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Robert Oser

GPO Box 453, Sydney, NSW 1043

Phone: (02) 9224-0218 Fax: (02) 9223-5215

Mobile: 0419 270 642

e-mail: raoser@ozemail.com.au

18 December, 1998

The Secretary
Review of Business Taxation
Department of Treasury
Parkes Place
Canberra ACT 2600

Submission to Review of Business Taxation

This is a submission made by me in a private capacity as an individual. I do not represent any interest group and my views are personal.

The submission exceeds 5 pages but is relatively short. In the circumstances I hope I can be excused for not including an Executive Summary.

Introduction

The groundwork laid out by the Review in "A Strong Foundation" should be endorsed by taxpayers who take an objective and rational approach to the subjects covered. The ideas to be discussed and analysed are not novel but have the merit of being expressed in terms of Australia’s circumstances as they are in 1998.

The Review should discuss the implications of its assumptions which are critical to the approach foreshadowed in "A Strong Foundation". The following stand out:

  1. The Review is doing its work in a low/no inflation environment. If tax deferral and/or absolute tax savings over a period have a high NPV, such benefits become a valuable, tradable commodity. Conversely, the acceleration or forced prepayment of tax liabilities, when interest rates are relatively high, discriminates between taxpayers and engenders taxpayer resistance. Thus "nominal" rather than "real" taxation seems the only practical way ahead.
  2. "A Strong Foundation" assumes it is feasible to translate the conceptions of economists into legal forms within the established system of law in Australia. Economic substance does not easily reconcile with legal formalism. At present, the basic building blocks of the tax law are not defined. Their meaning is derived from judicial interpretation rather than on the one hand, the musings of economists and the wishful thinking of business people and, on the other hand, the earnest zeal of bureaucrats. These building blocks include the concepts of:
    1. What is income
    2. When income is derived
    3. When expenditure is incurred
    4. Distinction between receipts of capital and receipts of revenue
    5. What is expenditure of capital or of a capital nature

The different worlds of lawyers and economists need to be reconciled but this crucial task must not be left to the Office of Parliamentary Counsel without appropriate guidance. "Integrated Design Processes" do not necessarily resolve the conflict.

  1. A prescription for better processes of Tax Administration can be put forward without a review of tax evasion and shortcomings in the system of self-assessment. In my opinion, these issues cannot be ignored whether or not they fall within the Terms of Reference when narrowly interpreted.
  2. The Terms of Reference call for overall revenue neutrality. This can be interpreted as stifling the discussion and influencing the outcome of the Review. It would be preferable if the Review assumed no such directive as to outcome in carrying out its work. The solutions proposed can be trimmed to fit into revenue constraints as a final step in the recommendations.

These assumptions and any others not made explicit should, in my opinion, be appropriately addressed in the Report of the Review to prevent flaws in what may otherwise be highly commendable solutions.

In the following paragraphs divided by headings, I submit the following in response to certain segments of the Discussion Paper. I do have views on aspects not mentioned in this submission and may comment at some later stage of the Review process.

The Problem of Complexity (Chapter 3)

Much has been made of the complexity of the tax law and its length with images of the 4000 pages.

I put the proposition that Complexity is the antithesis of Simplification. This goes further than saying that complexity is the other side of the simplification coin. Granted that some areas of the tax law are unlikely to lend themselves to simplicity, most notably, the treatment of financial arrangements, there are substantial areas of Complexity, as analysed in Chapter 3 which should be removed and can be removed without convoluted analysis.

Complexity also affects Equity in a way not stated.

When the tax laws are complex, difficult to understand, uncertain in their application or are perceived to be arbitrary in the way the Australian Taxation Office applies them then taxpayers feel aggrieved and believe they are treated inequitably. This result has nothing to do with the notion of Equity as espoused by theories of what is a good and what is a bad tax system. It is not a matter of either horizontal or vertical equity. In other words, if a new system were judged to have a high degree of horizontal equity but this were achieved by complex laws (of assessment and/or administration) then there will be no perceived equity.

There is another dimension to complexity which deserves consideration.

