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OVERVIEW


Building a strong foundation

A durable framework for income taxation

Reinforcing integrity and equity

Applying a cashflow/tax value approach

Building a strong foundation

Policy formulation

An architecture for reform

An integrated tax design process to bring together policy, legislative, administrative and compliance issues

129 An integrated tax design process is being proposed in order to ensure that policy, legislative and administrative/compliance concerns are all given appropriate weight and addressed in a comprehensive manner in the development of new tax proposals. As noted in A Strong Foundation, the experience in the past has been for policy development, legislative design and administration to be done sequentially with inadequate feedback between the three stages. This has often produced unsatisfactory outcomes from one, or indeed all, of the perspectives involved. The integrated approach has been adopted by the Review during the development of the issues papers, draft legislation and this report. This has demonstrated to those involved the practical benefits of adopting this approach and why the Review so strongly recommends it.
A Charter of Business Taxation

Setting out the objectives and principles for business taxation in a Charter of Business Taxation

130 The Review is recommending that a Charter of Business Taxation be adopted. The Review is also recommending the adoption of an enduring new framework for business taxation in Australia, based on national objectives and framework design principles. The setting out of these objectives and principles in a Charter of Business Taxation will give them lasting visibility, focus and status, and assist in making accountable those responsible for their implementation.

131 The Charter has as its core three national objectives:

 • optimising economic growth;

 • promoting equity; and

 • promoting simplicity and certainty.


132 Rather than being based on legislative authority, the Charter will rely on the continued support of all parties, both private and public sector, for its continuing effectiveness.
A Board of Taxation

A Board of Taxation will monitor the maintenance and development of the tax system

133 The Board of Taxation will be responsible for monitoring adherence to the Charter and for ensuring that it remains relevant to a changing business environment. Members of the Board will be drawn from the Australian business community. The Board will also include senior representatives from the Treasury, the ATO and one other Government agency. The private sector representatives will constitute a majority of the members and will be appointed on the basis of their personal capacities rather than representing particular interests.

134 The Board will advise on consultative processes to be followed in developing taxation policy and the related legislation and administrative practices.

135 The Board will also review and report on the performance of the business taxation system against the objectives and principles set out in the Charter. In addition, the Board will also participate in the development of a forward work program for the business tax system.
Forward work program

A forward work program will be part of a more open and inclusive process for the business tax system

136 There is a need for a more open and inclusive process for developing the business tax system and the Review is proposing the adoption of a forward work program as an important element of that process.
137 Treasury and the ATO will develop an annual forward work program for consideration by the Treasurer. The Board will be asked to comment on this program and then to monitor (not manage) its implementation. The forward work program will ensure a high level of awareness about policy issues under consideration by the Government. In cases where an issue was particularly sensitive there may be a need to keep confidential the fact that policy changes are being considered. However, it will be the intention that such cases should be very much the exception to the rule. In these cases the opportunity for direct input from members of the Board will still help to broaden the perspective in which the matters are being considered.

Legislation

Simplification strategy

An explicit focus on simplification is necessary

138 The Review is also recommending the adoption of an ongoing simplification strategy. The redrafting of the tax legislation which has been commenced by the Review, and which will continue as part of the implementation of the business tax reforms, provides a major simplification of the existing system. However, in the absence of specific processes to prevent it, there is a likelihood of many of these benefits being eroded over time as changes are made to the tax law in response to particular policy issues. The integrated tax design process proposed by the Review will help to reduce this risk. However, an explicit focus on simplification, both in assessing proposed changes and in reviewing the existing law, will provide a further protection against the creeping complexity which has been a feature of the last 30 years of tax legislative development. It will be a prime responsibility of the Board to be vigilant in drawing attention to any such tendencies.

Administration


139 The Review has brought into focus a number of significant problems with the administrative regime which governs the way business taxpayers interact with the system. In large part these problems derive from the piecemeal approach which has evolved, with each process being largely a discrete exercise. The regime for dispute resolution, in particular, predates the introduction of self-assessment and is needlessly tortuous, often unacceptably slow and costly, and overly adversarial. The Review has therefore recommended that the administrative processes be redesigned with a view to overcoming these deficiencies and reducing times and costs, particularly in relation to small claims.
A more comprehensive rulings system

Increasing the scope of the rulings system to provide greater reliability, timeliness, and certainty

140 The Review is recommending an expansion to the scope of the public and private rulings system consistent with the proposals made in A New Tax System. This will allow the Commissioner to issue rulings on procedural, administrative or collection matters and on ultimate conclusions of fact. In addition, the Review recommends that the Commissioner be specifically allowed to rule on the potential application of the general anti-avoidance provisions. These recommendations will remedy current limitations in the scope of the public and private rulings system, and provide greater flexibility and certainty to taxpayers.

A durable framework for income taxation

Cashflow/tax value approach

A more consistent framework will deliver greater integrity, simplicity and certainty

141 Fundamental to the reforms of the business tax system recommended by the Review is a principle-based framework for a reformed income taxation system.
142 The recommended framework is driven by the need to improve the structural integrity of the system, to reduce complexity and uncertainty, to provide a basis for ongoing simplification and to align more closely taxation law with accounting principles.

143 The existing law is based on legal concepts of income that have built up over time. Centrally, it involves the concepts of ordinary income, statutory income including capital gains and expenses, and losses of either a revenue or capital nature.

144 As a consequence of the evolution of the existing law, assets may be taxed in a variety of ways depending on the purpose for which they are held. This creates uncertainty and complexity in the law.

145 To distinguish expenses consumed in a tax year from expenses that essentially involve a conversion from one type of asset to another asset, the existing tax system uses the concept of capital expenditure. The absence of statutory principles has resulted in uncertainty and led to the mischaracterisation of some expenses.

146 The Review is strongly of the view that a more coherent and durable legislative basis for determining taxable income is essential to reduce uncertainty and complexity in the present system. A redesigned tax system will underpin a more consistent, transparent and sustainable tax system. Having a structure which is more enduring and robust, and which can flexibly accommodate future changes within the structure, has much to commend it.
Features of the cashflow/tax value approach

A consistent treatment of expenditure and assets is central to the new framework

147 Determination of taxable income under the cashflow/tax value approach involves recognition of the two components of a taxpayer's income -- the net annual cash flows from use of relevant assets and liabilities and the change in tax value of those assets and liabilities (see A Platform for Consultation, pages 27-34). Recognising the practical constraints in taxing the annual change in value of all assets, the use of tax values ensures that taxpayers will generally continue not be taxed on unrealised increases in asset values.

