MLC 703-Principles Of Income Tax Law- Essay

Question:

Kristie is 42 and decided to buy an investment property with a view to selling the land in the future to fund her retirement. She considered between buying an inner suburban house on a small piece of land or an outer suburban house on a larger piece of land. She eventually decided on the larger outer suburban house. Although her primary intention was to hold the house and sell it at her retirement, one of the factors that made her decide to buy the outer suburban house is that she wanted to be open to the possibility of developing the land in the future.
As it turned out, 12 months later Kristie got lucky in that her investment property was rezoned by her council, which meant that she was able to build a 5 storey apartment on its land (subject to local council approval). She went to a lot of work to get local council approval, which involved getting a professional planner to draft sketches and plans as to what the proposed apartments would look like. This cost her around $15,000. After gaining council approval, she decided that she did not want to be actively involved in the building process, and so paid a professional builder $7m to construct the apartment block (and demolish the existing house). When the apartments were complete rather than sell each unit individually, she sold the whole block herself to a rich investor for $12m.
Required: Ignoring Capital Gains Tax, discuss whether the sale of the apartment block generates ordinary income.

Answer:

Introduction:

A rental or investment property will be negatively geared if the amount of expenditures associated with such property and investment is lower than the amount of income accrued from such property and investment. For example if am investment has been acquired by using borrowed funds and if the net income from such investment is less than the interest expenses on such borrowed fund then such investment will said to be negatively geared.

Australian Taxation system and negative gearing:

Australian taxation system allows negative gearing deduction against the rental and other income of a tax payer to reduce the overall taxable income of the tax payer. There has been number of views on the issue of negative gearing and its impact on the taxation system in the country. However, it is still very much a feature of country’s taxation system and environment. Many have argued in favour of the negative gearing in taxation system of the country whereas many are completely against the deductions that are allowed for negative gearing in taxation.

Both points of view on the issue of negative gearing shall be evaluated and explained in the document to assess and evaluate the fairness, efficiency, protection and other relevant considerations of negative gearing in taxation system of the country.

Deductibility of negative gearing as per Income Tax Assessment Act, 1936:

As per the Income Tax Assessment Act, 1936, here in after to be referred to as ITAA 1936 in this document, the net investment loss arises from negative geared investment will be allowed as deduction fully from investment and other income including income from salary, wages and business income of a tax payer at the time of completion of tax return for a particular income year. In fact the ITAA 1936 further allows the tax payers to carry forward the losses from negatively geared investment and rental properties if the other incomes are not sufficient to absorb the entire losses from negatively geared investment.

Argument in favour of tax deductibility of negatively geared investment and rental properties:

As already mentioned that there has been number of arguments from both side of the spectrum regarding the deductibility of net losses form negatively geared investment and rental properties. Those in favour of the current tax system to allow deductions for net losses on such investments and rental properties give the following justification behind their argument to favour the tax deduction.

Section 8-1 of the ITAA 1997:

The general deductions as per section 8-1 of the ITAA 1997 allows tax payers to deduct from their assessable income any losses and outgoing to the extent the same is incurred in earning the assessable income of the tax payers or if the same was necessary for earning income from business. Thus, since the interest expenditures incurred on acquiring investment with the objective of earning investment income which is a part of the assessable income of the investor, it is only justified to deduct the net losses of such investments from assessable income of the tax payers.

It is a motivation to the tax payers to correctly report their assessable income:

Tax payers knowing that the losses from negatively geared investments and rental properties will be allowed as deduction from the investment and other income of the tax payers would be motivated to correctly report the assessable income.

Encouraging investors to make investment:

The Australian Government has supported the tax shelter of negative gearing as it encourages the investors to invest. Investment is essential for development of any nation thus, tax shelter of negative gearing is one of the many reasons that investors feel encouraged to make investment.


Protection from the Australian courts of negative gearing tax shelter:

The courts in the country have provided protection to the tax shelter for negatively geared investments and rental properties. Those in favour of the tax shelter use this as a point to support their argument of continuing with the tax shelter for negative gearing.

