ap_cgt01

Capital Gains:

What are they,

and how are they included in assessable income?

How can a receipt of a capital nature be included in income?

QUESTION: When does a capital gain arise? ANSWER:When a capital gain event happens! (that means there is a disposal of capital gains tax asset)

So what is a capital gains tax asset?

What capital gains tax assets are exempt from capital gains tax?

Do you want a 50% discount or a reduction of the cost base to reflect the effects of inflation? The choice you must make for events after 21/9/1999

How to work out the capital gain if the asset was acquired before 21/9/1999

Capital proceeds I understand, but what's all this about cost base and reduced cost base?

Capital gains less capital losses = net capital gain included in assessable income (its all in Division 102-5)

How can a receipt of a capital nature

be included in income?

Because sec 102-5 says it is - that's how!

102-5 Your assessable income includes your net capital gain (if any) for the income year.

(If you are wondering where, in the core provisions, this all comes from look at

section 6-10 Other assessable income (statutory income)

(1) Your assessable income also includes some amounts that are not *ordinary income.

Note: These are included by provisions about assessable income. For a summary list of these provisions, see section 10-5.)

To ease you into the rather complicated ways in which net capital gain is included in your assessable income, section 100 provides a kind of guiding overview. That's all it is. Just a guide to how the other sections will do the grunt work of including your net capital gain in your assessable income

100-10 Fundamentals of CGT

(1) CGT affects your income tax liability because your assessable income includes your net capital gain for the income year. Your net capital gain is the total of your capital gains for the income year, reduced by certain capital losses you have made.

So the net capital gain you enter in your return will be

total of capital gains less capital losses

(2) When you prepare your income tax return, you need to check whether you have made any capital gains for the income year.

You also need to check whether you have made any capital losses. You cannot deduct a capital loss from your assessable income, but it will reduce your capital gain in the current income year or later income years.

You can not deduct capital losses

from assessable income.

(Only from other capital gains)

When does a capital gain arise?

When a capital gain event happens!

(No capital gain event - No capital gain.)

So what are these capital gain events?

Division 104 explains the events which give rise to capital gains. They are given identifying numbers such as A1, B1, C1, etc and you will notice that these identifiers are used throughout the capital gains chapters.

The events listed in Division 104 will be examined in more detail in a later topic, but we will look at the most common of these events now.

CGT events
Event number and description	Time of event is:	Capital gain is:	Capital loss is:
A1 Disposal of a CGT asset [See section 104-10]	When disposal contract is entered into or, if none, when entity stops being asset’s owner	capital proceeds from disposal less asset’s cost base	asset’s reduced cost base less capital proceeds

If you look at Division 104 now, (and it would be well worth your while) you will notice that for every category of event described, there are four main characteristics which are described in detail. We will go through them for event A1, as shown above, but remember you will find these four characteristics for every event. They are

Description of event - section 104-10 (1&2)

104-10 Disposal of a CGT asset: CGT event A1

(1) CGT event A1 happens if you *dispose of a *CGT asset.

(2) You dispose of a *CGT asset if a change of ownership occurs, whether because of some act or event or by operation of law. However, a change of ownership does not occur if you stop being its legal owner but continue to be its beneficial owner.

Description of calculation of gain or loss - section 104-10(4)

(4) You make a capital gain if the *capital proceeds from the disposal are more than the asset’s *cost base. You make a capital loss if those *capital proceeds are less than the asset’s *reduced cost base.

Description of timing of gain or loss - section 104-10(3)

(3) The time of the event is:

(a) when you enter into the contract for the *disposal; or

(b) if there is no contract—when you stop owning the asset.

Exemptions and special rules which apply - section 104-10(5)

Exceptions

(5) A *capital gain or *capital loss you make is disregarded if:

(a) you *acquired the asset before 20 September 1985; or

(b) for a lease:

(i) it was granted before that day; or

(ii) if it has been renewed or extended—the start of the last renewal or extension occurred before that day; or

Note: You can make a gain if you dispose of shares in a company, or an interest in a trust, that you acquired before that day: see CGT event K6.

Compulsory acquisition

(6) If the asset was *acquired from you by an entity under a power of compulsory acquisition conferred by an *Australian law or a *foreign law, the time of the event is the earliest of:

(a) when you received compensation from the entity; or

(b) when the entity became the asset’s owner; or

(d) when the entity took possession under that power.

Event A1 takes place when a Capital Gains Tax ASSET is disposed of!

So what is a Capital Gains Tax ASSET?

Division 108 tells you all about capital gains tax assets (this is shortened to CGT).

It defines them in section 108(5)

(1) A CGT asset is:

(a) any kind of property; or

(b) a legal or equitable right that is not property.

So if any kind of property (or right) is disposed of, or even if you just stop being the owner of the property, then CGT Event A1 has happened.

While you are looking at, Division 108, it is worth looking at a couple of other definitions. You will notice that two kinds of property are given special definitions. These are:

Section 108(10) - collectables

Section 108(2) - personal use assets

Did you look them up?

