This episode runs through what the new Division 296 tax is, who it impacts, what investors should do to prepare for it.

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Mark LaMonica: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances, or needs.

Shani Jayamanne: So, we recently received a voicemail from John who had a question on the Vanguard ETF episode that we did recently. And his question was about the structure of the ETF and how that impacts fees.

John: Hi, Mark and Shani. I have just listened to your podcast on the Vanguard ETFs. And I was just wondering, because I’ve thought of this before, is the level of fees, these master ETFs have a management fee of 0.27%. Are all the underlying ETF fees included or not included in that, I imagine they’re not included? Does that mean there’s double lots of fees on these master ETFs? And if so, why not just invest in the underlying ETFs?

LaMonica: And what he wanted to know was whether investors were charged twice. So, once with the management fee for the ETF, for example, VDAL, and then twice on the underlying ETFs. For example, VDAL invest in VAS, the Vanguard Australian Shares Index.

Jayamanne: And the answer is no. Vanguard charges 0.27% for VDAL and rebates the fees for the underlying ETFs. So, you won’t be paying twice. You just pay that one fee that you do see. So, thank you, John, for your voicemail and your question. And thank you for obviously listening to the podcast as well.

LaMonica: And other people, you can leave us a voicemail. So, just a reminder that there will be a link in the show notes. So, you can leave us a voicemail. Will gets excited and sends it around. You can also leave us questions through YouTube, which would be better than some of the other comments we get on YouTube. You can also leave comments on Spotify or you can send the insults directly to me with my email address, which is in the show notes.

Jayamanne: So, today we are going to talk about something that is controversial. And it’s a listener requested episode. And that’s on the Division 296 tax proposal. And it’s colloquially known as the unrealized capital gains tax.

LaMonica: Okay, that’s this is a good one. Shani wrote an article on this. And people were very interested in the article. So, hopefully, this will be a very good episode. So, we’re going to try to take, and this is hard for Shani sometimes, we’re going to try to take a balanced view on this tax proposal at this point. And we want to preface this discussion by saying it isn’t our responsibility or area of expertise to criticize public policy, although, if you go to the pub with us, we will criticize pretty much everything. But we don’t want to talk about the opportunity cost of these policy decisions that the government has to make. Our job is just to present what’s best for investors and represent investors. Is that a good segue besides my stuff about the pub?

Jayamanne: I think so. We always like talking about the pub. But it really is to understand how the policy does impact investors and how investors are able to best prepare for any incoming changes. So, today, we’re going to go through the tax proposal and we’re going to give a brief overview of what it is and also run through some of the most common questions that we’ve received about it because we have received a lot.

LaMonica: Yes. And it has not been implemented yet. So, this was a proposal a while ago, but then there was a landslide victory by Labor recently. And especially in the House of Representatives, the Senate, as we’re recording this, is still up in the air a little bit. But basically, there’s nothing that’s going to stand in the way of implementing this tax, which as Shani said, is known as the very clear Division 296 Tax Liability Tax.

Jayamanne: And this includes the taxation of unrealized capital gains in super. And Federal Treasurer Jim Chalmers has confirmed that the Labor Party will plan to introduce the bill that was stalled and they will introduce it again.

LaMonica: And the tax was originally supposed to come into effect on the 1st of July 2025, but with this Senate composition only firming up in mid-May and the Prime Minister not planning to recall Parliament until August, this does look unlikely. The tax outlined in the superannuation in position bill would have to be applied retrospectively if it’s successfully passed in Parliament.

Jayamanne: So, one major point to make is that unrealized capital gains tax is only applicable for balances over $3 million. And this makes it tempting for many Aussies to ignore the policy because realistically, it only really impacts 0.5% of Aussies or 80,000 people that have a super account. But there are many Aussies that are opposed to it. And I think the ranks of us that do oppose it may grow as a large emission for this policy is indexation.

LaMonica: Yes, so it’s not indexed.

Jayamanne: Yes. So, let’s go through the policy.

LaMonica: As we said, the tax will apply to balances over $3 million. So, there’s an extra 15% on top of the existing tax on earnings. But this will include both realized and unrealized capital gains. A tax on unrealized gains means that you are taxed on an increase in the value of assets, even if it’s just a paper gain. So, an asset does not have to be sold, which is all the other capital gains taxes in Australia. The asset has to be sold to realize them. In this case, you don’t have to sell it.

Jayamanne: An example of an unrealized capital gain is a property that’s in your superannuation fund that you purchased for $500,000, which has grown in value in the next financial year on paper, to $600,000. You haven’t sold it, but the gain is taxed.

