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Review of Business Taxation
Submission in Response to "A Platform for Consultation"
16 April 1999
Review of Business Taxation
Department of the Treasury
CANBERRA ACT 2600
Review of Business Taxation
We present our submission in respect of the key issues raised in A Platform for Consultation as they relate to Australian entities.
This submission supplements other submissions by Arthur Andersen on:
as well as other confidential submissions.
We would welcome the opportunity to meet with the members of the Review to discuss the issues raised in this submission and address any concerns that you may have.
For your convenience, we have e-mailed the submission to you and have enclosed two (2) hard copies of the submission, as requested.
While no part of this submission needs to be kept confidential (we understand that the submissions will be made available to the general public) we would appreciate prior notice of any other context in which the submission may be used.
If you have any queries, please do not hesitate to contact me on 03 9286 8620 or:
Tax Practice Director
Press [F9] in the field code brackets to update the automatic Table of Contents
Summary of Submission*
Issues Affecting Implementation of Business Tax Reform*
Issues Raised in the Overview*
Policy Framework for Wasting Assets Chapter 1*
Goodwill Amortisation Chapter 4*
Taxation of Financial Assets and Liabilities Chapters 5-7*
Leases and Similar Arrangements Chapter 9*
Capital Gains Tax Chapter 11*
Capital Loss Recoupment Chapter 12*
Entity Taxation Proposals Chapter 15*
Collective Investment Vehicles Chapter 16*
Redesigned Imputation System - Chapter 17*
Defining "Distribution" in Entity Regime - Chapter 18*
"Profits First" Rule Proposals - Chapter 19*
Taxation of Trusts - Chapter 22*
A Framework for Consolidation Chapter 26*
Value Shifting - Chapter 29*
Taxation of Superannuation Funds Chapters 36-37*
Appendix 1 Consolidation Australian Holding Entity Requirement
Arthur Andersen is pleased to make this submission to the Review of Business Taxation (RBT).
Arthur Andersen has made various submissions, including:
and we have been associated with various submissions, including those of the Business Coalition for Tax Reform, the Institute of Chartered Accountants, and other organisations (in addition to participation in various focus group meetings and consultations in which Arthur Andersen people have expressed our views).
We therefore, in this submission, set out our views on various key issues in a concise form, with more extensive submissions on three areas:
We would be very pleased to elaborate on the issues raised in the submission, as required by the RBT Secretariat, and to attend further meetings in Canberra (in addition to the focus group meetings, and consultations in which Arthur Andersen partners have already participated).
As our other submissions cover aspects of the entity taxation proposals in considerable detail, our comments in this submission are of a general nature, with a focus on Australian-only entities and trusts.
Summary of Submission
1. Timetable for Implementation of Business Tax Reform
1.1 A staged reform process is necessary because a "big bang" implementation on 1 July 2000 (1 January 2000 for taxpayers with 31 December year-ends) is not achievable.
1.2 Consultation process and involvement of business after the conclusion of the RBT must be addressed.
2. Matters referred to in Overview
2.1 Broad alignment of accounting and tax treatment in some areas is supported.
2.2 Potential integration of certain accounting and taxation concepts is a second-order priority to be reviewed after first-round reform has been implemented.
2.3 Income retained in entities - no basis for the proposal is established.
3. A new policy framework for wasting assets - Chapter 1
We support the proposals for reform of the legislation but note that
3.1 Deductions should be available to whoever incurs the expenditure on the equipment.
3.2 Adjustment of cost base by anticipated proceeds is unworkable and inappropriate.
3.3 Cost base should be reduced by subsidies received.
3.4 Commencement of deductions should facilitate compliance.
3.5 Effective life must be improved, to align with economic life, as a priority.
3.6 Buildings and structures should be included in a consistent regime, with recognition of variations in effective life of buildings in different situations.
3.7 Alignment of accounting and depreciation rates is desirable.
4. Goodwill - Chapter 4
4.1 The term "goodwill" is a misnomer for a collection of business assets. The case for amortisation of the business assets known as "goodwill" is strong.
4.2 There is US precedent, and we would be pleased to assist in the consultation process and development of proposals.
5. Taxation of Financial Arrangements - Chapters 5-7
We support the proposals for reform of the taxation of financial arrangements, but note the following:
5.1 Elective mark to market tax accounting is strongly supported. A process for transactional basis mark to market tax accounting is also proposed.
5.2 We broadly support a hedging regime for anticipated transactions as proposed. However, we also recognise that there is a need for special hedging rules for a small class of large corporates with significant exposures denominated in foreign currencies. Our proposals are set out in this submission.
5.3 We strongly recommend that there be no realisation point at the time of the conversion of a convertible note (or similar instrument). Our recommendation is consistent with the RBTs proposal for scrip to scrip rollover relief.
5.4 We do not recommend deemed disposal rules. Arthur Andersen recognises that such rules would give rise to serious distortions in Australias financial markets.
5.5 Because in-substance defeasance arrangements give rise to substantially similar economic outcomes as legal defeasances they should be considered as a disposal for taxation purposes.
5.6 We do not consider that a debt forgiveness should give rise to assessable income in the hands of the issuer. Our experience suggest that the broad scope of existing debt forgiveness provisions are having widespread unintended results. Reform is recommended but subject to further and careful consideration.
5.7 There are no sound policy grounds for quarantining losses arising in respect of normal commercial transactions involving financial arrangements. The anti-avoidance provisions at Part IVA of the 1936 Act are more than sufficient to protect the revenue base.
5.8 We recommend that a single determinative approach be adopted for the debt/equity test. However, we recommend a single determinative factor different to that proposed by the RBT in its Discussion Paper. A default mechanism would be available for those instruments which could not be determined by the proposed test.
5.9 We consider bifurcation to be impractical and too costly. A blanket approach is recommended over bifurcation.
5.10 The proposals in respect of synthetic arrangements are largely accommodated by existing amendments introduced in 1997.
6. Leases and similar arrangements - Chapter 9
6.1 The leasing regime must allow for transfer of tax preferences. We demonstrate why arguments against tax preference transfer are misconceived.
6.2 If mechanisms to restrict tax preference transfer are needed, we prefer the US/NZ style Option 1.
6.3 Transactions involving tax exempt entities should qualify for tax benefits.
6.4 Case for reform of "tax exempt" provisions is overwhelming and must be a high priority.
6.5 A tax exempt provision must involve repeal of Section 51AD and replacement of Division 16D. The reform must include a statutory time period for a response (to avoid the current unworkable delays). The RBT should also consider whether the ATO is strategically the correct agency to handle this certification.
6.6 Limited recourse debt: the current Division 243 proposed for the Income Tax Legislation should be replaced.
7. Capital Gains Tax - Chapter 11
7.1 The costing of CGT proposals in Chapter 39 is incomplete and does not form a sound basis for decision making by the RBT or government. Further work is required, which (if it is unable to be carried out by RBT secretariat) should be done by expert consultants, who could perhaps draw on the US and UK experience. US and UK Treasury officials may be able to provide assistance in this regard.
7.2 Scrip rollover proposals are highly attractive, and should be expanded in scope beyond publicly-listed entities to include unlisted widely-held entities and also privately-owned entities.
7.3 Scrip rollovers should also be explored for certain "non-resident transactions" to facilitate global joint ventures, demergers, etc.
7.4 Concerns about tax avoidance or income substitution can be resolved by careful design of the measures and a monitoring program.
7.5 Investment by overseas superannuation funds into Australian venture capital (through fund managers) requires tax reform to overcome the current major tax inefficiencies.
7.6 We set out our observations about the form of capital gains tax relief appropriate for individuals. We consider that enhanced income tax return disclosure will improve the flow of statistics to enhance further tax reform.
8. Capital Loss Recoupment - Chapter 12
8.1 We support carryback of all capital losses generated after 1 July 2000 or, alternatively, the pooling of capital and revenue losses with the removal of indexation as a trade-off.
8.2 Enhanced income tax return disclosure will improve flow of statistics to enhance further tax reform.
9. Entity Taxation Proposals - Chapters 15-22
9.1 We have a problem with the tax-withholding proposals.
9.2 Resident Dividend Withholding Tax (RDWT) is preferable to DCT, but only if RDWT is clearly refundable to all taxpayers. We think that a variation of the TFN system would achieve the same integrity benefits.
9.3 We support measures to remove double taxation of tax-preferred income.
9.4 Collective investment vehicles (CIVs) should be permitted to distribute tax preferences because CIVs are substitutes for direct individual investment. We comment also on desirable definitions of CIVs, including coverage of wholesale trusts, WRAP accounts and the need for flexibility to deal with financial innovation.
9.5 We are surprised that the RBT has not considered a major defect of Australia's taxation system, whereby there is double tax on distributions through an entity chain where the receiving entity is in tax losses. This is a major issue, even more so under the entity tax system. We detail how the RBT can remedy this defect.
This is an existing problem and we urge proactive consideration of this issue by the RBT Secretariat.
9.6 We recommend against forced use of the notion of an "average franking rate" in the context of RDWT, as it robs an entity of flexibility.
9.7 The definition of "distribution" should not be defined broadly in respect of widely-held entities. Otherwise we see major practical problems in the interaction of various potential distributions made by companies.
9.8 The "distribution" definition would cause difficulty in respect of the use of trust assets in situations unrelated to business activities (eg. deceased estates). An "otherwise deductible" is needed to exclude non-business use of non-business assets.
9.9 The case for a profits first rule is not established as it was rejected by Government in 1996. Any such rule must exclude legitimate non-systematic capital distributions by entities.
9.10 Looking at trusts, we identify various necessary exclusions from the entity tax regime. We recommend that the legislation allow for additional exclusions to be introduced by regulation to deal with the (undoubtedly) many further situations which will be identified.
9.11 We identify a significant transitional issue arising for trust beneficiaries which have capital losses where the trust has capital gains. This requires legislative action if trusts are subject to the entity tax regime.
9.12 Charitable trusts are disadvantaged by DCT and RDWT. We suggest a mechanism similar to the current Tax File Number (TFN) whereby no entity withholdings are made from distributions to registered charitable trusts.
10. Consolidation - Chapters 25-27
We support the broad approach taken by the RBT to provide a systematic solution to the problems for company groups within the current income tax system, subject to the comments below:
10.1 A consolidation regime will clearly be complex. The system needs to be developed carefully through an ongoing process of consultation over time and is unlikely to be ready by 1 July 2000, and certainly not by 1 January 2000 (for early balancing entities).
10.2 As also stated in our other submission on consolidations, a foreign holding entity should be allowed for consolidated groups. Integrity and other concerns can be resolved.
10.3 We support a consolidation threshold of less than 100%, particularly in the case of employee share schemes and financing shares or units.
10.4 We agree that discretionary and hybrid trusts and private company groups could be given the option of coming within the consolidation regime. However, careful consultation is required to identify potential complexities. In particular the position of trusts and family groups should be subject to taxpayer election not forced consolidation rules.
10.5 Transitional rules introducing consolidation should encompass all members of existing 100% groups(including trusts) and should allow consolidation of their existing losses and franking accounts at the start date.
10.6 Managing intra group transactions such as dividends through tax loss entities needs to be addressed otherwise it will imperil the entire consolidation proposal. A US-style or NZ-style treatment (or some other suitable method) for dividends could resolve this.
10.7 The rules for losses of newly acquired entities should in our view allow taxpayers to adopt (possibly on an elective basis) one of the Options 2, or 5 or 6.
10.8 On exit from a consolidated group, the rules should enable severing of joint and several liability for the consolidated groups income tax liabilities. Also, franking balances should be treated consistently on entry and exit, by being allocated to the departing entity (possibly on an elective basis) - otherwise the departing entity's retained earnings will risk double tax.
10.9 We would support the adoption of the Asset Based Model for entity acquisitions and exits - in principle. However, we emphasise that many details of its operation are yet to be determined. Much more focused consultation is required to ensure that no double taxation will occur under either method.
10.10 International tax - CGT rollover relief should be retained for CFCs, and potential additional tax costs for foreign parent companies of Australian consolidated groups need to be fully considered and addressed in developing the rules for consolidation.
10.11 The interaction of the consolidation regime with other proposed measures needs to be carefully considered and refined, notably Taxation of Financial Assets and Liabilities, expense allocation rules and thin capitalisation rules.
10.12 The current consolidation proposals may result in major disadvantages for certain company groups for Australian or overseas purposes. For these reasons, we submit that RBT considers:
11. "Single Recognition of Losses and Gains" - Chapter 28
11.1 Proposals for "single recognition of losses and gains" (Chapter 28) are misconceived in our opinion.
11.2 Removal of the same business test would damage Australia's economy. There are strong reasons against removal of the same business test.
11.3 Duplication of unrealised losses - anti-tax avoidance measures could be developed to cover blatant tax loss trafficking.
11.4 Additional consultation is needed before any measures along these lines are developed.
12. Value shifting proposals - Chapter 29
12.1 These proposals are complex, and the RBT needs to move carefully to avoid creating major compliance difficulties
12.2 Any generalised CGT value-shifting rules need to be restricted to scenarios of non-arm's length parties, with a high associate inclusive interest in the group where value is being shifted
12.3 A significant de minimis exception is needed, to avoid compliance overload. We propose a threshold of the higher of 25% or $100,000.
Implementation of measures by 1 July 2000 is impossible, and a staged approach needs to be announced
A staged reform process is necessary in respect of the RBT proposals is necessary.
We believe that a "big bang" implementation on 1 July 2000 (1 January 2000 for taxpayers with 31 December year-ends) is not achievable. In particular we see great difficulties in:
(a) refinement of the consolidation provisions,
(b) development of entity-taxation distribution rules, and certainly a profits-first rule,
(c) development of Taxation of Financial Arrangements (TOFA) rules
to a workable form by 1 July 2000. In addition, that date coincides with the commencement of the GST regime and indirect tax changes which will preoccupy business for at least 12 months.
We therefore recommend a staged approach to the tax reform, over a period to be developed by the RBT.
Post-RBT Process for implementation needs to be developed
We understand that the RBT will cease work with the introduction of its Report by 30 June 1999.
However that report will be only one milestone along the road to tax reform.
As recognised in the Foundation document of the RBT, the process of policy- and legislation-development in tax matters in Australia has been flawed. Even the GST legislation process is not optimal.
We are concerned therefore to see an enunciated process for the Consultation Process and involvement of business after the conclusion of the RBT.
The process could involve a guidance or oversight role by a newly-formed independent committee, perhaps comprising some or all of the members of the RBT.
