A guide to the Henry Review and its proposed changes to marginal tax rates and CGT

Sam Rubin looks at the Henry Review's recommendations on marginal tax rates and capital gains tax (CGT) and the effect they could have on the industry.

The long-awaited Henry Tax Review was provided to the Government in December 2009, but was kept out of the public arena until the report was released on 30 April 2010.

The overall objective of the Henry report is to strengthen growth by maximising Australia’s wealth creation potential. The panel was charged with completing a review of the Australian tax system and providing a blueprint for reform.

The Henry Tax Review contained 138 comprehensive recommendations covering personal income tax, superannuation, family assistance payments, small businesses and retirement incomes.

An interesting recommendation, which has had minimal media coverage, is to change marginal tax rates (MTR), abolish all tax offsets and change how capital gains tax (CGT) is calculated. Further examination of the impact this proposal would have, if it were implemented, is provided below.

Tax recommendation

The Henry Review’s recommended changes to MTR are shown in Figure 1.

The impact of these changes to the current MTR is in Figure 2, demonstrating that an average Australian earning $58,000 per annum would be worse off.

Financial planning strategy opportunities – Changes to MTR

There are a number of tax minimisation strategies that would be affected by the recommended changes to MTR. Outlined below are a few of the strategies:

• A taxpayer would need to salary sacrifice their income down to the new tax-free threshold of $25,000 (currently at $30,000) in order to maximise the low-income tax offset;
• Investing via a corporate entity would be more attractive because the proposed corporate tax rate is 29 per cent compared to a 35 per cent marginal rate (assuming higher tax-free threshold already utilised);
• Investing via family trusts with non-working beneficiaries (eg, non-working spouse or adult children still studying) would be more attractive since it would be able to distribute income up to $25,000 tax-free (compared with $16,000 currently); and
• Salary packaging concessional and other non-super benefits may become more attractive.

CGT recommendation

Henry has recommended changing the current CGT methodology from a realisation method to an accrual basis. This means taxpayers with investment assets will be subject to taxation on the annual growth of the asset regardless of whether it has been realised or not.

One of the benefits of the current system is that taxpayers can defer their CGT liability until they dispose of the assets. In addition, the gain is concessionally taxed if the assets are held for long enough.

If the Government implements Henry’s CGT recommendations, the current 50 per cent discount would automatically be removed. We assume this would also apply to other investment structures such as superannuation funds, companies and trust assets.

The net return of long-term growth assets could be affected quite considerably. This would have a major effect on the core principles of financial planning and tax minimisation strategies.

For example, a client commences an investment portfolio of $100,000 and decides to reinvest for ten years. Assuming a 3.5 per cent income, 6 per cent growth and an MTR of 38.5 per cent, under the proposed CGT changes, the investor will be $25,665 or 12.7 per cent worse off when he/she sells in ten years.

Note: Some of the questions that are still to be clarified are:

• What happens if investments have fallen in value? Will the loss be a direct deduction or will it have to be quarantined for a future period?
• Who will be responsible for determining the annual valuation for certain assets that do not offer daily pricing (such as investment properties and structured products)?
• How will investors pay tax liability on non-divisible assets (such as property)?

Case study

John and Mary are aged 52 and 50 respectively, and are planning to retire in eight years. They have two children, aged 18 and 16, and both want to complete university.

Their annual salaries are $120,000 (John) and $55,000 (Mary). John’s superannuation is $350,000 and Mary’s is $75,000. John’s mother has recently passed away and has left him $300,000.

Conclusion

As the average Australian is likely to be worse off under these proposed changes to the MTR and the assessment of CGT, it will be interesting to see how the current Government – or future Governments – would consider this. If it is implemented, it will only strengthen the importance of full, ongoing financial advice.

Sam Rubin is head of technical services at IOOF.