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Implementing a unified entity regime

Recognising direct investors and small business

Rewarding risk and innovation

Responding to globalisation

Implementing a unified entity regime

Consistent treatment of entities including trusts

The Review's recommendations build on the Government's proposed reforms of the taxation of entities

276 In A New Tax System, the Government announced proposals to reform the taxation of entities. They included a consistent regime for taxing the income of entities, full franking of distributions, refundability of imputation credits, reformed tax arrangements for life insurance, consolidation of company groups and a consistent treatment of entity distributions. The Review was given the task of consulting on these proposals and developing detailed proposals for their implementation in the light of those consultations.

277 A consistent treatment meets the investment neutrality principle of A Strong Foundation. The alternative of taxing companies more like trusts, and allowing tax preferences to flow through, is generally not feasible from a revenue viewpoint.

A consistent entity tax regime will not preclude some exceptions under the entities regime, such as Pooled Development Funds, and some trusts will be excluded as suggested in A New Tax System

278 The general principle is that trusts will be subject to the entity tax regime. Consistent with A New Tax System, there will be specific exclusions from the regime for trusts created or settled only as a legal requirement or subject to a legal test or sanction. This approach distinguishes such trusts from trusts created at a settlor's direction. Exclusions are also justified in other cases for practical reasons. In particular, bare trusts, constructive trusts, the bank accounts of minors, and stakeholder and purchaser trust arrangements will be excluded.
279 Moving to a consistent entity tax regime does not preclude the maintenance of entity-focused tax concessions, for example the Offshore Banking Unit regime, Pooled Development Funds, Film Licence Investment Companies and employee share acquisition scheme arrangements.


The Review is recommending against the deferred company tax proposed in A New Tax System

280 A New Tax System proposed the achievement of full franking through the imposition of a deferred company tax (DCT). This would have required an Australian entity paying a dividend out of tax-preferred income to pay tax at the company tax rate on that income and therefore pay fully franked dividends as a result.
281 This proposal has been strongly opposed by business. One of the major concerns has been that any DCT paid would impact adversely on the after-tax profits of Australian companies. This would lead to negative perceptions by investors and impact adversely on share prices and the ability of companies to raise capital.

282 A second concern has been that the DCT would have sharply reduced the return available to foreign investors with further adverse effects on Australian companies and the competitiveness of Australia as an investment destination. The Review considered a proposal to offset this second effect through a DCT/dividend withholding tax switch. While this may have been an effective offset for most foreign investors, there would still have been adverse impacts on some investors. In addition, there is considerable uncertainty about the effectiveness of this measure in respect of possible reactions by other countries in terms of creditability of the Australian dividend withholding tax (DWT).

The Review is recommending the taxing of unfranked inter-entity distributions as an alternative to the deferred company tax

283 The alternatives to the DCT canvassed in A Platform for Consultation were a resident dividend withholding tax (RDWT) or taxing unfranked inter-entity distributions. After considering the outcome of consultations and further analysis the Review is recommending the taxing of unfranked inter-entity distributions.
284 The impact of both the RDWT and the taxing of unfranked inter-entity distributions was equivalent in many respects. However, the RDWT would have been more complex in its operation

285 As noted above, A Platform for Consultation canvassed the possibility of a company tax/dividend withholding tax switch. This option was originally motivated by the need to offset the adverse impact of the DCT on distributions of tax-preferred income to non-residents. The taxing of unfranked inter-entity distributions does not raise the same problem but it would have been possible to still implement the switch. This would have been of benefit to non-resident shareholders to the extent that it increased the proportion of Australian tax creditable in their home countries.

286 Further analysis revealed that a significant percentage of non-resident investors are tax exempt. These investors are currently generally exempt from Australian DWT. Removing their exemption, in order to implement the switch in a revenue neutral manner, could have led to negative perceptions about Australia as an investment destination. Hence the Review is not recommending adoption of the proposal.

The Review has endorsed the Government's proposals for the refund of imputation credits

287 The refund of imputation credits to complying superannuation funds, low marginal rate taxpayers and registered charities as proposed in A New Tax System has been endorsed by the Review. The Review's recommendations also address concerns that delays in paying such refunds may cause cash flow problems for taxpayers in some circumstances.


A comprehensive definition of distributions

The Review is recommending a broad definition of distribution which will encompass virtually all transfers of value from an entity to a member in their capacity as a member

288 A consistent entity regime requires for its development a consistent definition of what constitutes a distribution. The Review proposes a broad definition of a distribution as occurring when value has been passed from an entity to a member of the entity in their capacity as a member. Consequently it excludes benefits passed to employees in their capacity as employees, even when they are also a member.
289 A broad definition of distribution is the simplest and most equitable means of taxing benefits provided by entities to members. Such a definition adds integrity to the tax system as it restricts the situations in which value can be shifted from an entity to a member without being subject to tax. The recommended definition will apply to the provision of loans, or goods and services, at less than fair value.