Under a system of self-assessment, certain classes of taxpayers, notably companies, have to stand in the shoes of the Commissioner to make the Commissioner’s assessment. To the extent discretions remain in the law, the taxpayer is required to exercise the Commissioner’s discretionary power for or against itself. The more complex the law, the more difficult and more costly this becomes. To a person who is not a tax lawyer or tax accountant this process is an absurdity.

If Simplification is indeed a National Objective then the conflict with other objectives must be met head on. It the Review advocates compromise, the Review will not leave a lasting benefit to the business community. Compromise should be left entirely to the political process.

In the final analysis, Simplicity is what is required, backed up, to the extent practicable, with theoretical equity. My submission is that Simplification should take precedence over Complexity and theoretical Equity. References to Trade-offs and Weightings should not portend unwillingness to make clear-cut decisions.

Throwing complexity out of Business Taxation can be easily achieved and the number of pages of tax law dramatically reduced. "A Strong Foundation" largely identifies what is needed.

If the following are implemented, Simplification will be achievable:

  • The elusive distinction between revenue versus capital receipts is discarded when accruing to a business entity. All proceeds of an entity carrying on business should be on revenue account and should be treated as assessable income even if the particular receipts of the business are profits from the sale of an asset, the sale of the business itself, or a segment thereof. This is commented on elsewhere.
  • Tax concessions and tax preferences are repealed and strict neutrality is observed between business sectors and various economic activities. "Tax expenditures" should be dealt with outside the tax system.
  • Capital allowances are granted under a simplified system, which sweeps up ‘black hole’ expenditures. There is no rational reason why the 37 types of capital expenditures cannot be aggregated to 3-4, effective lives reduced similarly and methods of write-off reduced to one.
  • Groups of companies, which are 100% commonly owned, are treated as a consolidated taxable entity. This regime would avoid complex legislation to deal with intra-group asset transfers, loss transfers and artificial group transactions. The consolidation regime would also do away with the absurd anomaly that franking credits are locked into the taxpaying entity and cannot be moved within a group of companies without dividend payments. Generally, consolidation is superior to the present system of partial group relief in facilitating internal business reorganisations.
  • All transactions should be reported at arm’s length values. In other words, adapting the transfer pricing rules for international transactions should be considered in a domestic context.

Policy Design Principles -Taxation of Comprehensive Income (Chapter 6)

This notion has been the dream of tax economists ever since Henry Simons persuasively defined it in 1938. The Simons and Haig/Simons formulas may be too radical at this stage for Australian business. In as much as the classic formulation requires valuations and seeks to tax accretion to economic power there are as many new ills created than benefits in the promise of a more equitable and efficient tax base.

In particular, the practical problems of valuing assets and liabilities which are not homogeneous or for which no perfect market exists are overwhelming. Even for financial institutions the valuation of cash flows is anything but straight forward. For these and other reasons the extension of the concept to looking through the entity veil is not proposed by the Review. This is a commonsense decision.

Incidentally, when applied to Individuals (natural persons), Comprehensive Income as a tax base seems to be a Wealth Tax by another name.

Therefore, the theoretical concept of Economic Comprehensive Income should be adopted for business only to the extent of taxing realised "capital gains" as ordinary income. Conversely, realised "capital losses" should be deductible from any form of income. "Collapsing" the ordinary versus capital income distinction is an elegant way of expressing this reform. The CGT regime should be eliminated for entities but individuals are in a special position.

In the context of business activities, the theoretical case for taxing all net income, profits and gains as "income" or a "profit of a revenue nature" is reinforced by the following argument:

Under current management practices all assets, business lines, products and so on are scrutinised on given performance standards. If returns are inadequate then the assets, business are sold at the best price obtainable. Even if a business is profitable, everything is sale "at a price". This is as it should be in a competitive market. There is no rational argument for an artificial separation of gains of certain types as being on "capital account" and taxed under a regime different to other types of business income. A company is in business "to make money" and it does not much matter where the money comes from.

This reform would lead to increased efficiency in the allocation of business capital, improve neutrality and eliminate a large segment of complexity from the taxation of business. It can be implemented independently of the taxation of the ultimate owners of the business.

