When life gives you lemons: Squeezing after-tax returns from the CGT overhaul

Produced in partnership with Betashares.

With the first tranche of the Federal Government’s CGT reforms now legislated, one element deserves closer attention from advisers with clients in lower tax brackets: the proposed minimum 30 per cent effective tax rate on capital gains. This tax rate will apply to capital gains held by an individual, even where their marginal tax rate sits well below that threshold.

For retirees holding assets in their own name, non-working spouses and those scaling back at work as they approach retirement with taxable income below $45,000, this represents a meaningful shift. Under the existing CGT regime, an investor on a 16 per cent marginal rate faces an effective CGT rate of just 8 per cent on assets held more than 12 months. After the proposed CGT changes, they would face a minimum 30 per cent rate on indexed capital gains regardless. That can change the after-tax maths quite significantly.

At face value, the shift to CGT indexation together with the introduction of a 30 per cent tax floor looks unequivocally bad for this investor cohort. But it does present the opportunity to rethink what return profile may be most efficient for them.

The core insight: Not all returns are taxed equally

Consider two hypothetical equity portfolios, each delivering a 10 per cent p.a. total return on a $100,000 investment held over three years, with inflation running at 3 per cent p.a. Portfolio A has a growth focus, and returns 9 per cent p.a. capital growth together with a yield of 1 per cent p.a. Let’s assume that Portfolio B offered the same total return but 5 per cent of the capital growth was converted into income (so 4 per cent p.a. capital growth and 6 per cent p.a. income).

The table below compares the after-tax outcomes under the proposed CGT changes for a low tax rate individual (16 per cent marginal tax rate):

	Portfolio A (Growth focus)	Portfolio B (Income focus)
Capital growth (3 years, simple)	27% ($27,000)	12% ($12,000)
Income (3 years)	3% ($3,000)	18% ($18,000)
Total return	$30,000	$30,000
Indexed cost base adjustment (3% pa, 3 yrs)	-$9273	-$9273
Taxable capital gain	$17,727	$2727
CGT at 30%	$5318	$818
Income tax at 16%	$480	$2880
Total tax	$5798	$3698
After-tax return (3 years)	$24,202 (24.2%)	$26,302 (26.3%)
Annualised after-tax return	~7.5% p.a.	~8.1% p.a.

Source: Betashares. Hypothetical example for illustrative purposes only. Assumes simple capital growth of 3 years annual growth rate rather than annual compounding of capital growth, CPI indexation of the cost base at 3% pa and a 16% marginal tax rate. This example does not take into account any fees and costs, which may be different for the two portfolios.

Same market exposure. Same gross return. But, under the legislated CGT changes, subject to further detail being implemented through subsequent legislation, the income-oriented portfolio delivers approximately 0.60 per cent p.a. more after tax for this investor, purely because a greater share of the return is taxed at their actual marginal rate rather than the proposed CGT floor. Compounded over time, that gap can be material.

How covered call strategies fit in

This is where the ETFs that employ covered call strategies can become relevant. By writing covered calls over a core US equity position, these strategies effectively convert a portion of potential capital appreciation into option premium income. That income is generally distributed to investors and taxed at their marginal rate rather than the proposed CGT rate. Ideally the remaining capital gains track close to the indexed cost base to take advantage of the fact that only real, not nominal, gains are taxed on capital account. For the investor profile described above, that switch in return character has a direct and quantifiable benefit.

It’s important to note that a covered call strategy has an inherent trade off, the additional income generated comes at the cost of capped upside. This potentially means lagging the index in strongly rising markets, albeit with lower volatility. There are no guarantees that the total return of our hypothetical Portfolios A and B above will be the same. However, for an investor in this cohort, an income focussed return may be attractive, even before you consider the potential for improved tax efficiency.