Shareholder discounts by widely held entities are to be exempt

290 The definition would imply that discounts on goods and services provided by a member discount scheme would be treated as a distribution and subject to tax in the hands of the member. The Review is conscious that a number of major companies have shareholder discount arrangements in place. In order to minimise disruption to these arrangements, shareholders will be allowed an exemption on distributions via discounts from widely held entities where the discount is reasonable in extent, and is in respect of goods and services which the entity sells to the public in the course of its business.

291 The Review is also recommending that benefits provided by an entity to a non-member are treated as a distribution to a member if the non-member is a member of an associate of the entity providing the benefit. The most obvious example of where this provision might apply is where the parent company in a private company group directs a subsidiary to pay benefits to the members of the parent company. The effect of the provision will be to tax the provision of the benefit as if it were a distribution by the subsidiary and the recipient were a member of the subsidiary.

292 Proportionate provision of membership interests will not constitute a distribution where they are not expected to change the total market value of any member's interests. Disproportionate provisions of additional membership interests for no, or inadequate, consideration will be treated as a distribution for tax purposes to the extent of the shortfall in value.
Applying a `profits first' rule

A `profits first' rule is to apply to distributions from entities

293 To have clear and consistent arrangements for identifying the nature of distributions from entities in order to determine their correct tax treatment is important.

294 The Review is recommending that a profits first rule apply to distributions from entities to members. Entities will generally be required to distribute all retained profits before distributing contributed capital. This will prevent entities extending the period of tax deferral in respect of retained profits or streaming contributed capital and profit distributions to members in accordance with their tax preferences. The current law contains complex anti-avoidance provisions aimed at constraining these types of activity but the adoption of the proposed rule will allow these provisions to be repealed.
Measuring contributed capital

295 All entities will need to maintain a contributed capital account for tax purposes. The account will allow for the accurate identification of capital contributed to an entity, and will replace the existing rules for companies that are based on using a company's share capital account. Retaining the share capital account approach is not feasible given the inclusion of trusts in the entity system and the adoption of a profits first rule.
Distributions upon cancellation of member interests

A slice approach to apply to the cancellation of member interests

296 Distributions related to the cancellation of member interests will be split into profits, taxed and untaxed, and components using a slice approach. A slice approach effectively takes the slice of the company's contributed capital and retained profits attributable to a member's interests and uses that to identify the components in the payment to the member.

297 With the exception of on-market buy-backs the distribution to the member will be treated as follows:

 • the contributed capital component will be treated as proceeds on the disposal of the membership interest by the member;

 • the taxed profit component will be a fully franked profit distribution; and

 • the untaxed profit component will be an unfranked profit distribution.

298 For distributions related to on-market `buy-backs' the entire amount will be treated as proceeds on the disposal of the membership interest by the member. In on-market buy-backs members do not know the identity of the buyer of the shares and so this is the only practical treatment. The entity conducting the buy-back will benefit by being allowed a capital loss equal to the taxed profit component with no effect on the entity's franking account.

299 The current arrangements can involve double taxation in respect of on-market share buy-backs and liquidations and this will be eliminated under the Review's recommendations.

Life insurance and pooled superannuation trusts

300 The Government announced in A New Tax System major proposed reforms to the taxation of the life insurance industry. The Review has consulted widely on the basis of those proposals and its recommendations are broadly in line with the approach set out in A New Tax System. However, the recommendations include some transitional arrangements and a practical solution in relation to superannuation activities conducted by life offices intended to put them on an equivalent footing to superannuation funds.
A consistent taxation regime for life insurers

Life insurers will be taxed on a more rational basis in line with the treatment of similar activities by other entities

301 Existing taxation arrangements for life insurers are very complex with income and expenses being allocated to up to four classes of business.

 • Each class is subject to a different rate of tax.

 • Some classes include components which are exempt from tax or subject to different rates of tax.

 • Different calculations are required to determine assessable income for each class of business.

302 Tax avoidance opportunities can arise from internal dealings that exploit differences in the taxation rates of each class of business.

303 Existing taxation arrangements for life insurers are inconsistent with the treatment of similar activities carried on by other entities.

 • The income tax base does not include all income.

 • Similar economic activities are subject to different rates of tax depending on whether the business is carried on by a life insurer or a general insurer. For example:

- unlike general insurers, life insurers are not taxed on underwriting profit; and

- management fees embedded in premiums are not included in the assessable income of life insurers. However, all management fees are included in the assessable income of banks, public unit trusts and general insurers.

