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Submission No. 231 Back to full list of submissions
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Submission to the Ralph Business Tax Review

By SOUTH EAST QUEENSLAND REGIONAL ORGANISATION OF COUNCILS, concerning

 

Taxation of Leases, including Reform of Section 51AD/Division 16D of the Income Tax Assessment Act 1936

Taxation of Entity Distributions

 

April 1999

Executive Summary

- Taxation of Leases

Local Government seriously questions the justification for reform of the taxation of leasing as canvassed in "A Platform for Consultation". The issues raised seem to be somewhat academic, purist and detached. No empirical evidence has been provided of the adverse outcomes for the Commonwealth that leasing has caused in a period of almost four decades. On the contrary, the correct inference that might be drawn is that leasing has in fact facilitated desired outcomes involving in some instances tax preference transfer and stimulation of economic activity that was very much the object of the Commonwealth, where any direct cost to revenue was wholly subordinate.

Moreover, "A Platform for Consultation" does not provide any guidance as to what the likely effect on the widespread use of leasing will be that results from a wholesale change in the tax treatment as proposed. Local Government is concerned that the effect may be one of significant disruption to economic activity across the community though Local Government is not able to be sure of this any more than the Commonwealth can be sure that it will not do so. However, it seems to be inappropriate for the Commonwealth to proceed with its consideration of altering the taxation of leasing as significant a feature of Australia’s economy as it is, in the absence of any reliable indicators in this regard.

In the absence of any compelling evidence of an unacceptable cost to the Commonwealth revenue resulting from the current tax treatment of leasing, Local Government urges the RBT to defer any further consideration of altering the tax treatment of leasing pending a detailed and unrestricted review of the matter. At this juncture, Local Government is not aware of any demonstrable benefit for it, for its ratepayers or for the Commonwealth in embarking on a thoroughgoing change to the tax treatment of leasing, driven as it would seem to be by an abstract, philosophical purism that has had no regard for the commercial and community realities that have been an accepted and conventional feature of Australia’s business environment since leasing first appeared in this country.

- Reform of Section 51AD and Division 16D

It is the recommendation of the Local Government, in the strongest possible terms, that in the context of national tax reform, the existing provisions (Section 51AD and Division 16D) be amended so as to have a more limited scope and less prohibitive effect, and thus accommodate the changing role for modern Government in direct service delivery.

Regardless of the way in which the preferred option may be formulated as to its scope and application, the draconian effect of Section 51AD must be terminated at the earliest possible opportunity. Its practical effect when taken into account with the Corporations Law obligations of directors as they have evolved to the current time, is manifestly excessive and unable to be justified on any policy grounds. Instead, any replacement provision ought adopt the sort of approach proposed in Division 240 of the 1997 Act whereby a notional amount of income attributable to a hire-purchase arrangement is taxed in the hands of the owner, and capital allowance deductions, ie., accelerated tax depreciation, is denied. Whatever other reforms of the existing provisions may occur, amendment of the effect of Section 51AD in this regard is long overdue and ought be addressed as a matter of urgency.

Local Government is supportive of detailed consultation with the Commonwealth and the other States with a view to developing a set of objective "majority interest in assets" criteria and in exploring any concessional tests that may be appropriate in limited circumstances.

It is necessarily implicit in these objectives that reform of the existing provisions does not entail any extension of the income tax law so as to apply to arrangements that have in the past been accepted as not being subject to Section 51AD and Division 16D where "control" has not been apparent. In other words, any replacement provisions must not apply to existing arrangements that have been accepted by the ATO as not being subject to the existing provisions, such as described above. Nor ought any future arrangements of a similar nature to those accepted as not being subject to Section 51AD/Division 16D become subject to replacement provisions. It is submitted that any other approach would be regressive and contrary to economic reform objectives without demonstrable justification in terms of adverse consequences for the Commonwealth tax base. This objective can be described as an absolute "no detriment" rule.

