Capital Gains & Horses - Case Studies - April 2004

I can’t believe it – its been over nine years (January 1995) since I wrote a dedicated article on Capital Gains Tax and Racehorses. Lucky that my staff are awake to anomalies such as this, as I’m sure it’s a topic that deserves another article, especially given the number of new players to the industry since that time. Still, I don’t feel any younger for being told!

The Capital Gains Tax (“CGT”) laws have hardly stood still in these past nine years, with changes such as the introduction of the new 50% discount, Small Business CGT concessions and numerous ATO rulings and determinations clarifying the laws in this area.

This article will focus on case studies in the area of racehorses and CGT as I’m sure that you will again find this to be the best format for becoming familiar with these laws. Before I start the case studies, I will provide a useful summary of the CGT laws.

Hope to see many of you at my 2004 Easter Tax Seminar – see the advertisement in this issue for details.

Overview – important CGT rules for the horse industry

I summarise below the rules that you will find the most useful to know in the area of CGT and racehorses:

• Racehorses held by “hobby” owners are potentially subject to the CGT rules;
• A racehorse, or a share in a racehorse, acquired by a “hobby” owner for $10,000 or less (inc GST) does not attract CGT on sale;
• Breeding stock held by “hobby” owners are potentially subject to the CGT rules;
• Taxation businesses are not affected by CGT on the sale of their stock, though it will apply to capital assets within that business, eg a breeding property. Tax businesses are taxed under the ordinary income provisions of the Tax Act;
• CGT only applies to capital assets acquired after 19 September 1985;
• Capital losses are disregarded on the sale of racehorses. This applies to any asset that the ATO designates as a “Personal Use Asset”;
• Ordinary capital losses (eg relating to shares and property) can be used to reduce the capital gain on a racehorse;
• A capital gain is only taxed when the horse is sold or “disposed” of;
• Gifting a racehorse, or interest in a racehorse, can still attract CGT as the ATO inserts a “market value” as a sale price for the horse;
• A capital gain is calculated as the difference between proceeds received and the “cost base” of the horse. See “cost base” comments below;
• A capital gain is taxed at an individual’s tax rate – the higher your tax rate, the more CGT you will pay; and
• The owner of a racehorse disposed of after 21 September 1999 can claim a 50% CGT discount on the sale of the horse (33 1/3 % discount if owned by a super fund). But, the horse must be owned for at least 12 months and not owned by a company to obtain this discount.

CAPITAL GAINS & HORSES - CASE STUDIES

What is the “Cost Base” of my racehorse?

The five CGT “cost base” elements found in the Tax Act are noted below:

1. First element - the amount of any money or the market value of any property given, or was required to pay or give, in respect of the acquisition of the horse. Put simply, the “cost” of the horse;
2. Second element - the incidental costs incurred to acquire or sell the horse;
3. Third element - the amount of the non-capital costs incurred in the ownership of the horse provided the horse was acquired on or after 21 August 1991 (this element does not apply to a “personal use assets”);
4. Fourth element - the amount of any capital expenditure incurred to increase the horse’s value, provided the expenditure is reflected in the state or nature of the horse at the time of sale or disposal; and
5. Fifth element - the amount of any capital expenditure incurred to establish, preserve or defend the title to or a right over, the horse.

Example – cost base items

Following on from the general guidelines above, I list below some common “cost base” items for racehorses and breeding stock:

A. Racehorse

• Acquisition price;
• Commission;
• Specific legal and accounting advice;
• Advertising;
• Certain veterinary expenses; and
• GST paid on the above (if not claimed back)

b. Breeding stock

• Service fees (only if paid for). Utilising a stallion share not applicable;
• Costs of foaling;
• Sales preparation costs;
• Specific legal and accounting advice;
• Certain veterinary expenses; and
• Selling costs, including entry fees, breeders incentives, saleyard lodging, commission and advertising.
• Click here to continue onto the next page

CAPITAL GAINS & HORSES - CASE STUDIES

Case Studies

Case Study 1 - Racehorse acquired for over $10,000 and loss on a sale

• Tom, a doctor, acquires two horses at a 2003 yearling sale - “Bloodhorse Boy” for $16,500 and “Review Rager” for $55,000

• Tom has never bought a racehorse before and is a “hobby” owner for tax purposes. Tom is not registered for GST
• Tom acquires the horse in his new bloodstock company, “Tom Bloodstock Pty Ltd”. Being a doctor, Tom used a company to provide him with asset protection in the event that he is sued for negligence in the future
• Straight after purchase, Tom has the horse scoped and finds a serious palate defect not picked up by his vet at the yearling sales. An immediate operation, costing $5,500, proves to be successful
• “Bloodhorse Boy” wins his first metropolitan race in impressive style and is sold to Hong Kong interests for A$200,000. Horse owned for 13 months when sold
• Tom pays his bloodstock agent $11,000 as a commission on sale and his tax adviser $1,100 for advice on the tax implications of the sale
• “Review Rager” is an abject failure and is sold to a young girl as a farm hack for $1,000 (no GST)
• The company also owned some speculative mining shares that realised a capital loss of $30,000 when sold during the same tax year
• Company’s tax rate in the year of these sales is 30%
• All costs include GST unless advised otherwise

Tax implications of these sales?