304 The Review is recommending that these discrepancies in treatment between life insurers and other entities be removed. This will mean that:

 • the taxable income from the risk business of life insurers will be calculated on the same basis as the taxable income of the risk business of general insurers; and

 • the taxable income of the investment business of life insurers will be calculated on the same basis that applies to calculate the taxable income of the investment business of other investment entities.

The Review is responding to industry concerns by proposing transitional arrangements

305 An issue raised by the industry in consultations was a concern that for some products already sold the changed taxation arrangements on the future income from those products would involve an element of retrospectivity. The argument is that in many cases expenditure incurred early in the product's life is related to earning income later in the product's life. Essentially many of the life insurer's expenses are incurred up front. Consequently changing the tax regime applying to the income where that regime did not apply at the time the expenses were incurred could be a form of retrospectivity.

306 The Review accepts that these early expenditures are related to earning income over the life of the product and consequently should be deductible accordingly. This approach should also apply to all new products sold after the date of effect of the new measures.

307 As a transitional measure the Review proposes that only two-thirds of management fees derived on existing life insurance policies will be taxable for the first 5 years of the new arrangements. This will provide some recognition of the up front expenses incurred in respect of those policies and provide some broad equivalence to amortisation in determining taxable income relating to the earnings streams from this business.
Taxation of superannuation business of life insurers

The Review's recommendations will allow life insurers to maintain their current role in respect of superannuation through the establishment of `virtual PSTs'

308 For life insurers, the taxation of their superannuation business has also been a major issue. A New Tax System proposed that all the income of life insurers -- apart from retirement savings accounts -- be taxed at the company tax rate. This would have impacted on the superannuation business of life insurers. A Platform for Consultation recognised this and suggested that an efficient mechanism for ensuring prompt refunds of excess imputation credits in respect of investment returns assigned to superannuation funds would result in their effective tax rate of 15 per cent being maintained.

309 Reacting strongly to this proposal, the industry pointed out that about 80 per cent of the business of life insurers consists of complying superannuation business with around $123 billion of funds under management. The industry was concerned that the proposed approach would prevent tax-preferred income earned by life insurers being passed on tax free to superannuation funds. This would put them at a competitive disadvantage and result in the current business being transferred from the life insurance industry to pooled superannuation trusts (PSTs) or master superannuation trusts, involving the transfer of the $123 billion of securities and the resultant transaction costs.

310 The industry argued that the superannuation business of a life insurer should be taxed as a superannuation entity. The Review has recognised the force of this argument and that it accords with the general principle that similar activities should be taxed in a similar manner.

311 The Review is recommending that life insurers be able to set up a `virtual PST' rather than having to transfer the existing pool of assets to a newly established PST, thus avoiding the disruption and costs which would be involved. Assets relating to existing complying superannuation business and deferred annuity business will then be transferred to the virtual PST. The virtual PST will be required to be treated as a separate entity within the life insurer with separate accounts. It will then be taxed on the same basis as other PSTs. This proposal will address the life insurers' concerns and avoid the expensive and difficult task of transferring assets to a separate legal entity.
Taxation of policyholders

Bonuses will carry imputation credits to reflect tax paid by the life insurer


312 A New Tax System also proposed that policyholders be taxed on the grossed-up amount of bonuses allocated to them with the imputation credits reflecting tax paid by the life insurer on that income being refundable to the policyholder. This will be an equivalent treatment to that applying to individuals investing through other entities. However, it raised the issue of how to deal with the possibility that policyholders may be taxed on bonuses allocated but not yet paid.

Policyholders will be allowed the option of having bonuses allocated annually and taxed at that time or on maturity and only taxed then

313 A Platform for Consultation (pages 740-743) canvassed three options and these were addressed in the consultation process. As a result the Review is recommending that life insurers will be able to offer policies that:

 • allocate amounts for taxation purposes annually with the taxpayer paying tax at that time; or

 • allocate amounts for taxation purposes only on the surrender or maturity of the policy with the taxpayers paying tax at that time.

314 It is anticipated that the first type of policy may be attractive to lower income taxpayers where the availability of refundable imputation credits will result in them receiving annual net refunds of tax under such policies. Conversely, higher income taxpayers will probably prefer the second type because it offers the same tax-deferral advantages as those gained when companies retain income rather than pay annual dividends.

