Capital Gains Tax Events and Payment of Compensation - Essay Example

TAXATION Tax consultant Address: Telephone: Bella Address Telephone March 17, Dear MissBella, Re: Review of your capital gains Introduction Following your request, that we offer you our tax consultant services, we are pleased to provide you with the underlying approach to our work and how your capital gains would be treated. Capital gains are the value increase of capital assets net of any incidental costs such as transaction costs and brokerage costs. If an asset’s value decreases, then, a capital loss is realized. In principle and under the income tax rules, capital gains are included in the tax base when they accrue. Capital gains will be taxed upon the disposal or realization of an asset. The Australian taxation of capital gains has been aligned with the international norms.1 A half of the capital gains that individuals realize on assets they have held for twelve months and more, the effective tax rate is half the rate charged on other forms of incomes. Capital gains tax events The different events or transactions that give rise to either a capital loss or capital gains are called capital gains tax events. A full gamut of these events exist, and some of them frequently occur and affect many individuals while others are not common and affect few individuals.2 The knowledge of the various types of capital gains tax events is imperative since it influences how an individual works out his or her capital gains or capital losses. In addition, it affects the timing of such capital losses or capital gains. In case there is the occurrence of more than one capital gains tax events, the one used is one that that is most specific to the situation.3 Therefore, among the capital gains tax events are: the destruction or loss, which may be involuntary or voluntary, of an asset; cancellation, redemption or surrender of shares; the disposal of depreciating assets that are wholly or partly used for private purposes; where an individual ceases to be a resident of Australia; when an entity enters into a conservation covenant; making of payments by a company to a shareholder; where financial instruments are declared to be worthless by a liquidator; where an individual makes a contract to stop working in a given sector for some agreed upon the period; where a trustee makes a non-assessable payment; compensation payment; and making payments to a business by a local council after destruction of its assets. However, it should be noted that subdivision of land does not give rise to a capital gains tax event but a sale of any of the subdivision gives rise to a capital gains tax event4. Payment of compensation The benefits made give rise to a capital gains tax event. When capital gains are made from compensation made for destruction, loss or compulsory acquisition of a capital gains tax asset, it can be deferred. A compensation payment may arise as a result of disposing of part or whole of the underlying assets5. Such compensation is an insurance policy given after damage to a rental property. Such insurance policy will be treated like capital proceeds equivalent to disposing of an asset. In case the compensation is made in relation to a permanent reduction or damage in the underlying assets value, it is regarded as a recoupment of the propertys acquisition cost. If the payments are received and are not related to the underlying asset, such payments are treated as relating to the disposal of a right to seek compensation.6 Leases When a lease is granted, the time of the capital gains tax event occurs when the parties to the lease agreement enter a contract and where a contract does not exist, then the time of the event is the beginning of the lease. The capital gain is arrived at by deducting the expenses incurred in grant, renewal and extension of the capital proceeds while the capital loss is realized when the costs of the grant, renewal and extension are greater than the capital proceeds.7 Another capital gains tax event in leases is the grant of a long-term lease. Its timing is when the lessor issues the lease. To establish the capital gains under this case, the leased property’s cost is deducted from the capital proceeds arising from the grant, renewal and extension while the capital loss is determined by subtracting the capital proceeds from the leased property’s reduced cost base. A capital gains tax event also arises when the lessor pays the lessee to have the lease changed8. Under this scenario, the timing of this event is when the lease term is waived or varied. This event does not give rise to a capital gain, but the capital loss is the expenditure amount incurred to the agreement of the lessee. Another capital gains tax event happens when the lessor is paid for having the lease changed, and its timing is when the lease term is waived or varied. To ascertain the amount of capital gains, the cost base of the lease is deducted from the capital proceeds and under this capital gains tax event, there are no capital losses. Finally, a capital gains tax event under the lease is when the lessor is paid for altering the lease. The timing of this capital gains tax event is when the lease term gets varied or waived. The capital gains are determined by subtracting the expenses incurred in varying or waiving the lease from the capital proceeds while the capital loss is borne when the capital proceeds