- Taxation of Entity Distributions

Local Government supports the alternative which advocates the denial of dividend rebates on unfranked dividend distributions. This alternative alone avoids the effective taxation of dividends derived by Local Government which are paid out of tax preferred profits, thus retaining the attributes of the existing regime in so far as the taxation treatment of tax exempt dividend recipients is concerned.

Both the DCT and RDWT regimes produce inequitable and unacceptable consequences for Local Government. Each represents a disguised tax on ratepayers that cannot be justified on tax policy grounds.

These regimes provide a further disincentive for Local Government to corporatise relevant business operations and thus produce distortions in the choice of investment vehicle, in favour of direct Local Government investment.

1. Taxation of Leases including Reform of Section 51AD & Division 16D

In Discussion Paper 2, Volume I, "A Platform for Consultation", Chapters 8-10 examine the taxation of leasing and various options for altering the existing income tax treatment of leasing and similar arrangements. A consideration of Section 51AD and Division 16D of the Income Tax Assessment Act 1936 (ITAA 1936) is included in this analysis. A core concept in this analysis is "tax preference transfer" – see Paragraphs 8.21-8.25.

In the future, tax preference transfer will occur under the income tax law of the Commonwealth of Australia, in various ways – see paragraphs 9.40 - 9.44. In determining what restrictions are to be imposed on tax preference transfer that occurs by way of leasing between taxpayer entities, it should be recognised that for some 40 years, as a general proposition the existing income tax law has satisfactorily determined the tax consequences of various types of leasing arrangements, in accordance with broad tax policy objectives – see Tax Ruling IT28. Where there have been unsatisfactory outcomes, amendment of the income tax law has occurred eg, Section 51AD/Division 16D, to ensure tax policy settings have been secured. Other aberrant leasing arrangements that have been identified have been addressed by way of tax rulings eg. IT2051, TR95/30. A range of judicial decisions have assisted in the administration of the enacted income tax law eg. EA Mann, Citibank & Bellinz.

Moreover successive Commonwealth Governments have endorsed the use of ordinary commercial leasing arrangements and the tax preference transfer facility that they can provide in offering various investment incentives to the Australian business community eg. investment/development allowance leasing rules. Nowhere in "A Platform for Consultation" is there recognition that, broadly speaking, for such a long period, leasing has been a major means of financing the use of plant facilities consistent with implicit or overt tax policy objectives. Tax preference transfer, where it has occurred by way of leasing, has been consistent with, if not an intended consequence of, tax policy. This much is factually undeniable.

It must also be recognised that there is a need to limit the exposure of the Commonwealth tax base to tax preference transfers for the benefit of tax exempt entities and non-residents of Australia.

For the past two decades, Section 51AD and Division 16D have served this purpose, in an effective but highly cumbersome way. However, those provisions were formulated long ago, reflecting an economy that has evolved and been reformed very significantly since then "A Platform for Consultation" acknowledges the need for these provisions to be reformed – see paragraphs 9.76-9.82, and Appendix C thereto.

It is against this background that Local Government seriously questions the justification for reform of the taxation of leasing as canvassed in "A Platform for Consultation". The issues raised seem to be somewhat academic, purist and detached. No empirical evidence has been provided of the adverse outcomes for the Commonwealth that leasing has caused in a period of almost four decades. On the contrary, the correct inference that might be drawn is that leasing has in fact facilitated desired outcomes involving in some instances tax preference transfer and stimulation of economic activity that was very much the object of the Commonwealth, where any direct cost to revenue was wholly subordinate.

Moreover, "A Platform for Consultation" does not provide any guidance as to what the likely effect on the widespread use of leasing will be that results from a wholesale change in the tax treatment as proposed. Local Government is concerned that the effect may be one of significant disruption to economic activity across the community though Local Government is not able to be sure of this any more than the Commonwealth can be sure that it will not do so. However, it seems to be inappropriate for the Commonwealth to proceed with its consideration of altering the taxation of leasing as significant a feature of Australia’s economy as it is, in the absence of any reliable indicators in this regard.