Consolidated groups

Consolidation will allow a significant reduction in compliance costs for company groups while also reinforcing the integrity of the tax system

315 A New Tax System identified that the existing loss and asset transfer provisions for wholly owned groups of companies facilitated the creation of artificial losses and replication of losses in company groups. It is also possible for group companies to gain unintended tax advantages by dealing among themselves. Anti-avoidance provisions to address these outcomes are complex, adding to administrative and compliance costs, and have been unable to keep up with the growing adoption of various tax strategies aimed at achieving these kinds of undesirable outcomes.
316 In response, A New Tax System announced the Government's intention to consult with the business community on a move towards allowing wholly owned groups of Australian resident companies, fixed trusts and co-operatives to consolidate their tax position. The consultation was to be subject to the following principles:

 • intra-group dealings would be ignored for the purposes of the group's tax assessment;

 • eligible groups would be able to make an irrevocable choice to consolidate the whole group rather than have all entities in the group subject to separate tax treatment;

 • the existing group concessions would be replaced by consolidation and, therefore, repealed;

 • companies or trusts entering a consolidated group would be able to bring franking account balances into the group and also carry forward losses on a basis consistent with the principles underlying the existing law;

 • exit provisions would determine equity cost bases for entities leaving a consolidated group by reference to asset cost bases and equity cost bases on entry and to any cost base adjustments necessary during consolidation; and

 • companies and trusts exiting a continuing group would be unable to take carry-forward losses or franking account balances with them. The losses and franking account balances would stay with the continuing group.

The logic of allowing the tax system to ignore internal transactions is compelling

317 Consolidation clearly has the potential to deliver significant efficiency gains both to entity groups and the tax authorities. The logic of allowing the tax system to ignore what are essentially internal transactions appears compelling to the Review.
318 The Review is also recommending a more generous treatment for losses where entities consolidate. Broadly, an entity with carry-forward losses which satisfy the continuity of ownership test will be able to bring those losses into the consolidated group; the portion of the losses which relate to the group's interest in the entity at the time the losses were incurred may be claimed immediately, while the remaining amount may be claimed over 5 years.
319 Some submissions to the Review have argued for retention of the present system but have not shown how the acknowledged flaws to that system could be effectively overcome. Concerns about complexity commonly cite the US system as evidence. Complexity in the US derives from the 80 per cent ownership threshold for including subsidiaries in a consolidated group, and the consequent need to account for minority interests. The Review's proposal will require 100 per cent ownership for the purposes of consolidation and so the treatment of minority interests does not arise.
320 Business also raised a number of other concerns about the basic approach set out in A Platform for Consultation. There was concern about the need for a consolidated group to have an Australian resident head entity and some concerns about the possible treatment of losses.
321 The Review has addressed these concerns in its final recommendations.

Recognising direct investors and small business

Flow-through taxation

A specific regime for collective investment vehicles

322 The Review believes that it is very important that small investors have the opportunity to invest on the same basis and with similar opportunities for diversification as more wealthy individuals.

The CIV regime will put small investors on the same footing as direct investors

323 Wealthy individuals have the capacity to invest directly in a range of assets. If the returns from those assets are taxed on a concessional basis the direct investors retain the benefit of those concessions. Other individuals need to invest through a collective investment vehicle (CIV) in order to obtain the benefits of a diversified investment portfolio. However, if the CIV were to be taxed as an entity the benefits of any tax concessions would be `clawed back' by the imputation system. This would place these individuals at a disadvantage compared with wealthier individuals.

324 In recognition of such problems the Review is recommending that investments through CIVs be taxed on a flow-through basis. Tax-preferred income distributed to members by CIVs will be exempt from taxation, placing these investors in the same position as those who invest directly.

325 Eligibility criteria will needed to ensure that CIVs do not use this tax treatment to compete unfairly with ordinary businesses carried on by entities. Entities wishing to qualify for CIV treatment will have to:

 • be unit trusts;

 • be widely held;

 • have a single class of membership interest;

 • invest only in `eligible investment activity' -- essentially passive investments;

 • make a one-time election to be excluded from the entity tax regime; and

 • distribute all, or virtually all, of their taxable income each year. Reinvestment arrangements will be allowed.

326 Income earned through a CIV will retain its character as, for example, capital gains, dividends or interest. This is particularly important for non-residents' investments in CIVs where different tax treatments can apply to different types of income.
Rationalising the taxation of partnerships and other joint activities

Current arrangements provide opportunities for tax avoidance

327 The current tax treatment of the assets of a partnership uses an entity approach for the purposes of depreciation in that the depreciation allowances are used in calculating the taxable income of the partnership each year. When a partnership disposes of a depreciable asset, it accounts for any balancing gain or loss arising from the disposal.

328 However, when an interest in a partnership is sold (for example, an outgoing partner sells his/her interest to an incoming partner), the approach is to treat the whole of the asset as being disposed of by the old partnership to the new partnership at its market value. Where the market value of the asset exceeds its tax value, that would result in continuing partners being taxed on unrealised gains in respect of their continuing interest in the assets. To alleviate that, optional rollover relief is provided which allows the gain to be deferred until the continuing partners' interest in the asset is sold.

