Albert Einstein was quite correct when he said: “The hardest thing in the world to understand is the income tax.”
With the end of the tax year approaching, many share investors are turning their attention to methods of reducing their tax bills. While tax benefits should never be the main consideration when choosing an investment, it can be sensible to take advantage of legitimate tax minimisation opportunities.
A number of different approaches are available. Some of these, as further discussed below, push taxable income from the current year into the next year. Others push income from the current year into the indefinite future and/or involve replacing revenue gains by capital gains which are then taxed at a 50 per cent lower rate. Investing in low-yielding growth stocks appeals in this context.
Some approaches, including income splitting and the use of family trusts, keep the amount of taxable income unaltered but may make it subject to tax at a lower rate. Other approaches, such as using superannuation, involve a relatively low tax rate, but there are strings attached to the arrangements (including extra expenses) which may or may not make it all worth while in individual cases. Furthermore, there is always the possibility that the rules may change.
Investors who have incurred capital gains during the year may be able to offset these by disposing of other assets which realise capital losses.
Some approaches, such as using loans of various types (including margin loans), provide tax deductions for the interest. On the surface this sounds good, but in the process these may cost the investors more money than they save in this way.
Some approaches, such as investing in agribusinesses, involve an investment risk which may not always be appreciated.
There are also schemes being advocated by some so-called experts which involve a different type of risk – namely, that the Taxation Commissioner will apply Part IVA and disallow some claimed deductions – so great care is needed when considering these. Independent professional advice should always be sought.
Before discussing some of these approaches in greater detail it seems worth while to summarise some of the tax basics of relevance to share investors.
Income tax is levied separately in respect of the transactions occurring during each “financial year”. For most taxpayers this means the period running from 1 July to the following 30 June, both days inclusive.
Tax is imposed on each taxpayer’s “taxable income”, which is the “assessable income” less the “allowable deductions”.
The term “assessable income”, loosely speaking, means “profit” and covers both personal exertion income and the returns on investments. Typically it includes salary, wages, commission, bonuses, professional fees, profits from business operations, pensions, dividends, interest, rent and the like. It also includes the imputation credits attached to franked dividends.
Income does not have to be received in cash in order to attract tax. For example, interest merely credited to a savings account is assessable.
The “allowable deductions” fall into two main classes – those incurred in earning assessable income, which are deductible under Section 8-1 of the Income Tax Assessment Act 1997, and the so-called “concessional deductions”, such as donations to charities and contributions to superannuation funds.
Investment expenditure items are tax deductible – for example: fees for professional advice, the cost of financial journals, computer software, Internet access charges, bank fees, postage and telephone costs.
Also deductible is interest on money borrowed for the purpose of buying shares or making other income-producing investments and all other expenses of such borrowing. The expenditure and the corresponding income do not have to occur in the same financial year.
If the allowable deductions exceed the assessable income of any year then no tax is payable in respect of that year and a “tax loss” is said to be incurred. Such tax losses can be carried forward and used as offsets to assessable income in subsequent years.
The fact that each financial year is effectively a watertight compartment can at times be used to advantage. For example, arrangements can be made to make payments in respect of deductible items in June rather than in the following July.
Investment in fixed interest securities can similarly have regard to the due date of the interest, so that if desired a security with a July maturity date rather than one with a June maturity date can be chosen.
It is also possible to postpone asset sales from late in one tax year to early in the next tax year – but this involves accepting a market risk (prices can fall in the meantime).
Paying tax one year later than would otherwise be the case has a number of distinct advantages – the ability: to earn extra interest on this amount, to have the use of the money for other purposes and, in some cases, to lower the rate of tax which will apply.
For example, income in the $75,000 to $80,000 range is subject to 41.5 per cent tax in 2007-08 but only to 31.5 per cent in 2008-09. Similarly, income between $30,000 and $34,000 is subject to 31.5 per cent tax in 2007-08 but only to 16.5 per cent in 2008-09.
Quite apart from these changes to the statutory tax scale a lower tax rate may apply where an investor’s income drops – for example, because of retirement.
The other side of the coin is that one should also accelerate the incurring of outgo – for example, investment expenses can be paid in June rather than in the following July. On certain loans the interest can also be paid up to 12 months in advance.