If you dabble regularly in buying and selling shares, are you a share investor or a share trader? The answer to that question will determine how you’re taxed on any profits or losses you make on your share portfolio.
A share investor is someone who buys shares to hold onto long term, benefiting from the growth in value of the share and any income earned through dividends.
Any profits or losses you make from selling your shares will be subject to capital gains tax (CGT), meaning profits and losses will only arise when shares are disposed of. Most people who buy and sell shares are regarded as investors by the Australian Taxation Office (ATO), irrespective of how the investors see themselves.
A share trader is someone who buys and sells shares purely for short-term profits. Signs that you’re a trader include:
Lots of transactions
A clear profit-making intent
You run your activities in a business-like manner (eg, a large investment of capital, a well-developed business plan, extensive research and properly maintained books and records)
Someone who buys and sells shares as part of a business will treat those shares as trading stock, and gains or losses on them will be treated as ordinary income rather than capital gains.
The key tax advantage for a trader is that losses can potentially be offset against other income (subject to certain anti-avoidance provisions).
When capital gains tax applies and how it’s calculated
When you dispose of shares - assuming you are an investor, not a trader - you will normally have to pay CGT on any profits.
Typically, CGT arises when you sell shares but can also happen if you give them away or you stop being an Australian resident. CGT taxes any increase in value from the time the share was acquired.
Your capital gain is worked out like this:
Deduct the cost base from the sale proceeds. The cost base is the price you paid for the share plus incidental costs.
Next, take away any capital losses.
Then discount the gain. Individuals are entitled to a 50 per cent discount. The asset must have been held for 12 months or more for the discount to be available
The resulting figure is your net capital gain. This is subject to tax at your marginal rate
Any shares acquired before 20 September, 1985 are not subject to CGT.
Sometimes the proceeds and cost base of the share are not what was actually paid and/or received, but rather, the market value of the asset. This is typically to prevent people from minimising their tax by, say, selling the share to a relative for a low price.
Kerry sells some shares on the open market in March 2020 for $10,000. She acquired the shares in December 2010 for $5,000. She has brought forward capital losses of $2,000
Her gain is calculated as follows:
Rather than selling the shares, Kerry gifts the shares to her grandchild, Ben, who of course pays nothing for them. Because the shares were gifted, they will be treated as being disposed of at market value and Kerry’s capital gains tax calculation will look exactly the same as in example one. Despite paying nothing for them, the cost base of the shares to Ben will be $10,000 (their market value).
What happens if you make a loss?
If your sale proceeds are less than your cost base, you will make a capital loss. These losses can be offset against capital gains arising in the same year and, to the extent they are not used up, they can be carried forward indefinitely until capital gains arise to absorb them.
Capital losses can only be offset against capital gains, they can’t be offset against any other form of income.
If you dispose of an asset during the year and crystalise a capital gain, you might want to consider disposing of any other assets you own that are sitting at a loss. That way the capital loss can be offset against the capital gain.
This is a popular year-end strategy with share investors. Be careful though, if you sell loss-making shares, to crystalise a capital loss just before the end of the tax year and then buy the shares back again at the start of the new tax year. The ATO regards this as an artificial contrivance to generate capital losses.
Tax on dividends
The most common way for companies to pay returns to shareholders is by way of a cash dividend.
Dividends are paid out of profits that have already been subject to Australian company tax, which is currently 30 per cent (or 25 per cent for most small companies).
Recognising it would be unfair if shareholders were taxed again on the same profits, shareholders receive a rebate for the tax paid by the company on profits distributed as dividends.
These dividends are described as being 'franked’ and have a franking credit (also known as an imputation credit) attached to them, representing the tax the company has already paid.
The shareholder who receives a dividend is entitled to a credit for tax the company has paid. If the shareholder’s top tax rate is less than 30 per cent (or 25 per cent where the paying company is a small company), the ATO will, under current rules, refund the difference.
How tax on dividends works
Let’s say the taxpayer holds 1,000 shares in ABC Pty Ltd.
ABC Pty Ltd makes $5 of profit per share. It pays 30 per cent tax on that profit which is $1.50 per share, leaving $3.50 per share to be either retained by the business or paid out as dividends to shareholders.
ABC Pty Ltd decides to retain 50 per cent of the profits within the business and to pay shareholders the remaining $1.75 as a fully franked dividend.
Shareholders receive this with a 30 per cent imputation credit, which isn’t physically received but which must be declared in the shareholder’s tax return as income. This can then potentially be claimed back as a tax refund.
The taxpayer, therefore, receives $2,500 taxable income from ABC Pty Ltd, being $1,750 dividend income and $750 franking credit, as follows:
Applying that to different investors with different tax rates:
So, Investors 1 and 2 both receive refunds. Investor 1 might be a super fund in pension phase which doesn’t have to pay tax at all and which uses the franking credit refund to fund pension payments.
Alternatively, it could be an individual with no other income other than the dividends on these shares.
Investor 2 might be a self-managed super fund (SMSF) in accumulation phase, which uses the excess franking credit rebate to offset the 15 per cent contributions tax.
Investor 3 would typically be a middle-income individual who does not have to pay any extra tax despite having received $1,750 in income.
Investor 4 would be a higher-income earner who has to pay some tax on the $1,750 dividend but has reduced his tax rate on this income considerably due to the franking credits.
Dividend reinvestment plans
In some cases, shareholders are given the opportunity to reinvest their dividends in additional shares in the paying company. If that happens, the cost base of the new shares for CGT purposes is the amount of the dividend (less the franking credit).
Crucially, if you reinvest a dividend in this way, your income tax liability on the dividend is calculated in exactly the same way as if you’d received a cash dividend. That means you may have an income tax liability – and no cash to settle it with because the cash was all reinvested.
That needs to be kept in mind when you consider whether a dividend reinvestment plan is right for you.
Are international shares treated differently?
In essence, the rules for international shares are the same as for Australian ones. You’ll be liable to CGT on any shares you dispose of and you’ll be liable to income tax on any dividends you receive. The exception is that international shares won’t have franking credits attached to them.
Mark Chapman is director of tax communications at H&R Block