Tax Law Notes
Tax Law Note:
What are the Options for Taxing Capital Gains of Residents?
Last Updated: September 27, 2005
The treatment of gain on the sale or other transfer of property varies widely, even in the conceptual framework and the terminology used. The term "capital gain", which has a narrow meaning in some countries, is used more generally in others to describe gain from the transfer of property.1 Common-law countries often have special tax rules for gain on the transfer of assets other than business inventory or trading stock or similar property, and on the transfer of personal-use assets of an individual (consumer durables; a personal residence, for example).2 Other countries, typically those in the civil-law tradition, have either a narrower concept of "capital gain" or no such concept-business profits are taxed with no distinction drawn between gain on disposition of inventory and gain on the transfer of other property or other sources of income; individuals are taxed on gain on the transfer of specified assets. In either case, tax may be imposed without invoking the rubric of capital gain.3
The OECD model tax treaty refers to "capital gains" in the title of Article 13, which covers the treatment of gain on the transfer of property. The text of Article 13, however, does not use the term "capital", and refers only to gains from the alienation of property, dividing these into several categories (immovable property; movable property forming part of business property; ships, aircraft and other transportation property; and all other property). Because the term "capital gain" (or "capital gains") has a very specific and limited meaning under the domestic law of some countries, and no meaning in others, the terminology "gain on the transfer of property" or "asset-transfer gain" is preferred in discussing the topic in an international or comparative context, and those phrases are used interchangeably here. This note considers whether to tax asset-transfer gain; and, if so, how.
Country practice varies widely. The chart below illustrates in general terms the approach to "gain" concepts and the tax treatment applicable under a variety of domestic tax laws (without covering all the actual variations found).
Countries reviewing the taxation of gain on the transfer of property have a wide range of options. As a practical matter, it is helpful to take the following considerations into account when determining whether to tax asset gain:
Once it is determined that some or all asset-transfer gain should be taxed, and the categories of affected assets are established, the next step is to select a method of taxation.
The wide variations in country practice suggest considerable scope in selecting a method of taxation. Common approaches include:
From a drafting standpoint, the most straightforward approach might seem to be to include gain on the sale of any asset and to apply the normal tax rates. However, this method has substantial practical disadvantages, primarily for reasons of administrative feasibility.
Fashioning a Solution
Business Assets. Most countries considering the taxation of asset-transfer gain do so in the context of an income tax. Whether the income-tax system is global or schedular, typically there is a separate regime for taxing business income. Generally it makes sense to provide that gain on the sale of assets used in a business is included in business income. An exception (which may be called a rollover or an asset-replacement rule) is often made for business assets that are replaced by similar assets, so that taxation of asset-transfer gain does not act as a "toll charge" on the upgrading of business equipment. This result is automatically achieved for depreciable assets if a system of pooled depreciation is used.4
Assets Held by an Individual. In the personal income tax regime, a global income tax generally includes income and gains from all sources in the individual's income, and in many systems of this sort an individual is required to file an annual tax declaration reporting gain on the sale of personal assets. This approach makes it convenient to ask for a declaration of gains on personal-asset transfers, although some countries with a global approach nonetheless shift asset-transfer gain to a separate schedule of income. It is also common to allow an exclusion for the sale of tangible personal property, on the basis that it is administratively difficult to tax these gains, and that they are not economically very significant. Antiques and other collectibles may be excluded from the exemption.
To minimize the need to file returns, and economize on administrative costs, some countries provide a general exclusion for a specified amount of gains per year. Only if taxpayers have gains greater than this amount are they are required to report the gains. Care should be taken in designing any such exclusion. If it is set at a relatively high level, it will create an incentive for taxpayers to realize gains each year up to the amount of the exclusion. This problem can be addressed by lowering the amount of the exclusion or through anti-avoidance rules targeted at transactions where taxpayers sell assets and repurchase them within a specified period of time.
Some countries provide preferential treatment for gains on sale of a personal residence. For example, the tax on the gain may be deferred if the gain is re-invested in another personal residence within a stated period. This exclusion serves the same purpose as the asset-replacement rule in the business context: it ensures that taxation of asset-transfer gain does not place an undue burden on taxpayers who are moving from one residence to another. Another approach, simpler to apply, is a complete exclusion of gain on the sale of the taxpayer's primary personal residence.
