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Australian Taxpayers’ Associations

16 April 1999.

The Secretary
Review of Business Taxation
Department of Treasury
Parkes Place
Canberra ACT 2600
Email: rbt@treasury.gov.au

 

Submission on Review of Business Taxation
Discussion Paper No 2 - A Platform for Consultation

Dear Sir,

Please find enclosed the submission of the Australian Taxpayers’ Associations (referred to as the Association in this submission) on the Discussion Paper No 2 - "A Platform for Consultation".

As a preliminary matter, the Association notes that it is happy to have all of its submission made public.

The Association would like to thank the organisers for inviting us to attend the many focus groups that were conducted by the members of the review team. We found those group sessions enlightening and helpful to understand the reasoning behind the many of the options contained in the Discussion Paper. I am sure that the RBT members of the focus groups also found the discussions helpful and thought provoking.

Attached is an Executive Summary of the main issues. The Association notes, however, the magnitude of the Discussion Paper itself (i.e. it contains over 400 separate options) and of our submission, which is over 60 pages. Accordingly, the Association stresses that the Executive Summary will largely be an inadequate representation of the concerns and endorsements of the Association. Accordingly, I would urge you to consider carefully the detailed comments we have made.

This submission has largely been crafted along the lines of the Discussion Paper itself. The first section deals with our analysis of the issues outlined in the Overview of the Discussion Paper. The second section deals with each chapter individually. In forming our views the Association has concentrated its attention on the effects on Small Business of the proposals.

 

Yours faithfully,

Peter McDonald
National Director
Australian Taxpayers’ Associations

Australian Taxpayers’ Associations

 

Discussion Paper No 2
A Platform for Consultation
Executive Summary

The Association strongly endorses the adoption of a structured approach to business tax reform. As noted in DP2, such a structured approach should involve reliance on explicit objectives and principles combined with transparent benchmarking and integrated design of existing and proposed tax rules against those objectives and principles.

Rejection of Comprehensive Income base:

The Association does not accept the need for a comprehensive income base as the Association believe that taxes should only be raised at the point when an actual economic benefit arises, rather than a potential economic benefit in the form of an unrealised gain. Conversely, losses and outgoings should become deductible when they are incurred.

Need for Consistency (Neutrality) and Flow-through of Tax-preferred Income:

The Association considers that the taxing effect of a transaction or arrangement should, at the end of the day, be consistent regardless of whether that transaction was conducted by a company, trust, partner or individual. This involves true neutrality. That is not what is proposed under the government’s package. It is submitted that equity and neutrality (between different business structures) considerations dictate that there be flow-through of tax-preferred income through all such business structures (sole proprietorships, partnerships, trusts and companies).

However, as a result of the revenue neutrality constraints imposed on the Review, the Association suggests a more limited adoption of full flow-through of tax preferences (namely for "small business trusts" and "small business companies"), with such entities attracting a 36% rate of entity taxation (and retention of accelerated depreciation), rather than the mooted 30%. The Association suggests the adoption of a $5 million net assets threshold (adopted by Division 17A of the 1936 Act) in distinguishing between "small" and "large" business entities.

Small Business Option:

As noted above, on behalf of small business, the Association suggests that it would be a much more equitable system if taxpayers operating small businesses through companies or trust structures were able to obtain a full flow-through of tax preferences and pay tax at the current 36% rate. If large public companies want a 30% rate because of the ability to declare higher after tax profits and attract more non-resident investors, then let them pay for it themselves by giving up some of their own tax concessions. If necessary, the Review should consider a two-tier entity system for small business and large business entities, with the threshold between the two tiers set at the $5,000,000 threshold referred to above.

Rejection of Tax on retained Profits:

To overcome the problem of entities not distributing all of their annual income, the discussion paper canvasses the possibility of dealing with profit retention by way of some form of undistributed profits tax for closely-held entities. However, there are many valid commercial reasons for profit retention including providing low cost internal finance to the organisation, a lack of available funds to distribute cash dividends and the retirement of internal debt.

The existing Div 7A rules also prevent shareholders and beneficiaries from accessing those retained funds unless a written loan agreement was entered into prior to the loan being made, and that loan agreement stipulates a minimum benchmark interest rate and complies with the requisite maximum loan term.

With those rules in place, there is no possibility of the shareholders or beneficiaries being able to cause any mischief with the retained profits. Those funds can only be used to generate additional income for the entity in question. Accordingly, the Association submits that there is no need for an undistributed profits tax.

In any case, the Association submits that the previous experience with former Division 7 suggests that if such a tax were to be introduced, it would be difficult to avoid a complicated regime with high compliance costs. This would be inconsistent with the national objective of facilitating simplification.

International taxation benchmark:

The rules affecting the taxation of income derived overseas by Australian residents should be the same as those for domestic income derived by residents. The amount of tax payable on any transaction or investment should be the same for each like transaction or investment regardless of the nature of the entity used.

It is fundamental that investors are not penalised for investing locally or for investing internationally.

Reforming the Taxation of Entities:

The Association agrees that persons should be in a position to make commercially optimum decisions (including choosing commercially optimum business structures) without bias from the business tax system. However, the Association considers that it is more appropriate that companies be taxed like trusts currently are, rather than the other way round. Such a system would achieve both equity and neutrality. Indeed this would achieve true neutrality between business structures, as tax-preferred income would flow through all such entities removing the current distortion in favour of trusts and away from companies.

Fringe Benefits Taxation:

The Association considers that it would be appropriate to abolish FBT, and tax benefits, like other remuneration, in employees' hands. The change in the law to require the inclusion of essentially all fringe benefits on group certificates from 1 July 1999 (and in some cases from 1 April 1999) will facilitate such a reform.

 

Applying the Revenue Neutrality Constraint:

The Association disagrees that revenue neutrality dictates that a lowering in the company tax rate must be accompanied by reforms to the taxation of business investments that, in aggregate, represent net base broadening. Given that the changes to Australia’s business tax system are designed to make business more competitive, it stands to reason that achieving that result will result in higher assessable income and, in turn, higher revenue. If that were not the case then there is little reason to change.

Removal of accelerated depreciation rates:

The Association does not accept that the company tax rate cannot be lowered without the removal, or substantial reduction, of accelerated depreciation. As noted earlier in this submission, on behalf of small business the Association rejects the introduction of a lower company tax rate on this basis. Small business obtains no real benefit from a reduction in the company tax rate. Ultimately under the proposed system, the owners of small businesses conducted through companies or trusts will pay tax at their marginal rate of tax regardless of the rate at which company tax is set. Accordingly, small business would obtain no real benefit from the lowering of the company tax rate, and the revenue would not suffer.

Alternative Capital Gains Taxation:

The Association agrees that it is appropriate to take steps to make Australia's CGT system more internationally competitive (paragraph 266). One area that requires reform is the need for scrip for scrip CGT roll-overs. This would facilitate achievement of 2 of the National Objectives; namely, optimising economic growth and ensuring equity.

The proposal to examine the case for removing indexation is strongly rejected. It is inequitable that taxpayers should be taxed on nominal, rather than, real gains. There is no justification for denying taxpayers a cost base reflecting inflationary effects over the period that an asset is held.

Wasting Assets:

The Association recommends the adoption of the following simple rules with regards to depreciation including the following concepts:

    • the taxpayer who incurs the cost of expenditure on the asset should

be entitled to the depreciation deduction.

  • the deduction should be based on actual cost; and
  • deductions should commence when the item is installed ready for use.The Association recommends that all assets including buildings be written off based on their effective life.

Small items (of say, less than $500) should be deductible in full in the year in which the expenditure is incurred. This $500 threshold should be indexed annually for movements in the CPI.

The Association recommends that a choice continue to be offered to taxpayers between the diminishing value depreciation method and straight-line depreciation. Balancing adjustments should be allowed to be offset against the cost of new or existing depreciable assets. The removal of this concession will make it costly and, therefore, more difficult for businesses to upgrade their plant and equipment.

The Association strongly favours the introduction of legislation providing for tax deductibility of Black Hole expenditure.

Accelerated Depreciation:

Accelerated depreciation provides an incentive for small business to invest and update its plant and technology. The accelerated depreciation regime should be retained because :

  • it provides an incentive for capital investment which promotes the achievement of the national objective of optimising economic growth; and
  • There would be no reduction in the overall level of tax paid by the economic owners of small businesses carried on through trusts and companies as a result of a reduction in the rate of entity taxation. Accordingly, there is no justification for abolishing or emasculating the current accelerated depreciation regime.

To the extent to which large business favours the reduction in the company tax rate with accompanied abolition or emasculation of the current accelerated depreciation regime, then such an approach should be adopted for large entities only. A different regime with a higher entity tax rate, availability of accelerated depreciation and full flow-through of tax preferences should be available for small businesses (defined possibly by reference to the $5,000,000 asset threshold utilised in Divisions 17A and 17B (small business roll-over and retirement exemption) of the CGT provisions).

Goodwill:

The Association supports a deduction for acquired goodwill. To facilitate simplification a deduction should be allowed on a straight-line basis, say, over 10 years.

Capital Gains:

The Association notes the alternative to taxing at the individual rate of tax by providing a $1,000 CGT tax free threshold and capping the tax rate on capital gains at 30% may stimulate some taxpayers to free up existing investments. In certain circumstances these proposed changes may be advantageous to small business. However, in most cases smallbusiness would prefer the choice of having the current averaging concessions apply.

A better option is to cap the rate at 20% in line with the U.S.

The $1,000 pa. CGT tax-free threshold will do little to alleviate record keeping oradministration for Small Business. The amount is too low. We would recommend thatthis threshold be increased to $5,000 and be indexed to annual movements in CPI.

Scrip for scrip roll-over relief would be welcomed.

The Association does not endorse the suggested removal of the existing 50% goodwill concession and Small Business exemption. Rather, those provisions should be retained.Taxpayers should be given the option to utilise those provisions or the proposedgeneralised exemption of a % of all capital gains arising on the disposal of active assets of a small business.

The Association submits that a higher percentage than 20% of all capital gains would need to be exempted in order for the generalised exemption to be an attractive alternative.

CGT Indexation:

Indexation should be retained for the calculation of taxable capital gains. Equitydemands that only real gains be subject to tax.

The current CGT averaging process be retained as an appropriate mechanism for dealing with the "lumpy" nature of the derivation of capital gains. Again equity demands that such averaging be available.

The carry back of capital losses to be offset against past capital gains, is an improvement on the current system. However, the Association recommends that capital losses be available for a rebate capped at 20% in the year the capital losses are realised.

Involuntary Receipts:

The Association strongly recommends the adoption of Option 2 providing for a distinguishing between voluntary and involuntary receipts by deferring the tax liability on involuntary receipts.

The treatment of involuntary receipts should be extended to all situations where the acquirer had the power (even if not exercised in the circumstances) to compulsorily acquire the relevant asset.

Where a pre-CGT asset has been compulsorily acquired, the replacement asset should also have a pre-CGT status.

Any losses arising from a compulsory acquisition should be allowed at the time that the compensation is received.

The ability to defer the capital gain should not be restricted to situations where a replacement asset is purchased. The capital gain should be allowed to be offset against the cost base of existing assets.

Partnerships assets and interests:

For the purpose of simplifying record keeping, the Association recommends that the entity treatment of partnerships be adopted.

With the adoption of an entity approach the Association also recommends that the current 50% goodwill exemption threshold per partner be maintained.

Consistency of treatment of entity distributions:

As noted earlier, the Association recommends that "small business trusts" (those with net assets less than $5,000,000) continue to be taxed on the existing basis with full flow-though of tax preferences to beneficiaries (subject to a "clawback" on disposal of the trust interest in the case of fixed trusts). That is, such tax preferences should be tax-free in the beneficiaries' hands. If necessary larger trusts could be subject to the entity regime.

The Association also recommends that "small business companies" (defined by reference to the same threshold as "small business trusts") also be taxed on the same basis as that applying currently to trusts.

For entity chains the taxing of unfranked dividends is preferred as it would seem to be the simplest option, whilst avoiding the adverse foreign investment consequences of the deferred entity tax approach.

The proposal to refund excess imputation credits is applauded. Equity dictates such an approach.

The Association supports a refund system involving adjustment to an individual shareholder's PAYE obligations, or a refund by instalments where the taxpayer is not covered by the PAYE system.

Collective Investment vehicles:

The Association supports the exclusion from the entity regime of cash management trusts and other "collective investment vehicles" with flow-through taxation of the net income of such trust., as proposed by the Treasurer in his press release dated 22 February 1999. The Association notes, however, that that press release left unresolved the issue of the appropriate tax treatment of distributions of the profits of collective investment vehicles that are not paid out of the assessable income of such vehicles (tax preferred income)

The Association submits that it is appropriate for flow-through treatment to apply also to such tax-preferred income, so that distributions of such profits would be tax-free in the hands of investors. Neutrality and equity considerations demand such an approach.

Redesigned Imputation system:

The taxing of unfranked inter entity distributions does not give rise to significant calculation or collection issues and would be the simplest for small business to administer. It is therefore, the preferred option.

Defining Distributions:

The current concept of taxing beneficiaries on the basis of their present entitlements to trust income, should be retained.

Excess drawings by trust beneficiaries should be treated consistently with private company shareholder loans, to promote investment neutrality between companies and trusts.

Consistent treatment of Entity Income:

With regards to the availability of carry forward losses in trusts there should be a "group" test in determining whether there is a 50% change in pattern of distribution test. Where this test is satisfied the carry forward losses should be available.

Where an entity is unable to meet a tax liability there are sufficient existing remedies available for the Commissioner to pursue the unpaid tax and prosecute the controllers. Therefore, the Association does not recommend any expansion of these provisions.

Bringing Trusts into the Entity regime:

Notwithstanding the Association's preferred position that "small business trusts" not be taxed as companies, if the government insists on generally taxing such trusts as companies, then the Association agrees that it is appropriate to exclude the types of trusts set out in Appendix A from the entity regime.

The Association also agrees, again subject to its preferred position referred to immediately above, that the proposed taxation treatment of minors is appropriate.

For the purpose of simplifying administration, the unpaid income or capital entitlements of beneficiaries in a trust should be treated as distributions and loan backs, rather than establishing sub-trusts.

Difficulties and potential double taxation may arise on an in specie distribution to beneficiaries of a non-fixed trust.

In addition to recognising the primary production income element of a distribution that component representing a taxable capital gain should also be recognised and retain its character.