148 Defining income in a manner structurally consistent with both economic and accounting approaches to income measurement -- rather than relying on the current mix of statutory and judicial definitions of assessable income offset by an unstructured set of deductions -- supplies the high level unifying principle that cannot be found anywhere in the current income tax legislation. Application of that unifying principle will provide a structural integrity and durability to the income tax law that the existing patchwork definitions simply cannot offer, however they might be amended.

149 An essential element of income measurement is the deduction of expenses consumed in the course of deriving gains. A treatment of expenditure which is consistent with the accounting approach of classifying expenditure according to whether it gives rise to an asset on hand at year-end is a fundamental feature of the cashflow/tax value approach. All non-private expenditure, including existing blackhole expenses will be recognised in the calculation of taxable income --unless specifically excluded by the law for policy reasons.

150 Where the expenditure gives rise to an asset and that asset is recognised for tax purposes at the end of a year, its tax value will be brought to account at that time unless specifically exempted. This is similar to the treatment of trading stock in the existing law. Under this approach, expenditure will be deductible over the period in which identifiable benefits are received from the expenditure.

151 Concerns have been raised in consultations that the new approach may expand the tax base by stealth as a result of starting from a point of general principle and identifying exceptions by specific `carve-outs'. The Review has identified some expenditures, such as advertising, where a literal application of the approach might expand the tax base in such a way, and therefore has retained their treatment under the current system. In addition, the Review is recommending that, if experience discloses an unintended expansion of the business tax base, this be rectified -- either directly or by adjustment to tax rates.
Tax value of assets and liabilities

Critical features of the new approach are the tax value rules for assets and liabilities and the meaning of asset and liability

152 The cashflow/tax value approach provides for the change in the tax value of assets and liabilities on hand at year-end to be taken into account in the calculation of taxable income. Increases in the tax value of assets and reductions in the tax value of liabilities will add to taxable income while tax value decreases in assets and increases in liabilities will reduce taxable income.
153 The meaning of `asset' will draw on the accounting definition of an asset. Similarly, the meaning of `liability' will draw on the accounting definition. Some accounting liabilities, such as provisions for future employee entitlements, will have a zero tax value. Asset and liability are defined in the draft legislation accompanying this report.

154 Some transitional costs will be imposed on taxpayers and their advisors as well as the Australian Taxation Office as a result of the introduction of new concepts and newly defined terms such as asset and liability. The Review considers that these transitional costs can be justified because of the greater simplification, certainty, transparency and durability of the recommended framework. The new approach to structure will produce long term benefits for Australia's tax system which the Review believes will far outweigh the shorter term costs.

155 The adoption of tax values of assets and liabilities will have little practical impact on most small business taxpayers because of the Review's recommendations allowing them to opt into a simplified tax system that includes cash accounting.
Calculation of taxable income

Taxable income based on cash flows and changing tax values of assets and liabilities has greater structural integrity

156 In A Platform For Consultation (pages 39-44) the Review discussed two options for determining taxable income under the framework incorporating changing tax values of assets and liabilities. The choice was between maintaining the existing assessable income and allowable deductions dichotomy or adopting an approach based on cash flows and changing tax values of assets and liabilities. Both options are intended to, and would produce the same outcome as derived by current methods of calculation. The second option provides greater structural integrity and is recommended, for that reason.

157 The Review's recommendation is that the approach to be taken in framing the legislation for the calculation of taxable income should be based on cash flows and changing tax values of assets and liabilities. The recommended approach is not a revolutionary way of calculating taxable income that departs from all established processes. It does not result in radically different outcomes, such as bringing to tax unrealised gains. Substantively the same calculations need to be made under the existing law and the proposed approach. It should be noted that the new approach will not require any changes to existing computer systems apart from those flowing directly from policy reform measures. The results from current methods can be reconciled as shown in the example comparing the calculation of taxable income under the new approach with that under the current system in Attachment A, Section 4 of the report.

158 The recommended approach is consistent with accounting principles and provides a more durable structure for future taxation changes and a more logical framework in which to set out the basis for the calculation of taxable income. Greater integrity will flow from the consistent treatment of assets and liabilities promoted by the new cashflow/tax value approach.
General deductibility of interest

Non-private interest expenses will be immediately deductible

159 An implication of the new approach is that interest expenses of a non-private nature will generally be immediately deductible. Under present arrangements they are deductible in some cases, capitalised in others or not deductible at all. The boundary line between the different outcomes is not particularly clear -- leading to uncertainty and increased compliance costs.

160 The payment of interest simply ensures continued access to a level of funding rather than itself creating an asset. Therefore it is appropriate that, as a general rule, it be immediately deductible .
Recognition of blackhole expenditures

A major benefit for business will be the consistent recognition of so-called blackhole expenditures

161 The cashflow/tax value approach will also address the issue of blackhole expenditures. Under current law a number of business expenses are not recognised for tax purposes. Under the proposed approach all non-private expenditures will be included in the calculation of taxable income.

 • Where the expenditure improves a depreciable asset or is a depreciating asset in its own right, it will be deductible over time under the treatment for depreciable assets. For example, the cost of a successful feasibility study will be written off over the life of the resultant investment.

 • Where the benefit of the expenditure extends over an indeterminate period but is likely to decline, a statutory write-off is proposed -- over five years for incorporation expenses for companies.

 • Where the expenditure creates or improves a non-depreciable asset it will be included in the cost base of the asset. An example would be landscaping expenditure in relation to real estate.

 • Where the expenditure does not form part of the cost of an identifiable asset nor reduces a liability, it will be immediately deductible -- for example, business relocation costs or export market development expenditures.

Consistent treatment of prepayments

Prepayments will be taxed in the years to which the payments relate

162 Under the existing law an immediate deduction is allowed for advance expenditure incurred (prepayments) for the provision of services for a period up to 13 months. This 13 month rule allows an inappropriate bringing forward of deductions and also provides inconsistent treatment between payers and payees. As a general rule, a prepayment received by a taxpayer is not included as income until the services to which the payment relates have been provided.

