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Review of Business Taxation
Department of Treasury
CANBERRA ACT 2600
15th April 1999
A Platform for Consultation
The Property Council of Australia welcomes the strong commitment the government has made to reform Australias business tax system.
We submit our view to the Review of Business Taxation in response to its second discussion paper, A Platform for Consultation.
The Property Council looks forward to continuing its discussions with the RBT as your review continues its work.
Property Council of Australia
A Platform for Consultation
2.0 Review of Business Taxation: A Platform for Consultation
3.0 Entity Taxation and Property Trusts
4.0 Building Depreciation
5.0 Accelerated Depreciation/ Company Tax Trade-Off
6.0 Capital Gains Taxation
7.0 Other Issues
8.0 Revenue Implications
The Property Council supports the following package of tax reforms:
Mandating the existence of Collective Investment Vehicles (CIVs) within the consistent entity taxation framework, where such CIVs operate on a flow through principal that allows:
A tracing provision should be incorporated in the `widely held definition to ensure that where sub trusts are ultimately held upstream by a CIV, they receive the flow though benefits conferred upon CIVs.
Economic life to replace accelerated depreciation as the basis for determining write-off rates for the proposed integrated wasting assets system.
The `economic life concept to include those factors that drive obsolescence, including functional, economic, legal, environmental, social and aesthetic obsolescence.
Safe harbour write off rates for plant, equipment, fixtures and structures to be determined by the Tax Commissioner in consultation with a working party established by the Business Coalition for Tax Reform. In The interim, the existing Division 43 amortisation rates be mandated as the standard.
Replace the existing capital gains tax system with a tapered approach that is available to individuals and business entities.
The Property Councils main arguments in favor of its position are:
The Property Councils submission also deals with many other technical issues raised in the Platform for Consultation options paper.
The Property Council endorses the submissions of the Business Coalition for Tax Reform and the Investment Services Association of Australia.
This submission has been prepared by the Property Council with assistance from Arthur Andersen, in response to the release of A Platform for Consultation ("APC") by the Review of Business Taxation ("RBT").
The Property Council represents private investors and corporations who finance, own and manage shopping centres, commercial and industrial complexes, and hotels. Its members manage the property interests of more than non million ordinary Australians who are investors in real estate through their superannuation, life policies, unit trust and direct ownership.
The primary purpose of this submission is to outline the taxation, economic and practical implications of options discussed in APC for the property industry as a whole, and specifically property trusts. The submission provides constructive proposals designed to assist the RBT reform Australias tax system.
The submission focuses on the property sector and property trusts investors, in particular.
This submission is set out as follows:
2.0 Review of Business Taxation: A Platform for Consultation
The Property Councils vision for business income taxation in Australia corresponds closely with the RBT design principles and the benchmarks for reform outlined in APC. In particular, the Property Council supports reforms of business income taxation that result in an internationally competitive business income taxation system.
Moreover, the Property Council considers that the Governments business tax reform strategy should be directed towards improving Australias infrastructure, including that provided by the property sector. The infrastructure industry is a major contributor to economic growth and living standards as well as a major source of demand for many commodity areas including mining, wood products, chemicals, electricity and gas, transport and communications, petrol and coal, as well as the wider economy.
The property industry provides a livelihood for many professional and technical groups, such as architects, engineers and builders, as well as employment and training for hundreds of trades, including carpentry and painting.
The international competitiveness of the property industry is particularly important to Australias export performance. For example, the property industry provides the infrastructure that enables Australia to stand out as a significant and preferred corporate headquarters for the Asia-Pacific region. Without modern and efficient infrastructure Australia could not as effectively compete with its trading rivals, leading to a negative economic impact and loss of employment opportunities in Australia.
Further, the continuing establishment of Australia as a regional financial centre requires substantial communications and property infrastructure commitments in order to accommodate growth. Without this infrastructure, Australia would be unable to offer the required facilities to multinational businesses, with consequent effects on the wider Australian economy and business.
Moreover, the property industry plays a key role in providing accommodation to meet the anticipated needs of the tourism industry. The property industry is also a significant determinant of business costs in the wider economy. An internationally competitive economy provides optimum economic growth, encouraging savings and investment to provide employment opportunities for Australians.
Property trusts should not be tainted by the characteristics of trusts that are frowned upon, such as discretionary trusts. Property trusts provide no more opportunities for "income splitting" than bank accounts. Moreover, property trusts are already subject to a wide range of regulatory regimes, including the Corporations Law, the Australian Securities and Investments Commission Act and the Managed Investments Act, to name a few.
The Property Council supports many of the business income tax reforms outlined in APC. Most importantly, the Property Council strongly supports the following proposed reform options subject to the conditions discussed in more detail below:
The Property Council believes that these issues are critical in designing a business income tax system that will foster Australias long term growth prospects in an increasingly competitive, global environment.
However, the Property Council has significant concerns with several proposed business tax reform options and the practical implementation of such proposals. These are outlined in the following sections of the Submission.
The Property Council recognises the design principle of revenue neutrality adopted in APC. Accordingly the submissions in this paper have been framed in such a manner as to maximise revenue neutrality.
However, the Property Council considers that the way the revenue neutrality constraint has been structured by requiring revenue neutrality to remain consistent with the ANTS announcements is unreasonable. This is because the Government has already claimed much of the revenue from the major business tax reforms, even though some of the proposed measures (such as the Deferred Company Tax option) should clearly not proceed.
