By Daniel Archibald | CFA
"Of course I am minimising my tax. And if anybody in this country doesn't minimise their tax, they want their heads read, because as a government, I can tell you you're not spending it that well that we should be donating extra!" Kerry Packer
Tax on income earned from investments has generally formed part of an individual's tax base since the idea of personal income tax became a key source of government revenue about a century ago. At that time, investment income was primarily in the form of rental income received from property, but also included dividends paid to shareholders. In 1985, the concept of personal income was extended to also include realised capital gains, with the argument that an increase in the value of an asset represented an increase in the purchasing power of the asset holder; just like other kinds of income.
Degrees of tax minimisation
As highlighted by the late Kerry Packer, most of us will look to keep our tax bills as low as possible. The main caveat for most of us is to do so in a legal and ethical manner. When delineating between appropriate tax minimisation and less appropriate, tax strategies can be classified as evasion, avoidance or planning:
- Tax evasion (generally illegal and unethical)
- Misrepresent tax position to reduce tax bill
- Not acting in accordance with the letter and spirit of the law
- Penalty - tax recouping, fines and jail time
- Tax avoidance (generally legal but unethical)
- Conducting transactions to reduce tax bill
- Acting in accordance with the letter of the law, but not the spirit
- Penalty - Tax recouping and fines for strategies deemed to be for the sole purpose of avoiding tax
- Tax planning (generally legal and ethical)
- Structuring and managing investments to reduce tax bill
- Acting in accordance with both the letter and spirit of the law
- No penalties
Tax planning investments
It is appropriate for investors to consider tax consequences when making investment decisions. Tax is cost to investing and after-tax returns should drive the portfolio construction process. Various strategies might be employed by investors in order to keep a lid on tax leakages including:
- Tax exempt investments/structures - In Australia, residence and retirement schemes; In US, semi-government bonds
- Other concessionally-taxed investments and structures - E.g. pre-retirement schemes (superannuation), other assets
- Franking credits - This one is mainly for Aussie investors
- Geared investments - E.g. property, margin loans, instalment warrants
- Deferred tax investments - E.g. Infrastructure assets, agribusiness assets, preference for low income assets
- Managing capital gains - E.g. Appropriate capital loss harvesting in order to defer capital gains taxes
Though there can be grey areas between what constitutes tax avoidance and tax planning, in general, the tax man will be on your side if it is shown that there are other reasons (other than tax minimisation) for asset structuring or transactions. For example, contributing to superannuation does provide tax relief, but also provides a restricted savings pool for retirement. Of course, perhaps if we were all confident with how the government spent our tax monies we wouldn't have to worry about tax strategies at all.