163 The Review is recommending that prepayments be allocated over the income years to which the payments relate both for taxpayers incurring the expenditure and also taxpayers receiving the payment. There will be an exception to this rule for individuals and small business taxpayers using a cash basis of calculating taxable income. Most prepayments covering a period up to 12 months will be taken into account at the time of payment/receipt for cash basis taxpayers.

164 The proposed treatment of prepayments will improve the structural integrity of the tax system.
Definition and valuation of trading stock

A definition of trading stock is required to differentiate these assets from the more general class of investment assets

165 A concept of trading stock has been retained in order to recognise the specific characteristics of this category of assets. The valuation of trading stock will be the lower of cost or net realisable value, which is the accounting method of valuing inventories. Taxpayers will have the option to make a generally irrevocable election to use market selling value for trading stock. Trading stock will be limited to tangible assets and therefore will not include financial assets.
Assets receiving capital gains treatment

Certain assets will receive capital gains and loss-quarantining treatment

166 The Review has identified particular assets that will be subject to capital gains treatment. Individuals will only have to include 50 per cent of the nominal gain realised on any asset, while complying superannuation funds will include two-thirds of any nominal gain realised. Losses on these assets will be quarantined against capital gains for all taxpayers.

167 More detail on the proposed treatment of capital gains is provided later in this Overview and in the body of the report.
A no-detriment approach to involuntary receipts

168 The current taxation rules for involuntary receipts do not result in consistent treatment. The Review is recommending reforms that will ensure a consistent treatment of involuntary disposals in a range of circumstances. The aim of the reforms is to ensure that taxpayers are neither advantaged nor disadvantaged by the tax system in such cases.
A new approach to taxing fringe benefits
Transfer of liability to employee

Taxing fringe benefits in the hands of employees will significantly improve the equity of the tax

169 Taxing fringe benefits by imposing a liability on the employer is inequitable in a number of respects. Firstly, it imposes a tax liability on employers in respect of the income of the employee. Secondly, the tax liability is calculated at the top personal marginal tax rate irrespective of the marginal tax rate faced by the particular employee.

170 The Review believes there will be substantial benefits from transferring the tax liability for fringe benefits to the employee receiving those benefits and, with the other recommendations being made, the fringe benefits legislation could be repealed without any loss to revenue and with the elimination of a separate tax administration. Consultations have seen widespread, although not unanimous, support for the Review's position.

171 Consequently the Review is recommending that all employee fringe benefits be assigned to the individual employee and taxed under the PAYE system. This will ensure that income received as fringe benefits by an employee was taxed at the same personal marginal tax rate as any other form of employee remuneration.

The change will not significantly increase compliance costs relative to proposals in A New Tax System

172 There have been suggestions that such a switch would massively increase the number of taxpayers in respect of fringe benefits and so lead to significantly increased compliance costs. This reflects a confusion of who is liable for a tax with how the tax is to be collected. In fact the tax collection task will remain with the employer, as with the taxation of other elements of remuneration, and there will only be a minor change in the way the tax is to be calculated and remitted. The collection points will be identical with those under current FBT legislation -- the employers of those receiving the benefits. The fringe benefits assigned to an employee will simply be included in his or her income, in the same way in which bonuses are treated, and be subject to the current PAYE arrangements.

173 The fringe benefit changes announced in A New Tax System require that if total fringe benefits exceed $1,000 per annum, employers assign the benefits to individual employees on their group certificates. The Review is recommending no de minimis level except that, as now, the existing exemptions for irregular minor benefits under the current FBT provisions will be retained and the compliance costs associated with very low levels of fringe benefits will continue to be avoided. Consequently, the Review's proposals involve only a small additional administrative step added to the proposals in A New Tax System.

Some employment contracts may require renegotiation

174 The Review is conscious that taxing fringe benefits in employees' hands might require some renegotiation of employment contracts. For many employees on salary packages costed to include the full cost to the employer of any fringe benefits, including the tax itself, there will be no significant effect. The only exception will be the benefit for those employees who will be taxed on the fringe benefits at their own marginal tax rate where this is lower than the top marginal tax rate at which FBT is currently levied. The tax saving to the employer of transferring the fringe benefits tax liability to the employee will need to be reflected in a higher salary to the employee and the details of this may need to be negotiated. Such compensating increases to leave employees in the same position will not represent a higher cost to employers.

175 The result will be a more sound and equitable system. Now is also the time to make such a change in the context of a fundamental reform of the Australian tax system.

176 A New Tax System announced that the new FBT arrangements will apply from the 1999-2000 and 2000-01 FBT years of income, and putting in place arrangements to meet those requirements will impose a significant burden on employers. Consequently the Review is proposing that the transfer of tax liability for fringe benefits to the employee only apply from and including the income year 2001-02.
Exclusion of entertainment and on-premises car parking

The application of FBT to entertainment and on-premises car parking has always been contentious and administratively difficult

177 A New Tax System proposed that both entertainment and on-premises car parking be excluded from the requirement to report fringe benefits on employees' group certificates. This reflected a judgment that the allocation of these benefits to individual employees would involve unacceptably high compliance costs. In addition, the fringe benefit tax treatment of these items has always been contentious and complex.

178 The Review is recommending that business-related entertainment expenses no longer be treated as fringe benefits and simply be made non-deductible from and including income year 2002-03. The later start time is driven by the transitional revenue cost in the first year and the need for the Review's recommendations to be as revenue neutral as possible in each year.

179 The Review notes that removing entertainment from fringe benefits coverage will also mean that it was not taxable when provided by a tax-exempt employer and the offset of making it non-deductible is not relevant in such cases. The administrative difficulty of trying to address this issue is probably not justified given that such expenditure by tax-exempt employers is relatively minor.

180 The Review is also recommending that on-premises car parking be removed from FBT coverage. The Government has moved to exempt small business from fringe benefits on on-premises car parking and non-CBD parking is largely exempted because of a de minimis value rule. So exempting all `on-premises' car parking will make the treatment of this expense consistent across all forms of business as well as reducing compliance costs and removing a source of considerable annoyance and angst.
Reform of motor vehicle fringe benefits

Taxing of motor vehicle fringe benefits is to be reformed and made less concessional in order to finance other FBT changes

181 Without further adjustment to the fringe benefits regime, the net effect of these fringe benefits reforms would be revenue negative. However, the present treatment of car fringe benefits is unsatisfactory in a number of respects and strongly concessional. Reducing (while not eliminating) the concessionality of car fringe benefits will make the package of fringe benefit reforms revenue neutral in the short to medium term and allow some rationalisation of these arrangements.