Anti Avoidance measures:

The Association would welcome one reasonably simple anti-avoidance division in the Act.

The Association agrees that the current Act places undue reliance on specific anti-avoidance rules. Such rules should be kept to minimum, and, if possible, avoided altogether.

The Association suggests the adoption of a "significant purpose" test in any new robust, general anti-avoidance rule and in any specific anti-avoidance rule. The Association expresses its grave concern at the tendency in recent times to adopt a "purpose other than an incidental purpose" test. The Association suggests that such a test sets an inappropriately low threshold, and would be likely to catch in its "net" many innocent taxpayers and innocent transactions.

Fringe Benefits:

Where the tax liability for fringe benefits is transferred from the employer to the employee, the current concessions and exemptions in the FBT Act (e.g.: Remote Area Housing and superannuation contributions) should be maintained in the Income Tax Assessment Act.

Assuming that FBT is not abolished, an FBT threshold of say, $10,000 should be proposed. That is, where an employer provides fringe benefits with a taxable value of $10,000 or less, they would be exempt from FBT and not required to lodge an FBT return.

The current tax treatment of car fringe benefits should be retained, bearing in mind the potential adverse effect on fleet purchases and the flow-on effect for the local car industry. The Association notes the existence of other factors already adversely affecting the local car industry. These factors include the increased import competition flowing from the phased reductions in car tariffs, together with the likely deferral of new car purchases associated with the abolition of relatively high sales tax and the introduction of a much lower GST on cars. The combined operation of these factors may prove a virtual knockout blow for the local car industry.

In any case, any changes in valuing car fringe benefits should maintain an option of a simple statutory percentage of the car's cost, thus simplifying administration. Cars such as vans, utilities and small trucks should be exempt from FBT.

To simplify administration, the Association recommends that the financial year and FBT year-end be the same, with the fringe benefits return being incorporated with the annual income tax return.

Revenue Neutrality:

For the reasons indicated in the Overview section of this submission, the Association rejects the much publicised linkage between a reduction in the company tax rate and the scrapping, or substantial dismantling, of accelerated depreciation. In short, it proceeds on the logical fallacy of the company tax being a final tax. On the contrary, regardless of the rate at which company tax is set, under the proposed entity tax system, the rate of overall taxation paid will be determined by the marginal rate of tax of each shareholder of a company or beneficiary of a trust. That is, the revenue will be unaffected by any reduction in the company tax rate. Accordingly, there is no need for any base broadening!

In view of the above, accelerated depreciation should be retained. Its retention will also promote the National Objective of optimising economic growth.

The Association suggests that revenue neutrality should be measured by reference to the current tax system not by reference to the "Government's fiscal figuring that reflects the budgeted-for tax reform measures announced in A New Tax System" (paragraph 250). DP2's measurement of revenue neutrality prevents taxpayers being compensated for the revenue "take" by the Government flowing from the proposed denial of flow through of tax-preferred income in trusts. This is extremely inequitable!

The Association is disappointed that DP2 has not looked more closely at the tax imposts and overly complex legislation affecting small business.

The Association asserts yet again that the corporate tax rate should be aligned with the top individual marginal rate to avoid incentives for arbitrage. This should have been a proposal put forward and discussed in DP2.

PRELIMINARY

The structure of this submission is first to make general comments on issues addressed in the Overview in Discussion Paper 2 ("DP2"), Vol. 1 in the order adopted in that Overview. Comments are then made on specific Chapters of DP2.

GENERAL COMMENTS

Structured approach to Business Tax Reform (Overview p.9) :

The Association strongly endorses the adoption of a structured approach to business tax reform. As noted in DP2, such a structured approach should involve reliance on explicit objectives and principles combined with transparent benchmarking and integrated design of existing and proposed tax rules against those objectives and principles. Such a process should avoid the inconsistencies and anomalies that have resulted from the ad hoc development of the tax law over the last 60 years. It should also greatly assist judicial interpretation of that law which contributes to the achievement of those underlying objectives and principles.

Retention of an Income Tax Base (Overview p.11)

The Association supports the retention of the income tax base as the primary base for business tax arrangements. It is fundamental, however , that the rules are consistent across all entities unless there are justifiable reasons for departing from such a base.

Comprehensive Income Tax Base (Overview p.11/12 and p.29)

The Association does not accept the need for a comprehensive income base as the Association believe that taxes should only be raised at the point when an actual economic benefit arises, rather than a potential economic benefit in the form of an unrealised gain. Conversely, losses and outgoings should become deductible when they are incurred.

The Association agrees with the Review as to the cogency of the practical restraints militating against the universal application of comprehensive income.

Investment Neutrality Principle (Overview p.13) and Distributions of Tax-preferred Income (Overview pp.16-19)

The Association considers that the taxing effect of a transaction or arrangement should, at the end of the day, be consistent regardless of whether that transaction was conducted by a company, trust, partner or individual. This involves true neutrality. That is not what is proposed under the government’s package. It is submitted that equity and neutrality (between different business structures) considerations dictate that there be flow-through of tax-preferred income through all such business structures (sole proprietorships, partnerships, trusts and companies). However, as a result of the revenue neutrality constraints imposed on the Review, the Association suggests a more limited adoption of full flow-through of tax preferences (namely for "small business trusts" and "small business companies"), with such entities attracting a 36% rate of entity taxation (and retention of accelerated depreciation), rather than the mooted 30% (refer pp.3/4 of this submission for a more detailed discussion of this issue).

By accepting the need for consistent rules to apply across all entities, the Association wishes to make it quite clear that consistency of treatment is not another name or code for treating all, or even some, entities, equally badly. By way of background, the Association submits that the loss of tax concessions made available to a company, when the profits in question are distributed to a shareholder, is an unintended flaw of the imputation system.

For example, a capital gain made by a company and distributed to an individual shareholder will be taxed quite differently to a similar capital gain made on an investment held in the name of an individual. In that instance the shareholder will effectively be taxed on what would otherwise have been the tax-free indexation component of the gain. The distribution of profit arising on sale of goodwill, where the company has obtained the benefit of the 50% goodwill tax exemption, is similarly treated. Specifically, because that portion of the profits has benefited from such tax concessions, it has not borne company tax. Accordingly, when distributed to the shareholder, that portion of the profits must be paid out as an unfranked dividend. It follows that the shareholder must pay the full amount of tax (at their marginal tax rate) on what was tax-free in the company's hands.

By imposing the same regime on trusts, this flaw is replicated. It would be preferable to achieve investment neutrality between trusts and companies by allowing the current tax treatment of tax losses and tax-preferred income in trusts, to apply equally to companies. The cost to revenue could be minimised by departing from the ideal and only allowing such a flow-through of tax losses and tax-preferred income to relatively small private companies (perhaps adopting the threshold test utilised in Division 17A of the 1936 Act).

In any case, the Association notes that the government's approach does not achieve investment neutrality between different business structures. Rather, it creates 2 classes of business taxpayer; namely, on the one hand sole traders and partnerships (in respect of which individual investors obtain the benefit of tax concessions and losses made available at the entity level) and on the other hand companies and trusts (where individual investors are unable to access tax losses nor obtain tax-free, distributions of tax-preferred income). It is also submitted that investors should not be penalised from a tax point of view, for choosing to operate through a structure which offers to a certain extent the benefit of limited liability.

The ultimate tax payable on a transaction, when the profits finally flow through to an individual, should be the same regardless of the entity through which they choose to operate their business and investment affairs. That is, as noted above, there should be full flow-through of tax preferences in sole proprietorships, partnerships, trusts and companies.

The Association does not accept that the desirable method to correct this anomaly is to tax individuals on the same basis as shareholders. Again that would be neutrality without equity.

Full integration only occurs when the overall level of taxation imposed on the ultimate recipient is no more than the amount that would have been paid by that person if they had operated as a sole trader. By taxing an individual on tax-preferred income received via a company or trust structure, that individual is not being taxed on exactly the same amount of income, as would have been the case if a sole trader structure were adopted. This is notwithstanding that a credit (and indeed a refund) is available at the shareholder level. This merely achieves the same rate of tax as for an individual. However, the tax base is broader in the case of an individual receiving profits indirectly through a company or trust structure. Accordingly, full integration, and indeed, true neutrality proves illusory!

It follows that the statement made at paragraph 45 of DP2 concerning the purported achievement under the government's proposals of complete neutrality between taxable income received from direct investment and from distributions received from companies which are conduit entities, is fallacious.

The report acknowledges that companies and trusts are treated differently The Association supports neutrality between the tax treatment of trusts and companies, but not a uniform lack of equity. In our view, there should be flow through of tax-preferred income in both companies and trusts. Indeed it is submitted that equity and neutrality (between different business structures) considerations dictate that there be flow-through of tax-preferred income through all such business structures (sole proprietorships, partnerships, trusts and companies). This should be the case regardless of whether such an option would have an impact on the revenue, and may "run counter to the objective, expressed in the Review's terms of reference, of lowering the rate of company taxation" (Overview paragraph 53, p.17). The Association urges the Review to seriously consider such an option as being in the best interest of a fair and equitable tax system.

Tax Reform must be about getting it right. It must not be about espousing high principles and claiming to create a world class tax system when in fact the opposite is true.

However, it is likely that the flow-through of tax-preferences through company structures will only be considered in the context of an overall revenue neutral outcome. Accordingly, it is suggested that, as a trade-off, the 36% company tax rate (and accelerated depreciation) be retained, at least for small business company structures, notwithstanding that "A New Tax System" envisaged moving toward a 30% company tax rate. Again it is suggested that the definition of a small business company be by reference to the $5,000,000 threshold adopted by Division 17A of the 1936 Act.

On behalf of small business, the Association suggests that it would be a much more equitable system if taxpayers operating small businesses through companies or trust structures were able to obtain a full flow-through of tax preferences and pay tax at the current 36% rate. If large public companies want a 30% rate (as is suggested in the Financial Review of April 16 1999 (refer p.1)), because of the ability to declare higher after tax profits and attract more non-resident investors, then let them pay for it themselves by giving up some of their own tax concessions. If necessary, the Review should consider a two-tier entity system for small business and large business entities, with the threshold between the two tiers set at the $5,000,000 threshold referred to above.

The Association suggests that it is truly a "con" to offer a lower entity rate, but at the same time to broaden the tax base applying to individuals operating businesses through trust structures, by denying them the current flow-through of tax preferences. A lower entity rate is an illusory benefit for small business taxpayers as the proposed system will ensure that the overall rate of tax paid will be at the ultimate investor's marginal rate of tax (as a result of the fully refundable imputation credits attached to fully franked dividends). Whatever the entity rate is, it will give rise to a credit at the individual level at the same rate. At most a lower rate offers a timing advantage to the extent to which profits are retained in the entity. However, essentially the individual investor is indifferent to the rate of entity taxation because they receive a full credit for that entity taxation regardless of the rate at which it is imposed. A lower company rate benefits only those listed Australian companies wishing to attract non-resident investors, as a result of their reporting of relatively higher after tax profits. That is, there would be an apparent improvement in their international competitiveness!

The other part of the "con" is the myth that has been perpetuated of the necessity for a trade-off between the lowering of the company tax rate and the giving up of accelerated depreciation. That would be the case if company tax was a final tax, but in substance company tax is merely an interim tax, with further tax ultimately being payable at the shareholder level once the relevant profits are distributed. Again on behalf of small business taxpayers the Association points out that there will be no reduction in terms of the overall tax paid by a small business persons operating through a company or trust structure, as a result of such a lowering in the rate of entity taxation. Why then should small businesspersons give up the benefit of accelerated depreciation? This is just clandestine base broadening at its worst with no offsetting benefit for small business.

On the issue of tax incentives, the report states that they are designed to bias investment decisions in a particular way and, in many cases, are currently perceived as meeting their objectives at the entity level. Consequently DP2 (at paragraph 54) asserts that there are valid reasons for taxing preferred income from those sources in a different manner. With respect, that proposition cannot be accepted especially where those so called incentives are also available to taxpayers operating through other business structures

The capital works allowance is a classic example. Why should a distribution from a company or trust from this source be taxed as unfranked dividend (subject to payment of deferred company tax or the resident dividend withholding tax) and yet be tax free in the hands of a partner or individual. A person should be free to choose the most appropriate business structure for commercial reasons (including achieving limited liability) and not be constrained from adopting a company or trust structure by disadvantageous tax implications of such a structure. The proposal continues the lack of investment neutrality of the current system, whilst depriving persons operating through tax structures of the benefit if tax concessions.

For depreciating assets of the type that the capital works allowance targets, the purported concession is in reality a recognition of the reduction in the economic value of the asset and should be treated as such.

If the incentive is only available by investing in selected entities eg Research and Development expenditure then there may be a case for special treatment. However, even in that case, the Association would argue that investors in those entities are being asked to invest in untried and unproven business opportunities (ie take a high risk) and the return on their investment should be commensurate with that risk.

Even at the expense of risk to the revenue, there is no justification for disturbing the principle of consistency. If R&D is a desirable national objective then the concessions provided to encourage such investment should not be subject to revenue clawback

Income retained in entities (Overview p.18)

Since the repeal of Div 7 and the introduction of Dividend Imputation, there has been no compulsion for companies to distribute their profits regardless of whether they have been taxed in the hands of the company or comprise tax-preferred income. The income of trusts and other entities on the other hand have always been effectively taxed in the hands of the economic owner (person having a 'present entitlement') at that person’s marginal tax rate (even if not distributed). The effect of operating through a trust, partnership or sole proprietorship has been that the taxation of income has been on a ‘look through' basis where the owner of the income (and capital gains) is taxed.

For trusts, taxation occurs at the top marginal tax rate in the trustee's hands in the case of income to which no beneficiary is presently entitled.

In the case of fixed trusts, the benefit of receiving tax-preferred income tax-free, is offset by adjusting the cost base of the asset by the amount of the tax-free distribution. In effect that clawback is delayed until the disposal of the asset, except where the amount of the tax-free distribution exceeds the asset's cost base. In the latter case, an immediate deemed taxable capital gain occurs equal to the excess.

Such a system encouraged arrangements whereby companies became partners of partnerships or beneficiaries of trusts in an attempt to obtain the benefit of the lower company tax rate, whilst allowing flow-through of tax-preferred income to individual partners or beneficiaries.

With the proposed change to the taxation of trusts as companies, there will no longer be a need for such arrangements to be entered into, as any retained earnings will be taxed at the entity rate. The beneficiary will only be taxed at their marginal tax rate when that income is distributed. There is no doubt that such an arrangement will encourage retention of income in trusts.