There are also technical reasons under the tax law to support such a reform even if the foregoing reasoning is regarded as without sufficient merit:

  1. The fine line of distinction between income on the one hand and capital receipts on the other hand is a plaything of the common law which has defied clarity, certainty and stability of interpretation. Not much progress has been made since Lord Greene MR stated in judicial exasperation:
  2. "There have been many cases which fall on the borderline. Indeed, in many cases it is almost true to say that the spin of a coin would decide the matter almost as satisfactorily as an attempt to find reasons." (IRC v British Salmson Aero Engines Ltd [1938] 2 KB 482)

    In short, the present situation of characterising receipts, which are not within the CGT regime, is unsatisfactory and the preferred remedy is to abolish the illusory capital versus income distinction.

  3. In some industries and business activities, the treatment of proceeds of the business on capital account is not permitted. These include banking, general and life insurance, property development and share dealing. This differentiation between activities although clearly derived from case law is in conflict with risk neutrality.
  4. CGT treatment quarantines deductions for capital losses to recovery from capital gains. This restriction ignores the economic reality of the entity’s net position. It is a major non-neutrality as recognised in "A Strong Foundation."
  5. Net capital gains and indexation amounts in a corporate entity cannot be distributed to shareholders otherwise than as actual or deemed dividends [e.g. as a liquidator’s distribution] which are taxable. This is an unfair and unjustified result under the existing system which should be rectified in the event the CGT/capital receipts regime is retained.
  6. The most complex and difficult amendments to the tax law in recent years have been those which deal with CGT provisions to counter manufactured capital losses, value shifting, roll-overs and so on.

There is an important qualification to even a modified notion of comprehensive income as the tax base of business entities.

Income accrued (by valuation of assets less liabilities or under contract) should not be taxed if realisation has not occurred. This is to recognise that money or liquid assets from the subject of tax must be present to enable the tax to be paid. The United States deals with some aspects of this issue by provisions to cover "instalment sales".

In regard to the concept of realisation, a strong plea is added. There should be no extension of CGT roll-over provisions for "scrip-for-scrip" exchanges either within the existing CGT system or as a concession for individuals.

A form of CGT avoidance arises when the tax system permits non-recognition of gains in "scrip-for-scrip" exchanges in company takeovers. A tax system that is biased in favour of non-cash disposals is tantamount to sanctioned tax avoidance; it distorts capital markets and market values, and is anti-competitive. In this area of the Terms of Reference, Item 3.(c)(ii) should be rejected.

The foregoing recommendation regarding CGT should not be taken to advocate relieving individuals of special treatment of what are classified as taxable capital gains under the existing tax law.

Further relief for individuals is to be commended on risk reward grounds. This may be achieved by capping the rate to 30% as suggested in the Terms of Reference and/or by an exemption threshold, granted annually. The concession of "averaging" also warrants review since it offers limited relief in practice.

Finally, in relation to the tax base, it is thought that cash flow taxation or an expenditure tax base are too radical and too experimental to foist on to Australia at this time whatever the theoretical merits of these alternatives.

A note on Tax Incentives

For simplicity’s sake, the terms ‘incentive’, ‘concession’ and ‘preference’ can be taken to have the same meaning. If the Review intends to adopt a different view, this should be explained.

The elimination of tax incentives is advocated in this submission in the context of Simplification and elimination of Complexity as well as horizontal equity which leads to an efficient allocation of capital. "A Strong Foundation" indicates a similar view.

This note assumes that tax incentives will not disappear because the Review will equivocate or because political expediency will prevail. In that event, tax incentives warrant consideration from another standpoint (whether offering deferral of tax liabilities or absolute tax savings).

When a tax incentive or concession is written into the tax law, there will always be, in practice, qualifying taxpayers unable to take advantage of the incentive. For example, a start-up company cannot effectively utilise incentives which add to tax losses. Furthermore, large groups of well established companies endowed with incentives seem to be at an advantage when compared to SME’s thus reinforcing barriers to entry into an industry.

In such circumstances, market forces create transactions to share the benefit of the incentive with another entity which can make use of them. Common examples are tax loss transfers, R&D deductions and leases for short life depreciable property. Such transactions, often labelled as "tax benefit transfers" are anathema to the Treasury and the ATO. Yet, if the incentive is not utilised the fiscal policy of the Government is subverted. If some of the incentive is captured, even if shared in a transaction with another entity, this result is not necessarily a bad thing.

