Hold on to growth stocks under Ralph

The common wisdom about the Government’s changes to the capital gains tax system for individuals is that people should now turnover their portfolios frequently. This is not the case. Unexpectedly, it’s often better to keep on holding your high growth assets under Ralph, rather than turning them over frequently.

By Nick Ingram

The common wisdom about the Government’s changes to the capital gains tax system for individuals is that people should now turnover their portfolios frequently. This is not the case. Unexpectedly, it’s often better to keep on holding your high growth assets under Ralph, rather than turning them over frequently.

Before we go any further, please remember that this article is based upon proposed changes to current laws as at 30 September 1999. The final legislation, if passed, may have a different effect. It is a general guide only.

Ralph changes

In its response to the Ralph review, the Government announced a number of key changes to the way capital gains are taxed in the hands of individuals. Firstly, a person will be taxed on only half the nominal gain they make on the sale of a new asset (that is, an asset bought on or after 1 October 1999), so long as they’ve held that asset for a year. Note that the nominal gain is basically the difference between the disposal proceeds and the original unindexed cost base.

Secondly, indexation of the cost base for new assets (bought on or after 1 October 1999) has been abolished. And finally, as at 21 September 1999, the averaging provisions (that allowed an individual often to stay on their lower marginal rate, even with a capital gain) have been abolished.

There are transitional rules for assets purchased before 1 October 1999 (and held for at least a year). Basically, you have a choice as to how to treat the gains. You can assess them under the new system. Or you can assess them under the old system — with your cost base frozen as at September 1999. But you still don’t get averaging.

One year sale

So, doesn’t this new system mean that clients should turnover their high growth assets after a year? This is a key question. You would expect that with the freezing of indexation, there is no incentive to hold for the long term. Intuitively, if you’re not getting your cost base indexed to inflation then your real rate of CGT goes up each year. Surely it’s better to sell before your real rate of tax gets too high.

Surprisingly, this is not the case. You’re still better off holding your high growth assets for the long term, provided there are good investment reasons for doing so.

Ralph still has a cost base for CGT assets. What’s more, it is not indexed by inflation. Rather it rises at half the rate of growth you’re enjoying on your asset - often a much faster rate than inflation.

This is best illustrated by graph 1 below. This graph looks at a $100,000 investment in a unit trust which has enjoyed 7 per cent growth each year in an environment of 3 per cent inflation. The graph shows three lines. Line A is the account balance of the unit trust over time, growing at 7 per cent and before capital gains tax.

Line B shows the new cost base under the proposed Ralph system. This is the original $100,000 plus half of the gain. The gap between line B and line A is the realised gain the investor will pay tax on. Don’t forget they will pay tax on this gap (which is half the nominal gain) at their full marginal rate.

Line C shows the indexed cost base of the unit trust under the old system with 3 per cent inflation. The gap between line C and line A shows the amount of assessable capital gain that the investor will have to pay tax on under the old system.

As you can see, the new cost base under Ralph is actually rising at a faster rate than the old cost base. What this is saying is that the Ralph system effectively still has indexation built into it. There is no reason to realise gains on an annual basis.

Graph 1 shows that the new system beats the old system when you have 7 per cent growth when inflation is 3 per cent.

However, the new system doesn’t always beat the old. The old system does better where there is no significant growth in excess of the inflation rate.

As a very general rule, you need to be getting 3 per cent growth in excess of inflation for the Ralph system to give you a better result than the old system, if you ignore the loss of averaging which was unavailable to people on the top tax rate.

You should also note that to get a better result under Ralph, the 3 per cent return above inflation must come in the form of extra growth. If it is income growth that you reinvest, you get no advantage.

Selling annually

What if you did turn over your portfolio every year under the Ralph system? Let’s assume you turn over each year exactly, so you qualify to be taxed on only half the gain.

Graph 2 below compares turning over every year to buying at the start and holding. As you can see, after both 5 years and 10 years you’re better off if you’d just bought and held rather than turned over. This is for the same reason we all know already. It is better to delay crystallising a tax liability for as long as possible so you have more money working for you longer.

Graph 2 examines the net amount you have if you invested $100,000 at a 7 per cent growth. The graph shows the net amount after all taxes have been paid after five and 10 years.

The left hand column shows the amount you have if you invested the $100,000 and held for the five or 10 years, without turning the portfolio over. The right column shows the after tax balance of the same investment if we turn it over each year and crystallise the tax on each year’s gain.

As you can see, we’re better off if we don’t turn the portfolio over on the way through. This is because we are not losing investible funds in tax each year and taking the full benefit of compounding.

Graph 2 confirms what Graph 1 was showing. It makes no sense to keep realising gains after each year in an effort to keep the real rate of CGT down. It is better to rely on the new cost base indexation that is implicitly built into the new system and to avoid crystallising tax unnecessarily early.

Nick Ingram is distribution development manager at Westpac Financial Services.