In the remainder of this submission, certain terms are used which may be specific to the property industry. We therefore define these terms here.
Property Trust: A trust where the principal source of income is derived from real estate or interests in real estate. Property trusts may be listed (as in have their units traded amongst investors) or unlisted (such as being owned by other property trusts). Property trusts operate as collective investment vehicles, through which small investors may achieve a pooling of risk to access large commercial property investments normally beyond their reach.
Tax-preferred Income Income or capital arising from a permanent or timing tax benefit.
Tax-free Income Income or capital that arises from a permanent tax benefit.
Tax-deferred Income Income or capital arising from a timing tax benefit.
3.0 Entity Taxation and Property Trusts
The major issues of concern to the Property Council regarding the proposed entity taxation regime are to ensure that:
3.1 Property trusts must be included within the definition of CIV
The Property Council emphasises that property trusts must be included in the definition of CIV and subjected to flow-through taxation.
In this regard, the Property Council welcomes the Treasurers announcement that cash management trusts and other CIVs, including property trusts, will be excluded from the proposed entity tax regime, and subjected to "flow-through" taxation instead.
Property trusts are widely held collective investment vehicles, through which many ordinary Australian small investors can achieve a pooling of risk for investing into large commercial properties, such as shopping centres, office buildings and infrastructure projects. Further, property trusts generally distribute substantially all of their annual profits to participants, including tax-preferred income.
3.2 Flow-through of taxation is crucial
The Property Council strongly supports the taxation of CIVs on a flow-through basis, as it would provide individual taxpayers with the same capital aggregation and risk pooling benefits as the alternative entity treatment, but would offer major compliance benefits relative to that treatment. Entity taxation of property trusts would impose a major compliance burden on retirees and other small investors.
In particular, the proposed flow-through treatment of property trusts will ensure that there are no adverse cash flow effects for investors receiving distributions of income from these property trusts. This is critical because property trusts are a common investment for retirees, and other small investors, in Australia. For such investors, the regular distribution of profits from property trusts may be a major component of their income.
Although overall beneficiaries will not pay any extra tax, provided there are no other changes to the treatment of tax preferences or depreciation, there would be a significant negative timing impact on the cash flow of beneficiaries.
While this could be addressed through early refund mechanisms, as suggested in APC, such mechanisms would necessitate identification of people eligible for early refunds and increase complexity and administrative costs in making regular refunds to taxpayers. There may also be additional compliance costs for investors and for property trusts.
Further, the proposed flow-through taxation of property trusts is crucial from an equity standpoint as it would align more closely the tax treatment of investors in these funds and individual investors making equivalent direct (that is, non-intermediated) investments in commercial property. Both ordinary Australians and the wealthy should enjoy the same tax rights. There can be no assumption that investors will continue to invest in property trusts once the tax mix of direct vs. indirect investment in property is altered.
It would be inequitable, on the basis of competitive neutrality, to treat property trusts differently from other collective investment vehicles, such as equity trusts, bond trusts and cash management trusts.
Furthermore, international competitiveness necessitates the flow-through taxation treatment of property trusts as property trusts are taxed on a flow-through basis in most other countries.
If Australia were to move to an entity basis of taxation for property trusts, it would have a major negative impact on the availability of foreign capital for future property investment in Australia. Depending on the model of entity taxation adopted, foreign investors would either bear substantially more tax than currently (under the deferred company tax option) or would suffer negative cash flow consequences and an increase in compliance costs.
If property trusts were not taxed on a flow-through basis, property trusts may well change their distribution policies so as to maintain the power of unit holders to build wealth through interests in property. In particular, if entity tax applied, property trusts would be forced to consider retaining earnings rather than distributing most of their income to unitholders. The reduced distribution of income by property trusts to unitholders would harm the millions of Australian small investors who enjoy a stake in property trusts, either directly or through their superannuation fund. Many of these investors are retirees who rely on regular distributions from property trusts to maintain the self-sufficiency they deserve. It would also potentially reduce the revenue raised from these entities.
3.3 Defining the "widely held rule"
The Property Council submits that the "widely held rule", which is critical to the definition of CIV, should be modeled on the existing principles underlying the definition of a "public trading trust", in Division 6C of the Income Tax Assessment Act 1936 ("ITAA36"). Property trusts already comply with these rules.
For example, a CIV could be defined as any trust where:
(1) any of the units are listed for quotation on a stock exchange;
(2) any of the units were offered to the public;
(3) the units are held by 50 or more persons; or
(4) tax exempt entities, and/or a complying superannuation, ADF, PST fund, a life insurance company and/or a CIV holding a beneficial interest, directly or indirectly, cumulatively hold 75 per cent or more of the property or income of the trust.
Further, a tracing rule should be incorporated in the widely held definition to include sub-trusts in the CIV regime where they are widely held or indirectly widely held. The tracing rule would be applied at each level of the property trust ownership structure. An indirectly widely held sub-trust could be defined to include any sub-trust that, with tracing, satisfies the widely held rule outlined above.
This approach would be consistent with the objective of the widely held rule of ensuring that the relevant trust is not controlling or manipulating the property. If a sub-trust were ultimately widely held upstream, then the direct investors in the sub-trust would not be in a position to control the property.
A property trust can be a CIV or a stand-alone trust or a sub-trust. Sub-trusts are used extensively in the property trust sector because they allow a broad range of interests to hold a property and facilitate the dissection of interests in properties. These sub-trusts are generally not widely held entities in their own right, but they are indirectly widely held. Overleaf is an example of a typical property trust structure, involving a sub-trust.