This process must be addressed and established as soon as possible otherwise:
(a) the momentum of reform will be lost; and
(b) the integrity of the open consultative process of the RBT, and the expectations raised by the Foundation, Platform, and International Perspectives documents will be compromised.
Accounting principles to be used for tax purposes?
Arthur Andersen notes the discussion in the Overview about greater alignment of tax and accounting principles.
In general terms, Arthur Andersen supports a closer alignment of accounting and tax treatment in a number of areas (eg depreciation, goodwill). However, we are concerned that in many areas accounting principles do not necessarily reflect appropriate taxation treatment. For example, accounting treatment of exploration expenditure if at odds with the correct tax recognition.
Accounting standards were designed for financial accounting purposes reflecting a bias towards disclosure of risks and liabilities with a bias to economic assessment of an enterprise's risks and performance.
Example: Accounting standards in relation to foreign currency recognition provide for disclosures which are unrelated to the realised, definite, outcomes of transactions. The accounting approach has been rejected in Chapters 5-6 of Platform rightly, in our view as providing a basis for automatic calculation of taxable income along accounting lines for all taxpayers.
Therefore, while we believe that a proposal to more closely align accounting principles and financial statements for certain tax purposes has merit, the specific application of particular accounting standards to certain areas of taxation (such as in the above example) may be problematical and would need to be carefully considered in detail before any specific measures were proposed.
Recommendation: Consultation is needed, and this is a second-order requirement
Given the RBTs obvious time constraints and the attention being given to other, more high-profile areas of business tax reform, our recommendation would be to defer any further discussion and consideration of the specific use of accounting principles until after the rest of the tax reform program is implemented.
This will give the RBT and its successor the opportunity to review the need for such measures in the light of the first round of reform.
The Government could then bring together a working group to consider the options, as we consider that the issue is significant enough to be given separate consideration from the rest of tax reform.
Income Retained in Entities Should Entities be Forced to Distribute Their Income Annually?
We note the comments in paragraphs 56-59 of the Overview, in respect of the mis-match between the top personal and corporate income tax rate. The discussion raises the possibility of measures to force the distribution of retained earnings from entities to individuals holding interests in the entities.
We consider that such a proposal would be misconceived, and inconsistent with the very basis of the tax reform proposals.
In summary, the ANTS proposals involve the following elements:
In the circumstances, we believe that any proposals to force entities (including non-widely-held entities) to make distributions to their investors would generate highly undesirable economic outcomes. These include:
The proposal is even more inappropriate when considered in the light of the recently-introduced Division 7A of the income tax legislation (introduced only last year) which provides a strong regime which deems the provision of benefits by private companies to their shareholders to be dividends.
Division 7A already provides a strong instrument for the government to ensure that attempts by private-company shareholders to benefit from the funds available in an entity are taxable.
As a result, we submit that the proposal is unnecessary.
The proposal is fundamentally inconsistent with the entity tax concept
We note that this proposal would be (in respect of privately-held entities) an enforced flow-through of taxable income of the entity. In effect the entity would be taxed to some extent as a partnership or in the same way as a family trust is currently taxed.
We suggest that the community would be bemused if, after all the churn and change of the entity tax proposals, alteration of the existing trust regime, if the net effect was to have a somewhat similar proposal come into being enforcing a flow-through treatment in the most complex of ways.
We believe this proposal should not be proceeded with.
Arthur Andersen agrees that there is merit in harmonising the myriad different wasting-asset regimes in the income tax legislation.
We think it is important however that the harmonisation occurs in a way designed to enhance Australias business environment, rather than creating new complexities.
We agree that the current rules are complex and confusing they have generated, for instance, many rulings by the Australian Taxation Office, and have generated litigation such as the recent Federal Court decision in Bellinz vs Federal Commissioner of Taxation, in which the Federal Court disagreed with the application of a series of Rulings to the circumstances, and the process itself.
Of the two options to identify the taxpayer entitled to depreciation, we prefer option 1 which will grant depreciation of amortisation benefits to whoever incurs the expenditure to produce assessable income.
A reliance on option 2 the "controller" of the asset using accounting principles - will in our view:
(a) add confusion, given the fluid nature of such principles.
(b) create major problems. The very words "future economic benefits controlled by the taxpayer" raise issues which have generated confusion. For example the RBT itself, in Platform Chapter 9 proposes the replacement of provisions such as Section 51AD and Division 16D, which involve concepts of control, which have been found to have been most inappropriate in the context of providing a smooth-functioning taxation system. We agree with the proposals to replace Section 51AD and Division 16D.
We agree that the actual cost to the taxpayer should form the basis of the depreciation/amortisation claims.
Para 1.25 proposes that in some circumstances the cost base should be reduced by expected disposal receipts.
We consider there is no basis for such a provision and agree with the comments at para 1.26 that "the gain in equity or efficiency is not likely to be justified by the increased compliance and administration costs in the case of most assets".
Such rules would involve many practical problems. These notions are similar to the notions of a comprehensive income tax, or a valuation-influenced methodology as has been rejected in the context of the TOFA - Taxation of Financial Arrangements Measures. The problems include:
(a) how would the rules deal with changing expectations of retained value?
(b) how would the rules deal with technical obsolescence of an asset which might affect retained value estimates?
(c) what would be the compliance costs of the measures, and their integrity-related compliance requirements?
We are strongly of the view that this measure is inappropriate.
Arthur Andersen supports this proposal.
Businesses often receive subsidies and government grants in respect of incentives for particular types of capital investment. We agree that under existing law the bounty or subsidy is potentially taxable at time of receipt, which distorts the taxation profile as compared with the true economic profile of the investment.
We agree strongly with the ability for a subsidy to be recorded for tax purposes - at the election of a taxpayer - as a reduction in the asset cost base, thus affecting the basis for depreciation purposes.
We recommend that:
(a) the date an asset is first used or installed ready for use be the basis;
(b) there should be a provision (at election of a taxpayer) for a half-year write-off in the year in which an asset is installed.
This part-year "basket" approach is one attraction of the present mining and resources provisions (Division 10, etc.) in being the ability to collect all expenditure in one "basket" rather than having to generate massive asset registers calling for date - of - acquisition records, etc.
The current formulation of "effective life" is economically inappropriate. The notion of effective life of an asset requires reanalysis and reform.
Effective life currently broadly equates to the expected physical life of the asset (see Section 42-105(1) of the Income Tax Assessment Act 1997). This is, however, a different concept to the economically-effective life of an asset.
This issue is particularly important given the tendency of capital equipment to become technologically obsolescent over time, which affects its economically-effective life.
We believe that this is a core issue which must be addressed by RBT in the context of the tax rate versus depreciation trade-off which is proposed.
For example, a company may acquire a piece of equipment which will have its prime income earning capacity occurring over a period of say five years. At the end of five years the asset will continue to have a value and to be operational, but it is expected that the equipment might be on-sold and a newer more effective asset acquired. In this context, the definition of effective life under the current Income Tax Legislation looks to the anticipated overall duration of the asset's physical use by any taxpayer, and the taxpayer is unable to compress the effective life having regard to the taxpayer's five year forecast of economically-effective life.
This is one reason why the current law, with its depreciation loadings, is accepted by business. With the depreciation loadings, and existing broadband depreciation regime, the issue is tolerable.
If however the depreciation loadings and broadband arrangements were to be reduced or eliminated in the context of the tax rate versus depreciation trade-off, we believe that attention would focus back on the true definition of an effective life.
Effective Life Self-Assessment is preferred
As a result, we have a strong preference for option 1 - allowing taxpayers to sell assess the effective lives of assets.
Furthermore, as explained above, we believe that the definition of effective life should itself receive attention and should be improved to focus more closely on economically-effective life.
This may well mean that tax and accounting depreciation rates can be more closely aligned, which is desirable.
Arthur Andersen supports the inclusion of buildings and structures in an overall integrated depreciation regime. In our view, the treatment of buildings and structures is currently flawed and creates confusion and uncertainties in the context of taxation treatment of such investments.
We therefore prefer option 2 - the inclusion of buildings and structures in a consistent regime.
The RBT must realise, however, that there is clear evidence that buildings do deteriorate over time. While an overall "building and land" package may appreciate in value, the actual economic value of the building itself - removed from the land - does deteriorate over time, due to technological obsolescence and changes in the requirements of tenants.
For this reason, we believe that option 3 (reduce the rate of depreciation) is inappropriate.
We also strongly recommend that there be recognition that the effective life of a building can vary. There is no one standard effective economic life for a building.
Further development of these rules is necessary.
Arthur Andersen believes that there is a powerful case for the amortisation of goodwill, as part of the overall business investment taxation reform.
The term "goodwill" in this context is a misnomer. The "goodwill" of a business is in fact a collection of a large number of assets, many of a wasting nature, and which are worthy candidates for write-off in the same way as in respect of leases and franchises over wasting assets as discussed in Chapters 8 and 10. The designation "goodwill" covers inter alia:
We think the proposition is very simple. If such intangible assets are ineligible for any amortisation or write-off, then goodwill will be exposed as the large remaining black hole in the Australian business tax system.
We think that the support for amortisation of goodwill or certain of the intangible assets is strong:
(a) the vendor of a business is subject to CGT in respect of the gains on disposal of that business;
(b) correspondingly, the purchaser under Australias current tax regime has no entitlement to any amortisation in respect of the significant business assets comprising the various intangible assets (discussed above);
(c) as a result, it appears to us that every time a business is sold for a capital gain, there is an inefficiency created a withdrawal of taxation revenue by the government from the vendor, without a corresponding taxation benefit in respect of the acquiror of the business. It appears to us that this constitutes an economic inefficiency, and provides a sound basis for a staged amortisation of the acquired intangibles over time.
We stress that an amortisation over a number of years (in the US the period of amortisation is 15 years) provides a mechanism that:
(a) controls any negative cost to the revenue;
(b) provides a signal to the community that the taxation system is operating equitably and efficiently in relation to business combinations and acquisitions;
(c) is likely to discourage purely-tax-motivated business combinations (because the goodwill cannot be immediately written-off for tax purposes).
We would be pleased to consult with government and to the RBT on details of the US system, to explain its operation, and to develop an appropriate measure in Australia.
We believe that such a measure should be based on the alignment with the accounting treatment of goodwill (ie amortisation over a period not exceeding 20 years) that has recently been adopted in Australia, after rigorous debate by the corporate community.
We agree with the RBTs comments at 5.12-5.16 that a universal mark to market approach would result in considerable difficulties for taxpayers and is not consistent with efficient tax policy.
We strongly support an elective mark-to-market treatment to be available in respect of financial assets and liabilities. The ability to elect mark to market treatment should be sufficiently flexible to enable the taxpayer to choose whether to apply the mark-to-market treatment on a transactional basis, entity or asset wide basis. We also endorse a prudent legislative framework to protect the revenue base where transactional basis mark to market is applied. Accordingly, we would broadly support an elective mark to market approach "Option 3: A combination of approaches" outlined at 6.55 of the RBTs Discussion Paper 2.
Our comments below in relation to an elective mark to market approach are, therefore, primarily in response to the eligibility criteria for Transaction Basis mark to market.
The Discussion Document at 6.51 correctly identifies the transactional mark to market approach as providing taxpayers with the greatest flexibility. We would also agree that in order to protect the revenue adequate safeguards would need to be adopted. The set of safeguards identified by the RBT at 6.52 included:
Comments on Safeguards at 6.52
The above test requires the taxpayer to comply with all five of the safeguards identified above.
In our view, the requirement for the first two safeguards to be satisfied where a taxpayer acquires a financial asset/liability on arms length terms (being at the money) is completely unnecessary.
Where a financial asset/liability is acquired on arms length terms, and the safeguards set out below have been complied with, it is virtually impossible for a taxpayer to manipulate the tax outcome under the transaction basis mark to market tax accounting method.
In our opinion, the following safeguards will be more than adequate to protect the revenue in the case of financial assets/liabilities acquired on arms length terms:
We consider that there is no justifiable rationale for limiting eligibility for transactional basis mark to market on the basis that the taxpayer does not actively quote two way prices.
Because there should be no reasonably conceivable realistic opportunities for a taxpayer to exploit the transactional basis method tax would seldom (if ever) be the reason for it election. We would, nonetheless, be interested in further comments from the RBT outlining what it would consider to be non-tax grounds which would justify the transactional basis election for individual assets.
In circumstances where the financial assets/liabilities are not acquired on arms length terms, either of the following could apply:
(i) the Commissioner is required to apply a deemed market values; or
(ii) the elective transactional basis mark to market tax accounting is not available to the taxpayer.
As noted at 5.19 of the Discussion Paper, the ability to elect mark-to-market treatment would facilitate tax neutrality and efficiency in the pricing of the financial assets and liabilities.
It is critical that the new system can recognise the different commercial motives that investors may have. For instance, shares can be held as long term investments or alternatively to realise gains in the short term. Accordingly, the ability to elect for mark-to-market treatment should be flexible. This flexibility would allow the election to be used to tax long-term holdings on a realisation basis whereas other holdings could be taxed on a mark-to-market basis.
Provided the above safeguards are satisfied by the taxpayer, we consider that there is very little risk to the revenue in allowing transactional basis mark to market tax accounting. Mark to market treatment should be final once the election has been made.
As noted at 5.14 of the Discussion Paper, the main advantage of elective mark-to-market is no taxpayer is forced to incur valuation or cash flow problems. The Discussion Paper also notes that the types of taxpayers that would benefit from the ability to mark-to-market would include market makers. Such taxpayers tend to hold both long and short positions. Under a largely realisation-based system, they may be exposed to tax timing mismatches and volatility in tax payments. If market makers elect to use the mark-to-market method then they may be more competitive in international markets.
With flexibility in mind, we would support the implementation of the proposal outlined in paragraph 6.55 of the RBTs Discussion Document. Taxpayers can then be allowed to mark-to-market on either an entity wide or asset class basis. In addition, where this option is not chosen then individual transactions should be permitted mark to market where the taxpayer elects for that treatment.
As a general rule, an elective transactional basis mark to market tax accounting methodology would eliminate most of the timing mismatches associated with individual hedge transactions (provided both sides of the transaction were taxed on the same basis).
We consider that an elective transactional basis mark to market tax accounting methodology would benefit most individual hedging transactions with little (if any) risk to the revenue.
We have recommended that the transactional basis mark to market methodology be accompanied by two safeguards, being where the taxpayer:
In certain cases, Australian resident companies are required to prepare their financial accounts in accordance with US accounting standards. We understand that under FAS 133 it is difficult for a company to disclose non-financial assets on a mark to market basis for financial accounting purposes. In this situation, a company adopting a transaction basis mark to market policy for taxation purposes should be able to use its management accounts to support its position.
