Division 296: an exercise in poor design and dangerous precedent

Division 296 – Better targeted superannuation concessions, popularly known as the $3 million superannuation tax, is a controversial issue for all Australian taxpayers at the moment.

Among tax professionals, it has been widely criticised as a fundamentally flawed policy design, which goes against the well-established and accepted best practice for what good tax law should look like.

The Tax Institute’s Head of Tax & Legal, Julie Abdalla, FTI, said, “We absolutely support changes that make our tax system more equitable. No one is arguing against high wealth individuals paying their fair share. We are concerned that Treasury is introducing a legal precedent that says Australians can be taxed on money they do not have and may never have. There’s nothing equitable about that.”

“It’s unconscionable that Treasury is pushing this policy through with blatant disregard for the legal and equitable concerns raised by stakeholders. And it is particularly dishonest and disappointing to hear the Treasurer publicly state that no better solutions have been proffered, when many highly intelligent people and superannuation experts have presented various reasonable and workable alternatives.”

Support for an equitable tax system

There is substantial support from The Tax Institute, its members, and the wider tax community, for changes that make our tax system more equitable, including superannuation reform.

By design, good tax policy ensures that each person pays an appropriate share, based on their circumstances, to fuel the society in which we wish to live. But this outcome cannot and should not be achieved at the expense of sound law design principles.

Legislative change should be underpinned by some key objectives, including that it should:

1.      be readily able to be interpreted and understood, in order to make compliance with tax obligations simple;

2.      have a low level of administrative complexity and not create a disproportionate administrative burden; and

3.      be fair and equitable for all Australians, and sustainable into the future.

The proposed Division 296 tax fails on all counts. There are several better, fairer policy options to  tax higher superannuation balances, and to create a more equitable tax environment.

What is Division 296?

In a nutshell, Division 296 – Better targeted superannuation concessions is a proposed amendment to the ITAA 1997, which would introduce a 15% tax rate on those earnings attributable to the part of an individual’s total superannuation balance (TSB) that exceeds $3 million. For this purpose, taxable earnings would include unrealised gains. Division 296 tax would be assessed to the individual, in addition to any tax paid by their superannuation fund on actual earnings and capital gains.

Taxing high wealth individuals is a socially and economically acceptable policy intent. Where Division 296 raises equity concerns are the fundamental flaws in its policy design involving the taxation of unrealised gains, and the dangerous legal precedent this sets in our tax system.

Was there consultation on Division 296?

The Division 296 tax was originally announced as part of the Government’s Federal Budget 2023–24. The details of the Division 296 tax were briefly released for consultation on 3 October 2023, with a closing date of 18 October 2023.

On 19 October 2023, The Tax Institute made a submission to the Treasury in relation to Division296. In this submission, we raised many concerns with the proposed Bill, including that the consultation period of just 12 working days was grossly inadequate and did not allow stakeholders sufficient time to comprehensively consider the complex draft legislation and make a fully informed submission.

Recently, the Treasurer indicated that no one offered any alternative to taxing unrealised gains despite ample consultation. This is blatantly not true.

In our October 2023 submission, the Institute recommended various amendments to the draft Bill, which would bring it more in line with good tax policy design, including:

We also made a submission to the Senate Economics Legislation Committee on 26 February 2024 in respect of its inquiry into and report on the Treasury Laws Amendment (Better Targeted Superannuation Concessions and Other Measures) Bill 2023, consistent with our October 2023 submission. We appeared as an Expert Witness at the Public Hearing for the Inquiry on 18 April 2024.

What are the concerns around Division 296?

Taxing unrealised gains

The primary concern in regard to Division 296 is the introduction of the taxation of unrealised gains. As a fundamental principle, taxing unrealised gains is inconsistent with the well-established general approach in our current system of taxing capital gains on a realised basis.

Taxing unrealised gains is likely to place superannuants under financial stress, due to a misalignment between the tax bill and available cash flow. 

This issue is exacerbated by issues such as the lack of loss carry-back, considered below.

No indexation of the threshold

Inexplicably, the proposed policy lacks any threshold indexation – a key feature of other superannuation legislation. This means that, over time, more people will be subject to Division 296 tax, in the same way that bracket creep applies in the context of personal tax rates.