329 Chapter 14 of A Platform for Consultation described the possibilities for using the rollover relief to permanently avoid tax on assessable balancing charges. It also described how the rollover relief allows for the transfer of unrealised losses and yet allows the outgoing partner to obtain a corresponding capital loss.
330 The problems with the rollover relief can be addressed by abolishing the current approach and instead requiring partners to use the fractional approach. Under that approach, partners separately account for their share in any partnership transactions and assets. That approach could, however, have significantly higher compliance costs, particularly for those partnerships with many individual assets and whose partners are continually changing. An alternative approach would be to modify the current entity approach by taxing disposals of interests in partnerships in a manner similar to the current treatment of disposal of company shares and trust units. That approach would resolve the problems with the rollover relief and should be simpler to comply with, but would introduce some tax timing disadvantages for taxpayers.

There will be the option of a fractional interest approach or a joint approach combining both fractional interest and a modified entity approach

331 To balance the need for integrity in the law on one hand and the cost of compliance for taxpayers on the other, the Review proposes that taxpayers be given the option of adopting either the fractional interest approach or a joint approach. This will allow some assets and transactions to be taxed under the fractional interest approach and others under a modified entity approach.
Small business initiatives

The Government imposes significant costs on small business through using them as unpaid agents

332 Small businesses with annual turnover below $1 million represent over 850,000 businesses. These businesses find the compliance costs associated with the tax system to be a major burden. Not only do they incur considerable costs in respect of their own business income, but they are also required to collect taxes in respect of their employees' income and carry out other functions on behalf of the Government.

333 The Review believes that the growing burden being placed on business through the Government requiring them to act as its unpaid agents is a significant issue. Businesses have to carry out in respect of their employees a number of functions on behalf of government which are not central to their operation. This includes such standard functions as collecting PAYE tax instalments, but can extend to other areas such as prescribed payments, reportable payments, superannuation guarantee contributions, fringe benefits tax, child support payments and Higher Education Contribution Scheme (HECS) contributions. In addition to these activities there is the further provision of statistical data to the Australian Bureau of Statistics and information related to social welfare such as separation payments.

334 Some of these functions, such as collecting PAYE instalments, are closely associated with the operation of the business. While this does not detract from the argument for recognising the costs the task imposes on small business, and that it is essentially a government function that is being performed, it does imply that continued collection by small business is likely to be the most efficient approach. In other cases, such as separation payments, HECS and child support payments, the case for small business carrying out these functions, even if they were adequately compensated, is less obvious.

335 In some cases these functions can generate a cash flow benefit which offsets to some extent the costs to the business of carrying out these functions. However, this is more likely to be the case for larger businesses and, in any case, the degree of any offset varies significantly. Small businesses tend to be particularly disadvantaged by the imposition of these government requirements.

336 The Review considered measures specifically aimed at compensating small business for the costs associated with carrying out these functions for government. However, the diversity of functions performed and the diversity of small business itself made it difficult to design an effective response that could be delivered efficiently through the tax system. The Review is firmly of the view that some recognition of this is justified and this was a supporting argument in favour of reducing small business costs directly associated with the business tax system.

Reducing the compliance costs of small business is a high priority

337 The Review is recommending that businesses with an annual turnover of less than $1 million be given the option of adopting a simplified tax system consisting of:

 • a cash basis for recognising business income and cash based expenditure;

 • a simplified, and more generous, depreciation system; and

 • a simplified taxation treatment for trading stock.

338 Over 95 per cent of businesses have annual turnover below $1 million representing over 850,000 businesses. Table 5 shows the percentages of selected industries accounted for by businesses falling into this category.

Table 5 Percentage of industry accounted for and amount of tax paid by businesses with annual turnover of less than $1 million

Industry % $m
Accomodation, Restaurants and Cafes 90   139
Construction 97 1,324
Cultural and Recreational Services 98    122
Finance, Insurance and Business Services 96 3,167
Manufacturing 85    429
Primary Production 99 1,029
Retail 89    443
Transport, Storage and Communication 96    433
Wholesale 79    318

339 Small business proprietors must prepare and retain a myriad of documentation for taxation and other purposes and in doing so incur substantial labour and other costs. In addition, small businesses are less able to afford automated systems or convert to new systems because costs are high and considerable expertise is often required.

340 Allowing small businesses to determine their income and expenditure for tax purposes on a cash basis will reduce their compliance costs.

341 Small businesses which elect the cash basis of accounting will use simplified depreciation and trading stock systems. The simplified depreciation system will allow:

 • an immediate write-off for wasting assets where the cost of each asset is less than $1,000;

 • a pooling arrangement with a rate of 30 per cent (declining balance) for all other assets with an effective life of less than 25 years; and

 • a write-off of pool balances of less than $1,000.