As an additional safeguard, that the taxpayer should be required to identify the reason for using management accounts and the hedge transaction within 30 days.
While most timing mismatches associated with individual hedges of an underlying physical position are capable of being resolved by a transactional basis mark to market tax accounting system there is a sound case for special hedge rules for anticipated transactions.
We broadly agree with the recommendations set out at 6.65 6.70 of the RBTs Discussion Paper 2 in respect of anticipated hedges.
There is a small class of very large corporate taxpayers that have significant exposures of both financial and non-financial arrangements denominated in foreign currencies at any point in time during a financial year. Because of the size of these companies these exposures are typically hedged on a consolidated group basis through a central Treasury function. We believe that consideration should be given to hedging rules for these corporate taxpayers.
In this situation, we recommend that the company be required to maintain a Financial Treasury Policy Document. This document would be required to be updated periodically and would detail:
(i) the risk management philosophy;
(ii) a reasonable benchmark level approximating the underlying portfolio hedged on a periodic basis; and
(iii) the products that are used and when they are acquired.
The disclosure requirements associated with AASB 1033 Accounting Standard should provide corporates with a simple framework for corporate treasurers to document the details of the approved hedging strategy without undue risk to the revenue. It is anticipated that this policy would provide a tax neutral, low compliance cost strategy for recognising hedge transactions of very large corporate taxpayers.
The Financial Treasury Policy Document would require a signed annual auditors certificate, proving that the hedging strategy was consistent with the companys Risk Management Strategy. This certificate would need to be signed by the auditor and Public Officer and attached to the tax return at the time of filing.
To provide sufficient safeguards for the revenue, this option would only be available to taxpayers on written application to the Commissioner. The application would place the evidentiary requirement of showing that the taxpayer has adequate internal treasury functions available.
It is expected that:
(i) there would be a high standard of corporate governance and risk management controls expected of the taxpayer to adopt this methodology for recognising intra group hedges.
This requires the groups Financial Treasury Policy Document to be updated on a regular basis throughout the calendar year. This could be monthly, quarterly or half-yearly. We recommend either monthly or quarterly updates; and
(ii) the Commissioners policy guideline would recommend that this option be available only to those corporates with large foreign exposures to financial and / or non-financial assets and liabilities.
Chapter 6 of the Discussion Paper suggests that the exercise of the conversion option into a share should be a separate realisation point for convertible notes. To postpone the recognition of this realisation point creates a deferral of the economic income (refer 6.83).
In practice, the commercial mechanism in convertible notes is normally priced at (or around) the current market price of the ordinary share. Typically, the reason for the issue of convertible notes (rather than ordinary equity) is to avoid the discount which would be associated with a further rights issue.
Convertible notes normally carry a lower interest coupon rate than straight debt issues. The holder of a convertible note generally accepts a lower coupon rate in anticipation of being able to participate in upside equity gains at some future point in time.
On a practical level, assessing the convertible noteholder at the time of conversion effectively penalises the holder twice for a gain that may or may not materialise at the time of realisation. That is, the holder of a convertible note already forgoes a higher rate of interest typically available with normal debt products for the potential upside associated at the time of realising the instrument.
The exercise of the conversion option for a convertible note is not a factor which necessarily determines any value realised by the noteholder. This can only be determined at the time of disposal as the note will mirror the performance of the underlying share price (assuming it is increasing in value above the risk free coupon rate of the note).
The investor will realise the accrued gain based on commercial decision on how to maximise the return on investment. That is, the noteholder can either sell the convertible notes, redeem the convertible notes at maturity or convert them at some time prior to the final conversion date. There is no implied economic gain realised by the noteholder at the time of conversion.
On the basis that the convertible note price will typically mirror the performance of the underlying share there is no rational reason to tax them at any point in time different to the underlying share at the time of disposal. The exception is, of course, where the underlying share price loses value below the conversion price of the convertible note. The note would presumably hold its value in accordance with the risk free coupon rate for the note (and should not fall below this price). In this situation, there is neither a gain realised by the noteholder nor an incentive to convert to ordinary shares.
In our view a similar approach should be taken by the RBT in relation to converting preference shares and similar debt/equity instruments.
Arthur Andersen strongly recommends that the realisation point for convertible notes be recognised as being at the time of disposal of the share. In our view, determining a deemed disposal at the point of conversion would be inequitable in that it penalises the note holder for accepting a lower coupon rate and would unnecessarily impede financial market development. The proposition that a holder of such instruments derives an economic gain at the time of conversion is not is accordance with commercial practice.
The position recommended by Arthur Andersen is wholly consistent with the argument for rollover relief for scrip for scrip offers recommended at Chapter 11 of the RBT Discussion Paper 2.
Arthur Andersen does not consider that a deemed disposal rule is either appropriate or practical and would provide serious impediments in the financial market. This is particularly the case in a portfolio context where decisions relating to the risk exposure of the underlying physical assets are ongoing and evolving throughout the life of the physical asset. We consider that this proposal would create significant impediments and compliance problems, especially in relation to portfolio investors.
The deemed disposal proposals create a risk of forcing taxpayers that recognise income on a realisation basis into a mark to market methodology. This is a real risk for portfolio investors that are required to hedge their portfolio for prudential governance purposes.
The complexity and compliance difficulties associated with the deemed disposal proposals has the potential of forcing these investors into a mark to market tax accounting policy. This policy would be contrary to any policy initiative to make mark to market tax accounting an elective process.
In our opinion, the deemed disposal rules are not sufficiently well formulated to warrant further consideration as part of the proposals to reform the taxation of financial arrangements.
The Discussion Paper at 6.69 6.101 identifies uncertainties in the tax system for in substance defeasances. Our comments in relation to these transactions are set out below.
We recommend that where an in-substance defeasance occurs a disposal effectively takes place. In these situation we consider that it is reasonable to require the issuer perform a base price adjustment at the time of the defeasance.
An in-substance defeasance of a liability occurs where a debtor pays a third party an amount that is approximately the net present value of the debt in return for the third party agreeing to meet the debtors payment obligations.
Although there is no legal disposal of the underlying asset or liability in the case of an in-substance defeasance the economic equivalence to legal defeasances is such that any accrual code for financial arrangements would be best served by treating these arrangements as a disposal. We consider that this position would not create any significant compliance burdens on taxpayers. Moreover, this position would be consistent with the design principles of determinacy and neutrality as set out in the Issues Paper.
Where a taxpayer enters into an in substance defeasance arrangement, we consider that it is appropriate to require the issuer to perform a base price adjustment as if the debt had been disposed of in the manner of a legal defeasance.
Under existing law, the tax treatment of in-substance defeasance arrangements is uncertain. PFC offers 3 options, as follows:
1. Include any extinguishment gain in assessable income
2. Include any extinguishment gain in assessable income but provide an exception for financial distress
3. Apply extinguishment gains to recoup expenditure
We do not consider that an extinguishment of a liability should result in assessable income.
Further the socio-economic impacts of recouping expenditure in the case of financial distress needs to be carefully considered. In that regards experience with the existing commercial debt forgiveness rules is that it can have unintended consequences.
We consider that where a transaction is entered into for the dominant purpose of obtaining either a revenue or capital loss then that loss should be subject to the general anti avoidance provisions contained at part IVA of the 1936 Act. There is, in our opinion, no justifiable basis for separate loss quarantining provisions in respect of normal commercial transactions involving financial instruments.
Additional loss quarantining rules would be very complex and difficult to ensure corporate compliance. Legitimate revenue losses incurred in the normal course of business should not be subject to additional quarantining provisions.
From a purely tax technical perspective, the ability to bifurcate a financial instrument using financial valuation techniques appears to be attractive as a methodology for ascertaining the instruments underlying tax attributes.
Certainly the process of bifurcation has the advantage of removing the sharpness possibly associated with the blanket approach (although we believe that the default mechanism recommended above considerably reduces the degree of sharpness).
There is, however, a number of practical commercial problems associated with the application of bifurcation. On balance, we consider these practical considerations outweigh the perceived technical advantages associated with bifurcation as the preferred mechanism and should only be available in the manner prescribed above and for this reason it is not our recommended approach to the RBT.
Our analysis of bifurcation as the basis for determining the debt/equity distinction is outlined below.
The main problem with using financial valuation techniques appears to be that the vast majority of issuers in Australia:
(i) do not have the financial resources available to undertake such a valuation exercise to make decisions relating to how to either cost the market entry price of the issue or to determine the so-called economic substance of the instrument.
We understand from discussions with various market participants that Australia has less than 50 companies with sufficient resources available to utilise these financial valuation techniques.
The result of bifurcation would appear to be a significant increase in compliance costs associated with issuing instruments.
(ii) where a company has these techniques available, little (if any) correlation exists between the valuation process and the pricing of the instrument at the time of issue.
We understand from discussions with experienced market participants that the valuation exercise seldom dictates the pricing of an issue. Pricing of an issue placed in the market, typically relies on factors related to market sentiment, prior market experience of the issuer, coupon rate, dilution of investor base, control of the company, security of investment, volatility and discount.
(iii) the techniques of bifurcation are not sufficiently dynamic enough to accommodate the evolutionary nature of most instruments issued in Australia. Financial valuation techniques are only performed at the time of issue and are not used to assess the evolutionary nature of the instrument.
For the reasons outlined above we would not recommend the RBT adopt a valuation technique based upon delta to determine whether an instrument is debt or equity in nature for tax purposes. A valuation methodology based upon delta would, in our opinion, be difficult and costly for most issuers to determine and bear little (if any) correlation to the ultimate issue price of the instrument.
A delta based methodology would also require an arbitrary threshold in determining when an instrument is equity or debt in nature. This may or may not correspond to the economic substance of the issue and would seldom have any correlation to the pricing of the instrument.
We consider that the process of bifurcation based on financial valuation techniques is neither:
(i) a practical proposition for the great majority of issuers in Australia; or
(ii) a reliable indicator of the issue price.
As a general rule, therefore, we do not consider bifurcation to be a reasonable basis for determining the taxable character of financial instruments. On this basis, we are of the opinion that the RBT should recommend a blanket approach (where possible) in determining the taxable character of a financial instrument.
The recommended approach above provides a clear and easy framework in which issuers are able to ascertain the tax treatment for the vast majority of instruments issued into the market. The provision of a default mechanism provides additional safeguards to both the Revenue and issuers in issuing securities in the market place.
The primary concern of market participants with the existing provisions of the Income Tax Assessment Act 1936 ("the 1936 Act") in issuing instruments to the public is that there is a lack of certainty as to the appropriate tax treatment applicable to a wide range of debt/equity hybrid instruments. The difficulty with the debt/equity distinction was highlighted in theFull Federal Court decision in Radilo Enterprises Pty Ltd v FCT 96 ATC 4199. What is needed is a clearly defined set of tax rules which enable the issuer to establish the appropriate tax treatment at the time of issue for both the holder and issuer.
Our proposal is to resolve the uncertainty associated with the majority of instruments actively traded in the market place by adopting a single determinative methodology with the inclusion of a default mechanism (being used as a fallback position). We consider that the default mechanism would only be required to be used by a very small minority of issues (0-5%) in Australia.
We have also outlined our comments below in relation to this proposal and Options 1 and 2 discussed at chapter 7 of the Review of Business Taxation Discussion Paper 2.
The immediate concern with the fact and circumstance test is the appropriate weightings to be applied to each of the main factors i.e. repayment of investment, stipulated return, non-contingent payments, participation in gains and losses, priority in winding up, ownership, control and legal form.
It is our strong view that the so-called facts and circumstances test would not provide any greater certainty as to the appropriate tax treatment for issuers and holders of hybrid instruments than the existing rules.
We consider that the fact and circumstance test set out at Option 1, on balance, would increase the level of legislative complexity associated with the issue of such instruments and uncertainty in the market place. Accordingly, the facts and circumstance test would ultimately undermine the key design principle of determinacy referred to in the Taxation of Financial Arrangements An Issues Paper 1996 ("the Issues Paper"). Moreover, there is little likelihood that the application of a fact and circumstance test would materially (if at all) improve the other key design principle of neutrality referred to in the Issues Paper.
Arthur Andersen broadly supports (subject to the modifications discussed in the alternative proposal below) the adoption of a single determinative factor approach as a legislative framework for determining the debt/ equity distinction.
The Discussion Paper at 7.22 and 7.23 proposes a single determinative factor based on either:
(i) accepted valuation techniques; or
(ii) financial measures of the debt/equity components of a hybrid instrument.
An alternative single determinative factor was raised at 7.24 of the Discussion Paper based on a debtor/creditor relationship, or in conjunction with it, a definition of an effective company/shareholder relationship.
In our view the shortcomings of valuation techniques and financial measures are:
On this basis, we do not recommend the use of such techniques in applying a single determinative factor for the purpose of distinguishing debt and equity.
We consider that a single determinative debt/equity test consistent with the design principles of the Issues Paper could be achieved by adopting a checklist of accepted debt/equity characteristics. The test proposed should, in general, be a blanket approach to enhance simplicity of legislative understanding and taxpayer compliance. It may be possible that a bifurcation approach could be adopted in respect of certain instruments identified by the Commissioner (although we do not consider that this will be either necessary or desirable). We have commented on the issue of bifurcation as a separate matter below.
In our view the single determinative checklist should identify the key characteristic which identify debt or equity. Where it is not possible to clearly distinguish whether the instrument is equity or debt a default mechanism would then exist.
The default mechanism would provide a legislative framework for classifying such instruments to be one of either debt or equity. This characterisation would apply to all instruments which are unable to satisfy the primary test for either debt or equity. The approach recommended is diagrammatically set out below in diagram one.
Diagram One: Alternative Approach
In order for an instrument to be classified as debt for taxation purposes the following test would need to be satisfied:
The Debt Test
An instrument is treated as being debt in character for taxation purposes where:
There is an unconditional promise by the issuer to pay a sum, approximately the issue sum, certain on demand or at a fixed maturity date in the reasonably foreseeable future (referred to as the repayable principle test); and either
(i) There is an unconditional promise to pay an ascertainable return to the holder, either periodically or on a fixed date (referred to as the "yield test"); or
(ii) the instrument satisfies at least two of the following:
(a) the holder as priority in winding up against other creditors; and/or
(b) the holder of the instrument is not also the holder of equity in the issuer.
