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An increase in the Capital Gains Tax rate: would it make economic sense?

25 February 2020
– 3 Minute Read

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Yet again, there is speculation that the Minister of Finance will increase the Capital Gains Tax (CGT) rate in the 2020 budget.  There are several key issues with this, including lack of competitiveness internationally (and risk of decreased tax collections), absence of inflation indexing, and misalignment between the income tax and CGT rules.

Capital gains are included at a specified rate in a taxpayer’s taxable income. The CGT taxing rules that were introduced in 2001 were aimed at taxation of gains at relatively low inclusion rates. For more than a decade following the introduction of CGT, the inclusion rates remained constant at 25% for individuals and 50% for companies and trusts. The inclusion rates have significantly increased since. Following the last rate increase in 2016, the capital gains of companies are included in taxable income at 80% (22.4% effective tax rate), whereas the CGT inclusion rate for individuals is at a more palatable 40% (maximum 18% effective tax rate). Trusts are hardest hit. At an inclusion rate of 80%, trusts have an effective CGT rate of 36%.

The approximate average effective CGT rate of European countries is 20%. South Africa is more or less on par, but a further increase would result in tax rates in excess of the rates applicable internationally.  This creates more incentive for taxpayers to export their capital and possibly their skills.

Certain categories of taxpayers may be particularly vulnerable to an increased CGT rate, such as retirees, who need to “live off” the assets that they have accumulated during their working lives. Unexpected increases in the CGT rate could impair their quality of life as they age.

One of the reasons that CGT was introduced at lower rates than income tax, was because of the impact of inflation.  In Rand terms, an asset may be sold for a higher amount than its acquisition price, but this could simply reflect inflation (or the devaluing of currency over time).  Whilst there appears to be a gain, in real commercial terms there is no economic gain. For this reason, the Trump administration is considering inflation indexing in the United States, a jurisdiction with high CGT rates. Currently the South African tax system does not apply inflation indexing, and so it would not be equitable to increase the CGT inclusion rates without addressing this issue.

Another problem with the current CGT system is the way that expenditure is taxed.  One cannot claim any expenditure that is “capital” in nature, for income tax purposes.  In addition, only certain very specific types of expenditure directly linked to the acquisition or disposal of an asset can be taken into account as the CGT “base cost” of an asset. For instance, the cost of funding an asset can only be recognised as CGT base cost in limited cases.  There are numerous types of expenses for which there is no tax deduction or base cost recognition at all.  This has been explained away on the basis that not all “capital” receipts are subject to tax, given that capital gains are taxed at a lower effective rate than “ordinary” income.  If, however, there is an increase in the CGT inclusion rates in the 2020 legislative cycle, it would be only fair and reasonable that all expenses are fully recognised either as income tax deductible or as a cost that reduces capital gains.