are less than the lease variation and waiver expenditures. Taxation of Australian residents The residents of Australia make capital gains or capital losses whenever a capital gain tax event occurs to any of their across the world. In order to assess whether one is meeting the capital gains tax obligations, the following steps are taken. First and foremost, decide as to whether there is an occurrence of a capital gains tax event. The capital gains tax events are the events or transactions whose presence may lead to capital losses or capital gains.9 Capital gains tax event arise where an individual disposes of or sells an asset. However, if capital gains tax events happen to assets that were acquired before 20th September 1985, any capital loss or capital gains are disregarded. The second step is to work out the capital gains tax event’s time. The timing of a capital gains tax event is imperative since it is used to establish the income year in which one will show the capital loss or capital gain. In the case someone disposes of or sells an asset to another person, capital gains tax event occurs immediately the contract of sale is made. Where a contract does not exist, the capital gains tax event will occur when one stops to be the owner of the asset. The third step is to calculate the capital loss or capital gain. The computation is done using three approaches namely; the discount method, the indexation method, and the ‘other’ method. Under the indexation approach, one increases the amount of the asset cost by applying an indexation factor which is based on the rise in the consumer price index up to September 1999. This approach is strictly used for assets, whose acquisition took place before 11.45am on September, 21st 1999.10 When the discount method is used, the indexation factor on the asset cost is not applied. This approach is used to reduce the capital gain by the capital gains tax 50% discount and is done by subtracting the periods capital losses and other unapplied net capital losses brought forward from prior periods but on condition that the assets have been held for 12 months and above. In the case an individual has assets that qualify for the discount and the indexation methods; it is advisable that one chooses that approach which offers the better results. However, one’s choice of the method to use will be influenced by the size of the capital losses since the capital losses must be offset against capital gains prior to applying the capital gains tax event discount. The ‘other method is used foe assets that are bought and disposed of within 12 months because the discount method and the indexation method cannot be implemented. Under this approach, the capital gains are established by deducting the cost base from the capital proceeds. Exemptions and rollovers As aforesaid, there are instances when exceptions are allowed that make an individual to disregard his/her capital losses or capital gains. The exceptions are frequent in pre- capital gains tax assets, which are those assets whose acquisition took place before September, 20th 198511. In the case of a rollover, an individual is allowed to defer his capital losses or capital gains. Treatment of sale of shares To compute the amount of capital gain when shares are sold some steps are followed. First, the capital proceeds from each capital gains tax event is established. The capital proceeds from the sale of shares are: the amounts received from the purchaser, the market values of such shares where they are given away, and the amount of shares an individual receives on a takeover or merger. The second step is to work out the assets’ cost base including the indexed up cost base for assets acquired before September 1999. The cost base will be a total of what an asset costs; some incidental costs such as the agents and brokerage fees, stamp duty, investment advisers fees and legal fees; costs of owning assets and other expenses borne in establishing, maintaining as well as in defending the ownership of property (Global Property Guide 2015).12 The cost base of a share can be reduced by the value of the non-assessable payment, received from a company during the period an individual owned such shares. The third step is to establish whether capital gains have been made by deducting the asset cost from the capital proceeds. Capital losses On the condition the capital proceeds are less than the cost base; a capital loss is realized. Other than the current periods capital losses, there are capital losses from past periods, and they are deducted from the amount left after deducting this periods capital losses. These losses should be subtracted in a manner that offers the greatest benefits. The most significant benefits are mostly realized if these losses are deducted from the capital gains in this manner: first, capital gains realized by selling the shares within a period of 12 months and where the discount approach and indexation approach are not used; second, capital gains established using the indexation approach; and later the capital gains on which the capital gains tax discount applies. The losses from collectibles and the use of personal assets The capital losses that are suffered from collectibles in the current period as well as unapplied net capital losses in relation to collectibles from past years are deducted from current period’s capital gains. These reduce the capital gains