The debate over the proposed capital gains taxes continues. At this stage the tax updates are just a proposal and there may be changes during the legislative process. However, many investors are trying to wrap their heads around the changes and the potential implications if they become law.

To help I’ve created a spreadsheet that calculates the tax owed on capital gains under the current system and with the proposed changes. You can access that spreadsheet here.

There have been several recurring questions I’ve received from readers. I’ve provided the answers to those questions below.

How does the 30% minimum tax work?

Many investors have focused on the 30% minimum tax on capital gains in the government’s proposal. This minimum tax impacts investors in two tax brackets with lower marginal tax rates than 30%:

  • 0% marginal tax rate: People with taxable income between $0 and $18,200  
  • 16% marginal tax rate: People with taxable income between $18,201 and $45,000

Many people who are in these categories are retirees or young investors / students.

I’ve noticed some confusion about how this tax would be applied. Investors can still take advantage of discounts to capital gains under the indexation method proposed by the government.

The 30% is only applied after the discount which means investors who hold shares for multiple years will likely pay a far lower effective tax rate on capital gains than 30%.

Here is how it would work for an investor that holds shares purchased for $1000 for 5 years with 3% annual inflation.

The cost base would rise from $1000 to $1159. If the shares were sold for $2000 the nominal capital gain of $1000 has been adjusted to $841. Applying the 30% rate to $841 means $252.50 is owed in tax.

The effective tax rate on the nominal gain of $1000 is 25.23%. This likely provides little solace for someone who would have owed no tax on the gain but it is slightly better than the headline 30% minimum.

Effective tax rate on a portfolio

The Australian Financial Review has been running a series of articles warning about high effective tax rates on a diversified portfolio of shares. There have been claims that people will stop holding individual shares and instead shift to ETFs.

The basis for these claims is the different ways gains and losses are treated under the tax proposals. In the previous example I showed how the cost basis of a share changes under the indexation method of discounting capital gains.

In that example the $1000 nominal capital gain is discounted to an $841 capital gain for tax purposes.

However, when capital losses are calculated a different method is used. Only nominal losses can be used to offset gains. If the $1000 in shares were sold for $500 after 5 years of 3% annual inflation the capital loss would be $500 and not $659 as it would be if the cost basis was adjusted by indexation.

The concern that many people have is for shares that have nominal gains but real (or inflation adjusted) losses. An example would be a share position that appreciated a total of 5% in 5 years when there was 3% annual inflation.

The shares are now worth $1050 and have lost money on a real or inflation-adjusted basis. If they are sold there wouldn’t be a capital loss to offset gains on other shares in a portfolio.

In a portfolio with a few outsized winners and several shares that are just meandering along and not delivering returns that outpace inflation the effective tax rate on the total portfolio may be higher than it would be if the tax rules used inflation to index real capital losses.

In an index tracking ETF that holds a basket of shares this same impact wouldn’t occur. However, index tracking ETFs are almost always more tax efficient than a portfolio made up of individual shares.

Investors who will most likely be impacted by this difference in how gains and losses are treated under indexation are investors who hold shares for longer than a year but not multiple years. As I pointed out in my previous article on the tax changes indexation makes holding shares for an extended time relatively beneficial for investors.

In many scenarios taxes will still be higher than under the 50% discount on capital gains but letting inflation compound over longer periods can still make a difference in after tax returns.

The size of the impact is also based on the type of companies held in a portfolio. Historically around 50% of returns on Aussie shares have come from dividends where investors will still have the benefits of franking credits. As I pointed out in my previous article on a relative basis franked dividends are treated more favourable than capital gains.

For investors holding shares that don’t pay franked dividends like global shares or more speculative Australian shares the tax hit will be bigger. This will also likely be the case for investors holding thematic ETFs that frequently rebalance and distribute capital gains to investors.

Access the Morningstar tax calculator here.

If you have additional questions email me at mark.lamonica1@morningstar.com