342 The simplified depreciation regime will significantly reduce record keeping requirements. It also provides an element of acceleration compared with the use of effective life depreciation. For those businesses which will not benefit from a reduction in the company tax rate this will provide some offset for the loss of accelerated depreciation.

343 The simplified trading stock system will allow:

 • businesses with trading stock of less than $5,000 not to bring their trading stock to account; and

 • any increase in the value of trading stock not to be brought to account until such time as the increase exceeds $5,000.

344 Once again the motivation is to reduce compliance costs of small business where this can be achieved at acceptable costs to other tax system objectives.

Rationalisation of CGT rollover and exemption provisions for small business

345 The Review is recommending that the existing CGT concessions for small business be rationalised. The current CGT rollover relief, the CGT retirement exemption, and the CGT goodwill exemption provisions all have the same underlying objective -- that is to provide small business people with access to funds for expansion or retirement. These provisions are complicated and there is scope to merge and simplify them to make them operate more efficiently.

346 The recommendation will provide a 50 per cent exemption from all capital gains arising from the disposal of the active assets of a business with net assets of $5 million or less. The balance of the gain will be eligible for rollover into new assets or retirement. For individuals, the small business provisions will operate with respect to the CGT liability after the capital gain has been calculated under the proposed new arrangements for the assessment of capital gains. For example, if a small business person elects to take his or her gain on the 50 per cent reduction basis, the remaining 50 per cent of gain on active assets will be eligible for exemption and rollover.

Rewarding risk and innovation

Incentives for investing

The need for reform of Australia's capital gains tax was a major focus of submissions to the Review

347 Consultations have highlighted the current capital gains tax regime as an area of major concern to taxpayers. The Review believes that reforms to the current regime could substantially improve the operation of Australian capital markets and help support a stronger investment culture amongst ordinary Australians.
348 Australia taxes capital gains more harshly than most other comparable countries and certainly more harshly than other countries in our region competing for international investment. The competition for domestic and international capital for investment is strong and likely to become more intense. Failure to attract investment funds will mean lower levels of economic activity and fewer jobs.
CGT reforms for individuals and superannuation funds

The Review is recommending major reforms to the taxation of capital gains of individuals and superannuation funds

349 The Review's recommendations in respect of the capital gains tax regime for individuals will help to support a stronger investment culture amongst Australian households. The widespread privatisation of major public sector enterprises has greatly increased the number of Australian households owning shares. A less harsh CGT regime which encourages taxpayers to invest in such assets will help entrench and build upon these changes.
350 The Review is recommending that for individuals 50 per cent of the capital gain on assets held for a year or more will be included in the taxable income of the individual. Taxpayers will have the option of being taxed on this basis or on the full nominal gain above the cost base of the asset indexed to 30 September 1999. This will ensure that no taxpayer is taxed on capital gains at an effective rate in excess of 50 per cent of the marginal rate applying to other income.

351 Superannuation funds will be allowed the option of including in their taxable income two thirds of the nominal capital gain on each asset or full taxation on the nominal gain adjusted for any indexation accrued up to 30 September 1999.

Indexation and averaging is to be abolished

352 Funding this major reform will be revenue from the freezing of indexation, the abolition of the averaging provisions and increased realisations of capital gains as a result of the reduced taxation. The freezing of indexation will impact adversely on entities but they will receive major benefits from the reduction in the company tax rate. It is also likely that the lower capital gains tax on shares and other membership interests held by individuals will impact favourably on the cost of capital for entities. The one third reduction in the effective tax rate on the capital gains of superannuation funds is designed to be a broad offset for the loss of indexation but has been set on the generous side.

353 As noted in A Platform for Consultation, the current averaging regime has led to unintended outcomes at considerable cost to the revenue and the equity of the tax system. The major reductions in the effective CGT rate on most capital gains reduces the need for any averaging. The highest rate for individuals will effectively be 24.25 per cent including the Medicare levy.

354 A number of submissions argued strongly for the retention of indexation and the Review notes that there will be some investments which would receive better treatment under the current system than under the proposed reforms.

Proposed changes will send a positive signal to investors

355 The choice comes down to a judgment about which system sends the more positive message to potential investors, both domestic and non-resident. The Review believes that a significantly lower rate for individuals and superannuation funds is more effective in this regard and so will make a more positive contribution to the development of Australia's capital markets and a stronger investment culture.

Capital market incentives

Venture capital

Australia's relatively harsh CGT regime impacts adversely on venture capital investments

356 Investments in start-up firms involved in high technology or innovative businesses typically provide investment returns in the form of capital gains. They also tend to be higher risk investments. Australia's relatively harsh capital gains tax regime impacts severely on the capacity of such firms to obtain investors in Australia. As a result, Australia loses many such firms as they move overseas to obtain investment for further development. This reduces the incentive for other innovative businesses to seek to develop in Australia, and Australia loses the spin-off advantages of having a growing community of high growth, innovative companies.