• “Bloodhorse Boy” cost more than $10,000 and is subject to CGT on sale
• The cost base items that Tom can use to reduce his capital gain are:
  • $16,500 cost
  • $11,000 commission
  • $1,100 tax advice
  • $5,500 wind operation. If not undertaken soon after purchase and if they didn’t enhance the horse’s value and performance (see fourth element above), would not include. Most vet expenses can’t be included as they are “revenue” in nature

These cost base items total $34,100

• “Review Rager” sold for a $54,000 loss ($1,000 proceeds less $55,000 cost). The company cannot claim this capital loss as the asset is a racehorse. No doubt that this $54,000 loss would have been very useful in reducing the capital gain on the sale of “Bloodhorse Boy”
• But, the capital loss on the company’s share sales (they are not “personal use assets”) can be used to reduce the capital gain on “Bloodhorse Boy”
• Capital Gain is $200,000 proceeds - $34,100 cost base - $30,000 shares capital loss = $135,900
• Tax to pay is $135,900 @ 30% = $40,770. Note, could not use CGT 50% discount as horse owned by a company, even though he was owned for greater than 12 months when sold

CAPITAL GAINS & HORSES - CASE STUDIES

Case Study 2 - Racehorse acquired for under $10,000 and no 50% CGT discount

Facts

• Andrew and Margaret (“A&M”) jointly acquire “Richmond Lad” for $19,800 as a yearling at the 2003 yearling sales
• Six months later, they jointly acquire the unraced two year-old “Turf Burner” at a ready to run sale for $44,000
• The purchase of “Turf Burner” put considerable pressure on their cash-flow and they had to take out a personal loan to fund his purchase price.
• A&M have never bought a racehorse before and are “hobby” owners for tax purposes. A&M are not registered for GST
• “Richmond Lad”, after two excellent country wins and a metropolitan placing from only four three year-old starts, is sold to local interests for $100,000. Horse owned for over two years when sold
• A&M pay their trainer a $2,200 “spotting fee” for helping them source a buyer
• “Turf Burner” wins a listed stakes race his only start as an Autumn two-year old and is immediately sold to a leading stable for $350,000. Soon after his sale, the borrowing was paid out, though $2,000 (no GST) of interest was paid on the loan to the date of payout
• Their Bloodstock Agent is paid $22,000 as a commission for the sale of “Turf Burner” and he is also reimbursed $2,200 for his advertising of the horse
• The stable vet is paid $550 for a pre-sale inspection
• Their tax rates in the year of this sale was 48.5% (inc Medicare Levy)

All costs include GST, unless advised otherwise

Tax implications of these sales?

• “Richmond Lad”, as he is jointly owned, cost each partner $9,900 (inc GST). Accordingly as their share in the horse cost “$10,000 or less”, neither of them will pay CGT on sale
• “Turf Burner” is subject to CGT as each partner paid $22,000 (inc GST) for their share of the horse
• The cost base items that A&M can use to reduce “Turf Burner’s capital gain are:
  • $44,000 cost
  • $22,000 commission
  • $2,200 advertising
  • $550 vet inspection
• These cost base items total $68,750
• The interest on the loan of $2,000 is not a cost base item as a racehorse is a “personal use asset”, otherwise it could have been included as a third element cost base item
• Capital Gain is $350,000 proceeds - $68,750 cost base = $281,250, ie $140,750 each partner
• 50% discount again cannot be applied as the horse was not owned by A&M for more than 12 months
• Tax to pay by each partner is $140,750 @ 48.5% = $68,264

CAPITAL GAINS & HORSES - CASE STUDIES

Case Study 3 - Breeding a foal

Facts

• Jan is a keen breeder and has the one broodmare, “Gee Ess Tee”
• Jan has only ever had the one broodmare and, all things considered, is a “hobby” breeder for tax purposes. She is not registered for GST
• In the 2002 breeding season, Jan had her mare covered by the first season “shuttle” sire “Seabiskitt”, his service fee $13,200 (inc GST)
• The mare duly tested positive in-foal, her last service date 15 November 2002
• “Gee Ess Tee” foaled a very impressive colt on 15 October 2003
• Soon after foaling, feedback had reached Australia about the promising three year-olds that “Seabikitt” had running in the UK, which was a big thrill for Jan as “Seabiskitt” had only covered 40 mares in his first year
• Almost inevitably, Jan received a generous $40,000 offer for her weanling and sold her foal on 15 January 2004
• The only cost base items were a foaling fee of $110 and $220 for the cost of an analysis that Jan had prepared proving to her cynical buyer the outstanding “winners to runners” ratio “Seabiskitt” was enjoying in the UK
• Jan’s tax rate in the year of sale was 43.5% (inc Medicare Levy)
• All costs include GST unless advised otherwise

Tax implications of these sales?

