Capital. Gains. Tax. Three little words that strike fear into the hearts of many New Zealanders. Opposition to a capital gains tax (CGT) is so deep-seated that it has crossed ideological barriers to gain a reputation as a highly effective vote killer.

New Zealand is somewhat unusual in its position as many similar countries – including our closest neighbour Australia – have long had capital gains taxes in place. But resistance to it is such that it has been trialled and dumped as a tax policy many times. Likewise a long series of tax reviews and working groups have considered a CGT before deciding not to recommend the introduction of one.

None the less, when the current Labour-led Government took power they quickly set up their Tax Working Group (TWG) to investigate how the tax system might be reformed to make it more equitable. Since then, it’s been an open secret that the introduction of a CGT is on the agenda.

While the TWG’s remit is to advise on wide ranging tax reforms, public attention has been firmly fixed on whether or not it will recommend a capital gains tax on residential property. That makes the conclusions of the TWG a big issue for property investors.

In September, the TWG released its interim report on the “Future of Tax”. It makes it clear that the TWG believes capital income – gains from the sale of capital assets like property – is taxed inconsistently and that this situation needed to be rectified.

But rather than making a concrete recommendation on a CGT, as many hoped it would, the TWG emphasises that more work needs to be done before any conclusions can be reached. So what does the report have to say and what are the implications for investors?

What The TWG's Report Says

First up, it’s worth noting that the TWG’s report covers reform of the tax system in all areas – ranging from GST to business taxation to environmental taxes. It’s not just about the taxation of capital income. Rather in the words of the TWG’s chair, Sir Michael Cullen, it assesses the structure, fairness, and balance of the whole tax system.

However, for property investors, it is the TWG’s thinking on the taxation of capital income that is of interest.

Cullen says that extending the taxation of capital income has many benefits. These include improving the fairness of the tax system and the sustainability of the revenue base and levelling the playing field between different types of investments.

“Yet the options for extending capital income taxation can be complex, resulting in higher compliance and administration costs,” he adds. “We have made some good progress in setting out the main choices and options – but there is still a great deal of work to do before we provide our final report in February 2019.”

To this end, the interim report lays out two potential options for extending capital income taxation. These are extending the tax net to include gains on assets that are not already taxed and taxing deemed returns from certain assets.

Feedback on these options will inform the recommendations of the TWG’s final report. This suggests that some form of CGT is likely to be on the cards, even though Cullen claims it is not a certainty.

However, the interim report makes it clear that the introduction of wealth taxes or land taxes will not be recommended. Also, it emphasises that any extension of capital income taxation would apply from a future date – which is likely to be 2021 at the earliest - and would not have a retrospective element.

Capital Income Tax Options

The types of capital income that the TWG is looking at taxing include profits from investment properties, shares, the sale of businesses and possibly other assets that could go up in value but don’t fall under the existing tax net. Owner-occupied homes have been firmly excluded from any form of CGT from the outset.

None of this comes as a surprise. Nor does the first capital income tax option set out in the report. That amounts to a classic CGT which would only be paid once the asset was sold and a gain, or profit, was actually realised.

But what does come as a surprise is the second capital income tax option the TWG proposes: taxing deemed returns from assets which is also known as the “risk-free return method”. This approach means that people would pay a small percentage of the money they had invested in the likes of property or shares in tax each year.

Gilligan Rowe & Associates associate director Anthony Lipscombe says that while the TWG has put forward both methods as options they are clearly in favour of the realised gain method. “That is to say if a capital gains tax were to be recommended by them, then they will suggest that gains subject to tax arise when the relevant asset is sold.”

In his view, the risk-free return method is likely to be favoured by economic purists – but it has some practical drawbacks. “That will be what is driving the TWG to favour taxing capital gains on actual realisation of the asset.”

If a capital gains tax is to come in, it’s possible to surmise that it will come in on a realisation basis and will probably apply in such a way that gains on all assets are captured from a particular point in time, he says. “You can think of this as a valuation day concept. This means one possible consequence of capital gains tax might be that investors are incentivised to make improvements to existing property before the valuation day arrives.”

What It Means For Investors

For Lipscombe, it’s stating the obvious to say that the implementation of a “catch-all” capital gains tax will be disadvantageous for property investors “But I think what investors need to appreciate at the moment is that there is still a fair bit of water to flow under the bridge. It would be fair to say that one would be surprised if a capital gains tax is not recommended, but it is still not certain of being so.”