LaMonica: There are some nuances to this tax, as you can imagine. The tax is calculated on net earnings and not on individual holdings. So, simply put, it’s based on the gain at the portfolio level in your super. So, the gains and losses are netted off at that level. If your portfolio gains in value, you will pay tax. If your portfolio loses value, you will not pay tax.

Jayamanne: So, former assistant treasurer Stephen Jones was adamant that this would be a minimal change for the majority. He also confirmed that losses can be carried forward to offset future gains. But the policy lacks capital gains discounts or adjustments for time held and no consideration for when the gains will actually be realized.

LaMonica: So, what this means is that there’s likely to be double taxation when the asset’s disposed of. So, this tax presents fundamental issues for a lot of investors that will likely lead to changes in the way that Australians invest in super. So, we’ll go through more of this in a little bit, but let’s talk about how it’s calculated.

Jayamanne: So, it’s important to start with the fact that this policy is for the proportion of an investor’s balance above $3 million. So, determine how much taxes owe the first step is to calculate the percentage of earnings that are attributed all to this portion of the portfolio above $3 million. And the taxes across your total superannuation balance, or TSB, the ATO has an in-depth description of it, but it basically means it’s across all of your super and pension accounts. How it does differ, though, is that your TSB, for this instance, it doesn’t include any limited recourse borrowing arrangements or LRBAs.

LaMonica: A lot of acronyms, which I know you’re very into. So, good for you. But basically the most common superannuation accounts with LBRAs are self-managed super funds that have properties and then loans attached to them. So, the loan portion is not included in the calculation.

Jayamanne: So, say you have $4 million across your accumulation and pension accounts, you’d calculate earnings on $1 million or 25% of your TSB.

LaMonica: And there are adjustments that need to be made to this amount, though. The number does not include contributions or withdrawals. So, the purpose of this is to capture the growth of the fund. So, withdrawals that may have happened that year are added back in, and any contributions that are made are subtracted.

Jayamanne: So, last year’s adjusted number is then subtracted from this year’s adjusted number. So, if your fund was at $3.8 million in the year prior, adjusted with everything that we said before, the tax would be applicable on $200,000. This assumes that you don’t have any losses that you can carry forward.

LaMonica: And the proposal stipulates that your TSB, your total superannuation balance, does not include any limited recourse borrowing arrangements at LBRA. So, if you have $4 million across your accumulation and pension accounts, you calculate the earnings on $1 million.

Jayamanne: And if your prior year’s adjusted TSB is below the threshold, it’s substituted by 3 million for future calculations.

LaMonica: Does everyone have this? Clear as day at this point. So, it is difficult to digest this in audio format. Shani’s written a great article that, given the stats, it seems like most of Australia has read. So, you can go to that article. There is a link in the show notes, and she goes through a detailed example and goes through this step by step.

Jayamanne: And these are large numbers that we’re using in these examples. 3 million feels unreachable for many Aussies, which explains the lack of mainstream media coverage and outrage regarding this policy.

LaMonica: But the issue, as we said, we talked earlier about that indexation. So, the issue is that this is a stagnant $3 million, which means that it will capture more and more Aussies as they accumulate more funds in their super over the long term.

Jayamanne: And Deputy Chief Economist Diana Mousina from AMP has modeled this out to show that the average 22-year-old income earner will hit the cap before they hit retirement. Assuming full-time earnings, 3% wage growth, super returns, net of fees and tax and no change to the 12% super guarantee. So, $3 million will be hit basically when they’re 64.

LaMonica: And the model that she runs assumes that there will be no policy reviews or amendments to this policy. It’s just a projection of the current policy as it stands. The government has confirmed that the policy will have a more immediate review in two years to understand the impacts and practical implications of this tax.

Jayamanne: And we would never suggest that investors should base investment decisions on the hopes of policy amendments, even if it seems outrageous that the policy will be kept for decades without an indexation amendment.

LaMonica: But on the other hand, there is the tax-free pension threshold. So, we talk about this fair amount, all the super episodes. It’s currently $1.9 million. It’s going to increase to $2 million on the 1st of July in 2025. And this will continue to be indexed. So, some things are indexed, some things are not. So, that same 22-year-old from the AMP model that we talked about would have a much larger tax-free pension threshold. Unrealized capital gains tax will detract from the total return outcomes, but a larger percentage of their fund will be at that 0% tax rate. So, there are puts and takes to all of this.

Jayamanne: Again, we’re assuming here that super policy doesn’t change.

LaMonica: Yes, and it changes every year. So, who knows what will happen. But one thing that we should note is that this is going to disproportionately impact self-managed super funds.

Jayamanne: That’s right. Most high superannuation balances do sit in SMSF, which explains why the loudest voices in opposition of this policy are SMSF associations.