In the diagram above, listed property trusts A and B are widely held, and each owns 50 per cent of the sub-trust, which owns the property. It is submitted that this type of sub-trust is indirectly widely held, as it is ultimately owned by widely held entities.
Similarly, property trusts may be collectively owned by a group of institutions (usually 20 or less), that invest wholesale funds in property trusts on behalf of thousands of beneficiaries or investors.
The Property Council considers that these sub-trusts should also be included in the definition of a CIV, as they are indirectly widely held.
Accordingly, the Property Council suggests that any "widely held" rule incorporate a tracing element, as outlined earlier, allowing tracing through sub-trusts to ultimate holding trusts and other entities. This would ensure flow-through taxation of sub-trusts, and avoid discrimination against dual level investments as compared to single level investments.
Further, the treatment of sub-trusts as indirectly widely held trusts with flow through taxation treatment would recognise the high degree of transparency of these arrangements.
In this regard, property assets are getting so large and expensive that it is increasingly becoming less viable for one trust to own 100 per cent of a property, such as a shopping centre. As a result, there is a trend to diversification with property trusts typically owning a joint or minority interest in a number of shopping centres (through sub-trusts), rather than full ownership of any one property.
3.5 Flow-through of Tax Preferences
The Property Council considers that distributions of tax preferred income by property trusts should continue to flow-through to property trust investors as non-assessable income. This treatment would:
If the flow-through of tax preferences were not allowed, property trusts may well change their distribution policy so as to maintain the power of unitholders to build wealth through interests in property. The result would be that there would be little addition to taxation revenue if the tax preferences were neutralised on distribution.
3.5.1 Competitive neutrality
In Australia, property trusts operate purely as collective investment vehicles, through which small investors may achieve a pooling of risk for investing into particularly large commercial properties. Accordingly, it would be inequitable, on the basis of competitive neutrality, to treat these arrangements differently from direct investments by individuals in commercial property.
The collective nature of property trusts is reflected in the structuring of their property holdings. Property trust investments are structured so that the ownership of the property is separated from the management and development of the property. This separation of functions is outlined in the diagram overleaf and following. However, it should be noted that this is a generalisation of how property trust arrangements operate, and in practice more complex holding structures may be used. Nevertheless, the broad principles remain consistent.
In above diagram, the property is owned by the listed property trust. However, the trustee of the property trust has contracted out the management and development of the property to external property management and development companies.
The external management company manages the property. This involves letting the property, collecting rents, paying expenses, etc. The management company may also employ an investment manager to manage the funds of the trust. The management company is paid a management fee by the trustee based on a percentage of the gross rental revenue. The management company is subject to company tax on the management fee.
The external development company is responsible for the development of the property (e.g. the original construction, extensions, and renovations). The development company is paid a development fee by the trustee, which is subject to company tax.
The trustee has an organisational role, which involves outsourcing, for example, the decisions on which properties to invest in and the associated business risk analysis, and acts in a fiduciary role to ensure that the interests of the beneficiaries are protected.
The relevant comparison for competitive neutrality purposes is between property holdings held through property trusts and property held directly by individuals, rather than between property trusts and companies.
In this context, the flow-through of tax-preferred income to property trust investors would ensure equal treatment of those wealthy individual investors that can afford to invest directly in commercial property producing tax-preferred income (who will continue to get tax preferences) and smaller investors that do not have the financial capacity to buy a commercial property by themselves and invest through a property trust. Both ordinary Australians and the wealthy should enjoy the same tax rights. Moreover, if these small investors are disadvantaged, Australias national savings may be adversely affected.
In fact, competitive neutrality is particularly relevant with respect to property trusts because it is difficult if not impossible for individual investors to invest in commercial property on a small scale, unlike investment in residential property.
If property trusts were disadvantaged then, over time, alternative, more tax competitive structures would be likely to be developed to meet the market demand from small investors for collective investment vehicles. For example, property investment vehicles could be structured as joint ventures or partnerships, rather than trusts. However, this would involve enormous restructuring costs for the industry for no benefit to the community.
For example, property trusts are increasingly acquiring property from Australias major industrial companies seeking to free up their balance sheets and achieve a greater focus on their more productive assets. If property trusts were disadvantaged, this trend would most likely be reversed, with adverse effects for the efficient allocation of resources in the economy. This example clearly shows how a failure to provide a flow-through of tax preferred income would be to the immediate detriment of large parts of the Australian economy and the national interest.
Furthermore, unlike cash management trusts, which could easily be restructured, property trusts lack the flexibility to restructure due to stamp duty considerations. This should be taken into account in any policy setting.
3.5.2 Capital requirements
The property industry is very capital intensive, creating a constant demand for new capital inflows into the sector. In recent years, this thirst for capital has become more pronounced as large Australian institutions have been reducing their allocation of funds to property. Accordingly, the capital required for the ongoing expansion of the property trust sector is increasingly being sourced from foreign institutional investors.
In this context, the removal of flow-through of tax-preferred income through property trusts would result in a shift from the Australian property trust sector by these investors, as large segments of foreign investors tend to have a low tax rate. For example, Dutch and US pension funds, a major source of foreign capital, are exempt from tax. In fact, pension funds in most other countries are exempt from domestic taxation.
Uncertainty about the future tax status of property trust investors is already affecting foreign investment in the property market, with effects on investment, growth, and employment. This was clearly demonstrated in the week before the release of APC, when the property trust index of the Australian Stock Exchange declined by 7 per cent.