(c) the holder of the instrument does not have rights to participate in the management and/or control of the issuer.
An instrument is treated as being equity in nature for taxation purposes where:
There is no unconditional promise by the issuer to pay a sum certain on demand or at a fixed maturity date in the reasonably foreseeable future; or
(i) an unconditional promise by the issuer to pay a sum not exceeding the issue price; and
(ii) at least two of the following conditions are satisfied:
In making this submission Arthur Andersen recognises that there may be additional factors which could be applied in respect of the secondary debt/equity tests. However, it is recommended that the factors incorporated in the secondary test be kept to a minimum for simplicity.
We consider, however, that the factors identified above are the key material indicia applicable to both debt and equity. The tests are designed to accommodate a concise and reliable legislative framework for the vast majority of issuers. To provide sufficient flexibility for the market place a default mechanism is recommended (see discussion below).
Where the issuer is unable to clearly satisfy either the Debt or Equity test above the default mechanism would apply to the instrument. The default mechanism would operate on two levels. That is:
(i) the issuer would have an election to bifurcate into separate debt and equity elements. The election would be subject to conditions (refer below);
(ii) if the election is not made the issuer would be required to classify the instrument in accordance with the treatment specified in Regulations (if any);
(iii) if there is no election made or regulation the instrument would automatically default to equity.
The election would be conditional on the following:
(i) the issuer recognising the instrument on bifurcated basis for financial reporting purposes;
(ii) the issuer adopts the bifurcated elements for tax purposes of the instrument in accordance with its financial statements.
We consider that the default mechanism proposed helps remove the sharpness of the discontinuity in the tax treatment inherent in the blanket approach recommended at paragraphs 7.21-7.24 of the RBT Discussion Paper 2.
We also consider that there would be negligible (if any) revenue shortfall associated with this proposal.
To ensure consistency with the design principles of the Issues Paper and the RBT Discussion Paper 2, it is critical that the proposals endorse symmetry in the assessability and deductibility associated with all debt products.
Where a product is considered to be debt in the hands of the issuer, payments made in respect of the instrument should be treated as interest and deductible for taxation purposes. The risk is, otherwise, an instrument which is debt for the holder (but equity in the hands of the issuer) is subject to assessability on an accrual basis (irrespective of whether there are sufficient profits to make "interest" payments to the holder) while no deduction is available to the issuer.
Likewise, distributions in respect of equity instruments should be frankable and rebateable. On this basis, we would recommend the repeal of sections 46C and 46D of the 1936 Act.
We consider that the risks associated with synthetic arrangements considered at Chapter 7 (and Appendix A to Chapter 7) have largely been accommodated by the recent amendments to section 177EA and Division 1A in Part 111A of the 1936 Act.
In our view, an additional set of rules for synthetic related instruments is unwarranted and likely to have negative implications for investors in superannuation funds and insurance companies.
We consider that these issues should be undertaken as a separate review of Section 177EA and Division 1A in Part IIIA of the 1936 Act and synthetic instruments.
The Discussion Paper discusses the use of financial engineering to create synthetic arrangements. Synthetic instruments arising from these arrangements can be defined as new forms of financial instrument that can simulate the economic performance of one transaction while possessing a different legal form.
The examples outlined at Chapter 7 of the Discussion Paper (see also Appendix A of Chapter 7) refer to synthetic arrangement providing a tax benefit by the transfer of franking credits.
The ability of synthetic arrangements to transfer franking credits has now been virtually eliminated by the enactment of Section 177EA and Division 1A of Part IIIA of the 1936 Act. These anti avoidance provisions deny taxpayers the benefit of franking credits where:
(i) they are part of a dividend streaming exercise: or
(ii) the legal owner of the share is not sufficiently at risk at the time of payment of the dividend for a period of greater than 45 days (referred to as the 45 day rule).
Both rules dictate a high level of technical awareness to ensure taxpayer compliance. Notwithstanding the complexity of these rules, they are, unquestionably effective in achieving the stated objective to eliminate franking credit trading.
The recommendation to provide an additional set of anti avoidance rules for synthetic positions would, in our view, be:
(i) an unnecessary tax policy initiative given the existing provisions contained at Section 177EA and Division 1A of Part IIIA of the 1936 Act;
(ii) complex and costly to ensure taxpayer compliance. Based on the experience with the so called 45 day rule and franking credit amendments any rules dealing with synthetics will be extremely complex.
There is a real risk that the complexity and costs associated with such rules will force investors with managed portfolios (ie superannuation funds, insurance companies and fund managers) to a mark to market position.
There is also a risk that the costs associated with compliance are so great that they will provide a significant disincentive for the use of derivatives. This is the case notwithstanding prudent commercial and risk management requirements of portfolio managers.
Ultimately, these will represent increased costs to the organisations that use synthetics for best practice risk management purposes and will flow through to investors in the form of lower yields or greater risk.
(iii) complex to administer;
(iv) have a negative impact on the market and act as a disincentive for investors to invest in such instruments.
This is likely to have a negative impact on the Treasurers strategic objective to provide Australia with an economic and regulatory framework conducive to a leading regional financial centre. Moreover, if there is an increase in the practice of leaving positions unhedged (as predicted) it will create greater exposure and financial risk in the Australian financial community.
The rules regarding wash sales and straddles may lead to the denial of capital losses. It should be noted that investors who are liable to capital gains tax on their investments will often be unable to utilise these losses and thus any risk of reducing government taxation revenues will be limited.
In respect of the proposals in Chapter 9 and related proposals, Arthur Andersen has concerns about the approach adopted to reform.
Arthur Andersen believes that the taxation of leases must allow the transfer of tax preferences. We are strongly of the view that there is a sound economic case for allowing tax preference transfer through leasing.
Arthur Andersen rejects Option 1 at page 235, under which the taxation of leases would proceed without the opportunity for transfer of tax preferences, by recharacterisation of leases and similar transactions under a "sale and loan" approach.
We consider that Australias taxation system should, as a key design feature, "improve investment efficiency and competitive neutrality" as set out at para 9.35. As a result, any measure which offers tax concessions to a taxpayer, but prevents the taxpayer from converting the concessions into immediate economic benefits results in economic inefficiency.
In the context of acquisitions of assets, a taxpayer will often have start up losses, due not only to accelerated depreciation under the current system, but also to delays in establishing a market causing low initial sales of the product of a facility, or perhaps depressed prices for the taxpayers product (particularly in the resources sector).
In these circumstances, a taxpayer must have capacity to convert the value of tax benefits to an immediate economic advantage. Otherwise, the value of the tax benefits will be eroded on a present value basis, thus creating a bias against risky projects except for large companies with assured streams of taxable income and assured capacity to absorb tax benefits arising from capital investments.
There is thus an important equity issue in relation to leasing. Without an economically efficient tax-transfer mechanism:
1. Organisations which currently have tax losses (for reasons potentially quite unrelated to accelerated tax preferences) will be disadvantaged in capital expenditure decisions against other currently-taxable companies.
2. Organisations which have a risk of tax losses or a risk of tax benefits impeding their ability to offer franked dividends to their investors will be less inclined to invest in higher capital expenditure projects.
3. Small business, which often undertakes a significant risk to create new projects in emerging businesses where the market has not yet been established, will be further disadvantaged. This is particularly the case because small business in Australia is heavily reliant on debt finance for its business expansion, and is less likely to have a pool of assured taxable income against which depreciation deductions may be claimed.
As a result, Arthur Andersen believes that the taxation of leases must allow the transfer of tax preferences.
The arguments against allowing tax preference transfer cited in the Platform include a potential cost to the revenue by access to the benefits in respect of projects involving tax exempt entities.
We are strongly of the view that there is no empirical evidence that tax preference transfer has done any mischief or produced any adverse effect for the economy by way of the existing tax treatment of leasing. The tax preference transfer has a revenue effect but so does the leasing regime in the US, UK and most other developed countries.
Therefore we believe that this is not a high priority issue for the RBT in the ANTS process. In deciding where to allocate tax reform resources, we think that the RBT might consider the approach (particularly in this area) of "dont fix things that arent broken".
This claimed defect can be adjusted by appropriate rules for exempt-entity-related projects, which we discuss below.
"Cost to Revenue" suggestion is misconceived and breaches the RBTs equity objective
Another argument cited in the Platform relates to the revenue implications of removing all restrictions on tax preference transfers.
We suggest that this latter argument amounts in effect to a recommendation to perpetuate the inefficiency in Australias tax system the very type of defect which the RBT is seeking to eliminate.
This argument effectively proposes that the measures for allowing tax depreciation and amortisation should be costed on the basis that there will be an inequitable inability to benefit from the concession for some element of the Australian community unable to access the benefits of their expenditure on business fixed assets. We suggest that such a proposition is inappropriate in the interests of economic efficiency, investment neutrality and indeed taxpayer equity.
We strongly suggest that the RBT should recommend that government tax recognition of business investments should be costed on the basis that there will be an efficient tax-transfer mechanism, and that the leasing regime should not be developed along Canadian lines to deny tax benefit transfer as a general default proposition.
Of the two models cited at page 246, Arthur Andersen prefers the New Zealand/US regime Option 1 which restates finance leases as loans. We believe that this approach is strongly preferable to the Option 2 (Canadian) approach which has a default denial of tax benefit transfer to the leasing company in exchange for lower funding costs with the exception of specified exclusions.
We agree that there are two advantages of Option 1:
(a) Broad correspondence with the Australian accounting standard treatment.
(b) It allows the leasing company to be entitled to tax benefits associated with capital equipment where there is a predominant economic interest on the part of the leasing entity.
We believe that the disadvantages of this model are somewhat overstated:
(a) We agree that there will be some complexity. However, we suggest that this complexity will be significantly less than that which exists under the current Australian tax system with a motley assembly of tax rulings dating back to the 1960s, tax office practice which has been criticised in Australian courts, and large scale uncertainty. Codification of the rules will provide certainty.
(b) The observations made that operating leases are not in substance different to finance leases, or alternatively that finance leases could be restructured to become operating leases, does not recognise that from the viewpoint of the lessee user an operating lease is a substantially different economic transaction to a finance lease. Under an operating lease, the lessee-user has a significantly different risk profile, because major risks and rewards of ownership are suffered by the leasing entity. It is precisely this economic interest which justifies the leasing entity taking the benefits of tax depreciation.
Arthur Andersen strongly supports the reform possibilities touched on in chapter 9 of the Platform document, and in particular:
(a) We strongly support the removal of Section 51AD of the Income Tax Assessment Act; and
(b) We strongly support the improvement of the existing Division 16D or alternatively its replacement by a more modern package of provisions.
We agree that the long term solution to transactions involving tax exempt entities which are controlled by States or local governments would be an agreement between the three arms of Government as foreshadowed in para 9.54 of Platform. However, we expect that this will take time.
We believe that the RBT has the potential to substantially improve the economic efficiency, investment neutrality and equity of Australian taxation system by undertaking a reform of the existing Section 51AD and Division 16D in the short term.
Arthur Andersen believes that the case for reform is overwhelming.
There is increasing experience in Australia of governments outsourcing various functions to the private sector in a manner which transfers risk activities ranging from toll roads, to hospital activity, to computer service contracts; and privatisation transactions whereby previously government-owned assets and businesses are transferred to the private sector.
Both types of transactions involve some residual Government involvement, whether by:
(a) regulation of the business activities in order to ensure that community service obligations (CSO) are met and standards of service are maintained;
(b) provisions for eventual transfer of certain assets to government ownership in order to ensure that the communitys long term interests are protected.
These modern trends, of legitimate private sector involvement in activities regulated by Government or previously carried on by Government with real risk assumption by the private sector are often delayed and frustrated by the existing tax provisions.
The provisions which are obsolete and unworkable - are:
(a) Section 51AD, which provides that in the event of Government use of an asset or "control of use" of an asset, where there is non-recourse debt or deemed non-recourse debt financing more than half the value of the asset, all tax benefits will be denied including not only the taxpayers depreciation claims but also deductions for interest expense and all other expenses.
(b) Division 16D, which in certain situations, causes a denial of depreciation.
Section 51AD is clearly flawed and problematical. Amongst other defects:
(a) discussion about the Governments "control of the use" is patently inappropriate in these days of regulation.
(b) This provision generates ongoing difficulties in relation to transactions such as hospitals, prisons, toll roads and other typical asset scenarios where the Government has legitimate community service obligation requirements, and other standard setting processes, which result in difficulties.
(c) the experience is that with every new category of outsourcing, there are disputes and disagreements with the ATO and threats of litigation
(d) every project impacted is adversely affected by delays in turning around ATO opinions
(e) the ATO, in interpreting a patently-inappropriate piece of legislation, is extremely defensive it is cautious about establishing any precedent which might be used adversely against it in later transactions.
The cost to economic efficiency of Section 51AD is large.
Any argument for retention of Section 51AD would in our view be at total variance with the responsibility of the RBT to discharge its obligation to act in the national interest.
The ATO and the taxpayers have developed a routine of tax rulings and practices which work around the defects in Section 51AD. However these rulings, while commercially tolerable, are quite inappropriate as a matter of efficient interface with the tax system. The issues cover matters such as:
(a) when is government use of an asset not a "use" which disqualifies the project; and
(b) when does government regulation not amount to control.
More importantly, the rulings operate as a de facto exercise of ATO discretion, where there is no overt discretion conferred on the ATO under the law.
The Rulings are thus questionable, and we fear that if the rulings were examined by a Court of law, they would not be applied as occurred in the case of Bellinz in a related context.
We are sure that the RBT would not wish to participate in continuation of this unacceptable state of affairs.
Division 16D is poorly drafted and inappropriate for Australias current environment of privatisation, Government outsourcing and public : private partnerships. We believe, and we are sure that the ATO will confirm, that the existing Division 16D operates due almost entirely to the discretion on the part of the ATO to overlook non-compliance with Division 16D to save the depreciation deductions in respect of affected assets notwithstanding non-compliance with the strict technical requirement of Division 16D. The reliance on the discretion demonstrates that the "bright line" tests are inappropriately constructed.
We suggest that any independent analysis will show that Division 16D is honoured more in its breach and exercise of discretion than in its technical compliance.
The case for reform is strong.
Arthur Andersen believes that the key elements of reform in this area are as follows:
1. We strongly support the view of the RBT that the preferred approach is to allow the private sector owner of affected assets to be entitled to the tax benefits, except where the tax exempt entity has the "predominant" or "majority" interest in an arrangement chapter 9, Appendix C, para C.11.