From the perspective of Local Government, quarantined from any material tax preference transfer by virtue of Section 51AD/Division 16D, if the taxation of leasing were to be altered by the adoption of a "sale/loan" approach based on the Canadian model as seems to be favoured by the RBT, it would unquestionably and adversely affect ordinary operating leases of various forms of equipment that Local Government can acquire the use of in this way.

Practically, any increased cost would be borne by ratepayers or alternative arrangements would be adopted inevitably involving other costs.

In the absence of any compelling evidence of an unacceptable cost to the Commonwealth revenue resulting from the current tax treatment of leasing, Local Government urges the RBT to defer any further consideration of altering the tax treatment of leasing pending a detailed and unrestricted review of the matter. At this juncture, Local Government is not aware of any demonstrable benefit for it, for its ratepayers or for the Commonwealth in embarking on a thoroughgoing change to the tax treatment of leasing, driven as it would seem to be by an abstract, philosophical purism that has had no regard for the commercial and community realities that have been an accepted and conventional feature of Australia’s business environment since leasing first appeared in this country.

Leaving any change to the tax treatment of leasing aside, it is submitted that there is universal support for the repeal of Section 51AD with its draconian consequences, and for reform of Division 16D to overcome the uncertainty that its current form unavoidably generates.

In considering how these provisions may be best reformed regardless of any change to the tax treatment of leasing generally, it is instructive to review the practical difficulties encountered with their day to day operation. A central issue is that the provisions are drafted in a way that causes them to apply so broadly that they generate extreme uncertainty in circumstances that were not in contemplation when first enacted – Paragraph 8.34.

The current form of the existing provisions ultimately entails a determination by the tax authorities that the provisions do not apply. History demonstrates time and time again that this process is highly cumbersome, costly and fraught with uncertainty. It is understood that various State Governments are making more detailed submissions to the RBT in this regard, documenting some of the instances that are testament to gross inefficiency that the current provisions cause. The continual demand on scarce ATO resources as an onerous and invidious part of this process is undesirable and inappropriate as the ATO would agree.

Even if tax clearance is eventually gained, it generally comes at a significant cost. Local Government considers that the current wording of the existing provisions is too broad and imprecise and key terms, especially "control", "end-user", and "lease" have such general coverage that nearly all major projects directly involving the private sector in some form of service provision of what were previously "public services" are likely to encounter Section 51AD difficulties until the Act is modernised by the adoption of a more precise formulation for the future.

Recommendation

It is the recommendation of the Local Government, in the strongest possible terms, that in the context of national tax reform, the existing provisions (Section 51AD and Division 16D) be amended so as to have a more limited scope and less prohibitive effect, and thus accommodate the changing role for modern Government in direct service delivery.

At the very least, legislative amendments are required to re-define key terms such as "lease", "control", "use" and "associate", having regard to the way that Governments now do business, and facilitate the delivery of goods and services to the community by the private sector.

Appendix C to Chapter 9 of "A Platform for Consultation" outlines a number of options for reforming Section 51AD/Division 16D.

In considering these options, Local Government would submit these objectives:

1. Section 51AD, with its draconian consequences and highly cumbersome and uncertain formulation ought be repealed as soon as possible;

2. Division 16D ought be reformed to "cover the field" but be drafted so as to do so with certainty of application, avoiding the extreme administrative difficulties that have been the hallmark of the current "control" tests; and

3. Facilitating a legislative scheme that can more readily be adapted to meet the agreed objectives of the Commonwealth of Australia from time to time.

It is necessarily implicit in these objectives that reform of the existing provisions does not entail any extension of the income tax law so as to apply to arrangements that have in the past been accepted as not being subject to Section 51AD and Division 16D where "control" has not been apparent. In other words, any replacement provisions must not apply to existing arrangements that have been accepted by the ATO as not being subject to the existing provisions, such as described above. Nor ought any future arrangements of a similar nature to those accepted as not being subject to Section 51AD/Division 16D become subject to replacement provisions. It is submitted that any other approach would be regressive and contrary to economic reform objectives without demonstrable justification in terms of adverse consequences for the Commonwealth tax base. This objective can be described as an absolute "no detriment" rule.

