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Chapter 16: An alternative treatment for collective investment vehicles

The framework for reform

A New Tax System identified essentially two categories of taxation treatment for investments - individual taxation and entity taxation.

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A strategy for reform

Elaborating on and consistent with this policy approach is an intermediate category of flow-through taxation whereby income flowing through collective investment vehicles (CIVs) is assessed in the hands of investors in the CIV, not in the CIV itself. To qualify for flow-through taxation CIVs would need to be widely held and make full distributions of annual profits. Widely held fixed trusts, including cash management trusts, that are required to distribute all their gains annually would qualify. Whether or not distributions of tax-preferred income from CIVs should be taxed in members’ hands would need consideration.

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Key policy issues Advantages and disadvantages of taxing CIVs on a
flow-through basis.
How would ‘widely held’ be defined? How would tax preferences be treated?
Key characteristics of flow-through taxation are assessment of income in hands of investors and retention of the character of that income (for example as capital gains or interest income).

Advantages of flow-through taxation are:
- retention of character facilitates non-resident investment; and
- assessment in individual hands avoids cash flow detriments of entity taxation on income derived directly by the CIV.

The current definition of a public unit trust may be broadly acceptable as a definition of ‘widely held’ for CIVs established as trusts to qualify for flow-through taxation. Modification would be necessary if other entities were to be eligible. Option 1
Not taxing tax-preferred income;
- preserves tax preferences as with direct investments by individuals;
- involves a revenue cost compared to the consistent tax treatment of all entities; and
- requires restrictions be placed on the CIVs’ investment activities to avoid competitive advantages over other entities.

Option 2
Taxing tax-preferred income
- puts CIVs on a similar competitive footing to other entities.