182 Accordingly, the Review is recommending that the current statutory formula for valuing car fringe benefits be replaced with a schedular approach under which 55 per cent private use is assumed in determining the taxable value of a car benefit. Taxpayers will have the option of opting out of the formula and substantiating the actual degree of private use if they so wished. In either case, the treatment of car fringe benefits will still be concessional for most employees and so cars will remain a popular form of fringe benefit.
Treatment of exempt and rebatable employers

FBT concessions are not an efficient or appropriate way to assist charities and other tax-exempt bodies

183 As raised in A Platform for Consultation, dispensing with FBT and transferring tax liability to relevant employees will in itself eliminate the advantage enjoyed by exempt and rebatable employers from paying employees in the form of fringe benefits. Therefore a different approach will be required for these organisations if they are to be compensated for the loss of the advantage.

184 A New Tax System proposed to limit the amount of fringe benefits per employee which could qualify for concessional treatment to a grossed-up value of $17,000 per year. This suggests that one approach under the Review's proposals could be to allow each employee of a tax-exempt organisation an income tax deduction of $8,000 per year and a proportionate deduction for employees of a rebatable employer. (An $8,000 deduction will be of the same benefit as exempting from FBT fringe benefits with a grossed-up value of $17,000.)

185 The Review is concerned, however, that under this approach and that of A New Tax System the proposed upper limits on the amount of the concession will effectively become a floor and, in a very short time, it is likely that virtually all employees of tax-exempt bodies will be remunerated, taking advantage of this concession. The Review understands that under the arrangements prior to A New Tax System many tax-exempt bodies were not using the concession to the extent of the proposed limit. Now that it has been legitimised it will be clearly in their interests to reduce their employment costs by utilising the concession fully.

186 Where the tax-exempt body is engaged in business activity this tax break could provide them with a competitive edge over ordinary businesses. The Review is not convinced that the proposal in A New Tax System for a deduction for employees of tax exempts under its reforms will be sustainable in the longer term because of the eventual cost to revenue.

187 The Review considers that this element of government assistance to charities and the like should be removed from the tax system and replaced by a direct and indentifiable subsidy of an equivalent overall amount. A subsidy will be more transparent and deliver a better match between the intentions of government and the outcome. Addressing this problem now before it becomes more intractable and difficult has much to commend it.
Application of accounting concepts and principles

Subject to the overall objectives of tax policy there are clear advantages in more closely aligning tax and accounting treatments of transactions and assets

188 The Review has had regard to accounting principles and practice in formulating its recommendations and in many cases the proposals will move tax and accounting treatment much closer together. This will have significant benefits in terms of compliance. It will reduce the opportunity for taxpayers to pursue tax minimisation strategies on the one hand while attempting to maximise commercial outcomes on the other hand.
189 The Review is proposing that the ATO work with the accounting profession to identify differences in treatment. The future development of tax policy should continue to bear in mind the advantages of a closer alignment between the two systems, while recognising that the two are unlikely ever to be totally congruent.

Reinforcing integrity and equity

A better tax structure significantly reduces the need for specific anti-avoidance rules

190 The Review's recommendations will make a significant contribution to reducing tax avoidance through the removal of complexities and anomalies from the legislation and the adoption of a consistent approach to determining taxable income. This will remove many of the opportunities for taxpayers to avoid taxation through exploiting unintended loopholes in the law.

191 Tax avoidance needs to be distinguished from tax evasion on the one hand and sensible tax planning on the other. Tax evasion is illegal; it involves taxpayers undertaking actions which are expressly forbidden under tax or other legislation. Tax avoidance is not illegal and so is much harder to define. Tax avoidance could be characterised as a misuse of the law rather than a disregard for it. It involves the exploitation of structural loopholes in the law to achieve tax outcomes that were not intended by the drafters of the legislation or by the Parliament.

192 On the other hand, tax planning could be characterised as ensuring that a taxpayer achieves the best treatment for his or her income which is available under the law, as it is intended to apply. To the extent that tax planning does no more than ensure that taxpayers are aware of, and can take advantage of, intended features of the law, it helps to ensure that the intentions of Parliament are implemented. However, the boundary line between tax planning and tax avoidance is obviously less well defined than that between tax avoidance and tax evasion.

193 The sounder structure to the law and the more consistent approach to issues, which will eliminate many sources of tax avoidance, have allowed the Review to recommend the removal of a number of specific anti-avoidance provisions in the current law.
Streamlined general anti-avoidance rule

A streamlined general anti-avoidance rule

194 Under the proposed approach to tax avoidance, a streamlined general anti-avoidance rule will operate within a defined policy framework. The components of this framework are:

 • that structural reform should be the primary mechanism for responding to tax avoidance; and

 • a preference for general, over specific, anti-avoidance rules where a non-structural response is adopted.


195 The Review also sees a role for the Board of Taxation in monitoring the policy guiding the implementation of anti-avoidance provisions and advising whether any amendments are needed. To that end, the Board may consult with taxpayers on appropriate responses to tax avoidance.
Franking credit trading

196 A number of anti-avoidance provisions relating to franking credit trading and dividend streaming are contained in the current law. It is important to distinguish between these two activities.

197 Where an Australian entity only has income that has been taxed in Australia there is no scope for dividend streaming. Resident shareholders receive fully franked dividends and the imputation system ensures that the ultimate tax on the income is at the resident shareholder's marginal tax rate. Non-resident shareholders are exempt from DWT on the franked dividends they receive and so are effectively taxed at the company tax rate.

Allowing franking credit trading would be contrary to tax policy objectives

198 If franking credit trading were allowed non-resident shareholders could effectively sell their franking credits to residents. This would allow them to obtain at least a partial refund of the tax paid on Australian source income at the entity level and would not be consistent with the intentions of tax policy.

199 The situation is different if the Australian entity also derives foreign source income that is exempt from Australian entity tax because it is earned in a comparably taxed foreign country. Where dividend streaming is precluded, Australian entities must perforce distribute some of this income to Australian shareholders as unfranked dividends which are then subject to full rates of tax in the shareholder's hands. At the same time non-resident shareholders receive franked dividends but are unable to use the franking credits. The Review's response to this problem is set out later in the discussion of international taxation arrangements.