2. We agree with the observations in Appendix C, that an excessive reliance on "bright line" tests will lead to "bright line" problems. If there is an excessive number of tests with precise mechanical calculations and assessments required, these will not provide sufficient flexibility to determine the key issues whether or not a tax exempt entity has a predominant (or majority) interest in an arrangement.
Therefore, Arthur Andersen favours:
(a) A provision with a focus on economic risk without a multiplicity of complicated tests (like the present Division 16D).
(b) A discretion on the part of the relevant regulatory body to save transactions which did not comply with the bright line tests.
(c) We reiterate that experience with Division 16D shows that the bright line tests contained therein are now inappropriate (if they ever were appropriate) and the discretion has become the key element preventing a collapse of operation of Division 16D.
3. Arthur Andersen believes that the factors to be used should be developed in consultation with the RBT, ATO and interested industry participants over a short period potentially in the period until 30 September and would be capable of issuance in draft legislation late in 1999. We do emphasise the need for ATO involvement for the following reasons:
(a) The ATO and the industry have developed a series of guidelines over the years, which broadly look to exempt entities predominant interests and economic interests;
(b) In the interests of economic efficiency, and to prevent uncertainty in this business sector, it would be desirable to pick up existing useful precedents wherever possible.
4. We strongly support the notion of tax benefits being available as a default, unless a tax exempt entity has the "predominant" (or majority) interest in an arrangement. This formulation of the RBT is very attractive because it will ensure that de minimis Government involvement will not prejudice a transaction (we look forward to the creation, for example, of toll road or other projects where there need not be discussion about the tax risks associated with traffic lights!).
5. Issues which Arthur Andersen believes should clearly require attention in the formulation of the rules include the following:
(a) There should be an express provision that Government regulation of an industry, and requirements for community service obligations, do not automatically or ordinarily imply control of use.
(b) BOOT (build-owned-operate-transfer) projects are a common feature of public : private contracts. As a result, the existence of BOOT transactions must be recognised as acceptable forms of transaction (currently Division 16D contains a formal prohibition against BOOT transactions, but as stated above the ATO discretion is used to overcome this defect in Division 16D).
If the ATO is unable to participate in the development of guidelines, then we recommend that a group of Federal and State Government Privatisation or Treasury officers be assembled, together with the private sector, which can develop the rules.
(c) Repair obligations residing with the tax exempt sector should not prejudice the tax attributes of a project (as currently occurs with Division 16D).
The process involves consideration of the following major areas:
1. Timeliness of Response introduce a Statutory Period
Privatisation and infrastructure projects involve open tenders, with multiple participants, and often significant commercial deadlines. Currently, the experience of participants is that Section 51AD and Division 16D negotiations with the ATO can prove to be extended and lengthy processes.
We recommend that the legislation should be responsive to the commercial requirements of this industry where the tax attributes are critical to the commercial outcome by providing a statutory time limit for turnaround of an opinion by the ATO or other regulatory authority.
We note that time limits in commercial situations are built into:
(a) The Foreign Investment Review Board processes;
(b) The ASIC (Australian Securities and Investment Commission?) processes for regulation of new entrants into the market.
We propose that the legislation should contain a default time period (say 45 days) for the ATO to find that a tax exempt entity had a predominant (or majority) interest in an arrangement otherwise the arrangement should be allowed to proceed with the tax benefits being available to the participants.
2. Should ATO certify the predominant (or majority) interest in an arrangement?
We raise, as an issue for consideration, whether it is appropriate for the ATO to be the authority which might certify that a tax exempt entity has a predominant or majority interest - thus denying a potentially the achievement of tax benefits in respect of a project.
We make the following observations, as factors in the decision making process by the RBT:
(a) the ATO's charter gives it principally a revenue collection orientation. In the circumstances, we wonder whether it is appropriate or indeed fair for the ATO to have a responsibility for determining the commercial issues involved in respect of this decision making process. We note that the Development Allowance, and more recently the Land Transport Facilities Infrastructure Bonds arrangements call for two stage processes:
(i) an external regulator (or a group within Treasury) to establish the commercial qualification of a project for the concession; and
(ii) the ATO then to administer a totally defined set of tax rules, without being responsible for the threshold decision.
We are concerned, in a cooperative spirit, that part of the difficulties in relation to this area in the past have arisen out of the tension between the ATO's legitimate focus on tax collections, and the administration of measures which (in the final analysis( are about legitimate access to tax concessions.
(b) The ATO is under significant cost and budget pressures. As a result, our perception as professionals is that the ATO does not have sufficient resources to deal with infrastructure and privatisation issues on a timely basis when peak loads arise.
We believe that, if the ATO or another regulator was to be responsible for the certification of predominant interest, that it would be imperative that:
(i) there were sufficient resources available to turn around decisions promptly; and
(ii) as discussed above, there should be time limits on the decision making process - so as not to cause projects to fail because of the length of time taken to resolve the issues.
Chapter 9 of Platform contains discussions about non-recourse arrangements involving tax exempt entities (Appendix B).
Looking at Appendix B, we wonder about the extent of any "structured non-payment of non-recourse finance". We wonder how substantial this issue is, and therefore how significant the development of policy responses is.
The issue is currently addressed by existing anti avoidance legislation; and the existing Division 240 and 243 of the Income Tax Legislation.
Arthur Andersen welcomes the raising of this issue by the RBT. In particular we consider that:
(a) the existing Division 243 is inadequate, being poorly drafted and not well thought through;
(b) there is great merit in a properly analysed replacement for Division 243 to be introduced;
(c) we would be interested in the consultation process to develop such a regime.
In the interim period, we believe that the Federal Government should consider abolishing the existing Division 243, or standing over the commencement date of the Rules, pending development of an improved regime by the RBT.
Arthur Andersen strongly supports the initiative of the Howard Government and its Treasurer in referring to the RBT the possibility of real and abiding reform to Australias taxation capital gains tax system.
The existing system is:
However, it would be most unfortunate if the opportunity was not utilised due to:
(a) uncertainty over proposed costing of the measures occasioned by insufficient work having been done; and
(b) carrying out costing of the measure without proper regard for behavioural effects.
Arthur Andersen is of the view that the current costing methodology adopted by the secretariat to the RBT is incomplete and does not form a sound basis for judgement and decision making by the RBT or by government (we realise this has been done in a short timeframe).
We suggest that there will be behavioural effects occasioned by reform of CGT. In particular:
(a) US experience is that the reduction of capital gains tax rates was accompanied by a pick up in the tempo of economic activity.
We appreciate that the recent strong performance of the US is not necessarily caused by the CGT reform there.
However it appears to us that, as it became easier for private individuals to dispose of assets without the excessive impost of personal tax rates (after the introduction of CGT reform in the US), the propensity of individuals to dispose of assets increased. Thus, owners of businesses have fewer tax impediments in the way of business restructure and achievement of economic efficiency and the benefits of scale.
We submit that the US materials can be analysed with the resources available to the government, by reference to interaction with the US Treasury, and the US House of Representatives and Senate Committees which first explored CGT reform in the US.
(b) The UK has recently adopted measures for the reduction of capital gains tax, in the tenure of the current government. We submit that materials available to the Australian Government via the UK Chancellor of the Exchequer will also provide material about behavioural effects and policy input into the decision making process.
The costings at Chapter 39 of Platform in respect of CGT reform are of limited use only and are incomplete. The footnotes to Table 39.2 state clearly that they assume no behavioural effects because these are difficult to quantify.
If the Secretariat of the RBT consider it too difficult to forecast of the impact of tax reform, then we suggest that the Federal Government or the RBT should engage an external consultancy and the externally developed model should then be exposed and tested publicly, so as to build a proper consensus and a baseline for reform. Perhaps the US or UK Treasury Departments could be a source of assistance in this regard.
We believe it would be a great dis-service to Australia for an opportunity for generational change to be sidelined by virtue of "a lack of numbers" without a real commitment to undertake the research.
Arthur Andersen supports the desirability of a scrip rollover for public companies.
However, we believe that the scrip rollover proposal does not go far enough to achieve the requirements of the national objectives proposed by the RBT:
We submit that scrip rollover treatment should be available not only for public companies but also for:
(a) widely-held entities acquiring other widely-held entities (eg unlisted trusts, etc);
(b) widely-held entities acquiring non-widely-held entities (eg takeovers of private companies by public companies); and
(c) similar acquisitions occurring wholly within the non-widely-held sector (eg private companies acquiring other private companies). That is, we believe it would be quite counter-productive to Australias economic efficiency goals to prevent private companies, and private groups, from being able to merge to achieve the benefits of:
(i) economically-viable scale; and
(ii) the benefits of improved economic efficiency.
Arthur Andersen notes the work done by the Securities Institute of Australia in demonstrating the significant economic efficiency and net revenue positives emerging from this proposal.
We suggest that there is likely to be at least a significant gain by expanding the scrip rollover proposal to the non-widely-listed entity sector.
The ability to use scrip for scrip rollovers in international acquisitions and divestments should also be considered. Consideration of circumstances where such treatment is appropriate would include:
(a) Australian resident companies that "spin-off" a non-resident subsidiary. This helps Australian companies retain their competitiveness in attracting and retaining international equity investors in the international market place.
(b) Australian companies that acquire non-resident subsidiaries. Again, this assists Australian companies to remain competitive in the international capital market place.
Consideration should also be given to enabling CFCs to take advantage of scrip for scrip rollovers.
Rollovers are necessary to enhance the scale of Australian business.
The small business sector in Australia is an important generator of employment growth. The privately-held and small-business sectors of the economy have ownership held predominantly by private individuals the very same private individuals whose behaviour would be positively impacted by the public-company script rollover proposal.
Private individuals are subject to high rates of capital gains tax currently, and likely to remain subject to high income tax rates in the future.
The ability to have a CGT rollover, which enables a continued involvement in the business (albeit merged into a new business) in a way which does not involve any cash withdrawal is an important element which will encourage the process of business combination to achieve efficiencies and improved competitiveness.
The Platform suggests that the chief reason for not extending the relief beyond listed companies is the risk of tax avoidance. There is no indication of consultation with the US or UK tax authorities to confirm such by-products of their tax systems.
Arthur Andersen believes that the clear way of resolving these risks is to establish a focused process of consultation amongst the relevant industry bodies and ourselves, in order to formulate measures to limit the potential income-substitution effects. We believe that in a very short time period, a series of measures could be established which would provide a sustainable outcome for the Government. Additionally, we believe that the measures could include:
(a) a disclosure regime whereby entities benefiting from scrip rollovers were required to report such rollovers in their income tax returns (thus enabling the amassing of better quality statistics), and
(b) a clear commitment to review the concession after (say) five years, in order to refine and improve the concession once the favourable effects were known.
The worlds superannuation and pension funds (particularly from the US and UK) are a primary source of the world's long-term patient capital. It is also increasingly clear that Australias tax regime for dealing with international investment by pension funds and superannuation funds in patient capital is out of line with world practice.
In particular, funds managers representing international pension and superannuation funds, attracted to Australia to invest in Australian venture capital activities, find that they are subject to 36% Australian tax rates in respect of that investment. As a result, overseas funds managers bypass Australia, given that they can invest at a 0% tax rate in, inter alia:
It is clear that the prospect of attracting the long-term patient venture capital from this source would be a net positive for Australia. We submit that this investment inflow into Australia would:
(a) boost the size of Australian businesses which would become investees;
(b) would thus create jobs and employment;
(c) would enhance the development of the venture-capital funds-management sector, and the sophistication and expertise of the participants.
We suggest that a case can be clearly developed that a concession to inbound overseas venture capital is economic good sense, and would generate revenue benefits.
If this concession was restricted to investment in particular industry sectors, we would recommend that the targeting would be by way of regulation, with a carefully selected body of government and scientific experts being created to establish and recommend expansion or adjustment of the targeting categories to the Treasurer of the day.
We note the various options proposed in Chapter 11 and make the following observations:
(a) A capped rate, capped to the entity tax rate, is prima facie effective. However, we are concerned that this would be misunderstood by the community as being a regressive tax concession and thus would be politically difficult to achieve.
A better option would be a 20% or 25% reduction in the CGT rates across all income categories. We note however that, given the quite high personal tax rates, that even a 25% reduction would still result in approximately a 36% tax rate for highest-rate individual taxpayers.
(b) Stepped Rates
We are attracted to the idea of stepped rates.
Arthur Andersen believes that the tapered rates should have a taper of less than ten years - certainly in respect of active business investments.
We are therefore attracted to a rate structure more akin to the US structure, whereby the holding of an asset after a holding period (designed to eliminate speculative transactions) attracts the CGT rate. We would propose a minimum holding period of 18 months, after which active business assets (or shares in companies carrying on active business) would be eligible for a significant CGT concession prima facie a 50% reduction in the personal tax applicable.
If it was considered that an economy-wide CGT regime of this nature was too costly from a revenue viewpoint, then we would suggest as an interim measure that there might be a taper introduced in relation to passive assets (and we note the experience of the UK in this context) whereby a longer-period taper would apply in relation to passive non-business assets.
These proposals can be developed, and we would be pleased to participate in the development process. However, we note that the provision of a strong stimulus to business formation in Australia would be a profound and welcome way of stimulating economic activity in this country.
We support the initiative of the RBT in exploring measures to overcome the current "blockage" of capital losses.
Arthur Andersen supports Option 2, whereby all capital losses generated after 1 July 2000 should be able to be carried back.
We also support Option 3, where capital losses in respect of wasting business assets should be usable generally. This option could be explored as part of an overall broadened depreciation base including buildings and goodwill, no balancing charge rollover and a policy allowing for pooling of realised gains and losses.
We suggest that there would be merit in improving the income tax return disclosure in respect of the generation of capital losses, in order to enable the government to better track the creation and pattern of capital losses, in order to improve its policy making capacity.
Arthur Andersen would support a medium term position that capital losses should be able to be carried back indefinitely (in respect of losses generated after 1 July 2000).
Entity Taxation Proposals Chapter 15
The Government and the RBT have advanced three key national objectives as the foundation upon which the new system of business taxation is to be built, namely:
We are concerned that the entity taxation proposals will:
(a) Involve a high degree of complexity altering the taxation aspects of entities and their investors, entities and their distributions, entities and their tax profile, entities cash flows, and categorisation of entities in newly-developed ways;
(b) Create (particularly under the deferred company tax proposal, but even under the other more preferable proposals) a significant requirement for re-education of Australian and international taxpayers, changes in economic behaviour at both publicly-owned and privately-held entity levels; and
(c) Have the potential (unless certain features of the trust regime, the collective investment regime, and the profits first regime are remedied) to in fact result in inequitable outcomes for various categories of taxpayers and to disadvantage Australia in attracting international capital.