Given the seeming disregard for sound tax policy and fairness in thedrafting of Division 296, it is hard not to describe this as a deliberate action by the Government to ensure increasing tax revenues from this policy without any political backlash, now or in the future.

Utilising losses

The draft Bill proposes to allow superannuants with negative earnings to carry forward their losses to be applied against future gains. However, in some circumstances, a carried forward loss will not be permitted to be recognised or may result in inequitable outcomes. These include, but are not limited to:

• superannuation funds incurring large and unforeseen losses (for example, losses resulting from a severe recession or market crash) that exceed cumulative future gains; and
• individuals who die after incurring a loss and are unable to recoup the loss or transfer it to their estate.

Transparency of information and calculations

The proposed legislation states that the Commissioner will calculate the Division 296 liability and notify impacted taxpayers each year.

The Tax Institute is of the opinion, and has recommended to Treasury, that the data used by the Commissioner in assessing an individual under Division 296  should be made available to taxpayers and their tax advisers, so they can verify and estimate their tax bill.

Without this data, it will be challenging and time-consuming for Australians to verify the Commissioner’s calculations, and more difficult to plan saving and investment strategies that set them up for a comfortable retirement.

Review and recourse

It is also important that Australians have an avenue to dispute the calculated tax liability, without their first course of action being a costly and time-consuming objections process, review of the Commissioner’s decision by the tribunal, or a Federal Court appeal.

Transparent access to data would ensure this process could be administered smoothly by the ATO, perhaps through myGov or ATO Online Services for Agents.

What does “taxing unrealised gains” mean?

Australia has a capital gains tax (CGT). At a very high level, this means that if you own an asset – for example, an investment property – when it is sold, you will have to pay CGT on the profit (gain) that arises.

Division 296 would introduce a legislative precedent which would see Australians taxed on gains they have not yet made, and may never make. Your superannuation ‘earnings’ would include the hypothetical profit of all assets held in superannuation, despite the fact you have not in fact made a profit from the asset, not yet received any money from the sale, and may not even sell the asset for the amount that has already been subject to tax before its sale.

This is what is referred to as taxing unrealised gains.

Importantly, it is not an example of an “unrealised capital gains tax”. In superannuation, an unrealised capital gains tax applies to a person’s TSB movement in a financial year and the resultant calculation applies a flat 15% tax. In effect, no discount is allowed or selling costs etc. Hence, we end up with the term “taxing unrealised gains”, not taxing “unrealised capital gains”.

Why is taxing unrealised gains inherently unfair?

Introducing law which allows Australians to be taxed on unrealised gains – profits they have not yet made and may never make – sets a dangerous legal precedent. It raises concerns around cash flow at a time when cost-of-living pressures are already debilitating for many, and compliance costs are increasing. How many people will eventually be caught up in this tax and the future of poor tax policy design?

Generally, any policy that causes Australians to be forced to move assets out of superannuation to fund a tax liability imposed simply by having those assets is contrary to the fundamental goal of superannuation: to fund retirement and lessen the burden on the Government and young Australians who will otherwise bear the brunt of funding our aging population.

Forcing financial decisions based on a tax bill

One of the fundamental principles of our tax system is that people should not make financial decisions based solely on the tax outcome of those decisions. For example, no one should make a purchase just so they can claim it as a tax deduction.

Taxing unrealised gains would create a situation where Australians will be forced to make financial decisions based on a tax bill. If an asset is sold for a gain, the seller of the asset has made additional capital, which is then available to pay the associated tax. There is a symmetry between the tax liability and the ability to pay it.

On the other hand, if an asset has not yet been sold, the person who owns it has not gained any extra capital or ‘realised’ the value of their investment by releasing the asset’s value back into cash. They may not have cash available to pay the tax liability and may be forced to sell assets or use retirement savings to pay the tax bill. This will be particularly problematic for farmers and small businesses that are expressly permitted by law to hold their farming properties and business premises in superannuation, and cannot easily sell off part of their properties to pay the tax bill.