Chart 1.1 represents the price of Australian Listed Property Trusts (LPTs) over the last three months. The decrease in unit price of LPTs was initially attributed to a rise in 10 year bond yields. However, bond yields have since fallen while the value of LPTs has remained suppressed. The Property Council believes the suppression of LPT prices has been due to investor concerns over the full flow through of tax preferences.
The removal of flow-through of tax-preferred income through property trusts may also disadvantage superannuation funds (another major source of capital for the property trust sector) investing in property trusts. This is because of the bring forward of tax liabilities on the earnings of property trusts. This negative timing effect on the cash flow of superannuation funds may act as a disincentive for investment by superannuation funds in property trusts, as opposed to direct property investment. Small superannuation funds that invest in property directly, to avoid this distortion, would be burdened with less liquid property investments and lower returns.
Chart 1.1 Movements in Property Trust Prices
3.5.3 International Competitiveness
The flow through of tax preferred income through property trusts is essential if Australia is to remain internationally competitive in the property investment area. Funds for such investments are globally mobile and the flow to Australian investments will be seriously curtailed if the tax treatment of international investors is unfavourable. It is common international practice to allow flow through of tax preferences for property trusts.
For example, notwithstanding tax reform processes, the United States has recognised the special nature of property trusts and allows flow through of tax preferred income through Real Estate Investment Trusts ("REITs"). The flow through of tax preferred income through property trusts is also allowed in Canada.
3.5.4 Distribution policy
If the flow-through of tax-preferred income through property trusts were removed and tax-preferred income were taxed in the hands of unitholders, property trusts may opt to distribute only their assessable income and retain their tax-preferred income. This would allow property trust unitholders to defer the payment of tax on the tax-preferred income and maximise the benefit of the relatively concessional taxation of capital gains. This greater retention of earnings would be likely to have a negative effect on revenue.
Further, any tax driven incentive to distribute a lower proportion of property trust earnings to unitholders would create tensions between the demands of unitholders and the incentives faced by property trusts. The full distribution of earnings to unitholders is a key characteristic of property trusts. Investments in property trusts are made on the basis that they will return a yield that represents virtually all of the earnings of the trust.
The greater retention of earnings by property trusts would result in increases in the capital value of property trust units over time. However, unitholders may be forced to sell a proportion of their holdings to maintain their lifestyle. This may be difficult in practice, for the typical small investor, due to the high transaction costs that would be incurred in selling small parcels of units.
If the flow-through of tax-preferred income through property trusts were removed, the complexity associated with the business income tax system would be substantially increased due to the need for early refund mechanisms to address the resulting significant negative timing impact on the cash flow of unitholders.
As mentioned earlier, any early refund mechanisms would necessitate identification of people eligible for early refunds and increase complexity and administrative costs in making regular refunds to taxpayers. There may also be additional compliance costs for investors and for property trusts.
Moreover, retirees and other small investors in property trusts would be required to include tax-preferred income in their annual income tax returns. This would force these investors to learn about the imputation system, grossing up, tax credits and rebates, as well as fill in more forms the last thing retirees want is more hassle and more worries.
4.0 Building Depreciation
Division 43 of the Income Tax Assessment Act 1997 ("ITAA97") allows a taxpayer to claim income tax deductions based on the original cost of construction of new non- residential buildings and structural improvements, which are used for the purpose of producing assessable income.
Division 43 was introduced, originally as Division 10D of the ITAA36 in 1983 in recognition that infrastructure is a wasting asset. In recognising this, Division 10D ensured that structures and particularly buildings were given their proper recognition for tax purposes, a position which was needed to improve national productivity and international competitiveness.
4.1 Include Buildings and Structural Improvements in a Consistent Regime
The Property Council is strongly of the view that buildings and structural improvements should be incorporated into the general depreciation regime applying to plant and equipment, as proposed in APC, Chapter 1, paras 1.56-1.59 (i.e. Option 2). This would allow economic life depreciation of buildings and structural improvements based on the full purchase price of buildings, rather than construction cost.
An economic life approach recognises the physical deterioration of buildings as well as the fact that obsolescence of buildings is a result of exogenous change and is not easily controlled by the owner of a building. It is, therefore, a more complete representation of commercial investment realities and the true costs borne by building owners to earn income.
Further, there is a strong argument that the taxation consequences of owning a building should be consistent with the taxation consequences of owning plant and equipment. In both cases:
However, building owners are currently at a disadvantage to owners of plant and equipment in a number of ways.
Buildings are subject to statutory restrictions such that they can only be amortised over a set period of 25 or 40 years from the construction date, regardless of their actual useful life. The useful life of plant and equipment, on the other hand, can be self-assessed by the owner.
Owners of plant and equipment can have a cost base for the asset that is higher than the original cost of the asset when first installed for use. This will occur whenever the asset is sold to another user for a price in excess of the original cost.
A subsequent owner of a building has no choice in respect of the economic life of the building or the amount upon which deductions are available. The subsequent owner is locked in by the prior owners fact pattern, subject to any additional capital expenditure, which they may incur and wish to amortise.
4.2 Advantages of Including Buildings and Structural Improvements in a Consistent Regime
Given the above disadvantages for building owners, the inclusion of buildings and structural improvements within the general depreciation regime applying to plant and equipment would offer a number of benefits. In particular, it would ensure consistency in terms of the tax treatment of buildings and plant and equipment.