Some assets, for example assets held as investments, do not fit readily into the "business" or "personal" classification. For example, company shares are a common form of investment by individuals, but are not "personal" assets like the family home or automobile. Similarly, a company may hold a portfolio of shares as a capital-management strategy; their sale may be to improve the safety of the company's investment portfolio rather than for reasons of business operations. Although some countries distinguish among assets on the basis of the motive for holding the asset (the United States takes this approach), it is better to avoid tests based on the taxpayer's motive or intent. A typical approach is to draw distinctions based on the percentage of shares in the subsidiary company that are held. Holdings below a specified percentage may be treated as portfolio investments and gains on their disposition fully taxed. The treatment of gains on the sale of shares may also be linked to the rules for corporate-shareholder integration. For example, the new system in Germany generally exempts from tax one-half of dividends received by individuals (intercorporate dividends are fully exempt). The same treatment applies to gains on the disposition of corporate shares (taxation of half the gain for individuals - in those cases where the gain is subject to tax; and exemption for corporations).5
Inflation. A knotty problem in the taxation of asset-transfer gain is inflation. For example, if the inflation rate is 20 percent per year, an asset purchased for 100x at the beginning of Year 1 will sell for 500x at the end of Year 5. If the asset's cost base is not indexed for inflation, the taxpayer will be required to report a gain of 400x-yet all this gain is inflationary gain. None of it reflects real appreciation in value. The obvious solution is to index the asset's cost base for inflation, so that on its sale the adjusted cost base would be 500x and the taxpayer would not report gain. But there are two problems with indexing the asset base. First, it is a complicating feature in the income tax system. Second, the decision to index the cost base of assets without also indexing interest on loans creates a distortion, and this adjustment is even more complicated. For these reasons, the cost-benefit of an inflation adjustment for asset cost generally weighs out as worth the complexity only in situations of high inflation.6 Where the rate of inflation is more modest, either no adjustment or a favorable tax rate for long-held assets is a more practical choice. A "long-held" asset may be defined as one held for a period of at least a year, or a longer period such as 2-5 years. Of course, the inclusion of a rule allowing more favorable tax treatment of longer-held assets worsens the "lock-in effect," encouraging taxpayers to hold onto assets that, absent the rule, would have been sold sooner.
"Bunching" of Income. Another reason frequently offered for taxing asset-transfer gain at a favorable rate is the "bunching" or aggregation of several years' appreciation into a single tax year, the year of sale. The inclusion in one year of gain that accrued over several is a problem in an income tax with a graduated rate structure, because taxpayers who normally are taxed, for example, at a middle-bracket rate are likely to be pushed up to a far higher rate. There are some "ideal" solutions to this problem, from a theoretical perspective: accrue and tax unrealized gain annually; or allow income-averaging over several years, so that the asset-transfer gain is taxed at an average rate of tax. The complexity involved with these methods is a good reason to avoid them. As with the problem of inflation, use of a lower rate of tax often serves as a rough adjustment for the "bunching" problem. In a global income tax, the combined concerns about inflation and bunching of income often lead to a separate, flat-rate schedule for asset-transfer gain.
Losses. Appropriate treatment of losses on transfers of investment assets is very difficult. In any well-diversified investment portfolio, there will be some percentage of loss assets every year. If a taxpayer must sell a gain asset, it is often easy to match the gain with the sale of a loss asset-thus reducing the tax base to zero. There is nothing inherently illegal or immoral in this conduct. But, as a practical matter, the ability to zero-out investment income with investment loss may mean that the taxation of asset-transfer gain and loss is a meaningless exercise. For this reason, many countries greatly restrict the deductibility of losses from the sale of property.
For companies, the most common restriction is to prohibit non-business losses to be offset against business income. This rule requires a distinction between assets used in the business (losses are taken into account) and assets that are not.
In the context of the taxation of individuals, two restrictions are often applied. First, if the individual is a sole proprietor, loss on the sale of non-business assets is not available to offset business income (just as gain on asset transfers by an individual is taxable under a separate schedule). The individual files a business income tax declaration with respect to income of the sole proprietorship. Assets held by the individual but not used in the operation of the business are not treated as connected to the business activity. The gain rule for asset transfers by an individual requires the application of a separate schedule for non-business transfers. Second, non-business asset-transfer losses may be used only to offset non-business asset-transfer gains. Losses may be carried forward. While these limitations involve complexity, they may be considered justified based on the opportunity for selectivity in the timing of loss realization.
Ault, Hugh et al., Comparative Income Taxation 194-204, 446-47 (2004) (U.S., Canada, Australia, U.K., Sweden, Netherlands, Japan, France, Germany).
Thuronyi, Victor, Adjusting Taxes for Inflation, 1 Tax Law Design and Drafting 434 (1996).
Richard Vann, International Aspects of Income Tax, in 2 Tax Law Design and Drafting 718, 743-44 (1998)
John King, Taxation of Capital Gains, in Tax Policy Handbook 155-58 (1995)
Katz Commission, Chapter 6: Capital Gains Tax.
Krever, Richard and Brooks, Neil, A Capital Gains Tax for New Zealand (1990).
The series of Tax Law Notes has been prepared by the IMF staff as a resource for use by government officials and members of the public. The notes have not been considered by the IMF Executive Board and, hence, should not be reported or described as representing the views of the IMF or IMF policy.
1See generally Victor Thuronyi, Comparative Tax Law 260-63 (2003).
2Richard Vann, International Aspects of Income Tax, in 2 Tax Law Design and Drafting 718, 743-44 (1998).
3See generally Richard Vann, Tax Treaty Policy of Dynamic Non-Member Economies, in Tax Treaties: Linkages between OECD Member Countries and Dynamic Non-Member Economies (Vann ed., 1996); Thuronyi, supra note 1, at 263-65.
4See Richard Gordon, Ch. 17: Depreciation, Amortization, and Depletion, in 2 Tax Law Design and Drafting 715-16 (1998)).
5See Klaus Tipke and Joachim Lang, Steuerrecht 443 (17th ed. 2002).
6For the design of an inflation adjustment in an income tax, see Victor Thuronyi, Adjusting Taxes for Inflation, in 1 Tax Law Design and Drafting 434 (1996).