Just in case you didn't we will show you the definitions here. First collectables:

(2) A collectable is:

(a) *artwork, jewellery, an antique, or a coin or medallion; or

(b) a rare folio, manuscript or book; or

that is used or kept mainly for your (or your *associate’s) personal use or enjoyment.

(3) These are also collectables:

(a) an interest in any of the things covered by subsection (2); or

(b) a debt that arises from any of those things; or

Note: Collectables acquired for $500 or less are exempt. However, you get an exemption for an interest in one only if the market value of all the interests combined is $500 or less: see Subdivision 118-A.

Did you read the fine print?

If the collectible is worth less than $500 it is exempt from capital gains tax.

And now personal use assets:

(2) A personal use asset is:

(a) a *CGT asset (except a *collectable) that is used or kept mainly for your (or your *associate’s) personal use or enjoyment; or

(b) an option or right to *acquire a *CGT asset of that kind; or

(c) a debt arising from a *CGT event in which the *CGT asset the subject of the event was one covered by paragraph (a); or

(d) a debt arising other than:

(i) in the course of gaining or producing your assessable income; or

(ii) from your carrying on a *business.

Note 1: There is an exemption for a personal use asset you acquire for $10,000 or less: see Subdivision 118-A.

Note 2: A debt arising from a CGT event involving a CGT asset kept mainly for your personal use and enjoyment is a personal use asset to prevent any loss arising from the debt being a normal capital loss.

Check the fine print?

Personal use assets acquired for $10,000 or less are exempt from capital gains tax.

Does any kind of property mean any kind of property?

If you have read the previous paragraphs you will know that collectibles worth less than $500 and personal use assets acquired for $10,000 or less are exempted from capital gains tax. So not all kinds of property are caught by capital gains tax.

Let's look at the picture again.

Does an exemption apply?

So far, we know that if no capital gains tax event took place, there will be no capital gain.

But even if an event took place, no amount need be included if the property was exempt from capital gains tax.

We know that collectibles worth less than $500 Section 108(10) and personal use assets acquired for $10,000 Section 108(2) are exempted.

If you read through the description of event A1 in section 104-10(5) you will know about another important exception for assets acquired before 20 September 1985. That was the date on which the capital gains provisions were made part of the Income Tax Assessment Act. You will find similar exemptions in all the events described in Division 104.

However, the real place to look for exemptions is section 118. Look at it now.

Did you look? Here's the list just in case you chose not to.

118-A General exemptions

118-B Main residence

Generally, you are exempt from CGT when you make a capital gain on disposing of your main residence. But this can change depending on how you came to own the house and what you have done with it. For example, if you rent it out, you may be liable to CGT when you sell it.

118-C Goodwill

118-D Insurance and superannuation

118-E Units in pooled superannuation trusts

Let's look a little closer at the general exemptions under 118-A

There are 4 categories of exemptions:

exempt assets: for example, cars;

118-5 Cars, motor cycles, valour decorations and cultural bequests

118-10 Collectables and personal use assets

118-12 Assets used to produce exempt income

exempt receipts: for example, compensation for personal injury;

118-15 Exempt capital receipts

exempt transactions: for example,

118-40 Expiry of a lease

118-42 Transfer of stratum units

118-45 Sale of rights to mine

118-50 Issue or allotment of shares or units

118-55 Foreign currency hedging gains and losses

118-60 Gifts under Cultural Bequests Program

anti-overlap provisions (that reduce your capital gain by the amount that is otherwise assessable).

118-20 Reducing capital gains if amount otherwise assessable

118-22 Eligible termination payments

118-25 Trading stock

118-30 Film copyright

118-35 Research and development

The changes to the Income Tax Assessment Act, in general, and the capital gains provisions, in particular, which have effect from 21/9/1999

The Government issued a press release on 21/9/1999, which contained an overview of dramatic changes it intended to make to the tax system. These changes arose from a committee of inquiry it had established to make the tax system more user friendly for business.

The Rolfe Committee task: Change the tax system as much as you like, but you can't reduce the overall amount of tax collected!

The committee headed up by Mr Rolfe, was given one rather difficult condition to fulfil. The changes it proposed had to be revenue neutral. In other words, any changes to the tax law and practice to make them easier to comply with, could not lead to a reduction in the overall amount of tax collected.

The changes to the capital gains provisions were touted as reducing the amount of gain included in assessable income by 50%. In other words, only 50% of the gain would be included.

As usual, there was a catch!

To gain the benefit of the 50% capital gains discount, the taxpayer had to forfeit the benefit of reducing the gain to take into account the effect of inflation.