200 The Review accepts that there are sound arguments for preventing franking credit trading. Removing the current specific restrictions, and instead relying on the general anti-avoidance provision, would involve an estimated revenue cost of $300 million to $400 million per annum.

Franking credit trading restrictions are required but they need to be made less onerous for genuine commercial activity

201 The Review believes, however, that many of the current specific provisions on franking credit trading could be modified to reduce the impact on commercial transactions without any significant adverse impact on revenue. The Review is recommending an initial paring back of the undue breath of those provisions by measures to:

 • reduce the ownership period to 15 days;

 • further clarify what an `at risk' shareholding means;

 • reduce complexity and compliance costs for trust beneficiaries; and

 • increase the threshold exemption from the provisions from $2,000 to $5,000 of franking rebates for individuals.

Alienation of personal services income

Employees are increasingly seeking to change the legal form of their income from salary and wages to business income in order to minimise tax

202 There is evidence of a significant and accelerating trend for employees to move out of a simple employment relationship to become unincorporated contractors or the owner-managers of interposed entities while not really changing the nature of the employer-employee relationship. This process is known as the alienation of personal services income and moves the income received by the unincorporated contractor or the interposed entity out of the PAYE tax system. The arrangements have had the practical effect of these taxpayers claiming deductions not available to ordinary employees and, if there is an interposed entity, allows scope for income splitting. As the economic reality of the earning of their income is unchanged, their income should be taxed on the same basis as other PAYE income. This is consistent with the principle adopted by the Review that tax be levied on the basis of economic substance rather than legal form.

203 The effect of such arrangements on taxation can be nullified by treating for taxation purposes the income earned by personal exertion as akin to employment income and taxing it on that basis. This prevents the minimisation of income tax and protects the tax system from substantial revenue losses. The Review is recommending this approach to the alienation of personal income services in situations where there is a fundamental employer-employee relationship. There is no reason to interfere with the legal construct of these relationships which can be put in place for other than tax reasons. The Review is not proposing any changes to the contractual relationships. They can continue to exist and new ones be established. The only change is the way taxation will be assessed and collected.
Non-commercial activities

The ability of taxpayers to claim tax deductions for expenses associated with non-commercial activities associated with hobbies or lifestyle choices will be restricted

204 Some taxpayers pursue activities, as hobbies or for lifestyle reasons, which are non-commercial, but seek to claim the expenses against their other income. An example could be a professional person who has a property in the country mainly for recreational purposes but uses it to agist a small number of stock. Even though there may be no realistic prospect of the agistment activity earning a profit, the taxpayer may seek to claim all the expenses associated with the property and use the resultant deductions to reduce tax on their income from their professional activity.

205 Subject to a range of straightforward tests designed to prevent genuine but unprofitable small businesses being affected, the Review is proposing that losses arising from such activities will not be allowable against other income. They will only be able to be offset by income from like activities.
Losses and value shifting

206 The treatment of losses generally is a major issue in the business tax system. Under basic tax principles there is a clear case for immediate tax recognition of losses. The denial of immediate recognition of losses while taxing profits as they are earned significantly increases risks of investment and is a major non-neutrality in the business tax system.

207 No jurisdiction allows a tax refund in the case of losses, as opposed to offset against taxable income, because of the risk to revenue. Under a realisations based tax system taxpayers have an incentive to realise losses while leaving gains unrealised. The Review accepts that a more generous treatment of losses would involve an unacceptable revenue cost and would be likely to open major opportunities for tax avoidance. At the same time it has been cautious about proposals that would further restrict the availability of losses to taxpayers.

The same business test for the carry-forward of losses is to be retained

208 One example relates to the temporary duplication of losses and suggestions that the `same business test' should be removed in order to prevent loss carry-forward whenever the majority ownership of a company has changed.

209 When a company has accumulated losses this is reflected in the price of its shares. If a shareholder sells those shares his or her taxable income is reduced to that extent. Consequently the losses of the company are recognised in the hands of the shareholder. However, the company still has those losses on its books and can use them to offset later profits and so reduce company tax.

210 At this point the losses have been recognised twice, once in the hands of the previous shareholder and once in the hands of the company. If the company income freed from company tax as a result of the losses is then distributed to the new shareholders it would be taxed in their hands as unfranked dividends and there is no longer any double counting of losses for tax purposes. Note that the losses are only ever duplicated to the extent that shareholders sell their shares in the company.

211 The same business test allows companies to carry forward losses where the majority ownership of the company has changed but it is still conducting the same business. In these circumstances the temporary duplication of losses can be quite significant given that most of the shares have changed hands. In such situations taxpayers -- particularly members of closely held entities -- may have an incentive to delay the distribution of income and the unwinding of the loss duplication as long as possible. This led to suggestions that the same business test should be abolished so as to prevent the carry-forward of losses in such circumstances and their temporary duplication.

212 In fact the same mechanism can lead to the temporary duplication of gains. In these circumstances the revenue is collected twice on the same income. The situation is only corrected when the retained company income is distributed and the shareholder subsequently sells the shares and obtains the tax benefit of the capital loss.

213 This type of problem is generally accepted to be endemic to a system of entity taxation. The Review has concluded that the problems arising from the temporary duplication of losses do not justify the adverse impact on shareholders of denying the loss carry-forward in cases where businesses satisfy the same business test but the majority ownership has changed.

214 Nevertheless, the Review is extremely supportive of measures intended to prevent tax avoidance practices such as loss cascading and value shifting.

Loss cascading to be addressed through consolidation and for majority owned groups

215 Introduction of the consolidation regime and abolition of loss transfer and rollover concessions outside consolidation will effectively deal with loss cascading within company groups. It is also proposed to prevent tax losses being duplicated through the disposal of loss assets between entities in the same majority-owned group.

216 CGT value shifting refers to arrangements which shift value out of assets, often to other assets. It allows the generation and realisation of essentially artificial tax losses while deferring taxation of gains by not realising the assets into which the value has been shifted. While the current law has provisions to address this problem, they are deficient in terms of coverage and complexity. They also involve high compliance costs.