Even if the TWG does recommend a CGT there is no assurance that the Government will follow through on that recommendation, he says. “At this point in time there is no action that one can say investors should undertake because it is akin to telling someone how to play a game when we don’t know the rules.”

But the fact that nothing official has been decided in regards to a CGT doesn’t mean that investor opposition is not gearing up already.

The NZ Property Investors’ Federation is against the introduction of any such regime. NZPIF executive officer Andrew King says a CGT is unnecessary and won’t achieve the reduction of house prices that people believe. “It could also put people off investing in all sorts of things, including businesses, and divert them into buying bigger, personal houses which won’t be taxed.”

Likewise, prominent property investor David Whitburn is opposed to the introduction of a capital gains tax which he too describes as unnecessary. “I have concerns about the risk of creep, of any such tax spreading out to owneroccupied homes or being hiked up further – particularly if it doesn’t generate as much revenue as expected.”

Further, if the risk free return method is adopted, he questions what it will mean for family baches or the houses of elderly citizens who move into rest homes. “Those properties will qualify as second dwellings and be taxable. That could end up creating brutal situations for the elderly.”

Whitburn thinks that, given owneroccupied housing will be exempt from a CGT, it would be better if the existing bright-line test on residential property sales was just extended out further, perhaps to 10 years. “That would get them around the capital gains tax stigma. And for serious investors, as opposed to speculators, it wouldn’t be an issue as they hold on to properties long-term anyway.”

‘I have concerns about the risk of creep, of any such tax spreading out to owner-occupied homes or being hiked up further’ DAVID WHITBURN

Housing Market Impact

One of the popular arguments for the introduction of a CGT is that it would lead to house prices falling and a corresponding housing market adjustment. An example of this was Westpac’s release, earlier this year, of analysis showing capital gains tax would reduce house prices by 10.9% while taxing investors on a deemed rate of return would cut them by 19.5%.

However, it seems the TWG is not as convinced. The interim report reveals the TWG believes that tax has not played a large role in the current state of the housing market and is unlikely to play a large role in fixing it. Despite this, the TWG’s forthcoming work will include consideration of the housing market impacts of the options for extending capital income taxation.

‘It is a false idea that making people pay tax on their property investments will generate such a wave of selling, and fresh investor pullback, that prices will correct greatly’ TONY ALEXANDER

BNZ chief economist Tony Alexander takes an even stauncher view on the impact of a capital gains tax on the housing market. It is a false idea that making people pay tax on their property investments will generate such a wave of selling, and fresh investor pullback, that prices will correct greatly, he says.

It won’t and that’s because these days most investors have more time on their side before they “need” to sell. The vast majority have not bought property simply to make a pile of cash in only two or three years – despite what the media and the Government would have us believe, Alexander says.

“Some people may well have a timeframe in mind. But it is likely to be quite a number of years and involve a combined return from rental yield and capital gain. They know that achieving capital gain is a long-term process and you cannot predict short to medium-term property price changes. Most of them know what well known commercial property investor Bob Jones has repeatedly noted over the years. You buy and you hold.”

He believes that if a capital gains tax comes in, investors will simply shift their target and give themselves a few more years to achieve a wealth goal. “They will look to boost running yield by raising rents, perhaps by improving the quality of their property and targeting better tenants.”

This will make it harder for many tenants but it won’t lead to the big house price correction many are hoping for, he adds.

Capital Battle Looms

Perhaps the key takeaway point for investors is that a capital gains tax is by no means a done deal.

The multitude of competing interests in this area, including on the TWG itself, means it will be a tough job for the TWG to come up with a unanimous recommendation on capital income. Assuming it does, whatever it recommends will be controversial – and the subject of major political battles.

Whitburn says he is not convinced that a CGT, if recommended, would end up being implemented.

That’s because while the Labour and Green Parties officially support the introduction of a CGT, in the past NZ First has been opposed to it. During last year’s election campaign, NZ First leader Winston Peter said he was not ready to support any moves that Labour might make to extend capital gains taxes.

NZ First could well veto the TWG recommendation once the final report is released next year, Whitburn says. “A capital gains tax – even if the family home is exempt from it – would simply not be palatable to NZ First supporters and NZ First would be conscious of that when heading towards an election.”

Further, even if a CGT proposal does make it through Parliament, the Labour Party has pledged that it would only take effect after the next 2020 election.

Lipscombe says this effectively gives voters the chance to have a say on the ultimate imposition of a CGT. “In that if there is a new government in power they may have the numbers in Parliament to repeal the law before it becomes effective.”