357 A further knock-on effect is that the development of an effective venture capital market in Australia is constrained. A vicious circle emerges as investors are reluctant to undertake high risk investment under Australia's capital gains tax regime, firms move offshore to obtain investment, and there are fewer examples of Australian success stories to encourage Australian investors.

Non-resident tax exempt investors to be exempt from capital gains tax on venture capital investments

358 Consequently the Review is recommending significant CGT relief for venture capital. Non-resident tax-exempt pension funds, such as US pension funds, will be allowed to invest in venture capital projects in Australia and be exempt from capital gains tax. This will provide US pension funds with the same tax treatment they enjoy in the US and so allow Australian investments to compete for funding on an even footing with US firms. The US allows Australian superannuation funds to be tax-exempt in respect of capital gains on investments in the US.

359 A more vibrant and successful venture capital industry in Australia will do much to encourage Australian investors to commit funds to these types of firms. The collective investment regime (CIVs) recommended by the Review will ensure that small investors have the opportunity to participate in such investments while diversifying the risk to acceptable levels. The scrip-for-scrip rollover relief recommended by the Review will also provide significantly improved incentives for this kind of activity to take place in Australia.
Scrip-for-scrip rollovers

360 The business community has long claimed that the absence of CGT rollover relief for scrip-for-scrip takeovers between companies was a major barrier to rationalising of Australian business and the realisation of significant efficiency gains.

Rollovers to be allowed for scrip-for-scrip transactions

361 Rollovers will be allowed for scrip-for-scrip transactions involving takeovers where at least 80 per cent of the target entity is held on completion and at least one of the entities involved is widely held.

362 This change is expected to allow a significant rationalisation of many Australian businesses with consequent benefits in terms of economic growth, returns to shareholders and employment. It will also allow start-up and early stage businesses to be acquired by widely held entities without triggering capital gains tax for the entrepreneurs until they realise their investments, thereby encouraging new ventures.

Responding to globalisation

363 The interaction of the Australian business tax system with the rest of the world is a crucial determinant of the international competitiveness of Australian business. Arrangements in this area need to strike a delicate balance.

Australian companies operating in global markets bring advantages to Australia

364 There are major advantages to Australia in Australian companies expanding overseas. The growth and diversification of Australian companies into world class businesses is clearly central to Australia's longer term economic development and it is important that the tax system is as supportive as possible of these developments.

365 The Review's recommendations are intended to ensure that Australian business is not hindered from expanding overseas and that Australia becomes a more attractive investment destination for both resident and non-resident investors. At the same time the Review has been conscious of the need to reduce opportunities for avoidance and evasion of taxation through the use of offshore arrangements.

Foreign investment brings major benefits to Australia

366 Clearly Australia is also entitled to tax income earned in Australia by foreign investors in recognition of their use of Government services and infrastructure and, in many cases, national resources. On the other hand, foreign investment brings major benefits to the Australian community through:

 • increased levels of investment funding, higher economic growth and increased employment; and

 • the provision of important linkages to the international economy in terms of technology, management expertise, and access to overseas markets.

367 With globalisation of economies becoming increasingly pervasive there will be increasing competition for the pool of investible funds in the international market and Australia needs to be able to attract an appropriate share of these funds in the interests of the whole community.

Australians investing offshore

368 A major concern of the Review has been the treatment of foreign source income of Australian companies. As Australian companies grow it is inevitable that they will earn increasing amounts of their income from overseas.

Providing an imputation credit for foreign DWT will mitigate the disincentive to resident entities to invest offshore

369 Foreign source income repatriated to Australia from comparably taxed countries is not subject to Australian company tax and so does not give rise to imputation credits. If distributed to resident shareholders, the foreign taxes are ignored and the distribution is subject to another layer of tax. This has the potential to discourage offshore investments that offer higher returns, and hence more benefit to Australian shareholders, than domestic investments. Furthermore, direct investments by residents in overseas entities are already allowed a credit for foreign DWT and this treatment is also available for trust beneficiaries (and will be continued under the recommendations concerning resident CIVs).

370 The Review is recommending that Australia allow a credit for foreign DWT up to 15 per cent. This will mitigate the disincentive to resident entities to invest offshore and to repatriate dividends to Australia. It will ensure comparability of treatment with investments made by individuals directly into foreign companies or via CIVs.

371 The increased availability of franking credits as a result of the recommendation will improve the ability of Australian entities with foreign source income to pay franked dividends to Australian shareholders. However, some companies with a significant proportion of foreign source income will still find it difficult to pay fully franked dividends.