217 The Review is recommending general value shifting rules to apply a comprehensive and consistent regime across the full range of transactions and entities. This will significantly improve equity and efficiency as taxpayers will be taxed more consistently on transfers of value, whether they occur by way of conventional realisation or by value shifting. The new provisions will avoid the need for a continuing stream of anti-avoidance amendments as new value-shifting transactions are detected.
Minimum company tax

Introducing a minimum company tax is tantamount to admitting that reform of the business tax system is not feasible

218 As part of the agreement the Government concluded with the Australian Democrats to secure passage of proposals to reform Australia's taxation system, the Treasurer agreed to refer to the Review for its consideration:

 • the adoption of a 20 per cent alternative minimum company tax;

 • measures to limit the use of company structures for personal services; and

 • a review of the tax treatment of motor vehicle fringe benefits.


219 The Treasurer confirmed that the Review was already examining the concessional fringe benefits tax treatment of motor vehicles.

220 In relation to the second matter, the Review had already considered proposals in relation to the alienation of personal services income and the issue is discussed earlier in this report.

221 The motivation for an alternative minimum company tax (AMCT) springs from the fact that in some circumstances an entity's taxable income may be significantly less than its accounting income. An AMCT would be levied on accounting income or an adjusted taxable income. There are major components of accounting income which it would simply be inappropriate to subject to taxation. For example, many companies have substantial dividend income which has already been subject to company tax. Further, foreign source income is included in accounting income but, if it has been subject to a comparable tax rate in the source country, it is not subject to Australian tax.

222 Countries which have adopted a form of AMCT seem to have done so because they have not successfully been able to engage in fundamental reform of their tax system. This is the case in the US and Canada, the two countries which have an AMCT of this kind. The other three countries, Venezuela, Colombia and Pakistan, which have an AMCT, calculate the tax on revenue or assets, indicating that their income tax systems do not operate effectively.

223 An approach based on taxing amounts that would otherwise not be included in taxable income can only be justified on the basis of a judgment that these particular omissions from taxable income are inappropriate and should be overruled by the application of the AMCT. It would only be appropriate if our tax system is not to be made fundamentally sound.

224 A major focus of the Review's task has been to examine the basis on which the taxable incomes of businesses are calculated and a comparison with accounting income has been an important part of that analysis. The Review's recommendations will bring accounting income and taxable income closer together in a number of important respects. The most obvious example is the removal of accelerated depreciation.

225 However, in a number of other cases the Review has concluded that an accounting treatment would not be appropriate for tax purposes. For example, accounting practice uses accruals to a much wider extent than the Review believes would be appropriate for tax purposes.

226 If there are concessions in the tax system which are regarded as inappropriate the best approach is to address them directly rather than through an indiscriminate measure such as an AMCT. For example, an AMCT might result in income freed from taxation by virtue of the research and development concession being subject to tax. To avoid such an outcome, specific measures would be required under the AMCT arrangements.

227 Any other existing measures would also need to be considered for exclusion. It is obvious that if such a process were followed the merits of particular concessions would have to be judged and a decision made about their treatment under the AMCT. This is, of course, the process followed in developing the definition of taxable income for company tax purposes. Unless different decisions were made in respect of the AMCT and the company tax --  and it is difficult to imagine why this should be the case -- then the point of the AMCT would disappear.

Applying a cashflow/tax value approach

Capital allowances

Implementing an effective life regime

Wasting asset regime is to be rationalised

228 The terms under which capital expenditures can be deducted for income tax purposes are central to the taxation of investment income. Under the cashflow/tax value approach this issue is dealt with by the rules on determining tax value at the end of each income year.

229 For wasting assets the tax value at the end of each income year will reflect the depreciation rules applying to that particular asset. The capital allowance in that year for that asset will be the difference between its tax value at the beginning of the year and its tax value at the end of the year.

230 The existing tax legislation contains 37 different capital allowance regimes. These are to be replaced by two regimes: an effective life regime for business generally and an optional simplified regime for small businesses.

231 Under the effective life regime the taxpayer will have the option of self-assessing the effective life of the asset but will need to be able to justify the effective life chosen. The asset will be depreciated over its effective life.

232 Other features of the proposed depreciation regime are:

 • the taxpayer bearing the economic cost of the decline in the value of the asset will be entitled to the deduction;

 • assets will be able to be written off using either the prime cost or diminishing value method; and

 • if an asset is sold for more than its tax value the excess will be subject to tax in that year and if sold for less the difference will be deductible.


233 The Commissioner of Taxation has undertaken to review the current effective life schedule for assets so that taxpayers have an up-to-date guide to the likely effective lives of particular assets.

234 Special arrangements are proposed to reduce the compliance costs associated with depreciating low value assets. Wasting assets costing less than $1,000 can simply be combined in a pool and the total value of that pool will be written off at a diminishing value rate of 37.5 per cent per annum. The value of the pool will be increased when assets are added to it and reduced by any sale of assets from it. This approach will significantly reduce compliance costs for low value depreciating assets. Taxpayers will, however, be able to depreciate individual items if they elect not to use the pool.

235 The Review is also proposing that assets subject to depreciation will no longer be subject to the capital gains tax regime. This means that even if indexation were to remain a feature of that regime it will not apply to depreciable assets. This will simplify compliance significantly. It is unusual for a depreciable asset to be sold for more than its purchase price but in such circumstances the current regime would have allowed indexation for capital gains tax purposes. As a result many taxpayers felt obliged to keep records against this possibility.
Application to buildings and structures

Buildings and structures will be depreciable over their effective lives

236 A major change proposed by the Review is the incorporation of buildings and structures into the effective life depreciation regime. At present most buildings and structures are depreciable according to statutory lives on a coupon basis. This means that they are depreciated on the basis of their original cost without any regard to values established through subsequent sales.

237 Consequently many buildings and structures are depreciated at an inappropriate rate and the value of the deductions arising do not always accrue to the taxpayer bearing the economic cost of the decline in value.

238 The proposed regime will require that new buildings or structures be valued separately to the land on which they stand at the time of sale. Calculating depreciation as for other wasting assets will result in a much more appropriate depreciation regime for these assets.

239 The ATO, in consultation with affected taxpayers, will establish guidelines on the effective life of buildings and structures of various types.
Application to mining and resources

Treatment of mining expenditures will be rationalised and brought more into line with other industries

240 The generalised approach to capital allowances has also been the basis of the Review's recommendations in respect of the mining and resource industries. The recommended treatment is to identify when expenditure involves the creation of an asset and then allow the asset to be depreciated in accordance with its effective life.