Arthur Andersen is committed to a dynamic business environment in Australia on the basis that the development of Australian business both locally and internationally will generate the national income needed to sustain our growth and the welfare of Australias citizens. As well, Arthur Andersen recognises the Governments need for appropriate revenue streams, which represent the cash flow needed to sustain its ongoing obligations.
However, we believe it is clear that a number of the proposals contained in the Platform document create great risk for Australias business and taxation climate, with consequent long term risks for Australias welfare.
For this reason, Arthur Andersen advises the most careful attention by the RBT to the implementation of the measures, and recommends:
(a) Continuing consultation on development of the entity measures;
(b) A carefully considered approach to the transition and commencement dates in respect of the entity measures.
Entity Taxation Rules Deferred Company Tax is unacceptable, even if accompanied by streaming of foreign-source income to foreign shareholders
The deferred company tax regime proposed by the Government in "A New Tax System" is not the solution to the Government's concerns.
As contained in our other submissions, Arthur Andersen believes that the increased focus by the RBT and others on the DCT proposal since it was announced last August has only served to highlight further its unsuitability for Australia.
One major and material consequence will be the reduction in reported profits suffered by those entities subject to DCT.
Our concerns also relate to entities with foreign shareholders. Even a proposal to combine DCT with a streaming of foreign-source dividends to foreign shareholders cannot make the DCT economically effective:
(a) if a company had a foreign-source profit flow representing a particular percentage of its overall income, and had that same percentage of foreign shareholders, the company might conceivably stream the foreign-source income to foreign shareholders, retaining its Australian-taxed income to generate franked dividends to Australian shareholders.
(b) however if the company's foreign-source income over a period exceeded its percentage of foreign-source shareholders, that company, the streaming of foreign-source income would benefit foreign shareholders. However the lack of sufficient Australian taxed income to frank the dividends to Australian shareholders would still leave the company exposed to DCT liabilities and shareholders paying two layers of tax on the foreign income foreign tax and DCT.
Thus the streaming of foreign-source income to foreign shareholders will not remedy the defects of DCT.
The entity tax proposals contain:
a) base-broadening measures (taxing certain distributions not currently taxed) and
b) collection measures (DCT and RDWT).
We believe that if the base-broadening measures are implemented, and DCT is rejected there may be no basis to introduce RDWT.
The integrity of the tax system could easily be enhanced generating the same outcome as the RDWT - by an upgrade of the existing Tax File Number (TFN) system without the need for cash withdrawal by the paying entity as envisaged by RDWT. We recommend therefore that development of the TFN system should be the preferred strategy.
Resident dividend withholding tax is the "least worst" of the 3 entity tax proposals but Arthur Andersen strongly recommends that there must be refundability of excess RDWT where a shareholder's RDWT exceeds their income tax liability. This will often arise in respect of corporate groups which receive dividends from joint venture companies.
Arthur Andersen notes that RDWT will itself involve logistical issues in terms of the correct processes for withholding of RDWT. Transitional issues are discussed subsequently.
The options outlined for addressing double taxation in the context of the ongoing management of a DCT regime are either not commercial or potentially complex.
However, as stated at page 355 of Platform there is always a potential for double taxation of distributed tax-preferred income, even in the absence of DCT.
Arthur Andersen supports measures to allow for elimination of this double taxation in a considered manner. We recommend the following suite of proposals:
(a) Option 3 on page 360 of Platform (pre-payment of tax by an entity in respect of temporary tax preferences, to enable fully franked dividends) is a desirable strategy, already pursued by many Australian companies. Arthur Andersen supports a mechanism to more overtly allow entity tax prepayments, to enable fully franked dividends to be paid.
We disagree with the statement in para 15.62 that "it will be necessary to ensure that the prepayment was not used to protect distributions from untaxed profits arising from permanent tax preferences." Surely, if entity tax was paid, there is no requirement to surround the prepayment of entity tax with further conditions and analyses. We do not understand why the proviso in 15.62 is necessary.
(b) Arthur Andersen also supports the proposal for a refund of franking account surpluses on liquidation of an entity.
We believe that this is a worthwhile efficiency-related proposal. It recognises that if an entity has paid company taxes so as to establish franking account surpluses, then on liquidation of that entity with a closer alignment of entity and shareholder taxation a pass through of that franking account balance to the shareholders is appropriate.
Collective Investment Vehicles Chapter 16
Arthur Andersen supports the proposal contained in Chapter 16 for the exclusion of collective investment vehicles from entity taxation.
CIVs can be best understood as collective savings vehicles, and are more closely aligned to collections of individuals rather than to trading operations and entities.
As a result, the CIV-style entity should properly be treated in much the same way as an individual.
In our opinion, the collective investment vehicle concession designed to be a "carve out" to moderate the undesirable effects of entity taxation is a highly desirable reform, and is necessary to moderate the otherwise undesirable effects of entity taxation on savings in Australia.
Arthur Andersen strongly supports Option 1 on page 373 of Platform not taxing tax-preferred income flowing through CIVs.
The reason is very clear to provide competitive neutrality in respect of investments. CIVs (as the concept is developed in Platform) are really collective vehicles for drawing together the investment funds of smaller investors. Thus it can be seen that equity demands that CIVs should be treated similarly to small investors.
A simple cameo demonstrates this fact:
An individual with sufficient financial resources can purchase a $10m building and enjoy the legitimate tax deductions applicable to that property investment.
By contrast, an individual on average weekly earnings is unable to directly acquire a $10m building. For purposes of diversification of portfolio, that individual may wish to own a property interest but the mechanism appropriate for such a person is the acquisition of units in a property trust. If the property trust is unable to pass through to its ultimate investors - cash enjoying the normal incidents of property ownership, then the property trust as a CIV form will be restricted over time. Correspondingly, the small income individual will over time be disadvantaged from the viewpoint of investment options as compared with the higher income individual.
On an economy-wide basis, the equity effects of such a prohibition on tax-preference transfer would be significant.
Accordingly, Arthur Andersen believes that CIVs, restricted to passive entities as defined in Platform (discussed below) should not be subject to entity taxation and should have the ability to pass on tax preferences.
The greater development of the financial services industry, and entities now to be known as CIVs, has been due to the accumulation of household savings and superannuation in professionally-managed institutional investment funds.
The competitive neutrality of CIVs must be seen against the position of household savers investing directly. If difficulties arise through the involvement of managed funds, then household savings over time are channelled into new forms, such as the recent emergence of "WRAP" accounts (in effect, scenarios where institutions operate as mere nominees of individual investors, usually through the use of trust accounts under which the investor has an absolute, indefeasible interest in the asset).
As a result, we believe that the benchmark for analysis of CIVs is to consider their treatment against that of individual investors. If an individual investor invests in a property, or in a share, the tax consequences are known and the CIV tax treatment must approximate that of the individual.
We accept the comments in 16.23 that investment neutrality will require that CIVs should not participate in direct activity-type investments, otherwise there could over time be a threat to the company tax revenue base.
We note that the comments at 16.23 do recognise the existing "trading trust" rules in the income tax legislation, which aim to achieve a similar objective.
We support a refinement of the relevant guidelines in the existing trading trust rules, given the practical experience of those rules, which shows that there are some flaws in their operation in relation to areas such as:
Arthur Andersen agrees with the proposal that CIVs should be:
CIV treatment should be allowed for "wholesale trusts" or similar distributing entities while not in themselves being widely held, represent the pooling of funds of other CIV entities.
This concept of "wholesale trust" - and appropriate income tax definitions to cover these has been adopted in the current income tax legislation in respect of the holding period for shareholders to enjoy the tax attributes of dividends (commonly known as "the 45 day rule").
Passive distributing entities held by superannuation funds, life companies, etc. should also be eligible for CIV treatment, consistent with the approach used in the 45 day rule.
These measures ought not to compromise the integrity of the system, given the requirement for CIVs to derive passive income. That is, there should not be a large-scale conversion of trading businesses into CIVs simply because there was a realistic and equitable definition of "widely held".
We recommend that the drafting approach allow for "WRAP" accounts (nominee arrangements in respect of individuals) provided by financial institutions to be either defined as CIVs or excluded from the entity tax rules.
CIVs would need to be defined sufficiently broadly to enable continuing financial innovation to occur, in a way which did not prejudice the revenue.
Option 1, the Deferred Company Tax Proposal is, as expressed previously, inconsistent with the requirements of Australias economic system and Australias business entities. Because the proposal is internationally uncompetitive and highly inefficient for development of business entities in Australia, we do not support it in any way.
How should double tax through the entity chain be prevented under the full franking system?
Arthur Andersen believes that the RBT should take the opportunity to remedy one significant defect of the current taxation of dividends in Australia the wasting of legitimate tax losses or the so-called "dividend trap".
We note that, at para 17.74, the RBT states that "when distributions pass through a chain of loss entities, all of the approaches, as well as the current law, reduce losses through the chain".
This is an historical anomaly that offends the principle of equity. We question why the RBT has considered only those options that would perpetuate this anomaly.
There is a simple solution which we have added as an additional column to the RBT's own Table 17.2(c)(reproduced below).
Closer analysis of the examples in Table 17.2(c) illustrates the problem clearly. Although the table is prima facie concerned with the overall tax paid on the distribution, the data also highlights the "collateral damage" done (by way of reduced tax losses) to the receiving entity if one compares the "carry-forward loss" row with the "loss remaining to be carried forward" row.
Table .2: Comparison of mechanisms to prevent double company tax
(c) Carry-forward losses
(a) Exemption option ¾ assumes that loss is reduced by exempt income which would be equivalent to the amount of distribution received (i.e.$64).
(b) Calculated by applying corporate tax rate of 36% to the reduction in carry-forward losses
In the interests of integrity of the tax system, economic efficiency and equity, we strongly recommend that the RBT consider other options which would not reduce losses as entity distributions flow through other entities.
We believe that a better regime might be modelled along the lines of:
(a) a US dividends-received deduction;
(b) exclusion of dividends from taxable income or "channelling" of inter-entity distributions, so that the current-year or carry-forward losses of a receiving entity are not extinguished where taxed income is received from another entity.
New Zealand also has a measure along these lines, protecting tax losses from damaging interaction with dividend income.
These proposals are set out at the last column of the above table. They are particularly important when considered in the context of:
(a) the proposed expansion of the entity regime, so that trusts, and unit trusts holding shares in companies will come within the entity tax regime; and
(b) the expansion of the consolidation regime, whereby entities having losses and entities receiving dividends will be forcibly consolidated, with the potential adverse results occurring which have been able to be managed under the existing tax law.
This is an important issue, which we believe has not received extensive analysis.
However, we suggest that if this issue is not addressed, it will emerge as a major problem area as soon as taxpayers and groups of entities begin to operate under the new regime.
Page 388 of Platform notes the difficulties in respect of the RDWT proposal, where an entity has not paid sufficient entity tax to fully frank the distribution.
The discussion notes that the system might involve a continuation of the existing complexity in needing to distinguish between dividends franked by company tax and dividends "franked" by the withdrawal of RDWT, in order to provide a tracking mechanism for dividend withholding tax limitations in respect of dividends paid to foreign investors.
An alternative noted at page 389 of Platform is for entities to establish an average franking rate for a year, which would, as noted, lock entities into franking percentages for the entirety of a year. Because of the loss of flexibility involved in this proposal, Arthur Andersen does not support it. This is a situation where we believe flexibility and equity should not be traded off for simplicity.
In our view there are risks in adopting Option 1 on page 404 of Platform, applying a broad definition of distribution covering all benefits provided by an entity to its members.
In particular, we see the interface with this definition, when allied to the entity collection measures (RDWT, DCT, etc) and the potential "profits first" rule (Chapter 19) as generating significant compliance difficulties.
That is, we believe it is imperative that the expanded definitions of distribution should not force inappropriate results:
A public company has profits of $10 million. The public company pays tax of $3.6 million, and declares a dividend of $6.4 million to its shareholders. The company has, in addition, a shareholder discount scheme under which shareholders enjoy discounts of $100,000. In addition, the company has a capital return of $200,000 to shareholders.
In this situation, using expanded concepts of distribution, it is possible that the company might have total distributions equal to the dividend, plus the shareholder discount, plus the capital returns.
This cameo illustrates the potential complex situations which could arise under the entity taxation rules.
It provides in our view yet another indication of why the deferred company tax is inappropriate, because in the above situation the company could under some situations be exposed to DCT in relation to the shareholder discount and capital return, which could generate a permanent tax disadvantage to the entity.
For this reason, Option 1 is inappropriate, and Option 2 the exclusion of certain benefits provided by widely held entities is preferable.
The exclusions should cover not only those proposed at paragraphs 18.36 and 18.37 but also, in our view, other benefits not designed as dividend substitutes. So, for example, we believe there should be an exclusion for shareholder discount arrangements with public companies.
Arthur Andersen submits that the taxation of shareholder discount arrangements, as proposed at para 18.23, represents an unacceptable and highly complex response to an issue that does not generate a significant revenue on costs. Shareholder discount arrangements, unless in some way related to a "maximum discount per annum per share" or other limitation, bear no relationship to dividends rather they are a way for a company to enhance its standing and popularity in the stockmarket amongst smaller investors.
Distributions to Trustee beneficiaries
A wide definition of distribution would adversely affect distributions to beneficiaries of trusts.
There are many scenarios where assets are provided by trusts and indeed companies to shareholders, not related to business activities, in situations where long-standing arrangements are in place and where companies and trusts may have no cash with which to pay any taxes. In such situations it could be argued strongly that there are no distributions, and no intent to distribute annual profits to the investors.
For example, if a trust is established upon the death of a taxpayer where a life interest is granted to an asset such as a holiday home (which is not producing any income), it is possible that either a DCT or RDWT or FBT liability could arise in respect of the use of that asset by the beneficiary.
Alternatively, if there is a life interest in a family home including all contents to that home, and the contents include a valuable piece of artwork, a tax liability could a arise.
If there is an amount which is treated as a distribution, how will the liability for DCT or RDWT (or FBT) be funded? In many cases (such as the example given), the trust has no cash available to fund this obligation. Even though there is a "deemed distribution", the trusts only asset is the property (which is not income producing) and no cash.