Owners of buildings would be able to self assess the economic life of a building using their knowledge of the factors affecting its life. This would provide for a better allocation of the cost of the building over its useful life as owners are in the best position to estimate the economic life of the building, rather than being limited to an inconsistent and rigid statutory life.
In determining the economic life of a building, building owners would be able to consider the relevant factors, such as the intensity of use in the business, the wear and tear on the building, the intended expenditures on repairs and maintenance of the building, and the durability of the materials used in its construction.
Further, owners of buildings would have a cost base equal to the economic cost of the building, regardless of whether this is greater or less than the original cost of the assets when it was first installed for use. In addition, the full 100 per cent depreciation allowance will be available over the economic life of the asset, regardless of whether the original vendor held the building for longer than 40 years.
4.3 Implementation Issues
4.3.1 Separate valuation of buildings, plant and equipment and land
In some instances, the proposed approach would require the separate valuation of buildings or structures and the land they are situated upon at the time of sale.
We do not consider this to be a major impediment as buildings and structures can be distinguished from land and from plant and equipment Accordingly, it would not be a difficult task for professional valuers to calculate the separate components for tax depreciation purposes.
As acknowledged in APC, it is common practice in many other major countries to base building depreciation on purchase price and not on original cost. This has not given rise to insurmountable valuation problems in these countries and would be unlikely to create significant problems in Australia.
The split between plant and equipment and buildings is negotiated at arms length between purchasers and vendors. Moreover, in some cases, separate valuation is already required under the current tax system. For example, where a building and the land it is situated upon are sold, the land may be a pre-CGT asset and the building a post-CGT asset.
4.3.2 Buildings are wasting assets
In Chapter 1, paras 1.59 of APC, it is suggested that the proposed approach would:
The Property Council notes that the above argument would not be relevant if the indexation provisions are removed. Further, even if the indexation provisions are not removed, the above argument has equal application to buildings, as capital gains are rarely realised on buildings. From an economic perspective, buildings have a finite life and do depreciate in value.
Where a combined land and building package has appreciated in value, it is usually a result of an increase in the value of the land. The value of the building is likely to have depreciated in value due to physical decay over time, as well as the process whereby economic or technological obsolescence erodes the buildings capacity to fulfil a useful function.
Physical decay will usually be a gradual process, and is capable of being controlled by annual maintenance. However, obsolescence may occur suddenly due to technological or market change. In this regard, the rate of obsolescence of buildings has increased as the rate of technological change has accelerated.
A building may become obsolete for a variety of reasons, including the following:
The depreciation of buildings is clearly shown by the necessity for periodic refurbishment of buildings. The Property Council undertook two research projects in the past decade that proved buildings wear out in the course of producing assessable income. The research showed that office buildings have an economic lifespan of 22 years, shopping centres 18 years, and hotels 15 years.
Due to the changes in technology and obsolescence over the last decade, the economic life of buildings is declining at a faster pace. Consequently, the Property Council has now commissioned a new piece of independent research in order to review its earlier conclusions.
In the past, few buildings were demolished at the end of their economic life; instead they were totally recapitalised. However, technological change and the increased expectations of business tenants means that, increasingly, the only competitive solution for owners is to write off the entire building structure (demolish).
Some recent examples include:
The Property Council looks forward to sharing the completed results of this new report and its conclusions with the Government within the near future.
As a further example, shopping centres generally require major refurbishments approximately once every 10 years. Only some of these refurbishment costs are deductible. Some recent examples of major refurbishment programs are outlined below:
Burwood Shopping Centre was built in 1967 and refurbished twice in 1972 and 1978. This building was ultimately demolished in 1999 demonstrating that not only must buildings be refurbished to be economically productive but that they also depreciate to the point where the only viable option is to demolish them.
Woden Plaza was built in 1972 and purchased by its current owners in February 1986 for $74.8m. To date the total cost has amounted to $133.7m. This includes a major refurbishment in response to the economic environment and market research undertaken by its owner. The cost of the refurbishment between 1998 October 1999 is budgeted at $10.6m.
Appendix 1 provides some examples of buildings in Sydney and Melbourne that have either been demolished or undergone extensive refurbishment.
4.3.3 Blackhole Expenditure
Currently, a significant proportion of the costs of constructing buildings and structural improvements are blackhole expenditures. For instance, around 2 per cent of the costs of constructing a shopping centre are typically blackhole expenditures. Some examples of these blackhole expenditures include legal fees and regulatory fees.
The Property Council supports the proposal in Chapter 1 of APC to remove blackhole expenditures by, depending on their nature, making them deductible using immediate write-off or adding them to the cost of assets of the expenditure for depreciation purposes.
4.3.4 Transitional provisions
If buildings and structural improvements were included in the general depreciation regime for plant and equipment, transitional provisions would be required.
The Property Council considers that the new arrangements should apply to all buildings and structural improvements acquired, or for which construction contracts have been entered into, after the commencement of the new measures.
This option should minimise tax-induced distortions to investment decisions and the market prices of buildings and structural improvements, and facilitate the expeditious integration of building and structural improvements into the general depreciation regime, with the advantages outlined above.