372 As a possible response, dividend streaming in respect of foreign source income would allow an Australian entity to direct dividends arising from foreign source income to non-resident shareholders and maximise the franking credits available to resident shareholders. This would reduce the disincentive for Australian companies to increase their overseas operations.

Dividend streaming would also mitigate the disincentive for overseas investment but would not benefit as large a range of companies

373 However, dividend streaming only benefits the Australian shareholders of those companies with both foreign source income and non-resident shareholders, and ideally in the same proportion. In fact, a company with foreign source income but few or no foreign shareholders would under dividend streaming, have an incentive to increase the proportion of foreign shareholders. This is because an increased proportion of foreign shareholders would allow a larger proportion of the dividends paid to the remaining domestic shareholders to be franked.

374 Streaming would allow the unfranked dividends to be directed to the foreign shareholders but would not improve the position of the foreign shareholders. This outcome arises because foreign source income paid to non-resident shareholders is exempt from DWT as a result of Australia's Foreign Dividend Account arrangements and franked dividends are also exempt from DWT. Consequently, non-resident investors are unaffected by any change in the mix of these dividends in their total dividend income.

375 The Review sees considerable merit in allowing foreign dividend streaming but the revenue cost is significant and so it has not been recommended.

Recognising imputation credits that initially flow offshore

376 At present a New Zealand company operating through a subsidiary in Australia can earn imputation credits. However, when the New Zealand parent company has Australian shareholders there is a case for recognising that and allowing the proportion of Australian earned income attributable to Australian shareholders to flow through the New Zealand parent to those shareholders with Australian imputation credits attached.

377 The Review is recommending that Australia propose such an arrangement to New Zealand on a reciprocal basis. That is New Zealand investors in Australian companies with New Zealand operations will also be allowed similar treatment in respect of New Zealand imputation credits.

Foreign investment in Australia

A better treatment for foreign investment in Australia

378 As noted earlier neither the proposals for the DCT nor the company tax/DWT switch canvassed in A Platform for Consultation have been recommended by the Review. The recommended alternative of taxing inter-entity dividends does not impact adversely on foreign investors as the DCT would have done.

379 The proposed CIV arrangements will also facilitate investment by non-residents. Income passing through a CIV will retain its character as dividends, interest, capital gains or other forms of income. This is particularly important for non-residents where different forms of income attract different taxation treatments, both in Australia and in their home jurisdictions.

380 Australia already allows so-called conduit income -- foreign source income passing through an Australian entity to a non-resident investor -- exemption from Australian tax where that income has already been taxed at an effective rate comparable to that imposed on Australian source income. The Review is recommending that these arrangements be broadened to allow wider and more effective exemption of conduit income. However, the exemption will still be dependent on the income having been comparably taxed.

Allocating income between countries

Thin capitalisation rules to be reformed

381 There are opportunities for companies to seek to transfer taxable income from one jurisdiction to another, for example by adjusting the gearing of investments. An investment in a high tax jurisdiction can be highly geared so as to minimise taxable income in that jurisdiction and maximise it in a low tax jurisdiction. It is common practice for countries to have thin capitalisation rules which limit the degree of gearing that is recognised for tax purposes.

382 Australia's current thin capitalisation provisions are not fully effective at preventing an excessive allocation of debt to the Australian operations of multinationals because they only address foreign-related-party debt and foreign debt covered by a formal guarantee, rather than total debt. The Review is recommending that the provisions have regard to total debt. At the same time it is recommending a safe harbour gearing ratio of 3:1 compared with the ratio in the current thin capitalisation provisions of 2:1 for the more restricted class of debt. The proposals will bring Australia more into line with other countries such as New Zealand and the United Kingdom.

383 It is also proposed to expand the thin capitalisation rules for Australian multi-national entities that have non-portfolio investments in controlled foreign entities.

384 The Review is also recommending that further consideration be given to personal taxation issues relating to foreign expatriates and departing residents. The objective would be to encourage further venture capital investment in Australia and promote Australia as a global financial centre.

Renegotiating Double Tax Agreements to be a priority

385 The renegotiation of Australia's Double Tax Agreement arrangements with a view to reducing the level of withholding taxes and generally updating the treaties should also be a priority.

Improving Australia's international taxation regime

386 International taxation arrangements are an extremely complex area and, given the time frame of the Review and the breadth of other business tax issues which had to be considered, the Review has not been able to fully address all the issues in this area.

387 A particular concern is whether there are remaining features of the current arrangements which impact on the decisions of entities to remain in Australia or to locate here in preference to other countries.

388 Another priority area should be a review of Australia's foreign source income rules which include the controlled foreign company, and foreign investment fund, measures.

389 Consequently the Review is recommending that there be an examination of Australia's policy in these areas to ensure that the internationalisation and expansion of Australian business are not impeded by inappropriate tax arrangements.


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