An "otherwise non-taxable" rule is necessary
There is a need to address some form of exclusion in respect of non-business and non-income producing assets in these circumstances. For example, there would appear to be an exclusion from the proposed reforms to FBT in respect of principle residence held in an entity (see 18.64 on page 414 of A Platform for Consultation). This exclusion is only for FBT purposes. There is no corresponding exclusion if the amount was not subject to FBT but would have otherwise given rise to a DCT or RDWT liability (under Division 7A for example).
We recommend that the regime should include a clear otherwise non-taxable rule so that non-business and other non-income producing assets would not attract FBT, DCT or RDWT.
"Profits First" Rule Proposals - Chapter 19
Arthur Andersen is concerned that the "profits first rule" has re-emerged.
These issues were explored in a 1996 analysis which involved the discussion paper issued by the Treasury and the ATO in relation to corporate law simplification, large scale analysis and submissions, which culminated in the Taxation Laws Amendment (Company Law Review) Act 1998, which did not adopt the profits first rule.
We strongly recommend that the RBT team should review the papers available to the Government in relation to that analysis.
We are concerned that the profits first rule will itself give rise to complexity and uncertainty.
More importantly, we believe that the profits first rule will drive changes in Australian business behaviour. In particular, we suggest that a profits first rule would encourage:
(a) a tendency by Australian companies away from the issuance of equity (which will lose the flexibility of capital reductions to correctly reposition entities) and in favour of the use of debt;
(b) will create highly complex compliance regimes for entities, whether the slice or general "profits first" methodologies are adopted;
(c) will create distortions as between varying shareholders.
As we have stated in respect of Chapter 18, the interface of a profits first rule, with an expanded definition of distribution and an entity tax regime, will create ordering issues.
Consider the position of a company which in a year:
Assume that the franked dividend would (from an overall balance sheet and profit and loss perspective) exhaust the franking accounts of the company, and the reduction of capital is intended to be a legitimate capital reduction, not a dividend-substitution.
Such a regime would also make Australian companies less competitive in an international environment where they are competing for international capital against companies in other countries which still have a choice in returning profits or capital to shareholders (eg US and UK).
We can see immediate difficulties and complexities in the ordering of the transactions. We can see that an inappropriately-implemented profits first rule might mean that:
(a) the capital reduction might attract the profits first rule, reducing the franking account and causing part of the companys dividend distribution to be unfranked and therefore attracting entity taxation;
(b) we see this as a significant problem, given that entities typically make distributions in the year after they generate their income. With the exception of interim distributions, there is typically a lag in the distribution/dividend timetable which creates a "window" for a profits first rule to operate adversely in unintended ways.
Exclusions needed for legitimate non-systematic reductions of capital
If the profits first rule were to be considered appropriate, it would require adoption of carve-outs from the rule for legitimate non-systematic capital reductions by companies, not intended to be in lieu of dividends.
Arthur Andersen expresses severe reservations about the proposals for the taxation of trusts as entities.
Even if trusts were not subject to the DCT rules and were instead affected by RDWT, we foresee significant transition issues, as outlined below.
What trusts should be excluded from the entity tax regime?
We understand the concern of Government to ensure that substantial business activities are not conducted in trusts in a way which imperils the government revenue.
However, Arthur Andersen does have significant concerns in respect of the approach to inclusions of trusts. In particular, we note that the inclusion of trusts will catch not only substantial operating businesses, but also trusts which have:
(a) assets owned pursuant to wills;
(b) trusts which contain assets which are passive in nature, and are held in trusts for purposes of a family group's asset protection strategies;
(c) passive assets which are held in trusts rather than partnerships for no significant reason other than the historical flexibility for trusts;
(d) the exclusions do not currently cover certain child maintenance trusts or testamentary trusts. A life interest created in an asset after the death of a taxpayer is a trust. Therefore, entity taxation would apply to these trusts. Also, there would be certain trusts established for bona fide compensation purposes which would not fall within the exclusion.
Flexible mechanism for exclusions is needed
We recommend that a flexible mechanism be built in to the new regime to allow for additions and changes to be made as necessary to the list of excluded trusts. This mechanism for change could be by way of regulation or gazette notice, rather than by legislative change.
We believe that none of the categories of exclusions identified in Platform should be included in the entity taxation measures.
Deceased Estates need particular care and special transitional rules
Will trusts should be excluded from the entity tax regime where the will trusts involve fundamentally passive assets. The exclusion category in Appendix A (a two year exclusion for deceased estates) is in our view unsatisfactory because many estates currently in existence, and many wills in the community, provide for the creation of life interests over assets in favour of a spouse.
Application of a rigid two year administration period would generate substantial inequities in the broader community.
Even if a two-year-only administration period were to be mandated by the government (which we believe to be harsh in any event) then that two-year period could only be mandated after allowance of an appropriate transitional rule, sufficient to allow existing wills over time to be upgraded to ensure that tax "traps" does not arise.
We suggest therefore that an appropriate transitional rule be adopted in relation to deceased estates, that :
(a) the deemed inclusion of deceased estates in the entity tax regime should not apply in respect of any existing deceased estate; and
(b) nor should the proposal apply to any deceased estate arising from a death within two years after the commencement of the tax regime - assuming that the deceased estate was comprised principally of passive assets (that is, did not involve the conduct of an active trade or business). This phase-in period would allow taxpayers sufficient time to reconsider the structure of their existing estate arrangements.
Wills and estate issues are generally matters which are reviewed by taxpayers on an irregular basis. A generous temporary exclusion for trusts established under a will would recognise this intermittent review of wills.
This would provide the appropriate balance between equity and protection of the revenue.
Impact on beneficiaries with capital losses
We believe that a potentially significant difficulty arises, certainly from a transitional view, in respect of trust beneficiaries which have capital losses.
An implication of the entity tax proposal is that trust distributions will be re-characterised as being income - similar to dividend income. This will involve a change to the existing treatment whereby trusts which generate capital gains may distribute such capital gains to beneficiaries, distributions retaining their character as capital.
We foresee that this would create significant tax traps and disadvantages to many beneficiaries in Australia. In particular:
(a) assume that a beneficiary has a capital loss of $100 and the trust has an unrealised capital gain of $100
(b) after tax reform date, the trust realises the capital gain, and makes a distribution to the beneficiary
(c) prima facie the beneficiary will be assessable on the trust distribution as a revenue gain, without the ability to recover the carryforward capital losses.
This is an illustration of many transitional traps that will arise under the proposals. The remedy is to:
(a) provide a "tracing" and capital characterisation for trust distributions in respect of assets held in trusts at tax reform date perpetually or
(b) to provide such "flow through characterisation" for at least an extended period to enable beneficiaries to organise their affairs.
Funding entity tax liability and timing of refunds
Both ANTS and Platform require that charitable organisations register under the proposed rules in order for them to be entitled to claim refunds in respect of DCT payable by an entity at source prior to making a distribution to that charity. This registration procedure would appear to be required whether the DCT or RDWT options were adopted.
One of the obvious issues which will have a major impact for charitable organisations will be the cashflow timing of obtaining refunds. This issue has been raised in Platform on page 362 in respect of charities, and possible options for obtaining timely refunds has been dealt with on pages 362 and 364. However, these options are not practical as Option 1 requires what could be a lengthy delay prior to obtaining a refund, and Option 2 requires the calculation of estimates of refunds which would be overtly complex and, in most cases, highly inaccurate.
An alternative with respect to refunds could be some form of tax file number quotation mechanism by charitable beneficiaries to trusts. The beneficiary who has a tax preferred treatment (e.g. charitable organisations or superannuation funds) who would be entitled to a refund, could quote to the trust their tax file number at the time of the distribution. At the time of quotation the trust would be able to identify that DCT or RDWT would not be required to be paid (or would be required to be paid at a reduced rate) in respect of the distribution to that beneficiary.
The advantage of this option would be that there would be no requirement later for refunds and therefore delays would not be required prior to obtaining cash entitlements, and that there would be no requirement to estimate possible refunds based on prior year figures. In addition, the quotation mechanism may be able to be modelled on existing legislation and systems which are in place.
The integrity of the requirements of the Ralph Review of Business Taxation which have been established in A Strong Foundation and extended in Platform would be preserved.
We have identified various issues arising from the six high level principles outlined in Chapter 26 and Chapter 27 of A Platform for Consultation.
Principle 1: Consolidation to be optional, but if a group decides to consolidate all its wholly owned Australian resident entities must consolidate
Resident Holding Entity Requirement
We do not agree that an Australian resident holding entity should be a necessary requirement for consolidation. Many foreign groups have no single Australian resident holding company and restructuring the group to interpose a single Australian resident holding company may result in significant transaction costs, such as stamp duty and foreign taxes.
Importantly, existing grouping provisions for CGT rollover and loss transfers do not require the existence of an Australian holding company. Therefore, on transition to a consolidated regime, where company groups ineligible for consolidation lose existing grouping benefits, this could create an immediate disadvantage to many foreign owned company groups.
We understand that the ATO has specific concerns about allowing a foreign holding company for a consolidated group. The two main concerns appear to be the limited ability to trace ownership of foreign companies to confirm the 100% group relationship, and integrity concerns on disposal of Australian consolidated group members by the non-resident holding company.
In relation to the first concern, it is important to note that this issue already arises under existing tax law. For example, grouping benefits can be achieved between wholly owned Australian sister companies of a non-resident holding company. This issue does not appear to have been raised as a concern in the past and we do not believe that it should represent an overly significant concern in the context of consolidation. In order to alleviate such concerns, the rules could possibly require the consolidated group to provide detailed disclosure of ultimate ownership or, alternatively, provide some form of statutory declaration that the 100% ownership test has been satisfied. The latter approach would appear more appropriate in the context of Australias self-assessment regime.
We acknowledge that there may be certain circumstances where the inclusion of a foreign holding company in the consolidated group could give rise to a different CGT result on disposal of the Australian subsidiary companies than would otherwise be the case if an Australian holding company was used. This is discussed in Appendix 1. Although this is a valid point, it is an issue that is unlikely to be a significant practical issue and, in any event, should be able to be overcome.
Appropriate measures could possibly be included in the cost base adjustment mechanisms discussed in Chapter 28 in order to deal with this issue (if it is perceived as a major revenue concern). Alternatively, a deemed dividend mechanism on disposal of the subsidiary shares to cater for tax preferred income in the subsidiary companies may be a potential solution. In our view, this issue is not insurmountable and should not preclude the use of a foreign holding company in order to qualify for consolidation. It should be possible to overcome any perceived concerns through consultation.
We stand ready to participate in that process.
Trusts and Private Company Groups
We agree with the concept of including discretionary and hybrid trusts and private company groups within the consolidation regime. However, given the wide variety of factual circumstances that may arise, it would be impractical to impose hard line and mandatory rules that do not cater for different circumstances. Such an approach is likely to lead to inequitable results.
This is an area that will need to be developed with careful consultation to ensure that all potential complexities are addressed.
100% Ownership Threshold
The current RBT proposals suggest that consolidation should only be available in cases involving 100% common ownership.
The 100% requirement needs to be appropriately modified to account for:
We also note that the current GST grouping proposals are based on a 90% ownership test. We also would support any initiative to reduce the 100% common ownership requirement.
Merger Roll-Over Relief
Given the requirement to have (under the current proposals) an Australian holding entity in order to consolidate, we submit that there should be a rollover regime that would facilitate such structures being achieved, in the context of:
By allowing such a concession, consolidated groups (and all the benefits foreshadowed by RBT) could be achieved without creating immediate income tax costs in Australia.
However, foreign taxes arising out of such a restructure and transaction costs such as stamp duty may inhibit this type of restructuring.
Principle 2: Consolidated groups to be treated as a single entity
Problems with dividend rebate and losses will make consolidation problematic for many groups
Where a company receives dividends (including franked dividends) and has tax losses from its business operations or from interest expense, the company will effectively "waste" the associated dividend rebate, by offsetting its carry-forward tax losses against the dividend.
This issue (also discussed above under "Redesigned Imputation System") is not only relevant to leveraged acquisitions of dividend-producing shares, but could also arise where the shareholder company has business operations which have fluctuating income (eg resources, manufacturers, investors, tax preferences).
Under existing tax law, company groups can often manage this exposure by ensuring that loss companies do not receive dividends and/or by quarantining losses in certain companies. The enforced consolidation proposals may imperil legitimate preservation of tax deductions and dividend rebates.
If one member of a consolidated group receives dividend income and another member has tax losses, then under the consolidation regime, the tax losses would be utilised against the dividend. Under current law this wasting of losses would not occur.
We submit that the RBT should include a mechanism to deal with dividend flow-throughs. This is a major argument against the use of consolidation measures. This issue also relates to Chapter 15 of A Platform for Consultation, and is discussed earlier in this submission.
We submit that the RBT consider their policy in relation to losses and dividends at large (this is not just a franking issue) with possibly a deduction for dividends received a qualified exemption mechanism, or possibly a dividend-channel proposal (whereby dividend rebates would be isolated from corporate losses). US or NZ models are relevant.
Joint and Several Liability for Departing Entity [para 26.40]
Difficulties will arise with joint and several liability where an entity leaves the consolidated group. We submit that where a company departs the consolidated group there should be a cessation of joint and several liability for the departing entity.
If joint and several liability were retained by the departing entity this may make a unit or share sale unattractive to a potential purchaser. Tax considerations may therefore dictate an asset sale and lead to a commercial distortion away from unit or share sales.
Unit or share sales occurring at fair market value would not diminish the ability of the remaining consolidated group to meet the tax obligations of the group. Therefore, there should be no economic reason why the departing entity should continue to carry a joint and several liability. We agree that the system may need certain integrity measures to prevent essentially a stripping of entities from the consolidated group at below arms length values in order to avoid the joint and several liability.
Characterisation of Transactions [para 26.45]
The RBT is proposing to change the way transactions between group members are being characterised. We are concerned that a group would lose the ability to offset carry-forward capital losses if under the new characterisation rules the entire income and assets of the group were classified as being on revenue account.
A preference would be to consider the character of assets on an individual entity by entity basis such that the nature of the asset for tax purposes is not altered by consolidation. This approach is taken in the US consolidation model.
Any proposed changes in this area need to be carefully considered.
Implications for International Taxation
Outbound CFCs and CGT Rollover
There would be no CGT rollover available in relation to offshore CFCs if the consolidation measures are implemented as proposed. We submit that there is no equity or policy ground for eliminating such rollovers. Indeed, the regime needs to recognise and facilitate international mergers, so that groups can rearrange their CFCs to simplify their group and meet changing business needs.
Accordingly, we recommend the retention of the existing CGT rollover relief for CFCs.
