Investors are often confused about the difference between a revenue profit and a capital gain. People are even more confused by whether a loss is a revenue loss or a capital loss and are frequently bamboozled as to which type of loss can be applied against which gain.
Does it matter?
Characterisation as revenue or capital
By way of illustration, assume an investor, in addition to their salary, has gross gains from sale of shares of $10,000, an equivalent loss from sale of shares and also a $10,000 loss from a negatively geared rental property. All equities have been held for longer than 12 months and the investor is not a share trader.
There are three fundamental questions to answer:
- is the gain a revenue profit or a capital gain?
- are the losses revenue losses or capital losses?
- are there any restrictions in applying the losses against income or gains?
Characterisation of a gain or loss as revenue or capital is a matter of fact and circumstance having regard to many matters such as whether the investor is an individual or other legal entity, the investor’s intention and the nature of the activity undertaken.
In forming a view, the ATO will have regard to various factors including the dollar value of the portfolio, the type of securities, the frequency and dollar value of turnover, the average holding period and whether or not the investor has what the ATO would regard as a sophisticated trading strategy or methodology. Weighing these up, the ATO may reach a conclusion that the securities are held as revenue assets.
In contrast, a passive holding where equities are bought and sold infrequently is more likely to be regarded as capital. Unfortunately, there are no hard and fast rules as to what constitutes frequent activity.
Just to confuse matters, it is possible for an investor to designate one parcel of shares as a trading (revenue) portfolio and another as capital. Provided this is carefully documented and shares do not ‘drift’ from one parcel to another, the distinction can be made. Experience shows that the loss- making investments tend to drift towards the trading portfolio and the gains towards the capital portfolio – all too often after the event. This approach seldom survives close scrutiny by the ATO.
Rules of thumb
Given all of this, are there any rules of thumb? Whilst there are many exceptions the following could be adopted as guidelines:
- where a person holds an investment for longer than 12 months, any gain should be regarded as capital (but not always)
- likewise, any loss on sale of such an asset would be regarded as a capital loss
- a loss where expenses exceed income (such as a negatively geared rental property) is a revenue loss
- regular, high volume trading will be viewed as revenue gains and losses.
Moving to the loss rules, the following matters should be noted:
- revenue losses can be applied against either income or capital gains
- capital losses can only be applied against capital gains, not against income
- one dollar of capital loss offsets one dollar of gross capital gain
- one dollar of revenue loss offsets two dollars of gross long-term capital gain. That is, if the gain relates to an asset which a person has held for longer than 12 months, the 50% CGT discount applies to reduce the taxable amount to half of the gross gain. The revenue loss is then applied against this reduced amount.
The worked example
Where do these rules take us in the above example? The investor would offset the capital loss on shares dollar for dollar against the capital gain. The rental loss could be offset against salary.
If we change the example and assume the investor had no capital losses, they could apply the rental loss, either in full against their salary or part against the ‘after 50% discount’ gain of $5,000 and the remaining $5,000 against salary. The tax outcome would be the same in either case.
As an alternative, they might consider crystallising capital losses by selling shares with otherwise unrealised losses. Care would need to be taken with such a strategy as it may be viewed unfavourably by the ATO, particularly if the investor sold the investments prior to 30 June and bought back the same investments shortly after year-end.
As 30 June approaches, investors should take the time to review their portfolios and also the position they are taking in respect of tax treatment.
Ray Cummings is Principal of Greenoak Advisory Pty Ltd, and for 15 years was a Tax Partner at Pitcher Partners.