credits are also implemented, then the lowest conceivable average tax rate for the family group would be 27.5%.
Labor are proposing to reduce the income streaming benefit of trusts by imposing a minimum tax rate on trust distributions of 30%. In our example above this would render running the business through a trust a worse option than running the business through a company (i.e. trust = 30% and company = 27.5%).
For our family of five in the example above, the amount of tax being paid by the family would almost triple in the wake of the Labor reform.
Whilst my example may be extreme, there are literally thousands of trades people and other small business operators who earn incomes of around $200,000 pa and operate their businesses through a family trust. Where these business owners have a non-working spouse and/or adult children who aren’t yet in jobs, they are able to spread out the family’s income using the trust and reduce the tax they pay overall.
Notably, Labor’s proposal will not apply to certain trusts such as:
- Special disability trusts;
- Testamentary trusts;
- Fixed trusts or fixed unit trusts;
- Charitable and philanthropic trusts;
- Farm trusts (query what these are); and
- Public unit trusts (listed and unlisted).
Implications & Comment
Setting aside the ‘fairness’ of the current system, the proposed reform represents a seismic shift in the amount of tax paid by many small business owners. Moreover, the risk/reward for these small business operators would be significantly altered. Furthermore, it is likely that in the wake of the reforms many small business owners will need to restructure their ownership arrangements, thereby triggering stamp duty and other costs.
Taxpayers earning salaries, with little ability to spread their income across their family members may feel that the current income streaming benefits of trusts are unfair, while small businesses owners would generally argue that the tax breaks afforded through trusts are a fair reward for the entrepreneurial risks they take.
Labor proposes to limit negative gearing to ‘new’ housing from 01/01/2020. Investments made before this date will be grandfathered from the impact. Losses from new investments in shares and ‘existing’ properties will still be able to offset other taxable income.
Implications & Comment
Market prices in any capital market are finely balanced and represent the sum total of buyers and sellers opinions and needs at any given time. If negative gearing is removed, it is likely that the number of investor buyers in the housing market will be reduced. Thus, if the policy is implemented and all other things being equal, prices should fall.
How much of this Labor policy is already factored into market prices and how much is potentially to come is unclear (noting that Sydney housing has fallen 15% in twelve months).
Whether the reduction in house prices is a good thing or not will depend on your point of view. Homeowners typically don’t want the value of their equity reduced, while those aspiring to home ownership would like affordability improved.
Falling house prices are generally bad for the economy in the short run as consumer confidence and spending are eroded but can be good for the economy in the longer run as more Australians are able to enjoy the benefits of home ownership. Moreover, economists suggest that when taxpayers over invest in housing, it comes at cost to the economy overall. From an economic perspective surplus capital is better allocated to assets that create more economic activity/benefit – such as businesses and infrastructure.
Other Labor Tax Proposals
Reduction of the CGT discount from 50% to 25% C
Currently when an individual acquires an investment asset and later sells that asset for a profit, capital gains tax (CGT) is levied on the profit amount. However, if the asset was held for more than 12 months, then the gain amount is discounted by 50% before the CGT is levied. CGT is levied at the individual’s marginal tax rate.
Labor have indicated that they wish to reduce the amount of the CGT discount from 50% to 25% for investments acquired after 01/01/2020.
Implications & Comment
The reduction in the CGT discount will capture more tax from those who are asset rich (i.e. those with investment portfolios), while sparing those who earn good income but haven’t yet accumulated investment assets other than their home and super.
Reducing the Income Threshold from $250K to $200k for the additional 15% Tax on Concessional Superannuation Contributions (Division 293 tax)
Currently if your income plus any concessional (before-tax) super contributions is more than $250,000 you are liable for Division 293 tax of 15% on the amount of concessional contributions above the $250,000 threshold.
So those earning more than $250,000 pay a total of 30% tax on their concessional contributions, whereas taxpayers earning less than $250,000 only pay 15% contributions tax.
Labor will reduce the threshold for this additional tax amount to $200,000, thereby catching many more taxpayers.
Reducing the Non-concessional contribution cap from $100,000 pa to $75,000 pa
Currently Australians with super balances of under $1.6M can make after tax contributions (non-concessional) to super of up to $100,000 per annum. If they are under 65 they can also make three years’ worth of contributions in one go (i.e. $300,000) if they have enough headroom under the $1.6M limit provided they don’t make after tax contributions in the subsequent two years.
Labor plans to keep the contribution eligibility rules the same, but reduce the annual limit for after tax contributions from $100,000 to $75,000.
Implications & Comment
This change would further reduce the ability for those approaching retirement to increase their superannuation savings using lump sums. Australians saving for their retirement seeking to use superannuation will need to consider making non-concessional contributions earlier and over a more extended period of time in order to maximise their superannuation balance.