Following on from our prior Wire article on the potential impact of the new Division 296 tax changes, which can be read here, in this article we speak with taxation expert Alan Leung on the proposed changes along with other popular bond related tax questions.
Background
The taxation of fixed interest securities can be complex and dependant on individual circumstances. While FIIG does not provide tax advice, we touched base with an expert on the subject, Alan Leung, to give us some insights into how bonds can be treated from a tax perspective. Alan is the Founder and Managing Director of Aspiron Consulting Group, which is based in East Melbourne, and has over 25 years of experience in taxation matters.
Alan also holds a master’s degree in taxation, is a Fellow of Chartered Accountants Australia & New Zealand (CA ANZ), is a Fellow of CPA Australia, Chartered Tax Adviser with The Tax Institute and a Graduate of the Australian Institute of Company Directors (to name a few!). Having worked at global accounting firms Pricewaterhousecoopers and Ernst and Young for over 10 years, Alan established Aspiron Consulting Group in 2006, providing specialised tax advice to corporations, businesses and high net worth individuals.
Division 296
FIIG: Good morning Alan, first up, there has been a lot of buzz around Division 296, and bond investors have raised concerns on how it could affect them, what’s your thoughts on the topic?
Alan: The main impact of the proposed Division 296 tax is the imposition of a 15% tax on earnings attributable to the portion of a member’s Total Superannuation Balance (TSB) exceeding AUD3m. Two most controversial aspects of this proposed tax are the taxation of unrealised capital gains (unprecedented in Australian tax history), and that the AUD3m threshold will not be indexed.
Under the proposal, the effective tax rates on earnings in a super fund that has a TSB over AUD3m could be up to 30%, being 15% on the unrealised gain and then a further 15% on the gain when realised. If a death benefit is paid to certain non-dependent beneficiaries out of affected assets, additional tax of up to 17% tax may be payable, further increasing the tax burden.
Investment returns that are currently tax free being in “pension mode” would become “taxable” if the value of the assets exceeds the AUD3m threshold.
Importantly, there is no refund available for negative earnings, although notional reduction in asset values may be carried forward to offset future increase.
In a nutshell, taxing unrealised gains means that tax will be payable on gains super funds have not yet made, and perhaps will never make. Because the tax is calculated based on asset valuations at specific points in time (typically at year-end), funds holding volatile assets such as cryptocurrencies, speculative shares, or certain bonds may be particularly vulnerable.
Another critical feature of the proposed Division 296 is the lack of indexation for the AUD3m threshold. Over time, this could lead to more individuals being affected, especially given the long-term nature of superannuation savings and the stringent restrictions on withdrawing funds before retirement. This mechanism resembles bracket creep in personal income tax, gradually pulling more people into the tax net as asset values grow.
For example, consider Rachel, who currently has a modest AUD500,000 in her super fund, invested with an average annual return of 12%. After 20 years, her balance would grow to over AUD3.3m. Without indexation, Rachel would eventually find herself subject to Division 296 tax (even though her initial investment was relatively modest) and she would be locked in the higher tax environment unless she meets a condition of release.
In cases where individuals need to liquidate assets to pay the Division 296 tax, they may also incur additional costs such as capital gains tax or transfer duty, further increasing the overall tax burden. For funds with significant holdings in illiquid assets like land, selling assets to meet tax obligations may not be feasible or could be prohibitively expensive.
Bonds in Super versus outside of Super
FIIG: Another popular tax question is what are the differences in tax for holding bonds within your superannuation portfolio and outside of it?
Alan: One of the main advantages of holding bonds within a superannuation fund is the significantly lower income tax rate. Earnings from bonds are generally taxed at just 15% during the accumulation phase, and can be entirely tax-free in the pension phase. This compares favourably to the personal marginal tax rate, which can be as high as 47% including the Medicare Levy.
However, these tax benefits come with certain limitations. Investments held within a super fund cannot be accessed until the investor reaches preservation age or satisfies a condition of release. This restriction can limit flexibility, particularly for those who may need access to their funds earlier.
Holding non-AUD denominated bonds
FIIG: USD and Euro bond issuances are gaining popularity. How will holding these issues differ from holding AUD notes?
Alan: For most Australian taxpayers, the key difference between holding bonds denominated in Australian dollars (AUD) and those in foreign currencies such as US dollars (USD) lies in the added exposure to foreign exchange (FX) risk. For instance, if the AUD strengthens against the USD, the value of USD-denominated bonds will decrease when converted back into AUD. Depending on the magnitude of currency fluctuations (which can sometimes be significant) an investment gain may be partially or entirely offset by FX losses.
Additionally, any gain or loss from the disposal of a foreign currency-denominated bond must be translated into Australian dollars for tax reporting purposes. The Australian Taxation Office (ATO) provides specific guidance on how to calculate these amounts.
FIIG: Thanks Alan, that’s a good point you raise regarding foreign exchange risk and one we’re often asked by FIIG clients when they first invest in non-AUD denominated bonds. It’s important to be aware of currency fluctuations when repatriating funds, however one way to mitigate this is to maintain an allocation to USD and/or GBP bonds in the portfolio and recycle or reinvest the non-AUD exposure when the bond redeems or if the position is exited prior its maturity.
Also where a bond issuer is registered in the US, there are tax implications for investors outside the US who derive an income source but who do not pay tax in the US. A form, referred to as W-8 BEN, is completed and submitted to ensure a reduced rate or complete exemption of withholding tax is paid on such US based investments. However, for FIIG clients, the administrative task of this is seamlessly handled by the team, to ensure the tax implications in non-AUD denominated bonds registered in the US is minimal.
Premium bonds and tax implications
FIIG: We have one last question for you Alan, if a bond investor planned to buy a bond trading at a premium (at a price above $100 per face value), could they then redeem at $100 (referred to as par) to reduce their taxable income?
Alan: Unlike discount bonds (trading under $100 face value), premium bonds are those that trade above their face value. In general, if a premium bond is classified as a “traditional security” under Australian tax law, an investor may be entitled to claim a tax deduction if the bond is sold at a loss. This loss can potentially be used to offset assessable income from other sources, such as employment income.
However, there are several important exceptions to this general rule. The deductibility of the loss depends on various factors, including the type of bond, the terms of the investment, how the bond was acquired, and the specific circumstances surrounding its disposal. Given the complexity of these rules, individuals are strongly encouraged to seek advice from a qualified tax agent or accountant to ensure compliance and optimise their tax position.
Conclusion
These questions provide some insights into the way bonds are dealt with from a taxation perspective. As mentioned, tax treatment can vary greatly depending on an individual’s circumstances and as such we recommend you speak with your tax agent.