Consideration of the Options

First Option

Local Government agrees that the first option proposed in Appendix C to Chapter 9 of "A Platform for Consultation" is not to be preferred, for the reasons canvassed in the Appendix. It would likely result in no better a situation for the Commonwealth, the ATO, the States, the private sector and any other interested parties than is currently the case.

Second Option

The second option, by comparison, with the first option has considerable appeal, for the following reasons.

A majority interest in assets test is on the face of it simple, clear and unlikely to be susceptible to uncertainty as is the "effective control" test. It ought avoid definitional problems in attempting to define the scope of application of the replacement provisions, as between say leases of various types and various forms of service arrangements.

The challenge will of course lie in specifying those considerations by reference to which the majority interest is to be determined. This submission will consider that aspect in due course.

Third Option

Local Government does not support the third option as it would significantly broaden the scope of the existing provisions to embrace all service contracts, as Appendix C acknowledges. As submitted earlier, the existing provisions have been found in practice to be exceedingly intrusive, vexatious and cumbersome in their current form creating great uncertainty and potentially calamitous adverse consequences for those subject to them where no material tax preference transfer is evident or intended. Economic efficiency objectives would be subjugated to cost to Commonwealth revenue considerations where there is no apparent evidence of undue cost. Administrative difficulties and costs would increase exponentially and inhibit economic activity to the detriment of the community overall. There would not seem to be any justification for examining this option further.

Fourth Option

It is submitted that the fourth option would involve a degree of complexity and potential for disputation that is not warranted. It would suffer from much the same objections listed for the third option above. Further consideration is not warranted. It would be a backward step for the whole of the Australian community and could not be legitimately described as "reforms".

Second Option Preferred

As noted earlier, Local Government considers the second option to have considerable appeal in terms of simplicity, clarity and certainty.

The considerations which might be set to determine whether the majority interest in assets test is exceeded should also be clear, precise and certain.

They could include tests such as those that currently govern the application of Division 16D (which are based on the accounting tests for a finance lease), though it must be recognised that these are tempered by a discretion for the Commissioner not to apply the Division where it would be unreasonable for its to so apply. It may be possible, through an appropriate consultative process, to evolve additional precise tests perhaps based on practical experience with the administration of the existing provisions. It is noted again that reform of these provisions ought not raise the thresholds any higher than has been the case in the past, by an absolute "no detriment" rule. It would however, seem appropriate to distill those tests into a precise form and enshrine them in a legislative form.

There may be other objective criteria that are indicative of an interest in assets that warrant consideration. In this regard, it is noted that the Queensland Government is proposing a broad legislative framework as the basis for further consultation for reform of Section 51AD/Division 16D. It is submitted that this framework could serve as a suitable starting point for further consultation subject to the reservations described herein.

One factor that the Commonwealth continually points to in the context of the existing provisions is cost to Commonwealth revenue. This is a one dimensional test that compares the Commonwealth taxes that would, but for the tax preference transfer in mind, be collected in a particular year. In its simplest and most precise form, it is the tax projections for a particular transaction on a stand-alone basis that involves a tax preference transfer. The ATO requires these as part of its administration of leveraged leasing and similar arrangements – see Tax Ruling IT2051 at paragraph 4. It is submitted that this single dimensional costing should be compared with other benefits to Commonwealth revenue that are directly attributable to the particular transaction in mind. For instance, any major infrastructure project that may generate a cost to Commonwealth income tax in its early years may generate very substantial tax revenues for the Commonwealth in terms of:

  • sales tax/GST on goods/services for the project
  • tax on employment income of those engaged in the construction process and in operations of the facilities following completion;
  • tax on consultant’s/contractor’s profits engaged in the project;
  • tax on manufacturer’s/supplier’s profits that supply goods, to the project;
  • tax on financier’s income from the project, including while the project is itself unprofitable;
  • withholding taxes on foreign capital invested in the project.

This is not, and is not intended to be, a comprehensive list. But it does illustrate that a more balanced approach may be in the interests of the Commonwealth itself, if it were to adopt an overall approach to the cost/benefit of a project as a commercial entity would in this regard.

