As tax accountants, we focus on a range of great tax strategies for business families. However, the simplest tax strategy is often not discussed. It might be a wood for the tree’s position, or it might be that its simplicity is so clear that it is not worth addressing. However, wealthy families structure their investments properly and use this strategy extensively.
You do not pay tax on unrealised capital growth.
If a person had AUD 100m to invest, which generated a 10% income return, that person would pay AUD 4.7m in tax.
If the same person generated the same investment return, but it was in capital growth rather than income, that person would pay no tax at all.
The choice of entity, the person’s record keeping, and the timing of tax deductions do not matter. Unrealised capital gains are tax-free.
Wealthier business families commonly use this strategy. Why? Because you cannot spend unrealised capital gains to buy food, go on holiday, and buy a family home. At some point in time, every person must generate income, or realise capital gains, to spend money on private items.
The difference is that the personal spend of a family tends to be fixed. There are a few examples of outliers, but for most people in Perth, their day-to-day spending is ultimately capped. You cannot eat at Rockpool every night, and there is a limit on the price you can pay to go to an Eagles game – even if you are in the Locker-Room. So, for families with higher net wealth, the income or realised capital needed for personal lifestyle costs as a percentage of investment return is lower than that of other families. This allows those families to structure their investments to generate more capital growth that is unrealised, untaxed, and reinvested.
The timing benefit of this position cannot be overstated. If the same person detailed above (AUD 100m, 10% return) generated unrealised capital gains over 20 years, compared to the same person generating income, the net difference in wealth (assuming all after-tax income is reinvested) the net difference would be AUD 611m compared to AUD 266m.
The tax strategy has more than doubled the market value of the income only strategy.
So, how to do you convert income returns to capital returns? The simplest answer is choosing investments that generate capital growth as compared to income growth. Some types of private business are prone to capital growth – think of a farming operation or a business with an annuity income stream like financial planning. A predominantly service-based company, like medical practitioners, generally is income stream only and typically has no, or very little, resale value.
Alternatively, some asset classes, like property, are more prone to capital growth and generate lower income yields. If you purchase shares, simply choosing not to sell them means your capital growth is unrealised and untaxed.
Some investments are negatively geared. So, the income return, through debt, is nil, and the entire investment return is capital. The long-term hold of these assets means that the return on investment is tax-free.
A family can also choose to invest in a company. The franked dividends received are effectively tax-free and reinvested, increasing capital. The family does not change their shareholding in the company or the underlying investments.
The taxation of unrealised capital gains is a significant tax advantage, and for the reasons discussed above, wealthier families in business classically enjoy it. The government’s proposed (and delayed) Division 296 taxation on superannuation balances over AUD 3m is an example of the intended taxation on unrealised capital gains.
The taxation of unrealised capital gains does happen in Australia. The imposition of land tax in Australia is based on the asset’s value, not on its cost, so the unrealised capital value of the asset is taxed each year (noting that the family home and agricultural properties are exempt from land tax).
Further, in the US, the incumbent government had planned to tax unrealised capital gains on persons with net wealth of more than USD 100m. Further, in the UK, a trust will pay an inheritance tax every ten years based on the value of the asset, including unrealised capital gains, at the rate of 6% on the market value of the trust assets (less adjustments).
Further, many countries worldwide apply a death tax, so the estate pays tax on the value of the assets held by the deceased. The assets are not realised in the sense they are not converted to cash—the rate of death tax on the assets is determined by the market value of the assets transferred.
Australia is unusual because we do not have a death tax, and Australia refunds franking credits to individuals receiving franked dividends (other countries will indicate this is a refund of the underlying tax).
So, while generating unrealised capital gains as a tax strategy is simplistic and obvious to many – it is not evident to all. And, looking back as a Perth tax advisor, it is fair to say that the great tax advantages we enjoyed and gave tax advice to our clients were not that apparent until tax law was introduced, taking away that tax advantage. And suppose the government ultimately start taxing unrealised capital gains. In that case, we will all look back at the current tax strategy and marvel at how incredible this simple strategy was at the time.
The use of tax strategies to increase the after-tax wealth of a family in business is all we do at Westcourt. Our fiercely independent advice, single focus on families in business, upfront billing, and deep international network of over 31,000 staff make Westcourt a natural choice for any business family. Why not give us a call?