If you both acquired and sold the asset before 21/9/1999
Date asset acquired	Date capital gain event	Discount	Indexation	Averaging
Pre 21/9/1999	Pre 21/9/1999	No	Yes	Yes

*If you…* acquired the asset before 21/9/1999 but sold if after 21/9/1999 you get to choose either discount or indexation
Date asset acquired	Date capital gain event	Discount	Indexation	Averaging
Pre 21/9/1999	Post 21/9/1999
You get to choose		No	Yes	No
Or…		Yes	No	No

If you both acquired and sold the asset after 21/9/1999
Date asset acquired	Date capital gain event	Discount	Indexation	Averaging
Post 21/9/1999	Post 21/9/1999	Yes	No	No

The 50% discount on the capital gain

Versus

The reduction of the cost base to overcome the effect of inflation on the amount of the capital gain

When the capital gains legislation was first introduced, inflation, as measured by the Consumer Price Index, was running at a around 3% to 5% per year. This inflation represented a measure of how much less the taxpayer could purchase with the same amount of money. In other words, the value of the money used to purchase the asset, which had been sold, was now less than it had been when the asset was purchased. It was considered unfair that the assessable income of a taxpayer included the full increase in money terms, when the value of that money had decreased over the time the asset had been held. Accordingly, a formula was proposed to reduce the amount of the gain to reflect this 'inflationary increase' in the value of the asset.

Working out the amount

of the capital gain or loss

for assets acquired before 21/9/1999

Did you make a gain?

• You make a capital gain if you receive (or are entitled to receive) capital amounts from the CGT event which exceed your total costs associated with that event.

Did you make a loss?

• You make a capital loss if your total costs associated with the CGT event exceed the capital amounts you receive (or are entitled to receive) from the event.

7 steps to calculating the capital gain or loss

step 1

Work out your capital proceeds from the CGT event.

(To work out the capital proceeds: see Division 116)

step 2

Work out the cost base for the CGT asset.

For most CGT events, your total costs associated with the event are worked out in 2 different ways:

• For the purpose of working out a capital gain, those costs are called the cost base of the CGT asset.

• For the purpose of working out a capital loss, those costs are called the reduced cost base of the asset.

One of the main differences is that the costs are indexed for inflation in working out a capital gain (which reduces the size of the gain), but not in working out a capital loss. ( To work out the cost base and reduced cost base: see Division 110)

Step 3

Subtract the cost base from the capital proceeds.

(remember, costs are indexed for inflation in working out the COST BASE for a capital gain, which reduces the size of the gain)

step 4

If the proceeds exceed the cost base, the difference is your capital gain.

Step 5

If not, work out the reduced cost base for the asset.

(remember, costs are NOT indexed for inflation in working out the REDUCED COST BASE for a capital loss)

step 6

If the reduced cost base exceeds the capital proceeds, the difference is your capital loss.

Step 7

If the capital proceeds are less than the cost base but more than the reduced cost base, you have neither a capital gain nor a capital loss.

Cost base and reduced cost base.

One of the main differences between working out a capital gain and a capital loss is that the costs are indexed for inflation in working out a capital gain (which reduces the size of the gain), but not in working out a capital loss.

Division 110 talks about all the elements that are included in cost base, but to find out how the cost of the asset is actually increased to reflect the effect of inflation, you must look in Division 114-1.

Did you look?

We will repeat the example contained in section 114-1 here.

Example: Peter purchases a building as an investment on 1 January 1994 for $250,000. This amount forms the first element of his cost base.

He sold the building on 1 February 1996, for $500,000.

Consideration = $500,000

Cost = $250,000

Profit = $250,000

The amount of any capital gain will be measured in money terms, but money is not a very accurate measure over a long period. It's value decreases over time as the general price level rises - we refer to this tendency for the value of money to shrink over time as inflation. (Ask your grandfather how much a glass of beer cost when he was a lad if you don't believe us)

So if we use money values to measure a capital gain, it's like using a shrinking ruler. In order to try to keep the ruler as steady as possible, the actual cost of acquiring the asset (in money terms) is increased to take into account the change in the price level as measured by the Australian Bureau of Statistics in the Consumer Price Index each quarter.

To keep the ruler as steady as possible over the period during which the gain is being measured, we will increase the figure, which represents the cost of acquisition of the asset.

The index number for the quarter in which he sold the building (the March quarter 1996) is 119.0. The index number for the quarter in which he purchased the building (the March quarter 1994) is 110.4.

Applying section 960-275, work out the indexation factor as follows:

In our example, the asset cost $250,000 in March 1994, but if the same dollars had been paid to acquire the asset as are received when the asset is sold, the cost of acquisition would have been $250,0000 * 1.078 = $269,500.

How do we work that out? Simply multiply the cost of acquisition by the indexing factor, which, is the number ascertained by dividing the index number for the quarter in which the asset was disposed of (in our case the March 96 quarter - 119.0), by the index number for the quarter in which the asset was acquired.(In our case the March 94 quarter - 110.4)

That means the gain that is included in assessable income is less than the gain measured in purely monetary terms

Consideration = $500,000

Cost Base = $269,500

Captial Gain = $230,500

(Remember, costs are indexed for inflation in working out the COST BASE for a capital gain, which reduces the size of the gain but are NOT indexed for inflation in working out the REDUCED COST BASE for a capital loss)

How to work out your net capital gain or loss

Section 102-5(1) sets out the 4 steps you need to take

Add up your capital gains for the income year. Then add up your capital losses for the income year.
Subtract the total losses from the total gains.
If the gains exceed the losses, then also subtract any unapplied net capital losses for previous income years. If the result is still more than zero, then this is your net capital gain.
If the capital losses for the income year exceed the capital gains, the difference is your net capital loss. (You cannot deduct a net capital loss from your assessable income.)