In making these remarks it is not intended to be an apologist for transactions which fall to be struck down by anti-avoidance provisions in the tax law if the ATO is effective in its administration of the law. Rather, the case is put that the ATO should not wage war indiscriminately against market transactions arising from legislated tax incentives.

The recent barrage of legislation against "trading in franking credits" raises similar issues. There are legitimate views in the business community that the Treasury and Commissioner of Taxation should not pursue policies with the objective that the Government should make a profit out of the imputation system. The unreasonably complex and restrictive new legislation has this objective.

Finally, the question should be asked, if tax incentives are to be retained or granted in new forms in the future, why the Government permits the "wash-out" effect to deprive the ultimate ownership interests of the intended benefit.

These are aspects of Tax Incentives which the Review should not ignore.

A note on tax losses and Risk Neutrality

The severe restrictions on the utilisation of tax losses by companies and trusts are primarily driven by policies designed to "protect" potential tax collections. However, if risk neutrality and equity were to be observed, the carry back of tax losses would be permitted for a limited period; say 2 years, to borrow from the United States experience.

Apart from tax theory, this is advocated on grounds of business reality.

First, it is unlikely that a loss recognised under the tax law and, incidentally, in financial statements, in a given year of income, reflects losses of the particular year in which the loss is incurred or recognised. The likelihood is that the losses occurred in a previous year, years or over a period of years. To put it another way, the business reality is likely to be that previous years’ profits have been over-stated. Auditors at the receiving end of suits for negligence are familiar with the problem.

It follows that there is no logical reason for restricting the recoupment of losses from income of future years. Rather, prior years’ profits/taxable incomes should be adjusted.

As long ago as 1975, the Asprey Committee recommended a change in the law. That review also recognised that previous reviews of the issue as far back as the Spooner Committee (1950-54) rejected carry-back on grounds which had nothing to do with fairness, equity or objective reasoning. Tax law design which ignores reality and fairness in favour of maximising tax collections stands to be condemned.

The change to allow loss carry-backs may also reduce attempts to circumvent rules against trafficking in tax losses but this is a speculation.

A note on Investment Neutrality

The distortion explained in paragraph 6.67 is considered to be of major importance. The Review will presumably consider it in all its ramifications.

In my comments on Tax Administration, brief reference is made to the inducement for tax avoidance if the top marginal rate of tax for individuals substantially exceeds the company tax rate. This is a gap which is very difficult to administer so that it is not abused.

The rejection of the deferred company tax is called for on grounds other than its potential distortion on investment neutrality. Paragraph 6.67 reinforces the argument against its introduction.

If the full imputation system were working to its full extent and companies were obliged to report accumulated franking credits then shareholders would exert greater pressure on dividend pay-outs. This would reduce funding by unreasonable retentions and thus protect investment neutrality.

Policy Design Principles – Single Layer of Taxation and Integration of Ownership Interests (Chapter 6)

The intended meaning in paragraphs 6.62 to 6.66 of "A Strong Foundation" is not easy to follow.

There is one crucial aspect which calls for strong comment even at this preliminary stage, given that business entity taxation should be retained.

The proposed entity imputation regime including deferred company tax, calls for criticism.

As academic writings demonstrate, company and similar taxes are ultimately shifted to the individual whatever taxation system is imposed. At the practical level it has also been said that company tax under the imputation system is a withholding tax on income distributed to shareholders.

These considerations lead to the view that the proposals regarding entity imputation and deferred company tax are not measures to create a simpler and improved system. This proposal is no more than an extension of tax withholdings at levels in excess of ultimate liabilities to shift the responsibilities of the Commissioner of Taxation even more to the private sector.

To set up a system to collect tax where none is collected now and, in tandem, to set up a system for tax credits and refunds seems to be in direct contradiction of the objectives of the Review.

Surely, the emphasis should be to collect the proper amount of tax from the beneficiaries of the business income. It would be an indictment of tax administration if the ATO were unable to enforce collection of the proper amount of tax from the actual taxpayers and had to resort to imposing added layers in the collection system thereby placing fresh compliance burdens on intermediaries. The retention of "entity taxation" should not be exploited to facilitate tax collections from residents when the tax does not represent the final liability.