4.4 Reject Reduction in Depreciation Rate for Buildings
We note that any moves to reduce the depreciation rate for buildings and structural improvements, as proposed in APC, Chapter 1, para 1.6 (i.e. Option 3), would have a disastrous impact on investment and growth in the property industry by:
detracting from Australias status as a world class infrastructure and business location. If there is no recognition of the nature of buildings as a wasting asset, there will be no incentive to construct world class infrastructure. The effect of this on Australian businesses involved in supporting the infrastructure industries would lead to detrimental economic effects, with a corresponding effect on employment and the nation as a whole. The continued construction of world class infrastructure is therefore one of the aspects which underpins Australias productive capacity.
As outlined above, the Property Councils primary submission is that buildings should be included in the economic life regime for depreciation purposes. However, in order to avoid the consequences outlined above, the Property Council also submits that a "safe harbour" position should be implemented. Under this "safe harbour", a minimum available rate of depreciation or amortisation on building structures should be set which ensures building owners are no worse off than under existing Division 43. In this regard, we endorse the BCTRs submission on including a "safe harbour" or minimum depreciation rate cap on structures.
5.0 Accelerated Depreciation/ Company Tax Trade-Off
In Chapter 2 of APC, it is proposed that accelerated depreciation be removed or modified as a trade-off for a lower company tax rate.
The Property Council recognises the need for revenue neutrality and the benefits of a lower general company tax rate for overall economic growth, employment and welfare. However, it should also be recognised that for industries that are very capital-intensive in nature, the accelerated depreciation provisions are very important and critical to international competitiveness. In this regard, the property industry would suffer a net disadvantage if accelerated depreciation were removed and replaced with a lower company tax rate, as it is very capital-intensive in nature.
Nevertheless, the Property Council would support the replacement of the accelerated depreciation provisions with an economic life regime, provided:
It should be recognised that while it is difficult to match the actual depreciation of buildings and structural improvements with the depreciation of buildings and structural improvements for tax purposes, any differences would only be of a timing nature.
It is inevitable that there will be winners and losers in any trade-off between the removal or modification of accelerated depreciation and a lower company tax rate. However, in our view, the benefits of a neutral depreciation regime and a lower company tax rate suggest that this approach would reflect a sensible compromise between the interests of capital intensive industries, such as the property sector, and the wider economy.
6.0 Capital Gains Taxation
The current system of CGT in Australia is inefficient and imposes substantial deadweight costs on the economy. It encourages short-term consumption at the expense of saving and investment (and, therefore, future economic growth), and introduces distortions (non-neutralities).
One of the adverse efficiency effects of the CGT is the well-known "lock-in effect", which causes inefficiencies by penalising capital mobility. This distortion is attributable to the fact that CGT is determined on a realisation basis, so that investors with accumulated capital gains may not realise those gains in order to avoid the CGT. To the extent that this is the case, investors may hold on to assets that yield a lower rate of return than could be available if the portfolio were reallocated. This effect increases with the size of the unrealised capital gains associated with the asset and the rate of tax that would be payable. In such cases, the commercial decision is outweighed by the tax decision, and the investment portfolio is rendered inefficient.
The lock-in effect has lead to suggestions that capital gains taxation should be lower on longer-held assets. The US and UK have adopted a stepped rate approach by allowing lower effective CGT rates on gains from an asset in proportion to the length of time the asset is held. For example, the US has a stepped rate CGT system, which currently incorporates significantly lower CGT rates for assets held for more than 18 months (moving to 12 months from 1 December 2000). This approach penalises speculative traders, without creating a lock-in effect.
Furthermore, the taxation of capital gains in Australia is relatively severe compared with many other countries, particularly with low inflation when the indexation adjustment has little benefit. An internationally high rate of CGT means Australian investors demand more equity for a given cash outlay in an Australian enterprise, and a higher pre-tax rate of return, than do foreign investors. Since countries compete for mobile international capital, a relatively high CGT rate has adverse consequences for our international competitiveness.
A lower effective rate of CGT would increase the after-tax return to investors, lower the cost of equity capital and increase investment in assets providing returns in the form of capital gains. Enterprises could grow faster, invest more and employ more people.
In this regard, both the USA and the UK have recently reduced their effective rates of CGT. Under the UK capital gains tax regime, non-resident investors are excluded and CGT taper relief is available, whereby a proportion of the gross capital gain is not included as assessable income. This encourages a higher proportion of "patient" capital, which assists business investment. The widely held view is that the reductions in the effective rates of CGT in the US and the UK will be beneficial for investment and business development.
Accordingly, the Property Council supports:
6.1 Taper System
It is submitted that a tapered system should be adopted in Australia, incorporating steps based on the proportion of the capital gains that are taxable, rather than on the rate of CGT. This system should be extended to superannuation funds, pooled superannuation trusts (PSTs) and life companies, as well as individuals.
As mentioned earlier, this approach has been adopted in the UK. A tapered CGT system would minimise any lock-in effect and avoid the need to change the CGT rate every time personal marginal tax rates are changed. It would also reduce the effective rate of CGT to a more internationally competitive level. Capital losses should also be incorporated on a proportional basis depending on how long they had been held, to ensure symmetrical treatment of capital gains and losses.
In order to minimise the potential for a lock-in effect, the steps should reflect a short holding period, so the proportion of capital gains subject to CGT drops substantially after a relatively short period. For example, 70 per cent of the capital gain could be taxable after 2 years, 50 per cent of the capital gain could be taxable after 3 years and 20 per cent after 5 years.
This approach represents an effective compromise as it would penalise speculators and reduce the efficiency and revenue costs associated with investors holding assets for too long due to the lock-in effect. The concessional treatment could readily be funded by tightening up on averaging and by removing indexation.
