plan4CGT - Fundamentals - Capital assets

Higher level topic - Basic fundamentals

Also at this level - Effective tax rates; CGT Process flowchart.

Lower level - Inclusion rate; Annual exclusion; Administration

Lower level - Example of how CGT fits into income tax system;  Basic observations; Following year adjustments

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This page - Examples of what capital assets are. The intention of a taxpayer

 

 

What are these capital assets anyway!         see examples below

 The CGT legislation is meant to tax the disposal of capital assets. Think of it like this-

    The disposal of a revenue asset, such as trading stock, will be taxed in the normal way, (as income), whereas the disposal of a capital asset will give rise to the (more favourable!!) tax treatment encompassed by the CGT legislation.

But what is a capital asset?

    An “asset” is comprehensively defined for CGT purposes so as to include all types of property, moveable and immovable, tangible and intangible, (such as patents). Rights or interests in property are also caught. The only exclusion from the term “asset” is currency. See some examples of capital assets below. (SEE also exclusions).

Examples of capital assets

A capital asset is generally thought of as an asset that lasts a fairly long time and which may be used to generate income -

    Buildings (as capital assets) generate rentals (income)

    Farms (as capital assets) generate produce (income)

    Patents (as capital assets) generate royalties (income)

Some capital assets may not generate income as directly those mentioned above-

    Machines used in a manufacturing company

    Photocopiers

    Patents/secret processes used for protection against competition

Some capital assets won’t generate any income simply because of what they are to you-

    Your house

    Your timeshare unit

    Your boat

Some things look like capital assets but may not be-

    Township land in the hands of a developer, (stock)

     Loans in the hands of a bank, (floating or working capital)

    An asset bought with the intention of being upgraded and sold, (stock/wip)

Some things may not look like capital assets at all because they will inevitably be sold and cashed in-

    Krugerrands

    Endowment policies

Some capital assets are simply intangible-

    Usufructs

    Rights of access

    Goodwill

Ultimately, whether an asset is of a capital or revenue nature, depends upon a number of factors, the most important being the test of the intention of the taxpayer.

The disposal of a revenue asset will be taxed as income in the normal way. The disposal of a capital asset puts you into the CGT Legislation. It still puts you into the Income Tax Act, as there is no CGT Act in itself, but getting into the Income Tax Act via the CGT Legislation will usually, (but not always), give you a more favourable result due to the lower effective tax rate that will be applied to capital gains, (due to the inclusion rate).

Brief background - capital and revenue receipts and intention

The characterisation of a receipt as either income or capital is the essence of our income tax system. Income receipts are taxed at much higher rates than capital receipts. It could be said that income is the result of capital productively employed, (see what are capital assets). A typical example would be a block of flats. That asset would tend to be a capital asset in the hands of the landlord whose primary intention is to earn rental income. The sale of those flats in the future would tend to give rise to a capital receipt.

On the other hand, a block of flats would be a revenue asset, (trading stock), in the hands of a property developer whose primary intention is to sell those flats. The sale of the block as a whole or the piecemeal disposal of the flats would in this case produce revenue receipts. Such revenue receipts would be treated as normal income and taxed accordingly.

It is important to note that a single receipt from one transaction could be regarded as a revenue receipt if it was the taxpayer’s intention to derive a profit, (this is characterized as a profit making scheme). The underlying asset would again be trading stock.

There are certain objective tests, such as the nature of the assets sold, (the tree or the fruits of the tree), the cause of the receipt, (such as services rendered), the objects of a company, and so on, to determine whether the nature of a receipt is of a capital or revenue nature.

In order to test whether a receipt is of a capital or revenue nature one first looks to see whether a taxpayer trades in that particular item and then to see whether the asset was sold in the course of a profit making scheme. Should the tests prove negative, (from the taxpayer’s perspective), the proceeds derived from the realisation of the asset will not be regarded as a capital receipt. The primary subjective test adopted by the courts, in order to determine whether a receipt is of a capital or revenue nature is the test of the intention (of the taxpayer).

Here is a brief overview of some of the factors the courts will look at in determining whether the nature of a receipt is either capital or revenue-

  • What was the taxpayer’s intention when the asset was acquired?
  • Were there mixed intentions?
  • Is there any evidence of a change of intention? (see below)
  • What was the period of holding?
  • What are the characteristics of the taxpayer, (for instance estate agent/property developer).
  • The method and circumstances of the acquisition.
  • The method of financing.
  • The abilty to finance.
  • The taxpayer’s conduct in relation to the property.
  • The reasons for selling.

The change of intention of a taxpayer is particularly relevant now that CGT has been introduced. Prior to the introduction of CGT, if a taxpayer changed his intention in regard to a specific asset, (from that of capital asset to trading stock, for example), a tax liability would tend to arise only upon the disposal of that asset. This is certainly not the case anymore!

The CGT legislation has some peculiar disposal rules, in this regard paragraph 12’s “Events treated as disposals and acquisitions” are relevant. When an occurence desribed in paragraph 12 arises, the taxpayer is treated as having disposed of an asset and to have immediately reacquired it, without a disposal, (in the traditional sense of the word), having taken place). Many of these events or occurences involve a change of intention of the part of a taxpayer. These events can be appropriately be described as tax traps, however, some even create opportunities. The events that arise as a result of a change of intention are -

  • Assets that are held otherwise than as trading stock, when they commence to be held as trading stock.
  • Assets that are held as trading stock when they cease to be held as trading stock.
  • An asset that ceases to be a personal-use asset otherwise than by way of disposal.
  • An asset that is held otherwise than as a personal-use asset, when that asset becomes a personal-use asset.