There will also be no incentive to accelerate the distributions from companies (especially private companies). Public companies and widely held private companies will still have the pressure from shareholders to distribute dividends and the issue of hoarding profits for tax purposes should not be an issue.

To overcome the problem of entities not distributing all of their annual income, the discussion paper canvasses the possibility of dealing with profit retention by way of some form of undistributed profits tax for closely-held entities. However, there are many valid commercial reasons for profit retention including providing low cost internal finance to the organisation, a lack of available funds to distribute cash dividends and the retirement of internal debt.

The existing Div 7A rules also prevent shareholders and beneficiaries from accessing those retained funds unless a written loan agreement was entered into prior to the loan being made, and that loan agreement stipulates a minimum benchmark interest rate and complies with the requisite maximum loan term.

With those rules in place, there is no possibility of the shareholders or beneficiaries being able to cause any mischief with the retained profits. Those funds can only be used to generate additional income for the entity in question. That income would then be subject to tax at the existing corporate rate. In effect, such a process would promote increased savings and would reduce potential consumption. The delay in the receipt of any additional tax revenue from such a move would be more than offset by the benefits to the entire community from such increased savings.

NOTE: The irony is that any move by trusts to retain profits will have been generated by the very process of taxing them on the same basis as companies. Under the old rules all of the income of a trust was taxed in the hands of the beneficiaries at their marginal rate. Under the proposed rules those same trusts will be taxed at the lower corporate rate and the beneficiary will only pay additional tax (if any) when they receive a distribution.

Any move to include rules that force trusts to distribute distributions so that they are taxed at the beneficiary’s marginal tax rate actually defeats the purpose of taxing the trust as a company in the first place. The reason for this is that the beneficiary would end up being taxed on the exact same basis as under the present system. The practical effect will have been to increase the complexity of operating and managing a trust for no real gain.

In addition to the abovementioned reasons for not imposing some form of undistributed profits tax, the Association submits that the previous experience with Division 7 suggests that if such a tax were to be introduced, it would be difficult to avoid a complicated regime with high compliance costs.

Option No 1

Notwithstanding the Association's preferred position that no undistributed profits tax be introduced, where the loss to revenue is considered too great to allow trusts to retain profits, trusts and private companies could be required to distribute their profits within 8 years of the close of the financial year. Where a distribution is not made within that time, then those profits should be taxed at an additional rate (ie the difference between the tax paid and the top marginal rate at that time). When those dividends are ultimately distributed to the economic owner they would have imputation credits for the full amount of tax paid on those earnings.

Option No 2

Private companies and trusts that elect to distribute within 3 months of the end of the income year could be excluded from the requirement to have tax paid at the corporate rate. Where that election is made the shareholder and/or beneficiaries would be assessable in the income year when the profits were derived.

Option No 3

Investment companies and trusts (ie those engaged in passive investments as opposed to active investments) could be excluded from the corporate taxing rules and could continue to be taxed on the basis of the existing rules that apply for trusts. This is consistent with the collective investment proposal announced by the Treasurer on The shareholders and beneficiaries would be assessed each income year on their entitlement to the net income of the entity. The remaining companies and trusts (ie those engaged in active investments) would be subject to the new corporate taxing rules, but there would be no requirement forcing distribution of retained earnings other than market forces.

 

International taxation benchmark (Overview pp.19-25)

The rules affecting the taxation of income derived overseas by Australian residents should be the same as those for domestic income derived by residents. The amount of tax payable on any transaction or investment should be the same for each like transaction or investment regardless of the nature of the entity used.

It is fundamental that investors are not penalised for investing locally or for investing internationally. The ‘after tax’ return on an investment should be able to be determined using the same rules. For that to apply, resident taxpayers must be entitled to claim a credit for the taxes that have been paid overseas to avoid any double taxation of that income. That entitlement should apply to all taxes applied to the overseas entity and not just any withholding taxes that may have been imposed.

Likewise, the tax cost to a non-resident investor should be limited to the taxes agreed in the Double Tax Agreements. The imputation system should be modified to ensure that non-residents receive only unfranked dividends or distributions and those dividends should be taxed at the current withholding tax rate. The entity paying the dividend or making the distribution should be entitled to claim a refund of corporate tax paid (if any) in respect of those dividends or distributions.

Where the non-resident’s country of residence taxes that income on a more concessional basis than Australia, then that dividend or distribution should be required to be paid as a fully franked dividend with no withholding tax imposed. The linkage between a fully franked dividend and an exemption from dividend withholding tax involves no change from the current system. The requirement for certain dividends paid to non-residents to be fully franked is consistent with the current requirements (as a result of the operation of the anti-dividend streaming rules) where fully franked dividends are paid to resident shareholders. However, the proposal is more extensive in its operation than the current requirements and involves a different "trigger" for its operation.

As Australia is a net importer of capital, it is essential that our tax laws provide an environment that is conducive to international investment. Eliminating any possible double taxation of dividends or distributions provides the benchmark for such an outcome.

NOTE: The rules regarding distributions to non-residents will need to ensure that those dividends and distributions are directed to bona fide non-residents to avoid any possibility of avoidance practices emerging.

Tax Incentive Benchmark (Overview p.25/26)

The Association agrees with the business design principle that business tax incentives should be provided only following a formal assessment of their net impact on the national policy objectives, and only where assessed to be an essential or superior form of government intervention.

Reforming the Taxation of Investments (Overview pp.26-47)

Measuring Income from Assets and Liabilities

The Association agrees that, because of the potential simplification benefits, it is appropriate to move tax value closer to commercial value (paragraph 98,p.27 DP2).

It is also considered appropriate in measuring and taxing changes in value of assets and liabilities to adopt a combination of the mark-to-market, estimated asset life, accruals and realisation approaches depending on the class of asset and its particular characteristics (paragraphs 118 to 129).

The Association endorses as a matter of principle, an approach which measures gains or losses in respect of transactions involving debtors and/or current liabilities based on the actual economic value of those assets/liabilities, rather than their nominal or face value. However, the practical issues involved in such a valuation exercise may make the adoption of that principle unworkable (paragraphs 137-141).

Recognising Expenses

The Association welcomes the recognition of the need to fundamentally reexamine deductibility (paragraph 151). It is agreed that a priority issue in this regard is to provide tests for deductibility which ensure that there are no longer "black hole expenditures" which "fall through the cracks" in that they are capital in nature, and, therefore, denied deductibility under s.8-1 of the 1997 Act (formerly s.51(1) of the 1936 Act), and also not within the scope of the depreciation/capital works provisions. The Association agrees wholeheartedly that the income tax system should provide general recognition for the decline in value of all wasting business assets acquired by a taxpayer (paragraphs 143-147).

The move towards a more generalised treatment of income across all business activities, with annual deductions for interest allowed to the extent to which the associated borrowings are used to earn assessable income (broadly defined to include capital gains) is a positive one. This is an improvement on the current approach in respect of assets held for private purposes (ie the only income expected to be derived is on realisation of the relevant asset), where the interest would be included in the cost base (at least where the asset was acquired on or after 21 August 1991) for capital gains tax purposes. The Association agrees that it is appropriate to treat interest as the cost of maintaining access to capital funds underlying an investment. It follows that it should be deductible provided that there is a chance of deriving assessable income in some form (including but not limited to a capital gain) at some time in the future (paragraphs 168-173).

Rationalising Tax, Legal and Accounting Treatment

It is a valid process to consider whether legal concepts grafted on to the tax law from other legal areas are consistent with the object of moving the tax value closer to commercial value. If they do not, then the Association agrees that it may be appropriate to devise alternative formulations which do further that object (paragraph 177).

The Association also welcomes further consideration being given to alignment of accounting and tax principles in the two senses noted by the Review; namely, first basing tax rules generally on accounting standards for the recognition of revenue and expenses, and secondly, using some financial reports such as the audited financial statements of public entities, as the basis for calculating taxable income, or as the starting point for that calculation (paragraph 179). Such an alignment would undoubtedly promote the achievement of the third national objective of facilitating simplification with the associated benefit of lowering system operating costs. It would avoid or at least greatly simplify the current time-consuming task of reconciling accounting profit and taxable income.

Reforming the Taxation of Entities (Overview pp 47-59)

The Association agrees that persons should be in a position to make commercially optimum decisions (including choosing commercially optimum business structures) without bias from the business tax system. However, the Association considers that it is more appropriate that companies be taxed like trusts currently are, rather than the other way round. Such a system would achieve both equity and neutrality. For a more detailed discussion of the Association's position in this area, reference should be made to the discussion appearing above under the heading "Investment Neutrality Principle (Overview p.13) and Distributions of Tax-preferred Income (Overview pp.16-19)".

Unlike the government proposal, allowing flow through of tax preferences in sole trader, partnership, trust and company structures, would achieve virtual neutrality between business structures (as well as promoting equity). The different treatment of tax losses between different structures would prevent the achievement of complete neutrality. However, it would still be a great improvement on the government's proposal to tax trusts like companies.

The Association does, however, applaud one aspect of the government's proposed entity regime; namely, the proposal for refunds of excess imputation credits to be available to resident individual taxpayers and complying superannuation funds (with special arrangements for registered charities) (paragraph 201). This removes the current anomaly whereby excess imputation credits are lost which operates inequitably in the case of low income earners and complying superannuation funds which receive franked dividends (paragraph 204).

Tax Avoidance and Evasion (Overview pp.57 &58)

The Association agrees that it is better to have a single comprehensive general anti-avoidance measure, rather than resort to complex, specific anti-avoidance measures to ensure the integrity of the tax system (paragraph 222). However, the Association expresses its concern at the tendency in recent times to adopt a very low threshold test in specific anti-avoidance rules (dividend streaming and franking credit trading rules, for example) and in the new general anti-avoidance rule (s.177EA) incorporated into Part IVA.

Those rules have adopted a purpose test of "a purpose other than an incidental purpose", instead of the traditional Part IVA "sole or dominant purpose" test. In the Association's view such a test sets far too low a threshold for the operation of any anti-avoidance test (specific or general). It is understandable that the Commissioner may wish to lower the threshold below the Part IVA standard. However, it is submitted that a "significant purpose" test would be an appropriate compromise. This should both meet the Commissioner's concern at the difficulty of satisfying a Court even to the "dominant purpose" standard, but at the same time avoid catching "innocent" taxpayers in an anti-avoidance "net". It is noted that the Explanatory Memorandum to the dividend streaming anti-avoidance rules suggests that the "purpose other than an incidental purpose" test and the "significant purpose" test, equate. However, the Association submits that the former sets a much lower, and in its view, inappropriate, threshold.

The Association expresses its concern at the implicit suggestion that the continuity of ownership test (currently applying to the carry forward of company losses) would be abandoned. DP2 suggests as an alternative a measure requiring losses to be quarantined and allowed only against future assessable income in the same or similar activity (paragraph 226). The latter seems very similar to the "same business" test, which currently only applies if there is a failure of the continuity of ownership test. It would seem more appropriate to retain those tests and apply them to carried forward and current year losses of both companies and trusts under the new entity regime. This would imply a scrapping of the current, extremely complex trust loss rules.

Fringe Benefits Taxation (Overview pp.58 &59)

The Association considers that it would be appropriate to abolish FBT, and tax benefits, like other remuneration, in employees' hands. The change in the law to require the inclusion of essentially all fringe benefits on group certificates from 1 July 1999 (and in some case from 1 April 1999) will facilitate such a reform. It is noted that the Treasurer has dismissed out of hand such a change. However, the Association does not accept the Treasurer's purported reason for rejecting this mooted reform; namely, the administrative complexity of dealing with millions, rather than thousands of FBT payers. The taxation of benefits could easily be incorporated into the current PAYE arrangements. This would, if anything, be less administratively complex than the current system, as it would avoid the need for the FBT registration of employers providing benefits to employees. Such employers would in virtually all cases be registered for group tax purposes, thus stripping away one layer of complexity in the tax administrative arrangements.

Abolishing FBT and including benefits in employees' income would be more equitable from the point of view of taxing the recipients, rather than the providers, of such benefits. In addition, it would also overcome another more insidious inequity of the current system; namely, that many thousands of ordinary taxpayers with marginal rates well below the top marginal rate of 48.5% are forced to effectively pay tax on benefits at that top marginal rate. In saying this, the Association recognises the economic reality that virtually all employers pass on the FBT cost to their employees. The Association also notes that the only reason for the introduction of a system whereby fringe benefits are taxed in employers', rather than employees', hands, was purely political. The then Labour Government wanted to "plug" gaps in the then very narrow tax base, whilst at the same time placating its union constituency by not, in form at least, imposing an extra tax burden on union members.

The Association notes with some concern, consideration being given to a reduction in the concessional valuation of motor vehicle benefits (paragraph 228). If its becomes unattractive for employees to receive car benefits, then this is likely to have a dramatic effect on purchases of fleet cars (a very high proportion of which currently consist of locally manufactured cars). The Association notes the presence of other factors adversely affecting the local car industry. These include the increased import competition flowing from the phased reductions in car tariffs, together with the likely deferral of new car purchases associated with the abolition of relatively high sales tax and the introduction of a much lower GST on cars. The combined operation of all of these factors may prove a virtual knockout blow for the local car industry.

Assessing the Scope for Trade-offs between Base and Rates (Overview pp.63-72)

Applying the Revenue Neutrality Constraint

The Association disagrees that revenue neutrality dictates that a lowering in the company tax rate must be accompanied by reforms to the taxation of business investments that, in aggregate, represent net base broadening (paragraph 249). As noted in the discussion above under the heading "Investment Neutrality Principle (Overview p.13) and Distributions of Tax-preferred Income (Overview pp.16-19)", this proceeds on the basis of a logical fallacy that company tax is a final tax. Lowering the company tax rate merely lowers the proportion of company profits that bears tax up-front. When those profits are distributed, the extra tax (if any) needed to 'top up" the total tax payable to the top marginal rate will be paid by such high income shareholders. Other taxpayers will obtain refunds so that the total tax paid will be based on the marginal rate of each recipient shareholder. Clearly under such a system, a reduction in the company tax rate will not prejudice the revenue. There is merely a possible timing effect because of the ability under the current tax system to retain profits in a company. That occurs in any case regardless of the rate at which company tax is set!