The Property Council supports the removal of indexation, to simplify the CGT system, provided a tapered system of CGT is adopted as outlined above. Australia is one of the few countries that indexes capital gains. Removing indexation would simplify the law and reduce compliance costs.
If indexation were removed, transitional issues would be important. A possible approach would be to enable all assets to retain the indexation benefits up to the date of removal. This would imply that the assets would enter the new arrangements at their indexed cost base. Capital losses realised after the date of implementation would continue to be calculated by reference to the original cost of the asset (because they are calculated from the non-indexed cost base) or the reduced cost base.
Further, whether it is better to retain the current system or remove indexation ultimately depends upon future levels of inflation. Indexation currently provides substantial protection for long term investors against the possibility that inflation may increase in the future. Clearly, the possibility of this happening increases with the length of time an asset is held. In fact, this provides a sound basis for reducing the taxation of capital gains based on the length of time that an asset is held. It also raises the question of whether the proportion of capital gains subject to tax would be reviewed if inflation did increase. In the opinion of the Property Council, this issue should be kept under consideration if indexation is removed.
The Property Council supports the modification of the CGT averaging provisions, to remove the scope for abuse and simplify the CGT system, provided the rate of CGT is reduced to 30 per cent for entities and individuals.
The Property Council recognises that taxpayers that have variable income from non-capital gains can take advantage of averaging to realise assets selectively to reduce their effective tax burden. Averaging thus creates the potential for additional and significant taxation benefits for strategic taxpayers. The issue is particularly noticeable where taxpayers use the averaging provisions to duplicate the benefit of the tax-free threshold. While there are strong equity grounds for retaining averaging, some reform would be acceptable based on reducing the time over which averaging was permitted and limiting access to the tax free threshold for the purposes of averaging.
7.0 Other Issues
7.1 Partnerships and CGT
Property Council members are involved in a number of joint ventures. In particular, it is becoming increasingly common for shopping centres to be owned by a joint venture comprising two or more property trusts. The proposals in Chapter 14 of APC would have ramifications for these arrangements.
The Property Council supports the entity approach to the taxation of partnership capital gains (i.e. Option 2), discussed at p. 336 of APC. Under this approach, the partnership would be regarded as the notional owner of all the partnership assets, as is currently the case for depreciation purposes. The partners ownership interest would be in the partnership as a whole. The situation would be analogous to a shareholder that holds shares in a company, that have been purchased at different times and at different prices.
This approach would avoid taxing the partner or partners not selling their interests on unrealised capital gains. Taxing unrealised capital gains would cause cash flow problems. Further, it would be inequitable to tax partners on unrealised capital gains when other owners of assets are not taxed until realisation.
The entity approach would:
While there would be record keeping costs associated with different cost bases for different parts of the partners interests in the partnership, they appear to be manageable in the case of share ownership and could be readily adapted to partnership interests.
The Property Council considers that the RBT has overstated the benefits of consolidation. For example, there are major unresolved problems with the treatment of the movement of entities with losses into a consolidated group and deconsolidations. No view on consolidation can be formed until its scope and details are known.
The Property Council stresses that the introduction of a new consolidation regime should not be seen as time critical to the overall reform of business taxation. Specifically, consideration should be given to the deferred introduction of a consolidation regime. A significant amount of time will be required for taxpayers to adjust to the business reform measures. In addition, it must be ensured that consistency is achieved between relevant tax laws which may allow for a consolidation regime (for example, that trusts and companies are dealt with under the same consolidation rules for income taxes and GST).
The Property Council considers that any the consolidation regime should be as wide as possible, and apply to resident wholly owned property trust groups, including sub-trusts, that do not qualify as CIVs.
In addition, any consolidation regime should allow access to group-wide losses. Provided adequate stamp duty exemptions are introduced, this would facilitate and encourage the restructuring of property trust arrangements, such as the transfer of property between group trusts and the liquidation of unwanted trusts. Consolidation of property trust groups would also offer substantial compliance savings.
7.3 Scrip-for-scrip Rollover Relief
The life cycle of a typical business is characterised by frequent changes in the structure of the entity for commercial or legislative reasons, as it moves from one stage to another. For example, the business may need to be transferred to another company or entity, to meet the requirements of an expanded investor base. These transitions are generally treated for tax purposes as capital gain realisations, giving rise to tax-driven distortions.
For example, currently, a "scrip-for-scrip" merger or takeover of a company or CIV triggers the CGT provisions, because the taxpayer has disposed of one asset for another, even though there has been no realisation of cash. If a liability is instead deferred for example, if rollover relief is available the effective rate of CGT (in present value terms) is reduced.
Accordingly, it is not just the headline rate of CGT that is important, but also whether or not a transaction triggers a CGT liability. The current CGT rollover relief provisions are not sufficient and "lock-in" inefficient forms of business organisation. Rollover relief can improve economic efficiency by reducing the "lock-in" effect of CGT and encouraging the re-organisation and continued development of enterprises.
Australias current CGT provisions are a significant barrier to takeovers based wholly on scrip-for-scrip and the allowance of rollover relief in such circumstances may facilitate the development of a more efficient business sector in Australia through having a more efficiently functioning domestic capital market.
Moreover, many countries provide broader rollover relief than is available in Australia. In particular, some countries allow rollover relief when a business disposes of one asset and purchases another of a similar kind.