241 This approach has led to a recommendation to remove the statutory upper limits on the life of a mine. For a number of capital expenditures related to mining and quarrying the effective lives of the assets are effectively the life of the mine. The proposal is to allow taxpayers to self-assess the likely life of the mine and so allow these assets to be depreciated over that period.

Rationalisation of treatment of sale of mining and quarrying information

242 Receipts from the sale of mining or quarrying information will be included in the calculation of taxable income and the expenditures involved in obtaining that information will also be recognised. For example, the current limit on the deductibility of expenditure on acquiring information from another person is to be removed. Thus expenditure on information in relation to a mine or project judged to be viable at the time will be deductible over the life of the mine or project. In other cases it will be immediately deductible.

Exploration and prospecting expenditure will continue to be immediately deductible

243 Expenditure on exploration and prospecting will continue to be immediately deductible under the Review's proposals. The strict logic of the generalised approach would suggest that expenditure on unsuccessful exploration and prospecting would be immediately deductible, while successful expenditure would be written off over the life of the resulting asset. However, in many cases there may be significant delays before it is known whether the activity has been successful or before a mine is established. It is largely on the grounds of practicality that the current treatment is proposed to be retained.

244 Expenditure preliminary to the extraction of the minerals will be treated in accordance with the generalised approach. To the extent that the benefit of the expenditure will be realised in future years, it will be recognised as creating an asset and written off over the life of that asset. On the other hand, to the extent that the benefits are used up in the year the expenditure is undertaken it will be deductible in that year.

Financial assets and liabilities


245 There has been a long standing consultative process carried on by the Treasury and the ATO with private sector representatives in regard to developing more consistent and appropriate arrangements for the taxation of financial arrangements. The Review's recommendations address the major issues arising from that process.
246 The Review's key recommendations include proposals to achieve enhanced coherency and consistency in tax-timing treatments for derivatives and other financial arrangements, greater certainty at the borderline separating debt from equity, and comprehensive treatment of gains and losses from disposal and debt forgiveness.
Allowing elective market valuation

Taxpayers will be given the option of being taxed on financial instruments on a mark-to-market basis

247 For many transactions in financial markets the basis of measuring the gain or loss on the transaction in the audited financial accounts is mark-to-market. In such circumstances it may be convenient for tax to be levied on the same basis. This is likely to be particularly so where market makers may have a relatively balanced book on a mark-to-market basis but, if taxed on a realisations basis, their tax liabilities might be quite volatile due to timing mismatches in realisation.
248 The Review sees no grounds for denying taxpayers the option of valuing financial assets at mark-to-market for tax purposes provided the taxpayer takes a similar approach to all similar assets, and those transactions are identified as such at the time they are entered into and are accounted for on the same basis in the taxpayer's audited financial accounts.

249 A related issue has been the desire of many financial institutions to account for foreign exchange transactions for tax purposes on a retranslations basis. This falls short of mark-to-market in that only the impact of foreign exchange movements on the value of assets and liabilities is taken into account. Other changes in value are brought to account on an accruals or realisations basis. The Review sees no difficulty with allowing such an approach so long as it is applied consistently by the taxpayer to all relevant transactions.
Taxing financial arrangements on an accruals/realisation basis

Current arrangements for taxing financial instruments on an accruals basis will be extended and rationalised

250 The Review has taken a strong position generally against the taxation of unrealised gains. This position reflects concerns that taxing accrued but unrealised gains could cause cash flow problems for taxpayers and may result in taxpayers being taxed on gains which are ultimately never realised. The proposal for the accruals taxation of some returns on financial assets is an exception to that position. It represents a recognition that financial instruments can be readily constructed so as to provide deferred realisation of accrued gains and that the ready tradability of such instruments mitigates possible cash flow problems.

251 However, the Review's proposals will confine the taxation of returns to financial assets on an accruals basis to those instances where the returns, or elements of the returns, are known with a high degree of certainty. This greatly reduces the possibility of a taxpayer bearing tax on income which is ultimately never received. In some cases returns on assets may have two elements: a certain element represented by such things as fixed coupon interest payments, and an uncertain element relating to possible movements in market interest rates. In these cases the accruals regime will only apply to the certain element of the return. The uncertain element, be it a gain or a loss, will continue to be taxed on realisation.

252 The accruals regime will not apply to individuals and small businesses investing in financial instruments where there is not significant deferral of returns.

253 Consistent with the generalised approach, the Review is recommending comprehensive disposal rules that include recognition for tax purposes of the realised gain or loss on the partial or total defeasance of liabilities. Gains on forgiveness of debt will also be taxed subject to special offset rules to apply in cases of financial distress.
Recognition of hedges

The Review is not recommending general hedging rules

254 Many taxpayers employ hedging arrangements in order to manage market risk. Ideally the tax system should not unduly interfere with these arrangements. One solution would be for the tax system to identify both sides of a hedge and tax it on a consistent basis. However, the application of such an approach typically involves significant practical difficulties, leads to complex rules, and is not entirely successful in achieving its objectives.

255 The introduction of optional mark-to-market and the accruals/realisation approach will much more closely align the tax and commercial treatment of financial instruments and reduce the need for complex formal hedging rules in the tax system.

256 Consequently the Review is not recommending general hedging rules. It has been convinced however that there is a need for the tax system to recognise hedging arrangements in two sets of circumstances: internal hedges and hedging by gold producers of future production.

Internal hedging will be recognised for tax purposes subject to a number of safeguards

257 Internal hedging will be allowed between domestic business units of a taxpayer subject to certain conditions including that:

 • the hedge is between a business unit which accounts for all transactions on a mark-to-market basis and another business unit
which accounts for all its transactions under the proposed accruals/realisation regime; and

 • the transactions between the two units are at arm's length.