LaMonica: And then APRA-regulated funds. So, in examples, Australian Super, the largest super fund in Australia. Typically already take tax from their members on unrealized gains. So Aussie Super said in its submission during the legislative consultation process that large APRA regulated superannuation funds already typically incorporate tax on an accrual basis. So that includes realized and unrealized capital gain tax liabilities when they run those rules.

William Ton: I’m Will, producer of Investing Compass and here are this week’s must reads on Morningstar.com.au. Buffett has invested for over seven decades where his investing style and approach has evolved. There are many lessons, quotes and sound bites that investors take from him. In this week’s edition of Unconventional Wisdom, Mark has looked at free lessons to ignore from the Oracle of Omaha. Shani’s Future Focus column takes a deep dive into the controversial Division 296 tax, also known as the unrealized capital gains tax in super. She runs through how it works, why more Aussies are going to be impacted than we think and what investors can do to prepare for it.

If most Aussies now holding at least one ETF in their portfolio, it’s a hard proposition to ignore for beginner investors. Following on from a previous column on the beginner ETF portfolio, this week Sim explores the Aussie equity ETF market and compares two investor favorites in this category. Joseph’s featured article is the first edition of Stock Showdown, a new series that uses Morningstar Insights to compare the business and investment merits of different ASX companies.

To kick things off, Joseph enlists the help of our global mining analyst, John Mills, to compare BHP and Rio Tinto. How similar are the two mining heavyweights? Where do they differ and which one would John choose if he had to? Find out in the first edition of Stock Showdown. These articles and more they are available in the show notes. And let’s get back to Mark and Shani.

Jayamanne: Another point of contention for SMSF holders is that they typically hold a larger allocation to illiquid assets. Having to fund unrealized gains will require fore sale of assets if the members are unable to fund those tax liabilities with cash in or out of super.

LaMonica: Yeah, and I think it’s a good question for us to discuss. We talked earlier about how we would get to some of the impacts, but, you know, Shani, I think the question is, how would this policy, and you talked about in your article, how is this potentially going to change asset allocation in super funds?

Jayamanne: Yeah, so I think one of the major criticisms of the policies that it will meaningfully shift asset allocation and change it in superannuation. So instead of investing in illiquid assets, investors will instead turn to liquid assets to a greater degree.

LaMonica: And a large concern shared by industry bodies is that there will be a significant divestment in venture capital investments that fund the Aussie companies of tomorrow.

Jayamanne: So the Tech Council of Australia believes that around 25% of the money that goes into venture capital comes from SMSFs. Former Assistant Treasurer Jones has refuted this figure and he believes that it sits around 3%. He believes that the most common asset disposal scenarios will be for SMSFs that are holding property.

LaMonica: 25% and 3% are very different.

Jayamanne: They’re different numbers.

LaMonica: Yes, very different numbers. So the likely impact of the proposed tax policy is that large superannuation accounts will have to shift their asset allocation to higher proportions of liquid assets to fund these tax bills that people will get. So paying tax bills outside of super will be inefficient from a tax and cash flow perspective for most. So there are concerns that this will further lower return outcomes in addition to that direct impact of the tax.

Jayamanne: And one of the questions that we get asked is, has anything like this ever happened before? Is this a completely new way to tax individuals?

LaMonica: So normally, and I said this before, so normally tax liabilities are only generated after you sell something. However, there are a couple dimensions where this proposed policy is not actually unique.

Jayamanne: So I pay tax on unrealized gains every year that I’ve owned a house. So that’s land tax. Former Minister Jones also added that there’s taxation on unrealized gains on APRA regulated funds and stock in trade arrangements on businesses.

LaMonica: And then there’s Norway, Shani.

Jayamanne: There’s Norway.

LaMonica: Yes. One country, apparently this happens. So Wilson Asset Management did a research project on the impact of the policy on Norwegians where unrealized capital gains are taxed. So they found that taxation on unrealized gains has negatively impacted the people and industries of Norway, which is mostly oil and fishing. I’m making that up, by the way, although it’s probably right. It’s definitely oil. It’s definitely oil. But when the Norwegian government doubled the tax on unrealized capital gains, there were large capital outflows.

Jayamanne: And precedent alone doesn’t make a policy fair, regardless of whether this is unprecedented or not. It is a policy that will impact more Australians as we move forward without indexation.

LaMonica: And I think it’s unrelated to the unrealized capital gains. Aren’t the Norwegians the most happy or satisfied people in the world?

Jayamanne: I think they are.

LaMonica: It’s some Scandinavian country.

Jayamanne: I think it’s Norway.