The Association suggests that revenue neutrality should be measured by reference to the current tax system not by reference to the "Government's fiscal figuring that reflects the budgeted-for tax reform measures announced in A New Tax System" (paragraph 250). Such a measurement of revenue neutrality prevents taxpayers being compensated for the revenue "take" by the government flowing from the proposed denial of flow through of tax-preferred income in trusts. This is extremely inequitable!

 

Broadening the Investment Base

For the reasons indicated above, the Association does not accept that without the removal, or substantial reduction, of accelerated depreciation, there is limited scope for company rate reductions (paragraph 259). As noted earlier in this submission, on behalf of small business the Association rejects the introduction of a lower company tax rate on this basis. Small business obtains no real benefit from a reduction in the company tax rate. Ultimately under the proposed system, the owners of small businesses conducted through companies or trusts will pay tax at their marginal rate of tax regardless of the rate at which company tax is set. Accordingly, if a lower company rate will only be introduced accompanying by substantial dismantling of accelerated depreciation, then small business owners would be penalised without any accompanying benefit.

Alternative Capital Gains Taxation

The Association agrees that it is appropriate to take steps to make Australia's CGT system more internationally competitive (paragraph 266). One area that requires reform is the need for scrip for scrip CGT roll-overs. This would facilitate achievement of 2 of the National Objectives; namely, optimising economic growth and ensuring equity.

The proposal to examine the case for removing indexation is strongly rejected. It is inequitable that taxpayers should be taxed on nominal, rather than, real gains. There is no justification for denying taxpayers a cost base reflecting inflationary effects over the period that an asset is held.

Meeting the National Objectives

The Association again strongly indicates its disagreement with the suggestion that the government's proposed unified treatment of a limited range of business entities would significantly improve equity (paragraph 276). Those proposals would achieve neutrality in terms of the tax treatment of trusts and companies. However, as indicated earlier in this submission, that neutrality is achieved at a significant equity cost. In the Association's view, equity, and indeed, true neutrality, demands flow-through of tax concessions through all business entities (sole proprietorships, partnerships, companies and trusts).

 

COMMENTS ON SPECIFIC CHAPTERS

 

CHAPTER 1 - TOWARDS A NEW POLICY FRAMEWORK FOR
WASTING ASSETS

Overview

DP2 proposes a range of simplification measures for depreciation of tangible and intangible assets in this chapter. The options centre around the following questions:

    • Who should be entitled to deductions for wasting assets, ie the person who bears the economic loss or those that have control of the economic benefit?
    • When should deductions commence , ie when the asset is first used to produce income or some other method?
    • What should be the cost base for deductions, actual cost or alternatively, an amount based on expected reduction in market value?
    • What should be the write-off period , ie. effective life with special rules for buildings?
    • What method of depreciation should be used?
    • What should happen on disposal - should a profit be taken to assessable income or should a roll-over of the balancing adjustment be allowed?;
    • Should the regime be comprehensive with current non-deductible expenditure being included (the so called "black hole expenditure")?

Analysis and Recommendations

In its comments on this Chapter, the Association has taken a small business perspective.

Who Should Be Entitled To Deductions?

For simplicity the option based on who incurs the expenditure on the asset to produce assessable income would be preferred over the Accounting Concept of Control or legal ownership.

Most small businesses operate relatively unsophisticated accounting record systems, often based on cash balance at bank as a benchmark of profit. The introduction of the concept of control and who legally owns the asset would complicate their understanding of their business assets.

It is currently often difficult for small business operators to understand the concept of depreciating capital items they acquire. Introducing concepts of whom has legal ownership or "economic control" over an asset adds a further layer of complexity.

 

What Should Be The Cost Base For Deductions?

Deductions should be based on the cost or market value of gifted items as currently exists.

The alternate based on accounting concepts of depreciating the carrying value less the expected recovery on disposal, again introduces unnecessary complications and judgmental issues that would only add to the cost of compliance to small business.

Where subsidies are received in respect of the acquisition of the item, the preferred option would be reduction of the cost base for deduction purposes equal to the subsidy received.

The current provisions require subsidies or bounties for capital expenditure to be treated as assessable income. This can be unduly harsh on small business, as they tend to use most of their cash in-flow in the business and find it difficult to set an amount aside for tax.

The Association prefers the alternative approach put forward in DP2, noted above, of reflecting the subsidy or bounty in a lower cost base for the asset. Reducing the cost base would have the effect of taxing the subsidy over the write-off period for the asset - because of the lower depreciation deductions - rather than immediately. This would be a more concessional approach and would be welcomed by small business.

When Should Deductions Commence?

It is unlikely many small businesses would incur expenditure for wasting assets where there would be significant delay between acquisition and its use for business purposes. However, in principle the use of the current rule of write-off commencing upon the asset being installed ready for use is considered appropriate.

Over What Period Should Assets Be Written Off?

For small business the shorter the time frame for allowing a tax deduction for the capital outlay the better. Some consideration could be given to introduction of 100% write off of wasting assets acquired by defined taxpayers such as small business. This would save a lot of time and effort in maintaining depreciation schedules and asset registers and simplify record keeping. Obviously this would need to be a political decision designed as a concession or stimulus to a particular sector. However, in the absence of a 100% write-off, in principle the write off over the effective life (with continued application of the accelerated depreciation provisions -see comments on Chapter 2 of DP2) is favoured.

The current system of self-assessment or as an alternative adopting the effective life published by the Australian Taxation Office ("ATO"), is the preferred option. However, as identified by DP2, the ATO needs to urgently review and update their Table of depreciation rates on a consistent basis. This has not occurred for some time. There is also a need to include depreciation rates for more modern technology such as CD players, microwaves, dishwashers and dryers.

Should Buildings And Structures Receive Special Treatment?

Buildings and other structures should be depreciated and incorporated into the general depreciation regime. There is no compelling reason to have separate divisions in the tax legislation for the write-off of buildings as currently exists.

There already exists for the primary production sector the ability to depreciate buildings and improvements. This concept should be extended to all sectors.

A tax deduction should be extended to all buildings currently being used for producing assessable income. The options contained in DP2 limit the eligibility to buildings constructed or acquired after a specific date. To not extend depreciation deductions to all buildings would mean that certain business proprietors may purchase or construct a building because it qualifies for a depreciation deduction rather than acquire a building which is more suitable to their needs. This would not meet the policy design principle of investment neutrality (paragraph 34).

The introduction of a universal write-off for all buildings would require the adoption of transitional provisions and valuations, for buildings not currently qualifying for a write-off deduction.

Should Special Rules Apply to the Resource Sector?

The Association is of the view that either this does not have application to small business or the small size of the anticipated population affected does not warrant detailed consideration.

Should There Be Immediate Write-Off For The Small Items?

There should be an immediate write off for small value/low effective life items. This is justified simply on the record keeping requirements. There needs to be consistency between the Act and the Commissioner's Ruling on this issue. Currently the Act allows for items of less than $300 to be immediately written off but for some industries (the resource sector) and certain taxpayers, the Commissioner allows items up to a $500 amount to be written off immediately. Allowing a $500 write-off limit for depreciable assets for all businesses would ensure equity amongst all taxpayers and facilitate simplification.

The proposal to allow write off of items falling below a value or percentage of cost would be welcomed. However, the figure should be consistent with the small value limit adopted, ie. the current $300 (or $500) rather than the $100 suggested in DP2. The suggested alternate test of allowing a write-off when an item reaches 4% of the original cost, is also too low.

To avoid manipulation of this arrangement, an upper limit of say $10,000 should be set for annual deductions for items falling under this category.

Although not considered by DP2, the Association is of the view that the $300 or $500 limit for immediate write off should be indexed annually to the CPI. This indexation of threshold amount exists in other provisions of the Act.

What Write-Off Method Should Apply?

The majority of small businesses would be likely to adopt the Diminishing Value Method for acquisitions, as it initially provides the greater deduction, and hence faster return, on invested capital. The adoption of the write off for small balances would be welcomed.

The Association is of the opinion that there is no valid argument for the adoption of a single depreciation method using diminishing value over straight-line depreciation as is proposed. Two methods for depreciation do not overly complicate the tax system, but rather provide flexibility to reflect different wasting characteristics of assets and personal preferences of taxpayers. It is noted in this regard that some small businesses prefer the straight-line method, as it is simpler to calculate and administer.

How Should Assets Be Taxed Upon Disposal?

When an item subject to depreciation is disposed of, "balancing adjustments" arise to the extent the consideration differs from the written down value. A further tax deduction is available when the consideration on disposal of a depreciable asset is less than the written down value. On the other hand, an amount is included in assessable income when the consideration exceeds the written down value.

Where the balancing adjustment results in a profit to be included in assessable income, the Act currently allows the amount rolled over and offset against the cost of replacement or other depreciable assets.

The ability to apply balancing adjustments to replacement or other depreciable assets is similar in nature to the small business roll-overs under the current Capital Gains Tax ("CGT") provisions. The removal of such a concession would mean that a taxpayer would be liable to tax on the profits on the sale of plant and equipment even though they used the proceeds to purchase new plant and equipment. The removal would make it more difficult for businesses to upgrade plant and equipment and would again fail the national objective of seeking to provide the smallest impediment to economic growth.

How Should Black Hole Expenditures Be Treated?

Black Hole expenditure is expenditure which is neither deductible nor available for write-off. One such type of expenditure is feasibility studies and market surveys. DP2 recommends that unsuccessful feasibility studies and market surveys be deductible at the time of abandonment. On the other hand DP2 recommends that successful feasibility studies and market surveys be included in the cost of the asset and written-off in accordance with the write off rules associated with that asset.

It is unlikely many small businesses would incur significant expenditure on the other Black Hole items considered by this part of DP2 (eg. prospectus and underwriting costs, takeover defence etc.). However, a consistent treatment of this form of expenditure is welcomed.

Key Recommendations

The adoption of the simple rules with regards to depreciation including the

following concepts:

the taxpayer who incurs the cost of expenditure on the asset should

be entitled to the depreciation deduction.

. the deduction should be based on actual cost; and

. deductions should commence when the item is installed ready for

use. The Association recommends that all assets including buildings be written

off based on their effective life.

Small items (of say, less than $500) should be deductible in full in the year in which the expenditure is incurred. This $500 threshold should be indexed annually for movements in the CPI.

The Association recommends that a choice continue to be offered to taxpayers between the diminishing value depreciation method and straight-line depreciation.

Balancing adjustments should be allowed to be offset against the cost of new or existing depreciable assets. The removal of this concession will make it costly and therefore more difficult for businesses to upgrade their plant and equipment.

The Association strongly favours the introduction of legislation providing for tax deductibility of Black Hole expenditure.

 

Chapter 2 - The Case for Accelerated Depreciation

Overview

Chapter 2 looks at the current accelerated depreciation provisions and whilst acknowledging such provisions are about timing, reaches the view that the accelerated deduction may be seen as a "loan" by the Revenue. DP2 seems to suggest that the accelerated depreciation provisions should be abolished as part of the trade-off for the reduction of the corporate tax rate to 30%.

Analysis and Recommendations

Replacing Accelerated Depreciation with an Effective Life Regime

Currently depreciation is based on the effective life of the item and the accelerated depreciation rates are applied.

For the reasons set out in the Association's comments on the Overview section of DP2, the Association rejects the concept of a substantial dismantling of the accelerated depreciation regime in return for a reduction in the company tax rate. The Association also notes that such a strategy would be inconsistent with promoting the National Objective of optimising economic growth, as it would undoubtedly discourage capital investment. The Association notes the current expressions of concern that (the current high levels of) growth is being fuelled merely by consumer sentiment, whilst there is a simultaneous run-down in capital investment items. In such a climate the Association notes that anything which is likely to adversely effect capital investment is a matter of grave concern.

DP2 is clearly biased toward the perspective of larger international corporations with its emphasis on international competitiveness.

Apply Effective Life Depreciation with a Loading

There are no compelling grounds to replace the current system with one based on effective life with a loading. This is basically what accelerated depreciation is all about.

Key Recommendations

    1. Accelerated depreciation provides an incentive for small business to invest and update its plant and technology. The accelerated depreciation regime should be retained because :
  • it provides an incentive for capital investment which promotes the achievement of the national objective of optimising economic growth; and
  • There would be no reduction in the overall level of tax paid by the economic owners of small businesses carried on through trusts and companies as a result of a reduction in the rate of entity taxation. Accordingly, there is no justification for abolishing or emasculating the current accelerated depreciation regime.
    1. To the extent to which large business favours the reduction in the company tax rate with accompanied abolition or emasculation of the current accelerated depreciation regime, then such an approach should be adopted for large entities only. A different regime with a higher entity tax rate, availability of accelerated depreciation and full flow-through of tax preferences should be available for small businesses (defined possibly by reference to the $5,000,000 asset threshold utilised in Divisions 17A and 17B (small business roll-over and retirement exemption) of the CGT provisions).

Chapter 4 - Determining The Appropriate Treatment Of GoodwilL

Overview

DP2 raises the issue of an annual deduction for Acquired Goodwill but does not provide any recommendations. Currently there is no write-off on an annual basis for acquired goodwill. Acquired goodwill has a cost base for capital gains tax, this being used in the calculation of any gain or loss on ultimate disposal.

Analysis and Recommendations

Option 1 Allow Acquired Goodwill to be Depreciated

A deduction for acquired goodwill would be welcomed by all, in that it would provide an improved return to the purchaser. It would also bring the tax treatment into line with the accounting treatment (paragraph 4.18). DP2 indicates that on subsequent sale there would be an inclusion in assessable income of the total goodwill less any undeducted acquired goodwill, that is, a recovery of previously allowed amounts.

DP2 notes that if acquired goodwill were allowed to be depreciated, it would be deductible much earlier whilst created (internally generated) goodwill would still only be taxed on realisation. In order to achieve symmetry between acquired and internally generated goodwill, consideration could be given to recognising losses and gains in respect of the latter. However, this would create another difference between tax and accounting treatment of goodwill, as accounting standards do not allow the value of internally generated goodwill to be recognised in the books of a business. In addition, as noted in DP2 (paragraph 4.17), there are practical difficulties in valuing goodwill. This is particularly the case where there is no evidence as to the premium, which an arm's length purchaser would pay for a business over and above the market value of the physical and identifiable intangible assets of that business.

Option 2 Retain the Current Treatment

The current Act does not provide a deduction, but recognises any loss or gain on disposal of goodwill (subject to CGT concession and roll-over).

DP2 also raises the concept of the recognition of losses as well as gains during the ownership period. For example, if acquired goodwill decreases in value the taxpayer would be allowed to claim the decrease as a tax deduction. The adoption of such a position would add to compliance cost, and complexity as valuations would be needed.