Incidentally, the prospect of refunds of excess imputation credits recalls the successful schemes of the UK in the 1960’s when tax refunds were collected in respect of "franked" investment income even though no tax had actually been paid to the Internal Revenue.

A special situation exists in relation to collective investment schemes which merits consideration in the context of these proposals.

Australia has developed an efficient market of collective investment by individuals, retirement funds and others through the operation of unit trusts. This serves individual needs for risk sharing and has wide public acceptance. Widely held unit trusts serve as an important mechanism for marshalling private domestic savings and have wide public acceptance.

It is generally accepted that the rate of private savings is low in Australia when measured against the need for economic growth. Therefore, interfering with a system which works well in the capital markets simply for the benefit of the ATO and to accelerate tax payments, is to be rejected as a change for the better.

The Review should be in no doubt that a new system which levies a withholding tax by another name on certain unit trust distributions and listed companies will severely disadvantage investors who need to make claims for tax refunds or otherwise need to ensure that a tax credit is claimed.

Such a system of creating tax liabilities is in direct conflict with simplification and equity. The only advantage will be an illusory increase in tax collections and distort the Government’s budgetary position since such tax payments should not be appropriated to Consolidated Revenue until individual assessments have been finalised.

Tax Administration (Chapter 8)

The processes and formulation of Tax Administration policies and relationships seem to take the focus of the proposed review.

If revenue neutrality of reform proposals combined with a reduction in the tax rate of capital gains derived by individuals are to be observed then the Review will fail in its task if it does not tackle serious deficiencies of enforcement in the existing approach to tax administration.

Intentionally brief comments are drawn to the following:

  • The evasion of tax by participants in the cash or "black" economy, encompassing both legal and illegal business activities. It is not clear that ATO enforcement methods are sufficiently effective. Nor is it clear that high priority has been given to the recommendations made by the Cash Economy Task Force in May 1997.
  • The erosion of the PAYE tax base has been the subject of much media comment in recent times. No further explanation is warranted here. As explained in "A Strong Foundation" the problem would be fixed by legislation to modernise outdated legal concepts. Taxation Laws Amendment Bill (No 5) 1995 which lapsed did the job. Taxpayer compliance behaviour in this area is heavily influenced by the gap between the company tax rate and the top marginal rate for individuals, including Medicare levy.
  • It is believed there is wide spread abuse in the claiming of "work related expenses" in the tax returns of individuals. The loss of tax revenue is substantial and has been quantified by the ATO.
  • Non-residents are able to escape CGT liabilities from the sale of "taxable Australian assets" in the absence of a system of withholdings from remittances out of Australia.
  • The system of self-assessment whilst unavoidable, encourages gamesmanship by some taxpayers. Strategies of audit coverage and other measures which build the integrity of voluntary compliance need constant vigilance.
  • The public and private ruling system has been criticised and I do not wish to add to a list of perceived shortcomings. However, since a well functioning rulings system is fundamental to self-assessment, the Review should take heed of the comments which undoubtedly will be forthcoming from professional bodies and other groups.

By limiting the resources allocated to the ATO and by focussing on the percentage cost of each tax dollar collected, the ATO is pushed to tackle easy targets and those which are likely to yield the maximum tax by enforcement action. This tendency is seen in an even worse light once it is recognised that the cost of compliance is transferred to the taxpayer under self-assessment when compared with the "old" system when the Commissioner of Taxation was obliged by the law to make an assessment.

Government imposed constraints in remuneration levels of ATO staff significantly constrain the ATO from adequate staffing of many segments of the organisation.

None of these issues are novel or new. The issue now is that the Review should take a "hard nosed" look at this aspect of "Tax Administration" and not address the problems with mere rhetoric and elaborate organisational structures.

Concluding remarks

Taxpayers, professionals and the ATO must be getting close to tax reform exhaustion.

The legacy of the unfinished business of the TLIP, the elephantine gestation period for the taxation of financial arrangements, the steady flow of amending Bills and the impending introduction of the GST are about as much as the normal person can take.

It may be an unattainable goal, but the Review might think about some way to introduce stability into Australia’s New Tax System.

Robert Oser