Tacit approval by the Commissioner of Taxation:

An income tax notice was issued by the Commissioner of Taxation in December, 1967 in December, 1967 that gave tacit approval to the tax shelter for negative gearing. Thus, once the tacit approval has been given it shows the importance of tax shelter to the general tax payers in the country.

One of the most popular tax shelters available in the taxation system of the country:

The tax shelter provided for negatively geared investment and rental properties is without any doubt one of the most popular tax shelters for the tax payers in the country. Thus, withdrawing the tax shelter would be a very unpopular decision in the country and to the tax payers.

Argument against the tax shelter for negatively geared investment and properties:

There are number of points that have been put forward by those against the tax shelter provided for negative gearing investment and rental properties. A brief discussion on these points shall be helpful in understanding the fairness, justification or otherwise of the tax shelter provided on negatively geared investment and rental properties.

Ever growing on the tax revenue:

Though it is true that the Australian Government has continued its support for the tax shelter negative gearing however, the burden on tax revenue is ever growing. With each passing year the burden on tax revenue is increasing significantly. Withdrawing the tax shelter on negatively geared investments would reduce the burden on tax revenue to a certain extent.

The protection provided by the Australian courts are without considering the adequate reasons:

Though the courts in the country have provided protection to the tax shelter but the courts have not considered the subjective purpose of the tax payers for availing the benefit of tax shelter. In fact the courts have not made adequate inquiry on expenditures incurred on such investment and rental properties before proving protection to the tax shelter.

Foregone revenue to the extent of $175 million per year:

As per the ‘Reforms of Australian Tax System,’ published in June, 1985 an amount of $175 million is cost to the Government each year as it has to forgone revenue to that extent annually only for tax shelter on negatively geared rental properties.

Implementation of quarantine measures:

Quarantine measures were implemented in the year 1985 that restricts the tax shelter on negative gearing of rental properties to the extent of rental income only. Thus, loss in excess of rental income would not be permitted to be deducted from other assessable income of the tax payer however, the tax payer has the option of carrying forward the excess loss to deduct the same form future rental income. This shows that there is a need to do the same with tax shelter on negatively geared investments. As a result of the quarantine measures the revenue of the Australian Government for 1986-87, 1887-88 were higher by $55 million and $100 million respectively. In-fact 1990-91 onwards the revenue of the government increased by $195 million annually due to the effects of quarantine measures.

Conclusion:

By evaluating the point of views of both sides, i.e. those in favour of tax shelter for negatively geared investment properties and those in favour of abolition and removal of the tax shelter it can be said that though the tax shelter is certainly contributing to the growing burden on tax revenue however, it is not unfair and inefficient to be removed completely. Protection of Government revenue is definitely a valid consideration however, it is not sufficient to completely abolish the popular tax shelter.

References:

Beghin, John, and Mark Melatos. "The trade and welfare impacts of Australian quarantine policies: The case of pigmeat." In Nontariff Measures and International Trade, pp. 271-286. 2017.

Blunden, Hazel. "Discourses around negative gearing of investment properties in Australia." Housing Studies 31, no. 3 (2016): 340-357.

Burton, Mark. "A Review of Judicial References to the Dictum of Jordan CJ, Expressed in Scott v. Commissioner of Taxation, in Elaborating the Meaning of Income for the Purposes of the Australian Income Tax." J. Austl. Tax'n 19 (2017): 50.

Davidson, Peter, and Ro Evans. "Fuel on the fire: Negative gearing, capital gains tax & housing affordability." ACOSS Papers (2015): 29.

Fullarton, Lex. Heat, Dust, and Taxes: A Story of Tax Schemes in Australia's Outback. Columbia University Press, 2014.

Grudnoff, Matt. "Top gears: How negative gearing and the capital gains tax discount benefit the top 10 per cent and drive up house prices." (2015).

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Paul, Erik, and Erik Paul. "Globalisation." Australia in the US Empire: A Study in Political Realism (2018): 21-67.

Pawson, Isla. "Reframing Australia's housing affordability problem: The politics and economics of negative gearing." Journal of Australian Political Economy, The 81 (2018): 121.

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