It may then be worthwhile to include as a relevant factor in determining majority interest in assets whether the transaction produces a positive contribution to Commonwealth revenues overall, rather than persist with the single dimensional approach as policy justification for the reformed provisions. In other words, the policy objective should be put in proper perspective, so that the compliance exercise does not become an end in itself.

It might also be noted that in determining what the cost to the Commonwealth of conventional leasing might be, it may be far more instructive for the Commonwealth to have regard to the "multiplier effect" rather than the one dimension approach that is used in "A Platform for Consultation", as justification for altering the tax treatment of leasing.

Moreover bearing in mind the immutable nature of the existing provisions and their absolute inability to weigh up competing economic objectives of the Commonwealth from time to time much less any objectives of the States that the Commonwealth may support/endorse from time to time in terms of economic reform, there would seem to be a case for including provision for the Commonwealth to disregard any excessive interest in assets test where it was determined to be in the national interest to do so. Any such decision might, or might not, be subject to conditions that the Commonwealth may wish to agree with, say, a particular proponent for a particular project of considerable benefit to the community in terms of meeting needs in an economically efficient way.

Obviously, if factors were to be adopted which were other than precise factual attributes of a particular transaction, it would not be appropriate for the ATO to be responsible for the administration of the process. Rather, that would seem to best be the responsibility of the Commonwealth Treasury, or some appropriate body properly qualified to determine the matter, but only insofar as the cost to revenue and national interest considerations were involved. Otherwise, the tests should be self-evident and not dependent on considerations of "control", "use" etc.

Local Government is supportive of detailed consultation with the Commonwealth and the other States with a view to developing a set of objective "majority interest in assets" criteria and in exploring any concessional tests that may be appropriate in limited circumstances.

Regardless of the way in which the preferred option may be formulated as to its scope and application, the draconian effect of Section 51AD must be terminated at the earliest possible opportunity. Its practical effect when taken into account with the Corporations Law obligations of directors as they have evolved to the current time, is manifestly excessive and unable to be justified on any policy grounds. Instead, any replacement provision ought adopt the sort of approach proposed in Division 240 of the 1997 Act whereby a notional amount of income attributable to a hire-purchase arrangement is taxed in the hands of the owner, and capital allowance deductions, ie., accelerated tax depreciation, is denied. Whatever other reforms of the existing provisions may occur, amendment of the effect of Section 51AD in this regard is long overdue and ought be addressed as a matter of urgency.

In conclusion, Local Government is encouraged by the recognition in "A Platform for Consultation" of the need for reform of Section 51AD and Division 16D. It has offered the foregoing submission in a genuine attempt to make a positive contribution to the reform process based on its past experiences and positive expectations for the future in this regard. On the other hand however, Local Government is extremely concerned about the apparent lack of justification for altering the tax treatment of leasing and urges the RBT to proceed with that aspect of its review only after all the relevant issues have been properly canvassed, analysed and weighed up in terms of what is in the best interests of the Australian economy.

2. Taxation of Entity Distributions

(a) Overview

The Ralph Committee’s Second Discussion Paper proposes three options to the reform of the existing dividend imputation regime. These options are:

(i) a deferred company tax (DCT) regime;

(ii) a resident dividend withholding tax regime; and

(iii) taxing unfranked inter-entity distributions.

These alternatives have been raised in response to perceived deficiencies in the existing dividend imputation regime. The stated deficiencies are:

(i) the complexity of the existing provisions;

(ii) the ability to stream franking credits so as to maximise their value in circumstances where a recognisant outcome of the existing regime is an imperfect utilisation of franking credits;

(iii) the relative inequity of low marginal rate shareholders’ inability to fully utilise imputation credits.

(b) Discussion

Set out below are comments in relation to each of the alternatives identified in the Discussion Paper. However Local Government notes that the first and second deficiencies noted above in relation to the existing regime being those pertaining to perceived complexity and streaming issues, may be overstated.

In so far as the franking credit streaming issues are concerned, the Government has implemented relatively stringent anti-avoidance provisions, including provisions enacted over the past twelve months which largely address this issue. Accordingly it is submitted that the ability to "stream" on a prospective basis has been significantly curtailed.