earned from collectibles. The capital losses from the personal use assets should be disregarded.13 The personal use assets are those assets that are not collectible and are mainly for personal consumption. In the case the total of the current periods losses and the unapplied net capital losses exceed the available capital gains; these capital losses are carried forward to be offset against capital gains in future years. Treatment of Bella’s capital gains tax events The inherited house The house that Bella inherited from her father is not a capital gains tax asset since it was purchased by her father in 1984, making it fall under assets that were bought before September, 20th 1985. Therefore, even though this house was valued at $350, 000 in 1995 resulting in a $316,000 capital gain and further at $620,000 in 2010 resulting in a capital gain of $586,000, these capital gains should be disregarded. The further increase in value in 2013 to $800,000 results in a capital gain of $766,000, which is also disregarded. Construction of new buildings Before building the new houses, the demolition and rebuilding costs amounting to $80,000 should be deducted from the $700,000 capital proceeds from the sale of the larger house. Other expenses to be subtracted from these capital proceeds are the marketing costs adding up to $10,000. The approach to calculating the capital gains of this capital gains tax event is to use the ‘other’ method since this house was constructed and sold within a period of 12 months. In this case, the capital gain is equal to $642,000 ($700,000-$10,000-$80,000*60%). The other house that is under the lease will have a rent of $21,600 after the 12 months ($1,800*12). These revenues will be subject to the income tax at the applicable tax rate. After this period, the $500,000 capital proceeds will be used to assess the amount of capital gains where the marketing expenses of $7,500 and $600 legal expenses will be deducted. In this case, the capital gains will be $509,900 ($550,000-$7,500-$600-$80,000*40%). Effects of departure to Dubai On the day that Bella left Perth for Dubai, under the Australian tax, it would have been deemed that she disposed of all her capital gains tax assets at their market value as at that date.14 This makes Bella liable to pay the Australian capital gains tax where it is deemed that she made any capital gains. Treatment of furniture and household goods The disposal of personal assets such as the furniture and other household items are exempted from the capital gains tax. The loss suffered from the sale of Bella’s household goods of $4,000 should not be subject to the capital gains tax. The capital gains tax does not also apply to depreciating personal assets. Therefore, the sale of the dining set for $8,200 up from $3,000 and a wardrobe for $4,200 up from $360 should not be viewed as capital gains. The compensation payment of $2,500 received from the insurance company as a result of damage to the antique worth $4,000 should be treated as a recoupment of the antiques cost base since tenants utterly destroyed it. Treatment of shares The capital gains of $57,000 realized from the sale of shares at $72,000 that were acquired in 1984 at a cost of $15,000 will not be subjected to the Australian capital gains tax and it is thus disregarded. However, the capital gains of $16,000 from the sale of shares for $50,000 purchased in 2009 for $34,000 will be subjected to the Australian capital gains tax. Treatment of 2010 losses These are past periods’ losses and are carried forward to be offset against some capital gains in the future. Therefore, these losses should be subtracted from the capital gains realized from the sale of newly constructed buildings. Bella’s net capital gains for the year ended 30 June 2015 Capital gains from the sale of the larger house = ($700,000-$10,000-$80,000*60%) = $642,000 Capital gains from the sale of the smaller house = ($550,000-$7,500-$600-$80,000*40%) = $509,900 Capital gains from the sale of 2009 share = $16,000 Less capital loss brought forward = $10,000 Net capital gains $1,157,900 Bibliography Australian Taxation Office. Compensation payments. March 6, 2015. https://www.ato.gov.au/General/Capital-gains-tax/Selling-an-asset-and-other--CGT-events-/Compensation-payments/ (accessed March 16, 2015). —. Leases. June 7, 2014. https://www.ato.gov.au/General/Capital-gains-tax/In-detail/Events/Summary-of-CGT-events/?anchor=Leases#Leases (accessed March 16, 2015). Australian Taxation Office. Personal Investors Guide To Capital Gains Tax 2014. Guide, Sydney NSW: Australian Taxation Office, 2014. —. Summary of capital gains tax events. June 7, 2014. https://www.ato.gov.au/General/Capital-gains-tax/In-detail/Events/Summary-of-CGT-events/ (accessed March 16, 2015). Burman, Leonard E. Taxing Capital Gains in Australia:Assessment and Recommendations. Sydney: Tax Policy Center, 2009. Exfin International Pty Ltd. Capital Gains Tax (CGT). 2014. http://www.exfin.com/australian-capital-gains (accessed March 16, 2015). Global Property Guide. Taxes are high in Australia. January 20, 2015. http://www.globalpropertyguide.com/Pacific/Australia/Taxes-and-Costs (accessed March 16, 2015). KPMG. Taxation of international executives-Australia. 2015. http://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/taxation-international-executives/australia/pages/income-tax.aspx#10 (accessed March 16, 2015). Read More