Double-dipping in Australians’ hip pockets

If a person is forced to sell assets to pay a Division 296 tax bill, substantial costs such as CGT and transfer duty are likely to be incurred. Not only would they be paying tax on unrealised gains, but on actual capital gains as well.

While this stands to raise considerable revenue for Treasury, it is also likely to have an outsized impact on Australians’ investment and savings plans.

This is the opposite of good tax policy design.

Taxing unrealised gains in action:

Example 1

John is a farmer with significant rural landholdings. He is asset rich, but cash poor. His assets – farming land, farm equipment and machinery, livestock – are all vital to his farming business and livelihood.

John has diligently saved for retirement and in doing so, has purchased significant portions of farmland through his self-managed superannuation fund. He is now subject to tax on unrealised gains from the value of this farmland and faces a hefty tax bill.

John has had a tough year and had to purchase feed for his livestock at higher costs due to volatility in global markets, and a new tractor after it broke down. He has no cash with which to pay this tax bill, because it has arisen from a “gain” he has not yet made.

To pay the bill, he is forced to quickly sell a large portion of his land at a bargain price. After the sale, he is also met with a hefty CGT bill and after paying both tax bills, is left with no profit to show for it. With less land available, he must reduce his livestock headcount for the next year, which has a knock-on effect of reducing his income, so that he is now under considerable financial stress.

Example 2

Jack and Sally have worked all their lives and proactively saved to fund their retirement, which is just a year or two away. Like many Australian couples, they are the only two members of their self-managed superannuation fund. They have made contributions to super and have carefully grown their investments over time.

Years ago, Sally purchased a two-bedroom flat as an investment, in a Sydney suburb that has since doubled in population. Now, her TSB is just over $3 million, so under Division 296, she is now subject to tax on unrealised gains.

Sally does not have cash on hand to pay this tax bill. To pay it, she must release savings from her superannuation. In doing so, her tax adviser suggests she restructure her investment plan, which she put in place years ago, to fund the tax bill. Because they are part of an SMSF, Jack’s retirement savings also take a hit, even though his TSB is well below the threshold, which he is particularly unhappy about.

Now, they are behind on their retirement savings plan and tensions are running high. Sally now has to seriously consider delaying retirement while she builds their nest egg back up.

What are the alternatives to taxing unrealised gains?

Although the fundamental policy design of Division 296 is flawed and should not be implemented in its current form, the need for genuine tax reform that makes our tax system more equitable remains.

The Tax Institute is not opposed to a reduction in the concessional treatment of superannuation. However, the mechanism of taxing unrealised gains sets a dangerous precedent and alternatives should be given due consideration.

Three alternative approaches, which have been raised in numerous consultations with Treasury, include:

1. Deeming to determine the taxable income for taxing large super balances

This is a system already used in Australia in the context of the means test for social security entitlements. Instead of referencing actual earnings, investment capital has a statutory interest rate applied to ‘deem’ the level of taxable income. It is simple as the range of investments can be extensive, and neutral in that it does not influence investment behaviour. The proposed Division 296 model of determining who is in scope for the additional tax could still apply (though the threshold should be subject to indexation). However, the taxable earnings would derive from the application of deeming. This removes the problematic principle of taxing unrealised gains.

2. Add a tax return label for SMSFs

The majority of superannuation funds affected by Division 296 are likely to be SMSFs. For SMSFs that have only one member account, an additional tax return label could be added so these taxpayers are able to calculate their Division 296 liability based on their share of the SMSF’s actual taxable income for the income year, which is readily calculable.

 We consider that this approach would reduce the potentially precedential impact of the taxation of unrealised gains under Division 296.

3. Different accounting methodologies for SMSFs

If Treasury is settled on the fundamental structure of the formula for the calculation of this new tax, then Regulations could be drafted to account for the differing accounting methodologies required for SMSFs.

A legislative instrument could be made to adjust the TSB to ensure that unrealised capital gains are not captured in the formula. This would ensure the legislation better achieves the stated goal of sector neutrality.

These alternatives, though widely regarded by industry experts as more equitable and more aligned with accepted best-practice for tax policy, were rejected by Treasury.