In relation to the perceived complexity of the existing regime, it is submitted that this rationale is similarly overstated. To the extent that complexity is a function of the way in which the provisions have been drafted, that issue is capable of being addressed as part of the Government’s ongoing Tax Law Improvement Project.

(i) Deferred Company Tax (DCT) Regime

Local Government strongly opposes the proposed DCT regime. It is submitted that a DCT regime as proposed discriminates against shareholders unable to benefit from imputation credits, such as Local Government entities whose income is exempt from Federal income tax.

The proposed DCT regime is tantamount to a tax on such Local Government entities in so far as distributed tax preferred income is concerned, through the imposition of the DCT at the entity level. In other words, the DCT represents a tax on Local Government that cannot be justified on the basis of the considerations listed above and represents a new tax on the ratepayer communities that Local Government represents. Not only is there no apparent policy justification for this new tax on ratepayer communities but it is starkly in conflict with the exclusion from the DCT regime of "collective investment vehicles."

While Local Government is not a collective investment vehicle for individuals in the same sense as those contemplated in Chapter 16 of "A Platform for Consultation", in a broader sense Local Government holds assets directly or indirectly and uses them to generate revenues for the benefit of its ratepayers. It has no other purpose in this regard. Those profits, taxed or otherwise, are not distributed to ratepayers as such but in effect they are, in setting rates and other charges each year.

There is no apparent policy justification for not refunding DCT credits to Local Government when viewed in this way.

In addition, the proposed DCT adversely impacts upon the value of companies as a result of DCT being imposed at the corporate (entity) level (i.e. a charge against company profits). That in turn adversely impacts upon the cost of capital to such entities.

Furthermore, the proposed DCT has the potential to significantly alter corporate dividend policies in order to manage the timing and incidence of DCT. That is, the regime will potentially have adverse cashflow implications for Local Government Shareholders of Local Government owned corporations and will create distortions to dividend distribution policies.

Subject to appropriate consultation Local Government may be supportive of a DCT regime modified to provide a refund of imputation credits to shareholders whose income is exempt form Federal income tax.

(ii) Resident Dividend Withholding Tax (RDWT)

Local Government is similarly strongly opposed to a RDWT regime as proposed. While such a regime is potentially more favourable at the entity level relative to the proposed DCT regime, it has a similar adverse impact on Local Government shareholders given the absence of a refund of RDWT for Local Government shareholders whose income would otherwise be exempt from Federal income tax.

In addition the proposed RDWT regime will give rise to a compliance burden for corporate entities paying dividends through having to track shareholder status.

Local Government is supportive of appropriate amendments to the RDWT proposals to facilitate the availability of refunds for RDWT imposed at source, in a similar way to the refund mechanism proposed for non-resident shareholders of companies in receipt of dividend income. An alternative amendment could be the ability to exempt designated shareholders, such as those whose income is currently exempt from income tax, from the proposed RDWT regime. Local Government submits that such amendments would provide an equitable result whilst maintaining the Government’s required integrity objective.

(iii) Unfranked Inter-Entity Dividend Distributions

The third alternative to implement a full imputation system entails a denial of dividend rebates for inter-entity unfranked dividends. It is submitted that this alternative alone achieves an equitable result for Local Government recipients of dividends paid out of tax preferred income.

(c) Summary of Recommendation/Submissions

Local Government supports the alternative which advocates the denial of dividend rebates on unfranked dividend distributions. This alternative alone avoids the effective taxation of dividends derived by Local Government which are paid out of tax preferred profits, thus retaining the attributes of the existing regime in so far as the taxation treatment of tax exempt dividend recipients is concerned.

Both the DCT and RDWT regimes produce inequitable and unacceptable consequences for Local Government. Each represents a disguised tax on ratepayers that cannot be justified on tax policy grounds.

These regimes provide a further disincentive for Local Government to corporatise relevant business operations and thus produce distortions in the choice of investment vehicle, in favour of direct Local Government investment.