There also exits at the moment a difference between the legal concept of goodwill (following Murry's Case 98 ATC 4,585) and the accounting concept.

Key Recommendation

The Association supports a deduction for acquired goodwill. To facilitate simplification a deduction should be allowed on a straight-line basis, say, over 10 years.

Chapter 11 - Towards a More Competitive Regime For Taxing Capital Gains

Overview

Chapter 11 of DP2 looks predominantly at the treatment of capital gains in respect of investments. The initial part of the Chapter is devoted to questioning various economic outcomes that may be affected by the taxing of capital gains.

The Chapter then proceeds to look at specific policy options being:

CGT provisions for individuals.

Scrip-for-scrip roll-over relief.

Targeted concession for certain types of investments.

CGT provisions for small business.

Analysis and Recommendations

CGT Provisions For Individuals

Currently any taxable capital gain is included as taxable income and taxed at the individual's marginal rate of tax, subject to a form of averaging in calculating the rate of tax applicable to the capital gain.

DP2 provides some preliminary views and alternate treatments for Capital Gains Tax, these being:

        To cap the CGT rate for individuals at 30%;
        The adoption of a step rate CGT depending on the time over which the asset is held;
        The introduction of a $1,000 per annum CGT tax-free threshold.
        It also proposes the elimination of indexing and averaging. This is addressed in Chapter 12.

It is difficult to predict the impact of a rate reduction or other changes to taxing of capital gains on small business or its operators. It obvious for some the imposition of a tax on capital gain at the marginal rate is an important factor in the decision whether to realise an asset or not. A step rate CGT depending on the time over which an asset is held would merely influence the sell decision and may lead to assets being held until the lowest step rate is available. This influence could be counter-productive for small business in that the owners may hold on to an asset well past the time of its usefulness.

The Association believes that capital gains should be taxed separately from other types of income. We also believe that the rate should be set sufficiently low to encourage investors and entrepreneurs to invest in new and existing business enterprises in Australia. The rate should be commensurate with the U.S. and be no higher than 20%.

The introduction of a threshold of $1,000 exemption would alleviate often troublesome compliance calculations yielding little or no reward to the Revenue. However, the Association believes that the threshold is too low and would not provide any real benefits to small business.

 

Scrip-For-Scrip Roll-over Relief

The Association would welcome the introduction of roll-over relief on a scrip-for-scrip basis. Indeed the Association has been one of the main bodies leading the push for such a reform for some time. Although this would not have a major impact on small business, it would benefit many small shareholders and companies and would remove an impediment to current scrip for scrip disposals. The proposal would improve equity in such circumstances. The reason that the current situation is quite unfair is that shareholders may be compelled to sell, either by a legal (compulsory acquisition of minority shareholders where the takeover company reaches a 90% or more holding in the target company) or economic imperative. However, in a pure scrip for scrip takeover, they will receive no cash with which to discharge a CGT liability. In many cases shareholders have intended to hold the target shares for the long term. This was the case, for example, for many of the former Bank of Melbourne shareholders in the Bank of Melbourne/Westpac merger.

The Association noted that several economic commentators have recently suggested that a scrip for scrip CGT roll-over would provide a substantial stimulus for takeover activity. This should promote the National Objective of optimising economic growth. Specifically, it should promote that objective by ensuring that managers of underperforming companies are subject to the ultimate sanction of takeover. Takeovers may be more likely to succeed in that shareholders will not be constrained from selling their shares if that is the optimum commercial decision, by being subject to CGT (but without having received any cash to discharge that liability). That is, it removes the tax bias from the commercial decision whether to sell the shares or not.

Targeted Concessions for Certain Types of Investments

DP2 indicates that, in order to promote improved international competitiveness, generalised CGT relief should be considered for investments in high technology start up companies.

The Association supports such a concession as it provides the necessary stimulus for such ventures to be established in Australia and not overseas as at present. The current CGT system and the penal level of tax rates operate to stifle development of high technology businesses in Australia. It is also one of the contributing factors for the brain drain of Australian technologists to other countries where more favourable treatment is available.

CGT Provisions For Small Business

DP2 addresses the current concessions available to small business :

1. CGT roll-over relief where a small business operator disposes of some or all of their business and reinvests the proceeds (Division 17A);

2. the CGT exemption where the proceeds from the sale of an asset active of a business are used for retirement (Division 17B); and

3. the 50% concession for goodwill (Division 19).

DP2 acknowledges the complexity of the current small business exemption and roll-over provisions, and the difficulty in administering the 50% goodwill concessions because of a lack of a precise meaning of goodwill and difficulties in valuation. The current small business roll-over and CGT exemption provisions are often an impediment to proper structuring of a business, particularly with regards to the protection of assets from commercial activities. This leads to a need to compromise in order to remain eligible for the small business CGT concessions currently available. However, the Association welcomes in this context the announcement made in A New Tax System of the extension of such provisions to cover situations where land and buildings integral to a business are owned by an entity related to the entity operating the business. Broad design details as to the manner of operation of these new measures were released by the Tax Office on 13 August 1998 (document no. 077).

DP2 proposes a possible substitution of the current goodwill exemption with a 20% exemption on the disposal of all active assets of a small business. Small Business for this purpose is defined as those with net assets of less than $5 million.

On the basis of simplicity, the availability of an alternative general exemption would be welcomed. However, as there will be many situations where the substantial part of a capital gain relates to the goodwill component of a sale, the Association submits that the 50% goodwill and other concessions should still be available, at the option of the taxpayer, instead of the general exemption. In addition, the Association queries whether the 20% level would be generally high enough to compensate for the amount of CGT which would be exempt if the 50% goodwill exemption were applied.

Key Recommendations

An alternative to taxing at the individual rate of tax by providing a $1,000 CGT tax free threshold and capping the tax rate on capital gains at 30% may stimulate some taxpayers to free up existing investments. In certain circumstances these proposed changes may be advantageous to small business. However, in most cases small business would prefer the choice of having the current averaging concessions apply.

A better option is to cap the rate at 20% in line with the U.S.

The $1,000 pa. CGT tax free threshold will do little to alleviate record keeping or administration for Small Business. The amount is too low. We would recommend that this threshold be increased to $5,000 and be indexed to annual movements in CPI.

Scrip for scrip roll-over relief would be welcomed.

The Association does not endorse the suggested removal of the existing 50% goodwill concession and Small Business exemption. Rather those provisions should be retained. Taxpayers should be given the option to utilise those provisions or the proposed generalised exemption of a % of all capital gains arising on the disposal of active assets of a small business.

The Association submits that a higher percentage than 20% of all capital gains would need to be exempted in order for the generalised exemption to be an attractive alternative.

 

Chapter 12 - Indexation, Averaging and Quarantining Of Losses

Overview

Chapter 12 of DP2 looks at the removal of indexing, averaging and quarantining of capital losses. This is on the basis that any adjustment to the CGT provisions of themselves would need to be revenue neutral and therefore any concessions provided or outlined in the previous Chapter and those in Chapters 13 and 14 would need to be compensated for.

Analysis and Recommendations

Make The Treatment Of Assets More Uniform By Removing Indexation

DP2 notes that Australia is one of the few countries that indexes the cost base of an asset in calculating the capital gains.

DP2 proposes removal of indexation from all assets or alternatively only from assets eligible for depreciation.

The original rationale for the adoption of indexing to determine a capital gain was such that taxpayers should only be assessed on their "real" capital gain, that is, after allowing for inflationary effects.

Whilst we are currently in low inflationary times the inflationary impact is probably minimal. However, should higher inflationary times exist, then the removal of indexation will cause the taxation of a gain where there may not be any real gain on the disposal of the asset. The inflationary impact of the introduction of GST is an example.

Although the removal of the indexation provisions may facilitate simplification of the tax legislation it imposes an impediment for economic growth. In a high inflation environment taxpayers may be reluctant to dispose of assets when they need to acquire more efficient or better assets. In addition, such a suggestion fails the national objective of ensuring equity, as equity demands that taxpayers should only be subject to tax on real, rather than, nominal gains.

There is clear distinction between appreciating assets and wasting assets. The Association would accept that wasting assets should be removed from the CGT system and be subject to balancing adjustments on disposal under the depreciation rules. Indexation for appreciating assets should be retained. Together with the capping of the rate at 20%, it would provide the basis for a world’s best system and would excourage the development and relocation of new businesses to Australia.

Modify the Rules for CGT Averaging

DP2 considers that the averaging provisions should be removed because of the apparent "abuses" by taxpayers of the concession.

Currently in the calculation of the rate of tax payable on the taxable capital gain component of taxable income a form of averaging applies. Basically the taxable capital gain is divided by 5, with that amount being added to ordinary income to calculate a rate of tax applicable to the taxable capital gain. The amount calculated is then multiplied by 5. The effect for some is that the taxable capital gain component is taxed at a lower marginal rate.

The "abuses" referred to are the fact that taxpayers are actually utilising the averaging concessions by disposing of CGT assets when their ordinary income is low. If this is "abusing" the concession it makes you wonder what would be considered legitimate usage. DP2 seems to have overlooked one of the original concepts of tax; namely, that is taxpayers should be able to legitimately use the tax measures available to order their affairs (choice principle).

The Association disagrees strongly with the proposal to abandon CGT averaging. Equity demands that taxpayers not be penalised when a relatively large capital gain takes them into a higher tax bracket. The averaging provisions are an appropriate way of dealing with the "lumpy" nature of capital gains ie that they are not derived evenly on a periodic basis, unlike ordinary income.

Reform the Taxation Treatment of Capital Losses

Currently capital losses are quarantined and can only be offset against realised capital gains.

DP2 proposes the following options in respect of capital losses these being:

1. Allow carry forward at an appropriate interest rate;

2. Allow carry back of losses to offset earlier gains;

3. Remove quarantining of capital losses where gains on assets are

assessed on an annual basis;

4. Limit quarantining of past and future losses to shares and units in

trusts.The Association submits that capital losses should be claimable in the year they are realised. That is, Option 4 is endorsed. Under the current system a capital gain is included in assessable income and capital losses are quarantined and can only be offset against a capital gain. This restriction on capital losses has often been criticised as inequitable.

Given that tax is calculated by looking at an artificial time frame, the proposed option 2 allowing the carry back of capital losses to offset against earlier capital gains, is an improvement on the current system, but does not achieve symmetry.

The other options proposed by DP2 offers little benefit to small business or indeed ordinary taxpayers. Option 3 would lead to additional compliance costs by requiring annual valuation and assessment of any unrealised gains. Option 4 effectively creates different classes of capital losses with the effect that the system remains distorted. In other words, the existing problems with the CGT system are replicated.

The Association favours a system where a refundable rebate is available against any excess losses in the income year those losses are realised. That rebate would be calculated by reference to the person’s marginal tax rate, but be capped at 20%. That would result in symmetry between gains and losses.

 

Key Recommendations

Indexation should be retained for the calculation of taxable capital gains. Equity

demands that only real gains be subject to tax.

The current CGT averaging process be retained as an appropriate mechanism for dealing with the "lumpy" nature of the derivation of capital gains. Again equity demands that such averaging be available.

The carry back of capital losses to be offset against past capital gains, is an improvement on the current system, but the Association recommends that capital losses be available for a rebate capped at 20% in the year the capital losses are realised.

 

 

 

 

Chapter 13 - Involuntary ReceiptsOverview

DP2 recommends that "involuntary receipts" (ie various forms of compensation for loss or damage to, or compulsory acquisition of, an asset) be given a simpler and more consistent treatment - especially in view of the equity problems associated with their current treatment.

As a result two options are put forward:

Option 1 - treat involuntary disposals as a realisation event for taxation purposes with there being no distinction between voluntary and involuntary receipts; and
Option 2 - distinguish between voluntary and involuntary receipts by deferring the tax liability on the latter in certain circumstances.

In view of these options, DP2 also outlines associated policy issues to be addressed. These include:

What is the appropriate boundary line for determining whether a transaction is involuntary?
How do the CGT and income tax provisions interact in relation to compensation receipts
Should pre-CGT status be maintained for replacement assets?
What treatment should apply to losses?
Is there a need for anti-avoidance rules?
What restrictions are necessary on the availability of Option 2 treatment?

Analysis and Recommendations

Under existing CGT rules, compensation receipts for involuntary disposals are taxed in an inconsistent manner and, in some cases, on the basis of the Commissioner's administrative practices.

DP2 offers two options - neither fully addressing all of the problems. Option 1 proposes the removal of existing legislative and administrative concessions. It makes no distinction between involuntary compensation receipts and other receipts. In the Association's view, Option 1 is inequitable. Under Option 1 taxpayers will be liable to tax on compensation received from an involuntary disposal, notwithstanding that this CGT event was triggered by events outside the taxpayer's control. Such an approach would prevent taxpayers from having sufficient funds to replace the asset which was subject to the involuntary disposal.

The second option is to effectively codify the current administrative arrangements in addition to the existing statutory concessions.

Unfortunately, DP2 deals only with compensation for loss of physical assets and fails to propose solutions to the more difficult issues arising in relation to compensation for negligence and breach of contract.

With regards to the key policy issues we make the following specific comments:

What Is the Appropriate Boundary Line For Determining Whether A Transaction Is "Involuntary"?

In many cases a Government or public authority has the power to compulsorily acquire an asset. However, in many cases that entity will choose not to exercise that power, and will acquire the asset instead by mutual agreement with the owner.

The Association recommends that an involuntary receipt is defined as any amount received where the acquirer has the power (even if not actually exercised) to compulsorily acquire the relevant asset. This will give the term a very wide meaning, and should specifically include situations described above.

How Do the CGT and Income Tax Provisions Interact In Relation To Compensation Receipts?

The Association recommends in this situation that the CGT provisions apply to any involuntary receipt dealing with the disposal of an asset. However, the Association agrees with DP2's recommendation that compensation for loss of business profits or loss of earnings should be subject to ordinary income tax as currently exists.

Should Pre-CGT Status be Maintained for Replacement Assets?

DP2 suggests that if there is a case for treating involuntary receipts differently from voluntary receipts, then there is a case that the pre-CGT exempt status of the asset is retained. That is, where the involuntary receipts (being compensation for disposal of a pre-CGT asset) are used to acquire a replacement asset, that replacement asset will have a pre-CGT status where the market value of the replacement asset was not higher than the asset disposed of (eg destroyed or compulsorily acquired).