There are also strong practical reasons for rollover relief, for example when there is no cash from a transaction (such as a scrip-for-scrip swap) to pay a tax liability. Further where a scrip-for-scrip merger or takeover occurs the cost base has not changed and the shareholder has a continuing interest in the same assets together with those combined through the merger. If the transaction is wealth generating the tax ultimately collected is greater since the original cost base is retained.
For these reasons, the Property Council considers that rollover relief should be as broad as possible, covering mergers of non-listed widely held property trusts and superannuation funds. Further, the proposed CGT rollover relief should be extended to foreign investments that are subject to the controlled foreign company provisions.
As property trusts are primarily publicly listed, and entry and exit prices are determined on a daily basis, valuation issues would not arise. Further, there are strong equity reasons for extending rollover relief to these trusts, in strictly defined circumstances.
Moreover, in practice, the provision of rollover relief in these circumstances would not result in a loss of revenue, as this activity is not currently occurring, due to the tax impediments outlined above.
7.4 Quarantining of Capital Losses
The quarantining of capital losses, so that they may only be offset against capital gains, is regarded by many taxpayers as unduly harsh. It is a barrier to risk taking and speculation, and can impact unfairly on some taxpayers that are unable to utilise capital losses quickly or at all.
Currently, the quarantining of losses can disadvantage those undertaking risky projects. A misallocation of resources and lower economic growth is likely to result from this non-neutrality. If the CGT system was risk neutral (a key policy design principle proposed by the RBT), with consistent and symmetrical treatment of gains and losses, it would no longer discourage risk taking.
The Property Council supports reforms to the capital loss provisions to enable the:
However, the Property Council does not support the option of retaining quarantining of capital losses for shares and units in trusts assessable on a realisation basis, regardless of the type of taxpayer and circumstances for holding the asset. This proposal would be inequitable and would divert investments away from these investment vehicles.
7.5 Abolition of Stamp Duty on Transfers or Conveyances of Business Property
In A New Tax System ("ANTS"), circulated by the Treasurer, the Hon Peter Costello, MP, in August 1998, the Federal Government outlined arrangements to replace state and territory stamp duties on transfers or conveyances of business property and various other state imposts, with a Goods and Services Tax ("GST").
The Property Council supports the abolition of stamp duty on transfers or conveyances of business property as soon as possible, for a number of reasons, including the following:
7.5.1 Timing Issues
It is important that the proposed removal of stamp duty from transfers or conveyances of business property and shares be simultaneous. Otherwise, arbitrage opportunities and distortions will arise. For example, if stamp duty were removed from shares, before being removed from real property, there would be a further disincentive for investments in business property, compared to shares.
Timing considerations will also play a part with the introduction of the GST. The GST will increase construction costs, which are not currently exposed to sales tax. Increased construction costs, in turn, will necessarily lead to increased payments of stamp duty, which will create even greater distortion in the investment mix. Therefore, it is critical that stamp duties be removed and that they are done so simultaneously with the introduction of the GST.
Further, the Property Council considers that stamp duty exemptions must be introduced to assist with any corporate restructuring that is a direct or indirect result of the implementation of the proposed tax reforms.
7.6 Fringe Benefits Tax on Car Parking
Car parking provided on-premises by an employer can be a taxable fringe benefit if commercial alternatives are available nearby. The Property Council has made extensive submissions on this issue in the past. The Property Council considers that car parking provided on-premises should not be subject to Fringe Benefits Tax where it is a bona fide and legitimate business expense.
8.0 Revenue Implications
The Property Council contends that the above proposals would be broadly revenue neutral in the context of the tax reform measures announced in ANTS.
The Property Council has not developed revenue estimates for the flow-through taxation of property trusts due to the Treasurers announcement that property trusts will be excluded from the proposed entity tax regime, and subjected to flow-through taxation.
The Property Council considers that there is no revenue rationale for the removal of the flow-through of tax-preferred income through property trusts. As mentioned earlier, if the flow-through of tax-preferred income through property trusts were removed and tax-preferred income were taxed in the hands of unitholders, property trust distributions of tax-preferred income to unitholders could be expected to fall. This greater retention of earnings would be likely to have a negative effect on revenue..
The Property Council expects that the revenue implications of moving the depreciation of buildings and structural improvements to an economic life basis, in line with plant & equipment, would not be significantly different from the revenue cost of the current system of depreciation of buildings and structural improvements.
The introduction of a tapered CGT system, as outlined above, would result in a substantial reduction in revenue. However, the increased revenue collected through the removal of indexation and the removal or modification of the averaging provisions would offset this loss of revenue.
Moreover, the long-term effects of the above proposals, due to the improved incentives for building construction, will result in further activity and growth in the construction and property sector, as well as other sectors of the economy. The flow-on effects, in terms of higher investment, employment and international competitiveness, should result in higher revenue recovery in the medium term.
In conclusion, the Property Council notes that the property industry is a very capital intensive industry, and given the nature of property trust structures, one in which investors are normally subject to individual not corporate income tax. In this respect, the Property Councils support for the removal of accelerated depreciation in place of a reduction of corporate tax represents a significant concession by the industry.
A reduction in corporate tax rates will have no immediate impact on the property trust industry, and therefore the removal of accelerated depreciation is a real and immediate cost. However, the Property Council and its members recognise that other sectors of the Australian economy, and as a result the interests of the nation as a whole, are better served through this trade off. Accordingly, the Property Council considers that agreement to this trade off, whilst directly against the industries own best interest, is the better position to adopt for the sake of the national economy.