Tread carefully with share loss CGT claims

Known as “wash sale” arrangements, offsetting share losses for tax minimisation purposes could make the taxman sit up and notice. TERRY HAYES explains.

By Terry Hayes

Known as “wash sale” arrangements, offsetting share losses for tax minimisation purposes could make the taxman sit up and notice.

In the current volatile sharemarket conditions, those owning shares that are “under water” – that have a value now less than when they were purchased – may be tempted to minimise their overall tax position by entering into what are known as “wash sale” arrangements.

It’s a relatively exotic term but, in its simplest form, a wash sale might occur where someone sells shares they own to crystallise a loss on those shares to then offset that loss for tax purposes against capital gains they have made elsewhere.

Once this is done, they buy back the same number of shares in the company they sold and effectively end up in the same position except that they have been able to offset their capital gains (and thereby reduce their tax).

The tax office has now released a taxpayer alert (TA 2008/7) outlining its concerns with these arrangements, including the possible application of the anti-avoidance rules of the tax law.

The type of wash sale arrangement the alert covers is where a taxpayer disposes of, or otherwise deals with, a capital gains tax asset (for example, shares) to generate a capital or revenue loss, but where in substance there is no significant change in the taxpayer’s economic exposure in the asset.

This may occur where the interest in the asset is in some way reinstated by the taxpayer in order to apply a resulting capital loss or allowable deduction against a capital gain or assessable income already derived or expected to be derived.

The Tax Commissioner said the tax office is not concerned with the genuine disposal of an asset at market value. He warned, however, that, in certain circumstances the tax office may determine that wash sale arrangements are schemes to reduce income tax. The Commissioner said that anyone who is uncertain about their deduction entitlements should seek independent tax advice or request a private ruling from the tax office.

The alert states that the tax office is concerned where reinstatement of the taxpayer’s interest is done with the sole or dominant purpose of generating a capital or revenue loss to offset against a capital gain or assessable income when, in substance, there is an intention to acquire the same or substantially the same asset or the taxpayer still benefits from the asset.

Continues next page…

An example from the alert illustrates what the tax office’s concerns are.

Kelly maintains a large share portfolio. She sells a parcel of Alpha shares from her portfolio on 20 March 2007 and makes a capital gain of $62,000 in the year ended 30 June 2007.

In early June 2007, she receives a financial booklet discussing various end of year tax saving strategies. As a result of what she reads, she reviews her share portfolio and notes that her shares in Echo Ltd are currently trading at $1.20 per share.

Kelly’s reduced cost base for her Echo shares is $2.42 per share. Acting on one of the strategies outlined in the booklet, she devises a plan that would allow her to crystallise the unrealised loss and maintain her interest in Echo. In view of this, she contacts her broker on the same day to obtain information on the market and the current expectations as to the price of the Echo shares. He assures her that there have been no relevant market announcements and that he expects, based on the information available to him, that there will be no significant movements in the price of the Echo shares over the next couple of days.

Acting on her broker’s advice, Kelly places with him a sell order for 50,000 Echo shares at $1.20 per share. Her capital proceeds from the sale transaction are $60,000, and her reduced cost base is $122,000 (including the $1000 transaction costs her broker charges her), giving her a capital loss of $62,000.

The next day, Kelly instructs her broker to buy 50,000 Echo shares. The price of the stock has now moved up to $1.21 per share. He charges Kelly $1000 for transaction costs associated with the sell and buy orders.

The result is that Kelly offsets the $62,000 capital loss against the $62,000 capital gain when preparing her income tax return for the year ended 30 June 2007.

The tax office view is that, for tax purposes, the scheme includes all the steps leading to the entering into, and the implementation of, the planned sell and buy transactions, the incurrence of a $62,000 capital loss and the offsetting of that capital loss against the $62,000 capital gain by Kelly.

The tax office considers that the facts surrounding the entry into the scheme, including the adoption of the strategy in the financial booklet, and the advice received on the expectations as to price, suggest that Kelly planned to purchase back the same number of Echo shares shortly after she sold them.

Accordingly, the tax office says it would conclude that the disposal and acquisition of the shares 24 hours later constitutes a scheme within the meaning of the tax anti-avoidance rules.

The tax office position would be that Kelly’s dominant purpose in entering into and carrying out the scheme was to obtain a tax benefit in the form of a capital loss. Under the relevant provisions of the tax law, the Commissioner could cancel the tax benefit (of the loss).

The Tax Commissioner says that anyone who has already claimed deductions for any losses they incur under these arrangements should consider telling the tax office so it can help them sort out their situation. He added that if taxpayers contacted the tax office before it then contacts them for an audit, they may be entitled to reduced penalties.

The tax office’s warning is timely given the run up to 30 June that produces all sorts of schemes to reduce tax.

Related stories:

>> SME capital gain pain eased

>> CGT: The ‘sleeper’ headache for SMEs

>> Claiming tax losses – be warned! The taxman is watching

Terry Hayes is the senior tax writer at Thomson Reuters, a leading Australian provider of tax, accounting and legal information solutions.

For more Terry Hayes features, click here.