• The foal was subject to CGT as it had cost more than $10,000 to breed (though the ATO may have also argued that it was subject to CGT if cost was under $10,000, on the basis of the foal was plant disposed of when it was used for a “private/non-taxable’ purpose – ATO currently clarifying this)
• The cost base items that Jan can use to reduce her capital gain are:
  • $13,200 service fee
  • $110 foaling fee
  • $220 UK analysis

These cost base items total $13,530

• Capital Gain is $40,000 proceeds - $13,530 cost base = $26,470
• 50% CGT discount does apply, as the foal was “held” for greater than 12 months. Though the foal was sold only three months after foaling, under special CGT rules relating to assets that are “created”, the “acquisition date” of the foal is the date that work “commenced” to create it. This date is the last date of service, ie date of conception. As the foal was conceived on 15 November 2002, a sale date of 15 January 2004 equates to a “holding” period of some 14 months
• After 50% CGT discount, reduced capital gain is $13,235 (50% @ $26,470)
• Tax to pay is $13,235 @ 43.5% = $5,757

CAPITAL GAINS & HORSES - CASE STUDIES

Case Study 4 - “Hobby to Business” and CGT issues

Facts

• Albert is a property developer who enjoys racing horses, though he only ever had a maximum of two horses at any given time. He has always liked a bet and the social side of racing and never had the “patience” for breeding
• Capitalising on the huge profits he had recently made out of inner Sydney “off the plan” sales, Albert buys two fillies at the major 2000 yearling sales – a $150,000 (no GST) “Danehill” filly at the Magic Millions (“Danebert”) and a $100,000 (no GST) “Zabeel” filly at the Inglis Easter sales (“Zabbert”)
• Albert, at the time of purchase and racing these fillies, was a “hobby” owner for tax purposes. Albert is not registered for GST
• At last Albert doesn’t have to rely on punting to make a profit out of his racing – both fillies win multiple group races over their three seasons of racing
• At the start of 2004, Albert retires his two bonny fillies. Against his better instincts he decides to have a “crack” at breeding – they were his “lucky” horses after all and he couldn’t stand someone else making huge profits on their foals
• At the time of retirement, his fillies were valued by an accredited bloodstock agent and Albert was thrilled with his opinion – “Danebert” was valued at $400,000 and “Zabbert” at $500,000. The agent is paid $330 for his services
• Albert was not going to take his breeding activities lightly and decided to structure his breeding activities as a “taxation” business – he certainly had the quality of stock to justify this and his business plan indicated considerable profits in the future
• Albert’s long time accountant, Pattie, is also given his horse breeding income and expenses to assist in preparing Albert’s 2004 year tax return
• The very first thing Pattie does is prepare a Bloodstock Taxation Schedule for his two valuable young broodmares, and she brings them into the business at their “market values” of $400,000 and $500,000 respectively. Why? Pattie reasoned that Albert would obtain a greater tax “write-off” if the mares came into the business at these higher values. Property was still booming and he needed every tax concession he could get!
• Albert’s tax rate in the 2004 tax year is 48.5% (inc Medicare Levy)
• All costs include GST unless advised otherwise

Tax implications of these sales?

• Unfortunately, what Pattie didn’t consider is that Albert had to pay Capital Gains Tax on the introduction of his mares into the business, given that their “market values” considerably exceeded their 2001“cost” prices. Transferring a “hobby” to a “business” constitutes a “disposal” of the stock to that business – even though no money changes hands!
• The unwelcome Capital Gain on each disposal is significant, being $249,835 ($400,000 market value less $150,000 cost less agents valuation $165) for “Danebert” and $399,835 ($500,000 market value less $100,000 cost less agents valuation $165) for “Zabbert”. In total, a prima facie capital gain of $649,670 was triggered at the time of the new breeding business start-up
• The only consolation is that the 50% CGT discount could be claimed for these two fillies, given that they had both been held for over 12 months. The discounted capital gain is $324,835 (50% @ $649,670)

CAPITAL GAINS & HORSES - CASE STUDIES

Could this CGT disaster have been avoided?

Yes! Pattie could have elected to use “cost”, not “market value”, as the value that the mares were introduced into the new taxation breeding business. This option is clearly outlined in the Tax Act. By electing “cost”, no CGT would have been payable. Of course, “cost” gives a lesser “write-off” for the mares, but given that Albert is paying huge tax at the moment, he would have welcomed the opportunity of trying to defer his tax liabilities as much as possible.

Bottom line – proper tax planning is vital when a breeding business is commenced as there maybe CGT consequences you would never have thought of.

You are welcome to contact me if you wish me to clarify or expand upon any of the matters raised in this article.

PAUL CARRAZZO CPA
CARRAZZO CONSULTING CPAs
22 BLACKWOOD ST, NORTH MELBOURNE VIC 3051
TEL: (03) 9329 7044
FAX: (03) 9329 8355
MOB: (0417) 549 347
E-mail: This e-mail address is being protected from spambots. You need JavaScript enabled to view it
Web Site: www.carrazzo.com.au

DISCLAIMER

Any reader intending to apply the information in this article to practical circumstances should independently verify their interpretation and the information’s applicability to their particular circumstances with an accountant specialising in this area.

Reproduced with permission from the Australian Bloodhorse Review © Copyright 2004