To ensure equity to all investments and other business activities, the Association strongly recommends that the Act replacement assets retain the pre-CGT status of assets destroyed or compulsorily acquired. It is difficult in practice to ensure that the market value of the replacement asset is not higher than the asset disposed of. The Association suggests some flexibility in this area. That is, a more practical rule would preserve the pre-CGT status of the original asset where the replacement asset's value did not exceed the value of the asset disposed of by 25%.

What Treatment Should Apply To Losses?

DP2 suggests that when an involuntary disposal would give rise to a CGT loss, the appropriate treatment consistent with the treatment of gains would appear to be deferral of realisation of the loss and an increase in the cost base of the replacement assets. This would defer the realisation of the loss until depreciation was claimed or the asset was disposed of.

An alternative treatment would be to allow the loss at the time that the compensation is received. It is conceded that this would create an uneven treatment between gains and losses in that the taxpayer would be able to defer the gain but realise any loss immediately. However, notwithstanding this, in order to facilitate simplification it is submitted that allowing the loss immediately would be the preferred option.

Is There A Need For Anti-Avoidance Rules?

DP2 suggests that it is possible for related parties to be involved in value shifting arrangements whereby one entity overcompensates a related entity for an involuntary event, such as damage to an asset.

As the Association believes that these situations would be unlikely to occur in a small business situation, no observations are put forward on this point.

What Restrictions are Necessary on the Availability of the Option 2 Treatment?

DP2 discusses whether special treatment for receipts from involuntary disposals should be restricted to situation where a replacement asset is purchased.

The Association recommends that the restrictions should be minimal and also recommends (as suggested in DP2) extending the provisions for deferral of capital gains on involuntary disposals to cases:

1. Such as easements where there is no realistic replacement asset and the original asset is retained. Any capital gain should be able to be applied to reduce the cost base of the original asset.

2. Where an asset is not disposed of but suffers a reduction in value, the compensation should be offset against the cost base of the asset whether or not the existing asset is repaired or improved.

3. Where the compensation exceeds the cost base of the original assets, it will be acceptable that any excess recoupment could produce an immediate tax effect. However, any roll-over relief existing under the current CGT provisions in regards to replacement assets should also be available.

Key Recommendations

The Association strongly recommends the adoption of Option 2 providing for a distinguishing between voluntary and involuntary receipts by deferring the tax liability on involuntary receipts.

The treatment of involuntary receipts should be extended to all situations where the acquirer had the power (even if not exercised in the circumstances) to compulsorily acquire the relevant asset.

Where a pre-CGT asset has been compulsorily acquired the replacement asset should also have a pre-CGT status.

Any losses arising from a compulsory acquisition be allowed at the time that the compensation is received.

The ability to defer the capital gain should not be restricted to situations where a replacement asset is purchased. The capital gain should be allowed to be offset against the cost base of existing assets.

 

Chapter 14 - Disposal Of Partnership Assets And Interests

Overview

For purposes other than CGT, a partnership is treated as if it is a notional taxpayer, in the sense that it is required to calculate its net income or loss as if a taxpayer. However, a partnership itself is not liable to tax. Rather, partners are taxed on their share of partnership net income and deduct their share of partnership losses. Under this approach, partnerships claim deductions (depreciation) for capital expenditure on depreciable assets and account for any balancing gain or losses on their disposal.

Partnerships do not account for disposal of assets for CGT purposes. Rather, CGT adopts what is known as the "fractional interest" or "look through" approach. Under this approach, each partner's interest in a partnership asset is taken to be itself an asset. When a partnership sells an asset, partners are treated as disposing of their respective interests in the asset.

DP2 notes that the fractional interest approach under CGT is complex. It requires each partner to keep separate records of their respective interests in partnership assets. In the case of depreciable assets, it largely negates the advantage to partnerships of being allowed to prepare a single depreciation schedule. That is, each partnership will have a depreciation schedule and each partner has to maintain a separate asset register in case an asset is disposed of.

DP2 acknowledges that many taxpayers either have difficulty in complying with the CGT record keeping requirements or are unaware of their responsibility to do so.

DP2 essentially puts forward two options:

Option 1 - Extend the fractional interest approach to depreciation provisions.
Option 2 - Apply an entity treatment of partnership.

 

Analysis and Recommendations

Extend the Fractional Interest Approach to the Depreciation Provisions

This would broadly require each partner to separately account for their respective interests in an asset for depreciation purposes in the same way that they are already required to do for CGT purposes. As a result, each partner would separately calculate their depreciation deductions and any depreciation balancing charge according to their share of the cost of an asset or the price they paid for acquiring the interest in the asset. This procedure can become very complex and the record keeping can become onerous for partners, especially those in larger partnerships where most partners have very little involvement in day to day administration.

Apply an Entity Treatment to Partnerships

Under this approach, the partnership would be regarded as the owner of all the assets of the business, and the partner's ownership interest would be in the partnership as a whole. In this way, the fractional interest approach currently used for CGT purposes would be moved back from individual assets to the partnership as a whole.

Consider situations where partners sell interests in, or assets of, the partnership, and where partners retire and new partners are admitted. This would result in partners having a range of different cost bases for different parts of their interest in the partnership (analogous to shareholders owning shares in a company acquired at different times for different prices). This approach would eliminate the need for balancing adjustment roll-over relief and complex record keeping requirements for small business.

In the Association's view, the entity treatment (Option 2) of a partnership is the preferred option.

DP2 suggests that under the entity treatment, a capital gain would flow through to the individual partners. However, DP2 is silent in relation to capital losses. It would be important to clarify this matter. That is, whether capital losses are held in the entity or flow through to the partners.

DP2 also fails to discuss the treatment of the "goodwill exemption" available under the CGT provisions. The provisions dealing with goodwill exemption broadly state that half of any capital gain arising from the disposal of goodwill is exempt from CGT, provided that the net value of the business disposed of and related business is less than the net asset threshold (1999 - $2,248,000).

Currently, each partner (under the fractional approach) can individually qualify for the 50% goodwill exemption on the basis that each partner's net assets do not exceed the threshold.

The Association recommends that this concession be maintained if an entity approach to CGT were to be adopted. That is, the net asset threshold should increase depending on the number of partners in the partnership.

Key Recommendations

For the purpose of simplifying record keeping, the Association recommends that the entity treatment of partnerships be adopted.

With the adoption of an entity approach the Association also recommends that the current 50% goodwill exemption threshold per partner be maintained.

 

Chapter 15 - A Fairer And More Consistent Treatment Of Entity DistributionS

Overview

Chapter 15 commences with the comments that the current system of taxation of entities can lead to different tax treatments of income depending on the entities used and is therefore inappropriate.

It also expresses the view that the existing imputation system is overly complex and notes that taxpayers who are unable to use the imputation credits made available with franked dividends, lose those credits. DP2 puts forward the concept of introduction of full franking of all distributions, for improving integrity through the entity chain, as well as refunding excess imputation credits.

DP2's proposal to tax trusts as companies and to require franking of all distributions appear to be set parameters for the Review. No further discussion .is offered.

The Association is of the view that for small business, the taxation of trusts as companies would be disadvantageous. Many small business trusts currently distribute to individuals whose average rate of tax is lower than the proposed 30% entity tax rate. The incidence of tax will therefore increase as well as the complexity and cost of administration of the tax affairs of those small businesses currently operating through a trust. Recovery of any excess franking credits by the individual beneficiaries will also add to the compliance complexity and also may cause cash flow burden to small business. In addition, the owners of trusts will lose the benefit of tax preferences available at the entity level.

For a more detailed discussion of the Association's attitude to the proposal to tax trusts as companies, reference should be made to the material appearing under the heading "Investment Neutrality Principle (Overview p.13) and Distributions of Tax-preferred Income (Overview pp.16-19" in the Overview section of this submission.

DP2 contends that Section 46 rebates, that is a rebate for dividends received by companies, can create tax benefits by manipulation of transactions through companies in a group, as well as perpetuating a number of features that the review process identified as undesirable. The major discussion of the Chapter is focused on this area.

Analysis and Recommendations

What Are the Options for Achieving Integrity through the Entity Chain while Recognising the Impact on Foreign Investors?

DP2 proposes three options for achieving integrity through an entity chain these being:

1. Imposing a deferred company tax;

2. Applying a resident dividend withholding tax; and

3. Taxing unfranked entity distributions.

The above options are explained in detail in Chapter 17.

Whilst not common, some small businesses may operate using a number of different entities where currently unfranked dividends are paid to other entities within the group.

As noted earlier in this submission, the Association asserts that equity and neutrality demand that, at leat in the case of small business entities (those with net assets not greater than $5,000,000), companies should be taxed as trusts rather than the other way around. For larger trusts, the proposed entity regime could apply.

The remainder of this discussion assumes a universal entity regime for trusts and companies notwithstanding the Association's preferred position.

Of the three methods proposed by DP2, the taxing of unfranked inter-entity (outside a consolidated group) distributions would be the preferable option for small business.This option is favoured on the basis of simplicity and reduced compliance costs. Both the "deferred company tax" and the "resident dividend withholding tax" unnecessarily complicate record keeping and administration of an entity and individual shareholders.

How Might the Potential for Double Taxation of Distributed Tax-Preferred Income be Addressed?

This section addresses the potential for double taxation that may arise from use of one of three methods set out above.

Inequities could arise because of timing adjustments, being the movement in provisions for such things such as employee benefits, doubtful debtors etc.

Most small businesses do not raise provision for employee benefits or doubtful debts and would be unlikely to have "Tax Preferred Income". The Association has not, therefore, made any comments in relation to this proposal.

Who Would Have Excess Imputation Credits Refunded?

Under the current system excess imputation credits received by a shareholder (for example, where imputation credits exceed a shareholder's tax on income, including income other than the dividend in question) are not refunded and, cannot be carried forward to a subsequent year. This is inequitable and disadvantages a shareholder who might not derive sufficient income in a particular year to fully utilise the imputation credits. It means that the overall tax on company profits in some cases exceeds the shareholder's marginal rate of tax.

The concept of having excess imputation credits refunded is supported but may equally be able to be achieved by legislative changes to the current system. Furthermore, unlike the current system imputation credits should be allowed to be offset against Medicare levy and superannuation surcharges.

When and How Might Excess Imputation Credits Be Refunded?

Depending on how, in particular, the income of trusts is to be taxed (this is to be discussed in a later Chapter) there exists timing differences between payment of tax and the ability of the individual stakeholder to acquire a refund of any excess imputation credits.

DP2 provides the following options:

Provide a refund at the entity level at the time of distribution; or
Provide a refund to the investor by instalment during the year.

Option 1 would ideally envisage that in some way the investor's individual average tax rate is made known to the entity and this is taken into account at the time of the distribution. An alternate proposed is that standard rates be applied.

Dividends would be paid to the investor grossed up for the expected refund. The entity would then need to recover this refund from the Australian Taxation Office.

The second option proposes refunds could be obtained through the Australia Taxation Office by the investor through instalments during the year where the taxpayer is not covered by the PAYE system. DP2 suggests that the availability of refunds could be subject to special conditions.

The only simple and certain method would be to refund any surplus franking credits on assessment of the individual investor. However, such a method would have potential substantial cashflow disadvantages.

Key Recommendations

The Association recommends that "small business trusts" (those with net assets less than $5,000,000) continue to be taxed on the existing basis with full flow-though of tax preferences to beneficiaries (subject to a "clawback" on disposal of the trust interest in the case of fixed trusts). That is, such tax preferences should be tax-free in the beneficiaries' hands. If necessary larger trusts could be subject to the entity regime.

[underlining purely to highlight changes]

The Association also recommends that "small business companies" (defined by reference to the same threshold as "small business trusts") also be taxed on the same basis as that applying currently to trusts.

For entity chains the taxing of unfranked dividends is preferred as it would seem to be the simplest option, whilst avoiding the adverse foreign investment consequences of the deferred entity tax approach.

The proposal to refunding excess imputation credits is applauded. Equity dictates such an approach.

The Association supports a refund system involving adjustment to an individual shareholder's PAYE obligations, or a refund by instalments where the taxpayer is not covered by the PAYE system.

 

Chapter 16 - An Alternative Treatment for Collective Investment Vehicles

Analysis and Recommendation

The Association supports the exclusion from the entity regime of cash management trusts and other "collective investment vehicles" with flow-through taxation of the net income of such trust., as proposed by the Treasurer in his press release dated 22 February 1999. The Association notes, however, that that press release left unresolved the issue of the appropriate tax treatment of distributions of the profits of collective investment vehicles that are not paid out of the assessable income of such vehicles (tax preferred income)

The Association submits that it is appropriate for flow-through treatment to apply also to such tax-preferred income, so that distributions of such profits would be tax-free in the hands of investors. However, as indicated earlier in this submission, the Association asserts that it would be appropriate to have a wider exclusion from the entity regime; namely, also to exclude from the entity regime "small business trusts" (with net assets less than $5 million). The current taxation treatment should apply to such trusts. That is, beneficiaries of such trusts should be taxed on the assessable income of the trust to which they are "presently entitled". Further, they should pay no tax on distributions of such tax-preferred income (except in the case of a fixed trust, and only where the tax preferred distribution exceeds the cost base of the trust interest).

Chapter 17 - How A Redesigned Imputation System Would Apply To Entities

 

Overview

Chapter 17 addresses the mechanics associated with the options set out in Chapter 15, these being the options to improve the integrity down the entity chain of the redesigned system. The options recommended in DP2 include:

Option 1 - Impose a deferred company tax;
Option 2 - Apply a resident dividend withholding tax;
Option 3 - Tax unfranked entity distributions.

For each of the first two options, two questions asked are:

How should the deferred company tax or resident dividend withholding tax be calculated; and

How should the deferred company tax/resident dividend withholding tax be collected.

DP2 also looks at how the franking account should operate, ie. either on a tax income basis or a tax paid basis.

Currently a franking account reflects the amount that can be distributed that has borne tax, ie. a tax income basis. DP2 supports the proposition that franking accounts should be on a tax paid basis so it is easier to determine under the deferred tax system what the amount of deferred tax is. This is based on the rationale of simplification, given that all dividends must be franked. It removes a layer of complexity existing in the current franking system.