LaMonica: And I know it’s not Sweden because I saw a Swedish speaker at a conference and he was making fun of the Norwegians.

Jayamanne: They also have the highest financial literacy rates in the world.

LaMonica: Well, there we go. They need that financial literacy to calculate…

Jayamanne: …unrealized capital gains.

LaMonica: Yeah, exactly. So one thing I think it’s interesting for us to talk about is alternatives. So are there better ways to approach this? So the government has decided and we’re not going to comment on this. The government’s decided that people that have a balance over $3 million in their super funds should pay more taxes. So whether that’s fair, whether that’s not fair, that’s for you to figure out. But the point is, if you’re implementing the tax, what we want to explore is could it have been implemented raising similar levels of revenue, achieving the policy directives in a better way for investors?

Jayamanne: And again, we’re approaching this in a way that considers the best outcomes of investors while still achieving a higher tax revenue outcome. And the first alternative is a higher tax on realized capital gains above $3 million. This is the simplest alternative approach. It basically allows investors to still plan for the long term without tax impacting asset allocation decisions.

LaMonica: And a second alternative is to tax withdrawals on higher balances. So if your mandatory balance withdrawals are above a certain threshold, so let’s say $150,000 a year, so that would be 5%, right, of $3 million. If it’s above that, it means you have more than $3 million and you would just apply an extra tax. A third alternative that I actually think is the best one, although Shani thinks it’s very politically unfeasible. And I’m sure she’s right, although I went to parliament on Saturday.

Jayamanne: Did you talk to them about this?

LaMonica: I didn’t. I went on the I went on the best of parliament tour.

Jayamanne: Okay, what was the best of parliament?

LaMonica: I don’t know. They took us to the roof. We went in the different chambers. I learned about pink marble and things like that, the House of Lords. Very educational. But Shani does not think this is politically feasible and inheritance tax. So taxing balances over a certain threshold when the owner dies. This would mean there’s no change to the asset allocation. Or retirement strategy. You can let your kids worry about that when they inherit it.

Jayamanne: Exactly. So what can investors do? And I recently wrote an article for my column and it’s about the lessons that we can learn from Salim Ramji, who is the CEO of Vanguard.

LaMonica: Shani went to a talk and would not stop talking about how much she thought this guy was great.

Jayamanne: But one of the lessons that resonated with me was that while investors do hate uncertainty, when they know a clear path forward, they just move on and adjust.

LaMonica: And there’s little, obviously, any of us individually can do to change tax proposals. What we can do is put ourselves in the best position to create and build wealth despite the constant changes in super. And that’s challenging. But yeah, you got to set yourself up for success.

Jayamanne: And again, as we have that review of the policy that’s already scheduled in for 2027, there’s a more likely chance that there will be a change as opposed to other tax policies that don’t have reviews scheduled in.

LaMonica: So in the meantime, there are a couple approaches for investors. So one, obviously, work with a tax professional to utilize losses where possible to offset gains. Plan for liquidity needs. Now, especially if you hold illiquid assets in your super, that may mean shifting asset allocation. So consider holding new contributions in cash to avoid unnecessary taxes or transaction costs. Use spousal contributions strategically to spread balances and reduce exposure above the cap. That’s important to remember. This is on individual accounts. So yeah, utilize your spouse if they have less.

Jayamanne: There’s two sides to every argument, and it’s not any different with this new tax proposal. For both sides, you really come back to the purpose of super, and that’s saving and investing for your retirement.

LaMonica: And to encourage saving for your retirement, there are tax concessions that are given in super. It’s not a tax haven with the side benefit of saving for your retirement. So the government believes that $3 million, at $3 million threshold is an adequate amount for retirement savings. That is until it isn’t, which will occur without indexation.

Jayamanne: The opposing argument is that retirement is a long-term endeavor, forcing investors to reduce their risk capacity and hold liquid assets anticipating a tax bill does not serve the purposes of superannuation, nor does it pass the fairness test with potential double taxation.

LaMonica: And I think importantly, this policy reduces confidence in the superannuation system. This is changing the goalpost that reduces trust and investing over the long term in this vehicle. So the tax will slowly start without indexation, slowly going to start to suck in more and more Australians as they become victim to the lack of indexation. More people will question the wisdom of locking up money in super.

Jayamanne: And part of being a long term investor is adjusting to changing conditions, which are inevitable over decades, long time horizons. And regardless of the fairness of the policy, await the policy outcome and plan to optimize your position accordingly.

LaMonica: All right. Great. Well, thank you very much. A reminder, you can leave us a voicemail. We’ll try to answer those before different episodes that we go through. And thank you very much for listening. We appreciate your support.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)