CGT Change: How to avoid the triangle of sadness

The 2026 Budget proposal to replace the 50% CGT discount with cost-base indexation reintroduces an old structural problem: capital gains and capital losses are calculated on different cost bases. For investors holding a portfolio of direct shares, that asymmetry can result in tax being paid on a real economic gain that simply isn’t there. Pooled investment vehicles, including ETFs, could potentially mitigate the problem.

The Government’s framing is that investors will only be taxed on their real capital gain. In a static, single-asset world that framing holds. But in the real world many Australians hold more than one stock or single investment, and the way indexation works in practise has a quieter consequence that the headline numbers don’t capture: gains and losses are no longer measured against the same yardstick.

Under the proposed reversion to pre-1999 indexation, a capital gain is calculated by reference to the indexed cost base. A capital loss is calculated by reference to the original (nominal) cost base. The two never meet in the middle.

Under the existing 50% discount regime, every share in a portfolio is measured against the same mark – its original cost base¹. The economic gain at the portfolio level and the taxable gain at the portfolio level are identical.

To demonstrate this, take the following hypothetical 3 stock portfolio example, where Stock A and B are sold for a profit and Stock C are sold for a loss.

The calculation of both capital gains and losses are from a common starting point, in this case $10,000. In other words where a capital loss exists it can be used in full to offset the tax that might otherwise be payable on all or part of a capital gain. As a result, the net taxable capital gain ($6,000 + $300 – $1,000) matches the net economic gain at a portfolio level, being $5,300. Then, under the discount method CGT is applied on half of that amount ($2,650) to provide an offset for inflation.

Under the pre-1999 CGT indexation regime, the cost base of each asset is uplifted in line with CPI over the holding period. However the calculation of a capital gain or loss is different depending the value of each individual asset at disposal. If an individual asset or share is sold for:

– Greater than its indexed cost base: a taxable capital gain is recognised, calculated as sale proceeds less the indexed cost basen- Between the original and indexed cost bases: there is no recognised taxable capital gain or loss
– Less than the original cost base: a capital loss is recognised, calculated as sale proceeds less the original cost base. Indexation does not apply to losses.

The middle zone in the chart above is the problem – the triangle of sadness, if you will. It is the gap between the two cost bases, and it widens every year the asset is held. Real economic losses that fall inside the gap are invisible to the tax system, so they cannot be used to offset real economic gains elsewhere in the portfolio.

Below we show the outcomes under CGT indexation for that same three stock portfolio, assuming that the cumulative inflation of 15%. On the surface, the proposed regime produces a lower taxable gain for the stocks A and B that are sold for more than their purchases prices. That is the headline the Government wants you to see. But strip out the 50% discount that the current regime then applies to look at the real return outcomes on a portfolio level, and the comparison changes.

Under pre-1999 CGT indexation a “real” loss (a loss after adjusting for inflation) is not recognised and therefore cannot be used to offset the tax that might otherwise be payable on capital gains. In our example, the worse-than-inflation returns of the Stock B and Stock C do little to shield the tax payable on Stock A. From a tax perspective the capital losses on Stock A and B are either eliminated entirely or materially diminished by measuring them against the lower notional, not the higher indexed, cost base.

As result the taxable net capital gain for the portfolio is $3,500. Yet the investor’s real gain at a portfolio level is only $800, after accounting for cumulative inflation of 15% over 5 years on the $30,000 initial investment. Assuming the investor’s marginal tax rate is 47%, they would pay approximately twice as much in tax as the real gain, leaving them significantly behind after inflation.

Now consider the same three stocks held inside a single pooled investment vehicle, whether a managed fund, an ETF or a listed investment trust. The investor’s cost base is the unit price they paid, not the prices of the underlying stocks. The fund itself is the CGT asset.

In our example, the investor buys units at a cost base of $30,000 (the sum of the three $10,000 stock holdings) and redeems at $35,300 (the sum of final portfolio value). The fund’s cost base of $30,00 is indexed up to $34,500. The taxable gain is $800, matching the portfolio level real economic gain. The investor is not penalised with a higher tax bill as a result of some of the stocks within the portfolio underperforming inflation.

One important caveat is that this example assumes the fund or ETF simply buys and holds those three stocks – there is no turnover within the fund over the 5-year period.

The gap between the indexed and nominal cost bases is small in year one. By year five it is 15 percentage points wide in the scenario above. By year ten it could be 25 to 30 percentage points wide. Long-term investors who hold diversified direct share portfolios, sit fully exposed to this widening asymmetry. Holding through a market drawdown is rewarded by the current rules and are likely to be quietly penalised by the proposed ones.

The AFR has reported analysis suggesting that people with a diversified portfolio of individual shares directly could face tax rates up to 50% more tax than Treasury’s own estimates imply. The asymmetric loss treatment described here is a meaningful part of that gap.

There was one important caveat within the arguments above for a pooled vehicle, such as an ETF or unlisted managed fund. The comparison above assume that the ETF or fund had no turnover during the 5-year hold period.

Turnover within the portfolio held by a fund leads to capital gains being distributed to the investors in that fund, and at the margin this tax drag that detracts from after-tax performance. However index tracking ETFs are generally more efficient at reducing ongoing CGT than unlisted funds, as discussed here.

As we have said before, the proposed CGT changes are not a reason in themselves to change your asset allocation. But structure matters more than ever. The new rules strengthen the case for holding growth assets in tax-efficient structures. Superannuation, investment bonds and ETFs held outside super are materially more efficient than alternatives such as direct stock investing or unlisted funds.