Analysis and Recommendations

Impose a Deferred Company Tax

Under this option all profit distributions would be franked. This would hopefully remove the complex rules determining when franked or unfranked dividends can be paid, including rules regarding franking deficit tax and franking additional tax. Similarly it will remove the need for complex anti-dividend streaming rules

Deferred company tax would be levied where the profit distributed by an entity has not previously been subject to company tax at the entity level. This could be determined using the franking account system. The deferred company tax would be the amount of deficit in the franking account at a specified time. DP2 puts forward a number of options concerning when this deficit should be collected, without providing any real conclusion.

 

Apply A Resident Dividend Withholding Tax (RDWT)An RDWT, if adopted, would be levied on unfranked distributions paid from a resident entity to a resident individual investor. It would also apply to unfranked distributions paid from one resident entity to another (other than in the case of consolidated groups).

The franking account system would be used for determining the amount of unfranked distributions. When an entity makes a distribution to a resident investor and the distribution can not be franked from its franking account, the entity would withhold RDWT and this would allow the net distribution paid to the investor to be fully franked. In this way, the distribution would be either franked by credits from its franking account or by the withholding of RDWT.

Where an entity receives a distribution that is franked by the payment of RDWT, it would credit its franking account in the same manner as other franked distributions. Unfranked distributions paid to foreign investors would be subject to the existing non-resident dividend withholding tax (generally 15%).

Where distributions are paid between resident entities, and have, therefore, been subject to RDWT, and are subsequently passed to foreign members, the domestic dividend withholding tax would be refunded. In order to provide a refund, should a distribution be made to foreign investors, entities would have to maintain an additional franking account to record the amount of RDWT attached to a distribution. A distribution would also have to separately identify the proportion that is franked from the franking account and the proportion franked by the RDWT account.

Tax Unfranked Entity Distributions

Unlike the other options, taxing unfranked inter entity distributions does not give rise to significant calculation or collection issues. This option proposes that any entity, which receives an unfranked distribution, will be subject to tax (apart from distributions paid within a consolidated group). Unfranked distributions would simply be included in the assessable income of the entity. Once tax has been paid on the distribution, it should not be subject to further tax through the entity chain.

The option of taxing unfranked inter entity distributions appears the simplest and most efficient from the point of view of minimising compliance costs.

Key Recommendation

The taxing of unfranked inter entity distributions does not give rise to significant calculation or collection issues and would be the simplest for small business to administer. It is therefore, the preferred option.

Chapter 18 - Defining " Distribution " In An Entity Regime

Overview

Basically Chapter 18 looks at how to define distributions under the entity regime.

The law currently is structured for companies based on dividends. However, due to the differing legal nature of trusts the current law is not readily transferable to such entities.

DP2 looks at three options these being:

Option 1 Apply a broad definition of distribution covering benefits provided by an entity to its members;

Option 2 Apply a broad definition of distribution but exclude certain benefits provided by widely held entities;

Option 3 Adopt Options 1 or Option 2 but tax certain benefits under Fringe Benefits Tax.

Analysis and Recommendations

The Association intends to concentrate on Option 1 in the following decision, as it is the most relevant to small business.

Option 1

DP2 proposes the adoption of what it terms "accounting principles", such that distributions occur when value has passed from the entity to a member in that capacity to the extent it represents profits. Chapter 19 discusses the definition of profit.

Distribution to members could include the following items:

The passing of value from the entity to a member in any form including a reduction in a liability and the provision of good or services at other than fair value;

The value being provided to the member in that capacity including value given in satisfaction of a right to receive income, or capital from the entity (for example, share buy backs), the amount of the distribution decreasing by any value provided to the entity in exchange for the value received;and

Distribution occurring when the value is paid, credited or otherwise transferred.

The terms "Member" and "associates" would be widely defined.

In many ways the proposal would have little impact on small business currently using companies as the current combination of the definition of dividend and the treatment of non-commercial loans or advances to members would tax most distributions to shareholders. Those who operate in a trust would experience substantial tightening in the rules and a consequential reduction in their ability to draw funds from the entity.

From a small business perspective, treatment of a present entitlement as a distribution would provide for easier administration, with beneficiaries being taxed as currently on the present entitlement but subject to some form of franking (if ultimately adopted). Consider a situation where draw-downs are in excess of tax profits or entitlements so created. To the extent that they represent profits, the beneficiary should be provided with the option to either treat them as loans subject to commercial repayment of principal and interest, or alternatively elect that they be included in the recipient's assessable income. This treatment would be consistent with the provisions dealing with shareholder loans from a private company. There would need to be transitional rules in order that profits arising prior to the introduction of the entity taxing concept could be distributed without further tax impost.

Key Recommendations

The current concept of taxing beneficiaries on the basis of their present entitlements to trust income, should be retained.

Excess drawings by trust beneficiaries be treated consistently with private company shareholder loans, to promote investment neutrality between companies and trusts.

 

Chapter 21 - Consistent treatment Of Entity Income

Overview

Chapter 21 looks at a number of issues in attempting to obtain consistency in tax treatment between structures proposed to be taxed under the entity regime.

Analysis and Recommendations

How would the taxable income of Entities Be Calculated?

DP2 says simply (in three lines) that the calculation of taxable income for entities as a general rule is to be determined in a manner consistent with that currently applying to companies.

For small business it is unlikely that there would be any change in the calculation of taxable income as currently trusts calculate their net income in a matter that is consistent with that of determining taxable income for companies.

How Should Unincorporated Associations be Treated?

It is unlikely that small business would be impacted under this heading. Accordingly, no comments are made on this issue.

How Should the Taxation Treatment of Losses Be Aligned?

DP2 points out fundamental differences between companies and trusts and takes the view that notwithstanding that achievement of full alignment is not possible due to the differences and the nature of non-fixed trust and other entities, greater consistency is achievable.

In substance the following proposals are made:

Entities should be able to recoup the benefit of prior and current year losses or bad debt if there is a continuity of majority beneficial ownership.

For non-fixed trusts there would need to be majority continuity of beneficial ownership, for fixed interests in hybrid trusts, no change in control, and less than a 50% change in the pattern of distribution for non- fixed interests.

There would need to be either a continual testing for continuity of ownership depending on whether the entity was considered closely held or widely held.

Depending on the view of how the 50% change in pattern of distributions were to be calculated the impact on small business may be negligible.

Currently where a non-fixed trust does not elect to be a "family trust" for the purposes of the trust loss provisions, then it needs to pass three tests in order to be able to utilise carried forward or current year losses. One of these tests is the pattern of distributions test.

The pattern of distributions test currently requires that there be a less than 50% change in pattern of distribution over the period from the loss year to the year of attempted recoupment. However, where a beneficiary does not receive the same percentage of income in each year, the test is calculated based on the lowest percentage of income received in the defined period (not exceeding 6 years) prior to the year of attempted recoupment.

By way of example a simple distribution pattern

Earlier Year Year of Recoupment

A 40% 10%

B 40% 10%

C 20% 80%

Based on the lowest percentage of distributions to the relevant beneficiary under the current rules in the example provided the trust would have failed the pattern of distribution test as the lower percentage on each distribution only adds up to 40%.

In the Association's view, the test should be more liberal. It should be taken on a group basis similar to that used under the Capital Gains Tax provisions. This involves looking at when there has been a change of majority underlying interests, ie; as a group based on the test year distribution has there been a greater than 50% change? Following on from the above example on a group basis, there has not been a greater than 50% change in distribution and therefore the losses should be carried forward.

On What basis Should Entities Be Classified For Taxation Purposes?

In order to obtain a consistent basis DP2 put forward three options these being:

Use the "public" and "private" distinction.

Use the "closely held" and "widely held" distinction.

Draw on the Corporations Law.

Fundamentally for small business the use of any of the above methods would arrive at the same result. However, the Association suggests the use of the terms and concepts of option 2 (being either "closely held" or "widely held"), as they are likely to be more easily understood by small business operators.

DP2 gives a proposed definition of a "closely held" entity as entities where 20 or fewer individuals hold directly or indirectly 75% or more of the interests in profits or interests in capital of the entity. All other entities would be widely held.

What Rules Should Apply when An Entity Moves Between Different Tax Regimes?

For small business it is unlikely that there would be significant movement between closely and widely held entities structures.

DP2 offers no suggestions on this point.

How Should A Tax Liability Be Met if The Entity has Insufficient Assets?

The Association believes that, particularly in the case of small business entities, the current law provides ample opportunities for the Commissioner to pursue the collection of outstanding revenue where the ultimate owners of the entity have placed the entity into a position such that it is unable to meet its taxation liabilities.

DP2 does not put forward any proposals. However, the Association notes the existence of the Crimes (Taxation Offences) Act 1980 (Cth). This provides the Commissioner with an appropriate remedy where the controllers of an entity place it in a position such that it is unable to meet its tax liability.

Which Trust beneficiary Should Bear the Economic Burden of The Tax Paid By The Trustee?

For small business entities it is generally the family group that ultimately bears the economic impact of tax paid.

Therefore it should be up to agreement between the trustee and the relevant beneficiaries to determine which if any assets are to bear the economic burden of the tax liability under the entity taxation concept.

Key Recommendations

With regards to the availability of carry forward losses in trusts there should be a "group" test in determining whether there is a 50% change in pattern of distribution test. Where this test is satisfied the carry forward losses should be available.

Where an entity is unable to meet a tax liability there are sufficient existing remedies available for the Commissioner to pursue the unpaid tax and prosecute the controllers. Therefore, the Association does not recommend any expansion of these provisions.

 

Chapter 22 - Bringing trusts Into the New Entity Regime

Overview

Chapter 22 of DP2 considers various issues concerning the introduction of trusts as an entity into the new entity tax regime.The issues considered under Chapter 22 are:

What trusts should be excluded from the new entity tax system?

What should be the taxation treatment of trust distributions to minors?

How should some specific trust issues be addressed?

How should an entitlement to unpaid income or capital of a trust be treated?

When should a trust be treated as having being created or wound up for taxation purposes?

How should distributions from trusts attract the benefit of certain primary production arrangements?

What issues arise with the cost base of the beneficial interest in trusts?

What issues arise with deceased estates and testamentary trusts?

Analysis and RecommendationsWhat Trusts Should Be Excluded From the New Entity Taxation System?DP2 proposes the exclusions of certain trusts from the entity tax regime. These are identified in greater detail in Appendix A to the Chapter. However, in broad principle, trusts that are to be excluded are those that have been created or settled only to satisfy a legal requirement or be subject to legal tests or sanctions.

In addition the following type of trusts would also be excluded, these being:

Trusts where the trustee holds property on trust with no interest in or duty as to the trust property other than to hold that property for the absolute benefit of specific beneficial owners, that is the beneficiaries are absolutely entitled to the trust property; and

Constructive trusts. A trust where the law of equity imposes a liability upon a person to account for certain property as if that person was a trustee.

Small business trust entities would not generally fall into one of the above exclusions.

What Should Be the Taxation Treatment of Trust Distributions to Minors?DP2 looks at the current treatment under Division 6AA of the Act, that is taxation of income to minors and the treatment of child maintenance trusts. Again, for most small businesses this will be a peripheral issue with limited distributions (generally equal to the Division 6AA threshold as increased by operation of the low income rebate) currently being made to minors by way of trust distributions.

DP2 proposes that the current taxation of minors be retained. Where the distribution to the minor is in the form of franked distribution as may be required, the amount below the tax threshold will be refunded. There will need to be a mechanism in place to provide the refund. This will no doubt require the lodgement of additional tax returns for minors including the obtaining of tax file numbers for them.

This will lead to further compliance requirements and in the end possibly the non-lodgement of minor beneficiary returns and hence loss of refund.

How Should Some Specific Trust Issues Be Addressed?

The Association is of the view that this either does not have application to small business or the anticipated population affected does not warrant detailed consideration.

How Should an Entitlement to Unpaid Income or Capital of A Trust Be Treated?

Under trust law a beneficiary becomes entitled to income or capital of a trust by being made presently entitled as a result of a decision of the trustee to exercise its discretion to apply that income or capital to, of for the benefit of, that beneficiary.

Although a beneficiary may have present entitlement to the income or capital, a trustee may retain within the trust estate the money or property which represents that income or capital. This money or property is held for the benefit of the beneficiary. There are currently two interpretations of the characteristic of these unpaid income, or capital entitlements. The first is that the amount remains part of the existing trust estate whilst under the other interpretation the retained monies or property is held under a separate trust.

DP2 puts forward two options being:

The rebuttal presumption; and

The distribution and loan back.

Under Option 1 the unpaid entitlements would be seen as forming part of the existing trust estate. However, there could be a rebuttal, in the form of an agreement between the trustee and relevant beneficiaries, that the unpaid entitlements will be held by the trustee in a separate trust.

Under the distribution and loan back option any amounts due to the beneficiary would be treated as a loan by the beneficiary to the trust.

For most small businesses the current present entitlement and loan back arrangement is preferred as it is simpler to understand and simpler to administer. Many small business owners, through lack of sophistication, treat trust funds as their own. The Association notes the requirement to consider each withdrawal as a distribution with a reckoning date to determine whether there have been excess distributions as compared to the franking credits available. This may involve a requirement to pay deferred tax/resident withholding tax. Such a scheme will add to the administrative burden of business operating through trust structures.

When Should A Trust Be Treated As Having Been Created Or Wound Up For Taxation Purposes?

Currently the Association considers that the issue is fairly straightforward. That is, either a trust is settled or terminates. The question of when a resettlement of a trust occurs has been under consideration by the Tax Office for some time. However, in the Association's view, it is clear from case law (eg Gartside v Inland Revenue Commissioners [1968] AC 553) that the mere discretionary objects of a discretionary trust can be changed without a resettlement occurring. On the other hand, takers in default in respect of the capital of a trust could not be changed without a resettlement occurring. The reason for the different consequences is because of the different nature of the interests of each class of person in the trust fund. Mere discretionary objects have what is referred to as a mere spes (ie a mere hope or expectation that the trustee will exercise his discretion in their favour). Such persons are not recognised as having any beneficial interest in the trust fund. Takers in default of appointment in respect of capital (or income) on the other hand have either a vested interest subject to defeasance or a contingent interest. However, that interest is expressed, it amounts to a beneficial interest in capital (or income).

The Association notes the implication in DP2 (at paragraph 22.47) that "…a substantial alteration in the interests of existing or potential beneficiaries or discretionary objects" would amount to a resettlement. However, as is clear from the above discussion, discretionary objects of a trust do not have a beneficial interest in the trust property. Accordingly, additions or deletions to discretionary objects can be made without a resettlement occurring.

DP2 raises the possibility of reforming the taxation treatment of trust resettlements.