Inbound CFC Issues (Notably US Owned)
US companies have a potential foreign tax credit problem under the consolidation regime addressed in a separate submission by Arthur Andersen. Specifically, the Australian consolidation proposals deem tax paid by a consolidated group to be attributed to the Australian holding company. This would cause problems for US earnings and profits purposes, where the profits were for US purposes treated as having been derived at the lower tier. The payments of net tax attributed for Australian purposes to the top company would conflict with US rules and result in loss of foreign tax credits in the US. This possible disadvantage and any other potential tax disadvantages for foreign investors need to be carefully addressed.
Principle 3: Current grouping provisions to be repealed
We would prefer not to see an overly simplistic adaptation of this principle. Such a proposal would be inequitable for many groups.
What may be needed, particularly in the case of wholly owned groups that may not be eligible and/or willing to consolidate for legitimate reasons, is:
Principle 4: Individual entity losses and franking account balances able to be brought into the consolidated group
A Platform for Consultationprovides 6 options as to how to bring carry forward losses into a consolidated group.
Option 1 provides that where group companies have carry-forward losses at the date of commencement, then those losses would become available under the consolidation regime, provided that those losses were groupable prior to commencement of consolidation.
Losses would not be available to the consolidated group under the same business test ("SBT"). Accordingly, such losses would be forfeited on entry to the consolidated group. As this is a departure from existing law, and has the potential to disadvantage groups with SBT losses, we are not in favour of this approach.
As a transitional measure, we submit that all Section 80G group members (and wholly owned trusts) at a specific date should be able to consolidate and pool their losses, franking accounts etc.
On a prospective basis, we submit that for new entities joining a consolidated group, they should be able to elect either Option 2, 5 or 6.
Option 2 allows carry-forward losses to be brought into a consolidated group subject to a modified SBT. If the loss company entering the consolidated group is able to satisfy continuity of ownership, the losses are immediately available. Where the continuity of ownership test is not satisfied, the rules allow the company to bring the losses in over 10 years, provided the loss entity satisfies the SBT in the year the loss is incurred and a specified period immediately before entry into consolidation.
Although this approach involves some degree of departure from existing law, it would appear to be more equitable than Option 1. Importantly, Option 2 also allows trusts to bring carry-forward losses into the consolidated group. We see this as highly desirable from an equity perspective.
We believe that Option 5 is also a reasonable approach and may be the best option for new entities acquired subsequent to the introduction of consolidation. This Option allows an incoming entity to carry forward its own losses where the consolidated group is not able to satisfy the existing loss transfer rules. This approach is equitable and would appear to carry a high level of integrity. One point to address, however, would be the treatment of sub-group losses, where such losses may be eligible for transfer within the sub-group under existing law but are not eligible for transfer to other group members outside the sub-group. Option 5 should not have a time limit on recoupment of losses.
Option 6 provides a similar result to Option 5 in the context of carry-forward losses. However, it may prove disadvantageous if, by being left outside the group, the loss entity is not eligible for other group concessions such as CGT rollover relief.
Under both Options 5 and 6, it would also be necessary to clearly determine how post-consolidation losses incurred by the external loss entity are treated (ie are they available to the consolidated group as incurred or only after the pre-consolidation losses have been fully utilised).
Principle 5: Carry-forward losses and franking balances to remain with the consolidated group on an entitys exit
If franking credits were to remain with the consolidated group, an exiting entity might leave with substantial taxed retained earnings but no franking credits. This may lead to double taxation when the exiting company subsequently pays unfranked dividends from those profits. Conversely, the consolidated group might have substantial franking credits but insufficient accounting profits to distribute the franking credits by way of dividend.
We therefore recommend that an entity should be allowed to take franking credits on exit (possibly on an elective basis). A reasonable approach may be to allocate franking credits based on the proportion of Exit Entity Retained Earnings to Group Retained Earnings.
Principle 6: Provisions to be established for determining the entity cost bases on exit
Both of the proposed models for determining an entitys cost base on departure require substantial record keeping. The Asset Based Model ("ABM") also requires allocation of purchase consideration across all assets of the entity on acquisition (including goodwill). However, the ABM creates one cost base for assets and should also be adopted for depreciation purposes. The ABM provides more consistency between accounting and tax treatments.
We would support the adoption of the Asset Based Model in principle. However, we emphasise that many details of its operation are yet to be determined.
As a transitional measure, consolidated groups should be entitled to use the Entity Based Model for existing group companies.
Careful consultation is required to ensure that no double taxation will occur under either method. We would prefer not to have an overly simplistic model that causes economic damage.
Arthur Andersen is concerned about the approach adopted in Chapter 28, and the potential economic damage caused by implementation of the proposals in a partial way.
We acknowledge the RBT's attempt to consider the issue, and to propose possibilities for reform of the business tax system on an economy-wide basis.
However, we have great concern about the approach adopted.
Our greatest concern relates to the proposals for the removal of the same business test or amendment of the existing continuity of ownership test in relation to entity losses. We believe that this proposal, if introduced without extensive consultation, would have the potential to generate real economic damage to Australia.
If the concern is artificial trafficking in capital or revenue losses, this can be dealt with by carefully focussed reforms. The existing same business test is rigorous and challenging in any event. However, to propose economy-wide measures to deal with situations which arise only in tax avoidance scenarios is seriously misconceived in our opinion.
There are many reasons against removal of the same business test as proposed in Chapter 28:
1. We believe that no case for system-wide reform has been demonstrated in Chapter 28. We note that, in every situation where a shareholder in a company (or holder of an interest in an entity) sells their share or entity interest for a value in excess of net tangible assets, the buyer is paying a high price - in recognition of the future profit potential of the business. That is, in our submission, every entity sale for a price in excess of the net tangible assets underlying the business represents a situation where the price has been set by reference to the future profit/income stream of the business.
As a result, on an economy-wide basis, we submit strongly that there is very large scale gain-duplication occurring in the Australian economy. For example recent share trading activity in internet-related and mobile-telephone-related entities reflect high prices in recognition of the future income earning potential of the business. The share transactions generate strong income tax and capital gains tax revenue for the government in the appropriate circumstances.
We submit strongly that there can be no basis for generic economy-wide restructure of the tax law in relation to the treatment of losses unless there is a clear demonstration that any loss to the revenue arising from loss duplication are greater than the gains to the revenue arising from gain duplication in the economy.
2. Even where an entity incurs losses, we believe it is quite misconceived to suggest any direct or systematic correlation between the losses in an entity and the valuation of an investor's shares in that entity - certainly in the case of active or listed businesses.
Many shareholders who acquire publicly traded entities do so in complete ignorance of the entity's taxation profile (with the exception of its ability to pay franked dividends). The share dealing activity takes place for prices determined by reference to the business assets and their future income earning potential, with typically little recognition of tax losses - except in the most significant scenarios of massive loss of shareholder value.
Thus we believe that the core proposition - of a purported relationship between the value of tax losses and an entity and its sale price - is simply not established in the context of the trading businesses. We note that there is no economic modelling of that proposition in Chapter 28.
3. Even if there were a correlation between the values applied to an entity and the state of its tax losses, this would not constitute immediate "loss cascading" from a revenue perspective as proposed. There are several reasons:
4. From an equity perspective, any proposals to deny realised losses to businesses carrying on the same business activity would be catastrophic.
Visualise a public company which, in the context of ordinary share turnover in its publicly listed shares, has a continuity of ownership of 50.1% in a year. In a significant share transaction, a 1% line of its stock is sold to a new shareholder.
The outcome of Chapter 28 is that this 1% share sale would result in the company's:
We suggest that this example, put simply, illustrates the extreme inequity of the proposals.
To the extent to which any such measures would propose to be applied to revenue losses, comprising business losses, our initial comments are applicable. We consider no basis for such reform has been made out.
Our key proposition is that we see measures for duplication of unrealised losses going hand in hand with measures for duplication of unrealised gains. We believe that, in order to maintain equity and generate economic efficiency, the RBT must introduce measures dealing with both sides of the equation in tandem, and as a legislative design, both measures should be in the same chapter or division of the income tax legislation.
Otherwise, we believe that there is on a net economy-wide basis, no rationale for preventing duplication of unrealised losses, while at the same time allowing duplication of unrealised capital gains.
Again, we reiterate that scenarios of tax-avoidance-related trafficking in unrealised losses can be dealt with by carefully-tailored amendments, without subjecting the entire tax system to change in circumstances which have not been justified.
We suggest that the solutions will require extended and focussed consultation, in order to ensure that distortions are not created in the tax system.
Arthur Andersen notes the desire of the RBT to present an integrated value-shifting regime, to replace the current income tax legislation, and the desire of the RBT to pursue a structural solution.
However, our concerns relate to the compliance overload which might result from such measures. For this reason, our comments are focussed on the compliance and integrity issues.
The existing value-shifting rules are complex in operation, require costly analysis in ordinary bona fide situations, and require costly valuation activity in totally arms'-length transactions.
We believe that the value shifting rules, if they were to apply in the comprehensive manner set out, should only apply in scenarios where the parties affected by value shifting arrangement or transaction had a substantial interest in the entities.
We propose for consideration an associate-inclusive value-shifting group of 50% (requiring that the parties affected have an interest of more than 50% in the overall entity involved).
Otherwise, we can see such a generalised value shifting approach imposing an intolerable burden onto ordinary commercial transactions as between a minority investors acting at arms' length.
In any broad-ranging value-shifting model, the compliance costs must as an urgent priority be anticipated and reduced.
We support, therefore, a strong, de minimis exception. The current regime - the lower of 5% of a share's value or $100,000 - brings into its net many transactions which require careful analysis where no tax avoidance is achieved or considered. We consider that a more sensible de minimis exception would exclude transactions except where the value being shifted was the higher of 25% or $100,000. By setting the threshold at the higher level, the test could be more focussed on the potential situations of avoidance which are the logical object of the test.
We support the development of safe harbour rules, such as those proposed in respect of the transfer of depreciable fixed assets.
We believe that this project should involve its own separate consultation process, in order to refine the integrity, compliance and administration measures - and to properly balance them against their compliance costing proposed on taxpayers.
Arthur Andersen believes that the tax reform process has far-reaching implications for the superannuation industry.
We believe that the ANTS reform process urgently needs to be harmonised with measures to review the taxation of superannuation funds generally otherwise there will be real damage to Australia's superannuation sector a source of patient long-term capital in the economy.
To maintain superannuation as a viable form of investment into the future, superannuation funds must be competitive with other investment vehicles.
At present superannuation funds benefit from a lower tax rate (although some of this benefit is clawed back by the tax on benefits paid out). Balanced against this are RBL (reasonable benefit limit) rules, compulsory preservation rules and tax penalties such as the superannuation surcharge, which prevent excessive investment in superannuation.
Superannuation is thus, at present, only marginally competitive against other forms of investment and we are concerned that, in the absence of any positive action, the position will be further eroded as a result of the tax reform process.
With a combination of:
we believe that superannuation funds will be at a disadvantage compared to other forms of investment if the present superannuation regime is maintained. It is likely that investors will prefer the lower tax and greater flexibility available through other forms of investment.
Given that the superannuation industry is a significant contributor to Australias economy and a primary source of patient long-term capital - and the Governments strategy is to encourage retirement savings as Australias population grows older, we do not believe that such an outcome would be viewed as desirable.
We therefore recommend that the RBT give this matter further consideration and, if necessary, recommend to the Government an additional, separate inquiry into the effects of tax reform on the superannuation industry.
We believe that the time might have come where taxation of superannuation funds should be reduced or indeed eliminated.
Proposal to tax Pooled Superannuation Trusts (PSTs) is inappropriate
We disagree strongly with the proposal in Chapter 36 to tax Pooled Superannuation Trusts (PSTs).
We think this is inconsistent with the spirit and intent of the CIV measures. The CIV proposals have overtaken the PST proposal.
Further, it creates an unnecessary tax payment/tax credit situation for no reason discernible to us.
It would simply result in the decline of PSTs and the movement of the funds to CIVs for no economic or revenue advantage, in our view.
If the proposal is motivated by tax avoidance practices, those practices should be addressed by anti-avoidance measures.
Appendix 1 Consolidation - Australian Holding Entity Requirement
The current reform proposals only allow consolidation for Australian companies with a foreign parent where the Australian companies reside under an interposed Australian holding company. We understand that one of the reasons for this relates to a concern regarding the calculation of tax on disposal of the Australian subsidiaries by the foreign parent. The examples below illustrate the issue.
The first example shows a structure with two entry points into Australia and the second shows a structure with a single entry point into Australia through an interposed wholly owned Australian holding company.
Asset Cost $100
Asset Cost $100
In both examples the historical cost base of the investment in the wholly owned Australian subsidiaries B and C is $200 (shares in B and C having a cost base of $100 each). B has one asset with a cost base of $100. In both examples the market value of Bs asset increases to $1,000 before it is sold. B reinvests the proceeds of $1,000 from the sale.
Assuming in both scenarios the Australian companies are eligible to consolidate, the cost base of the shares in B will be adjusted up to $1,000 under the proposed cost base adjustment rules.
The issue addressed by the RBT is that, in theory, As subsequent divestment of shares in the Australian group could result in different tax results under the two scenarios.
In Case 1, A disposes of the shares in its Australian subsidiaries B and C for the market value of $1,100. The adjusted CGT cost base consists of $1,000 for shares in B plus $100 for shares in C. Therefore, A will not realise any taxable capital gain.
In Case 2, A sells its shares in the Australian Company AHC, a wholly owned Australian parent of subsidiaries B and C. Whilst the market value of shares in AHC is $1,100, As cost base in AHC is only $200. The proposed cost base adjustment would not create a cost base adjustment in the AHC shares. The sale of AHC shares therefore triggers a taxable gain of $900.
We understand that RBT team members consider that an Australian holding company, as in Case 2, is needed to ensure the preferred tax outcome in relation to tax preferred income (i.e. unfranked profits).
The issue does not arise in respect of depreciable fixed assets which have been sold. Prima facie, the relevant tax preferences are R&D, unique one time expenses such as perhaps exploration, pre-CGT gains and the indexation element of post-CGT gains.
We find it hard to identify the true revenue significance of this issue. Even if tax preferences were a concern of the RBT, there would be a potential solution. For example, there could be a deemed dividend or wash-out of tax preferences on disposal of the local company by the foreign holding company, where the local company was being consolidated with another local sub of the foreign holding company.
We think that further work is needed to justify the true revenue disadvantage of this feature. It would be unfortunate if major compliance and reorganisation, and transitional tasks were required for a measure of no great significance.