Special arrangements will be introduced to facilitate goldminers hedging future production

258 Gold miners have sound commercial reasons for wanting to hedge future production sales to reduce uncertainties about future cash flows and to benefit from the contango that is a constant feature of the gold market. Taxation arrangements need to accommodate these legitimate commercial interests while ensuring that they do not allow opportunities for undue tax deferral. After extensive consultation with gold producers the Review's recommendations represent a compromise between these two objectives.
Debt/equity hybrids

The Review is recommending a more certain boundary line between debt and equity

259 Debt/equity hybrids can pose classification difficulties under the tax system because the tax treatment of debt and equity is different and unclear at the border. This is a particular problem when the returns from the hybrid instrument flow to non-resident shareholders.
260 In order to achieve greater certainty and simplicity, the Review is recommending that hybrids be classified for tax purposes as either all debt or all equity. Returns on a hybrid classified as equity will be frankable and taxed as dividends in the hands of the investor. Conversely, returns on a hybrid classified as debt will not be frankable, will be deductible, and will be taxed as interest.

261 Hybrids will be classified on the basis of a debt test. Non-converting instruments will be categorised as debt if, leaving aside the impact of any indexation factor, they provide the right to repayment of at least the amount originally invested within 20 years. For converting instruments a tougher debt test is to be applied. This will require that the net present value of expected future returns at least equals the amount originally invested.

Leases and rights


262 The Review's proposals will improve the treatment of leases and rights, remove some major areas of tax avoidance or minimisation but also correct some deficiencies in the current law which unfairly penalise taxpayers.
Leasing and other rights over depreciable assets between taxable entities

The Review's recommendations will not disturb `routine' lease arrangements

263 `Routine' leases -- essentially leases with equal annual rental payments, other than those involving high value items for long periods -- will continue to be taxed on much the same basis as now. This will mean little change for short leases of most items of equipment.

`Non-routine' leases will be subject to `sale and loan' treatment if accelerated depreciation is abolished

264 Non-routine leases are essentially those in relation to large value items where the lease is for a long period, or where the specified annual payments are not a good reflection of the economic benefits being transferred. If accelerated depreciation is abolished as recommended, such leases will be subject to a `sale and loan' treatment which negates any tax-deferral benefits arising from the structuring of lease payments and removes tax disadvantage associated with up-front lease premiums.

If accelerated depreciation is retained, tax preference transfer will be allowed for `non-routine' leases

265 Should accelerated depreciation be retained despite the Review's recommendations, `non-routine' leases will receive cashflow/tax value treatment and not the `sale and loan treatment'. This will address structuring of lease payments but will also enable the transfer of tax preferences through lower lease payments currently allowed in respect of taxable entities. This is of significant benefit to tax loss entities. It enables them to obtain the benefits of tax preferences immediately, rather than having them reflected in a larger tax loss which would not be recognised for tax purposes until the entity returns to profit.
Tax-exempt entities

266 The Review notes that the revenue cost of allowing tax preference transfer to tax exempt entities -- many of them State and local government bodies -- would be significant if accelerated depreciation was retained. However, any arrangements to prevent such transfer inevitably involve the policing of poorly defined boundary lines and require the taxation authorities to make difficult, and often contentious, judgments.

Section 51AD to be abolished

267 The Review recommends that section 51AD be abolished, as part of a package of reforms relating to tax exempt leasing. The Review believes that the severe treatment of arrangements that are currently subject to section 51AD is unnecessary. The Review also believes that, providing appropriate structural measures are in place, leases and similar arrangements involving tax exempts should not be treated differently simply because they are financed using non-recourse finance.

If accelerated depreciation is abolished, there is still a need to address structuring of lease payments

268 If accelerated depreciation is removed as recommended, the Review believes that most leasing arrangements involving tax exempts should be taxed on the same basis as leasing arrangements between taxable entities, although a narrower definition of `routine' leases should apply. However, service arrangements and leases of buildings involving tax exempts should receive the cashflow/tax value treatment, to address the potentially high cost to revenue from structuring of payments which could otherwise arise.

If accelerated depreciation is retained, arrangements for denying access to tax preferences by tax-exempt bodies to be rationalised

269 Should accelerated depreciation be retained, the Review is recommending that Commonwealth and State officials examine possible arrangements for replacing Division 16D, that would make the application of this restriction more consistent and transparent. The Review recognises that even improved legislative arrangements would necessarily remain relatively complex and uncertain in their application. The Review believes that a better long-term solution would be for the tax system to allow tax preference transfer to tax exempts and for the Commonwealth and State governments to come to some agreement about offsetting the revenue loss to the Commonwealth.
Offshore use of assets

Tax preference is to be denied for any assets used offshore except for where they are primarily used for non-leasing purposes

270 The Review is also proposing that tax preference transfer be denied in respect of assets used offshore except where the assets are primarily used for non-leasing purposes by an Australian taxpayer. This will ensure that assets used offshore for non-leasing purposes, such as planes in the fleet of Australian airlines, will not be denied access to tax preferences.
271 The abolition of accelerated depreciation will remove the need for such provisions.
Addressing the assignment of leases

Tax avoidance through the assignment of leases will be addressed

272 Tax avoidance through lease assignment arrangements will be prevented under the Review's recommendations. Under current arrangements lessors can arrange to receive the benefit of the accelerated depreciation on an asset in the early years of the asset's life but then assign the lease to a tax-exempt body when those benefits begin to be clawed back in the later years of the asset's life. The purchase of the asset is usually arranged through non-recourse finance. This has been a significant area of tax avoidance.

273 Structural reforms recommended by the Review will address these effects. These reforms include general debt forgiveness provisions and measures to prevent the use of the current balancing charge rollover provisions to minimise or avoid tax on depreciable assets. These measures, combined with the cashflow/tax value approach incorporated in the new legislation, should be effective in preventing tax avoidance through lease assignments. Pending the implementation of these structural reforms, the Review is recommending that all relevant benefits received on assigning a lease, including any associated debt or liability from which the assignor is relieved, be included in taxable income.
Unifying the taxation of other leases and rights

The proposed treatment of rights will enable expenditure on rights to be written off and will provide a more favourable outcome for grantors in some cases

274 Rights over non-depreciable assets will also receive a rationalised tax treatment under the Review's proposals to provide a fairer and more consistent treatment to taxpayers. This will allow, for example, some rights not currently deductible, except as a capital loss at the end of their life, to be written off over their life.
275 The treatment will also recognise that as the length of the right granted in respect of a non-depreciating asset increases, the granting of the right comes to more closely resemble a disposal of the asset, either in part or totally, and should increasingly be taxed on that basis.
(Continued)

 

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