DP2 proposes two options:

To define the concept of resettlement for tax purposes; or

Ignore resettlement and apply value-shifting rules.

Under the first option DP2 proposes rules that could lead to the trust being resettled for tax purposes even when there are merely "changes or additions to the beneficiaries or classes of beneficiaries in trusts". The Association submits that, to the extent to which this comment is intended to extend to such changes or additions to the discretionary objects of a trust, it is broadening the concept of "resettlement" beyond the common law concept. In the Association's view, there is no justification for purporting to merely clarify the meaning of this concept for tax purposes, but in reality broadening the concept beyond the common law meaning.

The Association suggests a codification of the common law meaning of "resettlement" discussed in detail above.

How Should Distributions from Trusts Attract the Benefits of Certain Primary Producer Arrangements

DP2 proposes, in respect of trusts that are engaged in the carrying out of primary production activities, that beneficiaries would still be entitled to averaging provisions and to access the farm management deposit arrangements on an individual basis.

Without these proposed special provisions, distributions by trusts under the entity taxation system would no longer retain their original character.

If beneficiaries are taxed on a distributed basis, then there will need to be additional accounting records maintained in order to determine the component of income being distributed representing that of primary production. This is just further recording keeping for little or no advancement over the current system.

No doubt there will also be a need for transitional and anti-avoidance provisions associated with the concession being offered to the primary production sector.

What Issues Arise With the Cost Bases of the Beneficial Interest in Trusts?

Currently apart from unit trusts (and takers in default of appointment in respect of capital in discretionary trusts), beneficiaries do not have an interest in a trust. Therefore, the distribution of any capital to the beneficiary is dealt with under special rules in the current Act.

The current Act provides that where there is a distribution of an asset to the beneficiary of a non-fixed trust, then the trust is deemed to have disposed of the asset for its market value with the beneficiary deemed to have acquired it also at market value. The tax consequences of the transactions are determined within the trust only.

Under the entity method where there has been a return of capital then there is the potential for beneficiaries of a non-fixed trust to be exposed to double taxation. This arises as the beneficiary would generally have no cost base to apply against the return of capital in the calculation of any taxable capital gain.

Whilst this is in some ways consistent with the taxation of distributions from companies, at least there the shareholder has had the opportunity to acquire the shares for some valuable consideration.

The proposal under DP2 is inequitable and would lead to taxation at the entity level and at the beneficiary level with effectively all the assets distributed being subject to some form of taxation.

What Issues Arise With Deceased Estates and Testamentary Trusts?

The Association generally endorses the proposal to exempt from the entity regime, deceased estates (other than testamentary trusts) the administration of which is concluded within 2 years of the date of death.

The Association also indicates its general agreement with the rules relating to life tenant and remainder interests set out in Appendix B to Chapter 22.

What is not Said

What is clear, but not actually stated in DP2, is that under the entity method, trust distributions would no longer retain their characteristics, ie primary production income, dividends and capital gains etc. It is proposed to specially treat primary production income. However, it is not proposed to identify and have a special treatment for capital gains.

This is likely to impact on many small business entities. Currently capital gains distributed by a trust to individuals form part of determining the overall capital gain or loss position of the individual. On this basis, the capital gain from the trust can be offset against an individual's capital losses and will be subject to averaging concessions.

Under the proposed entity taxation system where the capital gain loses its character, these concessions will not be available.

Key Recommendations and Conclusions

Notwithstanding the Association's preferred position that "small business trusts" not be taxed as companies, if the government insists on generally taxing such trusts as companies, then the Association agrees that it is appropriate to exclude the types of trusts set out in Appendix A from the entity regime.

The Association also agrees, again subject to its preferred position referred to immediately above, that the proposed taxation treatment of minors is appropriate.

For the purpose of simplifying administration, the unpaid income or capital entitlements of beneficiaries in a trust should be treated as distributions and loan backs, rather than establishing sub-trusts.

Difficulties and potential double taxation may arise on an in specie distribution to beneficiaries of a non-fixed trust.

In addition to recognising the primary production income element of a distribution that component representing a taxable capital gain should also be recognised and retain its character.

 

Chapter 24 - Anti-Avoidance Provisions

Overview

Chapter 24 looks at the current Act's over-reliance on specific anti-avoidance provisions

Analysis and Recommendations

DP2 proposes that there be a more systematic approach to dealing with avoidance issues.

The Association agrees that, where possible, underlying structural flaws in the tax base should be addressed with structural improvement (paragraph 24.16). The new systematic approach to the development of tax legislation consistent with defined national objectives should improve the structural integrity of Australia's tax legislation.

However, the Association also agrees that it is appropriate to have a robust, general anti-avoidance provision to deal with flaws in the tax system which cannot be addressed with appropriate structural change (paragraphs 24.9 and 24.18). Undoubtedly the content and scope of such a general anti-avoidance rule needs careful consideration to diminish unintended consequences and promote certainty. Reliance on specific anti-avoidance rules should be minimised.

What Should Be The General Approach To Anti-avoidance Issues?

DP2 really provides only a generalised view leading to the advocating of a robust general anti-avoidance rule rather than specific measures dealing with individual subject items. However, it does not put forward any suggested models of general anti-avoidance rules.

In the Association's view, the current anti-avoidance measures in the Act with its mix of specific and general is both cumbersome and often difficult to interpret and apply. In particular the general anti-avoidance provision relating to the obtaining of "franking credit benefits" requires the consideration of sixteen tests (eight tests from the existing s.177E and eight specific additional tests) to determine whether there is an application of those provisions.

As noted in the Overview section of this submission, the Association expresses its concern at the tendency in recent times to adopt a very low threshold test in specific anti-avoidance rules (dividend streaming and franking credit trading rules, for example)

Those rules have adopted a purpose test of "a purpose other than an incidental purpose", instead of the traditional Part IVA "sole or dominant purpose" test. In the Association's view such a test sets far too low a threshold for the operation of any anti-avoidance test (specific or general). It is understandable that the Commissioner may wish to lower the threshold below the Part IVA standard. However, it is submitted that a "significant purpose" test would be an appropriate compromise. This should both meet the Commissioner's concern at the difficulty of satisfying a Court even to the "dominant purpose" standard, but at the same time avoid catching "innocent" taxpayers in an anti-avoidance "net".

It is noted that the Explanatory Memorandum to the dividend streaming anti-avoidance rules suggests that the "purpose other than an incidental purpose" test and the "significant purpose" test, equate. However, the Association submits that the former sets a much lower, and in its view, inappropriate, threshold.

In the main most small businesses would be unaffected by the anti-avoidance provisions in their day to day operations. Nevertheless with regards to tax planning its is important that small business operates with a level of certainty as to the tax outcomes of its transactions.

What Specific Issues Require Further Examination

DP2 looks at various specific issues however, the Association is of the view that in the main small business would generally be unaffected by the specific issues addressed.

Key Recommendation

The Association would welcome one reasonably simple anti-avoidance division in the Act.

The Association agrees that the current Act places undue reliance on specific anti-avoidance rules. Such rules should be kept to minimum, and, if possible, avoided altogether.

The Association suggests the adoption of a "significant purpose" test in any new robust, general anti-avoidance rule and in any specific anti-avoidance rule. The Association expresses its grave concern at the tendency in recent times to adopt a "purpose other than an incidental purpose" test. The Association suggests that such a test sets an inappropriately low threshold, and would be likely to catch in its "net" many innocent taxpayers and innocent transactions.

Chapter 38 - Towards A Better Regime For Taxing Fringe Benefits

Overview

DP2 recognises the complexity and compliance costs associated with FBT, but the main areas of suggested change do not address that issue. Furthermore no alternatives to the Government's proposal to require fringe benefits to be reported on group certificates are outlined. Therefore, the compliance difficulties and costs in allocating benefits between employees and reporting these on the group certificates have not been addressed.

DP2's strategies for Tax Reform include:

To improve equity, transfer tax liability from employer to employee.

To simplify compliance and address key administrative issues.

To improve efficiency, remove distortions in valuation of fringe benefits.

Analysis and Recommendations

To Improve Equity, Transfer Tax Liability from the Employer to Employee

The major suggested change is to remove FBT as a tax on employers and replacing it with a tax on employees by reference to the value of benefits. The reason for this suggestion is the current system is seen as inequitable. The proposal is to tax benefits at employees' marginal rates, rather than all at the highest marginal rate, as is currently the case under FBT.

This change could create significant savings for some employers, especially small business employers who employ juniors or pay low wages. For example, where an employee on the 31.5% marginal tax rate is provided with a fringe benefit the fringe benefit is currently liable to an effective 48.5% tax rate. Under the proposals the effective tax on fringe benefits will be 31.5%.

However, in switching the Fringe Benefits Tax liability from the employer to the employee DP2 does not address how certain exempt and concessionally treated fringe benefits are to be dealt with. For example, under the current FBT legislation remote area housing and remote area holiday travel is subject to a reduction of 50% in the FBT liability with superannuation contributions and reimbursement of relocation cost exempt from FBT. If there are no adequate income tax concessions provided in relation to exempt and concessionally treated fringe benefits, certain employees, and therefore employers, especially those operating in regional or remote areas of Australia, will be disadvantaged.

To Simplify Compliance and Address Key Administrative Issues

DP2 suggests that, in view of the complexity of the current rules, entertainment should be excluded from FBT and be treated, as it was before 1995, as a non-deductible expense.

DP2 also takes the view that on-premises car parking benefits are unlikely to be abused. In the interest of administrative simplicity, DP2 suggests that this benefit should be excluded from FBT while remaining deductible for income tax purposes.

In relation to aligning the FBT year with the income tax year, DP2 has suggested it would like further guidance from business. The Associations' view is that the FBT year should be aligned with the income tax year, incorporating the lodgement as part of the Annual Income Tax Return.

Although the Association welcomes the simplification proposals, they do not provide significant savings in administration. The Association recommends that a threshold be introduced where an employer is exempt from FBT and therefore not required to lodge an FBT return. For example, the threshold could be fringe benefits with a taxable value of $10,000 in any year.

To Improve Efficiency, Remove Distortions in Valuation of Benefits

The current regime for taxing car benefits is seen as too concessional by DP2, and the examples in most of the numerous options presented result in a higher tax cost in respect of employees on the highest marginal tax rate. However, some of the suggested methods result in a lower tax cost in respect of employees on lower marginal rates. The options put forward include:

A schedule of statutory operating cost amounts, with an option deemed business percentage; or

Altering the percentages in the current statutory method.

It appears that the result of implementing either of the alternative valuation methods in DP2, would be that the attractiveness of salary packaging a car will decrease significantly for higher paid employees.

We do not see any problems with DP2s proposal. However, we suggest that a simple statutory method be maintained for the sake of simplifying administration. We strongly recommend that certain work-related vehicles such as vans, trucks and utilities retain FBT exempt status where they are only used for work related and home to work travel.

Key Recommendations

Where the tax liability for fringe benefits is transferred from the employer to the employee, the current concessions and exemptions in the FBT Act (eg: Remote Area Housing and superannuation contributions) be maintained in the Income Tax Assessment Act.

An FBT threshold of say, $10,000 should be proposed that is, where an employers provide fringe benefits with a taxable value of $10,000 or less they would be exempt from FBT and not required to lodge an FBT return.

The current tax treatment of car fringe benefits should be retained, bearing in mind the potential adverse effect on fleet purchases and the flow-on effect for the local car industry. The Association notes the existence of other factors already adversely affecting the local car industry. These factors include the increased import competition flowing from the phased reductions in car tariffs, together with the likely deferral of new car purchases associated with the abolition of relatively high sales tax and the introduction of a much lower GST on cars. The combined operation of these factors may prove a virtual knockout blow for the local car industry.

In any case, any changes in valuing car fringe benefits should maintain an option of a simple statutory percentage of the car's cost, thus simplifying administration. Cars such as vans, utilities and small trucks should be exempt from FBT.

To simplify administration the Association recommends that the financial year and FBT year-end be the same with the fringe benefits return being incorporated with the annual income tax return.

 

Chapter 39 - A Revenue Neutral Perspective

OverviewThe basis of the terms of reference given to the Review Committee was that any changes proposed would have to be in a revenue neutral context. As stated in the Overview section of this submission, the Association suggests that revenue neutrality should be measured by reference to the current tax system not by reference to the "Government's fiscal figuring that reflects the budgeted-for tax reform measures announced in A New Tax System" (paragraph 250). Such a measurement of revenue neutrality prevents taxpayers being compensated for the revenue "take" by the government flowing from the proposed denial of flow through of tax-preferred income in trusts. This is extremely inequitable!

The review has set about looking at this neutrality with two separate objectives in mind:

1. To lower the company tax rate in response to the broadening of the base.

2. The scope to alter taxation arrangements applying to capital gains.

 

Key Recommendations and Conclusions

For the reasons indicated in the Overview section of this submission, the Association rejects the much publicised linkage between a reduction in the company tax rate and the scrapping, or substantial dismantling, of accelerated depreciation. In short, it proceeds on the logical fallacy of the company tax being a final tax. On the contrary, regardless of the rate at which company tax is set, under the proposed entity tax system, the rate of overall taxation paid will be determined by the marginal rate of tax of each shareholder of a company or beneficiary of a trust. That is, the revenue will be unaffected by any reduction in the company tax rate. Accordingly, there is no need for any base broadening!

In view of the above, accelerated depreciation should be retained. Its retention will also promote the National Objective of optimising economic growth.

As noted in the Overview section of this submission, the Association

suggests that revenue neutrality should be measured by reference to the

current tax system not by reference to the "Government's fiscal figuring

that reflects the budgeted-for tax reform measures announced in A New Tax System" (paragraph 250). DP2's measurement of revenue neutrality prevents taxpayers being

compensated for the revenue "take" by the Government flowing from the proposed denial of flow through of tax-preferred income in trusts. This is extremely inequitable!

The Association is disappointed that DP2 has not looked more closely at the tax imposts and overly complex legislation affecting small business.

The Association asserts yet again that the corporate tax rate should be aligned with the top individual marginal rate to avoid incentives for arbitrage. This should have been a proposal put forward and discussed in DP2.

ACKNOWLEDGMENT

The Association acknowledges the significant contribution of Garry Bourke (Director-Taxation Services, Australian Taxpayers' Associations) in drafting this Submission. The contributions of Ross Watson (National President), Peter McDonald (National Director), John Stephens (National Vice-President), Cyril Tolson (President, W.A.), and Grant Stokes (S.A.) are also gratefully acknowledged.