New Tax Rules Already Moving Markets

Tax can really move investment markets, with the best example being the shrinking property values and sales in most Australian states since the crackdown on negative gearing and capital gains tax in this year’s Federal Budget.

It is fairly clear that the property market has reacted strongly and quickly to the rising tax burden for landlords, with buyers drying up fast in response to the reality of lower tax deductions and higher exit taxes.

That is shown by rare falls in both the large Sydney and Melbourne markets, although other Australian cities are proving more resilient.

However, the effect on the share market will take longer to determine after a period of rapid legislative changes left investors uncertain about how various share market sectors and structures will be hit.

Interestingly, these eventual tax effects have probably already started happening even though the capital gains tax changes will really only start next financial year.

That is because investors start to anticipate what is coming and act early to make sure they are in the shape they want to be in when the changes come through.

Overall, I am expecting the changes to be positive for the share market, although there could be less investor support for start-ups, which would reduce the number of new floats.

Move from Traditional Portfolios

The really big change though is likely to be a gradual move away from running a personal share portfolio made up of several individual company stocks in favour of buying pooled funds such as those offered by ETF’s and also through buying shares in listed investment companies such as Australian Foundation Investment Co (ASX: AFI).

The reason the flood of money towards mostly passive ETFs and the slightly more active LICs is a fairly major technical difference in the operation of the new capital gains tax.

Under the old system, capital gains on assets held for more than a year were reduced by half – the CGT discount – and then assessed according to the taxpayer’s marginal tax rate.

Under the new system the discount is replaced by an inflation adjustment which means only real gains above the inflation rate will be taxed.

There is also a minimum 30% capital gains rate no matter what marginal tax rate the taxpayer has which is a very unpleasant news for many investors who were planning to sell some shares in years in which their marginal tax rate is low or non-existent—usually when retired.

Many of these investors are probably in the process of selling down some of their share portfolios before the tax changes eventuate to take advantage of the window in which the old tax system remains.

Alternatively – as I explained here – they may decide to adopt Warren Buffett’s long-term approach and stick with their investment effectively forever.

Tax Change Advantage

The technical change that the inflation adjusted CGT brings is that there is less scope to deal with stocks that have gone up at less than the inflation rate but are still up on their purchase price in nominal terms.

So, if inflation has run at a total of six per cent over two years under the new system and this stock has only gone up by 4% over the same time, there is less scope for offsetting the “lost” 2% of real gains.

That contrasts with the situation for an ETF or a listed investment company in which gains and losses and even sub-inflation gains are all brought to account internally and netted out so that the tax will be applied in a more even and effective way.

Franking Even More Desirable

The other wrinkle to consider here is that under the new system, capital gains will be taxed more harshly than before – particularly with the CGT 30% floor rate – but income in the form of fully franked dividends will continue to be taxed more lightly than alternatives such as bank interest, depending on the taxpayer’s marginal tax rate.

By contrast, within superannuation CGT remains at just 10% for assets held for more than a year and reduces to effectively zero when the fund moves from accrual to pension mode.

That makes superannuation funds a much better vehicle to shoot for growth rather than personal share portfolios held in your own name.

What we may well see emerge is a change of investment strategies between superannuation and direct investments, with super funds continuing to invest to maximise capital gains but personal share portfolios increasingly skewed towards concessionally taxed dividend income using ETFs or LICs.

CGT Caveat Uncertainty

Adding to the uncertainty here is that there is not yet enough detail around some of the government’s compromises through a proposal to allow company founders, employees, and investors in start-ups to keep accessing the 50% CGT discount with some caveats.

Exactly how the “innovation” exclusion will work and how innovative floats and companies will be determined is so far unclear courtesy of the somewhat hurried response to criticism about the tax changes.

What is clear is that the trend towards passive ETFs – and even other forms of ETF – looks set to continue and even accelerate due to their better treatment under the new inflation adjusted CGT which comes to force in the middle of next year.

Another factor that could favour more money coming into the share market is that it could be an ideal alternative to the money that has until now flowed to the residential property market.

For example, somebody who was previously attracted to a negatively geared investment property under the old rules might see the alternative of a negatively geared basket of commercial property assets in the form of Real Estate Investment Trusts or an ETF containing them as a great alternative.

Negative Gearing Still an Option

Commercial property is not covered by the prohibition on negative gearing and property listed on the ASX has the advantage of greater diversification and professional management and the ability to sell smaller parts of a holding very quickly.

By contrast, directly held property is lumpy, concentrated and is an all or nothing investment in a single asset.

By the same token, as I covered here, negatively gearing a share portfolio is another strategy that we may start to hear a lot more about and this could become a much more attractive strategy – along with purchasing lightly geared ETFs.

All of this should ensure more rather than less activity on the share market with superannuation continuing to invest for growth and back start-ups while personally held portfolios might start to become more dividend focussed.

The important thing to remember though is that tax is only one consideration when investing and it is usually a mistake to base an investment decision purely on tax.

The importance of considerations such as diversification, liquidity, profitability and future prospects remain vital so the tax changes should result in a modification of current strategies rather than wholesale changes.

The one exception to that rule is probably family trusts and associated bucket companies, which have become much less attractive because of the tax changes.